, 33267 THE WORLD BANK East Asia and Pacific Region Private Sector Development Unit BANKRUPTCY OF STATE ENTERPRISES IN CHINA -- A CASE AND AGENDA FOR REFORMING THE INSOLVENCY SYSTEM -­ Washington, DC September 20, 2000 FILE COPY. , PREFACE Many state-owned enterprises in China are today loss-making or non-viable, and a large number have since long been in default to their creditor banks. Credit allocation and asset reallocation are thus not as efficient as they could be. The importance of this issue has been recognized by the authorities and both short term targets to curtail loss-makers among the state owned enterprises, and the longer term objective of fundamental enterprise and financial sector reform are high priorities for the country's leadership. As business failures are a universal feature of competitive markets, effective insolvency and creditor rights systems are fundamental building blocks of sustainable development. While there are a wide variety of national insolvency regimes, all effective systems provide clear procedures to manage financial distress, facilitate predictable risk sharing and establish a binding, collective proceeding to maximize the value of the firm's assets, whether as a going concern or in liquidation. The existence of such a framework facilitates access to credit and underpins contract enforcement. Hence, effective insolvency and creditor rights systems are important to both domestic and international investors and creditors, and are crucial to reducing the risks of financial instability and handling financial crises when they occur. The bankruptcy regime in China has had a number of positive outcomes. It has allowed the bankruptcy of more than 20,000 enterprises, of which more than half were SOEs. In the process, it has reallocated many assets, often to stronger firms, to more efficient uses, and/or to non-state operators. Most fundamentally, this has been achieved while maintaining social stability and avoiding financial system collapse. Moreover, the, system has built practical experience in courts and local administrations, as well as in valuations and auctioning, and it has helped to create some public understanding of bankruptcy, and acceptance of the principle by workers and officials. . However, these achievements have come at high costs. With social stability and municipal development interests prevailing over creditor interests, creditors have generally achieved very low recovery rates. This result has affected banks' balance sheets directly; has deterred banks from initiating bankruptcy themselves; and has affected their willingness to lend. The absence of personal bankruptcy legislation is further hampering the development of lending to smalVmicro enterprises and consumers. For managers and owner representatives of SOEs, bankruptcy has been a temptation rather than a threat. Bankruptcy has lost much of its motivating force for good governance and management, and for corporate restructuring. Although the court process itself has generally been quite fast, it often takes a long time for the local government to decide on the bankruptcy route and secure the debt write-off. It has also been difficult to liquidate assets under the current process which often leads to unrealistically high valuations. The long run-up to bankruptcy filing, and to a certain extent the proceedings while management stays in place, could lead to asset stripping. Moreover, the environment has been changed drastically since the Bankruptcy Law was introduced in 1988, and even since the debt write-off program was initiated in 1994. Social liabilities such as pensions and unemployment benefits are now rapidly becoming pooled beyond the individual enterprise, town, and sector. Financial sector stability is now receiving higher priority than before the region's financial crisis. The bankruptcy regime is based on the notion of a wholly state-owned enterprise with state banks as creditors and with workers interested solely injob security and wage or severance/pension income. Today, however, many SOEs have non-state minority shareholders or joint venture partners. Trade creditors are becoming more sophisticated, and large firms have bondholders or borrow abroad through window companies. Employees have large deposits in banks and 30 million citizens own stock, giving them stakes beyond their wage income. The technical capacity of courts, restructuring agents, and support professions has been growing, albeit at uneven pace and with important gaps. Finally, the important role of the private sector has been embraced constitutionally, as well as practically for employment generation. These changes call for less administrative u 4 .3 __ 21 , At • '" I intervention in bankruptcy cases, for more regard for non-state creditors, and for ensuring that private debtors are subject to an effective bankruptcy system. This study reviews the principles and actual implementation of China's bankruptcy system for state enterprises, assesses the system in light of the changing environment and lays out a large number of specific recommendations, concerning the policy, legal framework, procedures, and institutional capacity for state owned enterprise bankruptcy, and China's credit system more broadly. The main empirical basis were interviews in five cities, with an emphasis on a sample of 15 specific bankruptcy cases. The cities Shanghai, Shenyang, Changsha, Wuhu, and Loudi represent a wide range of town size, and legal/business infrastructure development. Some of them were included in the government's pilot debt write-off program ("Capital Structure Optimization Program"). Apart from the case studies, interviews were conducted in these cities as well as at the national level with representatives of government agencies (responsible for SOEs, banks, labor/social security, land, etc.), the judicial and legislative system, banks and other creditors, service professionals (valuators, accountants, lawyers, etc.), and debtor enterprises. The study team was led jointly by Klaus Lorch and Loup Brefort, and included Messrs./Mmes. Cliff Garstang, Carmen Genovese, Gordon Johnson, Shenhua Wang, from the World Bank and Li Shuguang (China University of Law and Politics), Wu Valin (Deloitte Touche Tohmatsu). Messrs. Chunlin Zhang and Daochi Tong (World Bank) provided additional inputs. The State Economic and Trade Commission (SETC), particularly through the Merger & Bankruptcy Office and Loss-Making Enterprises Turnaround Office within its Enterprise Reform Department supported and facilitated the study for its successful implementation. Messrs. Shao Ning, Qin Yongfa, Liu Wenbin, Zhou Fangsheng and many of their colleagues provided valuable guidance and support throughout, and the fieldwork was supported by the Economic and Trade Commissions in each locality. A range of other government and non-government institutions and members of the judiciary at the central level and in the five municipalities also contributed information and perspectives. In particular, the study team owes a lot to ETCs of Shanghai, Shenyang, Changsha, Wuhu and Ludi for their assistance, insights and hospitality. A number of experts from government and academic institutions in Beijing participated in the discussion of the first draft of this report and made valuable contribution, among them are Prof. Wang Wei guo (China University of Law and Politics), Mr. Zhou Fangsheng and Ms. Liang Van (SETC), Prof. Feng Tongqing (China Labor Colleage), Messrs. Niu Nanjie and Li Li (Orient AMC). The Chinese version of the final report was translated by Prof. ' Wang Weiguo. We hope this study will provide all those interested in the development of a sound financial and enterprise sector in China with new ideas concerning the future development of an effective insolvency regime in China. Javed Hamid Director Private Sector Development East Asia and the Pacific January 2001 11 \ EXECUTIVE SUMMARY The Importance of a Good Bankruptcy System. Many state-owned enterprises (SOEs) in China are today loss-making or non-viable, and a large number have since long been in default to their creditor banks. Credit allocation and asset re-allocation are not efficient. The importance of addressing this issue is recognized in particular since China experiences slower economic growth, a regional investment climate still affected by the Asian crisis, and the challenges of global competition under WTO accession. A tbree-year target to curtail loss-makers among large SOEs and a longer~term objective of fundamental enterprise reform are high priorities of the country's leadership. So are the resolution of non-performing loans tbrough asset management companies to improve solvency in a fragile banking sector, and a shift of resources towards the increasingly private small and medium enterprise sector. All these initiatives require an effective and efficient system of reorganizing insolvent enterprises, and transferring resources out of non-viable uses and into more productive ones. In case of liquidation, the asset distribution to creditors should be fair and transparent. A well-working bankruptcy system, with its underlying tbreat to those who under-perform, should also be a driving force in the corporate governance exercised by the managers and owner representatives of enterprises. Neighboring countries further learned off late the necessity of an effective bankruptcy threat for resolving widespread corporate distress. With China's move to a market economy, wider issues must be addressed as well: The inability of workers to share a large portion of the social burden oftransition due to widespread employment and the redefinition of firms' social responsibilities; the risks for state-owned banks to continue assuming a large financial burden from SOE insolvency; and the desirability of transforming enterprise ownership and promoting market-led restructuring to permit the state to concentrate on its core responsibilities. Purpose and Methodology of the Study. This study reviews China's bankruptcy system for state enterprises, assesses it in light of the changing environment, and lays out recommendations for the short and longer term. The report gives primary attention to financial aspects, social dimensions, legal principles, and institutional issues. The main empirical basis were interviews conducted in a diverse set of five cities (Shanghai, Shenyang, Changsha, Wuhu, and Loudi) in mid-1999, and a special sample of 15 bankruptcy cases. The main counterpart of the study has been the State Economic and Trade Commission (SETC), particularly its offices on Merger & Bankruptcy and on Loss-Making Large Enterprises. Summary Assessment. The study finds that bankruptcy of state and non-state enterprises has been quite widespread since the mid-90s, with more than 25,000 cases. Recent years saw even bankruptcy cases of very large SOEs, listed firms, foreign joint ventures, financial institutions, and debtors with large foreign liabilities. By now, the notion and importance of bankruptcy are widely accepted among China's leadership and public. Considerable experience has been gained and capacity built. This has allowed. state enterprise bankruptcies, once filed, to proceed quickly in the courts. Most importantly, social and financial stability have been maintained. All this also provides a foundation on which to build an improved insolvency system. The current insolvency system does need reform. While there are today several parallel insolvency regimes ­ for SOEs under a pilot program, other SOEs, non-state corporations, and some special economic zones -­ most are quite spotty, and practically none applies to natural person enterprises. A new bankruptcy law, whose drafting is well advanced, should be introduced without delay and apply in principle to all forms of enterprises. Its application to SOEs that are not incorporated or operate in special public interest areas, however, would best be phased in within 3-4 years after further strengthening ofthe social security system. The study concentrates on the bankruptcy of SOEs. If finds, first, that their bankruptcy process is unfriendly to creditors and hardly an effective "stick" to motivate enterprise performance. Creditors have little influence on the process, are treated inconsistently, and suffer violation of their secured claims for the sake of settling III $4 A ., I affected workers .. Creditor banks commonly recover only 3-10% of their claims. Second, bankruptcy seems often not to lead to an efficient reallocation of resources. Procedural and institutional shortcomings make the insolvency process