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The Governance Structure in Bankruptcy Reorganization: Problemsand Contermeasures

LUAN Fugui, LI ManAccounting School, the Capital University of Economics and Business

luanfugui@163.com

Abstract: In bankruptcy reorganization systems, stakeholders have a stronger conflict on interests, andcomplex relationship of interests. This paper makes a detailed discussion on the basic conditions of corporate governance in reorganization, and analyses the problems existed in the composition of

bankrupt supervisor and shares transfer, etc, under the special condition in China, and makesrecommendations of the improvisation on governance patterns in bankruptcy reorganization.Keywords: Bankruptcy Law, Bankruptcy Reorganization, Governance Structure

Bankruptcy reorganization is the reconstructive legal system for those enterprises in trouble but stillhave the hope to revive to get saved. The PRC Enterprise Bankruptcy Law (hereinafter referred to asBankruptcy Law) came to operation on June 1, 2007 divided the enterprise bankruptcy cases into threeimportant components: reorganization, conciliation, and liquidation. Its main character is to change theformer passive liquidation bankruptcy system mainly based on liquidation to active reorganization

bankruptcy system based on conciliation and reorganization. The foundation of the reorganizationsystem greatly restricted and prevented the adverse knock-on effect brought about by the bankruptcyliquidation and the resulting enormous social costs and economic costs. However, the full developmentof the advantages of bankruptcy reorganization system depends on the optimization and effectiveimplementation of governance structure. This paper offers references to compensate for thedisadvantages of corporate governance structure theory and improve the bankruptcy reorganization onthe governance structure through the summary of corporate bankruptcy restructure practice andsummary of governance structure of bankruptcy reorganized enterprises.

1 The basic procedure and stakeholders of reorganization

Chapter VIII Reorganization of Bankruptcy Law sets the rules that if enterprises are unable to repaydebts that are due, and the assets are insufficient to discharge all debts or apparently lack the ability todischarge, the debtor or the creditor may apply directly to the people's court to reorganize the debtor; if the creditor applies for the liquidation of the debtor, after the court receives the appliance and before itannounces the debtor bankrupted, the debtor or investors whose contribution takes more than one tenthof the registered capital of the debtor may apply for reorganization. The basic procedure is shown inFigure 1.

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Figure 1 The Progress of Reorganization

Seen from Figure 1, the main relationship during the restructure period include: the debtor's enterprises,strategic investors, creditors, employees, supervisors, the peoples court, etc., bankruptcy reorganization

procedure has a multifaceted feature in participation, which means that the relationship of interests of the bankruptcy reorganization procedure is complex, and the conflicts are intense, and shows thefollowing relationship: 1.The claims and liabilities relationship between debtors and creditors; 2.theinvesting relationship between investors and debtors; 3.the labor law relationship between debtors'enterprises and employees; 4.The control and coordination on the stakeholders by the court.

2. The conflict of interests in enterprises bankruptcy reorganization

YES

NO

YES NO

Thecreditorsmeeting

Whether toAcceptApplication

Court

Debtor Investor Creditor

The Group of Employee Claim

The Group of Country tax Claim

The Group of Warranted Claim

e roup oSimple Claim

The Group of Investor

Appoint theSuperviser

Reorganization Plan

Whether to Pass andApprove of theReorganization Plan

DeclareBankruptcyLiquidation

Suspend theBankruptcyProceedings

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2.1 The stakeholders conflict of interests in reorganization processWhen enterprises are in normal operation, the cash flow is sufficient to meet the due debts or most duedebts, creditors will normally follow the order of maturity and pay the debts, thus the conflicts betweenall groups are not obvious. For example, when enterprises are in normal operation, the ranking claims is

predetermined for the maturity debts and outstanding debts, the liquidation of debts and wages, and the payment of taxes. The shareholders receive dividends and bonuses, the creditors receives the principaland interests claims, executives get rewards and high social status, employees get wages, the localgovernment can increase employment rate and collect taxes and so on. Only when enterprises bankrupt,will all the conflicts of stakeholders come to the front at the same time to compete with each other toargue about the order of withdrawal 1.First, conflicts exist between shareholders of debtors and creditors. In bankruptcy reorganization, theequity of reorganized enterprises will be accordingly adjusted. New shareholders are introduced, the

