Readers of European and American economic news will find that the high frequency of “bankruptcy” and “bankruptcy reorganization”. They are common for little-known small companies as well as for famous giant multinational companies. Even General Motors, which was known to the general public, once entered bankruptcy reorganization. Aggravated by global epidemic in 2020, many well-known large companies have gone bankrupt. In Europe and the United States, “bankruptcy” seems to be common, but Chinese entrepreneurs do not seem to be ready to face it.

Although in fact, China’s Enterprise Bankruptcy Law had come into force as early as June 1, 2007, but for more than ten years, this law is rarely cared. The reason is naturally determined by various factors in the context of its tradition and times.

On March 4, 2018, the Supreme People’s Court issued the Minutes of the National Court’s Work Meeting on Bankruptcy Trial, which marked the official complete activation of China’s corporate bankruptcy legal system. Subsequently, bankruptcy courts specializing in bankruptcy cases began to be established all over the country. On June 22, 2019, the National Development and Reform Commission, the Supreme Court and more than a dozen ministries and commissions jointly issued the Reform Plan to Accelerate and Improve the Exit System of Market Entities, which means that corporate bankruptcy as the main exit method of market entities will become the norm. The high level of issuers also indicates that it will affect every market entity and mainly the companies and entrepreneurs who are the investors or managers.

In this regard, entrepreneurs should take the basic course of “bankruptcy”, so that they can “face up to bankruptcy”, “understand bankruptcy” and “use bankruptcy well”, and make isolation and prevention arrangements with individuals in advance of the business risks of the enterprise.

I. Face up to “bankruptcy”

First, they should face up to the word “bankruptcy”, that is, to face up to the legal system of bankruptcy.

Obviously, the word “bankruptcy” is not only a word with strong negative connotations in Chinese traditional culture and concepts, but also a word with bad luck. This is just like many people are reluctant to buy insurance because they feel that they are cursing their early death. For Chinese entrepreneurs, they still have to overcome considerable psychological barriers when they consider the risks posed by bankruptcy at the beginning of their business or when their business is going well. This is due to human nature and is completely understandable.

However, the legal term “bankruptcy” not only indicates that the enterprise’s bankruptcy, but also includes a complete set of bankruptcy legal systems. An essential significance of this system is to protect the enterprise and even the individual entrepreneurs. Therefore, a common term heard is “bankruptcy protection.” Of course, this kind of bankruptcy protection has prerequisites, and will only work for those who are prepared. Entrepreneurs should not only overcome the psychologically rejection of the word “bankruptcy”, but also objectively and rationally understand the bankruptcy legal system in advance as soon as possible.

The other is to face up to the phenomenon of “bankruptcy”, that is, to face up to business risks.

Since China's reform and opening up, its economy has been developing rapidly, and so is China’s enterprise development. In this context, even if an enterprise fails in business or is in debt, entrepreneurs have more opportunities to cover the early debts through various methods to regain or restart a business. The 30-year high-speed growth has caused Chinese entrepreneurs’ weak sense of risk of “inability to get up after a fall”. They are more concerned about how to make money, while ignoring risk prevention.

However, in recent years, as China’s economy has obviously stopped growing rapidly, enterprises have had their liabilities increased, with declined profits and the ability to resist risks. The economic cycle that Chinese entrepreneurs have never experienced is arriving. For Western developed countries that have experienced hundreds of years of capitalist development, their entrepreneurs have long developed a strong sense of prevention against inherent business risks, and have long had a mature bankruptcy legal system for self-protection. The Chinese entrepreneurs must first make up for this lesson in terms of risk awareness, accept the objective law of completely unavoidable business risks, and make risk prevention in advance.

II. Understand “bankruptcy”

Article 2 of the Enterprise Bankruptcy Law stipulates that where an enterprise legal person cannot pay off his debts due and his assets are not enough for paying off all the debts, or he apparently lacks the ability to pay off his debts, the debts shall be liquidated according to the provisions of this Law.

In the above provision, corporate legal persons mainly refer to companies established in accordance with the Company Law. Those relating to private entrepreneurs are limited liability companies and joint stock company limited. It can be seen that the bankruptcy legal system is closely linked to the company legal system and the legal system related to debt settlement. It is necessary to understand the impact of the bankruptcy legal system and the relevant knowledge of these two aspects.

1.What is the “independent legal person” and “limited liability” of a company?

With years’ development of the rule of law, many people have learned the knowledge or had personal experience that if a contract or commercial activity is signed or carried out in the name of the company, the company shall bear the responsibility in the event of a dispute, and the other party can only use the company as the defendant in the court. Most people just know it but don’t know why that is. The company has the status of an independent legal person and should legally enjoy rights and assume responsibilities independently. To put it simply, a company is a “person” formulated in law. Of course, it should “accept the consequences of its own doing”, which makes the company a debt firewall between the business risks of the company and the shareholders.

