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China Embraces Bankruptcy, U.S.-Style, to Cushion a Slowing Economy

The Wall Street Journal. logo The Wall Street Journal. 11/7/2019
a man riding a bicycle in front of a building© Imagine China/Alamy

XI’AN, China—In the trenches of China’s debt-addled economy, the government has made a startling decision: Let companies fail.

That has left creditors angry, debtors fighting to save their businesses and judges on a mission to promote the benefits of bankruptcy.

After years of pumping out financial support to keep the economy humming and workers happy, China has embarked on a debt reckoning. Beijing is building a bankruptcy system to take on a significant pickup in corporate defaults.

The country now has more than 90 U.S.-style specialized bankruptcy courts to help sort through a morass of corporate debt that, until recently, would have been swallowed by state banks and other creditors.

It is a sign that Beijing is worried about the number of failing companies and trying to find a fix. The system is helping, many lawyers, foreign investors and lenders say, as it takes some pressure off local governments that lack the resources for so many bailouts.

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The bankruptcy system in China, drawing on U.S. chapter 11 provisions, aims to allow companies to restructure under court protection to keep businesses alive and pay creditors over time.

China’s system differs significantly in at least one respect: Bankruptcy courts here sometimes are inclined to protect shareholders over debtholders—with the aim of averting social unrest.

Reorganizing or liquidating companies is proving to be a messy process in many cases, marred by disagreements, protests and disarray in a country with a steep learning curve in the bankruptcy process.

Last year more than a thousand people, including judges, bankers, home buyers and employees packed into a university auditorium here in China’s northwest to hear how a court-appointed law firm would sort through more than 7.5 billion yuan ($1.07 billion) in claims against a failed real-estate company.

Hundreds of police officers and security personnel stood watch because of fears that grievances would turn to violence.

About 7 miles away, a 21-building complex had stood unfinished since late 2014 after the company sold thousands of apartments and storefronts and then defaulted on its debts.

Liu Changyun, now 50 years old, paid roughly 600,000 yuan ($84,700) in 2013 for a storefront in the hopes of opening a small restaurant in the complex. She is still waiting, selling food from a cart nearby. “I own nothing in my whole life but this,” she said recently.

China introduced formal bankruptcy laws in 2007. But courts routinely rejected applications from struggling businesses and their creditors because of concerns over potential social unrest and large-scale layoffs.

Many insolvent companies chugged along with state subsidies and loans from state-owned banks. Some simply walked away from their debts, leaving creditors hanging.

Beijing is trying a new tactic. Most of the country’s bankruptcy tribunals have opened since 2015. New courts were added this year in Beijing, Shanghai and Shenzhen. Court-appointed administrators—law firms and accounting firms that help verify claims, organize creditors’ meetings, list and sell assets—increasingly make use of China’s online culture, as authorities look to handle more cases and process them faster.

After a decade of rapid expansion and heavy borrowing, China’s growth is slowing. Courts nationwide accepted close to 19,000 corporate bankruptcy filings in 2018, more than triple the number two years earlier.

They included the reorganization of steelmaker Bohai Steel Group Co., which buckled under more than 200 billion yuan ($28 billion) in debt—the largest failure of a state-owned Chinese enterprise in years. Some of Bohai’s assets will be taken over by another steel company and creditors are in the process of being repaid partially or in full.

Authorities “sensed the economic slowdown and that weaker companies would not survive, and needed a mechanism to deal with that,” said Ron Thompson, a managing director of restructuring and advisory firm Alvarez & Marsal who has worked in China for close to three decades.

Concerns grew last year amid the U.S.-China trade conflict. In an opinion piece published in a state-run media outlet, Du Wanhua, a high-ranking official at the Supreme People’s Court of China, said higher trade tariffs could lead to more bankruptcies. The courts should start “repairing the house before it rains,” he wrote, using a traditional Chinese phrase.

There are more than $17 trillion in outstanding bank loans in China, according to Wind, a financial data provider. Regulators have told banks to recognize loans more than 90 days past due as nonperforming; official data put nonperforming loan ratios at 1.81%, reflecting a total unpaid principal balance of about $319 billion. That low ratio is widely thought to understate the level of bad debt on banks’ balance sheets.

The court system has relieved some of the burden from local governments that kept companies afloat to prevent the kind of mass layoffs and financial losses that could shake China’s economy and political leadership.

The courts’ role in resuscitating or liquidating businesses is “not only an economic issue but also a social-responsibility issue,” said Ye Bingkun, a 46-year-old bankruptcy judge in Xiamen. “Bankruptcy is like the hospital for companies.”

Some are still getting accustomed to the process.

As the real-estate and construction company Zhejiang Dengfeng Traffic Group was undergoing liquidation in Hangzhou, two law firms and an accounting firm that a court had appointed as case administrators said in August they had received threats from individuals who disagreed with the order in which creditors were being repaid.

The company had been a large employer, building highways in and around the southeastern city. The case administrators have been auctioning some of the company’s assets—from unfinished apartment buildings to jade sculptures—on Alibaba Group Holding Ltd.’s Taobao, an eBay-like online marketplace, to recoup funds for more than 2,000 creditors.

Some people “have prepared knives and collected the personal information of judges and administrators,” and urged others to do the same, the administrators said in a public WeChat post. It said staffers working on the bankruptcy case at one point temporarily moved from a local government office into the city’s court, where security was tighter.