vulnerable to irregularities; secondary markets for assets are underdeveloped; and restructuring alternatives to liquidation are few. The newly established asset management companies could foster positive changes here if they enjoyed sufficient freedom of action. Third, the entitlements of labor affected by SOE bankruptcy are quite substantial under a special program that applies to the larger SOEs. Combined with incomplete pooling across firms, this has deferred many bankruptcies a long time for lack of funds. Tight limits on the debt write-off by banks have also delayed many bankruptcies. In the meantime, many workers languish in half idle factories with neither full current nor lay-off pay, assets are neither efficiently used nor recycled to better uses, and moral hazard further weakens the firm. To address these various deficiencies, the report makes a large number of specific recommendations concerning the policy, legal framework, procedures, and institutional capacity for SOE bankruptcy, and China's credit system more broadly. While concerns for social stability will remain the overriding constraint to the scope and nature of SOE bankruptcies, and local-center tensions will continue to affect implementation practice, a window of opportunity for reform is gradually opening up. Social security is increasingly getting pooled; the Asian crisis brought more attention to financial system soundness; the rule of law has lately been enshrined in the Constitution; and ownership diversification and private enterprise are now officially acknowledged. The Evolution of Bankruptcv. A Trial Law for State Enterprise Bankruptcy (hereinafter: Bankruptcy Law) was introduced as early as 1986. For years, it remained rarely applied. This started to change in 1994 with a special Capital Structure Optimization Program (CSOP) for industrial SOEs in a few pilot cities. This program addressed social constraints by earmarking land use rights (LURs) of the liquidated debtor to pay for the "rehabilitation" of its workers, and ensuring that the firm's main social facilities are taken over by the municipality. The firms for this program have been selected quite administratively and the process, although involving the courts, has largely been handled by local government representatives. The creditor banks have little choice but to allocate to these cases a substantial portion of their annual write-offs, which are tightly capped by tax rules; this created the notion of a "debt write-off quota" under the CSOP. Later, a degree assigned even mortgaged L URs to labor rehabilitation, and the program was expanded to most large towns. With these changes, the number of SOE bankruptcies under this program skyrocketed in 1996 to some 1,100 cases that involved 680,000 workers, RMB 43 billion liabilities and more than RMB 10 billion write-off quota. More recently, the program got concentrated on larger firms so as to help achieve a three-year target of slashing the number of loss-makers among large and medium SOEs. Hence, the number of new cases dropped to 133 last year but still involved about half a million workers and RMB 18 billion debt write-off quota. Bankruptcies multiplied in the mid-90s not only under the CSOP, though. The annual number of all bankruptcies together rose from 277 in 1989-93 to 2,100 in 1994-95 and further to 5,640 in 1996-97. In that latter period, more have half the cases were SOEs, of which three quarters were small SOEs outside the CSOP. In these two years together, as many as 1.5 percent of all SOEs entered bankruptcy proceedings. Unifying the Bankruptcy System. Non-SOE bankruptcies involved mainly firms with collective, private, and mixed ownership. Such cases fall under some rudimentary provisions in the Civil Procedures Law and Company Law, and Opinions of the Supreme Court, and sometimes additional provisions of Special Economic Zones. The deficiencies of this sketchy framework have shown in the bankruptcy of Guangdong International Trust & Investment Corp. (GITIC) and other cases involving large listed debtors or foreign creditors. Natural person enterprises and individual persons are not yet subject to any bankruptcy regime. In total, we see a proliferation of bankruptcy regimes and yet many gaps and flaws. A new bankruptcy law has been drafted in 1995-96. It would apply to state and non-state enterprises, and cover also natural person enterprises. The draft largely resembles the bankruptcy laws of market economies. iv , For example, it envisages a proper trustee function, strengthens the role of creditor committees, and provides an elaborate option of court-supervised reorganization that can be initiated by debtors. Despite its quality, the draft has not yet been submitted to parliament. The Government and Party seem concerned that the social implications of SOE bankruptcy, if pursuant to the new uniform law, could slip out of their control. Legal experts, on the other hand, have been reluctant to give up the notion of uniformity and inject a chapter on special treatment of SOEs. This study recommends to introduce the draft new bankruptcy law in the near future, with minimal delays for further drafting improvements. We suggest that the new law not differentiate between state and non-state enterprises but that its effectiveness for state-owned debtor enterprises that are not incorporated or operate in non-competitive sectors be left at the discretion of the Government to decide but in any case no later than the year 2003. Until such time, those enterprises would remain under the present SOE bankruptcy law. The CSOP be ended no later as well, and apply improvements in the meantime. For incorporated SOEs in competitive sectors the new law would be effective immediately. To minimize the transition period, financial and social system reform should be deepened and accelerated. This will create the conditions that will ultimately permit the state enterprise sector as a whole to be subject to the new bankruptcy law and to abandon the old bankruptcy law altogether. Deepening the Involvement of Creditors. SOE bankruptcy has largely served to cleanse the assets of liabilities after the authorities have decided on the future use of the business (under "whole takeover" of the entire asset bundle and employees) or key assets (such as land use rights). Protecting the interests of creditors has been a lesser priority. The bankruptcy process lacks the transparency that would come with independent decision-making and involvement of the creditors. The court-appointed liquidation commissions include mainly agencies that represent enterprise owner and employee interests. They should ideally be replaced with independent experts or, less desirably, supplemented by creditor representatives; even if the latter had no vote their participation could raise transparency. There is also a creditor assembly, but as long as they get engaged only late in the process, have few powers, and are not more actively encouraged by the courts few creditors other than the main state-owned commercial banks show up. To enhance their influence, courts could choose to treat the assembly's right to be consulted as a veto right. Moreover, the creditor meeting could be given more legal recourse, for instance, to contest the fairness of the proceedings rather than merely the denial of a bankruptcy petition. Treating Claims More Consistently. In implementation practice, SOE bankruptcy does not always stay all creditor claims in a systematic manner. For example, the purchaser under a "whole takeover" might assume bank debt but not other payables. Trade creditors in particular are often virtually ignored. The order of priorities among social claims has varied at times from the law, too. Even the payment of employee rehabilitation fees has occasionally been inconsistent among the employees of a firm beyond a desirable degree of flexibility. Such instances stem often from weak procedures or institutional capacity. Reducing the Vulnerability to Irregularities. Disregard for creditor interests, inconsistent treatment, and inefficient reallocation of assets are frequently the result of irregularities to which the SOE bankruptcy regime is vulnerable. (i) The review of pre-bankruptcy transactions by the liquidation commission tends to perfunctory. It should be mandated to present a report on its review to the court. (ii) The firm's top management often remains in place throughout the bankruptcy proceedings. More rapid replacement would reduce moral hazard. (iii) Asset valuations are carried out by entities that are licensed by and commonly affiliated to the local government that dominates the bankruptcy process. A recent policy by the Ministry of Land and Resources to spin off land valuation entities and have them supervised at a higher administrative level should be resolutely implemented. (iv) Not for all assets of the estate are attempts made to dispose on competitive markets with open access and wide and early advertisement. The establishment of land exchanges should be accelerated. Auction rules should ensure more transparency and accollntability (conflicts of interest, legal recourse against auction houses, etc.). (v) The purchaser under "whole takeover" is often selected before the bankruptcy application and, if state-owned, may get its arms twisted to rescue a non­ viable facility. In such takeovers, too, competition and transparency should be fostered. Public tender, v including negative-price tenders and investment tenders, could be used more widely. The access of potential non-state and foreign buyers to bankrupt SOBs could be facilitated in non-critical sectors. Limited institutional capacity has been another source of irregularities and inefficiencies. While groups of judges in large cities have accumulated considerable bankruptcy experience, small-city courts have not. Moreover, courts are not entirely independent from the authorities. One might contemplate more frequent transfer of cases to higher courts, more rotation of judges, and perhaps specialized bankruptcy chambers for entire regions. Bankruptcy should also get more attention in the education of judges, and at accounting institutes, business schools and law schools in general. Special training and certification could help build the trustee profession that will most likely be needed under future bankruptcy legislation. The capabilities of AMCs and banks in bankruptcy and work-out would benefit from enhanced technical skills, stronger incentives for credit collection, and insolvency specialists contracted with adequate incentives. A central institution could be appointed to help, under and beyond the CSOP, to help reveal irregularities in bankruptcies, disseminate good practice, promote relevant education, and develop the trustee profession. Realizing the Potential of the Asset Management Companies. Four AMCs have lately taken over many non-performing loans from state-owned banks. These AMCs could become driving forces for bankruptcy and reorganization if they had adequate autonomy, tools, and capabilities. The AMCs could use various strategies to enhance their voting power in the creditor assembly. To facilitate the cooperation of AMCs with banks in cases where both hold credit claims, the banks need more scope for debt write-off and debt restructuring. Government-owned AMCs could get the right to initiate bankruptcy against SOEs without line bureau approval, at least in non-critical sectors. A first bankruptcy filing by an AMC incurred last winter, against a larg~ listed firm. To send the right signals, it is important that the country's leadership fully support such pilot cases. Broadening the Options for Reorganization. Many insolvent enterprises might become financially viable after thorough reorganization. For Chinese SOEs, however, there are only few options for out-of-court and in-court reorganization, and creditors have only limited influence on the process. As a result, restructuring has often not taken place at a point when the debtor still a fair chance of recovery. Out of court, the main restructuring option for an insolvent SOB is merger. Such mergers are eligible to debt write-off quota under the CSOP. However, the CSOP and its quota are limited in scope, and tax rules discourage banks from write-off by banks outside the quota. Court supervised reorganization is foreseen under the Bankruptcy Law, but it is rare since the creditors have no right to initiate it and the debtor and its line bureau would rather initiate merger or "whole takeover" instead. The "whole takeover" is a liquidation, legally speaking, but the whole bundle