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Cover story

Time for plan B?

1 March 2023

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Misunderstood by many, the bankruptcy regime in China requires urgent legislative and administrative upgrades to inject market logic into the economy. As Luna Jin reports, meaningful endeavours are being made to revitalise businesses

Compared with developed markets such as the US, with its modern bankruptcy law based on 130 years of history, China faces the duality of an infant bankruptcy mechanism and a complicated economic reality, where a growing number of business entities are in dire need of an exit.

The brief history of China’s bankruptcy law is very much intertwined and in step with the country’s social reform since 1978. The top legislature set out to make the Enterprise Bankruptcy Law almost simultaneously with the country’s opening up, but only in 2007 did the law officially come into effect at a time when China’s market took in more diversified players, with some naturally descending into zombie enterprises under increasingly intensified competition.

Negative perceptions of the idea of bankruptcies are still common in China. After all, society has only moved onto the notion in a little more than 10 years, while in the recent past there was simply no need for putting any socialist enterprise to an end.

Quite often, local governments harbour a bias against corporate insolvency, and will even block the bankruptcy process of big state-owned companies to promote the idea of growth and keep a nice employment rate. Debtors are reluctant to file for bankruptcy for fear of being held accountable for operating irregularities, and make do with the cheaper liquidation process, while creditors each want a share of the proceeds first through their individual enforcement proceedings.

However, the table is turning as parties have witnessed successful restructurings of conglomerates in recent years, including HNA Group, Founder Group and Tsinghua Unigroup, testament to how the bankruptcy reorganisation procedure not only removes zombie companies but also serves as a constructive rescue to distressed businesses.

In the midst of change, the professional community of lawyers, accountants, bankruptcy judges and government officials are working together to bring investors, creditors and debtors to a consensus, and to formulate creative and ground-breaking schemes to pay creditors back.

Michelle Luo, a senior partner at Hui Ye Law Firm in Shanghai, observes that there has been a significant increase in the number of cases where companies have opted for bankruptcy restructuring on their own initiative, compared with past years.

Behind all the effort, fruitful explorations in different cities have developed effective, but still inconsistent, methods.

To provide a solid basis for practice, and to catch up with international norms, the need for filling in legislative gaps, and for supporting measures from various government departments, has become crucial.

INSTITUTIONAL CHANGE

The judicial system is gradually establishing specialised bankruptcy courts across the nation and drawing up different guidelines for bankruptcy practices, but these rules vary and are rarely harmonised.

The pre-reorganisation system, which bridges in-court and out-of-court procedures, is rapidly gaining traction in China and has played a valuable role in practice.

In October 2021, the State Council issued an opinion on pilot work regarding innovation in the business environment, mentioning the introduction of a pre-reorganisation system for bankruptcy in the first six pilot cities of Beijing, Shanghai, Chongqing, Hangzhou, Guangzhou and Shenzhen.

According to Gao Meili, a senior partner at Dentons China in Beijing, courts in different regions of at least 17 provinces and cities around the country have formulated 41 guidelines for pre-reorganisation to date.

However, the effectiveness of these local guidelines remains questionable. Due to a lack of uniform rules and regulations, “in practice there are even problems with pre-reorganisation being seen as a tool to extend the period of restructuring, as a testing ground for the official restructuring procedures, or as a through train for appointing administrators”, says Gao.

Luo says that, precisely because of the lack of a superior law, there are inconsistencies in the rules on pre-reorganisation in terms of: how to apply for one; the duration; the selection and renewal of administrators; the suspension of execution procedures during pre-reorganisation; the release of the measures for preserving the debtors’ assets during pre-reorganisation; the continuation of the voting mechanism and the effectiveness of voting; and the succession of creditors’ committees from pre-reorganisation to court proceedings.

