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China Special Situations Insight (Jun2022)

2022.06.29 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 June 2022 for your easy reference.


I. Investment in Distressed Real Estate in China: Transaction Structures (I) – De Facto Debt in the Form of Equity

(First published on JunHe's LinkedIn page on 1 June 2022)


The financing of real estate projects is not an easy transaction in China, especially in recent years. With the dramatic increase in the price of real property, the government has introduced strict policies to control prices as well as restricting finance for real estate projects. In the light of this, developers are now unable to borrow cheap money from banks for new real estate projects, and distressed construction works that are in progress will remain unfinished and in dispute for a long time without any regular financial support, even if the real property is in a prime location with great value. There is a consensus that so long as an investor manages to provide financing through alternative routes and helps complete the real estate project, the sales revenue of the project would then make huge profits in return.


  • Brief introduction of de facto debt in the form of equity


A popular structure that many investors could deploy to finance real estate projects is called de facto debt in the form of equity. This structure looks like equity investment but is in fact lending in its nature.


Usually, an investor would first become a majority shareholder of a project company by way of a capital increase and then provide a shareholder loan to the project company. The increased capital and the shareholder loan should make up the entire funds that an investor provides to the project. The investor (as the majority shareholder) and the original controller (as the minority shareholder) will enter into a put option agreement, pursuant to which the investor shall have the right to require the original controller to purchase all the shares held by the investors on the maturity date of the investment, at a price including an agreed return on the investment. The put option of the investor ensures the exit of its investment, but it also reveals the nature of the investment as a lending.


To secure the shareholder loan and the put option obligations of the original controller, the investor will take security over the real property and take over absolute control of the project company. If the investor cannot achieve the investment exit, it can enforce the security or sell the project company to obtain sufficient proceeds.

Some important issues regarding the structure


The structure of de facto debt in the form of equity is a feasible approach for both foreign and domestic investors, as real estate investment was not included in the latest negative list for foreign investment. However, given that the structure has the appearance of equity investment but has lending as its nature, there are some important issues that investors need to be aware of.


(1) The legal nature of the structure is controversial, as a judge may currently hold a different view on this point. If a judge regards the structure as private lending, considering that the investor will not take on any risk from the business of the project company, the rate of return on the investment may be capped at four times the loan prime rate (LPR). However, if a judge regards the structure as equity investment, then the investor may lose control of the project company when the company becomes bankrupt; in which case we suggest that our clients take urgent legal action to exit from the investment before the bankruptcy and assert claims against the original controller for put option.


(2) An investor may not obtain returns in a certain time period before the investment exit, because the project company can only distribute dividends to an investor once the company has made a net profit. An investor needs to use alternative methods, for example, if returns are required on a quarterly basis, an investor may collect proceeds from the project company by way of financial advisory fees.


(3) If an investor is an offshore entity, it may not be able to provide shareholder loans to the project company, because real estate companies generally do not have any quota for foreign debt.


Financing real estate projects usually involves many different matters, such as corporate, real estate, banking, court proceedings, foreign exchange control, bankruptcy and tax. Therefore a comprehensive solution and structure is required to advance and close a deal.

 

II. Investment in Distressed Real Estate in China: Transaction Structures (II) – Acquisition of Distressed Assets under Mezzanine Finance from Asset Management Companies (AMCs)

(First published on JunHe's LinkedIn page on 8 June 2022)


Due to the tightening of policies in recent years, the financing of real estate projects is becoming more difficult in China. In general, a developer will not be able to borrow money from banks without satisfying certain conditions required by PRC law, including but not limited to obtaining land use right certificates, construction land planning permits, construction project planning permits, and construction commencement permits. Therefore, many developers seek to finance their real estate projects from shadow banks such as asset management companies (“AMCs”). Mezzanine finance is a popular structure and usually includes de facto debt in the form of equity and shareholders’ loans. More information regarding de facto debt in the form of equity can be found in our previous article. From our observations, the big four AMCs have done many mezzanine financing transactions of this kind over the last 10 years, and most of these are now in default. These distressed assets are becoming more attractive to investors, especially where the mezzanine financing deals are secured by quality collateral, and the AMCs are willing to sell at a discount.


Typically, in this mode, an AMC would become a majority shareholder of a project company by way of a capital increase and then provide a shareholder loan to the project company. It is advisable for investors to design a comprehensive structure of acquisition and consider the following aspects.


  • Important issues regarding the acquisition of De Facto Debt in the Form of Equity from AMCs 


(1) The transfer of an equity asset by an AMC is generally required to be conducted publicly through legally recognized asset exchange institutions at the provincial level or above. 


