China Special Situations Insight (Jan 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 January 2022 for your easy reference.

I. Risk & Mitigation Strategies: When Mortgaged Land under an NPL is Identified as Idle Land 

(First published on JunHe's LinkedIn page on 5 January 2022)

NPLs secured by real property in prime locations in China have always been more attractive to NPL investors. Land may be identified by the government as idle land if the construction thereon is delayed due to various reasons. If the land on which the land use right has been mortgaged to secure an NPL (“Mortgaged Land”) is identified as idle land, the realization of the security interest may be significantly affected, or such interest may even be lost.

As provided in the Measures for the Disposal of Idle Land, idle land refers to plots of land that fall into the following scenarios:

• construction fails to commence one year after the date set out in the land use right grant contract or allocation decision ("Scenario 1"); or

• construction has commenced but is then subsequently suspended for more than one year, and the completed portion is less than (i) one-third of the area of land for construction or (ii) 25% of the required total investment ("Scenario 2").

Of concern to many investors is the potential impact once Mortgaged Land is identified as idle land. In response to this, we highlight four major legal consequences which may adversely affect the interest of NPL investors as well as some proposed mitigation strategies.

1. Where the Mortgaged Land is identified as idle land under Scenario 1 caused by the holder of Mortgaged Land (“Mortgager”)

(1) Imposition of fines

The government may choose to impose fines on the Mortgaged Land at 20% of the land granting or allocation fee (“Fines”). Current legislation in the PRC does not state that Fines shall be discharged prior to any loan with security interest on Mortgaged Land from the disposal proceeds of the same. Local practices however may vary from place to place. To be on the safe side, investors are advised to deduct any Fines from the evaluation of NPLs.

(2) Withdrawing the Mortgaged Land without compensation

According to the relevant laws, if construction fails to start on Mortgaged Land for more than two years, the government has the right to declare the Mortgaged Land as idle land and even decide to withdraw the Mortgaged Land without providing compensation to the Mortgager. In practice, local governments for some reason may not always exercise such a right without giving the owner a chance to remedy. Given that this is a matter within the discretion of the government, and if this does happen, then the creditor would lose its security interest over the Mortgaged Property, we advise that investors carve out the security interest on the Mortgaged Land in the evaluation of the relevant loan.

2. Where Mortgaged Land identified as idle land under Scenario 1 is attributable to government acts or force majeure, or under Scenario 2

(1) Withdrawing Mortgaged Land with compensation

The government may decide to take back Mortgaged Land by providing compensation (“Compensation”) to the Mortgager. The creditor may be entitled to recover Compensation with priority based on its security interest created. Usually, the Compensation is lower than the market price of the Mortgaged Land but not lower than the costs incurred by the Mortgager to obtain the said land. Therefore, investors are advised to consider, among other relevant elements, if the land granting or the allocation fee of the Mortgaged Land is sufficient to cover the outstanding debts and decide whether to acquire this loan or not.

(2) Exchanging another piece of land for the Mortgaged Land

The government may decide to supply the Mortgager with another plot of land of equivalent value and the same usage purpose (“New Land”) as the replacement of the Mortgaged Land, in which case the creditor will lose its original security interest on the Mortgaged Land. It is possible to file a mortgage registration on New Land in the case of a restructure of debt through amicable negotiation, however, given that NPL investments usually are hostile acquisitions, it is unlikely that the Mortgager would be cooperative in such a filing of a mortgage registration. Under this situation, investors are advised to consider the risk of losing the security interest on the Mortgaged Land and assess the impact on their returns accordingly.

II. New Regulations for NPL Investors: A Brief Introduction to Security Registration of Movables and Rights 

(First published on JunHe's LinkedIn page on 12 January 2022)

NPL investors often deal with equipment mortgages, receivables pledges and other security on movables or rights when they are sourcing and investigating NPL portfolios. Although most movables and rights do not provide a higher value compared with standard real estate, some securities on movables and rights may affect a portfolio appraisal because they will also bring about the repayment of loans during an NPL resolution.

Following a decision made by the State Council outlining the unified security registration for movables and rights on 22 December 2020, the People’s Bank of China recently promulgated the Measures for the Unified Security Registration of Movables and Rights (in Chinese, 动产和权利担保统一登记办法) (the "Registration Measures"), which detail the requirements and procedures for registering the security on movables and rights that will come into effect on 1 February 2022.

What is the purpose of the Registration Measures?

The Registration Measures serve to unify the security registration for certain movables and rights, with a view to further standardizing registration procedures and facilitating business finance.

The Credit Reference Center of the People’s Bank of China has been appointed to administer the registration for security on movables and rights, and all registrations will be processed on the Publicity System for Unified Registration of Movables (https://www.zhongdengwang.org.cn/) (the “Publicity System”). Currently, the following can be registered on the Publicity System in accordance with the Registration Measures: (a) mortgage of manufacturing equipment, raw materials, semi-finished products and finished products; (b) pledge of receivables; (c) pledge of deposit receipts, warehouse receipts and bills of lading; (d) finance leases; (e) factoring; (f) retention of ownership; and (g) other registrable security of movables and rights, except for the mortgage of motor vehicles, ships and aircraft, pledge of bonds, fund interests, and equity and property rights in intellectual property.