Luo cites the Shanghai Bankruptcy Court’s version of a trial guideline for pre-reorganisation as an example. The conditions for applying for pre-reorganisation in the document are set mainly from the perspective of the development prospects of the industry to which the company belongs, the company’s internal governance and operations, and other aspects of the company’s capability to continue to operate, with the court mainly considering the value in the company’s reorganisation. By contrast, she says, “courts in some regions will also take social stability into account when setting the conditions for starting the pre-reorganisation”, noting the regulations of the Shenzhen and Nanjing courts.

On the question of whether the measures for preserving debtors’ assets can be released in pre-reorganisation, Luo says that some local courts have positive provisions while most courts only allow for the release of preservation within the jurisdiction of the city court.

In this regard, Zhang Jianjian, a Shanghai-based partner at Haiwen & Partners, suggests that China needs to adopt a bankruptcy protection mechanism as soon as possible, drawing on international experience to add such a mechanism prior to liquidation and restructuring, which also bridges to pre-reorganisation.

“The biggest obstacle for pre-reorganisation now is that it is impossible to suspend the execution and litigation procedures of individual cases, or suspend payment during pre-reorganisation, leading to poor results,” says Zhang.

It remains to be seen whether the expectations of the industry will eventually be incorporated into the law, as the Standing Committee of the National People’s Congress is currently further refining a draft amendment to the Enterprise Bankruptcy Law.

Changes are also needed at the administrative level. The handling of an insolvent company involves not only legal procedures, but also the resettlement of employees, disposal of land, plant and equipment, payment of taxes, credit repair, treatment of suspected crimes, and other issues involving social security, taxation, public security authorities, land and resources, housing and construction, and financial regulation. These require the co-ordination of various departments, so the intervention of administrative power is indispensable.

The government-court linkage mechanism, which aims to strengthen the synergy between government departments and the judiciary in related matters, is being rolled out nationwide.

Gao, of Dentons China, says that as the number of bankruptcy restructuring cases of listed companies increases, a dedicated supervision mechanism for these companies has been systematised, and securities regulators and the courts are becoming increasingly adept at working with each other.

In March 2022, the Shanghai and Shenzhen stock exchanges issued regulatory guidelines on bankruptcy restructuring matters, providing updated regulatory advice on information disclosure, suspension and resumption of trading, insider information and lockup periods in the bankruptcy proceedings of listed companies, clarifying practical issues that had previously been prevalent in the restructuring process.

In November, the Nanjing Intermediate People’s Court and the China Securities Regulatory Commission’s (CSRC) Jiangsu bureau jointly issued a notice that they would work together to strengthen their co-operation during the restructuring of listed companies and to enhance rescue effectiveness, the first collaborative mechanism in the country specifically for restructuring listed companies.

Leo Hou, a Beijing-based partner at Global Law Office, says that some cities conducting pilot projects on business environment innovation are also exploring positive measures such as: “Optimising the land and property disposal procedures of insolvent businesses; optimising the mechanism for unsealing and disposing of property in bankruptcy cases; and further facilitating the access of bankruptcy administrators to information on the property of insolvent businesses.”

INNOVATIVE REPAYMENT PLANS

When restructuring conglomerates that are “too big to fail”, a restructuring plan that meets the interests of all parties often requires maintaining the normal operation of the company’s main business while at the same time advancing the restructuring procedure in a narrow timeframe. This difficult task has been described as “performing surgery on a high-speed train”.

Faced with varying shareholdings and debt realities, in practice, bankruptcy lawyers have been creative in devising an abundance of solutions in their practice.

In the substantive consolidation of Nanjing Construction Group and 24 other companies with a debt size of more than RMB130 billion (USD19 billion), Tang Jianhui, an equity partner at Zhong Lun Law Firm in Nanjing, says that the case was innovative in introducing equity-type assets as a resource for restructuring investment in the absence of investors willing to provide cash.

