Imminent changes: insights and prospects for China's insolvency restructuring market

The insolvency restructuring market in China is undergoing significant transformations in terms of legislation, judicial practice and law enforcement.

The momentum of these changes accelerated notably in 2022, propelled by a combination of factors, including:

• The persistent macroeconomic environment;

• China’s pandemic prevention and control policies; and

• The government’s heightened emphasis on optimising the business environment.

As China faces a mounting debt crisis in key sectors such as real estate and household consumption, policymakers have recognised the imperative to revise and enhance the country’s bankruptcy regime. This response is aimed at addressing the pressing needs of the entire economy and society.

The authors believe that the impact of these changes will have a profound historical significance for China, with 2022 potentially serving as a mere starting point.

The growth rate of China’s GDP has been gradually declining since China’s economy entered a ‘new normal’ phase in 2015.

According to data released by China’s National Bureau of Statistics, China recorded a GDP of RMB 121 trillion (approximately $17 trillion today) in 2022, a growth rate of only 3%. This growth rate is the lowest since the implementation of China’s reform and opening-up policy, attributable to the impact of the pandemic and other unexpected factors.

The financing environment and liquidity for Chinese enterprises (especially private enterprises) are becoming increasingly difficult as a result of the ongoing macroeconomic downturn and the deepening structural reform on the supply side of the country to ‘reduce capacity, de-stock and de-leverage’. As an example, in response to the overheated real estate market, the Chinese government implemented restrictive financing measures, including the introduction of the ‘Three Red Lines’ policy for the real estate sector. These measures aimed to curb excessive borrowing and debt accumulation.

However, these policies have had unintended consequences, leading to a liquidity crisis in 2022 for prominent private real estate companies such as Evergrande and Sunac. Consequently, these companies were compelled to initiate the restructuring of their domestic and foreign debts.

Against this backdrop, the number of corporate bankruptcy cases in China as a whole has been growing rapidly. In its Work Report for 2023, the Supreme People’s Court of China noted that in the past five years (2018–22), Chinese courts concluded 47,000 bankruptcy cases, a staggering increase of nearly 291.6% compared with the preceding five years.

The growth is more pronounced in some economically developed regions. For example, the number of bankruptcy cases grew eight-fold in Shanghai, rising from 161 in 2018 to 1,288 in 2022.

Meanwhile, China’s bankruptcy judiciary is gradually strengthening, placing greater emphasis on efficiency and the degree of informatisation. By the end of 2022, China had established 17 specialised bankruptcy courts, along with nearly 100 intermediate and basic people's courts, and some higher people's courts had set up liquidation and bankruptcy tribunals. The total number of bankruptcy judges serving nationwide exceeds 500.

In terms of digitalisation, online claim filings, online creditors’ meetings, online bankruptcy information announcements, online quotations for debtors’ property and auction disposals are being observed, partly due to the impact of the pandemic. These digital means have resulted in significant time and cost savings in case trials.

In addition to the significant increase in the number of cases and trial capacity, high-profile cases involving debts of hundreds of billions or trillions of dollars are beginning to emerge. For example, on January 17 2022, seven well-known Chinese education groups, including Tsinghua Unigroup, announced that their reorganisation plans had been approved by the court, leading to the settlement of more than $200 billion of debt. Additionally, on April 24 2022, HNA Group, along with 320 other companies, completed its reorganisation, successfully resolving trillions of dollars of debt.

The authors note that in these major cases, government agencies took the lead in establishing special enterprise bankruptcy and liquidation groups. These groups, facilitated by the ‘government-court linkage mechanism’, played a crucial role in expediting the filing and trial of cases. Moreover, the courts appointed these groups as administrators for the cases.

In response to the liquidity crisis faced by large conglomerates, the courts leaned towards utilising the Rules of Consolidation and Restructuring to address complex debt problems.

The range of debt repayment tools employed also exhibited a degree of diversity, including debt-to-equity swaps, debt extension and interest rate reductions, distribution of beneficiary rights in trust plans, and cash settlement.

