Bankruptcy derivative litigation: the "dilemma" and "breakthrough" of creditors in dealing with individual liquidation and revocation risks in bankruptcy proceedings

LABEL： Debt restructuring , Dispute Resolution and Litigation ,

introduction

According to Article 32 of the Enterprise Bankruptcy Law of the People's Republic of China, the administrator has the right to sue and request the court to revoke individual liquidation actions of the bankrupt enterprise within a certain period of time. Creditors often face difficulties in providing evidence and unclear legal application when facing such individual liquidation revocation lawsuits.

We recently acted as an agent for a creditor of a financial institution to handle a second instance litigation for an individual settlement dispute. This article will attempt to combine this case to propose our thoughts on the above legal provisions, discuss the "difficulties" and "breakthroughs" that creditors face in dealing with individual liquidation revocation lawsuits, and provide ideas for creditors to mitigate the potential risks brought by such disputes.
1、 Creditors' dilemma in dealing with individual debt cancellation disputes

In order to enrich the debt repayment assets of bankrupt enterprises and maintain fair compensation for creditors, the Enterprise Bankruptcy Law grants the administrator the right to revoke specific actions taken by the debtor during a certain period before bankruptcy. This article focuses on the individual repayment behavior of the debtor referred to in Article 32 of the Enterprise Bankruptcy Law within 6 months before the acceptance of the bankruptcy application, also known as "biased repayment behavior". According to this provision, the revocation of such behavior requires the following conditions to be met:

The repayment occurs within 6 months before the acceptance of the bankruptcy application: generally speaking, the date of acceptance of the bankruptcy application is the date on which the court makes an acceptance ruling on the debtor's bankruptcy application.

When the liquidation occurs, the debtor is in a bankruptcy situation, namely the situation of "inability to repay due debts+insolvency or clear lack of solvency" as stipulated in Article 2 (1) of the Enterprise Bankruptcy Law.

The liquidation did not benefit the debtor's property: This is a provision of Article 32 of the Enterprise Bankruptcy Law, but it is also one of the difficulties in individual liquidation revocation cases. Please refer to the following text for details.

At the same time, judicial interpretations clarify that Article 32 of the Enterprise Bankruptcy Law does not apply to partial repayment behaviors, including: the debtor's repayment of the creditor's rights that have been secured by their own property within the value range of the secured property; Repayment made through litigation, arbitration, and enforcement procedures; Water and electricity bills paid to maintain basic production needs; Pay labor remuneration and compensation for personal injury. [2]

Based on the above provisions, when the "defense" administrator initiates individual liquidation revocation lawsuits, creditors usually face two difficult situations:

Regarding the question of whether the debtor has a bankruptcy situation when repayment occurs, firstly, the Enterprise Bankruptcy Law does not consider the subjective state of the creditor when receiving repayment as an exception to determine whether the right of revocation is established. That is to say, even if the creditor does not subjectively know that the debtor has a bankruptcy situation, it is still difficult to use this as a defense against the right of revocation. Secondly, creditors usually do not have evidence of whether the bankrupt enterprise is "insolvent" or "lacks solvency" when repaying its debts. Therefore, when examining and determining this factual issue, the court often relies on the financial information of the enterprise held by the bankruptcy administrator. As external entities of bankrupt enterprises, creditors find it difficult to effectively challenge the evidence presented by the bankruptcy administrator.

Regarding whether the repayment benefits the debtor's property, both the Enterprise Bankruptcy Law and judicial interpretations exclude the repayment behavior that benefits the debtor's property from the scope of revocability. But there is no further provision in laws and judicial interpretations on how to determine "benefiting the debtor's property". In practice, creditors often need to explain to the panel from multiple aspects such as finance and business how the liquidation behavior benefits the bankrupt enterprise, and the burden of proof and argumentation is relatively heavy.

In the individual settlement dispute cases we represented recently, the company faced both of the aforementioned difficulties. After taking over the second instance of the case, we conducted a comprehensive review of the repayment process involved and provided sufficient evidence and reasoning to the second instance court, successfully winning the court's support for some of our viewpoints. Based on the situation of this case, we now share two "breakthrough" directions that creditors can try when facing the dilemma of individual liquidation revocation lawsuits.
2、 One of the directions of "breakthrough": advocating using loans to repay loans to benefit the debtor's property
1. "Benefiting the debtor's property" has not yet formed a unified standard for judgment

As mentioned earlier, the clause in Article 32 of the Enterprise Bankruptcy Law excludes the repayment behavior that "benefits the debtor's property" from the scope of the administrator's revocation right. However, there are different understandings in judicial practice regarding the so-called "benefit" judgment standard:

           

