Perspective | Bankruptcy Subordinated Debt and Related Judicial Opinions

On March 4, 2018, the Supreme People's Court issued the "Minutes of the National Court Bankruptcy Trial Work Conference" (hereinafter referred to as the "Bankruptcy Trial Minutes") Article 28, which states that "if there are remaining assets after the bankruptcy property is repaid in accordance with the order specified in Article 113 of the Enterprise Bankruptcy Law, they may be used in turn to repay civil punitive compensation, administrative fines, criminal fines, and other punitive claims arising before the acceptance of bankruptcy." This provision for the first time establishes the principle of subordinated claims and their repayment order, but does not provide detailed regulations or guidance on the scope and specific operation of subordinated claims. The so-called "subordinated claims" refer to claims that are ranked after ordinary bankruptcy claims in the order of repayment in bankruptcy, and subordinated claims can only be repaid if there are remaining assets after ordinary bankruptcy claims have been fully repaid. Creditors of subordinated claims can participate in creditor meetings, but usually do not have voting rights or the right to exercise set-off.

Currently, there are no clear legal provisions regarding the specific classification and identification rules for subordinated claims in the field of bankruptcy legislation in our country. In bankruptcy practice, reference is made to the legislative rules of subordinated claims in the bankruptcy laws of foreign countries (such as the United States, Germany, Japan, etc.). Based on different causes, they are mainly divided into three categories: statutory subordinated claims, adjudicated subordinated claims, and agreed subordinated claims. In terms of judicial practice in our country, bankruptcy subordinated claims mainly include the following aspects:

Punitive claims mainly include fines, penalties, and compensation fees imposed by judicial authorities and administrative entities on debtor enterprises. The double interest on delayed performance stipulated in Article 264 of the Civil Procedure Law of the People's Republic of China, and punitive compensation ordered due to illegal acts, such as those stipulated in Article 55 of the Consumer Rights Protection Law and Article 148 of the Food Safety Law, are also included.
 

Case 1: China Industrial and Commercial Bank Co., Ltd. Shenyang Shenhe Branch and China Foreign Transport and Storage Company Bankruptcy Claim Confirmation Dispute Case, (2021) Liao Min Zhong 498.

Judicial Summary:

For bankruptcy claims not listed in the repayment order by law, the people's court can reasonably determine the repayment order according to the principle that personal injury compensation claims take precedence over property claims, private law claims take precedence over public law claims, and compensatory claims take precedence over punitive claims. If there are remaining assets after the bankruptcy property is repaid in accordance with Article 113 of the Bankruptcy Law, they may be used in turn to repay civil punitive compensation, administrative fines, criminal fines, and other punitive claims arising before the acceptance of bankruptcy. The delayed interest that the debtor should pay double according to the effective legal document in this case belongs to the category of "civil punitive compensation arising before the acceptance of bankruptcy," and its right to be repaid in the bankruptcy procedure has not been deprived, but it should be legally ranked after the ordinary bankruptcy claims specified in Article 113 of the Bankruptcy Law. The legal design and provisions regarding the repayment order of bankruptcy claims can, to some extent, avoid reducing the repayment rate of the debtor's basic transactional ordinary claims, preventing the legal penalties against the debtor from being transferred to other transactional ordinary creditors, which aligns with the principle of fair compensation stipulated in Article 1 of the Bankruptcy Law. The first-instance judgment determined that the disputed debtor's delayed interest claim that should be paid double does not belong to ordinary bankruptcy claims, which is legally justified and should be maintained.

When examining bankruptcy claims, if the liquidated damages agreed upon by the creditor and debtor in a civil contract significantly exceed the amount of the creditor's loss, they are deemed punitive in nature and confirmed as subordinated to other ordinary claims.
 

Case 2: Guo Dongfang, Ningbo Zhongrui Taifeng Food Co., Ltd. vs. Nantong Xindagang Storage Development Co., Ltd. Bankruptcy Claim Confirmation Dispute Case, (2020) Su Min Zhong 50.

