Guarding against compliance risks in real estate enterprise financing

In recent years, as the central government has intensified regulation and control, signs of adjustment have appeared in the real estate industry, with property enterprises facing such phenomena as weak sales, increase in inventory, tight cashflow, etc. The real estate industry is essentially capital intensive, naturally reliant on a demand for funding, and, particularly at the moment, the demand of real estate enterprises for financing is extremely pressing. Real estate enterprises are also characterised by a large demand for financing, tying up the proceeds for a long period of time, etc.

In order to guard against financing compliance risks in the course of the financing process, a real estate enterprise will first select a compliant financing channel. When seeking financing, a real estate enterprise should opt for a financial institution – bank, trust company, insurance company, fund, securities brokerage, etc.

At present, the extension of project development loans by Chinese commercial banks to real estate enterprises remains the principal channel of financing. As credit has become tighter, real estate trust financing has become a main channel of financing, and with gradual policy relaxation, investment of insurance capital in immovable property is becoming more important. Instances of real estate enterprises seeking financing through such means as private equity (PE) and asset management plans have also become common.

The selection of an entity other than a financial institution for financing could lead to such risks as the invalidity of the financing agreement, and the inability to itemise such financing costs as project development costs.

Compliant financing method

Second, the real estate enterprise should select a compliant financing method. Financing methods can generally be divided into two categories – debt financing and equity financing. In addition to debt financing from a financial institution, a real estate enterprise can opt for equity financing.

If it satisfies listing conditions, it can attempt to secure the approval of the government regulator for financing through an initial public offering or additional offering. If it has an influential brand, it can opt to attract a foreign-invested real estate fund, or if it does not fall in either of the above categories, it can opt for the PE financing method.

If the method of financing that a real estate enterprise opts for is not compliant, it could face criminal prosecution. For example, engaging in publicity aimed at the public through the media, roadshows, brochures, mobile messages, etc., and attracting funds from non-specific entities and individuals without the approval of government authorities, or illegally attracting funds through such means as sale with a promise to refund the principal at a later date, sale-leaseback, specified buyback, sale of real estate shares, etc., where actual real estate is not available for sale or the sale of real estate is not the main purpose, could constitute the crime of illegally attracting, or attracting in a disguised manner, deposits from the public.

Illegal fund raising

In recent years, cases of real estate enterprises involved in illegal fundraising have occasionally arisen, the Wu Ying fundraising fraud case being a representative example. Between May 2005 and February 2007, Wu Ying, the legal representative of Zhejiang Bense Holding Group, illegally raised funds totalling RMB773.4 million (US$126.3 million) by offering high interest as the bait, paying high intermediary fees as the means, and using investment, loans, fund turnover, etc., as the guise, which he then used to repay the principal of the funds raised, pay high interest, purchase vehicles and spend lavishly. When the case came to light, RMB384.2 million was still outstanding. After numerous hearings, the Zhejiang Provincial Higher People’s Court rendered the final judgment on 11 July 2014, sentencing Wu Ying to life imprisonment.

Third, the real estate enterprise should ensure the truthfulness of basic information provided on the project. Regardless of the financing method opted for, a real estate enterprise is generally required to provide documentation and information on its equity structure, assets, finances and the project – including, but not limited to, the construction land for the project, approval of the project and government permissions for the project – and execute a written financing agreement with the funding party.

The financing party will usually require the real estate enterprise to provide a pledge or mortgage of the corresponding equity, assets or project as security, and the real estate enterprise will be liable for the truthfulness of the documentation and information it provides.

If, in the course of the financing process, the real estate enterprise deliberately provides false documentation or information, it could be required to bear the legal risk of civil fraud, and if the financing proceeds ultimately cannot be repaid, the enterprise and the persons directly responsible may be criminally liable.

Fourth, the real estate enterprise should ensure that the proceeds are used for the project and purpose designated in the financing agreement. In practice, the funding party will usually require scrutiny over the use of the proceeds. For example, when a real estate enterprise applies to a bank for a project development loan, the lending bank will generally require scrutiny over the loan proceeds, and when the real estate enterprise wishes to use loan proceeds, the lending bank will review the relevant construction contract or material procurement contract executed by the real estate enterprise and the third party, and make payment to the third party pursuant to the relevant contract.

Trust financing and insurance capital investment will also involve similar oversight arrangements. In practice, there have been instances where the real estate enterprise has failed to use the proceeds in accordance with the financing agreement, and diverted them for other purposes.

For example, the enterprise circumvents the measures for overseeing the proceeds through a fabricated contract and diverts them to another project. Once discovered, the financing party may call the loan, require the enterprise to bear liability for breach of contract, and, if the proceeds ultimately cannot be repaid, the enterprise and directly responsible persons may face criminal prosecution.

The author recommends that, when designing a financing plan, a real estate enterprise not be dazzled by “creative financing”. It should conduct an analysis based on the four points mentioned above to determine whether its financing plan exposes it to compliance risks, and do its utmost to avoid them.