Insolvency

China's insolvency regime is still developing. Insolvency remains a particularly sensitive issue in China because there many technically insolvent state-owned enterprises and financial institutions, forcing China to choose between economic inefficiency and mass lay-offs that could disrupt social stability.

Commencement of Insolvency Action

Both voluntary and involuntary actions are available (instituted by the debtor or a creditor, respectively). An insolvency action begins with an application in the People's Court for a declaration of insolvency; the applicant must show that the debtor is unable to repay its debts as they come due. A declaration of insolvency will stay all other proceedings against the debtor company, but usually requires the company to suspend its business operations.

Notification

The People's Court will notify creditors of the commencement of insolvency procedures by either written notice or public announcement. Creditors notified by written notice must claim their rights within 30 days of the date of receipt, and creditors who have not received written notice have three months from the public announcement to claim their rights. Missing these deadlines will extinguish the creditor's claims.

Property

All property either owned by the company at the date of the insolvency declaration or thereafter acquired is available for distribution to creditors, including intellectual property, real estate, equity investments and property recovered from a voidable transaction. This property is usually liquidated through auction.

Voidable Transactions

Certain acts of an SOE are deemed invalid if they are committed any time from six months prior to the court's acceptance of the insolvency petition to the date of the insolvency declaration (or committed by an FIE within 180 days prior to the commencement of liquidation):

* Sale of property at substantially below market value
* Concealment, secret distributions, or gifts of property
* Surrender of claims as a creditor
* Provision of security for previously unsecured debt
* Repayment of debts prior to maturity

Distribution Priority

Claims must usually be paid in the following order (although in some jurisdictions employee claims outrank even secured creditors):

1. Secured creditors
2. Insolvency expenses
3. Employee wages and unpaid social security payments
4. Outstanding taxes
5. Unsecured creditors

Corporate Bankruptcy Law

China recently adopted a new Corporate Bankruptcy Law to replace the provisional Enterprise Bankruptcy Law that has been in place since 1986, marking a major advance in its corporate bankruptcy system. The law will go into effect on June 1, 2007. This law clarifies the bankruptcy issues of financial organizations, balances the rights and interests labor and guarantee creditors, and redefines the liquidation order in enterprise bankruptcy. China's New Corporate Bankruptcy Law has been badly needed for quite some time, as the development of China's market economy has naturally resulted in increasing bankruptcies, especially in the state-owned sector.

The law covers all corporate entities including state-owned enterprises, private domestically funded enterprises, and foreign invested enterprises. Perhaps its most praiseworthy feature is a reorganization system to allow ailing enterprises to avoid bankruptcy. It also deals admirably with cross-border bankruptcy issues, and stipulates specific procedures for the handling of debt issues. It offers meaningful guaranteed property rights for mortgage holders, etc., and offers priority to mortgage holders, etc. over staff creditors such as unpaid employees, etc.(unfortunately, state-owned enterprises will not be subject to this rule before the end of 2008 at the earliest). Finally, it arranges for professionalized management of the liquidation process (instead of management by unpaid local government officials who frequently bungle the liquidation).