Legal relationships and defences for directed financing instruments

A wave of financial products known as “directed financing instruments”, “directed debt financing instruments”, or “directed financing plans” flooded the market around 2018, garnering widespread attention and enthusiasm from investors.

Against the backdrop of substantial financing demands among small and medium-sized enterprises (SMEs) and a keen interest from investors, the investment market flourished.

Directed financing instruments – characterised by low entry barriers, simple procedures and high returns – gained popularity as investment vehicles. However, over the subsequent two years, many of these financial products defaulted, as many financing parties faced difficulties in fund turnover, leading to numerous litigations and enforcement cases.

This article analyses the operational model of such financial products, and how trustees and investors can maximise rights protection and risk management.

Legal relationships

Directed financing instruments generally refer to investment and financing products registered with local financial exchanges, where qualified financing parties issue them to specific investors with an agreement to repay principal and interest within a specified period. Local financial exchanges require registration or approval from local financial authorities.

The issuance process of directed financing instruments involves product registration followed by issuance to qualified investors by underwriters. Investors directly sign financing contracts with the issuer, and investment funds are directly transferred to the issuer’s designated financing account, supervised by the trustee. Funds are approved to be transferred to the issuer’s account by the trustee.

On maturity, the issuer transfers the payable amount to its designated allocation account, under continued supervision by the trustee, for disbursement to investors.

Structuring

Directed financing instruments usually undergo phased registration and multi-term issuance, with the issuer providing certain credit enhancement measures, commonly through guarantees obtained by the trustee.

Structuring of directed financing instruments involves multiple parties including financial exchanges, issuers, underwriters (sponsors), trustees and credit enhancement.

The transaction structure is shown on the right page:

From the transaction structure perspective, directed financing instruments resemble private placements, sharing similar legal relationships with private placement bonds. But they are not traditionally understood, or termed, as standard private equity funds or private placement bonds. The main differences lie in:

Different trading venues and regulatory rules. Directed financing instruments are financial investment products issued by issuers through various local financial exchanges, whereas private placement bonds are primarily registered and issued on the Shanghai and Shenzhen stock exchanges or interbank markets.

Due to different trading venues, they adhere to different regulatory rules. Directed financing instruments are subject to the trading rules of various local financial exchanges, which vary, while different private placement bonds adhere to unified trading rules.

Different thresholds for issuers. Different issuance venues have different entry requirements for issuers. Overall, compared to private placement bonds, directed financing instruments have relatively lower requirements for issuer thresholds.

Different thresholds for investors. Local financial exchanges conduct risk assessments on investors, with eligible individuals becoming members. Directed financing instruments have lower investment thresholds for investors compared to private placement bonds, which have relatively higher ones.

Investor protection

After default of directed financing instrument issuers, investors mainly have two means of recourse against the issuer:

Trustee-initiated litigation. The underwriting agreement, trustee agreement and subscription agreement typically stipulate that the trustee can initiate litigation based on the agreement or resolutions of investor meetings.

The Shanghai High People’s Court once ruled against the trustee’s standing to initiate lawsuits, but the Supreme People’s Court overturned the ruling.

Subsequently, the Minutes of the National Courts Symposium on the Trial of Bond affirmed the bond nature of directed financing instruments and the representative’s status of trustees and bondholders in litigation and bankruptcy proceedings.

Investor-initiated or jointly initiated litigation. The minutes also affirmed that investors could initiate or jointly initiate litigation and participate in bankruptcy proceedings.

The above-mentioned methods have different effects on defending investors’ rights. Trustee-initiated litigation has lower costs and saves investors’ efforts; while investor-initiated or jointly initiated litigation allows real-time monitoring of case developments.

In some cases, numerous investors initiating litigation independently can exert pressure on the issuer, facilitating rights protection. Investors are advised to conduct specific analyses with trustees to determine the appropriate recourse method based on the circumstances.

Xu Yu is a senior partner and Pang Yuying is a partner at Hylands Law Firm.