of assets, most employees, and the pension liabilities are transferred to the acquiring firm. Not transferred are the liabilities towards banks and other creditors. What's more, the creditors have little influence on the decision to pursue "whole takeover" and can not ensure accurate valuations and sale at fair value. Since it often is little more than a cleansing of debt at the expense of creditors, Beijing has lately discouraged "whole takeover". The report recommends to revisit the regulatory framework for conventional workout practices such as maturity extensions and "haircuts" of loan principal. Since reorganization is often dependent on new capital, a legal framework remains to be developed for super-priority or debtor-in­ possession lending of fresh money to firms under insolvency proceedings. To allow better pricing of risk, the interest rate ceiling could be raised in the short term at least for loan rescheduling or new lending to firms under court-supervised reorganization. Also, the 1% cap on the tax recognition of loan loss provisions should urgently be lifted. A framework for secondary markets of debt should also be developed. The sale of loans should not be dependent on the cooperation of the debtor. Controls against state sector entities selling loans or assets from liquidation beneath their appraisal value could be relaxed if the sale is done competitively. The access of foreign or foreign-invested financial institutions to distressed yuan debt could be facilitated. The legal framework for industrial investment funds, which covers also turnaround funds that buy distressed debt or equity to restructure them for profit, should be finalized. VI , Safeeuarding Secured Interests of Creditors. The protection of secured interests is critical for the stability of the financial system and the scope of bank lending. The Bankruptcy Law excludes secured claims from the estate. However, a ministerial degree subsequently allowed mortgaged land use rights (LURs) to be used for employee rehabilitation expenses under the CSOP. It failed to stipulate that they be applied only after unencumbered LURs, and even indicated that they be applied prior to unsecured claims on non-land assets. This priority of worker rehabilitation over security interests has allowed more bankruptcies since it addressed concerns about socio-political stability and shifted financial burden from local governments (for covering shortfalls in worker rehabilitation fees) to the central authorities (for bank recapitalization). However, this priority should be carefully revisited as reforms in the social security systems and other parts of the environment are taking hold. Moreover, the occasional practices to use mortgaged LURs for labor compensation even in bankruptcies outside the CSOP, or to give worker entitlements priority even over secured non-land assets, need to be suppressed. There are further, general limitations to security rights. Many mortgages and guarantees by SOEs date back to a time when their legal framework was weak, and were later upon bankruptcy ruled invalid on various technical grounds. Even after the new Security Law of 1995, security interests are not easy to enforce. Courts in the debtor's town appear often reluctant to recognize security interests held by out-of-town creditors, or to enforce the rulings of courts from there; this enforcement problem needs sustained attention by the Supreme Court. To relieve the workload of courts, some self-help could be permitted to secured creditors. There are also various difficulties stemming from security registration that more standard registration practices and better legal recourse against registration agencies could help to address. Guarantees could be better evaluated and enforced if they were more strictly disclosed. Security interest in movable assets would benefit from a broader range of instruments than currently applied. Funding the Settlement of Labor. SOE employees who are laid off by bankruptcy are commonly eligible to "rehabilitation" payments whose level has been substantial. Protests by workers or retirees of insolvent firms seem to often concern the non-payment of their entitlements and perceived corruption rather than the level of their rehabilitation or pension claims. The rehabilitation fee aims in part at maintaining average rather than minimum living standards. Since the fee is determined by a city's average wage in the SOE sector, the presence of well-paying national or provincial SOEs can drive the fee up to a level that prevents the bankruptcy filing for smaller local SOEs. The fee is also seen as a compensation for a worker's loss of status and security as SOE employee although benefits get increasingly monetized and social services moved out of SOEs. Furthermore, housing of the bankrupt enterprise usually gets transferred to the municipality which then lets the laid-off employees continue to use it without rent, or they end up getting ownership of the housing at a low charge. Some distressed SOEs have used their last resources and a final bank credit to construct apartments, thus sealing the fate of the business but providing the employees with the windfall of apartment ownership. The subsidy inherent in either approach to housing could be taken into account when calculating the rehabilitation fee. Urban land used by the SOE is commonly the most valuable asset in bankruptcy. Under the CSOP, it is used with priority for rehabilitation expenses. The proceeds from "allocated" (Le. free-of-charge) LURs of a bankrupt SOE have not been systematically pooled across bankruptcy cases. Consequently, an insolvent SOE that used little land may not be allowed to go bankrupt, while another SOE with a large lot does enter bankruptcy but the excess value of its LUR may get channeled to some municipal development project or disappear through non-transparent valuation and sale. Last March, the Ministry of Land and Resources called for independent valuators and for sale through land exchanges. It also asked to establish municipal funds that pool the proceeds from selling hitherto "allocated" LURs that have been taken back from any bankrupted SOE of the city and earmark the fund with priority to rehabilitation fees. Implementing these policies should now be a high priority. The government might consider going further and adopt a universal policy to phase out the hitherto grandfathered use of "allocated" LURs by SOEs except for special public-interest areas. By levying substantial annual charges on "allocated" LURs SOEs could be motivated to convert them into VII f granted status, i.e. buy the use right and make it their asset. Eventually, the conversion could be made mandatory. This would give· municipalities more revenue that could be pooled for bankruptcy related and other social expenditures. It would also lead to more efficient use of valuable urban land, less local rent­ seeking, and better disclosure ofa firm's true efficiency. The Changing Environment of Bankruptcy. Social factors have indeed been a critical constraint to SOE bankruptcy. If half of all those SOEs that made losses in 1998 were liquidated on grounds of insolvency, some 20 million people would join the ranks of the urban laid-off and unemployed in the short term. Moreover, SOEs traditionally provided their workers comprehensively with social facilities and security. However, these constraints are gradually loosening as social security is undergoing fundamental reform. SOEs are transferring their health and educational facilities to the municipalities and selling their housing to their employees. Medical insurance has been introduced, pension systems are being pooled, minimum social welfare is being improved and, as noted above, municipal funds are to be established for lay-off related expenses. Such fundamental reforms take time, though. SOE bankruptcy has also been circumscribed by institutional capacity and incentives. Creditor banks suffer from weak corporate governance. Local-level enterprises and administrations tend to cooperate against national-level creditor banks, at times even in collusion with such a bank's local branch manager. The owner of a local SOE is at the same time responsible for labor welfare and local development. It might also control the valuation firms, and even courts are not entirely independent. Some of these factors, too, have started changing and will continue doing so in the coming years. For example, the large state-owned commercial banks may soon get corporatized and eventually listed. Banks are also revamping their internal incentives and capabilities for loan approval and credit management. Valuation offices are to become independent, and the rule of law has recently been enshrined in the Constitution. Finally, reluctance to involve private and foreign investors in the ownership of hitherto state-owned firms has constrained their bankruptcy or restructuring. In many cases, such investors may have stronger restructuring expertise, better synergies, clearer incentives, and deeper pockets than the bureaucratic organs that represent the state ownership. In September 1999, the Fourth party Plenum ofthe Party Central Committee decided to focus the state's ownership control on a few special areas. Only in national security, natural monopolies and some pillar industries would the state retain controL Other SOEs should be corporatized, and changes oftheir ownership would be possible. It is those SOEs that are still not corporatized, and those in non-competitive industries that shall remain in state control, that we recommend to submit to a new bankruptcy law not immediately but only after some more years of reform in social security and institutional capacity. In the meantime, various interim improvements could be made to their existing bankruptcy regime. Other state-owned enterprises could be subject to a new bankruptcy law without delay. Introduction of such a new bankruptcy system is a particular priority for the non-state sector which is playing an increasingly important role in China's economic transition and growth. viii I LIST OF CONTENT Executive Summary ............................................................................................................................... i List of Content ........... ........... ............................... ............................ ...................... ..... .... ..................... vii I. Introduction .................................................................................................................................... . II. The Development of China's Bankruptcy System .......................................................................... 2 III. Review of the Bankruptcy System ..................................................................................................... 5 a. A Stereotypical State-Owned Enterprise Bankruptcy ...............................................................5 b. Financial Dimensions ................................................................................................................ 10 Bankruptcy as an Administrative Process ........................................................................... 12 Stakeholder Biases against Creditor Interests ..................................................................... 14 Protection of Secured Interests ........................................................................................... 15 Consistency in the Treatment of Claims ............................................................................. 17 Reorganization and Financing Alternatives ........................................................................ 19 c. Social Dimensions .................................................................................................................... 22 The Level and Variation of Lay-Off Compensation ........................................................... 24 The Ranking and Funding of Social Claims in Bankruptcy ............................................... 25 d. Legal and Institutional Issues ................................................................................................... 29 The Multiplicity of Bankruptcy Systems ............................................................................ 30 Consistency in Bankruptcy Regimes .................................................................................. 32 Preparation ofa New Bankruptcy Regime and its Phase-In for State-Owned Enterprises. 33 Need for Transparency and Standardization ofImplementation Procedures ...................... 