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 biweekly basis, and this newsletter assembles all articles we published in March and April of 2023 for your easy reference.
I. An Introduction to Pledges of Receivables and Highlights for NPL Investors
(First published on JunHe’s LinkedIn page on 1 March 2023)
Pledges of receivables are a common form of collateral in NPL transactions. This article aims to provide a brief introduction to the pledging of receivables under PRC law and highlight some of the key issues for investors.
- What is a Receivable Pledge?
According to Article 3 of the Measures for the Unified Registration of Security over Movables and Rights (the “Registration Measures”), receivables refer to the creditor’s right to demand payment from a debtor for the goods, services, or facilities provided, as well as other payment requests the creditor is legally entitled to, including existing and future monetary claims, but excluding securities such as promissory notes, bonds, and checks.
According to Article 440 of the Civil Code of the People’s Republic of China, the type of rights a debtor or third party may create a pledge over include existing receivables and future receivables. Current laws and regulations do not provide a clear definition of existing receivables and future receivables.
(1) Existing receivables: This generally refers to receivables that already have a contractual basis, i.e., monetary claims on which a debtor and the subject of the receivables can be identified or specified upon the creation of the pledge.
(2) Future receivables: This usually refers to receivables that do not have a contractual basis when the receivables pledge agreement is executed but can be established in the future through the signing of contracts. Some examples set out in judicial interpretations include the right to income from infrastructure and public utility projects, as well as the right to receive payments arising from services or labor.
- The Establishment of a Receivables Pledge
Under PRC law, to duly establish a Receivables Pledge, the pledgor and pledgee shall conclude a pledge contract in writing and shall complete the registration procedures for the pledge. The receivables pledge is valid upon the completion of such registration. The Registration Measures, which came into effect on February 1, 2022, further clarify the scope of receivables that may be pledged, the registration requirements, institutions and procedures. The People’s Bank of China Credit Information Center (the “Credit Information Center”) is the registration institution for security on movables and rights, including receivables, and is in charge of the registration of security establishments, changes, cancellations and other related matters.
- Suggestions for Investors
(1) With respect to pledges on existing receivables, the pledgees shall confirm the authenticity of the receivables on pledge
According to the relevant laws and judicial interpretations, pledgees are obliged to strictly examine and confirm the authenticity of the pledged receivables and investigate the encumbrances on the same, through a unified registration system maintained by the Credit Information Center. If a pledgee cannot provide evidence to prove the authenticity of the receivables at the time of the registration of the pledge, the court will not support the pledgee’s request for repayment in priority from the receivables that have been pledged and registered.
It is suggested that when a receivables pledge is established, the pledgee shall obtain written confirmation in relation to the authenticity of the receivables from the debtor of the receivables. In addition, during the due diligence of NPL transactions, investors should take care to confirm that the original creditor has obtained evidence of the authenticity of the receivables at the time of the pledge registration.
(2) Regarding pledges on existing receivables, pledgees should promptly notify the debtors of the receivables pledge
In accordance with the Interpretation of Supreme People’s Court on Application of the Security System under the Civil Code of the People’s Republic of China, if the debtor of receivables does not receive any notice from the pledgee requesting performance to such pledgee and has already performed the debt to the creditor of the receivables, the court will not support the pledgee’s request for performance by the debtor. In this case, the debtor’s performance results in the loss of the receivables, and the pledgee will not be able to realize their security interest thereon.
The pledgee is thus advised to promptly notify the debtor in respect of the establishment, transfer and request for the performance of the receivables pledge, and to keep documentation proving such notification in good custody.
(3) The pledgee should promptly apply for an extension of the pledge registration
It is stipulated in the Registration Measures that the security holders should reasonably determine the registration timeframe based on the term of the principal debt. The registration period shall be no less than one month and no more than 30 years. Although the expiry of the pledge registration period does not necessarily invalidate the pledge, this may lead to disputes regarding the legal effect and priority of receiving repayment from the receivables pledged.
Therefore, it is recommended that a pledge extension be carried out in a timely manner to avoid any adverse effect on the receivables pledged.
