Convertible bonds generally refer to bonds issued by listed companies that are convertible into shares. In recent years, however, many investment companies have entered into convertible bonds investment agreements with investees with reference to the “convertible bonds” trading structure of listed companies, thus creating a “debt + equity” investment model.
Such transactions can be generally divided into two aspects: (1) the investing company acquires the “convertible bonds” product not effectively issued by the target company; and (2) the investing company, under certain conditions, shall have the right to request the conversion of the bonds into shares of the target company. From the perspective of legal relations, the first aspect involves a loan relationship, while the second denotes a conditional legal relationship of capital increase. For the latter, with the satisfaction of certain conditions, the investing company is entitled to request the target company to increase capital, and then acquire shares of the invested company by means of capital contribution in the form of a previous loan. The two legal relationships jointly form an unnamed contract.
In practice, such a transaction model frequently encounters a problem, that is, the target company may be performing excellently at the time of satisfying bond conversion conditions, and the existing shareholders of the company may disagree with the conversion but instead propose repayment of principal and interest on the loan, which will in turn cause numerous legal issues. For instance, is such a transaction enforceable? Will new shareholders have the right to claim invalidity of the transaction if any shareholding change occurs to the target company before the satisfaction of the conversion conditions? Can the target company demand loan repayment before the satisfaction of the conversion conditions? This article will analyse these questions.
Enforceability of the transaction. The author holds the opinion that the key to the issue is to review whether the transaction has been approved in the form of a resolution by a board of shareholders at the beginning. If such a resolution have been approved, and subject to the satisfaction of requirements in the company’s articles of association regarding the requisite percentage of votes, the capital increase should be deemed valid and enforceable. Yet an argument has emerged that, as conversion of bonds into shares involves changes of the registered capital and shareholders, as well as amendments to the company’s articles of association, and as the judge in charge of the enforcement cannot force the company to take said actions, such contracts shall be therefore unenforceable. The author believes such an argument is short of sufficient supporting grounds, as capital increase mainly involves an internal process that, unlike capital reduction, does not require notifying external creditors as their interests are not affected. Therefore, if the transaction has been approved as a resolution of the board of shareholders early on, and the shareholders have accepted the transaction model, the contract shall be enforceable.
New shareholders’ right to claim invalidity. As share transfer denotes an inclusive transfer of both shares and all attached rights and obligations, an existing shareholder’s transfer of shares to a new one also means transfer of not only the rights but also the obligations associated with the shares, upon which the new shareholder becomes entitled to the rights and assumes the obligations. The author believes that performance of a bond conversion transaction should not be affected by whether the existing shareholder has disclosed such rights or obligations to the new shareholder at the time of the share transfer.
Suppose the new shareholder could be made unbound, it would then be extremely likely that the existing shareholder might fabricate a transaction, rendering the “convertible bonds” contract meaningless and creditors unable to protect their interests. Therefore, if the existing shareholder has failed to make such disclosure, the new shareholder should seek remedies from the share transfer contract instead of claiming invalidity of the “convertible bonds” transaction.
Target company’s right to pay off debt before conversion. As demonstrated in the above-mentioned analysis, the nature of such a transaction is essentially a loan contract relationship before conversion conditions are met. Section 30 of the Provisions of the Supreme People’s Court on Several Issues Concerning the Application of Laws in the Hearing of Private Lending Cases provides that: “The borrower may repay the loan ahead of schedule, except as otherwise agreed upon by the parties.” Accordingly, some believe that the target company may propose early repayment before satisfaction of the conversion conditions if, and to the extent that, it is not prohibited by the investment agreement.
Investors engaging in such transactions should beware that such opinions strictly divide a “convertible bonds” transaction into two stages along the satisfaction of the share transfer conditions, where only the legal requirements applying to the stage are considered, and the conclusion that early repayment is allowed in such transactions is based on a loan relationship.
To avoid such an outcome, investors should on one hand stipulate in the transaction documents that the target company is prohibited from repayment ahead of schedule, while the investors shall have the right to choose whether or not to make the repayment. On the other hand, if a dispute resolution procedure is initiated in the absence of such agreement on prohibition of repayment, investors are advised to illustrate the integrity of such a transaction to the adjudication authority in terms of the background, model and purpose of the transaction, so as to prevent it from being simplified as a loan.
A growing number of investment models have emerged in recent years, many of which, although innovative, can hardly be examined and considered as named contracts. We need to take a dialectical view on such transactions. On the one hand, we should subdivide the transaction elements to identify applicable laws, while on the other hand, we should consider the integrity of the transaction and avoid dealing with disputes arising from such transactions in a divisive or simplified manner. Only then can the interests of both investors and investees be effectively protected.
Li Xin is an arbitrator at the BAC/BIAC