From this, it can be seen that judicial practice has not unified the judgment standards for the provision of Article 32 of the Enterprise Bankruptcy Law, and market entities find it difficult to establish stable expectations during transactions. Some scholars believe that the reason for the existence of different judgment standards for "benefiting the debtor's property" is largely due to the general wording of Article 32 of the Enterprise Bankruptcy Law, which makes it difficult to determine its specific scope. [3]
2. What is' benefit '? Starting from the legislative purpose of Article 32 of the Enterprise Bankruptcy Law

It is worth noting that the repayment behavior referred to in Article 32 of the Enterprise Bankruptcy Law does not necessarily involve the intentional infringement of the debtor's property by creditors to obtain a more favorable position for repayment. It also includes the behavior of the debtor repaying the due debts to creditors under normal transaction circumstances. The reason why Article 32 of the Enterprise Bankruptcy Law stipulates that such repayment behaviors that occur during the critical period of bankruptcy can be revoked is not only to avoid the loss of the debtor's property, but also to ensure that creditors are fairly compensated, prevent some creditors from obtaining a superior position for compensation due to individual repayment before bankruptcy, that is, to avoid "biased" results due to individual repayment.

We believe that the interpretation of "benefiting the debtor's property" should not deviate from the normative purpose of the aforementioned legal provisions. This provision is more appropriately interpreted as limiting the constituent elements of biased liquidation referred to in Article 32 of the Enterprise Bankruptcy Law. For individual liquidation actions that have not resulted in biased outcomes and have not reduced the debtor's assets, they do not fall within the scope of liquidation actions denied by Article 32 of the Enterprise Bankruptcy Law. On this basis, in response to the viewpoint that "individual repayment should increase the debtor's property", we believe that it seems to excessively expand the scope of Article 32 of the Enterprise Bankruptcy Law, which does not fully meet its regulatory purpose.

It can be confirmed that the rationality of this viewpoint is that judicial interpretations stipulate that the repayment of creditor's rights with security interests over self owned property cannot be revoked. It can also be considered that such repayment does not change the creditor's position within the value range of the secured property, and therefore does not have a biased result.
3. 'Repaying loans with loans' does not belong to biased repayment

In the aforementioned case we represented, there was a situation where the debtor immediately provided a new equivalent loan after each repayment, which conforms to the characteristic of "repaying loans with loans". In judicial practice, courts have different understandings of whether such repayments belong to biased repayment. Some courts, based on the aforementioned "viewpoint one", believe that "repaying loans with loans" does not actually benefit the debtor's property. [4] Even some courts believe that this transaction conceals the debtor's true financial situation and delays the time of risk outbreak, thus negating the disputed repayment behavior. [5]

Based on our previous views, we believe that the debtor's repayment behavior under the "loan repayment" item does not belong to the biased repayment that Article 32 of the Enterprise Bankruptcy Law aims to deny:

This type of liquidation did not result in any reduction of the debtor's assets. After the process of "repaying loans with loans" is completed, the debtor obtains new equal loan funds, and the total amount of debt has not changed, nor has its assets decreased. On the contrary, due to the effect of "repaying loans with loans", which is equivalent to extending the debt term, the debtor actually gains new term benefits.

This type of liquidation behavior has not resulted in individual creditors obtaining a more favorable liquidation position, which is a biased outcome. This is because in the process of "repaying loans with loans", there is an inherent high degree of consistency and continuity in the subject, amount, and transaction arrangement between the two loans, and the creditor has not received substantial compensation based on this transaction process, and the amount and repayment status of the debtor's debt have not changed.

In addition, when a company has not yet officially gone bankrupt and is only facing operational difficulties, efforts will be made to avoid the consequences of bankruptcy. By "repaying loans with loans", financial institutions provide new loans to distressed enterprises, and the debtor's repayment period is actually further extended, which is conducive to maintaining the stability of their capital flow and thus helping to slow down the deterioration of the enterprise's operating conditions. If this type of repayment is denied, no market entity will be willing to engage in transactions or provide new financing to struggling enterprises, which will actually create an unfavorable situation where such enterprises have no way to save themselves.