II. The Right of Habitation and its Impact on the Realization of Mortgage Rights
(First published on JunHe’s LinkedIn page on 22 March 2023)
The Civil Code of the People’s Republic of China (Civil Code), came into effect on January 1, 2021, and officially introduced the right of habitation for the first time. The establishment of this system may have important implications for NPL investors in terms of realizing real property mortgages. In this article, we provide a brief overview of the right of habitation, examine its potential impact on the realization of mortgage rights on real property, and propose practical suggestions for investors to mitigate risks.
- An introduction to the right of habitation
(1) Definition of the right of habitation
The right of habitation refers to a right that a natural person is entitled to usufruct of possessing and using another person’s dwelling as agreed in a contract, to meet a person’s need for habitation.
(2) Establishment methods and legal effects
According to PRC laws and regulations, the right of habitation can be created in three ways: 1) by entering a written contract, 2) by wills or 3) by a legal document issued by the people’s court or the arbitration institution that enters effect.
An application for the establishment or change to the right should be filed with the relevant real estate registration authority. The right of habitation is created upon registration and provided that the right of habitation is created by effective legal documents issued by the people’s court or the arbitration institution, the right of habitation is effective from the date the legal documents take effect.
When a claim is impaired, it can reduce attorney’s fees as well as other litigation-related expenses, thereby assisting the creditor in realizing its rights relief at a lower cost.
- Potential impact on the realization of mortgage rights
It is not stipulated in PRC laws and regulations whether the exercise of a mortgage right can extinguish the right of habitation on the same real property. Due to the relatively short period of time since the introduction of the right of habitation into legislation, there have been very few judicial cases published on open websites that discuss this matter. Based on relevant laws, judicial interpretations and cases, we provide the following analysis but considering that there are few effective judgements with respect to whether the right of habitation will be extinguished in the enforcement of mortgage rights, these views are to be further observed in judicial practices.
(1) If a mortgage was created prior to the creation of the right of habitation
It is not clearly stated under PRC law whether a right of habitation can be established on a real property with an existing mortgage without the consent of the mortgagee, and practices vary in different regions. Some cities, such as Shanghai and Guangzhou, have issued local regulations and guidelines requiring the written consent of the mortgagee for the registration of the right of habitation on a real property with an existing mortgage.
According to Article 28 Paragraph 2 of the Provisions of the Supreme People’s Court on Auctioning or Selling off Property by People’s Courts in Civil Enforcement (Provisions), existing leases and other usufructs on auctioned property will not be extinguished by the auction. However, if the existence of these rights affects the realization of the prior security interests or other priority claims, the people’s court should eliminate such rights before the auction.
Many courts are of the view that leases established after a mortgage right should be extinguished by the court during the enforcement of the mortgage right, due to the adverse impact on the realization of the mortgage right. Pursuant to Article 28 of the Provisions, we tend to believe that if a lease is replaced with the right of habitation (as a type of usufructs), the courts are likely to hold a similar opinion; i.e. that a right of habitation established after a mortgage right should be extinguished due to the adverse impact on the realization of the mortgage right.
(2) If a mortgage is created after the creation of the right of habitation
There is no law or regulation that allows a subsequently created mortgage to extinguish the right of habitation previously created. Pursuant to Article 28 of the Provisions, existing leases and other usufructs on the properties to be auctioned will not be extinguished by the auction, unless the existence of such rights affects the realization of the prior security interests or other priority claims. Since the right of habitation is defined as a type of usufructs under the Civil Code, we understand that an existing right of habitation established prior to the creation of the mortgage will not be extinguished by the auction of the mortgaged property, and it will continue to exist on the mortgaged property.
The right of habitation is established upon registration and is publicly acknowledged. Some courts hold that if a mortgagee knows or is deemed to know that a property already has a right of habitation and still agrees to establish a mortgage on it, which causes a decrease in the value of the mortgaged property, then the mortgagee should bear the negative consequences.
In the case of a right of habitation established prior to the creation of a mortgage, we tend to believe that the right of habitation is unlikely to be extinguished when enforcing the mortgage right. As a result, the disposal proceeds of a mortgaged property may be materially affected.
- Suggestions for NPL investors
Given the potential impact of the right of habitation on the recovery of a mortgaged property, we recommend NPL investors prudently verify whether there is any right of habitation on a mortgaged property by conducting registration information and document research with the relevant real estate registration authorities. If there is a right of habitation on a mortgaged property, it is suggested that investors confirm the priority order of the right of habitation and the mortgage and assess the potentially adverse impact on the valuation of the investment.
