China Special Situations Insight (Volume 1, Issue 10)

Key Points for NPL Investors on the Undertaking of Shortfall Payments in China

In a debt restructuring or regular financing transaction, it is commonplace in China for a creditor to take an undertaking of a shortfall payment and/or liquidity support (the “Shortfall Undertaking”) as a strategy to improve the quality of the debt.

Before the Civil Code, there was no specific law regulating a Shortfall Undertaking, resulting in some controversy as to their nature. Many investors take the view that a Shortfall Undertaking does not constitute a guarantee or security under PRC laws, therefore they can be used to avoid disclosure obligations by listed companies, and it is not necessary for the obligor who provided the Shortfall Undertaking (“Obligor”) to obtain shareholders resolutions or board resolutions. However, on January 1, 2021, alongside the implementation of the Civil Code, the Supreme People’s Court promulgated on the same day a judicial interpretation regarding the application of the security system (the “Judicial Interpretation”), identifying the nature of Shortfall Undertakings.

? What is a Shortfall Undertaking?

Generally, the payment of a shortfall refers to the circumstances whereby a borrower fails to repay all the debt pursuant to the relevant agreement, and an Obligor should make up the difference between the total debt and the repaid debt. This also means that the Obligor shall repay all the outstanding debt for the borrower. The liquidity support refers to circumstances whereby an Obligor will provide the borrower with financial support, in such an amount, form, and duration as may be necessary for the borrower to perform its payment obligations. Many investors tend to believe the Shortfall Undertaking shall have no relation to a guarantee or security in the literal sense; however, in legal practice this view may not be supported by a court.

According to the Judicial Interpretation, it has been made clear that the nature of a Shortfall Undertaking shall be determined as follows:

(a) if the relevant document manifests an intention of guarantee, the Shortfall Undertaking shall be treated as a guarantee;

(b) if the relevant document manifests an intention for an Obligor to participate in the debt or to assume the debt jointly, the Shortfall Undertaking shall be treated as a debt participation;

(c) if the relevant document manifests an ambiguous intention and it is difficult determine the true nature as to a guarantee or debt participation, the Shortfall Undertaking shall be treated as a guarantee.

? What NPL investors can do to protect their interests

Given that a Shortfall Undertaking will be regarded as either a guarantee or a debt participation as the circumstances may require, it is important for NPL investors to be fully aware of the following:

(1) Internal resolutions and disclosure obligations. Under existing PRC laws, whether a Shortfall Undertaking is eventually regarded as a guarantee or debt participation, NPL investors should always require a resolution from the shareholders meeting or the board of the Obligor and require the Obligor (if it is a listed company) to publish an announcement, for the purpose of ensuring the validity of the relevant transaction documents.

(2) Guarantee type and guarantee period. Usually, the Obligor will not specify the guarantee type and/or guarantee period in the relevant agreement, because the Obligor does not want a Shortfall Undertaking to become a guarantee. In this circumstance, it would be detrimental to NPL investors if a Shortfall Undertaking is regarded as a guarantee, because according to existing PRC laws, the guarantee shall become a general guarantee automatically (rather than a joint and several liability guarantee) with the guarantee period being six months only upon maturity of the debts.

(3) Clear wording. Given that the intention expressed in the relevant document will determine the nature of the Shortfall Undertaking, it is advisable for NPL investors to use clear wording in all transaction documents to express their true intentions as to minimize potential disputes.

For further information, please contact Catherine Miao, Head of Special Situations and Alternative Investment at JunHe LLP: [email protected] or +86-21-22086350.