1 Introduction. 2 Creditor Set-off as a Self-Help Remedy. October Contents. 1 Introduction 1

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1 October 2013 A Step Closer to the Recognition of Close-out Netting in China? -- Judicial Interpretation of the PRC Enterprise Bankruptcy Law by the Supreme People s Court 1 Introduction For as long as any derivatives practitioner could remember there have always been uncertainties surrounding the enforceability of close-out netting (i.e. the right to close-out transactions and to net their termination amounts) against counterparties in the PRC. To this end, the Interpretation on Several Issues concerning the Application of the PRC Enterprise Bankruptcy Law (II) (the SPC Interpretation ) 1 published by the Supreme People s Court on 5 September 2013 represents a further step towards recognising close-out netting against insolvent PRC counterparties under PRC law. Significantly, the SPC Interpretation confirms that creditors can use set-off as a self-help remedy and prescribes the limits within which a bankruptcy administrator must operate to challenge a creditor s right of set-off in court. The SPC Interpretation also gives further guidance on the recognition of debtor s property in bankruptcy proceedings. Contents 1 Introduction 1 2 Creditor Set-off as a Self-Help Remedy 1 3 Other Topics Relating to Debtor s Property 3 4 Further Observations on Close-out Netting 3 2 Creditor Set-off as a Self-Help Remedy Previously, under the old PRC Enterprise Bankruptcy Law (Trial Implementation) 2, a creditor must apply to the liquidation committee of the bankrupt debtor in order to set-off mutual obligations between the bankrupt debtor and the creditor. The PRC Enterprise Bankruptcy Law 3 (the Bankruptcy Law ) removes the reference to a creditor s application and instead allows a creditor to assert a right of set-off. However, despite the use of assert under the Bankruptcy Law, some uncertainties still remained as to whether a creditor s assertion of set-off can effectively operate as a selfhelp remedy, or is subject to approval and acceptance of the administrator. The SPC Interpretation has now clarified this uncertainty 最高人民法院关于适用 中华人民共和国企业破产法 若干问题的规定( 二 ), the SPC Interpretation is available here in Chinese; and the transcript of the questions answered by the Second Civil Division of SPC on the press conference held for the SPC Interpretation is available here in Chinese. For further information about the Bankruptcy Law, please refer to our previous bulletin. The PRC Enterprise Bankruptcy Law (Trial Implementation) was promulgated on 2 December 1986 and effective as of 1 November See section 40 of the Bankruptcy Law 中华人民共和国企业破产法, promulgated on 27 August 2006 and effective as of 1 June The Bankruptcy Law is available here in Chinese.

2 Set-off takes effect upon receipt by the bankruptcy administrator of set-off notice After restating that a creditor can assert set-off against the bankruptcy administrator 4, the SPC Interpretation clarifies that such set-off is effective upon receipt of the set-off notice by the administrator from the creditor 5 (unless the court orders otherwise following a successful challenge by the administrator). Accordingly, it is now clear that a creditor s set-off would operate as a self-help remedy under the Bankruptcy Law as it no longer requires the bankruptcy administrator to take any positive action for it to become effective. In the context of derivatives transactions, the SPC Interpretation would lend strong support to the recognition under PRC law of netting calculations, where all outstanding transactions are terminated as a result of one party becoming subject to the bankruptcy event of default. Limiting the grounds of challenge to a creditor s set-off The SPC Interpretation 6 prohibits an administrator from challenging a creditor s set-off upon any of the following three grounds: > the debt owed by the debtor has not become due as of the time when the bankruptcy petition is accepted by the court; > the debt owed by the creditor has not become due as of the time when the bankruptcy petition is accepted by the court; and > the debts owed by the debtor and the creditor to each other are of different types and nature. It is important therefore to note that unmatured debts (whether owed by or to the bankrupt debtor) and debts of different types and nature are qualified for set-off against the administrator. Limiting the period during which a creditor s set-off is open to challenge The bankruptcy administrator may challenge a creditor s set-off by filing a suit with the bankruptcy trial court within the agreed dispute period or, if no such period is agreed, within three months from the date of receipt of the set-off notice from the creditor. If the administrator s challenge is dismissed by the court, the set-off would be effective as of such notice date 7. Going forward, a party entering into a derivatives agreement with a PRC counterparty may wish to consider providing at the outset for a shorter dispute period for the purpose of bankruptcy set-off. An insolvent PRC counterparty will have little incentive to agree to shorten the dispute Article 41, SPC Interpretation. Article 42, SPC Interpretation. Article 43, SPC Interpretation. Article 42, SPC Interpretation. 2

