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Cablegate: Designing a System Creating a Bankruptcy

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ZNR UUUUU ZZH
P 130911Z OCT 06
FM AMEMBASSY BEIJING
TO RUEHC/SECSTATE WASHDC PRIORITY 9648
RUEATRS/DEPT OF TREASURY WASHDC
RUCPDOC/USDOC WASHDC
INFO RUEHSH/AMCONSUL SHENYANG 6989
RUEHGH/AMCONSUL SHANGHAI 6105
RUEHCN/AMCONSUL CHENGDU 7338
RUEHGZ/AMCONSUL GUANGZHOU 1638
RUEHIN/AIT TAIPEI 5980
RUEHHK/AMCONSUL HONG KONG 8276

UNCLAS SECTION 01 OF 05 BEIJING 021720

SIPDIS

SIPDIS

DEPT PASS USTR
USTR FOR STRATFORD, WINTER, ALTBACH, KARESH, ROSENBERG
TREAS FOR OASIA/ISA-CUSHMAN
USDOC FOR 4420/ITA/MAC/MCQUEEN, IA/LORENTZEN, HSU
GENEVA FOR CHAMBERLIN

E.O. 12958: N/A
TAGS: ECON EFIN EINV PGOV CH
SUBJECT: DESIGNING A SYSTEM CREATING A BANKRUPTCY
MECHANISM FOR FINANCIAL INSTITUTIONS

REF: BEIJING 19482

1. Reftel reported on Embassy discussions with
Professor Li Shuguang on September 6 about China's new
Law on Enterprise Bankruptcy. As Director of the
Bankruptcy Law and Restructuring Research Center at
the China University of Politics and Law, as well as a
member of the National People's Congress drafting
group which prepared the new law, Li is a leading
expert on China's bankruptcy regime. During the
September 6 meeting, Li told Emboff that China would
need new regulations to apply the new law to financial
institutions. On September 18, Li published an
article in "Caijing" (Finance) Magazine laying out
nine areas where he believes regulatory clarification
is necessary. An unofficial Embassy translation of
the article appears below. The original Chinese text
is available at
http://caijing.hexun.com/text.aspx?sl=2324&id =1832111.

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2. Begin unofficial Embassy translation of text of
Professor Li?s 18 September Caijing article:

Designing a Bankruptcy System for Financial
Institutions
by Li Shuguang

On August 27 of this year, the new "PRC Law on
Enterprise Bankruptcy" was passed by the National
People's Congress, and it will go into effect on June
1, 2007.

Article 134 in the supplementary provisions of this
law sets forth special regulations specifically for
the problem of bankruptcy of financial institutions.
In the nine months between the new "Bankruptcy Law's"
passage and when it goes into effect, the new law
gives the Central Government power to establish
procedures for financial institution bankruptcies. In
my view, any "implementation measures (or regulations)
on carrying out financial institution bankruptcy
proceedings" should emphasize resolving the nine major
problems listed below.

1. The definition and scope of "financial
institution."

At present, there is no law that provides a precise
definition for "financial institution." Generally,
institutions overseen by the three main supervisory
bodies, the China Bank Regulatory Commission (CBRC),
the China Securities Regulatory Commission (CSRC) and
the China Insurance Regulatory Commission (CIRC) are
regarded as financial institutions. Strictly
speaking, this is not an accurate definition.

Such a definition overlooks other, more important
supervisory bodies -- the Central Bank and the State
Administration for Foreign Exchange (SAFE). The term
"financial institution" should cover institutions
subject to the supervision of these agencies.

Some types of businesses supervised by financial
supervisory agencies are not considered financial
sector businesses. For example, the futures industry,
regulated by the CSRC, is considered part of the food
and beverage industry. However, the new draft "Law on
the Management of Futures Trading" has, in practice,
already classified futures trading as a financial
sector industry. So "financial institutions" already
includes the futures and derivatives trading industry.

Some institutions with financial assets supervised by
government finance agencies, such as financial groups
like CITIC Group and China Everbright Group, etc., or
financial asset management companies such as Huarong
Asset Management Co. and Cinda Asset Management Co.,
should be included in the category "financial

BEIJING 00021720 002 OF 005


institutions."

