In a bid to streamline its bankruptcy resolution process, China establishes a trio of courts in Shenzhen, Beijing and Shanghai.

The establishment of three bankruptcy courts in Shenzhen, Beijing and Shanghai at the beginning of this year underscores China’s efforts to streamline how it handles bankruptcy cases using centralized jurisdictions and more professional trials. 

The new courts are timely, given the skyrocketing number of bankruptcy cases, which is creating a need to speed up court proceedings. In 2017, Chinese courts received 9,542 new corporate bankruptcy cases, up 68.4 percent from the previous year. The courts settled 6,257 of these cases that year, up 73.7 percent year on year. 

The establishment of the Shenzhen Bankruptcy Court, the Beijing Bankruptcy Court and the Shanghai Bankruptcy Court will make it possible to replace the special bodies within the Intermediate People’s Courts that managed bankruptcy cases in those three cities. The new courts will handle corporate bankruptcies, compulsory liquidation, derivative lawsuits and cross-border bankruptcies.

Insolvency professionals say the establishment of these specialized courts is of utmost significance given that bankruptcy procedures in China have not traditionally been the most efficient. 

Still, even with these new institutions in place, hurdles remain to streamline the system, particularly regarding cross-border bankruptcies. 

CENTRALIZED PROCESS

Bankruptcy lawyers believe the new courts will act as an independent branch within China’s legal system to centralize bankruptcy cases, putting an end to the current inefficient – and often unfair – approach.

“The Enterprise Bankruptcy Law is a mix of special litigation law, debt law, business organization law and social law,” says Feng Gao, a senior partner at Jincheng Tongda & Neal (JT&N). “But bankruptcy cases are heard before the civil and commercial courts, as there are no specialized courts to handle them in most places in China. Case-filing is not easy, hearings are not professional, and the functions of the courts are not clear.”

When bankruptcy cases are handled just like commercial cases, a ruling may end up being unfair. 

Gao’s views are supported by Ting Zhang, a senior partner at Dentons.

“When derivative lawsuits are processed separately from bankruptcy cases, it not only wastes judicial resources but also makes it difficult to coordinate the cases," Zhang says.

In any case, lawyers believe that the use of centralized jurisdictions will translate into settling cases more efficiently. They also predict that a top-level bankruptcy court will come along.

These bankruptcy courts in Beijing, Shanghai and Shenzhen could show the country how cases should be handled and provide experience for China to proceed to the next step: establishing a top-level bankruptcy court. 

“More resources are expected to be allocated to improve China’s insolvency framework,” says Jianghua Xu, a partner at China Commercial Law Firm. “There could be a top-level bankruptcy court after the establishment of these three courts in Shenzhen, Beijing and Shanghai.”

BETTER BUSINESS ENVIRONMENT

Lawyers also point out that better bankruptcy procedures could improve China’s business environment and draw the country closer to its foreign peers in terms of resolving corporate insolvency. 

“The bankruptcy courts are set up to facilitate the market withdrawal mechanism, which improves the legal environment for doing business,” says Yucheng Jin, a partner at Guantao Law Firm. 

“The courts will help kill off the ‘zombie firms’ in the market. These firms take up resources and hurt the creditors’ interests,” Jin adds.

These “zombie firms” are mostly subsidiaries of state-owned enterprises. They are financially distressed but not subject to insolvency because of the support from the government and state banks. Pushing them out of the market will improve corporate efficiency and tackle overcapacity. 

Still, the number of bankruptcy cases before Chinese courts is a fraction of the cases that courts in developed economies elsewhere. Between 2015 and 2016, China had only a couple of thousand cases, while France, Hong Kong and the U.S. saw between 20,000 and 60,000 cases each. 

However, according to the World Bank’s Doing Business 2018 report, China only scored 55.82 in resolving insolvency, ranking 56 out of 190 economies. 

“The newly-established bankruptcy courts could help bridge the gap between China and the world. The U.S. and the U.K., for example, have set up bankruptcy courts to specialize in these cases,” Jin explains. “Their hearing of these cases through the division of labour has facilitated a set of effective rules and systems for resolving bankruptcies.”

Dentons’ Zhang and senior partner Meili Gao both agree. They say a bankruptcy branch independent of the legal system is similar to the model in other jurisdictions, and it provides a kind of protection on the market. 

CROSS-BORDER HURDLES

These new courts will also be handling cross-border cases - a response to today’s global market economy of which cross-border bankruptcy becomes an integral part, says JT&N’s Feng Gao.

“With a lot of capital flowing in and out as well as companies with businesses at home and abroad, the numbers of multinational corporations and cross-border bankruptcies also grow,” he adds.

In 2018, 60,533 wholly foreign-owned enterprises were established in China, up nearly 70 percent from a year before. The foreign capital utilized in China was $134.9 billion, while Chinese investments overseas stood at $129.8 billion.

In particular, the Shenzhen Bankruptcy Court is given a special task – to provide enhanced judicial support for China’s Greater Bay Area initiative. The plan promotes the integration of nine mainland Chinese cities with two special administrative regions, Hong Kong and Macau, to form an economic powerhouse. 

But the plan is likely to meet with inherited challenges, as there are three legal systems in the area, among other differences. Hong Kong and Macau, former European colonies, will remain separate jurisdictions until 2047 and 2049 respectively.

