Why stigma holds back China's bankruptcy law

More than two decades after the mainland's first bankruptcy law was passed, Cao Siyuan, who is credited with being the architect of the law, said Beijing was lagging in actively enforcing the provisions, and that their scope needed to be expanded.

A trial bankruptcy law was approved in December 1986 after a bumpy year-long legislative process and came into effect two years later.

In 2007, the government passed a new and more comprehensive bankruptcy law, introducing provisions for restructuring plans and widening the application of the law from state-owned enterprises to all entities with a legal-person status.

While China now has one of the world's best-written bankruptcy laws on its statute books, its provisions are yet to be robustly tested.

In an interview with the South China Morning Post, Cao attributed the slow progress mainly to what he called old mindsets originating from the era of a planned economy, and which remain deep-rooted in society.

Local governments and individuals in China are still excluded from the coverage of the bankruptcy law, while the number of corporates filing for bankruptcy remains low, even though hundreds of thousands of unprofitable enterprises exit the market every year, Cao said.

According to the Supreme People's Court, just over 1,000 bankruptcy filings were submitted to the nation's courts last year - a fraction of the 7.3 million or so civil and commercial cases filed during the year and the 800,000 companies that exited the market annually, on average, from 2005 to 2009.

The vast majority of failed companies, the data shows, chose not to go through formal bankruptcy procedures in court.

"Why has China's road of enforcing the bankruptcy law been so tough? It's mainly due to two misconceptions," Cao said.

"One is the belief that bankruptcy belongs to the world of capitalism and is against the interests of the socialist system. The other is a misunderstanding that declaring bankruptcy means putting an end to a business, and that is bad for the economy."

Such misunderstandings clouded the launch of the trial bankruptcy law in the 1980s and continue to hinder the smooth running of the law today, said Cao, widely recognised as the brains behind the drafting of the trial law.

"People have yet to fully realise the positive role of the bankruptcy law in terms of keeping the society and economy in order and encouraging the survival of the fittest through competition," he said.

To help achieve this outcome, Cao added, the mechanisms for electing and evaluating the performance of local governments also needed to be changed so as to tackle the obstacles that had hindered the enforcement of the bankruptcy law enforcement.

"For local government officials, having corporates pursue normal bankruptcy procedures when they are insolvent should be a showcase of operating a sound local legal environment instead of a face-losing matter that hurts their political careers."

Cao first floated his idea of a bankruptcy law for China in an article published in 1980 while he was a graduate student at the Chinese Academy of Social Sciences. By 1986, when the draft law got passed, he said he had published 99 articles on the matter in the mainland press in a bid to boost public understanding of the law.

The intensive efforts made by Cao and his prominent role in pushing forward the launch of the bankruptcy law earned him the nickname "Cao Pochan", or "Bankruptcy Cao".

Changing entrenched mindsets proved an uphill battle, although proponents of a bankruptcy law received a major boost in the autumn of 1984 from the tone-setting third plenary session of the Communist Party's 12th Central Committee meeting, at which members decided to reform the economic structure and transform the nation from a planned economy to socialist market economy, Cao said.

In 1984, a draft of the Law on Enterprise Bankruptcy and Reorganisation, authored by Cao, was published in the influential magazine Democracy and Legal System, spelling out the basic elements of a bankruptcy law.

Then a researcher at a think tank under the State Council, Cao helped Shenyang launch a test case in 1986 in which an anti-riot equipment plant filed the mainland's first case of corporate bankruptcy since the Communist Party took power in 1949.

The decision triggered "an earthquake", with workers gathering at the mayor's office to protest against losing their "iron bowls", but was resolved peacefully in the end, Cao recalled.

Since 1988, Cao has been running a private agency to offer advice to corporates about mergers and bankruptcies, and has often spoken at seminars domestically and overseas. His profile ensures that his views are frequently heard, and at the highest levels.

Still, he said, fears about the consequences of filing for bankruptcy remained so strong in society that many business owners chose to hide their wealth and secretly exit the market. Local government officials also did their best to stop businesses from declaring bankruptcy even when they were making heavy losses because of concerns this might stir up social instability and hurt their political careers, he said.

In reality, if a business files for bankruptcy, creditors might get some of their money back through the legal process and debtors also have a chance of being restructured to boost efficiency.

The provision of such a mechanism would also help businesses to stay vigilant against financial risks and be more self-disciplined about borrowing.

"A single shot on a bird is enough to keep all the other birds vigilant," Cao quipped.

To date, however, the bankruptcy law had been applied to only a limited number of corporates and very few financial institutions as the public believed the government was always ready to bail out troubled banks, he said.

Also, not one of China's thousands of city and provincial governments, with combined debt of more than 10 trillion yuan (HK$12.6 trillion) at the end of 2010, according to official audit results, has been ordered to go bankrupt, even though some are effectively insolvent after borrowing too much to finance infrastructure investment in the pursuit of high growth that secures the promotion of officials.

Provincial governments unable to repay debt should go bankrupt, as did Detroit, which last month filed the largest municipal bankruptcy in the United States, Cao argued.

"If the law's scope can be expanded and it can be properly implemented, I hope to see China have its first local government file for bankruptcy over the next three years," he said.

If any local government becomes the first to go bankrupt, the authority in trouble should start selling off its luxury office buildings and unnecessary official vehicles, trim staff and cut costs to repay as much as possible of the debt before the next administration was elected, he said.