proportion of original shareholders are reduced or completed deprived. Former shareholders will need totransfer their stock to creditors or strategic investors. And the price and proportions of the sharestransferred by the former shareholders have conflicts between large shareholders and small shareholders,and between shareholders and creditors. In addition, debtor's enterprises often, in practice, take theopportunities of reorganization to realize the strategy of spin-off first and then reorganize to transfer allor at least part of the effective assets, compensate the auction assets for the debts, only leave shellcompanies to be reorganized, in which case, the creditors will not get added value after reorganization.Second, conflicts exist between creditors. Apparently there are conflicts among creditors, debtor'sshareholders and employees. Creditors ask the enterprises to settle all due debts, especially thosecreditors with security rights tend to implement their security rights for their claims, instead of caring if the price of collateral will be reduced by auction and lead to damage to other creditors interests or if theauctions will in future add to the creditors interests.Third, conflicts exist among employees, debtor's enterprises and creditors. When a corporation comes to

bankruptcy and reorganization stage, part or the whole creditors enterprises and assets will be sold toothers as entities still in operation, the revenue will be used to pay the debts, or continue to operate the

part which is not sold to others, the profits of which will be pay the debts. Under such distressful

situation, in order to reorganize successfully, it is necessary for the enterprises to lay off part of itsemployees. Employees face the situation of unemployment and survive on unemployment insurances,and the chairman of the board and executives lose not only their wages but also their reputation. Thoughthose layoffs are disadvantageous for some employees, but the revival of the enterprise accords to theinterest of the majority.

2.2 The stakeholders goal conflict of reorganizationThe objectives of the bankruptcy reorganization system are: debt insolvency and business recovery,defending social interests, and realize the unity of personal interests and social interests. So the firstimplementations of the reorganization system are order, fairness, and justice, and pursue certainefficiency at the same time.From the government prospect, the main aim of the reorganization plan is to maintain social stability.The interest pursued in this stage, reflected as national economic order, is a kind of specifically existed

but vague and abstract social interest. Especially for the local government, the bankruptcy of keyenterprises in the local area may relate to people's livelihood. In such circumstances where socialresources are quite scarce, debtors in bankruptcy are subject to criminal prosecution, creditors oftenhave conflicts because of the debtor's property; employees lose jobs because of the bankruptcy; debtors'not paying their creditors--banks in a long term causes banks more risk, thus shake the stability of thefinancial system. Therefore, the reorganization aims to bring negative influences of bankruptcy tominimum through maintaining reestablishment and revival of enterprises and stablize social economicorder.

1 Han Changyin, The Constitution of Bankruptcy Legislations Public Policy. Degree Thesis of Peoples'University of China , p:36.

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However, those stakeholders who participate in corporation reorganization, ask for repayment as soon as possible, which are clearly visible, specific personal interests. First, from shareholder's view, if theenterprise is under insolvent circumstance, all property belongs to the creditor. If the companyrestructures successfully, the shareholders' investment will be preserved and value-added, thus,shareholders takes great initiation in reorganization the company; second, from the creditor's view,different kinds of creditors have different interests, and have different attitudes towards reorganization,

but every creditor would like himself to get compensated maximally; third, employees' interests accordsto the company's interests, they naturally hope the company would come to the revival.Though stakeholders of the bankruptcy reorganization enterprise have the above-mentioned conflicts,the future looks of these relations are consistent with each other. Creditors can get a more advantageouscompensation by reorganization successfully than bankruptcy and liquidation, shareholders can maintainand increase the value of assets, employees also want their companies to go through these difficulties to

provide them income and job. The key problem is, how to form a pattern through systematic design to build an effective governance structure, and to resolve the interest conflicts and objective conflicts of allstakeholders, thus they can achieve common interest, mutual promotion, common development.