35 Conflicted Institutional Roles and Need to Strengthen Capacity ........................................ 36 IV. Summary Assessment ..................................................................... ,............................................... 39 V. Recommendations for Reform ........................................................................................................40 a. Rapid Introduction of a New Bankruptcy Regime .................................................................. .40 b. Interim Improvements in the Bankruptcy of Non-Incorporated State-Owned Enterprises ...... .41 c. Enhancement of Institutional Capacity .................................................................................... 43 d. General Improvements in the Credit System ............................................................................ .44 Appendices A. Statistics on the Bankruptcy of State-Owned Enterprises in Four Cities ......................................... .ix B. Legal Texts Relevant for Bankruptcy in the People's Republic ofChina ......................................... x C. List of Readings ...............................................................................................................................xii IX Bankruptcies and Mergers under the Capital Structure Optimization Program, 1994-99 ........................ 3 The Capital Structure Optimization Program for Insolvent State-Owned Enterprises ............................. 4 Bankruptcy Cases Heard by PRC Courts ................................................................................................. 5 The Profile of Bankruptcies in Four Cities ............................................................................................... 8 Case Study: Bankruptcy and Good Management Can Lead to Good Use of Liquidated Assets .......... 11 Case Study: Bankruptcy as a Form ofInsider Privatization .................................................................. 18 Case Study: Bankruptcy May be a Better Deal than a Merger for an Acquirer but not for Creditors ..21 Case Study: Bankruptcy is Unsuccessful ifthe Use of the Assets Remains Non-Viable ..................... 22 "Granted" and "Allocated" Land Use Rights ......................................................................................... 26 Case Study: Issues of Housing and Land Use Can Defer Bankruptcy ..................................................29 Case Study: An AMC Sets a Precedent of Filing Bankruptcy against a Listed Firm ...........................31 Case Study: The Realization of Significant Land Value is not Shared with the Creditors ................... 3 5 x I BANKRUPTCY OF STATE ENTERPRISES IN CHINA - A CASE AND AGENDA FOR REFORMING THE INSOLVENCY SYSTEM­ I. INTRODUCTION In China today, many state-owned enterprises (SOEs) are loss-making or non-viable, and a large number of debtors have since long been in default to banks and trade creditors. l Credit allocation and asset re­ allocation are not efficient. The urgency to address this issue has been recognized in particular as the country has been experiencing slower economic growth, a regional investment climate still affected by the Asian crisis, and the challenges of global competition under future WTO accession. A three-year target to curtail the number of loss-makers among large SOEs, as well as a longer-term objective of fundamental enterprise reform are high priorities of the country's leadership. So are the resolution of non-performing loans through asset management companies to improve solvency in a fragile banking sector, and a shift of resources towards the increasingly private small and medium enterprise sector. All these initiatives require an effective and efficient system of reorganizing insolvent enterprises and transferring resources out of non-viable ones and into more productive uses. A well-working bankruptcy system, with its underlying threat to those who under-perform, should also be a driving force in the corporate governance exercised by the managers and owner representatives of enterprises. Moreover, the recent experience of neighboring countries has demonstrated the critical importance of an effective bankruptcy threat for resolving widespread corporate distress. Overriding concerns for labor welfare and social stability have hitherto been the main constraint to the scope and nature of bankruptcies in China. The administrative reallocation of enterprise assets for sundry development initiatives on the local level at the expense of creditors from other jurisdictions within China and beyond has added distortions to the process. A multiplicity of, and yet gaps in, bankruptcy regimes in China, has created further lack of clarity and legal security. While these social constraints and local-center tensions will persist in the foreseeable future, various other developments offer nonetheless an opportunity for substantial reform of the country's bankruptcy system. Social security is rapidly getting "pooled" beyond the individual enterprise, and supplemented by the transfer of housing ownership to employees. Political leaders, enterprise managers, and common citizens have become familiar with the concept of bankruptcy. Basic implementation c~pacity for bankruptcy has emerged through half a decade of practice in courts, liquidation commissions, and valuation offices. The rule of law has lately been enshrined in the Constitution, and important bankruptcy cases are signaling to enterprises not to count on bail-out by the state. Private enterprises are now formally acknowledged as an important element of the market economy that should be ruled by competition and law rather than administrative decision. A Plenum of the Party Central Committee has decided that state control needs to be retained only in natural monopolies, special public interest areas, and some pillar e'nterprises. The time has come to reform China's bankruptcy system. This study reviews China's bankruptcy system and assesses it in light of the changing environment. On this basis, the paper lays out recommendations for reform both in the short run and longer term. The bankruptcy system as defined here includes the policy approach, legal framework, processes and institutions. The note looks at the sequence from recognizing insolvency and deciding to file bankruptcy all the way to asset reallocation and worker settlement. I For 1998, loss-making state-o'Mled and state-controlled industrial firms reported Yuan 101 billion losses, while profitable ones reported Yuan 155 billion profits. In 1999, the situation improved with Yuan 85 billion losses and Yuan 182 billion profit. 1 The main empirical basis of the study were interviews in five cities conducted in May 1999, with an emphasis on a sample of 15 bankruptcy cases. The cities Shanghai, Shenyang, Changsha, Wuhu, and Loudi represent a range of situations in terms of town size, development of the legallbusiness infrastructure, and inclusion in the government's debt write-off program for bankruptcies and mergers. Apart from the case studies, interviews were conducted in these cities and at the national level with representatives of government agencies responsible for state-owned enterprises, financial sector, labor/social security, land, etc., as well as with representatives of the judicial and legislative system, service professionals (valuators, accountants, lawyers, etc.), banks, other creditors, and debtor enterprises. The main counterpart of the study has been the State Economic and Trade Commission (SETC), particularly the offices on Merger & Bankruptcy and on Loss-Making Large Enterprises within the Enterprise Reform Department. A supplementary informal background note on credit securities has been produced subsequently with the benefit of additional interviews conducted in August. 2 Key recommendations are reflected in this report. II. THE DEVELOPMENT OF CIDNA'S BANKRUPTCY SYSTEM A Trial Bankruptcy Law for State-Owned Enterprises (henceforth: Bankruptcy Law) was enacted in 1986 and became effective in 1988. The Supreme Court issued a set of related opinions in 1991. Also in 1991, the Civil Procedures Law introduced rudimentary provisions on the bankruptcy of legal persons in general, and the Company Law later added provisions on voluntary liquidation. Still, the. period from 1988-1993 saw only 277 bankruptcy cases per annum, mainly due to concerns about the impact on labor. In 1994, this barrier was overcome through State Council Circular No. 59. It stipulated that land-use rights be used first to support affected workers and retirees. In a way, it linked the main off-balance liabilities of enterprises (pensions and severance, as well as other labor "rehabilitation" entitlements stemming from the SOE employee status) to the main under-valued or off-balance assets (land use rights). The Circular also excluded enterprise-owned employee housing and other social assets from the bankruptcy estate. Circulars No. 113 and 130 introduced merger as the main restructuring alternative to bankruptcy, and set standard terms for debt restructuring in mergers. This set of regulations starting with Circular No. 59 created the so-called "Capital Structure Optimization Program" (CSOP). It applied initially to 18 large pilot cities. SETC assigned debt write-off "quota" to SOE bankruptcies and mergers in these cities, based on applications received from local Economic and Trade Commissions (ETCs) and involving consultation with the central bank. Since the Big-Four state commercial banks are only allowed to write off against existing provisions and this stock of provisions is effectively capped through tax regulations at 1% of the portfolio, this meant that the Government through the quota decided on the banks' utilization of their limited scope for debt write-off. In 1994-95, the quota was some Yuan 7 billion. A third thereof was used for 113 bankruptcies under the pilot and the other two thirds for mergers. Encouraged by this signal and a general atmosphere of reform, bankruptcies outside the CSOP also accelerated, reaching 2,100 per year in 1994-95. Applications for the quota still came in slowly, however, and the Yuan 7 billion were not entirely utilized. Labor concerns continued to prevent many bankruptcies. This was the case particularly where land use rights had been mortgaged and, therefore, under the Bankruptcy Law had to be used with priority to satisfY the mortgage holders. Such mortgages became even more frequent since a new Commercial Banking Law in 1995 required the Big-Four banks to henceforth secure their lending to all but the most creditworthy borrowers. In 1996, the authorities issued a Circular No. 492 that gave labor rehabilitation 2 Yan Zhang and Klaus Lorch: Taking and Enforcing Credit Security in China (forthcoming). 2 and pension expenses priority claims on land use rights even when these rights had been mortgaged by I the SOE, notwithstanding basic principles of the Bankruptcy Law. At the same time, the write-off quota was expanded to Yuan 20 billion for 56 cities. In that year, the number of bankruptcies under the CSOP rose to 1,100 SOEs with some 700,000 employees. In 1997 and 1998, the quota was further expanded to Yuan 30 billion and 40 billion, respectively, for now 111 cities. The bulk of loan loss provisions in the Big-Four banks was thus allocated to write-offs through administrative decision. However, ever louder complaints by creditor banks about their low recovery rates led to restricting bankruptcy, particularly bankruptcy involving "whole takeover" of the entire asset bundle and its continued operation by another firm. Mergers got favored instead. Circular No. 10 discouraged bankruptcies through "whole takeover", broadened debt restructuring in mergers, and made also some downsizing that does not involve merger or bankruptcy eligible to write-off quota. Inter­ agency working groups with secretariats at the ETCs were set up at the national and municipal levels to "regularize" the administration of the quota. The number of bankruptcies under the CSOP quota dropped by half to some 570 per annum in 1997-98, whereas mergers rose to 1,300. Disappointed with the lack of genuine restructuring under mergers, committed to drastically cutting the share of loss-makers among large SOEs within a three-year timeframe ending March 2001, and finding many non-viable SOEs among the thousands of firms being transferred from the military and police to economic bureaus, the Government changed the CSOP once more for 1999-2000. Bankruptcy receives again higher priority than merger. Central control of the process has been strengthened. Bankniptcies under the program are henceforth proposed by SETC and implementation is supervised by the provinces rather than the cities. The Big-Four banks are still able to negotiate changes to the list proposed by SETC, but they now do so on the central rather than local level. The write-off quota is no longer fixed for a year but assigned case by case. In 1999, 133 major bankruptcy cases were approved, with an average write-off quota of Yuan 135 million or a total of 18 billion. These cases focus on large loss-making SOEs in order to support the broad three-year target of slashing the number ofloss-makers among large SOEs. Bankruptcies and Mergers under the CSOp 1994-99 1800 45 i 1800 40 j [ c: • ~ e" 1400 35 0 II: I = (J ~ ;: '01200 30 i 1000 25 800 20 600 15 400 10 - Bankruptcies 200 5 c=JMergers -...