Why Bankruptcy Fails as a Disciplinary Tool in China

In the United States, bankruptcy laws play a crucial role in disciplining corporate management by holding them accountable for financial mismanagement and ensuring the efficient reallocation of resources.[1] China enacted its most recent bankruptcy law in 2006, which introduced reorganization and liquidation mechanisms applicable to enterprises in China creating a system that mirrors the U.S. Chapter 11.[2] However, bankruptcy filings remain low in China[3], and it often fails to serve this disciplinary function. The unique characteristics of China’s corporate governance, state ownership, and societal priorities significantly undermine the effectiveness of bankruptcy proceedings as a tool for financial discipline.

First, a central issue lies in China’s widespread state ownership of enterprises. Even after economic reforms introduced “corporatization without privatization,” the state continues to hold significant ownership stakes in key companies through pyramid structures and mixed ownership models.[4] This entrenched state presence blurs the lines of accountability, making it difficult for creditors and external monitors to hold managers responsible for poor financial decisions.[5]

Unlike private shareholders, state-appointed officials often lack personal financial stakes in the company’s success, diminishing their motivation to enforce rigorous financial discipline.[6] As a result, financially distressed companies, particularly state-owned enterprises (SOEs), are often shielded from bankruptcy filings by government interventions designed to protect jobs and maintain social stability.[7]

Second, Chinese courts wield significant discretion in accepting or rejecting bankruptcy filings, often influenced by local government concerns about social stability and regional economic health.[8] This discretion can delay or prevent necessary bankruptcy proceedings. Even when filings are accepted, state influence can dictate outcomes that prioritize preserving jobs over strict financial accountability.[9] Administrative authorities, rather than market forces, frequently dictate the resolution of financial distress. In many cases, local governments encourage SOEs to avoid formal bankruptcy by arranging state-led financial support or orchestrating asset transfers to maintain operations.[10]

Third, Chinese society’s traditional preference for social harmony and stability further complicates the use of bankruptcy as a disciplinary tool.[11] The stigma attached to bankruptcy remains strong, both culturally and politically. Instead of viewing bankruptcy as a strategic step toward reorganization and financial recovery, companies often see it as a last resort to be avoided at all costs.[12] This reluctance undermines the timely use of bankruptcy protection to address financial troubles.

Moreover, the high concentration of state-owned creditors also distorts typical debtor-creditor dynamics. State-owned banks often issue loans based on policy goals rather than strict financial assessments.[13] Borrowers frequently perceive these loans as government budget allocations rather than contractual obligations. Consequently, the financial discipline typically imposed by debt repayments is weakened, as SOEs assume that the state will intervene to cover their liabilities.[14] This lack of creditor enforcement diminishes bankruptcy’s potential as a mechanism for correcting managerial misbehavior and poor financial practices. Instead, the reliance on state bailouts and informal debt resolutions further erodes accountability.[15]

To strengthen bankruptcy’s disciplinary role, several reforms are needed. These include reducing state interference, fostering a professional community of bankruptcy administrators and specialized judges, and shifting societal attitudes toward viewing bankruptcy as a normal and constructive business decision. Introducing greater independence for creditors and enhancing judicial oversight are also essential to ensuring timely restructuring decisions.

Ultimately, while China’s 2006 Enterprise Bankruptcy Law represented a step toward modernization, deeply rooted governance practices and societal norms continue to limit its effectiveness. Addressing these systemic challenges is crucial for fostering a robust and market-driven corporate environment.

   Xuyou Zhang is a staff member of Fordham International Law Journal Volume XLVIII.

[1] See Weiying Zhang, China’s SOE Reform: A Corporate Governance Perspective, 3 Corp. Ownership & Control 132, 136–37 (2006).

[2] See Rebecca Parry & Yingxiang Long, China’s Enterprise Bankruptcy Law: Building an Infrastructure Towards a Market-Based Approach, 20 J. Corp. L. Stud. 157, 167 (2020).

[3] Cao Siyuan (曹思源), Qiye Pochan An Chuang 14 Nian Zuidi de Fansi (企业破产案创 14 年最低的反思) [Examination of the Lowest Bankruptcy Case Number in 14 Years], 2 HU-GANG JING JI (沪港经济) [Shanghai & H.K. Eco.] 20 (2010).

[4] See Curtis J. Milhaupt, The State as Owner – China’s Experience, 36 Oxford Rev. Econ. Pol’y 362, 365 (2020).

[5] See Li-Wen Lin & Curtis Milhaupt, We Are The (National) Champions: Understanding the Mechanisms of State Capitalism in China, 65 Stan. L. Rev. 697, 726-28 (2013).

[6] See Tamar Groswald Ozery, Illiberal Governance and the Rise of China’s Public Firms: An Oxymoron or China’s Greatest Triumph? 42 U. Pa. J. Int’l L. 921, 944 (2021); see also Donald C. Clarke, Corporate Governance in China: An Overview, 4 China Econ. Rev. 494, 499 (2003).

[7] See Randall Peerenboom, What Have We Learned About Law and Development? Describing, Predicting, and Assessing Legal Reforms in China, 27 Mich. J. Int’l L. 823, 844 (2006).

