China Law Insight : China Business and Intellectual Property Lawyers & Attorneys : King & Wood Law Firm : IP, Arbitration, Litigation, Securities, Foreign Investment

Given China's resilience to the financial crisis, it seemed a good place to meet redemptions and liquidity needs by selling positions. However, it was much easier to get money into China than to get it out.

Beijing has long been wary of foreign investors, imposing strict controls on FDI and offshore loans. Unable to resist GDP growth, renminbi appreciation and real estate expansion, investors wanted in – keen to avoid regulatory processes and wanting exit strategies. Offshore structuring appeared as a solution, but this was conceived against the bubbling real estate market – where much of the foreign money was headed.

I warned investors that 1 billion square feet of residential and commercial projects were underway in Beijing alone. But local banks and foreign funds provided cash; developers continued to build. The government tried to rein in a runaway market. The lending spigot at local banks ended, interest rates and down payment requirements increased and anti-speculation taxes were imposed. The bubble began to burst, with markets in south China suffering first. Developers, undeterred, bought more land and continued building. Their ambitions finally caught up with them last year.

China's listed real estate developers have seen their share prices fall by 80% from November 2007. Despite government efforts to revive the residential market, buyers are only responding to price cuts. Many of these developers are hemorrhaging cash, turning to non-banks and gray market lenders.

The unlisted firms have caused the most trouble. An IPO promised riches and so these developers expanded aggressively. They needed capital; foreign investors acquiesced. Investments were structured offshore and the money came onshore via preferred equities and convertible bonds issued by offshore companies with real estate holding companies in China.

Many large developers missed IPO deadlines, facing disgruntled investors. Alternative investment managers now face redemptions from investors and busted covenants and debt defaults from Chinese developers.

It seems, from the offer¬ing circulars, that few of the investors or developers knew what they were getting into. The developers gave guarantees, pledged unlisted shares, issued “no-IPO put options”. They agreed to pay punitive escalating internal rates of return, going from 30% to 70%, if the IPO was delayed by 18- 30 months.

The alternative investment managers who relied on “contractual” guarantees to protect their interests overlooked the clause in the circulars which states that offshore creditor rights are not enforceable in Chinese courts. Neither are judgments in foreign courts binding on Chinese corporations or citizens.

Many of the international law firms that developed these structures are now advising clients not to enter Chinese litigation. Yet they recognize that by the time the offshore judicial process concludes, Chinese developers would have transferred assets with any unencumbered value, or allowed onshore creditors to slap asset preservation orders on any remaining assets.
The international law firms are too pessimistic. Foreign investors can use the Chinese legal system to enforce their offshore creditor rights, seize collateral, freeze assets to keep them from disappearing, enforce guarantees and bring Chinese entrepreneurs to negotiate.

Most Chinese real estate developers sleep soundly yet foreigners remain engrossed in inconclusive meetings trying to answer their investors’ questions:
• What is the status of my investment in China and what is the condition of the Chinese partner?
• Is the original investment strategy still viable in the present climate?
• Should I continue to hold, sell or invest additional capital and if so is there a realistic business plan I can evaluate?
• If I continue to hold or invest is there a way to get closer to the company and its assets onshore to remedy some defects inherent in offshore structures?
• How do I limit my liability and is there a plan to get my capital out of China?
• Are my interests and those of the alternative investment manager still aligned?

My advice to foreign investors is: act now. Chinese business partners will inevitably satisfy local creditors first, unhesitatingly encumbering a foreign investor's secured assets. Investors must rectify the defects in their offshore structures so they can use local courts and rely on Chinese litigation to settle with local partners.

The end game is to develop a capital preservation and exit strategy, leading to an informed decision to invest, sell or stay the course.
 

C. The Reorganization Plan
The Administrator proposed the following reorganization based on SMC's financial status and characteristics.
 

a. SMC would repay the secured creditors with the asset(s) over which the security was created. Where the asset(s) is converted into cash, the corresponding secured creditor enjoys priority of repayment and a cash payment equivalent of 30% of the principal of the secured claim would be paid to the secured creditor.
 

b. The employees' claims and tax claims should be paid in full.
 

c. The unsecured creditors should be repaid 30% of the principal of the unsecured claims.
 

d. The shareholders of non-tradable shares of SMC transferred 50% of their equity shares they held to an outside company in Shanghai as consideration for funding SMC's cash repayment to its creditors. Up to 40 million of the non-tradable shares were transferred to the Shanghai company could be converted into cash at RMB 5/share and used to repay the creditors. The secured and unsecured creditors may apply in writing for repayment from SMC on a voluntary basis.
 

e. SMC then transfers all its existing assets (excluding those over which secured claims were created) to a Corporate Management and Consultancy company ("CCCMC") as consideration for CCCMC to repay the remaining claims outstanding upon cash repayment by the Shanghai company and the stock repayment for non-tradable shares.
 

On April 18, 2008, SMC convened the first creditors meeting and the Administrator submitted the proposed reorganization plan to the Court and to a creditors meeting for to vote. The plan was passed during the meeting and approved by the Court.
 

The Reorganized SMC
Upon the completion of the reorganization, SMC repaid claims of RMB 560 million and the creditors discharged claims of RMB 1.9 billion in total. All the assets and the outstanding portion of the creditors' claims were transferred to CCCMC. SMC was released from the said portion of liabilities and became a shell company without any assets or liabilities.
 

Compared with the reorganization of other listed companies, the reorganization of SMC had its own features. First, SMC's reorganization timeframe was short — the proceeding was concluded within 41 days from the day the Court accepted the reorganization petition. Second, SMC utilized shares, a fictitious “currency”, to fund a portion of cash repayment under the reorganization plan. This approach not only lowers the cost to the Shanghai company that assumed shares, but also provides reasonable compensation for SMC's creditors with the reevaluation of the company shares upon further asset restructuring.

The Importance of Reorganization for Listed Companies
By April 30, 2008, more than 10 listed companies in China had completed their reorganizations. Reorganization offers those companies that face a debt crisis due to their poor operation an opportunity of survival. To distressed public companies, reorganization is not only a means to gain a second life but also a tool to better protect their creditors and shareholders, alleviate the unemployment pressures of their employees, and stabilize the local economy.

As the most efficient method to solve a debt crisis, reorganization has been increasingly used in the debt restructuring of listed companies. It is also the most popular approach for parties to release the debt burden of a target company in merger and acquisition transactions in China.
Compared with other conciliation proceedings, reorganization has some advantages.

First, reorganization is time efficient. The company under reorganization does not need to negotiate with each of its creditors. The reorganization can be adopted with the consent of the majority of the creditors. Even if the creditors in a certain voting group rejects a proposed plan, the court may rule approve it if certain requirements are met.

Second, reorganization has a better chance of success. So far, no company has entered bankruptcy proceedings following an unsuccessful reorganization.

Third, as the number of companies qualified for becoming a shell company is small, more and more investors with substantial financial strength prefer to acquire shell companies via reorganization. Reorganization can lower the investment costs by alleviating the debt burden of the distressed company and repaying a portion of the creditors' claims with the stocks of the company and leave the investors with more funds for further asset restructuring.

Fourth, once the reorganization plan is approved by the court, the plan is binding on all creditors. This ensures that the distressed company is completely free from further claims by the creditors and becomes a shell company.

As an effective means of saving distressed companies and conducting debt restructuring in M&A transactions, reorganization creates a new mechanism that benefits all stakeholders of distressed companies.