Practice, prospects of substantive consolidation

The group economy is derived from the market-oriented and large-scale development of the modern economy. However, any debt problem in a group economy is more likely to cause widespread and systemic risks amid continued macroeconomic downturns, oversupply and liquidity crises faced by pillar industries.

Judge Wang Jing pointed out in her book, Study on the Legal System Construction of Substantive Consolidation Bankruptcy, that “the complexity in bankruptcy of affiliated companies is rooted in the contradiction between the independent legal personality of each member company and their status of being under common control. The existing bankruptcy system designed based on the model of standalone enterprise bankruptcy can hardly address the bankruptcy of affiliated companies, giving birth to substantive consolidation.”

Given the economic situation and social contradictions today, the Enterprise Bankruptcy Law should be upgraded to meet the needs of today’s market economy.

Judicial practice

Review of practices. The number of bankruptcy cases heard by China’s courts has been increasing in recent years. According to the 2023 Work Report of the Supreme People’s Court (SPC), a total of 47,000 bankruptcy cases were closed in the past five years.

In addition to the surge in bankruptcy cases, consolidated bankruptcy cases involving tens or hundreds of affiliates have also emerged, such as the consolidated bankruptcy of CEFC, Yurun Group and HNA Group. When dealing with the debt crisis of conglomerates, using consolidated bankruptcy proceedings for complicated debt issues better meets the fairness and efficiency doctrine of the bankruptcy law.

Judicial dilemma. The authors have observed that with bankruptcy cases handled in an increasingly market-oriented manner, the bankruptcy system has gradually become a normal way for enterprises or interested parties to address debt issues. The group economy has become an important entity in the socialist market economy.

However, the pursuit of the maximum conglomerate interests will easily ignore the independence of member entities. Therefore, the emergence of risk is often accompanied by asset transfer, confusion of assets and loss of independent will of legal persons.

Due to the lack of rules, the consolidation of affiliated companies in bankruptcy cases is often restricted by the lack of sources of law, disorder in the commencement of proceedings, unclear burden of proof, inconsistent examination standards and unclear relief procedures, easily triggering moral hazards and judicial disputes.

Revision and local regulations

On 29 May 2023, the Enterprise Bankruptcy Law was included in the preliminary consideration list of the National People’s Congress Standing Committee of China. Liu Guixiang, a full-time member of the SPC Judicial Committee, believes that the amendments to the Enterprise Bankruptcy Law should close the gaps in the consolidated bankruptcy system.

The SPC also keeps an eye on consolidated bankruptcy, suggesting a consolidation of assets and debts in its reply regarding the Harbin Department Stores Procurement and Supply Station’s bankruptcy filing. Since 2012, the SPC has drafted judicial interpretations and conducted studies on the substantive consolidation of affiliated companies in bankruptcy.

To meet the needs of judicial practice, the SPC eventually issued the Minutes of the National Court Work Conference on Bankruptcy Trials as a clear judicial policy on consolidated bankruptcy.

Since then, local operating guidelines have been issued successively to address consolidated bankruptcies. For example, the Guideline of Shanghai Higher People’s Court’s for Bankruptcy Trials (for Trial Implementation) upholds the above-mentioned minutes as the overarching principles for consolidated bankruptcy proceedings, providing for the issues of jurisdiction and appointment of administrators.

The authors found that the lack of legislation for consolidated bankruptcy rules led to inconsistent examination requirements, fragmented standards and burden of proof ambiguities in court hearings, making it hard to effectively protect the interests of parties. From another perspective, numerous local practices are meaningful explorations for the upcoming legislation.

The addition of rules

The current bankruptcy law includes separate chapters for three proceedings, which can be followed by another chapter for consolidated bankruptcy, in the authors’ opinion. The reasons are as follows.

First, in addition to creditors and debtors, the initiators of the proceeding should also include the administrator. The administrator plays a crucial role in advancing the bankruptcy proceedings, and is qualified to file for substantive consolidation. Also, the commencement mode should be determined according to the filing time for bankruptcy of affiliated companies or the main centre place of interest, and the jurisdiction rules should be clarified accordingly. The burden of proof may also be distinguished according to the identity of the initiator. For example, a higher initial burden of proof may be imposed on administrators or debtors who file for consolidation. If the applicant is the creditor, the threshold of proof can be lowered, reversing the burden of proof by placing it on the administrator or the debtor to disprove it to ensure substantive justice.

Second, the disregard of the corporate personality system is the jurisprudential basis of substantive consolidation in bankruptcy. However, the personality confusion of affiliated companies alone is not sufficient to justify the commencement of consolidated bankruptcy proceedings. Only when the confusion is serious enough to incur huge procedural costs and impair the interests of all creditors, can there be a value driver for initiating consolidation proceedings.

The key points of examination should focus on the asset confusion and distinction costs, which should be in a progressive relationship. That is, assess whether the assets are confused at first and then determine whether the distinction cost is too high. If assets are not confused or the distinction cost is low, there is no need to disregard the independence of corporate personality.

Third, the reconsideration hearing is mostly in writing, which actually deprives the interested parties of their substantive and procedural rights. Considering the procedural costs, the Civil Procedure Law may be referred to. In principle, the reconsideration should be a court hearing. If the applicant for reconsideration fails to provide new facts, evidence or reasons, however, the court may no longer hold a hearing.

Amy Ren is a partner at Llinks Law Offices. She can be contacted by +86 21 6043 3788 or by e-mail at amy.ren@llinkslaw.com
Shawn Xu is a contractual partner at Llinks Law Offices. He can be contacted by
+86 21 3135 8768 or by e-mail at shawn.xu@llinkslaw.com

Ren Jiaxin, an associate at Llinks Law Offices, also contributed to this article.