As noted, prior to 2017, the number of bankruptcy cases in China was relatively small and the growth was slow. The initiation of large-scale restructuring cases was primarily driven by national policies, especially those targeting state-owned enterprises. These policies aimed to effectively clear or rescue these enterprises in alignment with government directives. In recent years, there has been a shift whereby economic and market factors have started to play a more prominent role in restructuring cases.

The successful completion of numerous restructuring cases has also contributed to increased acceptance of the insolvency regime by society as a whole. Business operators have become increasingly aware that they can utilise the insolvency regime not only to address their business debt problems but also tackle individual ones.

However, policy factors cannot be ignored. For instance, the Chinese government places great importance on optimising the business environment and is committed to swiftly improving the indicators of the Business Enabling Environment proposed by the World Bank.

Among these indicators, the bankruptcy sector has long been considered a weak link for China. In this regard, in January 2020, the State Council issued the Regulations on Optimising the Business Environment, which explicitly mandates local governments to establish a coordination mechanism for enterprise bankruptcy and take the initiative in resolving administrative issues that may arise during the process of enterprise bankruptcy.

In July 2022, the Supreme People’s Court of China issued its directive titled Provide High-quality Judicial Services and Guarantees for Accelerating the Development of a National Unified Market. This directive emphasised the need to further enhance the business environment by effectively implementing the bankruptcy regime to ensure the rescue-and-exit mechanism of business entities. It proposed specific initiatives, including promoting the establishment of an association of bankruptcy administrators and a special protection fund for bankruptcy expenses.

In May 2023, the World Bank undertook a restructuring of the entire Business Enabling Environment assessment system. The authors believe that this change will prompt the Chinese government to offer more comprehensive and secure policy guarantees for corporate bankruptcy, as well as encourage judicial authorities to handle bankruptcy cases in a fairer and more efficient manner.

On April 11 2022, the Enterprise Bankruptcy Law of the People’s Republic of China (Revised) was officially included in the legislative plan of the Standing Committee of the 13th National People’s Congress and the legislative work plan for 2022. Subsequently, on May 29 2023, the Enterprise Bankruptcy Law of the People’s Republic of China (Revised) was listed as a preliminary item for deliberation by the Standing Committee of the National People’s Congress of China.

It has been nearly 16 years since the current Enterprise Bankruptcy Law of the People’s Republic of China was put in practice. However, the law lacks provisions addressing personal bankruptcy and is insufficient in dealing with new issues that have emerged from China’s bankruptcy judicial practice in recent years. These issues include:

• The rise in cross-border bankruptcy factors;

• The application of merger and reorganisation rules for large group enterprise restructuring;

• The growing demand for streamlined bankruptcy hearings in small and medium-sized enterprise cases; and

• The effective integration of out-of-court restructuring and in-court reorganisation.

Mr. Liu Guixiang, a full-time member of the Adjudication Committee of the Supreme People’s Court, believes that the revision of the Enterprise Bankruptcy Law needs further improvement in two aspects.

Firstly, there is the need to address institutional gaps by incorporating rules of bankruptcy of natural persons, cross-border bankruptcy, bankruptcy of small and medium-sized enterprises, bankruptcy of financial institutions, merger and bankruptcy, and pre-reorganisation systems.

Secondly, specific rules should be enhanced, including improvements to the administrator regime, augmentation of the bankruptcy protection fund, the establishment of a government coordination department, enhancement of the property preservation release regime, and a strengthening of the connection between enforcement and bankruptcy.

Additionally, some regions with legislative power have taken the lead in improving bankruptcy rules. For instance, regarding the fiduciary obligations of directors against enterprise bankruptcy, the Several Provisions on Improving the Market-oriented Law-based Corporate Bankruptcy Regime in Shanghai Pudong New Area came into effect on January 1 2022. These provisions state that directors and senior managers of an enterprise have an obligation to promptly file for bankruptcy when the enterprise meets the criteria for bankruptcy and to disclose business information to creditors. This ensures the prevention of further deterioration of the enterprise’s condition and asset depreciation. The provisions also outline liabilities for compensation related to these obligations.

