How arbitration tackles disguised debt in trust industry

Debt investment in the name of equity investment” (disguised debt) is a way of establishing trust plans in the trust industry. There has been no consensus regarding the exact definition of disguised debt, in theory or in practice. The China Securities Investment Fund Industry Association and the former China Banking Regulatory Commission stipulated some specific rules for regulation. Generally, disguised debt refers to an investment that is classified as equity, but that performs in effect like a debt. Such an arrangement may include a fixed payout and, under the prescribed trigger, a conditional buyout of the shares involved, making the trust investment similar to a guaranteed loan.

Specifically, the route taken to operate disguised debt varies according to its pattern of payout and buyout.

1. The repurchase or transfer of the equity. Parties agree in advance that the original shareholder or the actual owner of the special purpose vehicle (SPV), or companies associated with the investee, will repurchase or buy the equity at a fixed price. This arrangement in an investment contract or in a separated contract guarantees the return of the principal and the margin when the contracts are established.

2. The fixed dividend. Parties agree that, after the completion of the investment, the investors will have priority in the distribution of the dividend, and the dividend will be fixed irrespective of the business performance of the SPV. The cap on the dividend is equal to a prescribed sum of the principal and the margin. The equity that the investors have will be returned to the original owners under prescribed conditions or after certain periods.

3. Independent guarantee. Parties agree that the SPV’s original shareholders, actual owners, or an associated third party, will provide liquidity and guarantee the supplement of any price shortages of the prescribed dividend or repurchase. Such guarantee covers all the loss when the prescribed principal and the margin have not been realized.

Zhang Jiechao is an arbitrator with Beijing Arbitration Commission/Beijing International Arbitration Centre (BAC/BIAC), and vice general manager of the Beijing International Trust Company legal affairs department. BAC/BIAC’s senior manager, Terence Xu, also contributed to the article.