Economic Crisis Tests China's Enterprise Bankruptcy Law

The Economic Crisis is a Test of Character.

路遥知马力，日久见人心。(As distance tests a horse's strength, so time reveals' a person's heart.)

China's Enterprise Bankruptcy Law (EBL) came out after more than one decade of debates and compromises, and it was applauded for advancing China's efforts in establishing a truly market-oriented economy. More than two years after its promulgation, it has been tested in Chinese courts. For example, the Chinese company, Sanlu Group that manufactured tainted milk, went through an seemingly orderly liquidation process under the new Enterprise Bankruptcy Law.

Besides Sanlu, the law is also undergoing public tests in the context of massive failures experienced by small to miedium sized business in Guangdong Province due to the economic crisis. Like other bankruptcy regimes in many countries, the EBL was designed to provide orderly and effective means to sort out debtor-creditor relationships during difficult times. To accomplish that, the EBL allows liquidation (Chapter 7/13 under U.S. Bankruptcy law), reorganization (Chapter 11 under U.S. Bankruptcy law), or reconciliation (informal workouts). The law also contains detailed provisions governing the relationships, behaviors, and obligations of courts, creditors, debtors, creditors' committee, and the bankruptcy administrator. Overall, the law is a very comprehensive piece of legislation, and if enforced properly, it could be a effective tool to regulate market behaviors.

But, how is the law fairing in these difficult times? According to this report, the EBL is experiencing some significant growing pain.

As the global recession slams China, bankrupt business owners are shutting factories overnight. Often, they leave the mainland, afraid of angry suppliers and workers and uncertain about legal protections. Dongguan alone last year recorded 673 cases—up 24%—of owners fleeing their factories, leaving behind 113,000 unemployed workers owed $44.1 million. Labor disputes almost doubled, to nearly 80,000.

Many foreign investors, due to falling demands from the West, had no choice but shut down their businesses in order to stop the bleeding. One would think that most foreign investors who decried China's lack of legal institutions would throw their arms into the relatively well-developed and interests-neutral courts in Guangdong Province. The reason being that the EBL is an excellent way out in case of business failures, and that the EBL is not unfriendly to investors. Further, courts and judicial enforcements in costal areas, according to Professor Peerenboom, are in comparison better than those in interior China.

However, that is not the case. Many investors fled China, like those New Yorker debtors who escaped their debtors to populate the great State of Texas because New York law could not reach them in the early days of frontier history in the American west. In the case of debtors in China, they led to Taiwan, Korea, or wherever the "sword" of Chinese law cannot follow.

The excuse, as reported is:

But few judges have received the necessary training to understand the complex measure, so local officials often discourage hard-pressed owners from filing for bankruptcy. And by compensating creditors before employees, the law undercuts Beijing's desire to minimize labor unrest....

Putting aside the validity of the argument that local officials discourage the filing of bankruptcy, I think the excuse for not using EBL is a weak argument. True, many judges in China are not trained and versed in the EBL, but the fact is that Chinese courts set up special tribunals to handle special litigation. Those judges assigned to the speical bankruptcy tribunals are more qualified to handle liquidation cases. Further, this aversion and fear of the incompetency in Chinese courts and judges have got to stop at some point. Yes, the qualification of judges in all cases play a crucial role in the outcome of cases, and qualifications of judges vary widely from court to court. There is no exception even here in the U.S. But, because of China's recent efforts in moderninzing its judiciary by imposing strict requirements on qualifying judges, for example, law license, judges are getting more and more better trained and educated. In addition, because of the vast number of businesses and disputes in southern China in Guangdong Province, many judges are actually very experienced in economic disputes. I'd submit that many are more versed in such disputes than some in East Texas. Therefore, to use Chinese judge's perceived lack of qualification as an excuse for fleeing China instead of initiating bankruptcy proceedings under the EBL is an ancient and weak argument.

In sum, the EBL is flunking the test because it is not doing what it was intended to do.