3 period once a creditor s set-off is asserted and it seems clear that a unilaterally designated dispute period by the creditor would not be a dispute period as agreed to by the parties under the SPC Interpretation. 3 Other Topics Relating to Debtor s Property Once a debtor is declared to be bankrupt by the court, the debtor s property will be the sole source out of which secured and unsecured claims against the bankrupt debtor could be satisfied. In addition to set-off, the SPC Interpretation provides important guidance on the following: > separation of debtor s property from other property, or from commonlyowned property (articles 1 to 4); > preservation orders in respect of debtor s property (articles 5 to 8); > voidable transactions and claw-back (articles 9 to 19); > suspension and acceptance of proceedings and claims against shareholders, directors and senior management of debtor, and debtor s property (articles 20 to 24); > disposal of debtor s property, third parties exercising their rights to take back property held in debtor s possession (articles 25 to 29); > reimbursement of third parties for damage to or loss of property held in debtor s possession (articles 30 to 33); > continued performance of contracts of sale where seller retains title to goods transferred (articles 34 to 40); and > jurisdiction (article 47). 4 Further Observations on Close-out Netting The application of close-out netting to derivative transactions requires legal recognition of the right to close-out (i.e., early termination) and netting (i.e., set-off). The prevailing view among market practitioners is that a nondefaulting party s contractual right under a derivatives master agreement to close-out or early terminate all outstanding derivative transactions upon the counterparty s bankruptcy event of default is subject to the administrator s moratorium power under the Bankruptcy Law 8. Whilst the SPC Interpretation supports netting, it does not change the position in relation to the right to close-out. A contracting party who wishes to safeguard the right to close-out from an administrator s moratorium power would still need to consider applying the automatic early termination (AET) provision in its derivatives master agreement (so that all transactions are automatically terminated before the moratorium), although the validity of automatic early termination is untested under the Bankruptcy Law. 8 Article 18, Bankruptcy Law. 3

4 It remains to be seen if further judicial guidance or legislation would be issued or enacted to support the enforceability of the right to close-out and/or the validity of automatic early termination in the context of insolvency of a PRC counterparty. In particular, as the State Council Legislative Affairs Office is currently looking to enact bankruptcy regulations for financial institutions, it is hoped that close-out netting would be expressly recognised in the regulations. The recognition of close-out netting is especially crucial in light of the PRC s increasing internationalisation and the anticipated implementation of a mandatory clearing obligation for OTC derivatives in the PRC. Derivatives practitioners stay tuned. 4

5 Contacts For further information please contact: Chin Chong Liew Partner Simon Zhang Managing Associate / simon.zhang@linklaters.com Wayne Huang Associate / wayne.huang@linklaters.com David Mu PRC Advisor / david.mu@linklaters.com Ying Zhou PRC Advisor / ying.zhou@linklaters.com Karen Yung Senior PSL karen.yung@linklaters.com This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors. Linklaters LLP. All Rights reserved 2013 Linklaters LLP is a limited liability partnership registered in England and Wales with registered number OC The term partner in relation to Linklaters LLP is used to refer to a member of Linklaters LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP together with a list of those non-members who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ or on and such persons are either solicitors, registered foreign lawyers or European lawyers. Please refer to for important information on our regulatory position. We currently hold your contact details, which we use to send you newsletters such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this newsletter or other marketing communications, please let us know by ing us at marketing.database@linklaters.com. A th Floor, Alexandra House Chater Road Hong Kong Telephone Facsimile Linklaters.com