Competition, division between enforcement and bankruptcy laws

Enforcement law is designed to settle individual debts, following the basic rule of “first come, first served”. Bankruptcy law, on the contrary, aims for equal settlement among the creditors. The two laws are mutually exclusive and cannot concurrently be applied to a single case.

CURRENT STATUS

China’s civil enforcement provisions can be found in the Civil Litigation Law and related interpretations, which can be complex and poorly structured. Enforcement deals with the actual implementation of a court verdict. Currently, implementation of civil enforcement suffers from convoluted rules, a low success rate and a high level of discretionary power wielded by judges. Many enforcement actions have been called off because no enforceable assets were identified.

The bankruptcy legal system, on the other hand, is underpinned by the Enterprise Bankruptcy Law, related interpretations and relevant judicial documents issued by various local courts. Since the Supreme People’s Court (SPC) introduced and implemented the bankruptcy administrator system, allowing administrator-led teams to substantially take part in the management of bankruptcy cases, the bankruptcy capacity of courts has been greatly enhanced.

COMPETITVE RELATIONS

The enforcement law takes a “first come, first served” approach to settle individual debts: (1) the party applying for property preservation will have priority of compensation, and preservation grants the power of disposal; and (2) the party applying for enforcement will have priority of compensation, regardless of the order of a judgment.

The bankruptcy law aims for equal compensation. Once bankruptcy proceedings begin, all individual enforcement ceases, all property is released from preservation, and compensation is equally allocated to ordinary creditors except where certain creditors have priority of compensation.

In general, the enforcement and bankruptcy legal systems are in competition with each other in terms of application. Before bankruptcy, debts are settled with each creditor under the “first come, first served” principle of the enforcement law; once bankruptcy begins, the bankruptcy law takes over to settle all debts equally.

The bankruptcy law applies only to business entities or other institutions with insolvency capacity. Natural persons (unless in Shenzhen, where personal bankruptcy is piloted) can only resolve individual compensation under the enforcement system, including participating in allocation.

PRESERVING SECURITY

While enforcement and bankruptcy respectively focus on individual and equal settlement, they find common ground on the principle of “preservation of security”.

The concept of security over a target property falls under the bankruptcy legal system, but was mentioned neither in the Civil Code, nor the prior Guarantee Law. Property security under the bankruptcy law mainly refers to real rights for security, namely rights to mortgage, pledge of movable properties and lien. It also includes atypical forms of security such as the preservation of a seller’s ownership before a buyer’s fulfilment of obligations and finance leasing.

Under the rule of “preservation of security”, after disposal of the property over which security is made, the holder of real rights is entitled to priority in compensation, in enforcement or bankruptcy proceedings. However, the administrator may apply to the court for the cancellation of security provided for an unsecured property within a year before a bankruptcy application is accepted. This is a significant rule.

As long as there is valid property security before entering bankruptcy proceedings, the holder of real rights will have priority in the settlement of debts, which applies to both enforcement and bankruptcy.

DISTRESSED ASSETS

Distressed assets usually refer to a combination of debts, equity, seizure and mortgage, which the company struggles to resolve by itself. In civil enforcement, preservation may be nulled by bankruptcy, but the priority status of property security remains. Disposal of distressed assets under enforcement or bankruptcy systems can lead to drastically different results of allocation.

Although the rights holders of secured properties enjoy priority in settlement, whether via enforcement or bankruptcy, they are not free of all risks. If proceeds of the disposal are inadequate to cover all debts, the outstanding creditors’ rights will be relegated to ordinary creditors’ rights. The bankruptcy proceedings may also directly affect realisation of priority rights.

Distressed asset disposal is a complicated issue, involving the determination of legal relationship, the scale and priority level of creditors’ rights, asset valuation and disposal estimates, involvement of bankruptcy proceedings, and even psychological battles between the parties.

Bankruptcy and insolvency are not often considered the best route for dealing with distressed assets. Out-of-court settlement, pre-reorganisation and bankruptcy reorganisation are preferred.

KEY TAKEAWAYS

It is imperative to initially clarify the complex legal relationships, analysing how the debts and creditors’ rights, mortgages, seizures, guarantees, security, relocation of personnel, asset recovery and other factors affect the allocation of interests.

In addition, the participation of actual controllers, majority and minority shareholders, rights holders of secured properties, ordinary creditors, employees, potential investors and other stakeholders in the reorganisation, all acting in their own interests, will affect the result.

Lin Zeda is a partner at Han Kun Law Offices. He can be contacted by phone at +86 21 6080 0266 and email at zeda.lin@hankunlaw.com

Chen Jianhong is an associate at Han Kun Law Offices. She can be contacted by phone at +86 21 6080 0266 and email at jianhong.chen@hankunlaw.com