Sanlu Group Co. Bankrupt: Morally & Financially (Republish)

It has been reported that the infamous Sanlu Group Co. has been declared bankrupt by a Chinese court (h/t China Digital Times).  It is about time.

For background information, Sanlu Group Co. is one of the companies that manufactured and sold adulterated dairy products, including baby formula, tainted with industrial melamine.

Sanlu Group Co. and its board were thoroughly morally bankrupt.  The company knew that their products were contaminated by melamine when they used unsafe and impure milk during the manufacturing process.  Despite their knowledge of the danger that contaminated products might have on consumers, especially the young ones, they purposefully hid the information from the public and failed to disclose to the public until it was too late.  As a result, “[a]t least six infants died and more than 54,000 were hospitalized after 22 companies including Sanlu sold formula made from milk contaminated with melamine, an industrial chemical.”  When the news came out in waves about babies being sickened, I was too disgusted by the greed, immorality, and corporate filth to write anything about it.  To date, I still cannot imagine how the company managers and board members, who knew about the contamination before hand, sleep at night.  I have young children, and many of my friends and relatives in China have young children and babies.  The thought of harming helpless babies with poisonous food is too much to bear.  That is why I believe the entire management team at Sanlu Group Co. was morally bankrupt.

Now, Sanlu Group Co. is financially bankrupt in the legal sense.  “Sanlu’s bankruptcy was sought by a creditor of the company, Auckland-based Fonterra said today. The court’s ruling will ensure the orderly disposal of the company’s assets and repayment of creditors according to Chinese law, it said.”  According to the Bloomberg report, Sanlu has already been declared bankrupt by the Court after it accepted the case.  But this report is contradicted by another report in the widely read and respected Chinese financial newspaper Caijing, which reports that the Shijiazhuang Intermediate People’s Court No. 4 Tribunal has accepted the creditor-initiated petition but has yet to rule on it.  Irrespective of the discrepancy betweent the two news sources, a number of issues are noteworty, especially in light of the China’s new Enterprise Bankruptcy Law  (unofficial English translation) promulgated in 2006:

a.     Creditors can file a bankruptcy petition in the court of proper jurisdiction.  This right for creditors is provided for under Article 7.  When the debtor is unable to pay its debts when they become due, creditors have the right to apply for a reorganization or liquidation.  According to the Caijing article, a bank creditor applied for the liquidation of the debtor, Sanlu Group Co.  Presumably, the creditor has evidence to show that Sanlu could not pay its debts and reorganization is not the way to go.

b.     It is probably a smart move on the part of the bank creditor.  Under the Enterprise Bankruptcy Law, only the debtor in possession and the court appointed administrator can propose reorganization plans.  Without the right to submit reorganization plans, creditors lose a potential leverage point in the reorganization process.  Unlike the China, in the U.S. Bankruptcy Code, creditors can, after the exclusive period alloted for the debtor in possession, file their own plans.  In addition, even though various local governments (courts indirectly) have so far blocked lawsuits against Sanlu for products liability associated with the contaminated milk products, it is uncertain that whether some consumers could ultimately sue within the general two year statute of limitations.  Further, since the bank creditor is a secured creditor, it has the first lick at anything in the company.  One of the most applauded features of the new Bankruptcy Law is that secured creditors’ claims have superiority over employee compensation and other general claims.  With this priority, the secured bank creditor is guaranteed payment to the greatest extent before anyone else can jump in for a share.  So, it makes great sense for the bank to file for liquidation when Sanlu still has something left at this stage.

c.     Besides liquidation, reorganization and conciliation are also options for Sanlu under certain circumstances as provided in the Enterprise Bankruptcy Law.  According to the Caijing report, another compnay, Beijing Sanyuan Food Products Co., Ltd. is in the process of formalizing acquiring Sanlu.  Of course, as the new owner of Sanlu, Sanyuan plans to reorganize rather than liquidate Sanlu.  However, Sanyuan apparently did not anticipate that a creditor could race it to the court house and file for liquidation.  How will this strategic move by the bank creditor end up impacting Sanyuan is something to watch for in the future.  But I bet you Sanyuan is probably kicking itself for not filing for reorganization as soon as possbile after the M & A is consummated.  Of course, I am assuming that the M & A has already been done by the time the bank filed the liquidation suit.  This raises an interesting legal issue–does a prospective owner of a insolvent company have standing to file an application for reorganization?  (I don’t have the answer yet, and I’d love to hear your opinion.)

Won’t this be a good law school exam question?