3 Analysis on the problems of governance structure in reorganization enterprise

Governance structure, as a kind of institutional arrangement, its main function is to ensure the mutualsupport and constraints of all related person, to prevent fraud, promote justice and improve efficiency.However, in our research we have found that significant disclosure or irregularities exist in creditor composition, administration constitution and investors' shares transferring.

3.1 Vote groups of the claimsIn a sense, creditor's repayment of the principle of fairness is the first principle of the bankruptcy law.The intention of the bankruptcy system is to get the debtors fairly repaid, instead of losing theopportunity because of information asymmetries. Though Bankruptcy Law makes the greatest protectionto ensure the fair repayment of creditors, in practice, there exists the situation of damaging large

creditors' interests in vote groups of the claims. ST Canghua, for example, they make a dividing line based on 5 million RMB, between large and small ordinary creditor claims, in which the small ordinarycreditor claim group voted to pass the restructure draft and the large ordinary creditor claim group's votehas not meet the condition of the insolvency law. But the court believed that the restructure plan isfeasible, and it forced to make the decision of passing the reorganization plan in the case that the number of large ordinary creditor group, which took 90% of the whole claims, didn't meet the condition.However, as to the reason why making 5 million RMB as the dividing line, and why the reorganization

plan is feasible, the court doesn't make a detailed explanation.In order to protect the interest of creditors, the reorganization organization should be given morediscretionary rights on creditors composition. At the same time, we have also to prevent the abuse of this

power. We should also expedite researching on reorganization enterprise value evaluation, enhance thetechnical and persuasion of the courts adjudgement, prevent and reduce the loss of interests of vulnerable creditors.

3.2 Composition of supervisorsThe bankruptcy law sets the rules that, the post of supervisors are taken by liquidation agencies of relevant departments and organizations, or social intermediary organizations, such as law firms,accounting firms, bankruptcy liquidation agencies. By making research on firms, which implemented

bankruptcy and reorganizations, we have found that SASAC, local securities regulatory bureaus, CBRC,and financial organizations took part in as supervisors. Shanghai Huayuan Co. Ltd, for example, has

pointed the liquidation group, made of CRBC Shanghai Bureau, SFC Shanghai Bureau, Shanghai officeof financial service, Shanghai SASAC, Huarun Pharmaceutical Group, and Beijing King&Wood LawFirm as supervisors after the day the court announced to have accepted the application of reorganization.In China, bankrupted reorganized enterprises' setting the above bureaus as supervisors is to adapt our

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particular circumstances: 1.the liabilities of these enterprises are mainly loans of state-owned banks,claims of financial assets management companies and liabilities of other creditors, such as contractcreditors, and these enterprises' choosing SASAC, local securities regulatory bureaus, CBRC, and officeof financial services will have some authorities to coordinate the debtor's enterprises and creditors better,and make arrangements for state-owned banks and financial assets management companies as well asother debt settlements; 2, as enterprises in China still lack operation of precedent and experiences, it isquite difficult to run smoothly. At this stage, making government departments and financial agencies assupervisors ensures the effectiveness of bankruptcy supervisor system and balances the interests.However, this method also has certain disadvantages. According to the bankruptcy law, theresponsibilities of supervisors in the bankruptcy process include: taking over the debtor's property,investigating debtor's financial situation and making financial status report, deciding debtor's internaladministrative issues, responding for the research of bankruptcy claims, selecting methods of turningassets into cash, etc. Seen from this, the complex issues such as property management, disposition,distribution and continual operation in the bankruptcy procedure involves not only interests of all parties,

but also professional knowledge of law, auditing, accounting, at the same time plenty of time and energyare needed in the restructure of bankrupted enterprises. If only choose SAC, local banking bureau, SRB,office of financial services, and commissioning a law firm as the supervisors, we have to consider: 1. If these staff from these departments are suitable for bankruptcy reorganization, have necessary

professional knowledge and skills, and familiar with bankruptcy law and financial knowledge; 2.If thesedesignated supervisors are able to dedicate themselves fully into the bankruptcy cases out of their own

job, and not to influence the normal work of government departments with the increase of cases; 3.if these supervisors can be guaranteed objectivity and fairness.The above factors taking into account, the supervisor system should be based on professional accountingfirms and law firms, SAC, local Banking Bureau, financial services, Security Regulatory Bureau andgovernment organizations can play the role of coordination and communication. At the same time, inorder to solve these problems fundamentally, we should consider establishing liquidation system to

promote the development of supervisors.

