Enforcing conversion of bonds through litigation

By Li Chao and Fu Yuchen, Leaqual Law Firm
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Many private companies with financing needs, known as issuers, have in recent years adopted private placement of convertible bonds to broaden their funding channels, accomplished by entering into convertible bond investment agreements with investors on equity trading markets such as the Beijing Equity Trading Centre.

Under such agreements, and upon satisfying certain conditions, investors (or bondholders) are usually allowed to convert their held bonds to company shares at the stipulated price.

But while the conversion is supported by policies, its legal relationship is more complicated than conventional equity or credit financing, with only a limited number of applicable laws and regulations. This poses certain difficulties for bondholders to complete the conversion when disputes arise.

Normally, at bondholders’ decision to convert, the issuer should help with the business registration of relevant internal documents needed for the conversion. However, in the current business environment, it is idealistic to assume that all conversions can take place without a hitch, as the issuer may refuse to go along with the conversion out of concern for its own interests. In this regard, the authors of this article elaborate on important issues in using litigation to enforce conversion.

MAIN BASIC DOCUMENTS

Li Chao Leaqual Law Firm
Li Chao
Senior Partner
Leaqual Law Firm

Prospectus and convertible bond investment (or subscription) agreement. It is worth noting that the prospectus and investment agreement may stipulate different means of dispute resolution. As the prospectus is unilaterally prepared by the issuer, most judicial authority regards it as an invitation for offer. Especially when the prospectus precedes the convertible bond investment agreement, the authors are inclined to follow the dispute resolution clause under the latter.

Shareholders’ meeting resolution on the convertible bonds issue; capital increase; and amendment of articles of association. As the resolution may lack content on capital increase or amending the articles of association, the authors advise that investors request issuers and their shareholders to prepare a resolution that covers all grounds. If the issue is only detected after subscription the investor may claim that such missing provisions can be found in the prospectus, as most prospectuses include details on convertibility and means of capital increase, often with signature of all the issuer’s shareholders.

DEFENDANT’S ARRANGEMENT

Exercise of conversion rights would require the issuer to fulfil its co-operation duties. These mainly include: its shareholders forming a resolution on capital increase, subscription and amending the articles of association; issuing a capital contribution certificate; adding the bondholder to its register of shareholders; and helping the bondholder with industrial and commercial registration of changes.

In most disputes, the issuer’s refusal mainly stems from unco-operative shareholders. To enhance the deterrent effect of civil enforcement, the authors therefore suggest listing the main shareholders as defendants, along with the issuer.

ART OF CLAIMING

Fu Yuchen Leaqual Law Firm
Fu Yuchen
Associate
Leaqual Law Firm

When making its litigation claim, the issuer should ensure it is specific and clear-worded – as well as being executable and operable during civil enforcement. A claim simply to order the defendant to fulfil its conversion duty and convert the plaintiff’s claim against the defendant valuing at RMBxxx to xxx shares may seem ostensibly clear. But it lacks specific instructions on performance and fails to meet the requirements of article 461 of the Interpretation of the Supreme People’s Court on the Application of the Civil Procedure Law.

More succinctly, the authors suggest including these elements: (1) order the defendant shareholders to prepare a capital increase resolution based on the basic document (capital increase of RMBxxx by way of issuing xxx shares to be subscribed with the subscription money of RMBxxx paid by the plaintiff), and alter the articles of association; and (2) order the defendant to issue a capital contribution certificate to the plaintiff, record the xxx shares held by the plaintiff in the defendant’s register of shareholders, and proceed with the industrial and commercial registration of changes reflecting the capital increase of xxx shares and the plaintiff’s shareholder status.

The eventual claim may be fine-tuned based on the judge’s explanation or communication before conclusion of the first-instance trial.

POINT OF CONTENTION

Disputes mostly revolve around the question of whether the bondholder, an external creditor, has the right to request the issuer’s shareholders to prepare a specific resolution on capital increase and enforce industrial and commercial registration of changes, on the simple premise of an agreement.

Based on facts about the issue of convertible bonds, the authors believe such debts do not fall under the excluded situations specified under article 580 of the Civil Code about performance of non-pecuniary obligation. This is because the conversion clause does not violate any laws or regulations, and the performance of conversion duty by the defendants, both the company and shareholders, is not legally or factually unfeasible.

Against possible defence on the grounds of “contract privity”, the plaintiff may assess whether the defendant shareholders have signed on the convertible bond investment agreement or the prospectus – or if there is a shareholder resolution agreeing to the conversion or other such unilateral commitment – and present to the court the defendant’s declaration of consent to the conversion (or capital increase), which would be legally binding.

In summary, enforcing a conversion of bonds is no easy matter. To gain judicial support, bondholders should make thorough preparations covering basic documents, subject arrangements, explicit claims and feasibility of duty performance under the dispute.

Li Chao is a senior partner and Fu Yuchen is an associate at Leaqual Law Firm

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