When setting up a mortgage, NPL investors should specify in the mortgage contract that no right of habitation or other usufructs may be established on the mortgaged property without the prior written consent of the mortgagee.
III. The Nature and Legal Effect of Equity/Share Assignment by Way of Security
(First published on JunHe’s LinkedIn page on 12 April 2023)
As the market economy evolves, the demand for financing in the business community is increasing, leading to the emergence of new types of security. One such security is the use of equity/share assignment by way of security (hereinafter “Equity Assignment Security”), which has become recognized by Chinese courts over the years. The introduction of the PRC Civil Code and its related judicial interpretations have further acknowledged the legal status of the aforesaid form of security.
This article seeks to provide a comprehensive overview of Equity Assignment Security, including its definition, benefits, and potential risks. Additionally, practical recommendations for NPL investors considering this form of security will also be provided.
- Definition of Equity Assignment Security
Equity Assignment Security is deemed as a non-typical security in the PRC, that involves the transfer of equity by a debtor or a third party to the creditor for the purpose of securing a debt owed to the creditor. If the debtor fails to pay the debt when it is due, the creditor has the priority in repayment with the proceeds of the disposal of the equity through auction or sell-off. However, if the debt is fully repaid, the equity should be returned to the debtor or the third party.
To qualify as Equity Assignment Security, the following conditions shall be met: (1) there exists a creditor-debtor relationship between the equity transferee and the transferor or a third party; (2) the equity transfer must serve for the purpose of securing the debt, and not for actual equity transfer; (3) upon the maturity of the debt, the equity should be either returned to the transferor (in the event that the debt has been fully repaid ) or be disposed of with proceeds to repay the outstanding debt (in the event that the debt has not been fully repaid).
- Advantages and Risks of Equity Assignment Security
Compared to traditional forms of security, Equity Assignment Security provides greater flexibility and security. By transferring the equity to the creditor, it allows the creditor to gain greater control over the equity, which helps prevent the debtor/a third party security provider from mishandling the equity. The creditor can also protect the value of the equity by stipulating their rights, such as information and supervisory rights, in the agreements establishing Equity Assignment Security (hereinafter the “Agreements”) without infringing upon the actual management rights of the shareholders. Additionally, upon registration of the equity under the creditor’s name, it prevents other creditors from attaching such equity due to other debts, thereby safeguarding the interests of the creditor.
However, there are also certain risks associated with Equity Assignment Security. One potential risk is that the creditor, as a registered nominal shareholder of the company for which it holds equity subject to security, may be sued by other creditors of the company and held liable for the company’s debts to the extent of the unpaid or withdrawn capital by the debtor/a third party security provider. Additionally, if it involves an agreement that allows the creditor to take ownership of the equity when the debtor fails to repay the debt upon maturity, the Equity Assignment Security may be held invalid by a court, because such agreement is characterized as an “attributive pledge” to forfeit pledged assets and this arrangement is prohibited under the PRC laws to protect interests of a relevant pledgor.
- Suggestions for NPL investors
In order to ensure that the establishment of Equity Assignment Security is legal and effective, and to mitigate potential risks, we suggest NPL investors, as creditors/security interests holders, should:
(1) clearly state the true intent of providing security for a creditor-debtor relationship in the Agreements.
(2) register the equity subject to security with the company registry and become a nominal shareholder.
(3) specify in the Agreements that the creditor/security interest holder does not automatically acquire ownership of the equity subject to security when the debt is due but has a priority right to be repaid with the proceeds from disposal of the equity subject to security.
(4) conduct a thorough investigation to identify if there are any defects in the equity and stipulate in the Agreements that the creditor/security interests holder is not responsible for any shareholder’s contribution defects. If the creditor/security interests holder is sued by a third party for the capital contribution due to his nominal shareholder status, the relevant expenses and losses incurred thereby shall be indemnified by the debtor/a third party security provider.
(5) request the debtor/security provider to obtain written consents from other shareholders of the company for the transfer of equity subject to security and their waiver of right of first refusal in order to ensure the legal transfer of equity subject to security if such transfer involves an external third party, rather than a transfer between shareholders.
For further information, please contact:
Catherine MIAO, Partner, JunHe