In fact, there is also an exception clause in overseas bankruptcy laws regarding the revocation of biased liquidation: if the debtor repays the debt and the creditor provides new value to the debtor, the liquidation within the new value range is not revocable. The principle behind this regulation is that due to the existence of "posterior new value", there has been no result of damage to the debtor's property and the interests of other creditors, and it helps encourage creditors to continue transactions with debtors who are facing financial difficulties. [6] In the absence of similar explicit provisions in Chinese law, some courts have also recognized that such liquidation actions should not be revoked:

           

After our thorough reasoning and review of similar case judgments, the presiding judge fully recognized our viewpoint and believed that the "loan repayment" in this case did not substantially reduce the total assets of the bankrupt enterprise. Our client's status as a creditor has not changed, and the interests of other creditors have not been damaged. Therefore, such repayment behavior should not be revoked.
3、 The second direction of "breakthrough": advocating that the liquidation carried out by bankrupt enterprises on behalf of third parties does not belong to biased liquidation

In practice, creditors may simultaneously provide financing to other affiliated entities of a debtor, and the debtor may also have situations where it repays creditors on behalf of its affiliated entities. In the aforementioned case that we represented, the administrator's claim for revocation of the liquidation action also included partial repayment by the bankrupt enterprise on behalf of a third party, and the bankrupt enterprise itself did not assume any guarantee responsibility for the debt of the third party.

We are attempting to argue with the court that, based on the normative purpose of Article 32 of the Enterprise Bankruptcy Law, this provision is aimed at debtors who have bankruptcy situations to repay their own debts to their own creditors. If the debtor's repayment is not for their own debt, but for the repayment of a third party's debt on their behalf, then the creditor's claim against the debtor has not obtained a more favorable position for repayment compared to other creditors, and has not produced biased results. Correspondingly, according to Article 524 of the Civil Code of the People's Republic of China [7], after repayment on behalf of a third party, the creditor's claim against the third party has automatically been transferred to the debtor, and the administrator shall claim rights against the third party.

The final judgment of the court not to revoke the repayment made by the bankrupt enterprise on behalf of a third party is mainly based on two reasons: firstly, the court adopts our argument and believes that such repayment is not the repayment of the bankrupt enterprise's own debts, and therefore does not fall within the scope of individual repayment as stipulated in Article 32 of the Enterprise Bankruptcy Law; Secondly, the third party involved in the repayment is not a party to this case, and whether the repayment is revoked or not has a direct interest in the third party, so substantive proceedings should not be conducted.

From the above judgment, it can be seen that if the administrator only requests the revocation of the bankrupt enterprise's repayment on behalf of a third party based on Article 32 of the Enterprise Bankruptcy Law, creditors may still have room for breakthrough.

However, it should be noted that if the administrator exercises the bankruptcy revocation right granted by Article 31 of the Enterprise Bankruptcy Law on the grounds that such repayment behavior falls under the category of "gratuitous transfer of property", based on the difference in legislative principles and constituent elements, creditors may find it difficult to directly challenge the administrator's claim on whether such repayment belongs to individual repayment. When such a situation arises, we believe that creditors can try to argue whether the repayment actually caused damage to the debtor's property from the perspective of the relevant agreements made by the debtor when repaying on behalf of the debtor, the financial transactions between the third party and the debtor, or the third party's debt repayment ability, and then seek a breakthrough.
4、 Other suggestions for creditors

In summary, although creditors face various difficulties such as providing evidence and reasoning when facing a lawsuit from the administrator to revoke repayment, when they cannot apply the clear exemption situations in judicial interpretations, they can combine with Article 32 of the Enterprise Bankruptcy Law to find a strong breakthrough direction. If the administrator claims to revoke the repayment behavior based on Article 32 of the Enterprise Bankruptcy Law, and there is a situation of "repaying the loan with a loan" or repaying on behalf of others, creditors may consider responding adequately in the litigation process from such a perspective.

At the same time, in addition to the substantive litigation response direction we proposed above, we suggest that creditors should start from the following aspects to minimize the risk of liquidation being revoked as much as possible:

When negotiating financing terms with the debtor, it is advisable to track the debtor's financial status through contractual arrangements as much as possible, in order to identify the debtor's bankruptcy risk as early as possible. Especially when it comes to asset management products such as trusts, asset management plans, and private equity funds, managers need to fully consider the risk of individual repayments being revoked in the future, and make corresponding arrangements in the process of recovering underlying investments and distributing investor returns;

After the debtor enters bankruptcy proceedings, if the administrator actively communicates with the creditors to understand the relevant situation of the debtor's repayment before bankruptcy, the creditors can consider checking whether there are situations such as "loan repayment" or repayment on behalf of others, and fully communicate with the administrator based on loan management materials and other evidence, in order to avoid the risk of the administrator suing to revoke the relevant repayment.

5、 Conclusion

This article starts from the perspective of bankruptcy derivative litigation and, based on our personal experience of cases, attempts to stand from the perspective of creditors, providing possible directions for them to break through when facing individual liquidation revocation lawsuits. We also hope that a relatively unified understanding can be formed in legislation or judicial practice regarding the application of Article 32 of the Enterprise Bankruptcy Law and the definition of biased liquidation, in order to provide more stable expectations for commercial activities.