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China Special Situations Insight (May 2022)

2022.05.25 Catherine MIAO、Luo Chong、Gu Qian、Yang Qiao

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 May 2022 for your easy reference.

I. Investment in Distressed Real Estate in China: Key Issues for Legal Due Diligence (IV) – Official Permits and Certificates required for Real Estate Development

(First published on JunHe's LinkedIn page on 4 May 2022)

The compliance of construction and development of distressed real estate may materially affect the profitability of the investment. In this fourth article, we focus on the official permits and certificates required for real estate development.

The official permits and certificates required for real estate development

Real estate development in China is regulated by a mixture of laws, regulations and procedural guidelines set out by multiple governmental departments, and aspects of the development process may vary between cities. Despite this, the main principles and procedures are essentially the same. In general, prior to being issued with a building ownership certificate, real estate development encompasses the process of land use rights acquisition, project planning, construction and building, and completion acceptance. The following four permits and certificates relating to the aforesaid development process are mainly required to be applied for and obtained from the relevant government departments:

(1) A Construction Land Planning Permit: legal proof of permission to use a certain area and the scope of the land to construct the intended project, according to the zoning plan. 

(2) A Construction Project Planning Permit: legal proof that the intended construction project complies with the zoning plan.

(3) A Construction Project Building Permit: official approval that allows a contractor to commence construction.

(4) A Record-filing Certificate of Construction Completion Acceptance: legal proof that the completed construction project has passed the acceptance inspections conducted by various departments in charge of the environment, fire safety, greening, etc.

Potential legal risks if official permits and certificates are not obtained or followed

As noted in our previous articles, 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”). Based on the different transaction structures employed by the investors, we spell out below the potential risks when relevant construction permits and certificates are not obtained or complied with: 

(1) In the scenarios of Asset Acquisition and Equity Acquisition, if there exist buildings and structures constructed on the acquired distressed real estate that have failed to obtain any of the construction permits and certificates abovementioned, or pass relevant completion acceptance, or violate any planning requirements (“Non-compliant Buildings”), there is a risk of administrative penalties being imposed by the relevant authorities, such as demolition or confiscation of the Non-compliant Buildings and fines, depending on the severity of the circumstances.   

Among the administrative penalties abovementioned, some are imposed on the buildings (e.g., demolishing or confiscating the buildings) and some (e.g., administrative fines) are imposed on the developer. 1) With respect to the admirative penalties imposed on the buildings, the investor, after acquiring the distressed real estate, will continue to bear such risk of administrative penalties. 2) Regarding the administrative penalties imposed on the developer, although the purchaser (i.e., the investor) is not the original developer of the distressed real estate, some courts hold the view that the title transfer of the Non-compliant Buildings shall not serve as a legitimate reason for the purchaser to allow the buildings to exist and be used illegally, and thus the administrative penalties imposed on the seller (i.e. the developer) may also be imposed on the purchaser. Therefore, it cannot be ruled out that an investor may also face administrative penalties imposed on the seller due to the Non-compliant Buildings acquired. 

Moreover, if the building ownership certificate of the acquired distressed real estate is not obtained before the acquisition, the purchaser may not be able to obtain such certificate and put the real estate into use if there is any irremediable defect. 

(2) In a Loan Acquisition, usually the distressed real estate is the mortgaged property (the “Mortgaged Property”) securing the target loans. When disposing of such Mortgaged Property, if there are Non-compliant Buildings constructed thereon, it will greatly reduce the interests and willingness of perspective purchasers to acquire the Mortgaged Property, considering that potential administrative penalties may be imposed on the purchaser and the uncertainty of obtaining the building ownership certificate for the Mortgaged Property. 

Recommendations to Investors

In view of the potential legal risks abovementioned, it is advisable that:

(1) The investor shall conduct thorough due diligence on the target distressed real estate to investigate whether the corresponding official permits and certificates have been duly obtained in the progress of the development, and more importantly, examine whether the actual development and construction conform to the requirements set forth in the official permits and certificates abovementioned. If any construction permits and certificates are found to not be obtained or followed, it is critical to find out whether this is remedial or correctable, and, if so, what the cost would be.

(2) The relevant transaction document shall stipulate that as a condition precedent, the seller should rectify any irregularities of the development identified during the due diligence. Furthermore, investors shall require the seller to make representations and warranties in the transaction documents to the effect that all issues related to the incompliance of the development process have been truly disclosed, otherwise the seller shall indemnify the buyer for any loss due to such a breach.

