China promotes ‘zombie’ bankruptcies

Workers operate machinery on the assembly line at a Lyric Robert factory, operated by Guangdong Li Yuanheng Intelligent Automation Co., in Huizhou, Guangdong province, China, on Monday, April 18, 2016. Six years ago, if you bought an Apple iPhone or a pair of Nike sneakers, they probably came from Guangdong. But as the days of cheap land and labor recede, the province's businesses are in a race to upgrade or move. Photographer: Qilai Shen/Bloomberg©Bloomberg

Chinese bankruptcies have surged this year as the government uses the legal system to deal with “zombie” companies and reduce industrial overcapacity as part of a broader effort to restructure the economy.

Courts in China accepted 1,028 bankruptcy cases in the first quarter of 2016, up 52.5 per cent from a year earlier, according to the Supreme People’s Court. Just under 20,000 cases were accepted in total between 2008 and 2015. 

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China’s legislature approved a modern bankruptcy law in 2007 but for years it was little used, with debt disputes often handled through backroom negotiations involving local governments. 

“Bankruptcy isn’t just about creditor-borrower relations. It also touches on social issues like unemployment,” said Wang Xinxin, director of the bankruptcy research centre at Renmin University law school in Beijing. “For a long time many local courts weren’t willing to accept them, or local governments didn’t let them accept.” 

At a major Communist party meeting in October 2014 known as the Fourth Plenum, leaders pledged to strengthen “socialist rule of law”, including steps to lessen political interference in court cases. 

Now bankruptcy courts have been recruited into China’s drive for “supply-side reform”, which centres on reduction of overcapacity in sectors such as steel, coal and cement.

But there are concerns that the bankruptcy law will allow some zombie companies to continue operating. In guidance to lower courts, the supreme court has said they should, where possible, use mergers or restructuring rather than liquidation, in order to allow a company to emerge from bankruptcy as a going concern. This month the court provided several case studies of successful bankruptcies, all of which kept companies in business. 

“We shouldn’t promote simple slogans like ‘use more restructuring and less liquidation’. That’s not really accurate,” said Li Shuguang, professor at the China-EU School of Law at China University of Political Science and Law. 

“I personally think liquidations should be used more. Only enterprises with real value should be saved. The most important [thing] for zombie firms is to liquidate them. Then we can find better ways to deal with laid-off workers, like retraining and re-employment.” 

Experts say most legal bankruptcies involve small or medium-sized enterprises where the social impact is limited. Liquidation-style bankruptcies also far outweigh restructurings in terms of absolute numbers. But courts face strong incentives to keep larger enterprises operating. 

In general, bankruptcy offers greater protection to borrowers compared with dealing with creditors out of court. Without bankruptcy, a single creditor can block a proposed debt restructuring or writedown, even if most others agree. By contrast, judges have the authority to override holdouts and impose a settlement on all parties. 

“Once a court accepts a bankruptcy petition, creditors’ sealing off an office or seizing collateral is immediately halted, so it allows a company to return to production,” said Mr Li.

Additional reporting by Ma Nan

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