China in Transition

Putting in Place the Legal Framework for a Market Economy - High expectations for the Corporate Bankruptcy Law, Antimonopoly Law, and Law on Real Rights

Chi Hung KWAN
Consulting Fellow, RIETI

The market mechanism is often described as an invisible hand, but a market economy is not at all in a state of disorder; it works on the assumption of the rule of law. Moves to establish relevant laws are also afoot in China, which is striving to shift to a market economy. In addition to the new Corporate Law and Securities Law that took effect this January, the Corporate Bankruptcy Law was enacted in August and deliberations on the Antimonopoly Law and the Law on Real Rights have also reached the final stages.

Corporate Bankruptcy Law lays down the rules under which a firm will exit the market

The Corporate Bankruptcy Law stipulates the procedure for a company's bankruptcy and liquidation, and clarifies the rights of concerned parties such as employees and creditors in such a situation. In China, the current (Trial) Corporate Bankruptcy Law will be abolished when the Corporate Bankruptcy Law which was enacted in August, enters into force on June 1, 2007.

While the trial law only covered state-owned enterprises, the Corporate Bankruptcy Law will apply to all incorporated bodies with the addition of private enterprises, foreign-owned companies, joint-stock companies including listed firms, and financial institutions. As the new bankruptcy law will also cover financial institutions, it is expected that insolvent banks, securities firms, and insurance companies will be reorganized and even closed. In addition, taking into consideration the globalization of corporate activities, the bankruptcy law will be in line with international treaties. The new law will be binding over debtors' overseas assets, while Chinese courts will recognize and implement overseas court rulings on bankruptcies.

With the implementation of the Corporate Bankruptcy Law there will no longer be preferential treatment for state-owned enterprises that have no choice but to exit the market. Up to now, the state has provided huge assistance when some state-owned enterprises that became insolvent due to government policies such as development of the northeast region, industrial adjustments in the western region, shifting from military to civilian industry, and closure of drained coal mines and were forced into bankruptcy. These assistance measures included the rehiring of affected employees and the reduction or forgiveness of debts to banks. However, this sort of "policy-oriented bankruptcy" will come to an end by 2008, with the closure of some 2,000 companies that have already been authorized to use this system. After that, all firms will be required to follow the rules laid down in the bankruptcy law (note 1). As a result, the rule of market competition, namely survival of the fittest, will also come to apply to state-owned enterprises.

The Corporate Bankruptcy Law not only covers bankruptcy proceedings, but also stipulates the procedure for corporate rehabilitation. By "bankruptcy proceedings" I mean liquidation proceedings under which entities that have gone economically bankrupt convert all of their assets into cash or equivalent and pay dividends to their creditors. In contrast, corporate rehabilitation procedures attempt to rebuild a financially distressed firm by securing its financial recovery through such means as reducing or forgiving its debts. In this way, China's bankruptcy law also plays the role of Japan's Corporate Rehabilitation Law.

In the Corporate Bankruptcy Law allocation of the bankrupt party's property is made in order of priority: (1) bankruptcy expenses, (2) unpaid employee wages and labor insurance premiums, (3) delinquent tax, and (4) ordinary bankruptcy claims. Also, as in the case of other countries, including Japan, creditors with collateral, such as banks, have the right to auction off the property in collateral independently of the bankruptcy procedures and thus have priority in reclaiming their loans.

Antimonopoly Law strives to create a competitive market environment

The Antimonopoly Law aims to ensure fair competition, restrain monopolistic conduct, and is a key legal system for maintaining an orderly marketplace. In China, the law and regulations concerning the banning of monopolies are mainly stipulated under the Price Law and the Law against Unfair Competition. But because these laws could not meet the needs of the new environment as the shift to a market economy and market opening progressed, calls had mounted for the creation of a systematic and comprehensive Antimonopoly Law. In response to such demands, the draft of the Antimonopoly Law was submitted to the 22nd Standing Committee of the 10th National People's Congress in June, and is expected to be enacted as early as next spring.

The draft of the Antimonopoly Law bans (1) monopolistic agreements such as price fixing cartels among companies in a competitive relationship and collusion among bidders; (2) abuse of a dominant market position, such as price discrimination and refusing or forcing transactions; and (3) large-scale mergers and acquisitions among firms that could lead to a de facto restriction of competition in a certain area (note 2).

