Jury is out on ChinaÆs new bankruptcy law

China's new insolvency laws may open up a new landscape for investors such as distressed-asset hedge funds.
This is the first week in which ChinaÆs new restructuring and bankruptcy laws have been in play. Observers are waiting to see if there will be a tsunami of court applications from creditors frustrated by the obduracy of Chinese borrowers, tackling the companies that linger on in zombie state, unable and unwilling to meet their obligations. For investors, not least distressed-asset and event-driven hedge funds, the changing landscape brings new opportunities.

In the past, bankruptcy laws were frowned upon by the Chinese government as being prejudicial to the proletariat. Basket-case companies firing hard working comrades was perceived as being counter-revolutionary.

Now, China has a new set of bankruptcy and insolvency laws that were introduced on June 1st.

ôThe old law was not unified,ö says Mark Fairbairn, Hong Kong-based partner at White and Case. ôThere were different rules for different regions. To start, the process required the consent of ministers. It didnÆt work as there was a reluctance to put companies into insolvency.ö

The new laws are broadly modeled on the United States' Chapter 11 rules. It hasnÆt adopted that American moniker, but will be known as æRestructuring'. A Chinese company can enter restructuring, and find some relief by way of moratorium from its counterparties while it tries to sort out its problems.

There is also a more terminal route, which is that of æliquidationÆ. Creditors and debtors can file a petition to Chinese court for a company to be put into liquidation if it canÆt pay its debts and is insolvent.

If the company has a plan, then it can ask the court to appoint Administrators and enter into restructuring. If you are a shareholder holding more than 10% of equity, you can go to the court yourself and ask for a restructuring plan to be implemented.

A huge amount of power therefore devolves to the Chinese PeopleÆs Court. How will the judges interpret their new responsibilities and will they do so fairly? Or will they act like Indonesian courts, whose judges, having been bequeathed a solid Dutch legal system, proceeded to interpret it in a loose and unpredictable way, suggesting that their priorities lay elsewhere.

ôThis is the biggest question of all,ö says White and Case partner Alan Gover. ôThe new law has been promulgated in a fair way, but people are sceptical about how the judges will carry it out.ö

Counterparties and investors now have more leverage than they have had before in China. They do now have this new weapon in their arsenal to extract value. This might lead to a rush to the courts, though let us not forget that at present, there is an enormous amount of liquidity flooding China. Companies can have access to cash from a range of sources, so the acid test of the new legislation will be when that cash liquidity and financing dries up, and so a company is less able to defend itself against creditors making the representation to court that it is insolvent.

With the courts appointing administrators, it technically should not become a æfree for allÆ and there should, in theory at least, be some organization. For those who have visited China though, you may have noticed that waiting in a neat, quiet and orderly line is not their national forte.

The administrators will most likely be Chinese accounting firms. Western accounting firms may lay off, fearful of the risk of being liable for mistakes.

In other changes, secured creditors now go to the top of the heap when payouts are being made. In the past, the long-suffering, oppressed worker would take first place. He now has to wait for the secured creditors to be paid out. What this means is that if you are an investor placing yourself in the capital structure, keeping a death grip over fixed collateral just became an even smarter move.

Additionally, debt sourced from Chinese institutions now ranks pari passu with that provided by foreign financiers. This is a major shift in the sands. It is clearly set out in the new law, but the key to it is the will of the administrators to ensure that all creditors are treated equally.

Finally, the new law allows for Chinese court decisions to apply cross borders to subsidiaries of Chinese companies overseas. For foreign countries to accept their verdicts though, they are going to demand that those rulings of the Chinese courts are sane and fair, and not in any way corrupt or motivated by dark influence.

What it all means is that there are more things to think about. The sclerosis has been scalpelled away, and now it is up to the courts to handle all these new legal niceties. Investors nurturing a company for the long haul could find that a company is jettisoned into bankruptcy by a creditor. Break-up specialists may have a field day. Beleagured Chinese companies now have the succour of their Chapter 11 equivalent, but the overall stakes have just gotten a lot higher.

Who are the other winners in this scenario? Of course it is those who win big in every game in town; the legal fraternity.
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