- Debt Write-Off Quota 0 0 1994 1995 1996 1997 1998 1999 3 Since large bankruptcies take often more than a year to complete and the three-year target ends in March 2001, the priority is now shifting towards another policy objective, namely, the rationalization of some industries with severe excess capacity. Industries selected so far include wool and silk textiles, iron and steel, non-ferrous metals, sugar, and some defense industries. The Capital Structure Optimization Program (CSOP) for Insolvent State-Owned Enterprises, 1994-99 No. 113 18 56 111 Any location (including all (plus textiles, defense, and (medium or province "major" firms elsewhere) large loss- ca itals making firms) 1.Q 2M 30.0 ID fa 2.4 n.a. 17.0 n.a. 17.9 4.6 n.a. 9.0 n,a, 6.2 5.0 n.a ill 278 U2l 2486 2721 199 44 69 1,099 675 459 133 127 209 1,192 1,022 1,550 58 789 712 145 263 1375 1.930 ~ I 700-1.800 fa 18 54 858 804 425 na 127 209 517 1,126 1,453 na n.a. 674 na Bankruptcy + Merger: 113 1,099 675 459 199 76,800 680,000 n.a. n.a. 776,000 2.9 25.0 n.a. >24.9 67.9 4.9 43.0 n.a. n.a. 75.9 336 1192 1,022 1,550 164,000 1,130,000 n.a. n.a 64.6 29.2 n.a. >180.7 • Li~l>iJjties. '. .. . .... ·':l'Ite.~~d enterpri~~iti ~!c~{a ~anmuni~i~I~()B,had. been makj~~Iosses for ~wralyears. ItsIow'technology equipmeI\t.~~rcondt#~n; was·operatingi~.5% of;i~1t11~~c~ity,but ' . rprise was maintaining its full complement ()fovllr. 200entplOyeesiA-t the tim",\?fbQllkruPtey, the enterpriSiha(J. accOyer!' S.million Yuan in debts, 80% ofwhich to baftks, and.itsdebt to asset ratio exceeded 20()O4.. ) ~':~-- --:--,-:-~::-:,,:, ," '<;:-:,"< --,:,--"--- ,- ;--:------:~::::":-«::-<' ":,"<'.-- - -:<: - - ,::" Apetiti on fQrb~ptcywas ~ diffi(.)Ul~.to ~ . ." .'. emupicipality con~ced lUl0ther itie~1~.1996. TheCou~clpsed 1becasejp .1997. after delay oc~ioned by the . M~'the compenSatj municipalSO~ . notwanttoap~arfifumcially viable·anasustalnable. Although he!illw potenti;dinthemciUty, thelc:ssee was not interested in buying the assets lUld did nothave,th~re~urces to do so. However, he has invested his owOmOf\eYand used retained eamingsto pay the lease, provide the working caPital, and start rehabnitation.of the assets. . 1t the time ofbllilkniptcY,thef~eiUtY.luldail·Output of 20,000 tons/year with211S workers•. It now o~esat a profit, selling 'oyer 100,000 tons/year with 30 employees. In .spite of good results, however, the bankS have not yet resumed lending to this iprivate lessee. . This section will highlight five sets of issues: (i) SOE bankruptcy has been an administrative process, with little creditor involvement and transparency. The process can hinder the unfolding of market-based lending and borrowing. However, incentive problems in the main creditor institutions themselves are only now changing, which means that some administrative control over bankruptcy may remain necessary for an interim period. 11 e 4 . (ii) The incentives of key stakeholders in the administered bankruptcy process have caused a bias against creditor interests and against timely reallocation of assets to their best alternative uses. Therefore, while some administrative control may still be needed, it should be adjusted to reduce such bias. (iii) Secured interests are hard to enforce against insolvent enterprises. This discourages new lending. (iv) The treatment of creditors has been inconsistent across municipalities, within classes of creditors, and - through vulnerability to irregularities -- case-by-case between SOEs. More consistency could increase predictability and, thus, the security perceived by creditors as well as employees. (v) Effective reorganization alternatives once bankruptcy has been chosen and filed, and mechanisms to provide credit to viable but insolvent firms, have been few. This has limited the options for rescuing potentially viable firms as going concerns and obtaining better results for creditors. Bankruptcy as an Administrative Process In 1994-98, proposals for debt write-off under the CSOP were initiated on the municipal and provincial levels by debtor enterprises and their line bureaus. The local mUlti-agency CSOP taskforces then proposed candidates for debt write-off to the national CSOP taskforce. The latter reviewed the proposals and selected a nationwide list, taking into account a certain balance of allocations across provinces and sectors. Since 1999, most proposals originate at the national and provincial levels, since the quota is now used with priority for large enterprises and in the context of nationwide rationalization plans for certain industries. The CSOP taskforces include representatives of the central bank, and the SOCB headquarters approve the list before its finalization. Still, the main creditor banks have been only one of many parties involved, and not the main decision-maker. In particular, they have not been able to use write-off quota under the CSOP without taskforce approval, and their scope for debt write-off beyond the quota has been increasingly limited. In 1998, for instance, the write-off quota amounted to Yuan 40 billion. The total SCOB provisions for doubtful loans were less than Yuan 60 billion in that year, since they are effectively capped at 1% of loans outstanding. (Higher provisions are not recognized in assessing profit tax.) This left only some Yuan 20 billion outside the quota. SOE bankruptcy has largely been an administrative process to cleanse the assets of liabilities after the authorities have decided on the future use of the business (under "whole takeover" of the entire asset bundle and employees) or key assets (such a land use rights). The bankruptcy process of SOEs did generally not serve the function of allowing creditors to protect their interests. State agencies that represent borrower interests have been the main decision-makers in almost every aspect of the bankruptcy process from the selection of the enterprises, the actions taken during the bankruptcy, and the valuations involved, to finding the purchaser, negotiating the sale and settling the claims. The state also owns the SOCBs, but their supervisory organ (People's Bank of China) has been playing a minor role in industrial bankruptcies, except in the allocation of the national write-off quota. This government control of the process has lacked the transparency that would come with independent decision making and involvement of the creditors. While it is unavoidable to have the state playa role in bankruptcy for the time being, increasing the independence between the SOCBs, SOEs, the courts and government will be important for future economic development. The administrative nature of the bankruptcy process is rooted in a lack of market principles when the Bankruptcy Law originated in the mid-eighties. It also reflects the priority concern for social stability as the state sector started to layoff excess staff in the mid-nineties, when the CSOP was designed. The underlying model is that of a wholly state-owned debtor and wholly state-owned creditors, with the state as owner of both entities not leaving the bankruptcy process between them to market mechanisms because of the state's additional responsibility for controlling social stability and its stewardship of state sector employees. "Hierarchy" within the state sector has been used instead of "markets". This system, however, is increasingly at odds with a reality where many SOEs have multiple owners and non-state 12 creditors, and where employment is contractual and increasingly market-based. In other words, many • parties affected by a bankruptcy are no longer clearly part of the state sector "hierarchy". Indeed, China's economy today is supposed to rely on markets, underpinned by the rule of law. Moreover, in the implementation practice, SOE bankruptcy procedures seem sometimes used conveniently by the local authorities to further certain development interests rather than to maximize social security. The SOE bankruptcy legislation provides for a creditor meeting as a vehicle for creditors to prevent unfair treatment. In practice, this opportunity is only notional. Decisions are rather made by the LC. The creditor meeting has no control over the assets, and little legal recourse against the LC if something was done improperly. Moreover, contrary to the practice in many developed countries, creditor representatives don't have opportunities to participate in the decision process before the formal creditor meeting. Furthermore, the creditor meeting with the court and LC does generally not seem to be very helpful in making the process transparent to all interested parties. The LC includes mainly agencies that represent debtor and employee interests. This anti-creditor bias could be addressed by enhancing the role of the creditor meeting. This would help in particular banks other than SOCBs, as well as trade creditors from inter-enterprise or ''triangular'' debt, to express their legitimate interests and help ensure transparency of the process. Secondly, debtor and worker representatives on the LC should ideally be replaced with independent experts or, alternatively, creditor representatives should be added to the LC (as "other parties" as per the Law). The latter alternative would be the least desirable but might be practical during the phase-out period of the SOE Bankruptcy Law, since independent trustees are still an unfamiliar notion. It should be noted that creditor representatives are only considered in view of the fact that owner representatives of the debtors are already on the LC. SOCBs have in the past not had the right internal incentives to press for their interests in the SOE bankruptcy process. Bank managers have been evaluated on the performance of their portfolio and there has been no personal incentive to identify non-performing loans. Rules on interest accrual and asset write-down have kept many portfolio problems unrevealed. Moreover, although local branch managers formally report to the next higher-level branches, in practice many are also concerned about their relations with the local authorities who care less about the profitability of a nationwide bank. The creation of AMCs and commercialization of SOCBs indicate that creditors are supposed to henceforth playa role in enterprise restructuring. Creditors have now also started playing an active role in the reorganization and bankruptcy of some insolvent trust and investment companies and similar vehicles. Still, these changes in incentives and the related build-up of capabilities on the creditor side will take some time to take roots. This suggests that a certain degree of administrative control over the bankruptcy of genuine SOEs is still advisable for a few more years before it can give way to mere market forces. In the interim, however, the process should be made more participatory, transparent, consistent, and immune to misuse. An exception in this phased approach to reform' will likely be the AMCs. Their entire operation and employee incentives are supposed to focus on NPL resolution. This could justify giving AMCs a more powerful role than other domestic banks in SOE cases under the Bankruptcy Law. AMCs have more debt restructuring options available to them than commercial banks. However, since each AMCs assumed old NPLs of only one SOCB, each AMC will in many insolvency cases remain only one of several substantial creditors. Several steps could be considered to strengthen the role of the AMC in such cases. (i) The AMCs could establish a coordination committee among themselves, not to involve government representatives, that would facilitate negotiations between AMCs about individual debtor cases. The AMCs might even voluntarily agree to grant such a committee the right in certain situations to make decisions that bind each signatory AMC. In the case of 601 debt:equity swaps proposed by SETC for large loss-making SOEs in 1999-2000, the AMCs have agreed to give the lead to the AMC with the 13 largest claim on such an SOE; in case of dissatisfaction by another AMC, a meeting is convened between them and including also MOF, PBOC, and SETC. (ii) AMCs could swap loans among themselves in order to concentrate the claims on each creditor. AMCs could also purchase at a negotiated "market" price some claims that other creditors, including their patron SOCBs, have on the same debtor enterprises. In addition, AMCs could agree bilaterally or jointly with other large state-owned creditors, such as railroad, shipping, or telecom companies, on a framework to regularly coordinate their stance vis-a.