(2) The AMC (as the majority shareholder) and the original controller (as the minority shareholder) may enter into an option agreement, pursuant to which not only the AMC may have the right to require the original controller to purchase all the shares held by the AMC, but also the original controller may have the right to require the AMC to sell its shares to the original controller under certain scenarios (“Call Option”). To avoid any validity defects of the envisaged share transfer, investors are advised to confirm that the original controller is not entitled to any Call Option or has duly waived the same. Furthermore, investors shall require the seller to make representations and warranties in the transaction documents that the transferred shares are not subject to any Call Option, otherwise the seller shall compensate the investor for any loss in relation to such a breach.


(3) If there is any other shareholder holding shares in the project company, unless otherwise indicated in the articles of association, the proposed transfer of shares by the AMC to any third party shall be subject to the consent of more than half of the other shareholders. Those shareholders (other than the AMC) shall have the preemptive right to acquire such shares under the same conditions (“Preemptive Right”). Therefore, it is advisable to incorporate obtaining the consent and waiver of Preemptive Rights from the other shareholders as a precedent condition in the transaction documents. Likewise, investors shall require the seller to make representations and warranties regarding the same. If any other shareholder is unwilling to waive their Preemptive Rights, the investor may consider acquiring the beneficial interest rights of the target shares. In this case, the AMC will be a trustee holding the shares on behalf of the investor, who will then have indirect control over the shares of the project company.


(4) Given that de facto debt in the form of equity is in fact lending in its nature, it is common that an AMC may have not fully contributed its subscribed capital. Under PRC law, a creditor of a project company is entitled to claim against the shareholder who has not fulfilled its capital contribution obligation, to the extent of the principal and interest of registered capital subscribed by but not contributed by it, for compensating the outstanding debts of the project company. Therefore, investors are advised to reduce the evaluation of the investment accordingly.


(5) Foreign investors are allowed to participate in this acquisition approach since real estate investment is not included in the latest negative list for foreign investment. However, majority share acquisition by foreign investors may be subject to national security reviews if the military or other important fields concerning national security is involved. 


  • Important issues regarding the acquisition of shareholder loans from AMCs 


(1) In principle, it is a requirement that NPLs of AMCs shall be transferred by means of a public sale, which includes not only trading in exchange institutions, but also public auctions (including online auctions), and competitive negotiation. However, given that it is a mandatary requirement that an AMC can only sell the equity via qualified asset exchange institutions, where the AMC combines the equity and the shareholder’s loan in a package, (which is normally the case), the transaction can only be conducted through a qualified exchange institution.


(2) With respect to shareholder loan acquisition, if the investor is a foreign investor, after the purchase agreement is executed, the closing of the deal shall be subject to the filing registration with the National Development and Reform Commission.


To sum up, the acquisition of distressed assets under a mezzanine financing transaction covering de facto debt in the form of equity and shareholders’ loans from AMCs is more complicated than a normal acquisition. An initial, comprehensive plan for the transaction and solid protection mechanisms in the transaction documents are critical for a successful and profitable investment.

 

III. Investment in Distressed Real Estate in China: Transaction Structures (III) – Acquisition of a Distressed Single Credit by way of Offshore Special Purpose Vehicles (SPVs)

(First published on JunHe's LinkedIn page on 15 June 2022)


Apart from mezzanine financing transactions, which we explained in the previous article, investors may also invest in distressed real estate in China by acquiring the distressed single credit owed by real estate developers. Investors can use either an offshore SPV or an onshore SPV to acquire such distressed loans, and each type of the SPVs has its pros and cons. In this article, we elaborate on the transaction structure of offshore SPVs. In the next article we will discuss the transaction structure of onshore SPVs.


If a distressed single credit is owed by a real estate developer, the most efficient method for an offshore SPV is to purchase the single credit from one of the big five Asset Management Companies (AMCs) and complete the NDRC filings. Generally, there are four options in which an investor may choose to make a profit from a distressed single credit.


(1) Debt settlement with a real estate company


Due to the strict regulations for the protection of state-owned assets, AMCs are not permitted to waive their claims with respect to the principal amount of a distressed loan, though a waiver of the interest amount is permitted by the regulatory authorities. Such rules restrict AMCs from reaching settlement agreements with debtors. If AMCs pursue all claims under the loans against the underlying obligors, the debt collection will be long and inefficient. However, it is legal for AMCs to sell distressed loans to investors at a large discount, but such investors should not be the debtors. To achieve a quick debt recovery by way of loan sale, many AMCs would agree to waive the accrued interest on the loan plus a certain portion of the principal amount; the final purchase price of the distressed loan therefore could be even lower than the principal amount of the loan.


