Due to the COVID-19 epidemic, many observers are predicting an increase in claims relating to insolvency proceedings. Against the backdrop of the increasing prevalence of arbitration clauses and agreements governing commercial disputes, in 2021 courts are likely to face a growing number of claims at the intersection of both arbitration and insolvency law.
In the PRC, the applicable laws for arbitration claims against an insolvent debtor are the 2006 Enterprise Bankruptcy Law of the People’s Republic of China (“EBL“) and the Arbitration Law of the People’s Republic of China (“PRC Arbitration Law”).
There are two paths to bankruptcy under the EBL, both requiring approval from the competent people’s court. First, the debtor may voluntarily petition the court for bankruptcy, and second, a creditor may pursue an involuntary petition against the debtor.
Bankruptcy Results in a Stay of Arbitration Proceedings
Whether initiated by the debtor or creditor, a successful petition for bankruptcy results in a temporary stay of legal proceedings — including both litigation and arbitration claims — against the debtor. This stay suspends arbitration proceedings relating to the debtor until the court appoints a third-party administrator (the “Administrator“) to handle the debtor’s assets. Until such appointment, ongoing arbitration is suspended and the court is not permitted to direct any of the parties to submit further disputes to arbitration (EBL Art. 20). Note that while the EBL does provide for debtor-in-possession proceedings, in practice, in almost all cases an Administrator is appointed.
The Administrator May Disclaim Some of the Bankrupt’s Contracts, While Arbitration Agreements are Subject to the Strict Doctrine of Severability
Pursuant to EBL 18, once the stay is lifted, the Administrator has a special right to rescind the debtor’s unperformed contracts, but not an arbitration agreement within such a contract. This limited power of rescission is the result of how EBL Art 18 interacts with the strict doctrine of severability articulated in Art 19 of the PRC Arbitration Law. Under Article 19 of the PRC Arbitration Law, an arbitration agreement exists independently from the contract that contains it, such that a contract’s rescission (解除) does not affect the arbitration agreement within. Instead, the validity of the arbitration agreement is decided by PRC Arbitration Law Article 17(3), whereby arbitration agreements can be invalidated only when entered into “by coercive means”. In practice, showing coercion is only possible in exceptional cases.
In a similar vein, pursuant to EBL 31 and 32, the Administrator also has a special right to apply with the court or arbitration commission having jurisdiction over the matter to revoke a contract that is obviously unfair.
The Administrator Steps into the Debtor’s Shoes
Upon the Administrator assuming control of the debtor’s assets, the Administrator registers creditor claims against the debtor and steps into the debtor’s shoes during civil proceedings. First, creditors are required to submit their proof(s) of claims to the Administrator, who then tallies them to create a register of debts (EBL 57). This includes would-be litigants. Unregistered claimants may not bring claims against an insolvent debtor, and claimants seeking to stand on an arbitration agreement to circumvent this requirement are unlikely to succeed.
The Administrator reports to creditors once they are registered, who then supervise the Administrator’s efforts (Ibid Arts 23, 68–69). The Administrator must therefore participate in any applicable arbitration against creditors on the debtor’s behalf, while attempting to maximize the realizable returns of the other creditors. This is an ongoing duty. Where said arbitration continues even after the insolvency proceedings have concluded, the Administrator must nevertheless continue to perform the duties involved and carry such litigation or arbitration through to completion (Ibid Art. 122).
Once the Administrator takes charge of the debtor’s assets, is it business as usual for arbitration claimants against the debtor? The unfortunate fact for most arbitration claimants is that once the debtor enters insolvency, winning an award is still no guarantee that the claimant will recover the amount owed.
There are special procedural hurdles unique to insolvency law which require special consideration from arbitration claimants. Most creditors must follow the priority of claim order detailed in EBL Arts 43 and 113, which describe which creditors are paid first. These clauses call for priority payments to go to bankruptcy expenses, collective debts, medical and disability benefits, pension payments, old-age insurance premiums, employee wages, social insurance premiums, taxes, and finally “common bankruptcy claims”. Art 119 protects claimants whose civil or arbitration proceedings against the debtor extend beyond the conclusion of bankruptcy proceedings. It does so by apportioning a share of the debtor’s assets (proportionate to the claim sought) before an award or judgment is issued:
With respect to a claim that involved […] a […] pending arbitral decision […] [A]dministrator shall preserve the share involved in distribution in advance.
Facing an Administrator, an Arbitration Claimant Must Carefully Craft an Arbitration Strategy
The Administrator is an unusual adversary for an arbitration claimant.
During arbitration proceedings, the arbitration claimant faces an Administrator acting on the debtor’s behalf. The Administrator is also responsible for investigating the amount and validity of claims. However, when the arbitration claimant’s creditor rights have yet to be determined, that claimant may not always have a chance to exercise voting rights along with the other creditors (EBL Art 59, an exception to this is when the People’s Court is able to determine creditor rights provisionally). In addition, and perhaps to the arbitration claimant’s dismay, the Administrator also proposes how to apportion the debtor’s assets for the benefit of creditors (Ibid para Art 115(4)).
This would affect an arbitration claimant in two ways. First, this leaves the door open to the Administrator adjusting the arbitration claimant’s notional claim downwards as new evidence comes to light. Second, the Administrator can use their role as the drafter of the plan of distribution as leverage against the arbitration claimant. Depending on the size of the arbitration claimant’s claim relative to those of other creditors, it may be easily out-voted during creditor meetings. Once the Administrator’s distribution plan is approved by the Creditors’ Meeting, it is submitted to the People’s Court for approval (Ibid Art 116), and once approved, the debtor’s assets are liquidated and distributed to the creditors. If those creditors wrongfully enlarged their shares at the expense of the arbitration claimant, the claimant’s only recourse after dissolution may be a pyrrhic victory on appeal, since the debtor by that point no longer exists as an entity.
An additional consideration for arbitration claimants is the importance of carefully setting the notional value of an arbitration claim before the responsible people’s court. Once the people’s court grants the arbitration claimant a notional value, this may set a ceiling on their realizable award. Strategically speaking, the amount to be “reserved” for the arbitration claimant’s benefit under EBL Art 119 is difficult to increase after the debtor’s assets have been liquidated. This means that obtaining an unfavourably low “reserve” award could be costly for an arbitral claimant. By way of example, if only $1 million was reserved for the claimant, it does little good for a claimant to win a $5 million award, since any amounts that were not earmarked may be distributed to other creditors by the time the award is issued. Therefore to maximize the amount of a realizable award, an arbitration claimant’s attorneys must be ready to front-load their case and present the full merits of their claim before they may, in fact, have fully developed their arbitration strategy.
Overall, an arbitration claimant should carefully weigh the options available in devising a suitable arbitration strategy against an insolvent debtor.
Steele et al, “Trends and Developments in Chinese Insolvency Law: the First Decade of the PRC Enterprise Bankruptcy Law” 66 Am. J. Comp. L. 669 (2018) at 682
William Lu, “Arbitration and Insolvency Proceedings: The Chinese Law Perspective” Asian Dispute Review, Vol. 23, Issue 1 (January 2021) 18 at 20. See also Supreme People’s Court, “Application of the Enterprise Bankruptcy Law of the People’s Republic of China, Provisions on Several Issues (3)” People’s Court News Media Network, March 28, 2019, online: <www.chinacourt.org/law/detail/2019/03/id/149865.shtml>.