Back from the brink

In an underperforming economy, China’s bankruptcy regime is following a steep trajectory to maturity and doomed businesses are making a revival. Sophia Luo reports

ONCE REGARDED AS SOMETHING of a taboo, bankruptcy has now been generally accepted as an essential route for debt-ridden companies to deal with the burdens of the past, resolve debt overhang and take on a new lease of life.

Unfettered by bias towards the insolvency regime, which has long been perceived as debtor-friendlier, the market has embarked on an arduous and extensive journey, working to unravel the intricacies of achieving excellence in both bankruptcy approaches and execution. As China emerged from the grip of covid-19 and returned to a semblance of normalcy in 2023, the bankruptcy mechanism has been well on its way towards greater standardisation, normalisation and market orientation.

Economic recovery is by no means an overnight success, and many companies that managed to survive the covid winter have since had to close down.

Chen Feng, managing partner at Grandall Law Firm’s Shanghai office, says that the market value of bankrupt enterprises has currently expanded to hundreds of billions or even trillions of renminbi, compared with the previous range of billions and tens of billions.

Meanwhile, mixed ownership enterprises and even state-owned enterprises have begun to run into debt crisis.

From 2018 to 2022, as many as 69,700 bankruptcy cases were accepted by Chinese courts, accounting for more than 70% of the total number of cases since the promulgation of the Enterprise Bankruptcy Law in 2006. Among them, about 10% were related to reorganisation and reconciliation, resulting in the successful restructuring of nearly 3,200 companies.

The growing number of insolvent enterprises, and courts’ extensive experience in hearing bankruptcy matters, have set the stage for a wide range of innovative practices and new financing tools to play a bigger role.

Parties of lawyers, accountants, bankruptcy judges and government officials have made concerted efforts on institutional innovation, represented by the government-court linkage mechanism, and revitalised distressed businesses.

Gao Meili, a senior partner at the Beijing headquarters of Dacheng Law Offices, says: “The parties involved nowadays pay more attention to the bankruptcy mechanism itself to essentially deliver enhanced value to businesses and rebuild value for stakeholders.”

Weighing in on investment openings

Fortune and misfortune are two buckets in a well. In the context of the great changes in the global economic cyclical adjustment and industrial optimisation and upgrading, the crisis gripping China’s real estate sector has cast a shadow over the world’s second-largest economy. It has also presented a host of fresh opportunities and complexities in the realms of restructuring and non-performing assets (NPAs).

Gao Feng, a senior partner at the Tianjin office of Winners Law Firm, says that bankruptcy and reorganisation have become common among real estate developers and construction companies, as well as enterprises struggling with production difficulties, prolonged payment periods, declining profits, or even inability to make ends meet due to the country’s previously harsh covid control measures.

He says this is exactly where the new opportunities come in. Most real estate development companies need to continue construction of property projects during the restructuring process, and thus “some construction companies have already shifted their focus of business development to it”.

“In addition, for companies on the brink of bankruptcy due to covid control measures, there is no lack of good ones known for their better product competitiveness and operation efficiency under normal production circumstances,” he says. “All of these merit close attention from relevant companies and investors.”

Besides the restructuring of real estate firms and listed companies that has long been in the spotlight, Hou Yunjian, a Beijing-based partner at Global Law Office, says that the recent emergence of reorganisation involving financial institutions and internet enterprises is a new trend that warrants attention.

Speaking on the investment side, Xiao Aihua, a partner at Tian Yuan Law Firm in Beijing, says that many large investment institutions, including financial investors as capital providers and industrial investors as technology providers, have exhibited a keen interest in the field of bankruptcy alongside their traditional investment activities.

Tang Jianhui, an equity partner at Zhong Lun Law Firm in Nanjing, says that “the introduction of these strategic investors can optimise the allocation of resources and boost confidence, which has a bearing on the success of the restructuring”.

However, everything is easier said than done. Xiao says that it is not an easy task for investors and enterprises eyeing bankruptcy reorganisation to find each other when constrained by an information gap.

Furthermore, the slow pace of administrators and the judicial process makes it difficult to seize a restructuring opportunity. Additionally, inexperienced investors, overwhelmed by the complexities of reorganisations, often hesitate or even feel too intimidated to make a decision.

In terms of the recruitment of investors for bankruptcy reorganisation projects, Tang has yet to see an efficient matching of quality resources, and therefore expects the mechanism of introducing strategic investors to be further improved.

Chen, of Grandall, shares a similar viewpoint. “A lot of restructuring cases have gone nowhere simply due to the failure to recruit suitable investors,” he says.

In response to this, cities across China have set about establishing a resource pool of investors, with the efforts led by local governments, courts and administrators’ associations. Chen believes the significance of this initiative in effectively enhancing the success rate of reorganisation is clear.

Then again, the successful completion of restructuring is far from the end of the journey. Zhang Jianjian, a Shanghai-based partner at Haiwen & Partners, says the inadequate optimisation of the operation and governance of a listed company after reorganisation deserves special attention.

