Substantive Consolidation of Bankruptcy Proceedings in China: A Critical Examination.

• Author: Li Xiaolin

ABSTRACT:

Substantive consolidation in China is a judge-made law that is developed under the supervision and instruction of the Chinese Supreme People's Court (SPC). Chinese courts have applied substantive consolidation as a "routine" remedy in bankruptcy cases for enterprise groups. After the selection of Minfa Securities as a model case in 2013, the publication of the SPC Minutes in March 2018 marks another milestone in that the SPC Minutes codify the consequences, scope, eligible applicants, competent courts, procedural, and substantive requirements of substantive consolidation. In the SPC minutes in March 2018, the SPC for the first time emphasized that substantive consolidation must be cautiously applied in cases. The generality and vagueness of the SPC Minutes causes difficulty in its adoption as an effective guideline for Chinese courts. Moreover, individual creditors' interests are still ignored. Consequently, a corresponding shift in judicial practice is yet to become apparent, and the application of substantive consolidation in bankruptcy proceedings is still high. The current judgment numbering and publication system of China may have influenced the accuracy of the empirical data, but is nevertheless insufficient to rebut the assertion that substantive consolidation has been and continues to be overused in bankruptcy cases for enterprise groups in China.

1. INTRODUCTION

   The United Nations Commission on International Trade Law (UNCITRAL) defines substantive consolidation as the treatment of the assets and liabilities of two or more enterprise group members as if they are a part of a single insolvency estate. (1) The creditors of the entities that are substantively consolidated are deemed to be creditors of a single debtor and share pro rata out of the common pool. (2) Generally, in the few countries where the remedy is available, it is limited to exceptional circumstances (3) due to the concern that the routine application of substantive consolidation would undermine the benefits to be derived from the fundamental principle of a separate legal entity under modern corporate law--that is, a company is considered to be an independent legal person with its own rights and duties separate from its owners and managers. (4)

   China, however, is an exception. The Chinese Enterprise Bankruptcy Law (Chinese EBL) (5) is modeled after Western bankruptcy laws, notably the United States Bankruptcy Code. (6) Substantive consolidation in bankruptcy cases for "affiliated enterprises ([phrase omitted])--a term equivalent to enterprise groups in Chinese law (7)--is a judge-made law that the Chinese EBL has never expressly or implicitly authorized. The Chinese Supreme Peoples Court (SPC) has been instrumental in the formation and development of substantive consolidation. The SPC has also been influenced by the relevant rules of American bankruptcy law and the UNCITRAL Legislative Guide. (8) Unlike their American counterparts, Chinese courts have routinely applied substantive consolidation in bankruptcy cases involving affiliated enterprises, often without sufficient caution or prudence.

   Against this background, the SPC published the Minutes of the National Courts' Meeting on Bankruptcy Adjudication (hereinafter the SPC Minutes) on March 3, 2018, specifying the key aspects concerning substantive consolidation in bankruptcy cases for affiliated enterprises. (9) For the first time, the SPC emphasized the fundamental principle of separate legal entities in bankruptcy cases, and that substantive consolidation must be only granted in exceptional cases. The SPC's efforts have not been rewarded with a corresponding shift in judicial practice, however, and the success rate of the application of substantive consolidation in bankruptcy proceedings is still high. This article provides an overall examination of the laws and practices concerning substantive consolidation in China and assesses whether the SPC Minutes changes have met the SPC's expectations. To this end, Part I provides a brief introduction of the background of the article. Part II provides a review of how substantive consolidation has, under the instruction of the SPC, become a routine remedy in Chinese bankruptcy practice involving affiliated enterprises. Part III provides a comparison of the laws and practices before and after the issuance of the SPC Minutes. Part IV discusses whether substantive consolidation has been overused in China, and the conclusion is provided in Part V.

