China Special Situations Insight (July 2022)
JunHe's Special Situations team led by Catherine Miao has been actively involved in the special situations and alternative investment practice since 1999 and has been at the forefront of providing legal services in this area in China. The team has represented numerous landmark cases in the market such as representing a financial AMC in the first foreign investment in the disposition of non-performing assets in China in 2002, and representing Citigroup Global Markets Asia Limited in the first acquisition by a foreign investor of a NPA portfolio through buyout in China in 2004.
We have advised financial AMCs, local AMCs, investment banks, commercial banks, special situations funds, mezzanine funds, private credit funds, hedge funds, real estate companies, trusts, large private AMC, asset exchanges and large non-financial businesses, on various special situations transactions, including acquisition and disposition of NPLs, acquisition and restructuring of distressed businesses, debt to equity swaps, cross-border acquisition financing, structured financing, leveraged financing, direct lending, acquisition of distressed listed companies, and other investments including turnaround investments, investment in bailout funds, investment in property at court auctions, investment in bankruptcy reorganization, alternative investment, other high-yield investments and the financing of debt and equity in distressed and opportunistic situations. Our representation has involved special situations transactions with an aggregate asset book value of more than RMB 100 billion.
We have been sharing our insight in the special situations market in China on a weekly basis, and this newsletter assembles all articles we published in July 2022 for your easy reference.
I.Investing in Debt for Common Interest in Bankruptcy (I): Why This is Popular in China
(First published on JunHe's LinkedIn page on 6 July 2022)
Many special situations investors are particularly active in exploring opportunities in bankruptcy, as such special procedure would provide clean assets or special protections to investment. Debt for common interest is a special investment advocated by many administrators particularly during bankruptcy restructuring (“Common Interest Debt”), which could bring in large funds to sustain the business of a restructured company and possibly resurrect the company.
A Common Interest Debt refers to a debt incurred after a competent court accepts an application for bankruptcy, serving in the common interest of all the creditors. We use a bankrupt real estate developer as an example. If the real estate company becomes insolvent and enters bankruptcy restructuring, all the company’s assets including the constructions-in-progress are usually attached by certain creditors, thus the company would not be able to sell the constructions. We would see a vicious circle whereby the company is not able to repay its debt until it has sold the constructions, whilst the constructions cannot be sold as long as the debt is outstanding and the attachment remains alive. In this circumstance, if an investor finances the bankrupt company, the existing debt would be paid and the attachment on the real property would get lifted, so the company could continue and complete the constructions. Once the completed buildings are sold, the company would receive sufficient revenue to repay the loan provided by the investor and return to its normal track. The investor could make a profit from the Common Interest Debt and the real estate developer could get rid of its distress, which is a win-win situation.
Although a bankrupt company is insolvent as it does not have sufficient assets to repay all its debts, the existing laws in China allow special protections and advantages for investors who intend to provide financing and help a bankrupt company find a way out of its distress. Here are some legal rationales for investment in Common Interest Debt:
(1)Priority in repayment. Like the bankruptcy expenses such as the cost of administration, a Common Interest Debt may be repaid by the assets of a bankrupt company from time to time, which means that a Common Interest Debt is senior to employee wages, taxes, social insurance fees and any other unsecured debts.
(2)Guarantees and security are allowed for financing. To provide more comfort to investors, the Enterprise Bankruptcy Law stipulates that any guarantee or security may be provided in favor of investors of a Common Interest Debt. In practice, a bankrupt company usually has no clean assets for security purposes, but investors may require an affiliate of the company or even a third party to provide a guarantee or security, which is negotiable depending on the terms of the loans to be disbursed.
(3)No license requirements. Currently there are no restrictions or qualifications required by law for investment in Common Interest Debt. In practice, many types of entities have been involved in such investments, including asset management companies, private funds, and private companies. However, due to foreign exchange controls, foreign investors need to set up an onshore platform to invest in Common Interest Debt.
Despite the advantages in investing in Common Interest Debt, there are some controversial issues that need to be ascertained by law or judicial interpretation in the future:
(1)Does the priority in repayment also apply to the interest? The laws have not made it clear whether the interest accrued on a loan shall also constitute part of a Common Interest Debt. Given that loans provided during bankruptcy serve to benefit all creditors, we tend to believe that any interest accrued is also entitled to priority in repayment, otherwise the investors will be less motivated if their profits cannot be ensured.
(2)Is Common Interest Debt senior to other claims? There is a consensus that bankruptcy expenses and secured debts shall be repaid before a Common Interest Debt, but any unsecured debts are junior to the Common Interest Debt. In practice, the controversy lies in some special debts, for example, the outstanding construction costs and debts owed to homebuyers who have already paid the full amount or the majority of the purchase price; whether these debts may be paid before a Common Interest Debt is uncertain and shall be determined by the administrators on a case-by-case basis.
(3)Are all new debts incurred for the operation of a bankrupt company Common Interest Debts? The laws have not given the clear criteria for Common Interest Debt. It is uncertain if all new debts incurred after the initiation of bankruptcy shall fall within the scope of a Common Interest Debt, and this needs to be clarified by administrators considering the purpose of the debts. In practice, if the new debts serving for operation of the bankrupt company have been approved by the court or the creditors meeting, it is highly likely that they will be regarded as Common Interest Debts.