3.3 Shares downsizing and transferringIn the reorganization process, the shareholders need to transfer certain shares to repay the debts. In practice, it is generally divided to transfer different proportions for large and small shareholders.Shanghai Huayuan Co, Ltd, for example, large shareholders transferred 87%of their shares and smallshareholders transfer 24%of their shares; and ST Danhua, in the reorganization plan, it has been

proposed the opinion that large shareholders transfer 30%of their shares and small shareholders transfer 25%of their shares. For shareholders, if they want to insure their shares' value, they have to support thecompany's adjustment programs, or once the enterprises get bankruptcy and liquidated, their stock will

be worthless. For small shareholders, they believe the large shareholders are the main cause of the crisis,and debt liquidation should be solved by large shareholders, or at least they should take majorityresponsibilities; for large shareholders, they believe if large shareholders give more stocks than mediumand small shareholders, it will not reflect 'same shares of same rights'. Thus large and small shareholdershave strong conflicts on transferring shares.

Bankruptcy Law restricts that, when the reorganization plan draft involves in the adjustment of investor interest, a group of investors should be set to vote on these issues. However not dividing the groups bydifferent natures of shares but classifying all shares to one group doesn't reflect the differences of shareholders' rights.In practice, we should consider using special voting system, and classify the shares by substantiallysimilarities', which is to classify groups by different natures of shares, and different groups get differentadjustment and in a same group shares get adjusted too, to show fairness; at the same time, thedifferences between large and small shareholders, institutional investors and individual investors canalso be made standards of classifying groups to make different arrangements of rights. For example,classifying the shares of medium and small shareholders as one group. Because of their large number

but small percentage of the shares, their interests could be adjusted better, to pass through quickly the

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adjustment on the reorganization plan draft. It not only accords to the principle of efficiency, but alsoreflects the policy of protecting medium and small shareholders.

4. Optimization of Governance Structure in Bankruptcy Reorganization

4.1 The checks and balances between stakeholdersIn view of the basic principles of corporation governance structure and the analysis on the above

problems, we have made a conclusion that, from the time applied for bankruptcy to the time the courtmade the decision to go through the reorganization plan and to the end the reorganization plan, therelations stakeholders should fulfill their won responsibilities and enjoy certain rights to form arelatively complete governance mechanisms. Shown in Table 1.

DifferentStakeholders

Stage of Reorganization

Debtors Creditors BankruptcySupervisors

The People'scourt

Filing for Bankruptcy Voluntary bankruptcy;File an reorganizationapplication anddeliver relevantmaterials of proof

File to declare the debtor bankrupt using cash flowstandard;file an reorganizationapplication and deliver relevant materials of proof

Check theapplication andinstrument of evidencesupplied by

proposer;estimate the

probability of reorganizationand feasibility of application

The People's courtdecides to accept the

bankruptcy caseDeliver relevantmaterials on the basisof the judgment;discharge of debt or deliver the propertyto bankruptcysupervisors

In 30 days to 3months after the People's court decides toaccept the bankruptcy case,they should report their claims to the people's court;Members of the creditors'meeting enjoy the right tovote; Adopt a plan for thedisposition and distributionof bankruptcy property;convene the first creditors'meeting within 15 days after the expiration of the periodfor reporting claims.

The supervisors bedesignated by the

people's court ;Take over the

bankrupt enterprise;Put forwardadministrativemeasures about thedebtors' property;

Notify thedebtors andcreditors in time;Give notice andannouncement;designate

bankruptcysupervisors;

Convene the FirstCreditors' Meeting

The legalrepresentative of thedebtor must attend

the creditors'meetings and answer the creditorsinquiries; shouldn'tappoint director,supervisor, executivefrom other enterprises.