What advantages will the Registration Measures bring to NPL transactions?

The biggest advantage of the Registration Measures for NPL investors during acquisitions is in the phase of legal due diligence. In the past, if an investor intended to investigate a mortgage on manufacturing equipment, they had to attend the local branches (where the collaterals locate) of the State Administration for Market Regulation in person to obtain a search report, which took a lot of time and effort. However, the Registration Measures provide that any legal person, unincorporated organization or natural person may, after registering as a user of the Publicity System, inquire online into the security information of movables and rights, and the Publicity System will issue an inquiry certificate to provide results. This will save significant time and expense for the legal due diligence for NPLs.

Further, if an investor would like to take a new security on movables or rights in a debt restructuring or other financing transaction, the security registration can be completed within a short amount of time because the authority will not conduct substantive examination of the security.

What should investors be aware of during debt restructuring and other financing transactions?

Where an investor intends to restructure an NPL it has acquired or engage in other financing transactions, and the security on equipment, receivables or other movables or rights will be included in the security package, the investor needs to be aware of some key points for registration:

(1) The Registration Measures allow security registrations for most movables and rights, but it does not apply to the mortgage of motor vehicles, ships and aircraft, the pledge of bonds, fund interests, or equity and property rights in intellectual property, as the aforesaid mortgages and pledges shall be registered with other competent authorities.

(2) The amount of secured debt, security scope and restrictions on collateral transfer should be registered in the Publicity System. It is also advisable to make the description of collaterals specific and accurate; even if a general description of collaterals is required, the description should at least be able to identify the intended collaterals.

(3) The investor needs to extend the security registration before the expiry of the security term.

III. The Supreme People’s Court Implements House Purchase Restrictions in the Enforcement of NPLs

(First published on JunHe's LinkedIn page on 19 January 2022)

With a view to stabilizing house prices and reducing speculation, governments in various cities of China have implemented house purchase restriction policies to prohibit people without the relevant qualifications from purchasing local residential properties (the “Restriction Policies”). Enforcing the security on real estate by NPL investors is one of the most important methods to procure the repayment of loans, and proceeds from the disposal of property (i.e., housing prices) will be adversely affected if the Restriction Policies shall apply in the enforcement of NPLs.

On 1 January 2022, the judicial interpretations issued by the Supreme People’s Court regarding the judicial auction of real estate came into effect (the “Judicial Auction Interpretations”), which explicitly required the qualification of all purchasers before they participate in judicial auctions.

What do the Restriction Policies generally speak to?

Following a notice issued by the State Council on 26 January 2011 regarding the regulation and control of the real estate market, many cities in China, particularly first and second tier cities, enacted local policies to control the purchase of residential property. Even through the Restriction Policies may differ from city to city, the conditions for housing purchases are usually related to the registered households, tax payments, social insurance contributions or marital status of the purchasers, and most Restriction Policies would only allow a qualified purchaser to purchase one or two residential properties in the relevant regions.

What has changed with respect to the enforcement of security on real estate?

In the past, it lay with the discretion of the local government and courts to determine if the Restriction Policies shall apply in the enforcement of NPLs. For a long time, different provinces have taken different views on this. The courts in Guangdong province and Beijing officially implemented the Restriction Policies in enforcement proceedings around 2013 and 2017 respectively, whilst judicial auctions in Shanghai remained free from the Restriction Policies until January 2021. According to our observations, many real estate spectators and unqualified residents would act positively during the enforcement of real estate in Shanghai, because judicial auctions provided a backdoor for them to purchase residential property regardless of the Restriction Policies; therefore, it was very common for residential properties in prime locations to be sold at a price higher than the current market value. However, upon the implementation of the Restriction Policies in judicial enforcement in Shanghai, the price of residential property has quickly fallen back to market value or even lower.

According to the Judicial Auction Interpretations, when a purchaser applies to participate in a judicial auction of real estate, they shall undertake that they are eligible to purchase the property pursuant to the local Restriction Policies and voluntarily take all legal consequences; if a purchaser wins the auction, the relevant court shall examine all the supporting documents provided by the purchaser for the housing purchase qualifications before the court renders a judicial auction order. This means that all courts in China shall now implement the local Restriction Policies (if any) during the enforcement of security on real estate, and unqualified purchasers will not be able to participate in relevant judicial auctions or acquire ownership of relevant properties.

What should NPL investors do before acquiring an NPL?

Given that it is now clear that all courts in China shall implement the local Restriction Policies (if any) during the enforcement of security on real estate, NPL investors should consider the adverse influence caused thereby and reasonably determine the value of all relevant real estate while undertaking legal due diligence.