Disposal of default in stock-pledged repurchase transactions

The stock-pledged repurchase is a new financing method emerging in recent years. However, constant fluctuations in the stock market since 2018 have gradually exposed the risks of stock-pledged repurchase transactions.

Stock-pledged repurchases involve the repo seller (debtor) pledging its stock or other securities to the repo buyer (creditor) as collateral to raise funds. The parties agree to repay the loan and release the pledge in the future.

Stock-pledged repurchase transactions are divided into floor transactions and over-the-counter transactions. In floor transactions, traders report transaction data via the transaction system. Initial transactions, repo transactions and disposal of default involved are completed through the stock-pledged repo transaction system.

A floor transaction is a standard stock-pledged repo transaction method. An over-the-counter transaction is a fundraising service rendered by banks, trusts and other financial institutions. Involving pledge security for the loan under the principal contract, an over-the-counter transaction is a non-standard method of stock-pledged fundraising. For the purpose of this article, stock-pledged repo transactions mainly refer to floor transactions.

The following events will trigger default in stock-pledged repo transactions: (1) listing of the target securities is terminated; (2) the repo seller provides false or misleading information, or materially withholds or omits information in the process of the transaction; (3) the target securities under the account or special unit of pledge of the repo seller are frozen by a judicial authority, or subject to other compulsory measures; (4) the financial or credit status of the repo seller deteriorates, resulting in substantial impact on its repurchase capability on maturity; (5) the actual performance security proportion is lower than the minimum performance security proportion; or (6) the repo seller fails to pay the interest in the full amount on time.

In the event of the above-mentioned default circumstances, the repo buyer has the right to request the repo seller to fulfil the obligation of early repurchase, and to dispose of the target securities involving default.

DISPOSITION METHODS

When the repo seller is in default, the repo buyer may take the following actions in response:

The repo buyer (securities companies) may sell the pledged stock through the floor disposition procedures by itself. If the pledged target securities are non-restricted tradable shares and are not frozen by a judicial authority, the repo buyer may mandatorily liquidate through call auction or block trading to sell the pledged stock on the secondary market. As repo sellers of most stock-pledged repo transactions are majority shareholders of listed companies, or their persons acting in concert, the following provisions should concurrently apply to floor disposition:

1. Article 141 paragraph 2 of the Company Law: a director, supervisor or senior officer of a company shall declare to the company the number of shares he/she holds in the company and any variation thereof, and may not transfer more than 25% of his/her share in the company each year during his term of office.
2. Several Provisions on the Stock-selling by Shareholders, Directors, Supervisors, and Senior Management of Listed Companies (new provisions on stock-selling): the number of stock sold within any 90 consecutive natural days shall not be more than 1% of the total share capital of the listed company.
3. Implementing Rules of the Shenzhen Stock Exchange for Stock-selling by Shareholders, Directors, Supervisors, and Senior Management of the Listed Companies (implementing rules): if the stock is sold by call auction, the number of stock sold within any 90 consecutive natural days shall not be more than 1% of the total share capital of the listed company; if the stock is sold by block trading, the total number of stock sold within any 90 consecutive natural days shall not be more than 2% of the total share capital of the listed company.

Securities companies sell the stock as ordered by the court. The court may issue a notice for assistance in execution to the securities company, requesting selling of the stock. In the notice, the court may change the status of the stock to “sellable freezing” from “unsellable freezing”. The securities company may change the status of freezing through the transaction system. The stock will also be sold by call auction or block trading. Like the disposition method described above, the number of stocks sold is also restricted by the Company Law and the new provisions on stock-selling.

Unlike disposition by the creditor itself, disposition by court order requires that the stock is frozen all the time, to ensure stock safety.

The pledged stock may be auctioned or sold by the court. The court may auction or sell the pledged stock online or at the stock exchange when it commissions an evaluation organization to evaluate the stock. The selling price will be the winning bid. Auction and selling of pledged stock by the court will not be restricted by the Company Law or the new provisions on stock-selling. If the pledged stock is successfully sold, it can be cashed out rapidly.

In the case of bought-in twice, the court may sell the pledged stock directly. It should be noted that restricted tradable shares can only be disposed by auction or selling by court.

The court rules that the loan will be repaid with the pledged stock. If both auction and sale of the pledged stock by the court fail, the court may rule to repay the loan to the creditor with the pledged stock. The creditor may bring the ruling of the court and register stock transfer with China Securities Depository and Clearing Corporation Limited.

Judicial transfer. Law enforcement may transfer the frozen shares to the account or designated account of the execution applicant before further disposition. Some courts will mandatorily transfer the restricted tradable shares pledged to the account of the execution applicant. When the shares become non-restricted, they will be sold on the secondary market.

Pan Xiuping is a senior partner at Longan Law Firm. He can be contacted on +86 10 6532 5588 or by e-mail at panxiuping@longanlaw.com. Zhao Weijun is an associate at Longan Law Firm. He can be contacted on +86 10 6532 5588 or by e-mail at zhaoweijun@longanlaw.com