Relief issues of non-defaulting parties in bankruptcy cases

In the performance of a contract, a non-defaulting party can apply to the people’s court for insolvency liquidation, as per Article 7 of the Enterprise Bankruptcy Law, as the other side is not able to settle outstanding debt. If the people’s court accepts such an application and the administrator terminates the contract before both parties fulfil the acceptance in accordance with Article 18 of the Enterprise Bankruptcy Law, then how do we relieve the damage of the non-defaulting party arising out of the contract’s termination?

In accordance with Article 53 of the Enterprise Bankruptcy Law, the non-defaulting party may declare the claim of creditor’s rights to the administrator with regards to the damage stemming from the contract’s termination. However, the Enterprise Bankruptcy Law and the relevant judicial interpretations do not expressly specify the rules to use for such a right to claim damages. We would like to discuss issues on identifying and handling declarations of such creditor’s rights, based on our experience as bankruptcy administrator, so as to help the non-defaulting enterprise retrieve losses.

Scope of declaration of creditor’s rights to claim damages. We take the view that the scope of declaration of creditor’s rights to claim damages shall include, without limitation, liquidated damages, late fees, default interest and other payments in the nature of liquidated damages, based on the contract or the actual liability for damages arising out of the contract’s termination.

In accordance with Article 107 of the Contract Law, if a party fails to perform its obligations under a contract, or its performance fails to satisfy the related terms, it shall bear the liabilities for breach of contract such as to continue to perform its obligations, to take remedial measures, or to compensate for losses. If the administrator decides ex officio to terminate the contract, resulting in failure to continue to perform it, or fails to carry out remedial action, the party shall assume the liability for the breach to compensate for the losses, based on the contract’s termination. This is the basis for the non-defaulting enterprise to declare creditor’s rights to claim damages.

In accordance with Article 114 of the Contract Law, the parties may agree that if one breaches the terms of a deal, it shall pay a certain sum of liquidated damages to the other side in light of the circumstances of the violation, and may also agree on a method to calculate the amount of compensation for losses incurred as a result.

Can deposits on contracts be used directly to compensate for damages. If the enterprise applying for bankruptcy has paid, as agreed, the non-defaulter the performance security of the contract, can the non-defaulting party use such security directly to compensate for damage? We believe the non-defaulting party may apply directly to the administrator for compensation for damage within the range of security.

In accordance with Article 85 (1) of the Judicial Interpretations of the Supreme People’s Court on Several Issues Concerning the Application of the Security Law of the People’s Republic of China, where the debtor or a third party transfers the possession of the special account, sealed money, deposit or other forms of money to the creditor as pledge for the creditor’s rights after specifying the said money, the creditor shall have priority to receive payment with such money if the debtor does not perform its obligation. In line with the above provision, the enterprise applying for bankruptcy has paid performance security and the money has been made specific in the form of deposit. The money has been transferred to and in possession of the non-defaulting party as performance security, which conforms to the characteristic of pledge, which means a pledge in the form of deposit has been established. The non-defaulting party has right of pledge to the deposit.

In accordance with Article 208 of the Property Law, an obligor or third party may, for the security of the payment of debts, pledge his (its) movable properties to the obligee for possession, and when the obligor fails to pay due debts or any circumstance occurs for realizing the right of pledge, as the parties involved stipulated, the obligee shall be entitled to seek preferred payments from the said movable properties. In general, based on the contract, if the enterprise applying for bankruptcy defaults on its debt obligations due or the right of pledge is realized, the non-defaulter shall have a priority over the deposit.

In addition, in accordance with article 219 (1) of the Property Law, if the obligor has paid off the debts or the pledger has fulfilled the obligee’s rights as secured in advance, the pledgee shall return the pledge. In general, based on the contract, the enterprise applying for bankruptcy, after discharging the debt obligations or performing the contractual obligations, may request the non-defaulting party to return the pledged property, i.e., the deposit.

In accordance with article 37 of the Enterprise Bankruptcy Law, after the people’s court accepts an application for bankruptcy, the administrator may take back the pledge or lien through paying off the debts or providing a guaranty acceptable to the creditor. Where the value of the asset under a pledge or lien is lower than the value of the debt guaranteed under a debt settlement or substituted guarantee mentioned in the preceding paragraph, the market value of the asset at the time of the pledge or the lien shall prevail.

We take the view that, in bankruptcy cases, the deposit that the creditor has possessed shall still belong to the debtor and administrated by the administrator before the debtor fails to repay the debts due or the failure in realization of the pledge as the parties agreed. If the administrator requests the other party to refund the deposit, it may choose to repay the debts or provide a guarantee acceptable for the creditor.

Therefore, the debts referred herein before the enterprise applying for bankruptcy repays the debt shall include paying liquidated damages or compensating for losses or other liabilities for breach as agreed in the contract. The non-defaulting party shall be entitled not to return the deposit and claim against the administrator to use the deposit to compensate directly for damage, before acceptable guarantee is provided for the non-defaulting party.

Wang Wei is a senior partner and Fu Chengrui is an associate at Co-effort Law Firm