Zhong Lun was one of the co-administrators of the case, led by Tang, which involved more than 100 financial institutions and nearly 3,000 natural person creditors across the country. A service trust was also established, which transformed all the equity of related companies under the trust plan. Then shares of the trust were used to pay off the debt, and creditors could control all the debt-servicing assets collected through the trust and receive the future appreciation income, “truly realising the complete exit of the original shareholders, and all the inventory assets were used to pay off the creditors”, says Tang.

Beginning with the introduction of trusts in the bankruptcy restructuring of Bohai Steel Group in 2018, trusts have become an important part of an increasing number of restructuring plans of large enterprise groups.

Gao, of Dentons, says that in the substantive consolidation of HNA Group and 320 companies, the property rights trust set up in the case was the first in China to incorporate into the trust scheme as a whole the non-reserved underlying assets of investment by the restructuring investors.

“The introduction of the trust plan effectively resolved the conflict between the actual time required for disposal of non-reserved assets and the requirements of the Enterprise Bankruptcy Law on the timeframe for restructuring,” says Gao.

“It also achieved the effect of ‘exchanging time for space’ for the debtors through the trust’s right to income against debts.”

In addition to the introduction of the trust system, the other financial tool that has been applied in practice is the valuation adjustment mechanism (VAM).

Gao says that the approved restructuring plans of Yurun Group and Huiyuan Juice both set up pools of reserved shares or equity to be allocated to creditors in the event that the performance pledges party (i.e. the post-reorganisation company) did not meet its targets, in order to reduce the deviation of the actual value of companies’ shares after the debt-to-equity from the valuation at the time of approval of the restructuring plan.

To protect creditors’ right to information, which is of paramount concern, bankruptcy administrators often set up special mechanisms to help them keep abreast of key information.

Lawrence Yang, a partner in the Beijing office of JunHe, says that in the substantial consolidation of Dongying Fangyuan Nonferrous Metals and 19 companies involving RMB30 billion, which he handled last year, a high proportion of claims came from financial institutions and a large number of foreign creditors.

Therefore, a communication and consultation mechanism was established in order to safeguard creditors’ right to information. After the establishment of the creditors’ committee, the consultation mechanism was run in parallel with the committee’s deliberative mechanism.

“The administrator maintained close communication with the main creditors and reported regularly on the progress of the restructuring, and Fangyuan’s operations,” says Yang.

At the same time, as the restructuring attracted a lot of investment interest, it became a tricky issue to identify the restructuring investors in a fair, just and open manner. To this end, the administrator ensured that creditor representatives were fully involved in all aspects of the process, and that the evaluation process was open to all creditors.

Where the above-mentioned administrative measures are not yet in place, lawyers need to design reorganisation plans that are forward-looking, taking into account possible issues such as historical taxation and credit recovery, and setting up contingency plans within the repayment scheme accordingly.

Zhang, of Haiwen, says that in the restructuring case of a real estate company he worked on in 2022, the final settlement could not be determined due to historical tax issues, and the relevant taxes and fees could not be determined during the vote on the restructuring plan.

In response, the restructuring plan adopted a form of co-payment between creditors and restructuring investors where a tax amount was determined and set aside in the debt repayment resources. For any portion set aside in excess of the actual tax, the balance went to the post-restructuring company. If the portion set aside was not enough to cover the actual tax, the restructuring investor would pay the shortfall to ensure the completion of the restructuring.

These innovations and practices reflect a trend towards greater professionalism in the field of restructuring among investors, creditors, debtors, lawyers and the courts.

Luo, of Hui Ye, says that both banking institutions and capital management institutions – which are the main creditors in restructuring cases – and law firms, accounting firms, financial advisers and tax planning advisers – which are the main service providers – have become more organised in dealing with major restructuring cases, from the timing and operation of debt committees to the selection process of key intermediaries such as law firms and the handling of sensitive social issues.

Apart from the traditional bankruptcy legal capabilities, says Luo, “clients are placing more refined demands on the overall capabilities of lawyers, their ability to lead and co-ordinate various intermediaries, their communication and co-ordination with government task forces/working groups and the bankruptcy court, their communication and co-ordination with creditors, and the innovation, operability and acceptability of the restructuring plans”.

