Background
Bankruptcy in the PRC refers to a corporate collapse. There is no legislation governing an individual's bankruptcy.

Bankruptcy is a relatively new phenomenon in the PRC. Before the Chinese economy began to be opened up to substantial cross-border trade in the late 1980s and early 1990s, any business unable to pay its debts was likely to involve only PRC state-owned enterprises, upon which a solution (good or bad) could be imposed by government. Non-PRC creditors affected by the few defaults in the mid-1990s were dealt with quietly, on a bilateral basis, and succeeded in recovering at least all of the principal amount of their claims (and some even a little interest on top).

The onset towards the end of the 1990s of more widespread default of PRC companies in the repayment of debt, much of it to foreign creditors, made it impossible to deal with problems quietly and without a multilateral, all-creditor solution.

Initially the PRC reacted by allowing a large and high profile bankruptcy, namely that of Guangdong International Trust & Investment Corporation (GITIC). Shortly after the closure and bankruptcy of GITIC, the province's largest window company (i.e. a Hong Kong company used by PRC government authorities to raise funds), Guangdong Enterprises Limited (GDE) hit turbulent financial waters. Instead of turning to formal bankruptcy as a means by which to resolve GDE's problems, the Guangdong government embarked upon a process of discussion and negotiation with GDE's hundreds of creditors. Key features of what was a lengthy, complicated and costly but ultimately successful restructuring were the injection of assets and swapping of part of the debt for equity.

Other "ITICs" followed GITIC into trouble, the next largest of which was Guangzhou International Trust & Investment Corporation (with debt of US$1 billion to 164 foreign creditors). Other window companies also followed GDE into restructuring negotiations. During 1999 and 2000 consideration was given to asset injection schemes, but most of the deals which followed GDE ended up as cash deals, with foreign financial creditors receiving between 50 per cent and 100 per cent of the principal amount owed by the ITIC or window company, with creditors having to forego all interest, save in a very few cases.

Legislative backdrop
The PRC bankruptcy law is in need of updating. Whilst considerable effort and time has been devoted to the discussion and development of new laws, they have yet to be passed. The present bankruptcy legislation in the PRC is the 1986 PRC Enterprise Bankruptcy Law (Trial Implementation) for state-owned enterprises. This law was never intended to be permanent and by 1995 it was recognised that a new and more comprehensive bankruptcy law was needed. A draft law of that year was revised and replaced by a second draft in 2000. A third draft has been released. In June 2004, the new bankruptcy law (draft) was submitted to the Standing Committee of the PRC National People's Congress for review. It is uncertain when the new legislation will come into effect.

One of the key issues which has yet to be resolved is the extent to which employees' claims should be given priority. Meanwhile, the "trial implementation" of the 1986 continues to be good law. Bankruptcy proceedings are also affected by a number of other Chinese regulations and laws.

The present law was well tested in the GITIC bankruptcy. In the eyes of a number of creditors, it has been found wanting. Claims which appeared to have a sound legal basis, including swaps claims, claims under legally binding support letters and guarantee claims where GITIC failed to obtain approval from the State Administration of Foreign Exchange (SAFE), were disallowed or allowed only in part by the liquidation committee appointed by the Guangdong court to oversee the bankruptcy. The liquidation committee does not consist of creditors, but predominantly of government officials, with no relevant financial interest in the bankruptcy. There has appeared to be little, if any, effective means of challenging these rejections in the PRC.

Although the 1986 bankruptcy law applies only to state-owned enterprises, similar rules apply to non-state-owned corporate enterprises (including foreign-invested enterprises. All procedures are overseen by a liquidation committee. There is limited transparency and the application of the rules to date has resulted in a number of creditors receiving what they have perceived to be less than fair treatment.

PRC restructurings
Although the 1986 Bankruptcy Law makes provision for a settlement to be reached with creditors, upon which the bankruptcy of the company might be terminated and the company resurrected, there is no formal procedure through which such a settlement might be achieved. However, there has been much informal restructuring activity in the PRC, mainly involving state-owned enterprises.

Restructurings of PRC companies have taken several forms, some involving a complex restructuring of business, assets and debt, whilst others have resulted in a more straightforward full and final settlement of debt obligations by part payment. The process with negotiations has been slow in almost all cases. This has been caused by both the steepness of the learning curve up which the debtor, government authorities and the lenders must go and also because of the drawn-out decision making process which has necessarily preceded any final agreement.

Significant decisions throughout the process have required approval of the debtor, provincial authorities and state authorities. This has sometimes resulted in delays of months, which have been extremely frustrating to foreign creditors looking for a swifter resolution. For the most part, these delays have not been caused by a lack of willingness on the part of PRC borrowers and authorities to find solutions. Very substantial sums have been contributed by the state to assist the borrowers to settle their obligations.

The past three years of restructuring experience in the PRC have thrown up a number of issues in respect of which the international business community will be looking to the PRC to make improvements. These include:

• SAFE approvals. Any foreign creditor or investor expecting to be paid out of the PRC, needs to ensure that the relevant SAFE approvals have been obtained. Although these approvals are the responsibility of the PRC counterparty, it is the foreign creditor or investor which will suffer if they are not obtained, because PRC law deems the relevant obligation to be unenforceable, even in local currency. Foreign creditors have been somewhat alarmed, in recent restructuring deals, by the fact that even where SAFE approval was originally obtained further approval was needed before they could receive payment in China, but their concerns have been allayed by the present practice that these further approvals have been granted automatically.

• Support letters and letters of undertaking. In both the GITIC bankruptcy and recent restructuring situations, experience has shown that little, if any, reliance can be placed upon these letters, even where those letters appear to be governed by laws other than PRC law or where they appear to create legally binding obligations on the part of SOEs. In the past, parties extending credit to PRC-related entities have taken great comfort from such letters. In the future, these letters are unlikely to be given and, even where they are given, it would be prudent not to place reliance on them. Instead, parties extending credit to PRC-related entities must focus more on that entity's ability to repay and the taking of security outside the PRC in enforcement-friendly jurisdictions, such as Hong Kong. In part, this will necessitate a more rigorous examination of accounts than in the past.

• Accounting standards. During most of the PRC-related restructuring situations, it has been notable that the company's accounts indicated a solvent situation on a balance sheet test (i.e. assets exceeding liabilities), whereas on independent analysis the value of the assets has been only a small fraction of the liabilities. A large part of this has resulted from different accounting treatment of provisions in the PRC. When proper allowance, based on international accounting standards, has been made for provisions against book value of assets, the illusion of solvency has rapidly evaporated.


Written by DLA. For further information, contact: Janine.Canham@dla.com or tel: (852) 2103 0683 or Christopher.Clarke@dla.com or tel (852) 2103 0688.