[8] See Emily Lee, The Reorganization Process Under China’s Corporate Bankruptcy System, 45 Int’l L. 939, 973 (2011).

[9] See Zhen Li, Zhongmei Pochan Chongzheng Zhidu Bijiao Yanjiu (中美破产重整制度比较研究) [Comparative Analysis of Chinese and U.S. Restructuring Systems] (Mar. 15, 2011).

[10] See George M. Kelakos et al., Corporate/Debt Restructuring: Japan, the Hong Kong SAR & the People’s Republic of China—A Roundtable Discussion, 10 Am. Bankr. Inst. L. Rev. 1, 25 (2002).

[11] See Peerenboom, supra note 7.

[12] See Edith Hotchkiss, Kose John, Bo Li, Jacopo Ponticelli & Wei Wang, Default and Bankruptcy Resolution in China, 15 Annu. Rev. Financ. Econ. 369, 383 (2023).

[13] See Tamar Groswald Ozery, Illiberal Governance and the Rise of China’s Public Firms: An Oxymoron or China’s Greatest Triumph? 42 U. PA. J. INT’L L. 921, 968 (2021).

[14] See Zhang, supra note 1 at 145-46.

[15] See e.g., Li Shuguang & Wang Zuofa (李曙光 & 王佐发), Zhongguo Pochanfa Shishi Sannian de Shizheng Fenxi ---- Lifa Yuqi Yu Sifa Shijian de Chaju Jiqi Jiejue Lujing (国《破产法》实施三年的实证分析──立法预期与司法实践的差距及其解决路径思) [An Empirical Analysis of Three Years of the Implementation of China's Bankruptcy Law: The Gap Between Legislative Expectations and Judicial Practice and Its Resolution Path], 22 CHINA UNIV. POL. SCI. & L.J. (中国政法大学学报) 58, 68 (2011) (local government in China provides distressed companies with special budget allocation to maintain their listing qualification).

[1] European Parliament, EU AI Act: First Regulation on Artificial Intelligence (June 1, 2023), https://www.europarl.europa.eu/topics/en/article/20230601STO93804/eu-ai-act-first-regulation-on-artificial-intelligence.

[2] Id.

[3] European Union Agency for Fundamental Rights, Artificial Intelligence: A European Perspective (2020), https://fra.europa.eu/sites/default/files/fra_uploads/fra-2020-artificial-intelligence_en.pdf.

[4] Kirsten Martin, Reconciling the U.S. Approach to AI, Carnegie Endowment for Int’l Peace (May 2023), https://carnegieendowment.org/research/2023/05/reconciling-the-us-approach-to-ai?lang=en.

[5] Rashida Richardson, Predictive Policing Algorithms Are Racist. They Must Be Dismantled, MIT Tech. Rev. (July 17, 2020), https://www.technologyreview.com/2020/07/17/1005396/predictive-policing-algorithms-racist-dismantled-machine-learning-bias-criminal-justice/.

[6] Rand Corporation, Artificial Intelligence: Legal and Ethical Issues (last visited Jan. 10, 2025), https://www.rand.org/well-being/justice-policy/portfolios/artificial-intelligence-legal-ethical.html.

[7] Thomas Hale, The EU and U.S. Diverge on AI Regulation: A Transatlantic Comparison and Steps to Alignment, Brookings (July 15, 2021), https://www.brookings.edu/articles/the-eu-and-us-diverge-on-ai-regulation-a-transatlantic-comparison-and-steps-to-alignment/#:~:text=The%20EU%20and%20U.S.%20are%20taking%20distinct%20regulatory%20approaches%20to,rules%20for%20these%20AI%20applications.

[8] White & Case LLP, AI Watch: Global Regulatory Tracker – China, White & Case (last visited Jan. 10, 2025), https://www.whitecase.com/insight-our-thinking/ai-watch-global-regulatory-tracker-china.

[9] Center for Advanced Studies in Intelligence, In Their Own Words: New Generation Artificial Intelligence Development Plan, AIR University (last visited Jan. 10, 2025), https://www.airuniversity.af.edu/CASI/Display/Article/2521258/in-their-own-words-new-generation-artificial-intelligence-development-plan/.

[10] DLA Piper, China Releases AI Safety Governance Framework, DLA Piper (Sept. 2024), https://www.dlapiper.com/en-us/insights/publications/2024/09/china-releases-ai-safety-governance-framework.

[11] Kaan Sahin, The West, China, and AI Surveillance, Atlantic Council (May 19, 2023), https://www.atlanticcouncil.org/blogs/geotech-cues/the-west-china-and-ai-surveillance/.

[12] International Telecommunication Union, AI for Good Global Summit 2024, Int’l Telecommunication Union (last visited Jan. 10, 2025), https://aiforgood.itu.int/summit24/.

[13] Organization for Economic Co-operation and Development, AI Principles, OECD (last visited Jan. 10, 2025), https://www.oecd.org/en/topics/sub-issues/ai-principles.html.

[14] Global Partnership on AI, About Us, Global P’ship on AI (last visited Jan. 10, 2025), https://gpai.ai/about/.

This is a student blog post and in no way represents the views of the Fordham International Law Journal.