CROSS-BORDER INSOLVENCIES

In the context of global economic cyclical adjustment and industrial optimisation and upgrading, cross-border insolvencies have become a new norm in international economic activities. The number of cross-border insolvency cases is increasing, making judicial co-operation in cross-border insolvencies inevitable.

In practice, since 2014, when a US Federal Bankruptcy Court first recognised Chinese bankruptcy proceedings, there were only a few instances of foreign judicial bodies recognising domestic bankruptcy proceedings.

In 2019, Hong Kong’s High Court recognised the liquidation, and appointment of joint and several administrators by the Shanghai Third Intermediate People’s Court, in Shanghai Huaxin Group’s restructuring case; and the US Bankruptcy Court for the Southern District of New York recognised the bankruptcy proceedings of Louwa Group before the Beijing Chaoyang People’s Court.

In 2020, Hong Kong’s High Court recognised the bankruptcy proceedings of Shenzhen Nianfu Supply Chain before the Shenzhen Intermediate People’s Court; and the High Court of Singapore signed an order recognising the bankruptcy liquidation proceedings of Jiangsu Shuntian Ship Development before the Nanjing Bankruptcy Court as a foreign main proceeding.

In more recent years, there have been occasional instances where domestic courts have recognised insolvency decisions of overseas courts in accordance with the principle of reciprocity.

In May 2021, the Supreme People’s Court (SPC) issued its Opinion on Taking Forward a Pilot Measure in relation to the Recognition of and Assistance to Insolvency Proceedings in the Hong Kong Special Administrative Region, which was the first time for the SPC to issue a specific document on cross-border insolvency assistance. The pilot project was launched in the courts of Shanghai, Shenzhen and Xiamen.

Around the time of the pilot opinion, in August 2021, the liquidator of Samson Paper Holdings applied to the Shenzhen Intermediate People’s Court and was granted recognition and assistance four months later, becoming the first case of a mainland court recognising and assisting Hong Kong insolvency proceedings. In 2021, the Xiamen Maritime Court also recognised the judicial administrator status of Singaporean shipping company Xihe Holdings based on the principle of reciprocity.

However, Hou, of Global, cautions that these developments “still lag behind the needs of practice”.

Yang, of JunHe, says that “the current cross-border insolvency practice is built on a case-by-case basis, which entails high communication costs in individual cases and may drag on for a long time, which in turn makes it difficult to promote practice in the full rollout”.

Luo, of Hui Ye, says that China is not a party to international treaties recognising the status of insolvency administrators in other countries or regions, and the UNCITRAL Model Law on Cross-Border Insolvency, for example, does not apply ipso facto in China.

She says that, despite the principle provisions in the Enterprise Bankruptcy Law, there are still many practical challenges, for example, whether the recognition and assistance of Chinese courts in extraterritorial insolvency proceedings should give priority protection for the home country, or follow the principle of universal most-favoured nation treatment.

Gao, of Dentons China, suggests that “further regulation and refinement is needed in the areas of cross-border insolvency jurisdiction, the status and treatment of foreign insolvency representatives and creditors, the conditions and manner of providing judicial assistance to foreign insolvency proceedings, and the recognition and enforcement of foreign insolvency instruments”.

Zhang Jie, a partner at Tian Yuan Law Firm in Chengdu, says the extraterritorial effects of domestic insolvency proceedings and the effects of overseas insolvency proceedings in China should be of equal importance.

“The current law remains almost blank on cross-border insolvency jurisdiction and the extra-territorial effect of proceedings, and there is an urgent need to establish at the legislative level the insolvency jurisdiction of mainland courts over overseas incorporated companies,” she says, “[so that] the recognition can be sought from overseas courts and assistance can be provided to the mainland in relation to the commencement of bankruptcy proceedings for the overseas parent company, thereby blocking the overseas court from commencing or conducting further bankruptcy proceedings.”

