A TEST CASE FOR CHINA’S NEW BANKRUPTCY LAW - Alan Quasha
Recent events in China seem to illustrate
Mao’s point: “Everything under the heavens
is in chaos, and the situation is excellent.”
Amidst the gold rush mentality accompanying
the rapid growth of post-reform
era China, discussions of corporate bankruptcy
have been overshadowed by the
factors driving China forward. However,
the little-noticed, yet significant reform
in how bankruptcies, liquidations and reorganizations
are handled, and the way
in which the process plays out over time,
will be a major factor in how investors in
China evaluate risk.
With some warning signals on the horizon
that could test the strength of China’s
boom – lack of adequate energy, credit
problems and legal infrastructure – the
new bankruptcy law, which took effect in
June after 12 years of legislative debate,
could prove to be critically important.
In fact, it’s already being put to the test.
The recent experience of an international
medical equipment company with operations
in China shows that while far from
perfect, the new rules create the possibility
for orderly restructurings and represent
a significant step forward in China’s
embracing of a market-based economy.
While bankruptcy laws governing
state-owned enterprises in China have
been on the books since 1986, no formal
or unified rules existed for private companies,
foreign investment enterprises
(FIEs) or individuals. Rather than focus
on market-based challenges, the laws
sought primarily to address labor-related
issues and ambiguous language gave way
to mostly informal, subjective proceedings,
which had the added benefit of allowing
troubled organizations to “save
face”.
On August 27, 2006, the Standing
Committee of China’s National People’s
Congress (NPC), China’s top legislature,
finally adopted the Enterprise Bankruptcy
Law (EBL). For the first time, FIEs – not
just state owned enterprises – could enter
bankruptcy proceedings through an organized
process.
In addition, the EBL allows for alternatives
to bankruptcy, such as a reorganization,
which takes cues from U.S. Chapter
11 proceedings and allows a company
to emerge and continue to operate, and
“conciliation,” which provides a framework
for distressed companies and their
creditors to agree on a settlement. Importantly,
the EBL provides that secured
creditors are first in line to recoup funds,
followed by the employees and then the
unsecured creditors, and allows for either
the debtor or creditor to initiate a bankruptcy
filing.
The new law could not have come at a
better time.
Quadrant Management was brought in
to advise the troubled medical equipment
supplier in early 2007 – prior to the new
bankruptcy law taking effect. It was clear
from the outset that an orderly, out of
court restructuring would be a futile task,
given that the situation had devolved into
near chaos. The factory was producing at
a fraction of its capacity at negative gross
margins with a staff that could populate a
small U.S. city. Overhead costs were ballooning,
accurate and complete accounting
records did not exist and stealing was
common. A culture of careless spending
had been so engrained that even the local
taxi drivers charged five times the usual
rate to anyone affiliated with the company.
The factory manager refused to
lay off employees for fear of violence and
because, even if they were laid off, they
wouldn’t leave the premises. Vendors,
who were not being paid, threatened violence
and hired migrant workers to block
the factory doors with trucks. Fortunately,
no one was ever hurt and all this sound
and fury ended up being merely the first
phase of a negotiation.
The only options initially were to attempt
a bankruptcy under dubious legislation
or pursue an informal liquidation
under the PRC Corporation law. Neither
proved to be a fruitful course. Attempts to
pursue a formal bankruptcy, which would
have provided the greatest asset protection
even under the old laws, were arbitrarily
denied by the local courts, more
likely for political than legal reasons. Subsequent
attempts at liquidation proved to
be equally troublesome and creditor suits
began to mount.
After multiple applications for a formal
restructuring, the new bankruptcy law
took effect and three days later, the court
finally approved our motion. A month
later, an administrator was appointed
to oversee the proceedings. Assets have
been protected and the process, though
far from perfect given the growing pains
associated with the new law, is moving
forward in a positive direction.
The EBL clearly represents a major
step forward for China and, while our experience
illustrates how the system has
improved, it also reveals that much more
needs to be done to refine the process.
The EBL, though creating a much fairer
and more predictable system for debtors
and creditors, does not address all of the
intricacies of bankruptcy and has yet to
be fully accepted and put into widespread
use.
In the near term, the system may still
be prone to the wild antics and devious
business tactics that plagued the old system.
However, the more that China embraces
a market-based economy, the more
these issues will work themselves out,
thereby smoothing over the speed bumps
to growth.
Alan Quasha is founder, president
and CEO of Quadrant Management, Inc.,
which invests in and advises midsized
underperforming companies as well as
emerging businesses.
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