Judicial Summary:

In the 1.25 billion principal claim declared by Zhongrui Taifeng Company, 100 million is a cash return for the acquisition funds provided to Zhongrui Taifeng Company, and 25 million is compensation for all past losses caused to Zhongrui Taifeng Company due to the long-term non-payment of debts by Xindagang Storage Company. The overdue payment liquidated damages calculated on top of the existing loss compensation no longer possess the basic attribute of compensatory damages aimed at making up for losses, but have become a form of punitive compensation. Referring to Article 28 of the Bankruptcy Trial Minutes regarding the principles and order of repayment for bankruptcy claims, for claims where the repayment order is not clearly stipulated by law, the people's court can reasonably determine the repayment order according to the principle that personal injury compensation claims take precedence over property claims, private law claims take precedence over public law claims, and compensatory claims take precedence over punitive claims. If there are remaining assets after the bankruptcy property is repaid in accordance with Article 113 of the Enterprise Bankruptcy Law, they may be used in turn to repay civil punitive compensation, administrative fines, criminal fines, and other punitive claims arising before the acceptance of bankruptcy. In this case, the nature of the 54.225 million liquidated damages claimed by Zhongrui Taifeng Company can be identified as punitive compensation and subordinated to the repayment of other ordinary claims. The appeal reasons of Zhongrui Taifeng Company regarding this part are insufficient, and this court does not support them.

Article 39 of the Bankruptcy Trial Minutes stipulates that claims formed by related enterprises improperly utilizing related party relationships should be subordinated to other ordinary claims in the order of repayment, and the subordinated creditors shall not have priority in repayment for specific assets provided by other related enterprises. When identifying subordinated claims arising from related transactions, the court will examine the legality, reasonableness, and fairness of the related transactions, as well as the actual damage caused to the company and other creditors. If the related transactions are deemed illegal or obviously unfair, the corresponding claims will be classified as subordinated claims.
 

Case 3: Ordinary Bankruptcy Claim Confirmation Dispute Case of a Company in Chongqing and a Company in Wuxi, (2024) Su 02 Min Zhong 2518.

Judicial Summary:

According to the facts established in this case, Company A, Company Tai, and the original creditor of the debt involved, which was transferred to Company A, are all related enterprises. As stated in Company A's appeal, Company X adopts a unified fund scheduling method typical of group enterprises to jointly resist market risks. Under this unified scheduling, after Company Tai obtained loans from financial institutions, most of the funds flowed to related companies. Company Tai did not independently use the loan but had to pay interest on the loan to the financial institution, increasing Company Tai's debt burden. When Company Tai faced a shortage of funds due to the misappropriation of loans by related enterprises, the group did not transfer funds back from the enterprise that misappropriated Company Tai's funds but instead allocated funds from other related companies to Company Tai, thus forming a debt owed by other related companies to Company Tai. The debts that Company A acquired from related companies are such debts. It can be seen that the formation of such debts is merely a compensation for the misappropriation of Company Tai's funds by related companies, and Company Tai did not materially benefit from this. Therefore, such debts should be treated equally with other ordinary creditors who obtained debts by paying consideration to Company Tai, which is clearly unfair to other ordinary creditors. Thus, it is not inappropriate for the administrator of Company Tai to rank Company A's debt lower than that of other ordinary creditors.

1. Debts of shareholders when they have not fully fulfilled their capital contribution obligations
 

Case 4: The dispute over the confirmation of ordinary bankruptcy claims between Wuxi County Guohua Real Estate Co., Ltd. and Chen Zhongli, (2021) Yu 02 Min Zhong 612 No.

Judicial Summary:

Shareholders have committed faults that harm the interests of ordinary creditors, namely, when they were shareholders of Wuxi Guohua Company, they transferred their shares without fully fulfilling their capital contribution obligations. Due to the shareholders' failure to pay their contributions on time and in full, the debt repayment ability of Wuxi Guohua Company was severely reduced, jeopardizing the legitimate rights and interests of other creditors. From the perspective of good faith obligations, the shareholders, as the current shareholders of Wuxi Guohua Company, failed to fulfill their obligation to contribute truthfully. If shareholders are allowed to rank their claims against Wuxi Guohua Company equally with other ordinary creditors, it would contradict the legal responsibilities imposed on shareholders who fail to contribute under company law, leading to unfair results for other ordinary creditors. Therefore, the debts owed by shareholders to the company due to their failure to fulfill or fully fulfill their capital contribution obligations should be determined as subordinate debts, arranged to be repaid after other ordinary debts.

2. Shareholders' debts to the company when the registered capital is clearly insufficient to support the normal operation of the company

Case 5: The dispute over the confirmation of ordinary bankruptcy claims between Zhou Jiangping and Huai'an Zhongyu Real Estate Development Co., Ltd., (2021) Su 08 Min Zhong 1855 No.

