China's Hidden Bankruptcy

Throughout 2008, only 3,500 enterprises formally filed for bankruptcy in China. Hiding behind this tiny number however is the approximately 800,000 businesses that exited the market by either canceling their registration or having their business license revoked.

The rise in the number of these hidden bankruptcies has emerged since a new bankruptcy code came into force in China on June 1, 2007.

In order to solve problems that have emerged since the introduction of the new legislation, the Supreme People's Court has accelerated it's timetable to release judicial interpretations of the law.

The draft interpretation of the law on enterprise bankruptcy, which consists of more than 200 provisions, has already been circulated among judicial circles. In coming months, a new draft will be unveiled for feedback and advice from related authorities and the public.

After amendments based on suggestions received from stakeholders, the interpretation of the law on enterprise bankruptcy will come into effect next year.

Professor Li Shuguang, the vice principal of China University of Political Science and Law's Graduate School, noted that currently "the biggest problem is that hardly any enterprises have filed for bankruptcy." As one of the authors of the current bankruptcy law, he has paid close attention to its implementation.

According to Li, the huge gap between the number of businesses seeking bankruptcy and those exiting the market via other means demonstrated that most enterprise withdrawals were not in accordance with the procedures as stipulated by China's Law on Enterprise Bankruptcy.

"Among those 800,000 enterprises, some managed to responsibly resolve issues related to creditors' rights and to settle their debt, but many enterprises simply cancelled their license or registration in order to avoid debt obligations. This kind of withdrawal can be deemed as malicious bankruptcy or even credit fraud."

Li noted that there were far more bankruptcy cases when the former corporate bankruptcy law, introduced in 1986, was in effect. At that time bankruptcy was mainly instructed by government policy.

According to Li, these new methods of withdrawal provide no guarantee for creditors' interests and also bring about a higher risk of credit default in the market as a whole and amounted to a huge waste of quality assets.

Not only were these enterprises not making use of the market exit mechanism provided by the Law on Enterprise Bankruptcy, but in doing so, they also failed to take advantage of the the market economy's ability to efficiently allocate resources.

He believed that government intervention was the major cause of the huge drop in bankruptcy cases, saying "the Government has intervened too much in the market."

Prof. Li said, the reason a lot of enterprises that should make use of bankruptcy procedures don't, is because so many government officials fail to recognize that bankruptcy is a common method utilized by market economies. Bankruptcy procedures are used by market economies as a way to allocate resources.

A case in point was the bankruptcy of Sanlu Group, the dairy company at the heart of the melamine contamination scandal last year. Owing to governmental intervention, the Sanlu bankruptcy left a lot of unsolved problems behind.

"The new law put an end to government-endorsed bankruptcy and eliminated the use of incentive measures like the writing off of bad debts from banks, etc.," said Prof. Li. "This is one of factors that has contributed to the downturn in the number of bankruptcy cases."

According to Wang Xinxin, a law professor at Renmin University of China and also a expert adviser for the drafters of the bankruptcy law's interpretation, officials need to fully understand the way in which the law on enterprise bankruptcy plays a role in the allocation of social resources.

Aside from establishing a procedure for enterprise liquidation, the law also contains important provisions regarding mechanisms to save enterprises in financial trouble.

Many areas lacked special courts devoted to handling bankruptcy cases and this hampered the courts ability to handle bankruptcy cases, according to attorney Yun Zhengyou, a partner of Beijing's Wei Heng law firm who also served as director of the committee which dealt with China's first bankruptcy case.

No Chinese financial institution has declared itself bankrupt since the financial crisis hit.

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