In our next two articles regarding investment in Common Interest Debt, we will focus on legal due diligence and transaction structures, where some strategies regarding the controversial issues mentioned above will be discussed to achieve more protection for investors.
II.Investing in Debt for Common Interest in Bankruptcy (II): Key Issues for Legal Due Diligence
(First published on JunHe's LinkedIn page on 13 July 2022)
In our previous article, we introduced debt for common interest (“Common Interest Debt”) which is becoming more popular to investors. Due to its priority nature, Common Interest Debt provides valuable protection to an investment and a bankrupt company may find a way out of its distress, making this a win-win situation.
It is advisable to conduct legal due diligence before proceeding with a Common Interest Debt investment. A Common Interest Debt usually involves many different matters, therefore comprehensive legal due diligence is indispensable to provide a solid ground for the investment. We have highlighted some of the key issues that investors need to be aware of during the legal due diligence process.
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(1)The project to be financed by the Common Interest Debt. If a Common Interest Debt investment is used, for example, to finance a real estate project, the bankrupt company will continue the construction that is already in progress and then sell the construction upon its completion to obtain revenue for the repayment of its debts. To get an accurate evaluation of the project, an investor needs to have the full picture of the property. This includes information about the initial purchase of the land use rights from the government (including but not limited to payments for land premiums and taxes), the property area and the construction plans, the certificates and licenses already obtained, the full legal status of the construction (such as any mortgages and liens thereon), any property defects, and any other aspects that may affect the value of the project.
(2)Bankruptcy procedures. All information regarding the bankruptcy needs to be fully verified at the beginning of any investment process. Investors will need to deploy different strategies and accommodate different protections in the transaction documents, depending on the status of the bankruptcy.
(3)All assets of the bankrupt company. As discussed in the previous article, security is allowed for a Common Interest Debt; therefore, investors should investigate all assets of the bankrupt company to see if there are any clean assets available for security.
(4)All debts of the bankrupt company. A Common Interest Debt is senior to any unsecured debts, but there are still some debts that should be repaid first, such as bankruptcy expenses, construction costs and any debts owed to homebuyers who have already paid the full amount or the majority of the purchase price. It is important for investors to be aware of all the debts of the bankrupt company before they make a commercial decision.
(1)Meet with the administrator. Because the administrator oversees the bankrupt company and possesses most of the information an investor requires, we strongly recommend an interview with the relevant bankruptcy administrator. A meeting would make it easier to collect information or documents, and more importantly, it would help to build a good relationship with the administrator and lead to a more cooperative transaction.
(2)On-site searches with local authorities. Investors usually need the administrator to provide authorization documents, and they would then be able to conduct on-site searches regarding the project, registered information, and credit records.
(3)Online searches. This is similar to legal due diligence for an ordinary transaction. Investors need to visit online systems to check the company’s information, litigation, enforcements, security records, and any other relevant matters.
III.Investing in Debt for Common Interest in Bankruptcy (III): Key Issues for Transaction Documents
(First published on JunHe's LinkedIn page on 20 July 2022)
In our previous article, we highlighted some of the key issues that investors need to be aware of during the legal due diligence process for investment in debt for common interest (“Common Interest Debt”). When an investor has determined to proceed with the transaction after legal due diligence, it is advisable to follow the statutory procedures and accommodate some protections in the transaction documents to strengthen the safety and stability of the investment.
According to the Enterprise Bankruptcy Law and its judicial interpretations, when a bankruptcy application is accepted by a court, the bankrupt company shall obtain approval from the creditors meeting or permission from the court before it borrows money for this business, which shall constitute a Common Interest Debt. Investors need to investigate the bankruptcy procedures during the legal due diligence. If the first creditors meeting has not yet been convened, the bankrupt company shall obtain permission from the court; if a creditors meeting has already been convened, the bankrupt company shall obtain approval from the creditors meeting.
As discussed in the previous article, the laws have not made it clear whether the interest accrued on a loan shall also constitute part of a Common Interest Debt. We strongly recommend that investors place clauses in the transaction documents to specify the nature and priority of the financing. More precisely, the loan to be provided by investors should be categorized as a Common Interest Debt, and all principal and interest accrued thereon should, subject to commercial arrangements and negotiations, be senior to construction costs, debts owed to homebuyers, employee wages, taxes, social insurance fees and any other unsecured debts.
Investors may take security from a bankrupt company for financing. Usually there are existing mortgages or pledges on the important assets of a bankrupt company, and the loan to be provided shall be junior to such secured claims. However, if the current value of the assets is lower than the amount of the secured claims, and the Common Interest Debt to be provided would significantly increase the value of the assets, some security holders may concede its priority to investors.
Further, if a bankrupt company has no clean assets for security purposes, investors may require an affiliate of the company or even a third party to provide a guarantee or security, which is negotiable depending on the terms of the financing.
To avoid misuse of the financing, an investor may require a joint signing right with respect to the relevant bank accounts of the bankrupt company and the control revenue of the project. The loan can only be used upon approval from the investor and the administrator, and any revenue derived from the project shall be used in accordance with a waterfall agreed by the investor. In this regard, the investor can ensure that the loan is used solely for the agreed purposes such as the construction of the project, and any revenue will be applied for repayment of the loan and the construction of the uncompleted parts of the project.
For further information, please contact?Catherine Miao, Head of Special Situations and Alternative Investment at JunHe LLP: [email protected] or +86-21-22086350.