China Special Situations Insight (Volume 2, Issue 16)
Investment in Distressed Real Estate in China: Key Issues for Legal Due Diligence (VI) –Contractor’s Right of Priority in Receiving Repayment from Construction Project Proceeds
From our experience, it is not unusual to find during legal due diligence that the project developers of distressed real estate owe construction payments to their contractors. According to the Civil Code and relevant judicial interpretations, if a project developer fails to make the due payments under the construction contract, the contractor can make a request to the court to sell the project through an auction (unless the construction project is by its nature unsuitable for auction). The disposal proceeds thereof shall be applied to pay the construction price with priority over any mortgage and other claims on the construction project (“Construction Proceeds Priority”).
If there exists a Construction Proceeds Priority on a real estate mortgaged to secure an NPL, the profitability of the NPL may be reduced severely. We would like to highlight some important points below that concern many NPL investors.
(1) To what extent will contractors have Construction Proceeds Priority?
Generally, the construction price benefit from the Construction Proceeds Priority shall be the payment payable to the contractors explicitly provided in the construction agreement (“Construction Payment”). Any interest, default penalties, liquidated damages and compensation incurred on the overdue payment will not fall within the scope of the Construction Proceeds Priority. When a contractor claims for Construction Proceeds Priority, only the portion of the disposal proceeds attributable to the part of the project that the contractors have already constructed will be applied to pay the Construction Payment with the priority. This means that a constructor has no right to make a claim for priority with respect to the disposal proceeds of the land use right or any other part of the project.
(2) The time limit for contractors to exercise the Construction Proceeds Priority
It is also important to note that a contractor must make a claim for Construction Proceeds Priority within the period of time stipulated under PRC laws (“Exercising Period”). The court may not uphold the claim for Construction Proceeds Priority after the expiry of the time limit.
In terms of the Exercising Period in general, in accordance with relevant judicial interpretations:
(a) from 27 December 2003, the Exercising Period shall be six months commencing from the completion date of the construction;
(b) from 1 February 2019, the Exercising Period was amended as six months commencing from the date when the Construction Payment becomes due and payable to the contactor.
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(c) from 1 January 2021, the Exercising Period has been further extended to 18 months from the date when the Construction Payment becomes due and payable to the contractor.
However, the Exercising Period for a specific case shall be further analyzed based on the litigation process and other related facts.
(3) Whether Construction Proceeds Priority may be waived by the contractor
A project developer (employer of a project construction) and contractor may reach an agreement to waive or restrict the exercise of Construction Proceeds Priority on a distressed real estate (“Waiver”). However, if the court believes that the Waiver harms the interests of construction workers, the court will not uphold the claim that the contractor does not have Construction Proceeds Priority based on such Waiver.
(4) How to distribute the Construction Proceeds Priority within a construction project containing multiple buildings
In the case that a mortgaged property is part of a construction project containing multiple buildings upon which a contractor holds Construction Proceeds Priority, the question will arise with respect to the distribution of Construction Proceeds Priority on such mortgaged property.
This issue has not been clearly indicated in the current PRC laws and judicial interpretations. Local courts in different regions have manifested different attitudes in this regard. According to our observations, some courts may allocate the Construction Proceeds Priority in the disposal proceeds in proportion to their construction areas of each building, while others may make such allocation based on the overdue Construction Payment corresponding to each building according to the relevant settlement/audited reports. Therefore, it depends on the decision made by the relevant local court at its discretion on a case-by-case basis.
The Construction Proceeds Priority is one of the key issues to be investigated thoroughly in legal due diligence. If a Construction Proceeds Priority does exist and the contractor made a claim before the expiry of the Exercising Period, there would be a risk that the contractor may be entitled to benefit in priority from the disposal proceeds of the mortgaged real estate.?Investors are advised to take such risk into account during the evaluation of the NPL.
If investors wish to consider the possibility of acquiring the beneficiary right to the overdue Construction Payment with a valid Construction Proceeds Priority, a detailed introduction and analysis regarding this investment approach is provided in China Special Situations Insight Volume 1, Issue 3 (Will NPL Investors Have Priority over Mortgages When Acquiring the Claims for Overdue Construction Costs?).?
For further information, please feel free to contact Catherine Miao, the Head of Special Situations and Alternative Investment at JunHe LLP, at [email protected] or +86-21-22086350.