Ten Years to Sharpen One Sword: An Introduction to China's New Law on Enterprise Bankruptcy

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With the introduction of a modern comprehensive bankruptcy law, there are expectations that this legislation will help drive foreign investment in China and for it to increase substantially over the next several years.

The People's Republic of China's new Enterprise Bankruptcy law, passed in August 2006, is seeking to find balance between the country's cultural heritage of cradle-to-grave protection for all, while protecting social stability, with modernizing China's legal system to keep pace with its growing economy. There was no bankruptcy system in effect in China until the late Qing dynasty, which ruled until 1911. When the Com munists took power, any bankruptcy statutes that existed were abolished because they felt there was no need for bankruptcy law in a socialist system. Eventually, when China began embarking on economic reform in 1978 and opened its markets to the world, it became apparent to government leaders that bankruptcy legislation would be needed.

Two decades ago, China adopted the first trial step in what has been an evolving process to find a successful bankruptcy statute for the country. But China's 1986 Bankruptcy Law only applied to state owned enterprises (SOEs), which were not designed for profit, and the law provided no bankruptcy mechanism for the nearly five million private entities. The law was further restrictive by requiring bankruptcy filings to get government approval, and it limited enterprises to solely liquidation, not allowing alternate avenues, such as reorganization.

"Essentially, the government controlled the bankruptcy process. And you essentially had a lot of different bankruptcy laws that complimented and contradicted each other," explained Bruce Nathan, Esq., partner at Lowenstein Sandler PC to a large group of FCIB and NACM members during a recent teleconference entitled The People's Republic of China's New Law on Enterprise Bankruptcy. "A lot of provincial laws contradicted each other, resulting in inconsistent treatment of different enterprises, depending on the owner." According to Nathan, the result was that very few SOEs were filing for bankruptcy under the 1986 statute, compared to the number of insolvent entities.

With the switch to a more capitalist system, the SOEs have faltered and continue to do so, with 20% of these stateowned firms responsible for 80% of the non-performing loans in China.

In 1991, because of ongoing issues with the scope of the 1986 statute, the bankruptcy code in China was updated by the Civil Procedures Law, which applied to certain non-SOEs with legal person status. These laws were updated again in 1994, and then it took 12 more years to cobble together the latest version of the Enterprise Bankruptcy Law, which went into effect June 1, 2007.

"The problem is that China has another overarching goal--social stability--and this goal has prompted government intervention, at least under the old bankruptcy system," said Nathan. He added that the current question is whether this government goal for stability bumps up against the goals of the Enterprise Bankruptcy statute.

Nathan described that a perfect example of this question of balance is that certain SOEs are exempt from the latest Enterprise Bankruptcy Law and that they are governed by a policy bankruptcy program which was adopted by the state council of China, prior to the adoption of the 2006 statute. …