-vis important debtors. AMCs might even enter into agency agreements under which they would collect, against a commission, claims on behalf of other state-owned creditors. State-owned AMCs in other countries have sometimes been given a few carefully defined, special rights that are not available to other creditors. One example would be to lower for a limited number of years the qualified majority needed in votes of the creditor assembly for those bankruptcy cases where the debtor is a non-incorporated and wholly state-owned enterprise and a central Government-owned AMC holds at least one third of the unsecured creditor claims. Another example would be to give Government-owned AMCs the right to file bankruptcy against SOEs under the existing Bankruptcy Law without prior approval of the local line bureau. Any such special legal privileges of AMCs alone should be very limited, however, since they drive a wedge between different kinds of creditors, create further multiplicity in the legal regime, and affect legal stability. Where possible, the removal of obstacles to loan resolution should apply to all kinds of creditors. AMCs won't exist for all commercial banks, and will take over only part of the NPL portfolio of the SOCBs. To help banks resolve NPLs on their own, the 1% cap on the loan loss provisions that can be accounted as costs for tax purposes should be raised. Giving banks more scope for debt write-off would facilitate also their cooperation with the AMCs in the bankruptcy or workout ofjoint debtors. Stakeholder Biases against Creditor Interests Biases against creditor interests have resulted in part from tensions between social and financial priorities. They have played themselves out at the central and local level, and in the centerllocal relationship. Socio-political instability from mass unemployment without adequate,social protection has. been a key concern of policymakers. Stability of the financial system had historically been a comparatively lesser worry. Hence, in determining the speed and nature of lay-offs from insolvent firms the safeguarding of socio-political stability has prevailed over the safeguarding of creditor interests. Moreover, the leadership preferred until recently to implicitly transfer the social costs of bankruptcy to the creditors, assuming that the main creditors are SOCBs for which the state would ultimately take the responsibility through recapitalization, rather than explicitly bear these social costs through budget transfers for the affected workers. Introduction of the Banking Law and Credit Security Law in 1995 suggested a shift of these priorities. However, conflicting social concerns continued virtually blocking SOE bankruptcy until important creditor rights were moved aside under the CSOP, and a new bankruptcy law which had been prepared in parallel to supplement the two new laws has since been put on hold. Some recent developments have been weighing in for an adjustment in socio-political versus financial priorities, though. The Asian financial crisis has made policy-makers more aware of the potential for economic and socio-political destabilization from crisis in the financial sector. Slower economic growth has made higher demands on the Treasury, tightening the scope for bailing out the financial system. And WTO entry will expose banks to competition that will limit their ability to cover loan losses through high spreads. The current emphasis on reforming the social security system will help reduce the recourse to creditors to implicitly bear social costs of enterprise reform. Still, biases against creditor interests remain at work. Although the true quality of many loans has already deteriorated over time, pension claims have already accrued, and the future "rehabilitation" of labor has already become inevitable, there has been an inclination to avoid making such losses explicit and funding 14 them, for instance through the sale of bonds or state assets. Rather, such costs have been kept hidden in . the balance sheets of financial institutions. What's more, as long as their loan losses are not revealed banks can be taxed for their apparent "profit", as witnessed by the tight cap on tax deductibility of loan provisions. And the longer action is deferred against debtor enterprises, taxes and rents can be extracted from their operations as well. The recent transfer of large amounts ofNPLs to AMCs is an important step in recognizing costs incurred in the past, especially once the Government guarantee for AMCs bonds will be explicitly documented. The historical prevalence of socio-political over financial sector priorities has also a center/local dimension. The SOCBs at the core of the financial system are national institutions with financial backing of the central government. Social security, by contrast, is largely a local matter with local financial support. National policy and legislation may at times protect creditors but their implementation relies on the cooperation by local authorities. Through their influence on local valuation agencies, courts, enforcement organs and other institutional infrastructure, the local authorities have been able to blunt pro­ creditor initiatives of the central authorities. This might change over time as the rule of law, now enshrined in China's Constitution and driven also by WTO membership, gets strengthened. Moreover, the "pooling" of social security, including the pension system, may change the incentive structure on the local level. Still, social and political stability will remain an important local prerogative. Lay-off often leads to local protests not just because of employee concerns over income security but also due to their emotional ties and historical reliance on state sector employer from cradle to grave. What's more, there are indications from protests by laid-off workers in various Chinese cities that irregularities are often as much or more a source of their discontent than the lay-off per se. There may be discontent with managers of distressed firms who drain enterprise coffers through dubious transactions, buy enterprise assets at low price, or steal or misuse them outright, or with managers and officials who move valuable assets of weak firms into other firms without effort to capture their true value for the benefit ofthose stakeholders who are left behind. This means that, rather than just controlling the speed of lay:'off in the cities and compensating those who get laid-off, the authorities should step up their fight against such irregularities. In the sphere of SOE bankruptcy, for instance, the management of a bankrupt firm could be replaced more routinely with an administrator, pre-bankruptcy transactions could be investigated more rigorously, and asset appraisals should be removed from direct control by the municipalities. Center/local relationships are also important within the main creditor banks. Although a SOCB has a nationwide balance sheet its branch managers take lending decisions (within thresholds), are supposed to act against defaulters, and find ways to conceal deteriorating loan quality. Several factors may get the manager or officers in a local SOCB branch to lean towards local concerns rather than their bank's overall interests. Information asymmetry and weak rule of law makes close local relationships important for new lending. Low salaries caused by overstaffing make bank employees vulnerable to local rent-seeking. Managers who are not frequently rotated "go local" more easily. Branch networks that mirror state administrative boundaries are particularly susceptible to administrative influence. Weak internal information, evaluation and incentive systems further undermine the efforts of bank headquarters to align local staff to bank-wide prerogatives. Penalties against loan officers in case of loan default may encourage them to conceal loan problems rather than take early action. The AMCs bear less risk of staff being beholden to local powers to the extent that they will be organized across provincial boundaries, focus entirely on asset recovery rather than new lending, and incentivize staff appropriately. Protection of Secured Interests The Bankruptcy Law ranks secured claims ahead of other creditors. Such protection of secured interests is critical for stability of the financial system. Credit securities are key for banks' ability to extend credit particularly to small and medium-size borrowers, and to finance trade in an efficient manner. The 15 s !11M $ recognition of secured interests in potential bankruptcy would be critical especially for creditors' willingness to help distressed enterprises restructure themselves. In practice, however, secured interests are quite insecure in mainland bankruptcy cases: • SETC and PBOC stipulated in their Circular No. 492 of 1996 regarding the CSOP that land use rights (LURs) can be used for employee rehabilitation expenses even if these are granted LURs that have been mortgaged. This was reconfirmed in 1997 by the State Council in its Circular No. 10. Although seemingly at odds with the Law passed by the legislature, this decision of the executive branch is accepted and applied by the courts. This has contributed to the low recovery rates by creditor banks in SOE bankruptcies, which we found typically in the 3-10% range almost irrespective of security interests. LURs are often the only valuable item in SOE bankruptcy. The decision to overrule security interests on land, therefore, has played an important role in allowing more bankruptcies -­ short of transferring the social burden to the fiscal authorities. This policy decision may have been appropriate in the circumstances of the time. Due to its severe repercussions on the credit system, however, it should be carefully reconsidered as reforms in the social security system and other parts of the environment are taking hold. • Circular No. 492 has even gone further. Mortgaged LURs are to be applied to employee rehabilitation under the CSOP even prior to unsecured claims on other assets. And assets other than LURs can under No. 492 also be used to settle rehabilitation expenses if the estate of non-mortgaged assets does not suffice. Moreover, the subordination of land mortgages to employee entitlements has in practice been applied sometimes also in SOE bankruptcies outside the CSOP cities, and to some collective enterprises. • Many of the security interests in SOEs that went bankrupt in recent years dated back prior to the effectiveness of the Security Law that was enacted in 1995. Without a clear legal framework at the time, many of these guarantees and mortgages were subsequently ruled invalid by the courts upon bankruptcy. For instance, guarantees issued by one SOE for another were later often rejected on the ground that they were given involuntarily upon instruction by local authorities. Or a mortgage was declared invalid because the LUR was found ineligible for mortgaging, on the ground that it had not been effectively "granted" to the debtor because the debtor never paid the granting fee. • Even under the new Security Law, security interests are often not easy to enforce in practice. Creditors complain that courts in the debtor's town or province often appear reluctant to recognize security interests, or to enforce locally the rulings of a court from another jurisdiction. They may be particularly reluctant to enforce guarantees given by SOEs of the same locality. Moreover, self-help by secured creditors is not permitted under Chinese law. There are also some difficulties stemming from registration practices (e.g., reluctance to register mortgages with a maturity longer than the stated loan maturity, or requiring frequent re-registration). Some of these questions would take us beyond bankruptcy. Suffice to say that they add overall to the weakness of security rights. 