Judicial Summary:

Zhongyu Company is a sole proprietorship established by Zhou Mouping, who is also the legal representative and responsible for the company's operation and management, playing a leading role in the company's production and operation. In 2013, Zhongyu Company's registered capital was only 1 million yuan, and after increasing capital in 2014, the registered capital was only 20 million yuan. Based on this, it initiated a land project worth over 100 million yuan for real estate development, which was clearly insufficient to maintain the company's operations. Although the enterprise raised funds through various means to make up for the insufficient registered capital and initiated part of the project's construction, it later lacked funds to maintain the company's operations and advance the project, and this situation did not improve significantly, ultimately leading to Zhongyu Company's bankruptcy. According to the detailed source of funds provided by Zhou Mouping in the second instance, in addition to registered capital, it also included loans from others and operating income. CITIC Xincheng Asset Management Co., Ltd. was once a shareholder of Zhongyu Company, and the total amount loaned by CITIC Xincheng Asset Management Co., Ltd. and Zhou Mouping to Zhongyu Company exceeded 50% of Zhongyu Company's sources of funds, indicating that the company's operations relied significantly on debts owed to shareholders or actual controllers. In summary, the company's registered capital is clearly insufficient to support normal operations, and the company's operations rely on debts owed to shareholders or actual controllers. The debts formed by shareholders or actual controllers to the company should be determined as subordinate debts, arranged to be repaid after ordinary debts.

Case 6: Bankruptcy liquidation case of Chongqing Shouzhihui Game Co., Ltd.

Typical significance:This case legally applies the principle of 'equitable subordination' to subordinate the repayment of shareholder debts. The company's registered capital is clearly insufficient to support normal operations, and the company's operations rely on debts owed to shareholders or actual controllers. The debts formed by shareholders or actual controllers to the company should be recognized as subordinate debts. (Chongqing Fifth Intermediate People's Court published the sixth of the top ten typical cases of Chongqing Bankruptcy Court in 2020: Bankruptcy liquidation case of Chongqing Shouzhihui Game Co., Ltd.)

3. Debts formed by controlling shareholders or actual controllers improperly utilizing the independent status of the corporation

Case 7: Civil application for retrial of loan contract disputes between Company A, Company B, etc., (2023) Supreme Court Min Shen 2707 No.

Judicial Summary:

The principle of equitable subordination in bankruptcy proceedings, also known as the 'deep stone principle', refers to the control of a company over the debts owed by its subsidiary. When the subsidiary is unable to pay or is in bankruptcy proceedings, it cannot participate in the distribution with other creditors, or its distribution order should be subordinate to that of other creditors. Article 46 of the Bankruptcy Law states: 'If the shareholders of the debtor claim to offset the following debts with the debts owed to the debtor, and the debtor's administrator raises objections, the people's court should support them: (1) The debts owed to the debtor by the shareholders due to unpaid contributions or withdrawal of contributions; (2) The debts owed to the debtor by the shareholders due to the abuse of shareholder rights or related relationships that harm the interests of the company.' The above judicial interpretation clearly states that the debts owed to the debtor by shareholders who abuse their shareholder rights or related relationships that harm the interests of the company cannot be offset against the debts owed to the debtor, which is a specific application of the principle of equitable subordination. According to the provisions of the above judicial interpretation, if company shareholders abuse their shareholder rights or related relationships that harm the interests of the company, the repayment order of the debts enjoyed by shareholders against the company should differ from that of other ordinary debts. In this case, Company B's registered capital is 20 million yuan. Although Company B's registered capital does not violate the minimum capital requirements for real estate development enterprises, after Company B obtained the construction project and land involved through bidding on May 30, 2018, it relied solely on its registered capital, which was insufficient to cover the subsequent construction, decoration, and sales costs of the project. Company B did not increase its registered capital but raised funds by borrowing from its shareholders, Company A and Company C, at a high-interest rate, while mortgaging Company B's main assets to Company A. The above actions of Company A essentially utilized its position as a controlling shareholder to enjoy the benefits of Company B's assets while transferring the operational risks of Company B to external creditors. The original judgment found that Company A's actions constituted an abuse of the independent legal status of the company and the limited liability of shareholders, harming the interests of the company's creditors, which was not inappropriate. After Company B's bankruptcy, if Company A is recognized to have priority repayment rights over the mortgaged property, it would make it difficult for other creditors to be repaid, violating the principles of fair repayment and good faith in bankruptcy proceedings. According to Article 20 of the Company Law of the People's Republic of China, the original judgment that determined Company A's debts to Company B are subordinate to the repayment of other ordinary debts in the bankruptcy proceedings is legally appropriate.