Resolving illegal guarantee and fund occupation in reorganisations

By Wang Zhenxiang, Jingtian & Gongcheng
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Article 10 of the Opinions of the State Council on Further Improving the Quality of Listed Companies provides that listed companies planning to carry out bankruptcy reorganisation should first put forward a feasible resolution for any issue of fund occupation and illegal guarantee, making it an important part of a reorganisation application.

Illegal guarantee

王振翔,-Allen-Wang,-Jingtian_NPA-s
Wang Zhenxiang
Partner
Jingtian & Gongcheng

Invalidation by judicial decision. The Civil Code and its judicial interpretations on the guarantee system clarified that if the counterparty has not concluded a contract with the company regarding the guarantee as publicly disclosed and approved by resolution, such guarantee shall not take effect, and the company shall not be liable for any guarantee or compensation.

Thus, with ST Hemei, ST Antong and ST HNA Infrastructure it was claimed through judicial procedure that the illegal guarantee was invalid and the companies should not be liable for compensation. (ST refers to the term “special treatment”, and is used by the Shanghai and Shenzhen exchanges to indicate a company in danger of delisting, such as one undergoing reorganisat­­­­­­­ion).

Rescission by agreement. If the company cannot provide a solution for illegal guarantee in time to enter reorganisation, the increasing litigation and preservation measures may cause the company to lose talent, business and property value, eventually running the risk of delisting.

If any secured creditors are also creditors of the company’s shareholders, with the right to pledge the company’s shares, the delisting of the company will make it more difficult to realise their creditors’ rights. Therefore, it may be possible for secured creditors to waive, in writing, any rights enjoyed under the judgment document against the company by exempting the company from its guarantee liability.

Converted shares as repayment guarantee. When determined by a court that the company should bear the guarantee liability, the company may undertake to repay the creditors in the form of debt payment by shares that should be allocated to the controlling shareholders in the shares converted from capital reserves in the future.

Investor undertaking to gratuitously donate or assume full liabilities. In the case of ST Zhongnan reorganisation, since it was determined by a court that the company should bear the guarantee liability, the investor undertook to gratuitously donate, in cash or stock, debt-paying assets to the company, and to make repayments in accordance with the relevant rules under the reorganisation plan.

As for creditors’ rights not affirmed by effective court documents, the investor undertook to make a gratuitous donation in addition to the debt-paying assets listed in the reorganisation plan, maintaining the goal that the company would not suffer losses as a result of the settlement of secured liabilities.

The company may also introduce a prospective investor with good credit standing, who may issue a letter of commitment to the court to assume full responsibility for any possible repayment or compensation liability. In practice, ST Chunghsin and ST Hemei have introduced Zhejiang Shipping Group and WeiTV to assume full liability, respectively.

Special funds to guarantee repayment. Generally, the investor or an affiliated party may contribute to special funds used for settling any repayment liabilities in case of illegal guarantee.

Repayment in cash. The investor may gratuitously contribute to special funds for the company to resolve fund occupation.

Fund occupation

Provide pledge guarantee with assets. This usually applies to situations where funds are occupied to invest in assets such as real estate and equity.

Investor undertaking to assume full liability for repayment with the capital contribution of transferred equity. In ST Hemei’s reorganisation, the investor issued a letter of commitment to assume full liability for any possible guarantee or compensation. In ST Antong’s reorganisation, the investor undertook in writing to acquire the transferred shares converted from capital and use part of the funds to settle the creditors’ rights. If the reserved shares stipulated in the reorganisation plan prove insufficient against the contingent liabilities, such shares shall be provided by the investor gratuitously. Any shortage will be settled by the affiliated party, with the company bearing none of the liabilities.

Debt forgiveness, transfer and set-off. ST Huachang signed a debt forgiveness agreement with the creditor to partially exempt the company’s debt and offset shareholders’ occupation of the company’s funds. ST Hainan Airlines and ST Jingui transferred interest-bearing ordinary debt to shareholders and affiliated parties by signing a debt transfer and shareholder compensation agreement with creditors, or by setting special provisions in the reorganisation plan.

The creditors of ST Chunghsin and ST Zeus Entertainment agreed for the companies to offset debts owed to them with an equal amount of its receivables from the affiliated party, or offset mutual debts by signing a creditors’ rights and debts offset agreement with the occupier.

Offset debts with a portion of the shares distributable to the occupier. After ST Antong confirmed the conversion of capital reserve into share capital, it took a portion of the shares originally distributable to controlling shareholders and persons acting in concert for the sole purpose of offsetting fund occupation. ST HNA Infrastructure and ST CCOOP took a portion of the shares converted from capital reserves for the company and allocated them to the creditor to offset the debt.

Repay with gains from debt reduction in pre-reorganisation and reorganisation. It is stated in ST Zhongnan’s announcement that losses resulting from the inability to recover funds will be partially hedged against the gains from the company’s debt reduction in pre-reorganisation and reorganisation, so that such losses can be covered by the gains.

Some suggestions

The basic principle of resolving illegal guarantee and fund occupation is that minority investors should not bear the losses. With that in mind, the author recommends that:

    • Companies take the initiative in filing lawsuits to confirm invalidation of illegal guarantee.
    • The validity of relevant agreements and undertakings should be conditional on the acceptance of reorganisation application, or the approval of the reorganisation plan.
    • To reaffirm validity of the undertaking, investors should issue bank guarantees or take other measures as appropriate to ensure the performance of gratuitous donation or the assuming of full liabilities.
    • Outside the legal period of the right of rescission under the Enterprise Bankruptcy Law, companies should give priority to resolving violations with their own funds, or the proceeds from the realisation of its own property.

Wang Zhenxiang is a partner at Jingtian & Gongcheng

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Jingtian & Gongcheng

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