REAL ESTATE RESCUES

Against the backdrop of the central government’s macro initiative of “reducing leverage” in recent years to reduce the threat posed to the overall financial system by the over-indebtedness of developers, the real estate industry has generally tightened its cash flow since the implementation of the “three red lines” rules for financing regulation in the property sector, the centralised management of real estate loans by banks, and the strict control of land acquisition-to-sales ratios.

Real estate companies are under great pressure to survive, and a liquidity crisis is imminent, with industrial giants such as Evergrande defaulting on their debts one after another.

However, in late 2022, the central government’s policies took a turn. The central bank, the China Banking and Insurance Regulatory Commission and other authorities issued notices to support private enterprises in issuing bonds for financing, encourage commercial banks to provide M&A loans for real estate projects, and support capable financial institutions to help resolve the risks of distressed real estate companies through establishing funds and other methods.

The central bank will launch a RMB200 billion interest-free re-loan support plan for commercial banks to encourage them to support housing completion.

So, to what extent can these positive financing and borrowing policies ease the crisis of real estate companies? And what restructuring measures can be taken by distressed real estate companies to get out of trouble and ultimately revitalise their businesses?

“The current policies of various types of support for real estate companies in issuing bonds and financing are focused on supplementing liquidity for distressed companies with the task of housing completion, with priority being given to projects linked to housing completion such as constructions, rather than being used to support the continued expansion of real estate companies,” says Xu Shengfeng, an equity partner at Zhong Lun Law Firm in Shenzhen.

Xu suggests that distressed real estate companies that are well governed, focused on their main business and still well-qualified, but have tight balance sheets due to liquidity constraints and tightened credit from banks, could make use of a combination of policies in the judicial restructuring process such as issuing shares to purchase assets and financing in a non-public manner.

“This will give full play to the role of unsold property values and other inventory assets of real estate companies, introduce incremental liquidity, complete guaranteed delivery of buildings while properly restructuring debts and optimising balance sheets to achieve rebirth,” says Xu.

He suggests that distressed real estate companies that are still unable to solve the problem of historical debts, even after introducing liquidity for the task of housing completion, can start bankruptcy restructuring procedures to divest historical debts and repair corporate credit.

“Such measures can make full use of the advantage of restructuring of a real estate company and bring into play the experience and capabilities of commercial banks and asset management companies in terms of non-performing asset disposal and risk management,” he says.

For distressed companies that are seriously insolvent, lack inventory of assets, do not meet the conditions of current financing support policies, and have lost their restructuring value, Xu says they can explore the path of co-operation with associated high-quality projects in better asset condition to ensure the delivery of buildings under the principles of marketisation and rule of law.

“If necessary, they can consider being part of the substantive consolidation of other related projects, defusing the risks of various types of debts on a larger scale; or introducing a state-owned platform to ensure the delivery of buildings to take over the construction and management on behalf of the company, and initiating bankruptcy liquidation in accordance with the law after giving priority to protecting the legitimate rights and interests of home buyers, so as to completely clear the debt risks of troubled real estate companies,” says Xu.

Zhang Jie, a partner at Tian Yuan Law Firm in Chengdu, says: “A thorough and flexible bankruptcy restructuring process can, to the greatest extent possible, allow distressed real estate companies to enhance their market value, revitalise their assets, solve the problem of liquidity constraints, resolve conflicts between parties in a timely manner, and maintain social and livelihood order stability within the legal framework.”

Leo Hou, a Beijing-based partner at Global Law Office, adds that a company applying for bankruptcy restructuring must have a restructuring value as well as the potential to be rescued.

“Real estate companies that have financial problems but still have assets such as real estate in prime locations and construction in progress, good sales prospects and controllable costs for resuming construction, should promptly consider applying for bankruptcy reorganisation,” he says.