Examine materials of proof relating to the claims; applyto the People's court for

changing bankruptcysupervisors;Supervise bankruptcysupervisors and check their

payment;Select and change themembers of the creditors'meeting;

Put forward the planfor the disposition anddistribution of

bankruptcy property.

Judge and givelegal force to the

plan for the

disposition anddistribution of

bankruptcy property.

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Debtorsmanage

property and businessaffairs

Apply for the rightsto manage propertyand business affairs,if approved by the

people's court, theycan managethemselves, and besupervised by

bankruptcysupervisors.

Deliver the propertyand business affairs tocreditors; supervise

bankruptcysupervisors'reorganization affairs

ThePeoplesCourtRule for theReorganization

Bankruptcysupervisor manage

property and business

affairs

Carry out work according to therequirements of the

people's court or bankruptcy

supervisors, andanswer the creditorsinquiries faithfully

Make concession in theclaims; Supervise

bankruptcy supervisors;Examine the claims; Decidewhether to hold on or ceasethe operation affairs

Charge for the property and businessaffairs, or employother professional staff from other enterprise

or debtor enterpriseresponsible for them

Examine theapplication formdebtors aboutmanaging

property and business affairsthemselves;Supervise

bankruptcysupervisors'reorganizationaffairs

Bring forward thereorganization plan

If debtors manage property and businessaffairs by themselves,debtors Bringforward thereorganization planand explain it tocreditors' meetingand answer their inquiries

Break the creditors' meetinginto groups;take a vote on thereorganization plan

If bankruptcysupervisors to be thereorganizer, they bringforward thereorganization planand explain it to themembers of creditors' meeting andanswer their inquiries

Judge and givelegal force to thereorganization

plan

Termination of thereorganization process

Carry out thereorganization plan

Surprise the specific performance of thereorganization plan

Surprise the specific performance of thereorganization plan

Surprise thespecific

performance of thereorganization

planTable 1 The Right and Responsibilities of Different Stakeholders in Reorganization

4.2 The power supervision of the bankruptcy reorganizationTo effectively solve the conflicts during the reorganization period of all relations, we can divide theminto several interest communities, in which shareholders of debtor, chairman of the enterprise,supervisors, employees, and strategic investors are one community; creditors' meeting and creditors'committee are one community, professional organizations and their supervisors are one community, andthe court plays the rule of guidance and supervision among all communities. There are target conflictsamong all communities, and during the reorganization, they balance each other's rights and obligations,together to make efforts of the revival of the companies and indirectly protect their own interests.Specific structures are shown in Figure 2.

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Chart 2 Power Supervision of The Bankruptcy Enterprise

According to China's Bankruptcy Law, the basic procedure of bankruptcy reorganization is as follows:after the debtor's enterprise applies to the court for bankruptcy, the court suspends the claims of allcreditors, during which time all creditors have no rights to get any properties of the enterprise in no way,and the company still operates under the original operators; the court points supervisors(in the

bankruptcy and reorganization cases after the implementation of new Bankruptcy Law, it is often madeof local SASAC, security regulatory bureau, banking bureau, government departments and financialorganizations); divides all shareholders by their respective categories (secured or unsecured, with

priority or without priority); the reorganization person (debtor or the supervisor) proposes thereorganization plan; and vote on bankruptcy plan on the creditors' meeting. The whole process will besupervised by the peoples court.

Acknowledgements:

This paper is staged achievement of Beijing Planning of Philosophy and Social ScienceItem(09BaJG246), Key Program of Beijing EC (SZ200910038015) Research on the Value Assessmentof Bankruptcy Reorganization.

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Supervise

Entrust

Harmonize

Supervise

Pass thereorganization

plan

D ischarge of debt; deliver the

property

Shareholders,directors,executives,staff andworkers,investors of

bankruptenterprise

The Creditors'Meeting;Creditors

Committee

BankruptcySupervisors

Law Office andAccountin Firm

The People's Court

Deliver the plan for the disposition and

distribution of bankruptcy property

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