Strategies for debt-equity offset in disposal of NPAs

By Lin Xiaolu and Xu Lingjun, Jingtian & Gongcheng
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With the transaction of non-performing assets (NPAs) entering a new stage, the equity assets in the NPA package are attracting more attention, and may become a new earning point in the disposal of NPAs. Some NPA investment institutions focusing on special opportunities are beginning to target equity assets with neglected or under-assessed value in the NPA package, and enter the target companies by means of debt-equity offset, and then obtain exit earnings by operating and controlling these target companies.

林小路, Lin Xiaolu, Partner, Jingtian & Gongcheng
Lin Xiaolu
Partner
Jingtian & Gongcheng

There are two kinds of situations for debt-equity offset in the disposal of NPAs: (1) after the court evaluates and abortive auctions, it decides that the equity in a debtor’s subsidiary will be used to repay the debt; and (2) the creditor and the debtor reach an agreement to repay the debt with the equity of the subsidiary held by the debtor.

Either way, on the one hand, the creditor needs to ensure that it becomes a new shareholder of the target company by the debt-equity offset, while on the other, it needs to safeguard its rights to participate in management and supervision of the company to the greatest extent. Here are the key points and countermeasures of risk in the process of debt-equity offset, and after closing.

(1) Seal-up and pledge of equity assets

In accordance with the relevant provisions of the Supreme People’s Court (SPC) on enforcement and judicial practice, usually creditors can ensure that the court starts the evaluation and auction procedures for equity assets only when equity assets are not sealed up, or are sealed up first by the creditor and have not been pledged, or the amount of pledge is significantly lower than the actual amount of equity assets. For a case that the creditor enjoys priority, but equity assets are not sealed up first, although the creditor can apply to the court to first seal-up for transfer for enforcement, pursuant to the Reply of Supreme People’s Court on Issues Related to Disposing of Sealed-up Assets by the Court of First Seal-up and Priority Execution Court, in practice, due to the low level of effectiveness of this reply, inconsistent understanding among local courts, and other factors, the transfer success rate is low. Therefore, it is recommended to make full due diligence before debt payment to avoid the risk of being unable to dispose equity.

徐凌君, Xu Lingjun, Partner, Jingtian & Gongcheng
Xu Lingjun
Partner
Jingtian & Gongcheng

(2) Shareholders’ right to know

After the creditor obtains the debt-off equity and becomes the new shareholder, its right to know about the company needs to be guaranteed. The new shareholder has the right to review and copy the articles of association, minutes of shareholders’ meetings, resolutions of board meetings, resolutions of board of supervisors’ meetings, and financial accounting reports of the company. New shareholders can also review the company’s accounting books.

If the company refuses, the new shareholder can bring a lawsuit of the right to know. In many cases, to implement shareholders’ right to know, shareholders can understand the actual situation only by reviewing the original financial vouchers. Some cases, including those of the SPC, are beginning to support shareholders reviewing the original financial vouchers, and new shareholders can consider making corresponding arrangements in the shareholders’ agreement or articles of association.

(3) Company’s seals and licences

Ownership of the company’s seals and licences will affect the effectiveness of the company’s enforcement of agreement, control over the company’s account and other important aspects. When the creditor becomes the new controlling shareholder, the official seals and licences of the company may be under control of the management or a legal representative. If they refuse to hand the seals and licences over, the new controlling shareholder may consider filing a lawsuit.

The demands of the new controlling shareholder for the return of the company’s licences and seals are often urgent. Therefore, in such litigation, the parties concerned can simultaneously file an application for act preservation prohibiting the defendant from using the seals and licences.

(4) Dispute over company’s resolutions

After the debt-equity offset, it is necessary for the new shareholder to clarify the original resolutions of the shareholders’ meeting and the board of directors, and take timely legal actions against illegal resolutions that are unfavourable to the company. At present, the Company Law and its judicial interpretations clearly provide for three types of lawsuit on company resolutions: (i) confirming that the resolutions are invalid; (ii) revoking the resolutions; and (iii) confirming that the resolutions are not formed.

New shareholders can file different types of litigation on resolution disputes based on whether the resolutions of the shareholders’ meeting and the board of directors violate the laws and administrative regulations, whether the resolution procedures are illegal and violate the articles of association, whether the resolution contents violate the articles of association, whether to hold a meeting, and whether to vote.

(5) Shareholder representative litigation

If the new shareholder finds the interest of the company has been infringed by directors, supervisors or officers, and the company is omitted to sue for relief, it can file a shareholder representative litigation. In this kind of litigation, requiring the company’s management to sue is the premise. However, an exception is that if the situation is urgent, or if the prepositive procedure is impossible to realise, the new shareholder can bring a lawsuit directly. New shareholders also have the right to represent the converted company in recourse against acts that harm the company’s interests before they become shareholders.

Summary

Compared with traditional physical assets or real estate assets, companies of equity assets in NPAs have the characteristics of high return and high risk. Therefore, attention should be paid to the relevant risks and countermeasures in NPA investment. It is recommended to listen to the suggestions of professional legal teams before and after debt-equity offset, and take timely legal actions to provide relief when rights are violated.

Lin Xiaolu and Xu Lingjun are partners at Jingtian & Gongcheng

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Jingtian & Gongcheng
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