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China Special Situations Insight (Apr 2022)

2022.04.27 Catherine MIAO、Li, Yi_YI、LUO, Chong

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 April 2022 for your easy reference.


I. Investment in Distressed Real Estate in China: Key Issues for Legal Due Diligence (I) – Outstanding Land Premiums and Taxes 

(First published on JunHe's LinkedIn page on 6 April 2022)


The rapid growth of China’s economy has brought about a dramatic increase in the value of real estate and, at the same time, caused actual or contingent problems for the real estate industry. Some developers acquired lands in prime locations in early years, but the projects have become bogged down because the developers or the properties became distressed due to a variety of reasons, which have made the projects impossible to reach profitability. Many international and domestic investors have realized opportunities in this distressed real estate market and have set up funds to specifically bail out the distressed properties, so that they could make huge profits from the development and sales thereafter.


We have prepared a series of articles to highlight the major transaction structures and legal due diligence issues for investment in distressed real estate in China. The first part outlines the important issues that NPL investors need to be aware of during legal due diligence, and the second part outlines the major transaction structures that most NPL investors would deploy. We will continue this series and cover other investment structures and key issues when appropriate. In this article, we raise the importance of examining the full payment of land premiums and taxes regarding land use rights and set out the consequences if such fees remain outstanding.


  • Brief background for investment


When a real estate developer (or other enterprise) intends to acquire land use rights from the land authority, the buyer must participate in an auction and become the winning bidder; the buyer then qualifies to enter into a contract for the granting of land use rights with the local land bureau. The buyer shall pay all the land premiums and all relevant taxes to secure the title of the land use rights and complete the registration. Usually, the title transfer registration will not be completed if any land premiums or taxes remain outstanding, but a local government may grant special approval to allow the buyer to complete the title transfer registrations before paying the land premiums or taxes in full. According to our experience, it is not unusual across the country for a local government to make such an exception, and investors should not assume that all land premiums and taxes have been paid simply because the buyer has a title certificate for land use rights.


To invest in distressed real estate, generally investors will acquire either (i) the distressed real property or the equity in the company holding the distressed real property (collectively, the “Distressed Assets”) or (ii) the non-performing loans secured by distressed real property (the “Distressed Loans”). However, if any land premiums or taxes are outstanding, the investment will be adversely and materially affected whether the investors have acquired Distressed Assets or Distressed Loans.


  • The consequences of outstanding land premiums or taxes


If the buyer fails to pay all the land premiums or taxes pursuant to the contract for the granting of land use rights, the consequences will be as follows:


(1) Where the investor acquired the Distressed Assets, (i) the project company may need to assume the liabilities for the violation of the contract or the tax laws, including but not limited to paying a penalty in a large amount and losing part or all the land use rights; and (ii) even if all the buildings are well constructed and pass the acceptance examination, the project company may not be able to complete building ownership registrations and sell the properties.


(2) Where the investor acquired the Distressed Loans, in practice, the outstanding land premiums, taxes and penalty accrued thereon will rank ahead of the mortgages over the land use rights; this means the investor will not be entitled to all the proceeds from the disposal of the land use rights because certain proceeds shall be applied to pay the land premiums, taxes and penalties.


According to our experience, there is another circumstance that investors need to be aware of. If the local land bureau has not organized an auction for the transfer of land use rights, which violates the relevant regulations, and has transferred the land use rights to a buyer at a premium lower than the local base price for the land use rights, the buyer shall pay the difference between the agreed price and the local base price, otherwise the consequences set out above may still apply.


  • Strategies to outstanding land premiums or taxes


It is very important for investors to investigate the payment of land premiums and taxes during legal due diligence, although in some distressed loans transactions, the investor may not be able to verify the payment due to a lack of authorization from the underlying obligors. We suggest that our clients require the seller to make representations and warranties in the transaction documents that all land premiums, taxes and other relevant fees with respect to the project have been paid in full, otherwise all outstanding fees shall be borne by the seller.


However, if it is confirmed that there are outstanding large land premiums, taxes or penalties and such outstanding fees will materially affect the profitability of the transaction, investors should think carefully whether it is time to walk away.


II. Investment in Distressed Real Estate in China: Key Issues for Legal Due Diligence (II) – Leases on Distressed Real Estate

(First published on JunHe's LinkedIn page on 13 April 2022)


We have looked at six issues that NPL investors need to be aware of during legal due diligence for investment in distressed real estate in China. In this second article, we sum up the potential impact of leases on distressed real estate under different investment transaction structures. 


In general, investors of distressed real estate may acquire either (i) the distressed real estate (the “Asset Acquisition”), (ii) the equity in the company holding the distressed real estate (the “Equity Acquisition”) or (iii) the non-performing loans secured by distressed real estate (the “Loan Acquisition”). 


An investigation on an existing lease is essential during legal due diligence on distressed real estate, as a lease may have a material impact on the profitability of the investment.


  • The impact of a lease on real estate


If a lease exists on a target distressed real estate (the “Property”), the consequences will be as follows:


(1) In the case of an Asset Acquisition, a change in the ownership of the Property during the period that a lessee possesses the Property pursuant to the lease contract generally shall not affect the validity of such a lease contract. In other words, the lease will survive the transfer of the title of the Property, thus investors acquiring the assets will take over the same rights and obligations of the original lessor under the lease contract. 


(2) In the case of an Equity Acquisition, after an investor acquires a project company holding the distressed real estate, the project company’s liabilities and obligations under the lease contract will continue without any change. 