If an investor acquires the distressed loan at a low price, there will be a large margin for an investor to manipulate. In practice, if an investor (as the creditor) and the real estate company (as the debtor) manage to make a debt settlement whereby the investor agrees to waive a portion of the distressed loan, the real estate developer may become motivated to voluntarily repay the outstanding debts in a short time. This is a good method for an investor to collect the loan and make a profit quickly.


(2) Enforcement of mortgages on real property


Enforcing a mortgage through court proceedings is the traditional method of recovery. Enforcement may be lengthy, but it also has special advantages. Some mortgaged properties are in prime locations and the value of the properties would cover the interest to be accrued in the next one or two years; therefore, in practice, some investors may purposefully slow down the enforcement to accumulate interest.


The price of the real estate may also go up during the enforcement procedures, especially in first-tier cities in China. If the mortgaged property is sold at a higher price, then the investor would be able to recover more proceeds. They would also profit if there is an appreciation of the RMB during the enforcement, which in fact happened during the first cycle of NPL investment in China (from 1999 to 2007).


(3) Sale of distressed loans


Generally, onshore investors have more ways to utilize distressed loans, such as restructuring the debt and taking ownership of the property. If an offshore investor has acquired a distressed loan that is secured by properties with great value, many onshore investors would offer a high price to purchase the loans. This is also a good option for investors to exit their investment safely and quickly.


(4) Taking ownership of a mortgaged property


If the auction of a mortgaged property fails during the enforcement procedures, an investor will have the right to take the ownership of the mortgaged property and the debt (to the extent of the upset price) will be discharged. When an investor agrees to take the ownership of the mortgaged property, the court will issue an order to legalize the transfer of ownership. However, an offshore investor may not be able to obtain an ownership certificate even though the ownership has been legally transferred, because offshore entities are not permitted to hold real estate directly in China.


If an offshore investor has obtained a court order endorsing the transfer of ownership, subject to communications with the local real estate authority, an investor may (i) sell the property to a third party to exit its investment or (ii) transfer the property to a wholly foreign owned enterprise (WFOE) incorporated in China (with all necessary licenses obtained) for further development or the business of leasing.


IV. Investment in Distressed Real Estate in China: Transaction Structures (IV) – Acquisition of a Distressed Single Credit by way of Onshore Platforms

(First published on JunHe's LinkedIn page on 22 June 2022)


As discussed in the previous articles, investors may invest in distressed real estate in China by acquiring the distressed single credit owed by real estate developers. If investors already have an onshore platform, there will be more options potentially available which would make the deal more profitable. Please refer to our previous articles for foreign investors to purchase NPLs in China (Vol 2, Issue 9 & Vol 2, Issue 10) where these investment routes are discussed in more details.


Onshore platforms have the most flexibility with respect to investment in distressed real estate. Options that an offshore special purpose vehicle can deploy are also available to onshore platforms, and onshore platforms have more options to make a profit from a distressed single credit.


(1) Debt restructuring and additional investment


Investors may reach cooperative arrangements with real estate companies to achieve a quicker recovery and higher profitability, rather than initiating court proceedings to pursue claims against underlying obligors and potentially placing parties in hostile positions.


Usually, an investor will restructure a debt by raising the interest rate and extending the term of the loan. Investors will also provide additional funds to a real estate company by way of a capital increase to take shares in the company and shareholder loans. To have all the debt restructuring and new investment in place, the real estate company would provide an additional security package in favor of the investor. This is a win-win situation for both the investor and the real estate company, because the additional security package will put the investor in a safer place and the investor will receive higher profits from the investment, whilst the real estate company will have more time and money to develop and complete the projects.


(2) Taking ownership of a mortgaged property


There are certain considerations in the situation whereby an investor determines to enforce the mortgage of a real property through court proceedings. If an investor participates in an auction via a credit bid (subject to the consent of the relevant court at its discretion) and becomes the bid winner, or the auction of the property fails, the investor will then have the right to take ownership of the mortgaged property and the relevant amount of the debt will be discharged. This is different for an offshore special purpose vehicle, whereby the onshore platform can obtain an ownership certificate for the property so long as the court issues an order to legalize the transfer of ownership and the investor pays the relevant tax amount.


Upon obtaining ownership of a property, the investor may (i) sell the property to a third party to exit its investment or (ii) set up another wholly foreign owned enterprise (WFOE) incorporated in China (with all necessary licenses obtained) to take over the property for further development or for leasing purposes.

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