3 In order to facilitate the flow of new credit to SOEs, especially to small and medium firms that create new jobs, security interests other than on land use rights should definitely take priority over employee claims, including rehabilitation expenses. Practices that violate this principle should be suppressed since they can severely undermine the validity of credit securities and, thus, the flow of credit in the economy. As to land, the priority of worker rehabilitation over claims mortgaged with granted land use rights under the CSOP could be revisited. This review would need to take into account, though, the resulting shift of 3The legal rights and implementation issues of credit securities are discussed by Yan Zhang and Klaus Lorch in "Taking and Enforcing Credit Security in China" (forthcoming). 16 financial burden from the central authorities (for bank recapitalization) to local governments (for covering « shortfalls in worker rehabilitation fees). (See section IILc below) Consistency in the Treatment of Claims The treatment of creditors has been inconsistent within classes of creditors, across municipalities, and case-by-case between SOEs. One of the objectives of bankruptcy legislation is to stay all creditor claims in a systematic manner to ensure that all creditor rights are addressed transparently. In Chinese SOE bankruptcies, there is often inconsistency in how creditor claims are addressed. There were cases where the purchaser under a "whole takeover" assumed bank debt but not payables to trade creditors. Many trade creditors were virtually ignored and were not necessarily notified of the bankruptcy in writing, as LCs have often notified only major creditors. The payment of employee rehabilitation fees has varied across cities and cases. In some cases, the fee was paid directly to the laid-off employees and in others to the reemployment service centers who would in turn support them. Under whole takeover, many of the employees are usually taken over but others are laid off with a rehabilitation fee. These differences should be seen as useful flexibility where employees themselves are given the choice between options. Inconsistency has been an issues, however, where assets did not suffice to pay the entire rehabilitation fee. In some such cases the local government contributed to the deficiency, but more often the employees did not receive full payment. In extreme cases, the employees would have to rely on the minimum monthly social security benefits, which is considerably lower. . Inconsistent treatment can also stem from irregularities in the following areas: • Pre-Bankruptcy Transactions: Under the Bankruptcy Law, transactions prior to the bankruptcy should be reviewed to find any preferences that may have been given to certain creditors and to determine if there were any fraudulent transactions or illegal assets transfers. The LC has the power to review such transactions but the courts require no formal report. No such illegal acts were raised in the sample of cases that we studied. • Control of Assets during the Bankruptcy Process: Until the appointment ofthe LC, the assets remain in the possession of the debtor. Even thereafter the manager often remains in place until the bankruptcy process is completed. The moral hazard arising from this situation might lead to loss of assets. To which extent this risk is reduced by the involvement ofthe line bureau, asset management bureau and other agencies, and by the heavy penalties that misappropriation of state assets carries in China, our study has not been able to assess. • Transparency of Asset Valuation and Disposition: Asset valuations4 are carried out by licensed valuation enterprises for land use right and other assets, respectively. Only rarely are independent non-state valuators involved. Rather, they have in the past commonly been affiliated to and licensed by the local government, such as the land bureau in case of land valuation. Asset appraisals were not always ensured by the LC or the auction centers. The disposal of assets under liquidation is usually carried out with the help of property rights transaction centers or other auction facilities under the municipal government. Auctions seem to often not advertised widely and early. In the case of whole takeover, purchasers are usually found by the debtor enterprise, the LC, or the line bureau; transparent 4Paragraph 4 of Circular No. 10 provides that the "value of property-in-bankruptcy should be based on the appraisal and be the basis to determine the up-set price and fixed according to State stipulations. The property will then be auctioned in most cases and transferred according to relevant legislation, laws and regulations. The transfer price is determined by the market." 17 competitive procedures seem to be the exception. The purchaser has usually been an SOE, and in many cases had been identified before the bankruptcy was filed. To enhance consistency and transparency, and thus predictability, it should be mandatory to offer all assets of the estate on an open market, not just "primarily" or "in most cases" as stipulated in Circular No. 10. Lowering the minimum price if a first auction or tender failed would help bring about a sale. Even LURs should be disposed through such open markets rather than administrative decision, albeit remaining subject to applicable regulations on zoning, registration, and title transfer documentation. Auctions should be subject to regulations that safeguard transparency, fairness, and efficiency. Interested parties that are treated unfairly through irregularities in auctions should have legal recourse against the auction house even ifit is a municipal agency such as a Property Rights Transaction Center or Land Exchange. Auction rules for estate assets (except for small-value items) should require public announcement in media with national coverage, with a certain minimum of information, and with adequate lead time between advertisement and auction. Consideration could be given to eventually establishing at the national level an electronic Website where such media announcements are replicated. More broadly, the government should support the creation of nationwide markets for the assets offailed SOEs. Where "whole takeover" is chosen, the access of potential acquirers to bankrupt businesses should be broadened as well. Last year's Decision of the 4th Plenary Session allows for more non-state ownership in all but a few sectors deemed key for the nation. It also reconfirmed that that there should be less state control over SMEs. In implementing the Decision, local authorities should be explicitly encouraged to transfer bankrupt businesses in non-critical sectors to non-state buyers. Second, in sectors such as retail, wholesale, and transport where foreign ownership faces various restrictions until some time after WTO membership, these restrictions could be relaxed for cases of "whole takeover" ofSOEs under bankruptcy. Third, as in the case of individual assets, the sale of entire businesses under whole takeover should require wide public advertisement so as to give potentially stronger buyers, including those from other towns or provinces, a chance to make an offer. The award of licenses and other practices must not discriminate against firms from other provinces. 18 Encouragement could be given to efforts to conduct "whole takeover" through tender. Where the business including certain clearly specified social and employment obligations would have a negative value, bidders would not offer a significant price to be paid by them but rather the fiscal incentives that they want to obtain. Alternatively, tenders could be "investment tenders" where the social and other obligations are not specified in advance but, instead, each bidder indicates which social, employment, and other commitments he offers to assume. The difficulties of such investment tenders lie in, first, assessing the value and realism of these commitments in an objective and transparent manner and, second, monitoring and enforcing these commitments in the future. All this being said, the risk remains that a state-owned or even non-state firm may be armtwisted to bid for whole takeover of a non-viable business for the sake of protecting unproductive jobs and getting write-off quota for cleanse the business of its debt. Starting with Circular No. 10 from 1997, the central government has therefore sought to discourage whole takeover. Reorganization and Financing Alternatives Many insolvent enterprises, in China as elsewhere, might become financially viable after thorough reorganization. This can be advantageous for the creditors who trust that they will thus get more repayment in the longer run than they would get under liquidation in the short run. In developed market economies, such restructuring can takes place out of court, or through court­ supervised proceedings under bankruptcy laws. In either case, the creditors have to approve it. In court, a qualified majority of the creditor assembly has to approve the reorganization proposal. This gives creditors a say in the decision, yet protects such reorganization from unilateral actions of those few creditors who want payment immediately. Out of court, creditors who disagree with the reorganization proposal can threaten to cut off further funding, foreclose on collateral, or file bankruptcy. In some countries that suffer from widespread corporate crisis, the main financial institutions have voluntarily signed agreements that bind them to accept coordination or even arbitration decisions by an inter-creditor committee, across a large number of debtor enterprises. For insolvent SOEs in China, there are also out-of-court and in-court reorganization alternatives. However, each of these alternatives is de facto restricted to a narrow set of options, and creditors have limited influence on the process. • Out of court, the main restructuring option for an insolvent SOE is merger with another firm. Under certain circumstances, such mergers are eligible to debt write-off quota under the CSOP. Since 1997, CSOP quota is theoretically also available for debt write-off in the context of other forms of SOE restructuring that involve major lay-offs, but little quota has been approved for this purpose. Combined with the limited scope for debt write-off by banks outside the quota, this has meant that out-of-court restructuring other than merger has been relatively rare. s • Under court supervision, i.e. after bankruptcy application, reorganization could be pursued under some special provisions of the Bankruptcy Law. However, the creditors have no right to initiate it. The debtor and its supervisory organs, on the other hand, have little reason to pursue it: Had they wanted reorganization without cleansing the assets of liabilities, they would probably have chosen the above merger route rather than filing bankruptcy in the first place. Indeed, the reorganization route under the Bankruptcy Law seems to be used rarely, if ever. The "whole takeover" under bankruptcy is, in a legal sense, a liquidation. The old flTm is dissolved as a legal entity. The whole bundle of assets, many or all employees, and the pension liabilities are transferred 5 A study on mergers ofSOEs has been conducted with World Bank support by a Survey Group on SOE Mergers & Acquisitions in Shenyang and Zibo (mimeo, Beijing, 12/1998). 