In addition, financial organizations sponsored by the
Ministry of Agriculture, such as rural financial
markets and agricultural credit cooperatives, should
also fall within the definition of "financial
institution."

2. Who files for financial institution bankruptcy?

Article 134 of the new Bankruptcy Law provides that
"when financial institutions, such as commercial
banks, securities firms, or insurance companies, are
in the situation described in Article 2 of this law,
State Council financial supervisory agencies may apply
to the People's Court to reorganize or liquidate the
financial institution in question." This raises the
question of whether the financial institutions
themselves can file for bankruptcy, and whether
creditors can file for bankruptcy proceedings against
them.

Two considerations went into drafting this article.
The first consideration was that non-state-owned
financial institution bankruptcy cases need not
necessarily go through the State Council. The second
was that in the current "Commercial Bank Law,"
"Insurance Law," and "Securities Law," bankruptcies of
commercial banks, insurance companies and securities
firms must receive authorization from the State
Council as a prerequisite, companies which are not
commercial banks, insurance companies or securities
firms do not necessarily need to.

The regulations do not prescribe financial
institutions from voluntarily filing for bankruptcy.
Implementation measures (or regulations) should be
drafted so as to clarify which types of financial
institutions must report to or receive approval from
the State Council in filing for bankruptcy, and which
do not.

3) Prerequisites for Financial Institution Bankruptcy
Filings.

The "implementing measures (or regulations)" can
continue existing rules on prerequisites for financial
institution bankruptcies, and at the same time expand
their scope to include bankruptcy filings for futures
trading companies, large trust companies, and large
financial holding companies, requiring that the State
Council approve their filings as well. Bankruptcy
proceedings for other small- and medium-sized
financial institutions can be treated in the same way
as corporate bankruptcies.

4) Administrating Bankruptcy Proceedings for
Financial Institutions.

Because of the special nature of bankruptcies of
financial institutions, commercial administrating
bodies or administrators do not necessarily have any
special qualifications for taking control of the
assets of bankrupt financial institutions or
administering their affairs through bankruptcy
proceedings. They also lack experience in managing
financial risks or financial crises. A system should
be considered in which liquidation groups, or
administrating bodies are set up jointly by financial
regulators in cooperation with commercial specialists,
and in which individuals given responsibility for
administering bankruptcies would be drawn from the
ranks of experienced financial specialists. So,
"implementation measures" should specifically set
forth the qualifications, method of selection,
professional responsibilities and supervisory
conditions for administrators of financial institution
bankruptcy cases.

BEIJING 00021720 003 OF 005

5) Reporting of Claims against Bankrupt Financial
Institutions.

Because China is in a particular phase of economic
transition, commercial credit transactions tend to be
relatively chaotic, and in the disorderly use of legal
concepts, property rights, shareholders' rights,
creditors' rights and renters' rights tend to get
tangled together. It is not clear what really can be
considered debt. For example, when a commercial bank
goes bankrupt, is there a debtor-creditor relationship
between the bank and its account holders? If a
securities firm misappropriates its customers' down-
payments, is the customer whose funds were used in
such a manner a simple creditor or a secured creditor?
In terms of fundamental principles, these questions
are debatable and it is sometimes hard to make clear
distinctions.

As another example, after the Central Bank, the CSRC
and other agencies jointly issued the "Notice
regarding the questions related to individual claims
and customers' security trading settlement funds of
securities companies," quite a few investors have
different ideas. There is no question that individual
bank deposits, all types of financial bonds issued by
financial institutions and held by residents, and
settlement funds from customers' securities trades
fall within the category of debt instruments. As for
property entrusted by residents to financial
institutions for trading, and residents' negotiable
securities deposited in relevant accounts, but
misappropriated by financial institutions, different
opinions exist about whether they should be considered
as individual claims.

In line with the development of China's financial
markets and economy, new kinds of financial bonds will
continually emerge. I recommend that any
"implementation measures" clearly delineate personal
and institutional debts, but also give judicial
institutions room to make precedent-setting rulings
regarding the delineation of various types of
financial bonds.