However, there is a prerequisite for the company to independently assume legal responsibility, that is, the company is indeed independent, which is reflected in the company’s property. As a shareholder who controls the company, he shall ensure that the company’s property is independent. From the establishment to the operation, the property of the company shall be vested in the company; except for payment of full amount of capital contributions in accordance with the articles of association, the shareholders shall not transfer, misappropriate, or encroach on the company’s property; or confuse the company’s property with the property of shareholders or others. Otherwise, the company will lose its status as an independent legal person, and shareholders shall be liable for the company’s debts.

The so-called “limited liability” means that the shareholders’ liability to the company is limited to the amount of capital contribution. Namely, as long as the shareholders contribute the subscribed registered capital in place, they should not bear other responsibilities to the company, let alone the company’s debts. However, this “limited liability” is actually closely related to the company’s “independent legal person” status. Only if the company is in a legal “independent” state, shareholders will have “limited liability”. If the above independent legal person status of the company is undermined, shareholders may directly bear various shareholders’ responsibilities for the company’s debts.

2. Introduction and results of bankruptcy proceedings

General bankruptcy proceedings:

(1) Bankruptcy conditions: Two conditions must be met at the same time: the inability to pay off the debts due; and insufficient assets to pay off all the debts or the obvious lack of solvency.

(2) Initiation of bankruptcy proceedings: creditors or debtors can apply to the court for bankruptcy and liquidation of the company.

(3) General process: application → acceptance→ appointment of bankruptcy administrator → financial audit and declaration of creditor’s rights→ Creditors’ meeting → reorganization or settlement→ (Failure of reorganization or settlement) Declaration of bankruptcy → liquidation and distribution → termination of bankruptcy proceedings.

The result of bankruptcy:

(1) After the court declares the bankruptcy of a company, all enforcement cases shall be terminated;

(2) Since the enforcement cases are terminated, the original enforcement measures such as restrictions on high consumption and entry and exit will be lifted together.

(3) After bankruptcy proceedings are over and all the bankruptcy property is distributed, the remaining creditor’s rights will not need to be paid off.

3. Bankruptcy proceedings will expose or result in shareholders’ liabilities

In the above-mentioned bankruptcy proceedings, the most key elements are financial audits and creditors’ meetings, which will directly lead to the exposure of shareholders’ liabilities.

If entrepreneurs self-examine their companies in accordance with the previous standards regarding the status of independent legal persons of the company and limited liability of shareholders, the author believes that most entrepreneurs will find that they have committed almost all behaviors that affect the status of independent legal persons of the company. However, at least a few years ago, the court did not take measures against them, and there were not many cases where shareholders assumed shareholders’ liabilities. Here lies a very important factor. The behaviors that affect the company’s independent legal person status are all related to the infringement of the company’s property and interests, and such information and evidence are reflected in financial information or company’s internal documents. Under normal circumstances, since the creditors cannot obtain these information or documents, it is difficult to hold shareholders accountable in practice.

Once the bankruptcy proceedings are entered, the bankruptcy administrator appointed by the court will take over the management of the company as well as all financial information and documents, investigate the debtor’s property status, and produce a property status report. The main means of investigation and production of a report is to initiate bankruptcy audit. After the bankruptcy audits, acts that infringe on the interests of the company such as the transfer of the company’s property may be discovered and reflected in the final audit report.

The most common, the most traditional and crude practices that are  easiest to be discovered by audits are as follows:

(1) The subscribed registered funds have not been paid in full (including those that are not due);

(2) Immediate withdrawal after subscription;

(3) Shareholders’ borrowing of money or billing of current accounts;

(4) Inconsistency between bank turnover and certificates or contracts, etc.;

(5) Frequent and obviously unreasonable bank transfers between the company and individual shareholders;

(6) Use of the company’s property or funds for shareholders’ personal use;

(7) Related-party transactions;

(8) Various other situations that may infringe on the interests of the company.

The creditors’ meeting or creditors’ committee has the right to know the specific property and financial status of the company, and has the right to consult the bankruptcy audit report. The above-mentioned situation in the audit report will be of most concern to creditors, because for creditors, only by recovering as much the company’s property as possible will they obtain as much final distribution of bankruptcy property as possible.

At the same time, the evidence found in the bankruptcy audit can also be used to pursue other shareholders’ responsibilities stipulated in the Company Law in addition to the bankruptcy proceedings. For example, if the financial books are found to be incomplete during the bankruptcy audit, which ultimately leads to the inability to complete the liquidation, the shareholders need to bear the liabilities for the failure of the liquidation to the creditors. There are other potential shareholders’ liabilities arising from infringement of the interests of the company or creditors, and relevant evidence may be exposed in the bankruptcy audit.