In reality, given the close ties between mainland China and Hong Kong, mainland businesspeople could transfer assets to the subsidiaries in Hong Kong before seeking insolvency in China. And in many cases, bankrupt mainland companies have assets in Hong Kong and elsewhere. It has been difficult for bankruptcy officers to track down these assets. 

Therefore, handling cross-border cases that involve companies and assets in Hong Kong, Macau and mainland China would not be an easy task for the Shenzhen court. Dentons’ Meili Gao points out three challenges posed by having three different legal jurisdictions.

“First is the conflict of jurisdiction, as courts from the three places will decide if they have jurisdiction over a cross-border bankruptcy case based on their own law,” Meili Gao explains.

“Second is the difficulty in determining the applicability of the law. Currently, Hong Kong, Macau and mainland China have yet to come up with rules to specify which law would be applicable to solve procedural and factual issues in cross-border bankruptcies,” she adds.

The third problem, according to her, is that reciprocal recognition and enforcement of judgment would be difficult at the moment. 

Currently, there is no framework among these jurisdictions to mutually recognize insolvency orders despite five agreements on mutual help signed between Hong Kong and mainland China since 2006, two of which concerned with civil and commercial cases.

Dentons’ Zhang also acknowledges the current hurdle and illustrates examples. 

“If a Hong Kong company and a mainland company that are affiliated seek insolvency one by one, there needs to be coordination in the bankruptcy procedures of the two jurisdictions as there might be financial, asset and human resources control between these two companies,” Zhang explains.

“There is a lack of procedural coordination and actual understanding of each other’s bankruptcy law between Hong Kong and mainland China to resolve cross-border bankruptcies,” she adds. 

Zhang says in practice there are many red-chip companies listed in Hong Kong using the variable interest entity (VIE) structures. They are shell companies formed by transferring mainland assets and they are incorporated internationally and listed in Hong Kong. Zhang says they pose significant challenges to the legal professionals once they go bankrupt.

"It is very difficult to coordinate the handling of these companies' insolvency. Usually, the cases are handled separately by Hong Kong and mainland Chinese courts. The mainland court hears the bankruptcy case concerning the operating entity in China, while the Hong Kong court handles the liquidation of the listed entity," she explains.

"It would be of significance if we could look at the company as a whole to handle together both cases concerning the mainland operating entity and the Hong Kong-listed entity. It would be a win-win. Lawyers from the two jurisdictions can collaborate so a company can be seen as a whole in bankruptcy cases," she adds.

UNTYING THE KNOT

Cross-border bankruptcy cases are complicated, and little is known how the alignment among different jurisdictions would work so far. Lawyers put forward suggestions on what these newly-established specialized courts and legal professionals from the three jurisdictions might do.

Dentons’ Gao says the Shenzhen Bankruptcy Court has a geographically strategic position given its proximity to Hong Kong and Macau, so the court should be a pivotal force to seek solutions. 

“With its position, the Shenzhen court can focus on how to coordinate and settle these cross-border cases, such as setting up a cross-border bankruptcy mechanism, formulating rules and judicial procedures mutually acceptable by the three jurisdictions, establishing cross-border coordination rules, and so forth,” she suggests.

Meanwhile, JT&N’s Feng Gao calls for flexible application and an information-sharing mechanism.

“Legal professionals from the three jurisdictions could determine which jurisdiction to handle the main and ancillary proceedings, or they can opt for consent jurisdiction,” he says.

"There should also be an information-sharing mechanism to enhance communication and coordination for handling cross-border bankruptcies. Such a mechanism should help get information about the companies' claims and debts in the three places," Feng Gao adds.

He also notes that mutual recognition of the bankruptcy systems in the three jurisdictions is necessary, along with reciprocal recognition of qualifications of bankruptcy administrators or liquidators. 

Feng Gao’s suggestions are largely in line with those of Jin from Guantao, who also suggests a cooperation mechanism or framework among the three jurisdictions to address cross-border bankruptcy disputes.  

“Legal professionals from the three jurisdictions could determine which law to apply for different issues based on the actual situation,” he says.

“They should judge whether the laws of the three jurisdictions would need to be applied to address a particular issue. Without affecting their courts’ independence and fairness, officials from the three jurisdictions should establish a legal framework to enable so,” Jin explains. 

He adds that after all, reciprocal recognition and enforcement of a judgment is a more effective solution.  

China Commercial Law Firm’s Xu points out that the U.S. has a more comprehensive bankruptcy system to resolve cross-border bankruptcy, as reflected by chapter 15 of its bankruptcy code. It provides for the commencement of a bankruptcy case in the U.S. that is ancillary to an insolvency proceeding pending in a foreign country.

“But such a system is yet to be in place in China,” says Xu. 

“Given that the cross-border bankruptcy regime is yet to be mature in China, it is important for lawyers to enhance communication and be more agile when handling these cases,” he notes. 

He says the Market-oriented Bankruptcy Forum held in Shenzhen every year is a good exchange platform, for example. 

“Lawyers should be agile to realize their goals. In cases where the debtor has assets outside China and the bankruptcy administrator may face the problem of Chinese courts’ rulings not being recognized in other jurisdictions when collecting these assets, the bankruptcy administrator could collect and dispose of assets in other jurisdictions as the debtor,” Xu cites as an example.

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