As another example, the Enterprise Bankruptcy Law does not explicitly state that the principle of absolute priority should be applied. Due to the absence of specific rules, the authors have observed that in certain restructuring cases involving listed companies, the court tends to overlook the need for a balanced consideration of the interests of all parties involved in its judgment. As a result, the rights and interests of creditors are not adequately protected.

Based on the given context, China’s academics tend to believe that the principle of absolute precedence and its application conditions should be clarified in the ongoing revision of the Enterprise Bankruptcy Law.

In recent years, China’s residential sector leverage ratio has experienced a significant increase, rising from 48.98% in 2017 to 61.9% in 2022. In light of this growing concern and the need to address personal debts, China has initiated a pilot programme for a personal bankruptcy system or liquidation process. This programme aims to provide a fresh start for individuals who are considered “honest and unfortunate” debtors, enabling them to clear their debts and start anew.

In March 2021, the Shenzhen Special Economic Zone published the first regional personal bankruptcy regulation in China. On March 1 2023, the Regulations on Personal Bankruptcy in the Shenzhen Special Economic Zone reached their second anniversary since implementation. During this period, the Shenzhen Bankruptcy Court received 1,378 applications for personal bankruptcy. Among them, 293 cases were thoroughly registered and examined, and 239 cases of various types of personal bankruptcy were successfully concluded.

The pilot work has been progressing in an orderly manner, showcasing the systematic promotion of the personal bankruptcy system in the region.

However, the personal bankruptcy pilot in Shenzhen has also encountered several challenges. These challenges include difficulties in verifying the debtor's property, a reluctance among creditors to accept bankruptcy applications due to concerns regarding potential bankruptcy fraud, and other related issues. Additionally, there is a notable hurdle in obtaining judicial recognition and enforcement of bankruptcy cases in other regions, posing further complications.

In the legislative reform of the bankruptcy regime in China, there is a debate on whether to legislate individual bankruptcy separately or incorporate it within existing enterprise bankruptcy law, forming a comprehensive bankruptcy code. From the authors’ perspective, the latter situation seems to be more in line with the current conditions in China. The main reasons are as follows.

Firstly, Chinese social culture has not fully embraced the concept of personal bankruptcy and debt exemption. A separate personal bankruptcy law can be easily misunderstood by the Chinese public as a means for individuals who have overspent, overborrowed, or engaged in speculation to evade their debts. On the other hand, a bankruptcy code can be perceived as a more neutral and conciliatory measure.

Secondly, enacting a bankruptcy code aligns with the legislative tradition of civil law countries and the ongoing trends of codification in China.

Thirdly, an insolvency code is better suited to address the interface between commercial individual insolvency and enterprise insolvency.

Following a brief recovery in the first quarter of 2023, China's economy started to decelerate in the second quarter. This slowdown, coupled with weakening market expectations, has led to the depreciation of the renminbi, declining stock prices, and a decrease in asset prices. Concurrently, several institutions have adjusted their projections for China's economic growth in 2023, revising them downward.

Due to the lack of investor confidence and a deteriorating investment and financing environment, the authors predict that enterprises in a liquidity crisis will face significant challenges in obtaining assistance from external investors. This, in turn, is likely to result in a decline in restructuring cases.

Conversely, the authors expect the number of liquidation cases for enterprises, especially small and medium-sized enterprises, to increase further.

In view of the cost of the current enterprise bankruptcy system and the lack of social awareness, the protection of small, medium and micro enterprises by way of bankruptcy has been untimely and inadequate. As a result, adjusting the relevant systems in the future to better facilitate the utilisation of relief rights conferred by the bankruptcy regime for small and medium-sized enterprises may become a highly debated topic.