(3) In the case of a Loan Acquisition, usually the Property is the mortgaged property (the “Mortgaged Property”) securing the target loans. If, prior to the creation of the mortgage, the Mortgaged Property has been leased and possessed by a lessee, the lease shall not be affected by the mortgage, and the lease contract will continue to be binding on the buyer of the Mortgage Property. In practice, the existing lease will not derogate the validity of the mortgage, but the proceeds of the Mortgaged Property may be reduced significantly if there exists a long-term lease with an unreasonably low rent amount. A positive aspect here is that the existence of a lease may offer a recovery source for the debt collection. Where the debtor is in default and the Mortgaged Property is subsequently attached by the court, the investor as the mortgagee is entitled to collect the rent accrued from the Mortgaged Property as of the date of the attachment. This can be achieved either through the notification to the relevant rent payer by the mortgagee, or through a court enforcement in the litigation process. 


  • Strategies to an existing lease on distressed real estate


In the three scenarios above, the existence of a lease may have a positive or a negative effect on the transaction, depending on whether the rent is higher or lower than the market price. If the rent is a fair price or much higher than the market value, generally it will have a positive influence on the transaction. However, if there exists a long-term lease with rent much lower than the market price, the IRR of the investments in all three scenarios will be adversely affected. Therefore, it is advisable to take the following steps to better protect an investor’s interests:


(1) It is advisable to collect and review all the lease contracts and to identify all the detailed rights and obligations set out in the lease contracts as well as whether there are any outstanding liabilities to be borne by the lessor, particularly whether the rent is unreasonably low while the term is long. In the case of an Asset Acquisition and an Equity Acquisition, normally the project company and its shareholder(s) are willing to cooperate, and the lease contracts are available upon request. However, this may not be the case in a Loan Acquisition where the debtors and the mortgagors are in default. The lease contracts are private agreements between the lessee and lessor which may not be accessible by the investor unless being disclosed to them by the owner of the Property. Such information is also impossible to be completely obtained through public research. Although PRC law requires the lessors and lessees to complete the registration of lease contracts with the real estate management authority, in practice most lessors and lessees are reluctant to go through the registration procedure, as it is not a prerequisite for the lease contracts to take effect, and tax will be levied upon registration. One of the investigation approaches in legal due diligence is to carry out public online searches of judicial auction announcements relating to the Property and use the disclosed lease information as a reference point; Unfortunately this may not be a comprehensive investigation.


(2) It is advisable that investors require the seller to make representations and warranties in the transaction documents to the effect that all lease contracts on the Property and the seller’s outstanding liabilities thereunder have been truly disclosed, otherwise the seller shall compensate the buyer for any loss caused by such a breach by the seller.


III. Investment in Distressed Real Estate in China: Key Issues for Legal Due Diligence (III) – Mortgages on a Construction in Progress

(First published on JunHe's LinkedIn page on 20 April 2022)


To invest in distressed real estate in China, many investors will purchase non-performing loans secured by a construction in progress. In this third article regarding the key issues NPL investors need to be aware of during legal due diligence, we focus on the scope of mortgages over a construction in progress, particularly whether the security interest covers the use right of entire land beneath the real property.


While buildings are being constructed, a real estate developer would apply for financing and create security over the construction in progress in favour of the lender. Even though the intention is to have a mortgage over the uncompleted buildings and the entire land use right thereunder, the local registration practice may not serve that purpose. The registration system in many cities only allows for mortgage registrations for uncompleted buildings without covering the entire land use right, whilst the system in some other cities may have mortgages registered on both the uncompleted building works and the entire land use right. These registration practices have led to controversy on the scope of mortgages, especially when the mortgage registrations are made for the uncompleted buildings only.


  • Will mortgages be created on both the uncompleted buildings and the entire land use right?


According to the Civil Code, where constructions are mortgaged, the corresponding land use right to the extent occupied by the constructions shall be deemed as being mortgaged together. However, the scope of the occupied land use right has not been defined under the law, which means it remains uncertain whether (i) occupied land use right refers to the use right of part of the land directly and closely occupied by the construction (the “Directly Occupied Land”) or (ii) occupied land use right refers to the use right of entire land beneath the construction including the part of the land that is unoccupied (the “Entire Land”).


We are aware that, in practice, many judges (including judges in the Supreme People’s Court) have different views on this issue. Some judges have held that once the construction in progress is mortgaged, the Entire Land shall be mortgaged together as required by law; other judges have ruled that because land is divisible, the mortgage shall be limited to the Directly Occupied Land.


From our perspective, unless the local authority has registered the mortgage on both the uncompleted buildings and the entire land use right, the mortgage scope will remain controversial and NPL investors need to conduct further investigations before making a judgement.


  • What can NPL investors do during legal due diligence if a mortgage is registered only for the uncompleted buildings?


To justify the mortgage on the Entire Land, NPL investors will need to find evidence that the local registration authority has accepted the mortgage on the Entire Land. In this regard, we recommend the following:


(1) The investors may examine the mortgage agreement and all other documents submitted to the local authority to confirm that the parties agreed to create a mortgage on the Entire Land. According to our experience, the parties may record on an application form or other registration document their intention to mortgage the Entire Land, which will be helpful to the investors.


(2) The investors may have an informal interview with the local authority to check if they recognize a mortgage over the Entire Land or Directly Occupied Land.


(3) The investors may review similar decided cases in the relevant city or province, as this will reflect the attitudes of the local judges towards this issue.


If an NPL investor is undertaking a transaction where security shall be taken on a construction in progress, it is important to make the mortgage registration on both the uncompleted buildings and the Entire Land; however, if the local registration system can only register a mortgage on the uncompleted buildings, we would suggest that investors make it clear that the Entire Land shall be mortgaged in the mortgage agreement and all the other registration documents.

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.