Furthermore, in consideration of China's particular circumstances, the draft Antimonopoly Law also deals with monopolistic conduct on the administrative level. It bans the following conduct as it would abuse the authority of administrators and exclude or restrict competition: (1) compelling the purchase of products from designated vendors; (2) obstructing the free movement and competition of goods between regions; (3) excluding companies from other regions from local bidding for contracts based on standards, and restricting access to information; (4) restricting local investment and setting up of stores to companies based in other regions through discriminatory treatment; (5) forcing companies to implement practices banned under the Antimonopoly Law; and (6) creating regulations that eliminate or restrict competition. It is expected that this will help overcome the problem of the division of the domestic market by the protectionist policies of local governments.

At present, most of the monopolistic companies in China are state-owned enterprises and foreign businesses. In the course of deliberations, views are divided on which of the two groups the Antimonopoly Law should focus on, but it appears that in the end, both will be treated in the same manner.

Law on Real Rights aims to strengthen protection of ownership rights

The Law on Real Rights is an important law that protects citizens' property rights. The basic principle that "a citizen's legal private property will not be encroached upon" is clearly stipulated in the revised Constitution of 2004, but the establishment of a Law on Real Rights is a significant step forward in realizing this.

Deliberations on China's draft Law on Real Rights began in December 2002. Debate was suspended in 2005 in response to criticism of why a private property protection law was needed in a socialist country like China. However, in the fifth round of deliberations at the 23rd Standing Committee of the 10th National People's Congress this August, it was confirmed that property owned by a group, as well as that held by an individual, should be protected in the same way as state-owned property, and the draft is expected to be enacted at the National People's Congress next March. The draft covers movable property as well as real estate, but the focus is on regulations concerning issues that directly affect the livelihood of citizens, such as the requisition of farmland and the extension of land use rights in urban areas, and eviction from homes.

China, as an advocate of socialism, does not recognize the private ownership of land; land in urban areas is state-owned, while farmland is group-owned. Up to now, in the case of urban land for residential use, laws have only recognized the right to use the land (lease) for 70 years even if it was purchased. It has not been clear how to deal with the expiration of the lease, and it has been interpreted that the land is to be returned to the state. In the draft Law on Real Rights, the lease contract for residential land is automatically extended upon expiration, with the length of extension and rent to be decided by regulations set by the State Council.

Additionally, in connection with the recent increase in troubles over land appropriation, the draft Law on Real Rights boosts the degree of security to be provided to residents. Specifically, there are clauses that secure the livelihoods of farmers in cases where the land to be appropriated is farmland, while in the case of urban homes, residents' living conditions will be guaranteed.

On the other hand, the draft also increases the protection of state-owned property. Not only senior officials at state-owned enterprises but also their supervising authorities will face punishment for illegal acts that abuse their positions and make private use of state-owned assets.

A legal framework that contributes to improving the investment environment

Since its entry into the World Trade Organization, China has continued to open up its economy. However, it is not yet recognized as a market economy when conducting trade with developed countries such as Japan, the U.S., and the EU because it has yet to implement some of the laws necessary to support a market economy. Because China is not a market economy, when trading partners take antidumping action against Chinese products, they apply the production cost of a third country instead of the production cost in China as the benchmark for calculating penalty taxes, resulting in a higher tax rate. If China secures its position as a market economy by bringing its legal framework up to par, it will not only benefit Chinese firms, but also the many foreign companies that use China as a production base for exports through direct investment and outsourcing. Moreover, the implementation of these laws can strengthen protection of ownership rights and secure fair competition, the investment environment in China for foreign companies will be further enhanced.

September 22, 2006
  1. According to the "Notice on the Opinions concerning how to proceed with the policy-oriented closure and bankruptcy of state-owned enterprises" released this January, a total of 2,116 state-owned enterprises (3.51 million employees, liabilities of 227.16 billion yuan to state-owned financial institutions) will fall under this grouping in the next three years.
  2. In the draft, a system of prior notification and screening will be introduced for large-scale mergers and acquisitions, and companies will be obliged to notify authorities in cases where the participating firms have combined annual global sales of 12 billion yuan or more or if individual firms' annual sales exceed 800 million yuan in China.

September 22, 2006