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China Special Situations Insight (Nov 2021)

2021.11.24 Catherine MIAO、LiYi、GU, Qian、 YANG, Qiao、 WANG, Wanjun

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 November 2021 for your easy reference.


I. Can NPL Investors Approach the Debtor's Shareholders for the Repayment of Debt?

(First published on JunHe's LinkedIn page on 3 November 2021)


Traditionally, NPL investors would only pursue claims against underlying obligors or enforce security interests to achieve the recovery of NPLs. However, a shareholder of an underlying obligor may also be held liable for an obligor’s debt in certain circumstances, and this would increase the possibility of the repayment of a distressed loan.


Generally, a limited liability company incorporated under PRC laws shall have a separate legal personality, preventing its shareholders from bearing the liabilities for the limited liability company. We outline below some of the exceptional circumstances where the aforesaid rule is overridden, and creditors may directly pursue the debtor’s shareholders in their personal capacity for the repayment of the debt.


(1) Failure to pay the registered capital


In China, company shareholders are not required to fully pay the registered capital at the time of incorporation or within a fixed statutory timeline. The shareholders, as provided in the articles of association, have the sole discretion in determining the contribution schedule of the company's registered capital, except in the circumstances of bankruptcy or liquidation. However, this doesn’t mean that the shareholders are completely relieved from capital contribution obligations. Shareholders are still obliged to fully pay in the registered capital they respectively subscribed for within the operation term of the company. Otherwise, the company’s creditors have the right to collect the debts from the shareholder, to the extent of the unpaid capital, for the company’s unpaid debts. This also applies to a shareholder who fails to fulfill capital contribution obligations under a capital increase scenario and a shareholder who knowingly acquires the un-paid-in equity from the original shareholder in the equity transfer scenario.


(2) Withdrawing paid-in capital


Withdrawal of contributed capital is strictly prohibited under company law. A shareholder who withdraws or assists another shareholder to withdraw the contributed capital cannot appeal to the limited liability protection, and the relevant shareholder shall become liable, to the extent of the withdrawn capital and interest accrued thereon, for the company’s unpaid debts.


(3) Piercing the corporate veil


If a shareholder abuses the privilege of limited liability protection which seriously damages the interests of the creditors of the company, the legal personality of the company can be disregarded by the court and the relevant shareholder will thus be held jointly and severally liable for the company’s debts. The Supreme People’s Court has specified the following three circumstances where the legal personality will be disregarded by the court:

(a) Confusion of legal personality. The court will consider whether the company possesses its own assets as being independent from the assets of its shareholders, to determine if the legal personality of the company has been mingled with that of the shareholders.

(b) Excessive domination and control. This generally encompasses a situation where the decision-making process of the company is manipulated by the shareholders resulting in the complete loss of independence of the company.

(c) Significant shortage of capital. This means that in the course of business operations after the incorporation of the company, the amount of capital paid in by shareholders in the company is evidently incompatible with the risks taken by the company for its business, which manifests the shareholder’s intention to take advantage of the limited liability of the subsidiary to shift the risk to creditors.


(4) Incorporating a one-person company without independence of assets


If a natural person shareholder or legal person shareholder incorporates a limited liability company, and the shareholder is unable to prove that the company's assets are independent of the shareholder's own assets, the shareholder shall bear joint liability for the company's debt.


(5) Violating statutory obligations during liquidation


Where a company has been dissolved and has gone into liquidation, a liquidation committee is statutorily required to be formed to handle the liquidation. A shareholder acting as a member of the liquidation committee could be held liable for the loss suffered by the creditors, if the shareholder violates their statutory obligations or causes the loss by willful misconduct or gross negligence.


II.Can NPL Investors Still Rely on a Joint Announcement Published by an AMC to Preserve the Statute of Limitations?

(First published on JunHe's LinkedIn page on 10 November 2021)


Generally, the statute of limitations is three years under existing PRC laws, and a creditor can preserve the statute of limitations by delivering a payment demand letter to the debtors. Given that financial asset management companies (“AMCs”) manage numerous NPLs, it would simply be too burdensome and time-consuming for AMCs to deliver a separate payment demand letter to each underlying debtor of the NPLs. With a view to strengthening efficiencies in managing NPLs by AMCs, in the early years the Supreme People's Court of China successively promulgated several judicial interpretations including the 12-Article Judicial Interpretations (collectively, the “NPL Judicial Interpretations”), thereby shaping the special status of AMCs in China’s NPL market.


The NPL Judicial Interpretations stipulate the principle that AMCs can preserve the statute of limitations of acquired claims and notify the underlying debtors of the claims transfer simply by publishing an announcement to demand for payment in a newspaper with a national or provincial influence. However, whether the aforesaid principle will remain valid after 1 January 2021 is uncertain due to a change of the law, and NPL investors should care more about the terms in the claims transfer agreement to protect their interests.


