The legislation means workers' claims will no longer be regarded as secured assets in the event of insolvency CHINA'S RECENT PASSING of the new Corporate Bankruptcy Law on August 27, a Sunday, marked a significant step forward in the country's protection of creditors. It was also unexpected. 'China always catches you by surprise when approving legislation,' said Jackie Muk, partner, restructuring, at accounting firm KPMG. 'We have been talking about this draft bankruptcy law for over two years and no one expected it to pass now. Certainly not on a Sunday.' Existing legislation in China provides no easy way to liquidate a company or share the assets between creditors and workers. The new law gives creditors greater protection if a company is bankrupt, whereas in the past employees were paid off first. The move brings China more in line with international practices, where it is standard to pay creditors first. The bill will also permit firms struggling financially to request reorganisation and reconciliation with clients. The Corporate Bankruptcy Law applies to state-owned enterprises (SOEs) and privately owned companies, foreign and domestic alike. The law has been several years in the making. The draft law, which passed its ninth reading in October 2004, was expected to be approved last year and come into effect early this year. But its passage into legislation was held up by two issues. First, the question of whether to give priority to secured creditors or employees of the bankrupt company. Second, the test for insolvency. The first draft of the proposed bankruptcy law contained provisions for a balance sheet test and a cash flow test. To determine whether a debtor company was insolvent or not, the creditors had to show that it failed one or the other test. In the revised second draft, both tests had to be satisfied before a debtor company could be regarded as or proved to be insolvent, a requirement that critics argued would be difficult to satisfy in practice. Deciding whether to give priority to secured creditors or the employees of a bankrupt company was always going to be controversial. The Chinese government has long protected employees in China, most of whom were employed in SOEs. According to Alan Tang, partner and head of restructuring, insolvency and investigation at Grant Thornton, the State Council in 1994 issued a document stating that in the case of employee claims from major SOEs in bankruptcy, the secured assets had to be used to settle employee claims first. 'This concept is viewed from a different perspective in the west, where it would be unimaginable to use secured assets to pay off employees' claims,' Mr Tang said. The gap between international and mainland practices was recognised early in the redrafting process. The new law has settled the issue. In Article 132, the new law states that China will follow international practice and secured assets will belong to the secured creditors. Employee claims will not be allowed to eat into secured assets except in cases relating to claims that have accrued up to the date of promulgation of the new law, August 27, 2006, the day it was passed by the National People's Congress. Any employee claims accrued before and up to that date will stand a chance of being seen as a secured asset. 'The way I see it is that this particular change is very much in favour of the secured creditor,' said Rainier Lam, partner, PricewaterhouseCoopers. The new law applies to all companies, with the exception of certain SOEs that have already been subject to bankruptcy provisions as promoted by the State Council before June 1, 2007, when the law was effective. There are about 2,000 such large enterprises. According to the most recent data, released in October 2004, these enterprises belong to the so-called 'sunset' industries - un-modernised, unproductive, old and loss-making. Mr Tang of Grant Thornton said the new law and some of its provisions would cause a flood of bankruptcy cases. Not only had the scope of the new law been expanded to include non-SOEs, the mechanisms involved in declaring bankruptcy had been simplified, he said. Under the present system, the number of bankruptcy cases is between 5,000 and 8,000 each year. But the existing law allows only insolvent SOEs to be classified as bankrupt. Under current rules it is difficult for creditors to go to court and apply for bankruptcy of a debtor company, nor can a debtor company go to court and apply for its own bankruptcy. But under the new law, anyone, including the debtor company, can apply to the People's Court for bankruptcy. 'Under the existing and new laws, the process of bankruptcy comprises an element of reorganisation and reconciliation,' Mr Tang said. 'I can see under the new law a debtor company taking an active stand to go to court to apply for its own bankruptcy so that it gets attention from creditors and breathing space to start reorganisation and reconciliation with customers.' But KPMG's Mr Muk disagreed. 'I would like to see a flood of bankruptcies, but I don't think it will happen,' he said. 'Realistically, a lot of companies in China are having financial difficulties. There won't be a flood of bankruptcy cases just because of the passing of this law. 'Having said that, the law is effective June 2007 and there may be a small increase in the number of bankruptcies over the next few months just to ensure they use the old rules to do their bankruptcy filing. That's a possibility. But it won't be a huge number.'