2. THE SPC-GUIDED FORMATION OF SUBSTANTIVE CONSOLIDATION RULES IN CHINA

   In the United States, the power of bankruptcy courts to order substantive consolidation is not expressly authorized by a statute but is thought to derive from [section]105 of the United States Bankruptcy Code, which grants the courts general equitable powers to "issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title." (10) In China, substantive consolidation is also judge-made. This is a bold innovation for Chinese courts, considering the constraints imposed on the judiciary's discretionary powers in recent years. (11) The exception regarding substantive consolidation is attributed to the widely accepted view that Chinese judges should take a more active role in bankruptcy cases than in ordinary civil and commercial cases. (12) Scholars also proposed that the deviation stems from the global financial crisis, which led to a surge of bankruptcy cases after 2008 and motivated judicial innovation in bankruptcy practices. (13) As will be discussed later, the SPC authorized and promoted substantive consolidation as an innovation, because local courts are under the supervision of the SPC in every stages of the development of substantive consolidation.

   Like the supreme courts of many countries, the Chinese SPC is the highest judicial body in China that hears and decides cases on appeal or through other procedures from lower courts. (14) The powers of the SPC, however, are far more than that. First, the SPC has a quasi-legislative power in that it may issue judicial interpretations and judicial documents that are either legally or de facto binding (15) upon all local courts, including high courts at provincial level, intermediate courts at municipal level, people's courts at county level, and special courts, such as military courts and maritime courts. (16) To achieve greater consistency across these courts, the SPC selects cases from lower courts and publishes them as SPC Guiding Cases, which are officially binding and can be cited in judgments. The SPC also selects Model Cases, which are not legally binding and thus cannot be directly cited in the judgment, but are an authoritative reference for lower courts to follow. (17) In addition, Chinese courts have the constitutional right to exercise judicial power independently without interference from any governmental organization, social organization, or individual. (18) The supervision power of the SPC over the lower courts, which is also written into the Chinese Constitution, (19) has authorized the former to exert political influence upon the latter. (20) The formation and development of substantive consolidation is the result of a combined exercise of all these functions of the SPC.

   The SPC used to adhere to the principle of separate legal entity and was against consolidation in both substantive and procedural aspects. In a judicial interpretation published in 2002, the SPC opined that the subsidiaries of a bankruptcy debtor must file for bankruptcy separately. (21) Lower courts followed this approach, including a few high courts at the provincial level. (22) For a time, even communication and cooperation between courts involved in the bankruptcy of the same enterprise group were difficult and rare. For example, in GITIC Group, although the High Court of Guangdong Province declared the parent company Guangdong International Trust and Investment Corporation (GITIC) bankrupt, three wholly-owned subsidiaries of GITIC entered into bankruptcy proceedings before the intermediate courts of their respective registered offices, Guangzhou and Shenzhen. (23) Cooperation and coordination were possible only because of the leading position of the Guangdong High Court, which was the court for the parent company, and, is also the common higher court of the two intermediate courts. But in D'Long Group, the absence of a common higher court that could authorize or at least lead the coordination and cooperation eventually resulted in inefficient and piecemeal liquidation of the giant enterprise group. Bankruptcy proceedings against various group members of D'Long were conducted without coordination in different provinces despite the intermingling of assets, operations, and liabilities of the members. (24)

   The failure of D'Long Group inspired the first discussion of the drawbacks of the lack of substantive consolidation rules in China. Chinese scholars were concerned about the abuse of legal personality by Chinese companies and contended that in bankruptcy cases for enterprise groups, the court should assume the existence of personality intermingling among the group members and apply substantive consolidation. (25) The SPC's attitude toward substantive consolidation also started to change after the Chinese EBL went into effect. In 2007, the SPC authorized the Shenzhen Intermedia ate Court, which has a reputation as the pioneer (26) of Chinese bankruptcy innovation, to apply substantive consolidation in the bankruptcy case of Southern Securities Co. and its affiliated enterprises. (27) A few months later, Song Xiaoming, the then-Presiding Judge of the Second Division--the Commercial Division of SPC, spoke approvingly of Southern Securities in the Annual Review Meeting of National Courts Regarding the Bankruptcy of Securities Companies, providing a political endorsement for the legality of applying substantive consolidation in...