6. Reorganizing Bankrupt Financial Institutions.

Because the social repercussions of the bankruptcy of
financial institutions are relatively great, all
countries encourage financial institutions to choose
the option of reorganization when they go bankrupt,
unless there is no other possible choice. This
process generally involves the government injecting
capital, taking over the institution, placing it in
the care of a trustee, refinancing through the Central
Bank, or some similar method. Of course,
reorganization can also be left to the market.

I recommend that any "implementation measures (or
regulations" require that: 1) During the period of
reorganization, the debtor must not manage its own
assets, but rather should be taken over by the
government, placed under the care of a trustee, or
assigned to a specially designated administrator, in
order that the government can guide the reorganization
process. 2) The period of time to prepare a
reorganization plan for a financial institution should
be longer than for other enterprises. I recommend 360
days. 3) Financial institutions' creditors should be
divided into different kinds of categories than in
ordinary bankruptcy cases. In general, individual
creditor?s rights should be separated from financial
claims. The particular characteristics of creditors
and shareholders, such as depositors, holders of
securities, holders of futures, and holders of
insurance policies should be given consideration, and
at the same time, the problem of protecting the rights

BEIJING 00021720 004 OF 005


of claims of employees of financial institutions
should be given appropriate consideration. The
implementation and supervision of the reorganization
plan should receive close attention after its passage.

7) Monetization of Assets of Financial Institutions.

In financial institution bankruptcy cases, there are
essentially two types of assets -- tangible and
intangible -- which need to be monetized. The
intangible assets of financial institutions mainly
include their operating license trading rights, as
well as their so-called "license plate" (their brand
name), their marketing network and marketing
operation. These are a financial institution's main
assets, and their value is considerable.

In order to better carry out the monetization of the
assets of financial institutions, any "implementation
measures" should set forth that: 1) The value of
intangible assets must be assessed, not just tangible
assets. 2) The monetization of a financial
institution's assets, the disposition of its operating
license, its brand name, and the settlement of the
entitlements of its employees should be considered all
together, and listed in the conversion plan of
insolvent assets. 3) The assets of a financial
institution should be monetized openly, through the
mechanism of an auction based on the principle of
competition.

8) The Special Nature of Allocation of Assets in
Financial Institution Bankruptcy Cases.

In financial institution bankruptcy cases, Western
countries have established a principle of "limited
repayment," also known as "creditor's discount." This
means that when a financial institution goes bankrupt,
a limit is set on individual claims, below which the
creditor is repaid in full, but above which the
creditor only receives a set proportion of their
claim. In setting a ceiling, one must consider such
factors as this country's phase of economic
development, the investment capacity of investors, and
society's ability to bear the burden. In the past two
years, in dealing with the troubled securities firms
Dapeng Securities and China Southern Securities?and
the D?Long Group crisis, the People's Bank of China
and others used rules and methods based on purchasing
individual?s claims at a discount, in an effort to
appropriately solve the problem of the who gets
priority in repayment among individual creditors, and
treated all non-secured institutional creditors as
regular creditors. This type of principle can be
rolled into any "implementing measures (or
regulations)."

9) Guaranty Funds for Investors in Financial
Institutions.

According to the existing regulatory framework, three
major types of guaranty funds should be prepared for
the bankruptcy of financial institutions: a
depositor's insurance fund, an insurance holder's
guarantee fund, and a security investor's guaranty
fund. I believe that the first two will be set up and
designed in the same way as the already existing
protection fund for securities investors. But the
problem is that these three funds do not provide
protection for all bankrupt financial institutions.
As a result, in preparing "implementation measures" it
is worth considering whether the three funds should be
combined into a single Financial Institution Investors
Guaranty Fund, or as separate guaranty funds.

I believe, since each fund collects contributions in a
different way, and from different sources, the
principles and purpose of payment may vary, the

BEIJING 00021720 005 OF 005


establishment of such funds should be handled in a
flexible way. We could create three large funds, or
establish different funds for futures investors and
other types of investors, and set clear regulations on
the source of funding, coverage, function,
supervision, etc., and gradually increase the overall
scale and reserve ratio of each fund over time.

END UNOFFICIAL EMBASSY TRANSLATION TEXT.

RANDT

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