In case of above circumstance, we find that the firewall of corporate’s operating risks constituted by the company’s independent legal person status and the limited liability of shareholders has been broken, and the shareholders will directly bear the debts or other liabilities of the company. For individual shareholders, this kind of debt or liability affects not only the property in their personal name, but also the assets of the entire family.

4. Bankruptcy protection

For many companies that have been sued to the court for enforcement due to temporary capital turnover problems, even if the company’s production and operation can actually continue and return to normal business after surviving the difficulties, the court’s enforcement may directly sentence the company to death and the court really cannot continue to operate. For such an enterprise, it is a pity to end up this way, and it is also inconsistent with the state’s policy of protecting the entrepreneurial spirit.

In this regard, the bankruptcy legal system has established a protection mechanism. Article 19 of the Enterprise Bankruptcy Law stipulates that after the people’s court accepts an application for bankruptcy, the measures for preserving the property of the debtor shall be lifted and the procedure for enforcement shall be suspended.

According to the above provisions, once the bankruptcy proceedings are entered, all enforcement will be suspended, and the preserved company property will also be relieved of the preservation measures, and the bankruptcy administrator will take over the company. At the same time, there is an opportunity of reorganization or reconciliation which allows the continuous operation and gives the company a chance to be reborn.

III. Use “bankruptcy” well

According to foregoing introduction, the bankruptcy legal system is a double-edged sword, which can protect the enterprise in some cases but may also cause the risks of shareholders’ liabilities. It is not easy to keep yourself from being hurt by “bankruptcy” while using the “bankruptcy” well.

1. Operational compliance and financial compliance are prerequisites

From the beginning of the establishment of the company, shareholders must begin to consider shareholders’ liabilities. They should ensure operational compliance and the financial compliance in particular, as well as non-transfer or infringement of the company’s property; financially, the expenses and income of the company should be passed through the company’s bank account and credited to the company. Only in this way can the company’s independent property and independent status be guaranteed, and the company can independently bear the company’s debts and responsibilities without harming shareholders.

In addition, shareholders should not arbitrarily increase the responsibilities of themselves. For example, some people think that the company’s registered capital is better to be larger, and that they don’t even have to pay it in full immediately. Hence, they set a large registered capital. However, once the company enters bankruptcy proceedings, the subscribed amount needs to be paid in advance by shareholders.

2. Make enterprise architecture planning in advance

Under the premise of the company’s compliance operation, if the company’s operation is unsustainable, it can take the initiative to apply for bankruptcy protection or bankruptcy liquidation to get rid of debts. Therefore, it is very important carry out corporate structure planning.

One category is horizontal architecture. Many entrepreneurs, for convenience or unconsciously, put many different or unrelated businesses under one company. If one of the businesses has debt and the other is operating well, the profits of the latter will be used to cover the losses of the other. On the contrary, if you plan in advance and carry out business activities under two different companies, when one business is unsustainable, you can take the initiative to apply for bankruptcy and liquidation, and its debts will not endanger the other business company, which can isolate the risks.

The other category is vertical architecture. Nowadays, more and more non-family companies are jointly invested by different shareholders for profit. Since there may also be various potential shareholder risks, sometimes it is necessary to consider not to directly serve as an individual shareholder but to establish an actually operating company to serve as the shareholder, thereby providing an extra isolation.

3. Use “bankruptcy” to pursue the liabilities of debtors

Even though the enforcement by of the courts have been intensified in recent years with significant effect, if the company is the discredited judgment debtor, the transfer of company property by the company’s shareholders or actual controllers is still difficult to found through general superficial investigations. As a result, courts often end the case because there is no property for enforcement, and it actually becomes a bad debt.

In this case, you can directly apply for the bankruptcy of the company which is the discredited judgment debtor. The bankruptcy audit will find the clues about the transfer or infringement of the company’s property by shareholders, and you can find ways to have the debt settled through the shareholders. In fact, financial irregularities and shareholders’ abuse of the company’s assets can be found in most companies. Therefore, there should be a fairly high probability to achieve a certain effect.


Conclusion

After forty years of reform and opening up, Chinese entrepreneurs can no longer adopt traditional old concepts to treat their hard-earned wealth in an extensive and passive way, either speaking of the development of social economy or the improvement of the rule of law. Instead, they should establish a sense of active risk management, fully understand the legal environment, and establish an effective and long-term security mechanism for their accumulated wealth in advance.

1. The subject of bankruptcy stipulated in the Enterprise Bankruptcy Law is a corporate legal person, and the vast majority of corporate legal persons are corporate legal persons. For convenience of description, the “enterprise” or “corporate legal person” mentioned herein refers to the legal person of the company.