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China Special Situations Insight (Oct 2021)

2021.10.27 Catherine MIAO、LiYi、Wan Ziqian

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 September and October 2021 for your easy reference.


I. The Establishment of Local AMCs Remains Open to Foreign Investors in China’s NPL Market: Pros and Cons

(First published on JunHe's LinkedIn page on 29 September 2021)


Currently the major buyers of non-performing banking loans (“NPLs”) in the primary market of China include the five financial asset management companies (i.e., Cinda, Orient, Great Wall, Huarong and Galaxy) (the “Five AMCs”) and local asset management companies in different provinces (the “Local AMCs”). Only the Five AMCs and Local AMCs are eligible to bid for NPL portfolios which are comprised of three or more connections owned by Chinese banks.


Foreign investors now have an option to be involved in the special situations market in China by establishing a foreign-invested Local AMC. For example, Hainan NWS Asset Management Co., Ltd. (in Chinese: 海南新创建资产管理股份有限公司) is a foreign-invested company with investors based in Hong Kong, and in 2020 it was granted a license becoming the first foreign-invested Local AMC in China. The establishment of foreign-invested Local AMCs is one of the new methods to broaden investment strategies in respect to special situations in China, and this will probably bring in more foreign investors to compete with the Chinese Local AMCs, following the economic and trade agreement reached between China and the USA on 15 January 2020.


Compared with the Five AMCs, the Local AMCs have some disadvantages. According to the relevant regulations made by the China Banking and Insurance Regulatory Commission (the “CBIRC”), each Local AMC shall only purchase NPLs from the local branch of banks within the province of its incorporation, and they are not eligible to acquire NPLs from a bank situated in any other province. In August 2021, the CBRIC formally responded to a policy inquiry on its website where it further clarified that Local AMCs shall not purchase NPLs from the head office of a Chinese bank if the Local AMC and the head office are in different provinces.

However, establishing a Local AMC is still a good option for foreign investors, considering the following benefits in the primary and secondary markets of NPLs in China:

(1) Local AMCs can purchase NPLs from Chinese banks in the same province, regardless of the number of the connections.

(2) Local AMCs can purchase NPLs from foreign-invested banks nationwide, without any regional restrictions.

(3) Local AMCs can purchase the portfolio of individual NPLs from relevant Chinese banks nationwide, without any regional restrictions.

(4) Local AMCs can purchase NPL portfolios from the Five AMCs nationwide.

(5) Local AMCs can purchase distressed entrusted loans from banks nationwide.

(6) Local AMCs can purchase distressed trust loans from trust companies nationwide.

(7) Local AMCs can purchase other distressed non-financial loans from listed and unlisted companies nationwide.


II. The Standards for Substantive Consolidation in Bankruptcy in China

(First published on JunHe's LinkedIn page on 6 October 2021)


In recent years more and more large companies are entering bankruptcy due to the change of the economic situation in China. The bankruptcy of corporate giants usually comes with the substantive consolidation of affiliate companies, such as the consolidation of more than 320 affiliates in the bankruptcy of the HNA Group, which has caused significant concern to investors.


The legal consequence of substantive consolidation under PRC law is one of the most frequently asked questions. In the event of substantive consolidation, all claims and debts among the relevant affiliates shall be wiped out, and all assets and properties of the relevant affiliates shall be unified to repay the debts owed by all the relevant affiliates in one and the same proceedings, according to the statutory order of priority.


Currently there is no law or regulation providing detailed standards for the trigger of substantive consolidation in the PRC, and the Minutes of the National Court Work Meeting on Bankruptcy Trials (in Chinese, 全国法院破产审判工作会议纪要) only provides general principles for substantive consolidation. In legal practice, whether a company shall be included in the substantive consolidation rests with the discretion of the court.


According to our experience and understanding of the relevant policies, we have summarized the standards below upon the occurrence of which court is likely to approve the substantive consolidation:

(1) the relevant companies are affiliated;

(2) the bankruptcy conditions under the Bankruptcy Law have been satisfied for each affiliated company separately or when all affiliated companies have been taken as a whole, and where the bankruptcy conditions refer to (a) a company cannot repay all due and payable debts and the assets of the company are insufficient to pay off all its debts; (b) a company apparently lacks the repayment capacity;

(3) the corporate personality of the relevant affiliates has been highly mixed (for example, their assets, financial affairs, employees, management and business have been highly mixed);

(4) the expense for distinguishing the assets of each affiliate is too high;

(5) the fair repayment of creditors will be jeopardized without the substantive consolidation.


III. Will NPL Investors Have Priority over Mortgages When Acquiring the Claims for Overdue Construction Costs? 

(First published on JunHe's LinkedIn page on 13 October 2021)


Investors in China’s NPL market have kept a watchful eye on distressed loans which have until now been regarded as standard products and ones that generally bring returns. However, in the wake of the Evergrande Group’s recent debt crisis, attention is now on the claims arising from construction contracts. The Evergrande Group and its affiliates owe a huge amount of their construction costs to contractors who are desperate to sell such claims at a large discount to ease their own liquidity crisis.


According to the Civil Code and relevant judicial interpretations, in the event that a project developer fails to pay the construction costs, 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 costs with priority over any mortgage and other claims on the construction project (“Construction Proceeds Priority”). 


The Construction Proceeds Priority is the core value attracting NPL investors. According to our experience with other relevant transactions, our clients are most concerned with the coverage and transferability of the Construction Proceeds Priority. We would like to highlight some important points below for consideration and discussion.


To what extent will contractors have Construction Proceeds Priority?


