The most important legal document in bankruptcy and reorganisation proceedings is the reorganisation plan, and the adjustment to the interests of investors is one of its core steps. Although methods for adjusting investor equity may vary, equity transfer is the most common.
However, given financing challenges, shareholders often set security interest on equity to obtain financing. In this case, the adjustment to equity interest will undoubtedly affect vital interests of the pledgee.
Determining how to resolve conflict between the transfer and pledge of equity is not clearly defined in China’s Enterprise Bankruptcy Law or its judicial interpretation, and approaches taken in judicial practice can drastically differ from one court to another.
This article, based on the authors’ professional experience, introduces a form of such conflict, along with suggestions for resolution.
Party A, with a 51% stake in company A, borrowed RMB20 million (USD 2.7 million) from party B for production expansion. Party A used its 6% equity interest as security and completed registration of the pledge, but then failed to honour repayment obligations after the debts became due.
Subsequently, party A’s creditors applied for its reorganisation. Following court acceptance of the application, a bankruptcy administrator was appointed and heard party B’s explanation of the pledge.
In such a case, can the reorganisation plan adjust the pledged equity? Is the pledgee entitled to participate in the reorganisation procedure? Can the court enforce the reorganisation plan if the pledgee refuses to co-operate?
The legislative purpose of the reorganisation procedure is to rescue – as far as possible – enterprises deep in crisis, yet still retaining market competitiveness and profitability. Therefore, any solution to issues in the reorganisation procedure must adhere closely to this purpose.
Adjustments may be made to the pledged equities in the reorganisation plan. Basis for this can be found in both academic theory and judicial practice. First, in bankruptcy practice, the adjustment of pledged equities in the reorganisation plan is supported by most courts. Second, in theory, allowing reorganisation of pledged equities under the reorganisation plan will not prejudice the interests of the pledgee, and is in line with the legislative purpose of the reorganisation system.
Although the pledgee has priority in receiving proceeds from disposal of the pledged property, shareholders would be unable to recover any assets from the liquidation process if the enterprise was insolvent, and entered into bankruptcy and liquidation procedures with negative net assets. By definition, this would render the equity value worthless, with zero payouts, whether a priority or not.
Only through efficient reorganisation to maximise the company’s value can the equity be protected. Therefore, the rights of the pledgee are conditional on the smooth implementation of the reorganisation process. In effect, take it or leave it.
Does the pledgee have a right to participate in the reorganisation procedure? The Enterprise Bankruptcy Law stipulates that contributors have the right to be both informed and to participate in decision-making procedures regarding adjustments to contributors’ rights and interests. This aligns with the principle of balancing rights and obligations.
The law does not specify how to exercise the right to participate in procedures when equities with the pledge burden are adjusted, but to exclude the pledgee from participation would contradict the principle. Because the act of adjusting pledged equities in the reorganisation plan can obviously adversely affect the property rights of the pledgee, and is more closely related to their financial interests compared to contributors, failing to grant the pledgee protective rights would cause an imbalance of interests between the pledgor and pledgee.
Therefore, when there is an adjustment in pledged equity in the reorganisation plan, the pledgee may exercise the right to participate in procedures, such as voting for the reorganisation plan to the extent of pledged equities held on behalf of the original shareholder.
The reorganisation plan is enforceable against the pledgee. In practice, many pledgees refuse to co-operate with the registration of equity change on the grounds of article 443 of the Civil Code, that “the transfer of pledged equities is prohibited, except with the consent of the pledgor and the pledgee”.
But this is debatable. First, the legislative purpose of this clause is to prevent the pledge rights from being impaired by the shareholder’s wilful transfer, which does not mean that registration of equity changes in the reorganisation process still needs to be based on the consent of the pledgee. If the reorganisation plan is approved by the court, the transfer basis is no longer solely the will of individual shareholders, but also the binding and enforceable basis of judicial decisions.
Second, the purpose of a reorganisation procedure is maximised rescue of distressed enterprises. Successful reorganisation is the precondition for effectively exercising pledge rights.
If the pledgee is allowed to prevent the change of equity, the reorganisation procedure will not be able to proceed smoothly, leaving bankruptcy and liquidation the only way out. This is not only contrary to the intent of reorganisation, but also renders the pledge rights practically worthless.
Therefore, where the administrator applies for registration of an equity change by virtue of the reorganisation plan approved by the court, the pledgee should not obstruct on the grounds that the pledged equities are subject to transfer restrictions.
Based on the above-mentioned logic, the authors suggest four key issues for bankruptcy administrators to consider when addressing conflict over pledged equity in reorganisation:
- When taking over an enterprise, the administrator should investigate the debtor’s property and the situation of pledged equity by contributors;
- When recruiting investors for reorganisation, the administrator should truthfully disclose the pledge burden of equities by contributors and remind them of risks;
- When formulating a draft reorganisation plan, the administrator should not only listen to investors’ opinions, but also provide opportunities for pledgees to participate and listen to their views on how to adjust contributors’ interests; and
- Where the pledgee refuses to co-operate with a change in equity registration, the administrator should fully explain the legal consequences of non-co-operation. Failing which, the administrator may request the court to issue an assistance execution notice, requiring the registration authority to co-operate in the enforcement of the reorganisation plan and process the change of registration.