19 to the acquiring firm, but not commonly the liabilities towards banks and other creditors. The creditors have little influence on the decision to pursue "whole takeover", and can effectively not ensure accurate valuations and sale at fair value (for further elaboration see Section III.d.). The central authorities have lately discouraged the practice of ''whole takeover". The expectation to take over all employees is commonly the main deterrent for potential acquirers in "whole takeover". Most insolvent SOEs have excessive labor. In one case, the acquirer found 20 employees needed to run a facility that previously employed over 300. Acquirers might also prefer to staff their operations with employees of their own choice. The obligation to take over employees under "whole takeover" appears negotiated case by case. Over time there has been less of an obligation to assume all the employees. In Shanghai, for instance, a policy has emerged to separate the employee rehabilitation from the asset takeover. This has helped Shanghai to attract more offers and purchasers who were able to successfully tum around the companies. The reSUlting higher purchases prices for the unencumbered assets can help, in tum, to rehabilitate the laid-off workers. The limited set of options is not satisfactory for creditors. As a result, restructuring rarely takes place at an early point in time when the debtor firm would still have a better chance of recovery. And it often does not take place at all, meaning that more SOEs eventually get liquidated than would be the case under a better insolvency regime. To an unnecessary degree, economic value gets destroyed, creditors become reluctant to lend, and banks suffer from portfolio problems. Financial restructuring of distressed enterprises has been further obstructed by rigid limits on actions by creditor banks.6 SOCBs need special permission to extend credit maturity more than once. They cannot write down debt beyond their narrow 1% provisions (much of which is absorbed by the CSOP quota), and even from doing this they have been discouraged by Government calls for taxable bank profits. Moreover, commercial banks are not allowed to hold equity in non-financial institutions, which has greatly complicated any debt:equity conversions. These constraints will not apply to the AMCs. However, where debtor enterprises have not only non-performing debts to AMCs but also residual performing debts to SOCBs, or debts to other commercial banks, it will be difficult for the AMCs to negotiate a financial restructuring as long as these other creditors continue to be as severely constrained in their actions. For reorganization to succeed, it often requires fresh money for the debtor enterprise at a point when the reorganization is still under way and the firm may still be insolvent. In view of their very low recovery rates in SOE bankruptcy, and their lack of control over the process, creditor banks should be expected to be reluctant to provide credit to SOEs that face bankruptcy or are already in the court process. The fact that lending to highly insolvent firms shortly before bankruptcy did occur in the first half of the nineties in a number of cases that we studied was explained by government suasion, distorted branch manager incentives, and we&k internal controls. Our study suggests also that, while old creditor banks were usually not lending to new enterprises that emerged from some bankruptcy cases, an SOCB other than the bank that took the original loss would sometimes advance funds with strong encouragement of the local authorities. Today under the new Commercial Bank Law, banks seem to become somewhat more reluctant to engage in such practices. To make funding available for reorganization without jeopardizing creditor rights will require new practices and legal procedures. In developed market economies, the creditor assembly under the court-supervised reorganization can agree to a fresh borrowing by the insolvent debtor, with a super-priority given to this new credit claim over all old creditor claims. Fresh credit from some or many creditors can also be agreed outside court, 6 Some recent Recommendations by the Supreme Court (announced on October 27, 1999) on solving disputes over debts of SOEs aim at giving distressed debtors further relief from creditors so that they can restructure and recover more easily. For example, courts are to suspend the execution of foreclosure on credit securities if the debtor has marketable products with good potential; debt/equity swap should require debtor approval if the debtor has strong products and would be able to recover; and distressed SOEs are encouraged to settle debt with intangible assets or in-kind with labor services. 20 with such new credit usually getting securitized with debtor assets or other means; this, again, requires the consent of the other creditors, lest they take unilateral action in court that would undermine the reorganization. In China, court-supervised reorganization is rare and the potential role of a persistent creditor assembly is still largely untested. Out of court, truly voluntary inter-creditor coordination seems to be rare as well. In 1998 the Government introduced a special program of so-called "closed loans" by SOCBs to firms that were insolvent but had strong export potential for some of their products. These loans were given on the merits ofjust the export production itself without regard for the overall financial distress of the company. The lender expected to be repaid with priority. This priority wass based on regulations rather than laws, however, and not formally agreed by the other existing creditors. It has been a temporary initiative with a limited credit amount, aimed at macro-economic stimulation. More systemic arrangements to allow funding of reorganizations remain to be developed. The new bankruptcy law should include effective provisions to allow reorganization of insolvent enterprises. The current draft does indeed include an extensive chapter on such reorganization. Thebarikropt enterprise WllSeStablis~a 'ip 1956011 ~>large piece ofland in the ,immediatesw-burbs of a fast groWing city. It was initially aConective,aridbeoame.asbat'eh~ldint#petative in1994. Its only prodQct':"" utilized mainly in~iculture ­ uSed ,.fO. ,.~ .Sold. and distribUfedUIl~l:r~e ~.pl~g system. With· the .intro~le to adapt. . &~~~j990aildj996,the com~~b01TOwed;~~ heavil!'to puibhaseriewbigli~ mac~ery to l'rOdu~,~~mpletel~ diff~~typeofproducts•. l'he .' 'ho~ver; wasapparentlyij!ade withoutthoroughmln"ketana!ysis or Knowledge of; and contacts With, an entirely w ·U~~ base.In additipu. the coiilp!lIlyexperienced constant techniCal pt1)plems " \\lith· ~~ new machines andnev'efIllanagedto. pr()dUee to stated equipment.~HiQatiOns,lintil·j~.befure· ~PtCy:At the ti~ of bankruptcy, the Company;operated.~·less than 25% of~apli.city,but had tetaineditsjUll oonlpl~t of (}ver 400 \V(}tkers and 140 pensioners. Its~bt to.II$S~ol)tio exceeded.60%. Inpartietilar. ite:,wedover.5Q miUionYuan to 11 sirigle state­ owned bank, with only ont:-tentiil,.l:;fthiiamount subsequently recognized as properly oollateraIiiedby theCourt. '" , , ~ .':' -' ',' '" ' - ,'~ "; : The petition for bankruptcy ~s llandl!ltdUhder theCiyil Proced~ CQ~. As a.sharehOldingcooperative, the case was supposedly not subject to the BankrUpieyLaw,and the cSOP rules.~BankrUptey was ftloohlfue last quarter of 1996 and the t.:;ourt closed the case within six months. .The bankrupt enterprise was sold as II. whole through a somewhat oompetitive process. The Liquidation Commission received three offers. The Winning bidder an SOB group from the Province was selected because it offered thft.Jargestuprice, and was demonstrably very successful in producing and marketing similar types of produCts that. the bimktuptcenterprlS¢had failed to develop with its new machinery. HoWever, its growth was severely constrained·llyits poor location. 'l1,le .WOupsawa good opportunity to acquire a large~d welllGCated piece of land and a series ofbuifdings in goodC()nd~ll:.ipa: dynamic city with. good communiCations,}i.\V!IIltedto use them to relocate their headquarterS'.as well as Some: of ~~ir eXistjng production facilities. It was Wso interested in .acquiring .the. relatively new "productil)n fine, to expand its production ina m~ket that it already knew Well. The ~~clpality was keen on sec~ng8: dealwi!h a firianciwly solid group frobithesmnb pro~ince thatwouldtake.~n all the w9rkeis; gUl1t'at1tee ahlghJevel6f~llfactwirig activity .on the premises andoffet' good prospect ofsignificantadditlofu\itax ~vtlllue.The~Up acquired b<>tb:the. ~and.;ti!le rights and the assets ofthe bankrupt.enterpn~t'or abOut 30, miljiotl Yuan;' ~lf ~dincasl1andhwfby~partofthe'bankrupt firm's bank debt. Thelariduserigbtl1ad been 1m "ailocated'1 right of tht;: Pankrupfll!.ctory, valued at 'SQtDe 40 million YuaJl. The acquiring group ~totake()p all the workers anlt pensl9ners, "and no~habilitation '~;wen(~d.j\S !t.~t of the banlcrupt(:y proceJS,th~()reditors of the shareholciing 'cooPMttive ie~vered:. 1Ul):un(i 7 mpUOO'Yiian'(a recoverY,~o ofapproXimately 12%)~ with a further 15 milliOliYuan (or 25%)Wbrth of secured loamHransferredto the aei.xllltlt ofthe a(:quiter; . . Hadth~~AA!>een oo~~inc:e4t9acqllire~~s (}fth~ C()llective ~.tnetgetrather th~.PankruptCy. It would have had t() ~~afargreater!lhare, .of~collective(wthoughpofentiallyinvohiing:some debt reduction). , This would have beetj;ittl;the ~t (lfthe credi ..~in the Short run. In the long run,. it woUld;lkpend on whether a higher .debt burdenmlght have joop!lrdmldthe acq~·s financial viability. . Consideration should also be given to improving the legal framework to promote secondary debt and distressed lending markets to develop, since workout and restructuring are vitally dependent 'on new 21 .; , . $ 4 m capital. A range of actions could help promote such markets. The interest rate ceiling could be relaxed for new lending to firms under court-supervised reorganization and for NPLs that get rescheduled. Write­ offs from sale of NPLs beneath face value could be exempted from the write-off limit of banks. The common requirement that a debtor confirm receipt of the notification of the intended loan transfer to a new creditors and confirm the status of the loan should be relaxed so that the debtors cannot cast doubt on the validity of the transfer simply by withholding his confirmation. The controls against state sector entities selling assets beneath their valuation should be relaxed in the case of assets from foreclosure or liquidation. The draft regulatory framework for industrial investment funds, which would also cover turnaround funds that purchase loans or equity of distressed firms to tum them around with the objective to sell them later with a profit, should be finalized without much delay. The approval processes concerning foreign-exchange lending should be reviewed so as to remove undue obstacles to the purchase or sale of distressed foreign-exchange loans, including by foreign financial institutions. Moreover, the access of foreign financial institutions to the future market in yuan-denominated distressed debt should be facilitated as well. Case Stu!ly: Bankruptc:y is UnSuccessful irthe Use of the Assets Remains "N'op:'Viable . : :' '?;' i:,"'" ~ ,,' '",,/ ,'::~>~~,~~:':~ ~"<'I >:,' '-,>' , ":,~~L~>,'>',,", "<, ,!', ',:,':':' :, :1'1';,:1:::,':;:'\",: ':'!'i'r<>,:: ':,~~:}",,: ,', ' " Th~bahkrupted' enterprise,. a mUIiiclpallevel.S,PBWitll apptof'ipUltely:~~j)iie~ployees Was' engas,edin ligfu;fuami'aCtur~ iiactivity'. For the paSt several years, the factoryhaab#nio~ga;Hessithan30% capacity With equipmebfin .... ··i})OOr:. ~ndition, resultiIIs in continuous 10~~s: It.had tinan&d a large partofJ~s operanng ~sts~tially ~~.:~.1IJllc.·~0~'.i........ ~re recently. by askipg its employees to contribute cash tqwards workmg.~pital. When it entered b~ptcy in,mid~J~9p,the ~~ter.prise h~d ade~tJasset ratio?flJv~r2~?%~4o~ed its employe~s'alnlost l;.¥llionYuanin,sa\~.~~.~fir~~.~~ workingcapltal:loans; The premtseswere dtiapidated, an<,tl~ated at ani!:mp~ved road out of ·town.· ... ' . . /'..... . . . .........i ." " "";:';':n,:" ,~ '~,>x ,'0 '~",\, '", ",';:,' <,',::,::';:,:~,'::::kr{>/< :'\i:':J"0;: :';::", :,};i:'~1K'i-~'~:"<');:,"::;l":':'''i',! ,'"" The assets were yal~ed slightly higher than the pqtential rehabilitation ~~PThis would have alllJwed to ~y)UIlrehabIUtaflbQ. fees~6ut li~lp' by ~ municipalitY. }JQwever,no'bliyet'Wis e~i1yfo1ii'id t06u~at .thatpri~:This mi$htbave~bbU~~ptli~ . thUIiicipalityto financially supporttlie affected.workers. Instead; tlieemployees W~ persuadeved this scheme within tItreemo1,1ths afieracceptingthe c~, The eX!l:a;~hipjectiQnfromtlie employees wasJlSed, to seWe part oftheb~ptcy fees, and the Court agreed th.at the rest ~ settle<,! m. msta:!lmenP;, The new. firm also aSsunled.th~ social security arrears of the old one. It did not assume, hoWever, any of its otlier d~bts. and tlie creditors had to Write off all thei.. claims. . '. . . . .. . . ." . .. . The new s~holding cooperative has resUme<,l tlte ~ame production, with the same manllgementandworKfQr~i~8.lldtli~SiUUe outdated machineryasthe bankruptenterprlSe.Part oftlie cash cOntributed by ilieelUploYe~has ~n used\i) ()(intirluesOrne on production and the.new entity has not, so far, been able to make good its agreed schedUle ofpameI).ts 'tOtbe Court and the SociaISecurity. The former creditor bankS 'of the. bankrupted ent!:rprise1' unde~dabIYso,havetiOi b#n ~'lin,f1; ~ .!~s~: lending totlienew entity. However; a differentstate,.o~edbank ~~c:eptlyb~n cOnYmc:e4.by·tliepIQQ~g!ly~ep.tto. proyide a ne'Y 'Yorking capital loan. '>..... .~. ~. ... . ~ '.. '.' ,. u.~. . ~~'" Ih! Wi~oilt opel"!ltiOnal. chan~s and, 'Po~~~~I~,'1fes11capl~ tq.4pgr~~.~!?~'P~!l~~j~st~ep~~~.mUt~i~~!e~~