Generally, the construction costs with benefit from the Construction Proceeds Priority will be explicitly provided in the construction agreement, which usually consists of the remuneration of the constructors and the payment for the construction materials. However, any interest, default penalties, liquidated damages and compensation incurred on the overdue construction costs will not fall within the scope that the Construction Proceeds Priority purports to protect. When a contractor makes a claim for Construction Proceeds Priority, only the portion of the disposal proceeds attributable to the part of project that the contractors have already constructed will be applied to pay the construction costs with the priority. This means a constructor has no right to make a claim for priority with respect to the disposal proceeds of the land or any other part of the project.


It is also important to note that a contractor must make a claim for Construction Proceeds Priority within 18 months of the date from when the construction costs shall be paid to the contractors, otherwise the court may not uphold the claim for Construction Proceeds Priority after the expiry of the time limit.


Will the Construction Proceeds Priority be transferred to investors along with claims from the overdue construction costs?


This is not clearly provided under the existing PRC laws or judicial interpretations. Local rules in different regions have manifested different attitudes towards the transfer of the Construction Proceeds Priority, and judges in the Supreme People’s Court have also taken different views historically, since there has been a debate whether Construction Proceeds Priority shall be exclusive to contractors.


From our observation of relevant cases decided by the Supreme People’s Court in recent years, the latest publicly available case addressing the aforesaid issue was decided on 2 February 2021. In this case, the judges held that the existing judicial interpretation had not indicated the exclusivity of the Construction Proceeds Priority to the contractor, therefore the Construction Proceeds Priority shall be transferred to the investor along with the claims from the construction costs. However, given mainland China does not adopt a case law system, there is no guarantee that a judge will follow this rationale when hearing any future case.


What can investors do to mitigate the risks in the transfer of Construction Proceeds Priority?


If investors cannot accept the uncertainty regarding the transfer of the Construction Proceeds Priority, it is recommended that investors acquire the beneficiary right to the overdue construction costs. In this case the original contractor will remain the creditor of the construction costs on the record and the transaction structure shall be carefully tailored at the outset.


IV. Can NPL Investors Assume 24% as the Annual Interest Rate for Entrusted and Trust Loans? 

(First published on JunHe's LinkedIn page on 20 October 2021)


The second wave of NPL investment in China by foreign investors started in 2016 and during that time most investors tested the water by acquiring NPL portfolios. This led to a dramatic increase in the purchase price of NPL portfolios and accordingly a fall in profit margins. As the NPL market changes, many foreign investors have shifted their focus to single distressed loans secured by real estate in prime locations as they are more profitable. However, these loans are usually entrusted loans or trust loans being sold without much discount on the outstanding principal, hence NPL investors have to gain a profit from the interest accrued on the loan to increase the IRR.


In 2020, the Supreme People’s Court of China promulgated new judicial interpretations for private lending, slashing the cap of annual interest rates for private loans from 24% to four times the loan prime rate (LPR). This abrupt change caused consternation and confusion to investors in the Chinese NPL market. This is due to the fact that the nature of entrusted and trust loans is controversial and it is not clear under the existing laws whether these loans shall be regulated by the new judicial interpretations.


We set out below a brief analysis on some of our clients’ frequently asked questions:


Why is it possible that entrusted loans and trust loans may be regulated by judicial interpretations for private lending despite banks and trust companies being the financial lenders?


Generally, an entrusted loan in China refers to the disbursement of funds by an agent bank to a borrower on behalf of a fund provider. Although there are contradictory judicial cases regarding the nature of entrusted loans, we observed a trend in recent years that in the cases decided by the Supreme People’s Court judges are more likely to treat an entrusted loan as private lending, because the bank only acted as a trustee managing the loan whilst the funds were actually coming from the fund provider.


A trust loan is similar to an entrusted loan to a certain extent. The trust company only provides a channel to utilize the funds, and the trustor shall provide the funds and assume the loan risks. Our firm recently handled a case of a trust loan in the Shanghai Financial Court, where the judge took the view that the cap of the interest rate for the trust loan shall not be higher than the cap applicable for the private lending. Some NPL investors believe the circumstances should be different if a trust company uses its own funds to provide loans, in which case the funds are from a financial lender rather than from a non-financial entity or individual. However, this is uncertain and needs to be clarified by future regulations or legal practice.


Are the new judicial interpretations retroactive and do they cap all interest at the rate of four times LPR?


After an amendment to the judicial interpretations for private lending on 29 December 2020, the new judicial interpretations do not cap all interest at four times LPR, as the cap shall be different when the investors calculate the returns.


Without considering any special circumstance, if the lending is subject to the restrictions on the interest rate for private lending, the cap will be as follows:

(1) from the drawdown date to 19 August 2020, the cap on the annual interest rate is 24%; and

(2) from 20 August 2020 to the day when the loan is fully repaid, the cap on the annual interest rate is four times the one-year LPR published at the time when the loan agreement was signed (or the one-year LPR published at the time when the lawsuit is filed, if no LPR was applicable).


Is the cap applicable to default interest, penalties, liquidated damages, compensation and other payables?


The cap mentioned above does not only act on the regular interest rate. As provided under the judicial interpretations, the aggregate amount of the regular interest, default interest, penalty, liquidated damages, compensation and other payables shall not make the annual return for the loans exceed the cap, otherwise the excessive portion may not be upheld by the court. Nevertheless, according to some recent cases decided by the Supreme People’s Court, the expenses for the realization of claims such as attorney fees do not constitute a portion of the return of the loan, and such an amount should be paid by the obligors separately.


JunHe is the only Chinese law firm to be admitted as a member of Lex Mundi and Multilaw, two international networks of independent law firms. JunHe and selected top law firms in major European and Asian jurisdictions are “best friends.” Through these connections, we provide high quality legal services to clients doing business throughout the world.