“Considerable importance should be given to whether the restructuring investment plan carefully considers the company’s future sustainable development and is properly arranged,” he says.

In the meantime, due to the urgency of addressing debt and business crises, speculative risks are easily overlooked. “The supervision of the behaviour of all parties involved in the reorganisation process, as well as the prevention and control of the overall risk, should be strengthened,” suggests Zhang.

“Listed companies are advised to exercise caution when identifying the intentions of investors engaging in restructuring,” he adds.

Due to the complexity and involvement of a broad range of parties, the success of reorganisation can boil down to the right time in the right place, and with the right people. Amy Ren, a partner at Llinks Law Offices in Shanghai and Shenzhen, emphasises the importance of strong communication capabilities of all parties involved, a comprehensive awareness of market-oriented principles, and specialisation of work for the smooth progress of reorganisation practice.

In particular, Ren says that “market-oriented awareness is not only a direction, but also a whole set of methodology. Many key parts of the restructuring process, such as the selection and appointment of intermediaries, asset disposal and the recruitment of investors, are increasingly being carried out in a market-oriented manner. This has proven to be the least controversial approach, offering a solution that is most likely to satisfy all parties involved.”

Innovative plans

To enhance efficiency and unleash the full potential of bankruptcy reorganisation, the use of well thought out solutions and structures can make a big difference.

Xu Bangwei, a partner at Jingtian & Gongcheng in Beijing and Guangzhou, points out that setting up a fund dedicated to debt repayment through a trust can safely segregate assets and boost creditors’ confidence. “Additionally, introducing a valuation adjustment mechanism in the bankruptcy reorganisation agreement can incentivise management to actively promote the restructuring plan,” he says.

At the same time, Xu closely monitors the exploration and use of financial instruments such as debt restructuring securities and convertible bonds – tools now being actively tested by market participants in restructuring procedures.

Hou, of Global Law Office, possesses extensive knowledge on the significance of the trust system in bankruptcy reorganisation. He recalls his in-depth participation in the bankruptcy restructuring of Bohai Steel Group, which was the first case in China to apply trusts in practice, and the reorganisation of HNA Group. The case was known for the largest scale of trusts applied in China to date.

“It serves as a means to buy more time for asset disposal and debt settlement,” says Hou. “It is also a meaningful attempt to enhance asset value, optimise resource allocation, and improve the repayment rate of claims.”

However, he says that when it comes to the practical use of trusts, “certain issues such as trustee selection and determination of liquidation rate still persist”. He advises vigilance against the misuse of the trust system for corporate insolvency services to prevent administrators exploiting trusts as a vehicle for improperly transferring management responsibilities.

In contrast to bankruptcy reorganisation cases in foreign jurisdictions, a debt-for-equity swap is a less common method of debt settlement in Chinese procedures, according to Chen, of Grandall. He says this discrepancy is largely attributed to factors such as the limited access to equity by creditors of financial institutions.

Hence, insolvent enterprises may suffer restructuring failures due to the inability to attract external investors. Even if they manage to reorganise, they still face significant financial pressure. The increasing occurrence of companies undergoing bankruptcy for a second time in recent years is not surprising.

Refining the linkage mechanism

As a significant safeguard mechanism for bankruptcy reorganisation practices, the government-court linkage mechanism has gradually developed from a case-by-case approach to a more normalised and detailed framework in recent years.

Notably, the high-profile bankruptcy reorganisation cases of large conglomerates such as HNA Group and Founder Group cannot go without the protection provided by the government-court linkage mechanism.

Ren, of Llinks, notes the active exploration of innovative paths by courts across the country based on this mechanism. She takes as an example Longyan Intermediate People’s Court of Fujian province, which adopted a model of “functional government departments + law firm” as administrators. This model precisely defines the facilitating roles of the government and integrates them into the court’s trial procedure to effectively promote the restructuring process.

Gao, of Dacheng, says the scope of co-ordination through the government-court linkage mechanism has expanded to include post-trial matters, such as enterprise credit repair.

Gao points out that, under the guidance and co-ordination of the Beijing High People’s Court, the Beijing No. 2 Intermediate People’s Court successfully applied the government-court linkage mechanism for the financial credit repair of a medical device manufacturer during its bankruptcy reorganisation.

Chen, of Grandall, has high hopes for the effective performance of courts and local governments in carrying out their respective functions. In certain situations, bankruptcy cases may lack clear provisions or successful precedents. He says that, “under such circumstances, when the administrator puts forward practical solutions, the court needs to show a certain degree of courage and commitment”.

In other situations, certain local governments neither proactively facilitate bankruptcy cases nor wish to get overly involved in case-related work, which results in slow progress, while a few local governments intervene too much, potentially jeopardising judicial independence.

“Consequently, it is essential for the relevant departments to collaboratively establish more systematic, clear, enforceable rules for the government-court linkage mechanism. This will help clarify the necessary obligations of the government and establish boundaries for their actions,” says Chen.