The process is already fraught with emotion in China, Judge Ye said, where “the integrity of a person is the foundation of one’s life,” and defaulting on debt is seen as a moral failing.

“If you hear someone is bankrupt,” he said, “you may think this person is shameful.”

Chinese law only allows for companies to declare bankruptcy, not individuals. But the stigma can make creditors and borrowers unwilling to file, Judge Ye said—whereas in the U.S., “they think it’s giving businesspeople a chance for a fresh start. That’s the difference.”

In a Nanjing courtroom last year, Li Xinghua, the chairman and owner of a construction company, bowed in front of judges, creditors and bankruptcy administrators and pleaded for a second chance.

He had made a stupid decision, he said, after a state-owned bank refused to extend a new loan a few years earlier for his company, Nanjing Wonzeal Construction Decoration Shares Co.—and he borrowed instead from private lenders at high interest. The company racked up more than 200 million yuan ($28 million) in debt. When activity and revenue dropped, it couldn’t repay the loans, and filed for bankruptcy.

On the other end was Qian Xiaojun, who runs a small company that lent more than 6 million yuan ($855,700) to Wonzeal. He was among creditors who voted in favor of a court plan that let the company keep operating.

If the company closes shop, “we won’t even get 1 cent back,” Mr. Qian said.

The plan covers salaries and allows for a small share of Wonzeal’s debts to be repaid first, with larger creditors to be repaid over time. Mr. Li said the company has reduced staff and is undertaking short-term projects that can generate cash more quickly.

It is part of a shift from what Judge Ye described as policy-mandated bankruptcy—the government largely decides which companies fail or survive—to a “market-oriented bankruptcy” process that lets market forces decide who are the winners and losers.

Many lawyers, foreign investors and lenders say they have found Chinese courts efficient in processing cases and reorganizing or liquidating companies. The caseload is growing. In the southeastern city of Xiamen, where Judge Ye presides, the local court accepted fewer than 80 bankruptcy cases in the decade before the city set up a bankruptcy and liquidation tribunal in mid-2016. Last year, the new court processed 96 cases, most of them private companies in the manufacturing sector.

To speed up processing, courts have given judges productivity targets and evaluate them with a system that gives them more credit for handling bankruptcy cases. In southern China’s Hunan province, one standard bankruptcy case could be deemed equal to 30 civil cases when evaluating a judge’s performance, according to a guideline published last year.

China’s digital culture helps. Courts are using internet auctions on Taobao to sell hotels, machinery and other assets of failed companies. Bankruptcy administrators keep creditors and the public updated through social-media accounts on Tencent Holdings Ltd.’s popular WeChat app. Some courts use online video links to facilitate participation in hearings.

Keeping people content throughout the process remains a concern. Chinese courts sometimes ignore laws that dictate the order in which creditors should be repaid.

In some cases involving publicly listed companies, courts give priority to small investors who have suffered losses to keep them from stirring social unrest, at the expense of debtholders and other creditors that rank higher in repayment priority, said Xu Defeng, a law professor at Peking University.

After the state-owned and Shanghai-listed Fushun Special Steel Co. underwent a bankruptcy reorganization in court last year, its debt payments to secured creditors were suspended. Under a court-approved plan, the company agreed to pay them an annual interest of 2.8% and start to repay the principal debt after five years.

Shareholders of the Shanghai-listed company have fared better. Their shares rose in value after Fushun emerged as a debt-lightened company at the end of 2018 when its bankruptcy proceedings concluded.

In the U.S., by contrast, shareholders in companies that have filed for bankruptcy usually lose their ownership stakes or see them become effectively worthless when assets are sold to pay creditors.

Unorthodox court decisions that protect shareholders at the expense of debtholders are hurting creditors’ rights and could potentially undermine the bankruptcy system, Mr. Xu said.

After construction of the 21-building Yihefang complex in Xi’an ground to a halt in 2014, home buyers and other creditors begged the developer and the local government to find a way to resume construction.

Some individuals called government officials on their personal phones to implore them to take responsibility for the project, while others protested outside government offices with banners, some reading “give my blood-and-sweat money back,” according to several home buyers.

The development was run by Jiao Yanqin, a local businesswoman who had high ambitions for the 28.7-acre plot, with a blueprint that included a kindergarten, gardens and stores surrounded by high-rises.

Like many private companies that ran into financial trouble, Ms. Jiao’s company took out loans from nonbank lenders that charged rates of more than 20%. The company couldn’t sustain the payments.

In the summer of 2018, the city’s court accepted a bankruptcy petition filed by one of Yihefang’s private lenders, and reorganization proceedings began. Ms. Jiao ceded control of the developer, and a local law firm was appointed as the case’s administrator.

Following a bidding process that drew half a dozen investors, another developer was chosen in April to take over the project.

The new firm, a subsidiary of a regional state-owned construction company with a record of building apartment complexes, estimates it will cost 350 million yuan ($50 million) to complete the project. Last month, workers were painting the outside walls of several buildings and construction elevators had been installed. Stacks of new building materials were on-site.

Ms. Liu, the food seller, said she spent her family’s life savings to buy the storefront to open a restaurant. A big draw for her, she said, was the complex’s location near three subway lines used by many morning commuters.

“If there are a lot of people, that will be good for breakfast business,” she said.

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