SHOULD CREDITORS RELY ON THE NEW PRC ENTERPRISE BANKRUPTCY LAW AS A USEFUL COLLECTION REMEDY?

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1 SHOULD CREDITORS RELY ON THE NEW PRC ENTERPRISE BANKRUPTCY LAW AS A USEFUL COLLECTION REMEDY? Frederick D. Holden, Jr. Orrick, Herrington & Sutcliffe LLP Hong Kong October 15, 2007 Overview of the Enterprise Bankruptcy Law The first PRC bankruptcy law was adopted in 1986, but covered only liquidation of state owned enterprises (SOE s). Thousands of non-competitive SOE s were liquidated, with enormous governmental subsidies of displaced employees. In these policy bankruptcies, laid off workers were given priority over even secured creditors, to minimize social unrest. After 20 years, workers and secured creditors rights have been readjusted. The new law was adopted on August 27, 2006, and has been in effect since June 1, Workers claims accrued by the August 27, 2006 passage of the bankruptcy law continue to have priority, and the 1994 policy bankruptcy program s carve-out for identified SOE s will continue into Otherwise, all corporations and similar entities (but not partnerships) are now under one law. There is still no law for personal bankruptcy. Most significantly, reorganization (rehabilitation and restructuring of debt) and conciliation (composition and settlement of unsecured debt) are now alternatives to liquidation, so going-concern value can be preserved. Any creditor, as well as a debtor, may initiate a reorganization or liquidation proceeding, alleging the debtor is unable to pay its due debts. A petition may, of course, be contested. It is generally predicted that most debtors and creditors will, at least for the near term, prefer an out-of-court workout to testing the new law. Even after some cases proceed, the courts not being bound by precedent and the openness of many judges, often young or illiterate, to improper influence, have led to the common prediction that filings seeking reorganization will be rare. Overview of the new Property Rights Law This law was adopted March 16, 2007, also after many years of preparation, and has been in effect since October 1, Encumbrances of future or after-acquired assets, similar to a floating charge, are now formally recognized. OHS West:

2 This allows sale of collateral free and clear of the security interest, until a default or crystallization event occurs. But the encumbrance is recognized only on non-real estate assets of manufacturing facilities, raw materials, work in process and finished goods. It does not cover accounts receivable or intellectual property. Limiting application to certain assets makes use of this financing device risky, as proceeds may not be covered. In a bankruptcy, the court could follow this law narrowly and thereby be able to dedicate proceeds of encumbered inventory to employees claims. Foreclosure is expected to be generally by court process. The new bankruptcy law does not specify that a secured creditor is entitled to payment from assets subject to a floating charge. Pre-bankruptcy crystallization may reduce that risk. Many issues concerning the relative priorities of security interests in fixed collateral seem also unresolved in the law. The Supreme Peoples Court (SPC) has ordered local courts to organize training sessions, and has asked those courts, as well as lawyers and the public, to submit suggestions on handling cases under this law. The SPC will then issue interpretations. At this time, both of these new laws are tentative and not well integrated with each other or the Security Law. As soon as the SPC publishes interpretations, however, integrating these new laws and clarifying the treatment of collateral proceeds, reorganization could be an attractive remedy for creditors. Will unbridled court discretion pervade the proceedings? Formerly, liquidation of SOE s was subject, in virtually all cities, to the Capital Structure Optimization Program, supervised by the National Development and Reform Commission (formerly the State Planning Commission), which gave priority to employee resettlement payments over security interests. SOE s often provide more than goods, services and jobs. They provide guaranteed housing, education and health care. These expensive benefits put many SOE s in dire straights and make liquidation or reorganization very problematic. When only SOE s were entitled to bankruptcy relief, and liquidation was the only form of relief, bankruptcies were planned by the government, and the government provided funds to settle the debts. Judges therefore understandably developed a habit of deferring to the government. Judges may view having broad discretion as essential to minimize disruption in bankruptcy proceedings, especially in liquidation of SOE s. If the Chinese economy turns down, judges may desire to stem a tide of bankruptcies, and there is no clear standard for accepting or rejecting an application. Accepting applications may, however, be the only key discretion point in cases of non-soe s. OHS West:

