Insolvency in China – how to minimise risk when a customer is facing bankruptcy

Insolvency may involve economic hardship not only for the insolvent debtor, but also for creditors having large claims against the insolvent entity. When China's Enterprise Bankruptcy Law (the "Bankruptcy Law") came into force in 2007, it marked a significant improvement in the legal framework of Chinese insolvency proceedings.

The Bankruptcy Law introduced so-called "bankruptcy reorganisation", a corporate restructuring scheme resembling US "Chapter 11" proceedings. Under the Chinese scheme, insolvent enterprises are allowed an attempt at regaining solvency, with the bankruptcy administrator either controlling or supervising the continuation of business. Meanwhile, there is also a suspension of enforcement proceedings against the insolvent enterprise, which implies that creditors holding a valid judgment and/or award will have to wait until the reorganisation either succeeds or culminates in bankruptcy liquidation.

The seller's key question

If the insolvency results in bankruptcy liquidation, an appointed bankruptcy administrator will collect assets belonging to the insolvent enterprise, convert these into cash and distribute same to creditors as dividends. However, as always, the creditors' respective
dividends tend to be considerably lower than the value of their claims, as the insolvent debtor’s debt generally exceeds the cash generated from the collected assets. A key question is therefore how a seller otherwise can secure either full payment or return of the object, should their buyer go bankrupt.

Avoid relying on circumstance

Under the bankruptcy proceedings in China, the estate may generally only seize property owned by the insolvent debtor. The seller could therefore claim that the buyer has yet to acquire the ownership of the object pursuant to the Chinese Property Law. Pursuant to this law, ownership to movable goods normally transfers from seller to buyer upon physical delivery. If the buyer goes bankrupt before delivery and the purchase price has not been paid in full, the seller may take back goods in transit.

However, these rules are too reliant on arbitrary circumstances to provide adequate protection for payment in valuable supply contracts. Already at the contracting stage, the seller should instead, as creditor for the purchase price, seek to secure the debt owed from its counterparty.

Agree on collateral

A well-tried procedure for securing the debt is to pre-agree in writing that the buyer shall offer property as collateral to secure their payment of the purchase price. This should be agreed when drafting the supply contract. Under the Chinese Bankruptcy Law, such an agreement will give the seller the right to satisfy their claim before the estate may seize any remaining value of said property.

Multiple forms of collateral exist under Chinese law, including guarantees, pledges, mortgages and floating charges. For commercial purposes, non-possessory security interests such as mortgages are convenient, allowing the buyer to retain possession of the object placed as security. Chinese law acknowledges mortgages for movable and immovable property alike. For stock, goods and other assets disposed of in the course of business, Chinese law provides for floating charges covering categories of objects in fluctuating amounts.

Retain ownership

If the buyer's assets are of little or deteriorating value, or are to be incorporated into other objects, the buyer might lack adequate property to place as collateral.

If so, the seller may secure payment with the sold object itself. This is done by way of a title retention clause, in which the parties agree that irrespective of delivery, the seller retains legal ownership (title) to the movable goods until full payment of the purchase price. Logically, the seller should therefore be able to retrieve the object from the bankruptcy estate without further involvement. However, the Supreme People's Court has stipulated two exceptions.

Firstly, the bankruptcy administrator may choose to fulfil the contract, and keep the object while offering security for the payment. In essence, this should nonetheless ultimately ensure payment to seller.

However, secondly, the seller's claim for return of the object will not be supported if 75% or more of the purchase price has been paid. The buyer's estate may then keep the object, but shall instead settle the remaining price. If not settled, the seller's losses can, upon seller's request, be regarded as a priority claim, which is paid out before dividends. In other words, 75% payment marks a threshold at which the seller, despite owning the object, is compensated for the remaining price more like a creditor with collateral than an owner.

In any event, the seller may lose the retained ownership if the buyer proceeds to sell the goods to an unknowing third party. Therefore, title retention clauses may in certain respects leave the seller somewhat more at risk than the aforementioned collateral rights.

While not entirely fail-safe, it overrides the implications of delivery, and demonstrates that predictable insolvency protection is best when sought in the contract itself.