(3) In a Loan Acquisition, investors should consider lowering the evaluation price of the distressed real estate with Non-compliant Buildings, considering the abovementioned risks that potential purchasers in the market will face.

II. Investment in Distressed Real Estate in China: Key Issues for Legal Due Diligence (V) –Priority Notice Registration of Mortgage

(First published on JunHe's LinkedIn page on 11 May 2022)

To create a mortgage over real estate, the creditor and the mortgager will usually conduct a formal mortgage registration on such real estate. However, in some cases, a mortgage registration cannot proceed due to a variety of reasons. For example, the real estate to be mortgaged was pre-sold to the mortgager when it was still under construction, and the ownership certificate of which has not yet been issued by the authority. In this scenario, the creditor and the mortgager may register a priority notice of mortgage over the real estate in order to procure future mortgage rights and restrict the ownership transfer of the same. 

Generally, a priority notice of mortgage is not sufficient for establishing a mortgage right on the real estate. The parties to the priority notice of mortgage are supposed to apply for a formal mortgage registration within 90 days following the date when the conditions for conducting a mortgage registration are ready (“Validity Period”), otherwise the priority notice of mortgage shall become invalid. 

Legal effect of a priority notice of mortgage

If a distressed real estate is registered with a priority notice of mortgage (“Mortgaged Property”), the consequences will be as follows:

(1) Priority in receiving repayment from the disposal proceeds. In general, a mortgage shall be enforceable after a formal mortgage registration is completed within the Validity Period. According to the relevant judicial interpretation which came into effect on 1 January 2021, when the following conditions are met, the right holder of the priority notice of mortgage (“Right Holder”) may be entitled to claim priority over the disposal proceeds of the Mortgaged Property, even without completing a formal mortgage registration: (a) the initial real estate ownership registration of the Mortgaged Property is completed; (b) the priority notice registration is within its Validity Period and the creditors’ right validly exists.

(2) Securing sequence of mortgage. According to the relevant judicial interpretation, when the Right Holder duly claims priority of repayment under item (1) above, their mortgage right shall be deemed as established from the date of the priority notice of mortgage. 

(3) Special protection mechanisms in bankruptcy. After a mortgager enters into bankruptcy and the Mortgaged Property with a priority notice of mortgage is regarded as the bankruptcy property of the mortgager, even if a formal mortgage registration has not been completed, the Right Holder shall have the right to claim priority of repayment from the disposal proceeds of the property, except for when the priority notice of mortgage is created for any unsecured debt, and such priority notice is registered within one year of the date when the bankruptcy application is accepted by the court. It provides protection to the interest of other creditors from a fairness perspective in the bankruptcy of mortgager.

(4) Imposing restrictions on the transfer of ownership or the creation of any encumbrance over the Mortgaged Property. Under the PRC laws, without the consent of the Right Holder, any ownership transfer of the Mortgaged Property or creation of the right to habitation, easements, or mortgage shall be determined to have no legal effect on the real estate.

Best practice regarding priority notice of mortgage

It is very important for investors to investigate whether there exists any priority notice of mortgage on the distressed real estate during the legal due diligence. If a priority notice does exist, it is advisable that the following steps are taken to better protect investors’ interests in NPL acquisitions:

(1) If the Right Holder is the seller of the NPL, the investor as the buyer should pay attention to the progress of the initial ownership registration of the real estate and ensure a formal mortgage registration be applied within the Validity Period when conditions for the registration are satisfied, so as to preserve the validity of the priority notice of mortgage and effectuate security interest over the real estate. 

(2) If there has been a priority notice of mortgage created by a third party creditor rather than the seller of the NPL, investors should exam whether the Validity Period of the priority notice of the mortgage has expired. If the priority notice of mortgage is still valid, investors should fully consider the risk that a third party may be entitled to claim priority in the future to receive repayment from the disposal proceeds of the distressed real estate, and the evaluation of the NPL may be adversely affected. 

(3) In the case of debt restructuring, the investor and mortgager may create a priority notice of mortgage on the distressed real estate when conducting mortgage registration is not feasible, and they should duly convert such a priority notice of mortgage into a mortgage registration as soon as practical. Local requirements on formality and process vary in different areas. Take the policy in Shanghai as an example: the local authority will convert a priority notice of mortgage into a formal mortgage registration automatically when the pre-sold house is transferred and registered in the name of the purchaser.

III. 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

(First published on JunHe's LinkedIn page on 18 May 2022)

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.

Legal effect of a Construction Proceeds Priority 

(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

(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. 

Best practice regarding Construction Proceeds Priority

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?).

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