3 There is no stay of the enforcement of creditors rights until the application is accepted. The court will not rule on the application for 15 days, subject to extension up to 37 days. Therefore, although the court might decline to accept a petition for reasons outside of creditors interests, creditors would not be worse off for trying. And if the petition is accepted, creditors may have remarkably strong powers. How independent of the courts will administrators be? Upon acceptance of a bankruptcy application, the court will appoint an administrator to take possession of the debtor s property and manage the business on behalf of the creditors. Administrators have powers similar to Hong Kong liquidators, but should be far more subject to unsecured creditor control. There is an option of U.S.-style debtor-inpossession, but only if creditors prefer. There is initially no equivalent of the Office of the U.S. Trustee or the Hong Kong Official Receiver s Office to support the setting of creditors meetings and the like. On April 12, 2007, the SPC adopted Provisions for the Appointment of Administrators for Trials of Enterprise Bankruptcies and Provisions for Determining the Remuneration of Administrators for Trials of Enterprise Bankruptcies. These regulations require local registers of qualified administrators, clarify factors making a person too interested to qualify, and set caps on compensation that the people s court should determine. By the first meeting of creditors, the administrator must determine whether operations should continue. It will be critical whether independent accounting and similar firms or state-owned asset management companies (AMC s) will be appointed by courts in the early proceedings. (AMC s are already resolving non-performing loans for state-owned banks.) Will creditors committees control reorganizations? Creditors, by majority vote of the number of unsecured creditors at any duly called meeting at which creditors holding at least half of the unsecured debt by amount attend, can exercise remarkable powers. Among other things, they can review the administrator s fees and expenses, supervise the administrator, move the court for replacement of the administrator, approve settlements, approve business plans and asset dispositions, approve plans of reorganization, determine when and if operations should cease, and approve distributions of liquidation proceeds. The votes so taken will bind all creditors. The court will have a role only where creditors fail to reach a resolution, a creditor alleges action taken at a meeting was contrary to his interests, or creditors seek to replace the administrator. Creditors meetings will therefore probably be well attended. OHS West:

4 A creditors committee (including employee or union representatives) will likely be elected to perform these functions in most large cases. They have the potential to be far more powerful than U.S. committees, almost with the authority of a court. Therefore, unsecured creditors may find bankruptcy to be a more viable debt collection procedure than they do in the U.S. Even secured creditors, who almost never favor a U.S. bankruptcy for their debtors, may find bankruptcy preferable to a foreclosure proceeding in court. The bankruptcy law allows for relief from the stay of the enforcement of security interests (but does not state the basis on which it is to be granted.) Likewise, secured creditors may request adequate protection of their property rights (but the grounds are not stated.) Secured creditors remedies are not stayed at all in a conciliation proceeding. Will there be forced liquidations or conversion to creditor ownership, when creditors prefer that? A restructuring plan is to be filed by the administrator or debtor within 6 months of the acceptance of a petition for restructuring. This deadline can be extended only for 3 months, after which conversion to liquidation is mandatory. Voting on a proposed restructuring plan is by majority in amount of each class. Rejection by a secured creditor may be overriden by the court only if the creditor will receive the value of its collateral and compensation for payment deferral. Rejection by unsecured creditors can be overriden only if they will receive at least as much as they would in liquidation and the plan is fair to all classes, among other tests. Holders of two-thirds of unsecured claims must approve any conciliation. Should creditors be leery of initiating a case where foreign cooperation will be essential? A Chinese bankruptcy is to be binding on assets worldwide, but that will depend on comity being extended by foreign courts. Foreign ancillary proceedings will be possible only if the judicial process in the PRC becomes more transparent and predictable. Consistency of rulings by PRC courts will therefore be critical to comity by foreign courts. Recognition in China of rulings of foreign courts is not likely. In addition to common standards for non-recognition of a foreign ruling, such as its violating basic principles of the laws of the PRC, a Chinese court is directed by the statute not to recognize any foreign insolvency proceeding that would impair the lawful interests or rights of creditors inside the PRC. Virtually all foreign insolvency proceedings would fall into that description. Even Hong Kong liquidators may not be recognized on the mainland, due to a lack of a treaty or reciprocity relationship. Recognition, which will be essential in OHS West:

5 some matters, will be a matter of negotiation, in which protection of Chinese interests must be assured. Should we go so far as to encourage our clients to consider purchasing non-performing loans made to Chinese businesses? Knowing there now is a way to force loans to be repaid, or for the creditor to become an owner if not repaid, could create an opportunity for the purchase of a portion of the vast quantities of NPL s now held by Chinese banks. Once the SPC issues interpretations, especially if they recognize a floating charge on proceeds of collateral and set standards for acceptance of petitions, NPL purchasers may realize sizeable profits. Purchasers should, however, limit their holdings to loans to non-soe S that do not have significant pre August 27, 2006 employee claims, and no need for assistance of foreign courts. OHS West: