Protection of Creditor’s Rights Under the Chinese Bankruptcy Law – Revocable Transfers and Preferential Payments

March 13, 2017

Chinese bankruptcies have surged recently as the government uses the legal system to deal with “zombie” companies and reduce industrial overcapacity as part of a broader effort to restructure the economy. According to figures from the Supreme People’s Court, Chinese courts accepted 5,665 bankruptcy cases in 2016, an increase of 53.8% from the previous year1. As the Chinese government and the courts become more receptive to bankruptcies, without a mature market-based credit system in place, the risks heighten that debtors and creditors could try to game the bankruptcy process. 

In part to address this issue, like in many countries, the Chinese Bankruptcy Law gives bankruptcy administrators the right to revoke certain payments and transfers of assets within a statutory period before the commencement of bankruptcy proceedings. This right of revocation ensures that the debtor’s properties are properly preserved and creditors are treated fairly. Specifically:

  • Revocable Transfers. If the following acts happen within one year before the Court accepts a bankruptcy application, they are revocable: transfers of assets free of charge, transactions at obviously unreasonable prices, providing collateral for unsecured debts, repayment of debts which have not come due, or waiver of debts owed to the bankrupt enterprise.2

  • Preferential Payments. Repayment by a bankrupt debtor to individual creditors will be treated as revocable if they are made (i) at a time when the debtor is insolvent during the six months before the court’s acceptance of the bankruptcy application and (ii) so long as the payment does not benefit the bankruptcy estate of the debtor. Payments made in accordance with a court ruling or arbitral award are not considered preferential payments and are exempt from this rule.

The table below compares the two categories of revocable acts.

 

Covered Acts

Time of Occurrence

Exceptions

Defense

Revocable Transfers
  • transfer of assets free of charge
  • transaction at obviously unreasonable price
  • providing collateral for unsecured debts
  • prepayment of debts
  • waiver of debts owed to the bankrupt debtor 

within one year prior to a court accepting the application for bankruptcy

no

no

Preferential Payments

repayment to individual creditors

within six months prior to a court accepting the application for bankruptcy

(1) debtor's property benefits from such repayment; or
(2) repayment made pursuant to a court ruling or arbitral award

the debtor was solvent

I. Proceedings in Revocation Lawsuit

In general, revocation proceedings must be initiated by the court-appointed administrator in connection with the bankruptcy proceedings. If the administrator wins the action, the transaction will be revoked and relevant properties will be returned to the bankruptcy administrator for further handling.

A creditor does not generally have standing to initiate such a revocation action during the bankruptcy proceedings. However, within two years after conclusion of the bankruptcy proceedings, a creditor may petition the bankruptcy court in respect of a revocable act that is not caught by the bankruptcy proceedings. The theory is apparently to discourage the bankruptcy process from being used to defraud creditors where a debtor seeks to escape liabilities through the bankruptcy process and transfers assets prior to the bankruptcy proceedings to third parties for safekeeping.

II. Issues

(i) Absence of Intent in Cases of Revocable Transfers

It is notable that the Bankruptcy Law does not require a showing of intent for a transaction to be revocable. Such actions are considered “fraudulent” per se if they happened within one year prior to the initiation of the bankruptcy proceedings. The bankruptcy administrator and creditors also have rights to void fraudulent transfers, but that requires a showing of intent.

The per se rule for revocable transfers under the Chinese law obviously makes life easier for the bankruptcy administrator and creditor. However, some issues arise from this approach. Transactions in the ordinary course of business, even without harming creditors, may be subject to revocation. For example,

  • if a debtor, within the one-year statutory period, sought to forestall creditors by offering a guaranty on an existing loan in order to extend the repayment period for the loan, such guarantee would be revocable; and
  • charitable contributions within one year before the bankruptcy could be similarly revocable as lacking sufficient consideration.

(ii) Heavy Burden of Proof to Show Preferential Payments

Similar to the US rule governing preferential payments, China’s Bankruptcy Law frowns on “repayment to individual creditors” prior to the commencement of bankruptcy proceedings. However, there are some notable differences. Under US law, only payments made to creditors within 90 days before the bankruptcy proceedings (one year in the case of payments to an “insider”) can be revoked as preferential payments under a rebuttable presumption that the debtor was insolvent during this period. In other words, the burden of proof is on a creditor to prove that the payment should not be revoked because the debtor was solvent when the payment was made. By contrast, under the Chinese law, a payment to a creditor may be revoked if it was made within six months prior to commencement of bankruptcy proceedings and if the administrator is able to prove that the debtor was insolvent at that time—i.e. although the preference period is longer, the burden of proof is on the bankruptcy administrator. 

(iii) Irrevocability of Payment Made in Litigation, Arbitration, or Enforcement Procedures

If a debtor pays an individual creditor pursuant to a court ruling or arbitral award, such payment is not subject to revocation as a preferential payment except in the narrow case where the bankruptcy administrator can prove that the debtor maliciously colluded with relevant creditors to jeopardize the interests of other creditors. At best, this rule will encourage creditors to be quicker to bring legal proceedings, making it harder for a debtor to try to avoid bankruptcy. At worst, to the extent it would be difficult for a bankruptcy administrator to prove collusion between debtors and creditors in connection with preferential payments outside court proceedings, it potentially creates a significant loophole for a debtor and its preferred creditors to bankruptcy-proof preferential payments.  

(iv) Revocability up to Two Years After Completion of Bankruptcy Proceedings

The rule allowing creditors to seek revocation of transactions within two years after the completion of the bankruptcy proceedings calls into question the closure and certainty that otherwise is supposed to come from bankruptcy proceedings. Creditors who have received payment within one year before the commencement of the bankruptcy proceedings (such as a bank) may not have closure until two years after the bankruptcy is completed.

III. Observations

In an opinion issued by China’s Supreme People’s Court in 2015, the Supreme Court called on local courts to urge bankruptcy administrators to examine debtor’s transactions made prior to the acceptance of a bankruptcy case and to encourage and facilitate the exercise of revocation rights by administrators. In addition, local courts are also required to help with coordination if administrators need cooperation from government agencies to exercise such revocation rights.

This is arguably a signal of the government’s desire to see that creditors are treated equitably through the bankruptcy process. However, it is also likely that local courts may not be that warm-hearted if the only thing at stake are the interests of foreign creditors. Unfortunately, bankruptcy proceedings are still reportedly subject to interference from local government officials, who rarely prioritize offshore bondholders. Moreover, PRC courts exercise wide discretion in bankruptcy cases, and it is rarely transparent what standards are applied to such acts of discretion.

*O’Melveny recognizes legal consultant Siyu Hu for his valuable contribution in researching and drafting this article.

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2. These acts are described in Article 31 of the Bankruptcy Law. It should be stressed that transfers of assets described under Article 31, which are revocable, should be distinguished from transfers of assets described under Article 33, which are void ab initio regardless of when the transfer took place. Specifically, under Article 33 hiding or transferring property to avoid creditors, fabricating debts or recognizing unreal debts would all be treated as void.

O'Melveny & Myers LLP is a foreign law firm registered with the Ministry of Justice of the People's Republic of China. Under current Chinese regulations, we are allowed to provide information concerning the effects of the Chinese legal environment, but we are not authorized to practice Chinese law or to render legal opinions in respect of Chinese law. We work in cooperation with a number of Chinese law firms. Should you require a legal opinion in respect of any Chinese law matter, we would be happy to assist you in obtaining one from a Chinese firm.

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