What do AMCs usually do to preserve the statute of limitations in an NPL transaction?


Currently, when an AMC sells an NPL to an investor, the AMC would only publish a joint announcement with the investor in a newspaper, relying on which to preserve the statute of limitations of the underlying loans. This is a more cost-efficient method for AMCs, compared with sending a separate payment demand to each of the underlying debtors.


What has changed in terms of the joint announcement in a newspaper?


In order to align with the Civil Code and ensure the unification and correct application of the law, the Supreme People’s Court repealed 116 documents including certain NPL Judicial Interpretations as of 1 January 2021. As a result, the actual effect of making a joint announcement in a newspaper becomes uncertain, and it is no longer 100% certain that a joint announcement will help NPL investors preserve the statute of limitations or help AMCs perform their notification obligations regarding claim transfers.


What should NPL investors do to protect their interests?


Before any new regulations come into effect to ascertain the legal effect of a joint announcement, it is advisable for NPL investors to be careful when negotiating a claims transfer agreement with an AMC and to ensure the following:

(1) After the transfer of an NPL, the AMC should (i) publish an announcement to notify the claims transfer and demand for payment in a newspaper which has a national or provincial influence and (ii) send separate claims transfer notices and debt collection letters to all underlying debtors by way of a notary service.

(2) The AMC should make representations and provide warranties that if any legislative, judicial or administrative institution promulgates a new regulation with respect to claim transfers or debt collection in the future, the AMC shall perform all obligations immediately pursuant to the relevant regulations.

(3) If any underlying debtor makes a defense on the grounds of the non-receipt of a claims transfer notice, the AMC should immediately notify the judicial institution and the debtor of the claims transfer in writing.


III.The Acquisition of Distressed Entrusted Loans, Trust Loans and other Non-Financial Assets by Foreign NPL Investors with Offshore SPVs

(First published on JunHe's LinkedIn page on 17 November 2021)


As mentioned in a previous article released on 20 October 2021, there is a trend whereby more investors are shifting their focus to distressed entrusted loans and trust loans, which are usually secured by real estate in prime locations and are more profitable. Under the regulatory framework currently in place, distressed entrusted loans, trust loans, private loans and other non-banking loans are generally treated as non-financial assets. If a foreign NPL investor has sourced a distressed non-financial loan, it cannot simply use an offshore SPV to acquire the loan from the original lender, because the NDRC or the SAFE will not generally grant a permit for this kind of transaction. One feasible route is to acquire the distressed non-financial loan through a financial asset management company (“AMC”). This is a two-step solution as the AMC will first purchase the distressed loan and then sell the loan to an offshore investor after completing a filing with the NDRC.


With respect of the above-mentioned two steps required to achieve the acquisition of non-financial assets by foreign investors through an offshore SPV, we have highlighted below some of the important issues that NPL investors need to be fully aware of before initiating a transaction.


Step One: acquiring the non-financial assets by AMCs from the original lender


The authority has imposed strict supervision on AMCs for non-financial transactions. If an AMC has interest regarding a non-financial asset, the following conditions are prerequisites:

(1) the non-financial asset should be distressed;

(2) the non-financial asset is authentic, valid and clean; and

(3) the non-financial asset (i) is not prohibited from acquisition by laws and regulations, (ii) does not involve national security and sensitive information, (iii) is not owed by state-owned debtors or secured by state-owned assets (unless the AMC waives the security), or (iv) is prohibited from acquisition by regulatory institutions.


Step Two: acquiring the non-financial assets by an offshore SPV from AMCs


Most NPL investors are already clear about the NDRC approval as a necessity for the cross-border transfer of distressed assets. However, according to our experience, there are some risks that NPL investors may neglect with respect to such transactions.


(1) A “bridge” transaction is prohibited by the regulatory authority


Although AMCs have a special license and status in China’s NPL market, the regulatory authority has never allowed them to take advantage of their unique license and status to undertake “bridge” transactions. In practice, to avoid being interpreted as acquiring certain loans for a specific investor, an AMC would usually hold a distressed loan for a certain period of time before the next sale, and when the AMC sells the loan, it may bundle the distressed loan with other distressed assets to manifest that the acquisition and disposal of the distressed loan are conducted according to the AMC’s own business plan and strategy. NPL investors will need to discuss this with an AMC and go into further detail before they decide to acquire distressed non-financial assets through the AMC.


(2) Public bidding is required for the sale of distressed assets


To protect state-owned assets, AMCs must organize a public sale to dispose of the distressed loans, even in the case of a single distressed loan. This is a real risk for NPL investors because the public sale is open to all potential investors, and there will be no guarantee that a particular investor shall win the bidding even though it is the very particular investor who has introduced the project to the AMC. In our experience, it is not unusual that an unexpected participant may win the bidding by offering a higher price; therefore, it is important for NPL investors to consider all aspects of the project and evaluate the risk at the outset of the transaction.

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.