China Special Situations Insight (Volume 2, Issue 23)

Investing in Debt for Common Interest in Bankruptcy (III): Key Issues for Transaction Documents

In our previous article (Volume 2, Issue 22 ), we highlighted some of the key issues that investors need to be aware of during the legal due diligence process for investment in debt for common interest (“Common Interest Debt”). When an investor has determined to proceed with the transaction after legal due diligence, it is advisable to follow the statutory procedures and accommodate some protections in the transaction documents to strengthen the safety and stability of the investment.

• Acknowledgement from the creditors meeting and court

According to the Enterprise Bankruptcy Law and its judicial interpretations, when a bankruptcy application is accepted by a court, the bankrupt company shall obtain approval from the creditors meeting or permission from the court before it borrows money for this business, which shall constitute a Common Interest Debt. Investors need to investigate the bankruptcy procedures during the legal due diligence. If the first creditors meeting has not yet been convened, the bankrupt company shall obtain permission from the court; if a creditors meeting has already been convened, the bankrupt company shall obtain approval from the creditors meeting.

• Specific clauses regarding the nature of the financing in transaction documents

As discussed in the previous article, the laws have not made it clear whether the interest accrued on a loan shall also constitute part of a Common Interest Debt. We strongly recommend that investors place clauses in the transaction documents to specify the nature and priority of the financing. More precisely, the loan to be provided by investors should be categorized as a Common Interest Debt, and all principal and interest accrued thereon should, subject to commercial arrangements and negotiations, be senior to construction costs, debts owed to homebuyers, employee wages, taxes, social insurance fees and any other unsecured debts.

• Guarantees and security

Investors may take security from a bankrupt company for financing. Usually there are existing mortgages or pledges on the important assets of a bankrupt company, and the loan to be provided shall be junior to such secured claims. However, if the current value of the assets is lower than the amount of the secured claims, and the Common Interest Debt to be provided would significantly increase the value of the assets, some security holders may concede its priority to investors.

Further, if a bankrupt company has no clean assets for security purposes, investors may require an affiliate of the company or even a third party to provide a guarantee or security, which is negotiable depending on the terms of the financing.

• Control of bank accounts and revenue

To avoid misuse of the financing, an investor may require a joint signing right with respect to the relevant bank accounts of the bankrupt company and the control revenue of the project. The loan can only be used upon approval from the investor and the administrator, and any revenue derived from the project shall be used in accordance with a waterfall agreed by the investor. In this regard, the investor can ensure that the loan is used solely for the agreed purposes such as the construction of the project, and any revenue will be applied for repayment of the loan and the construction of the uncompleted parts of the project.

For further information, please contact Catherine Miao, Head of Special Situations and Alternative Investment at JunHe LLP: miaoqh@junhe.com or +86-21-22086350.