Probe in debt for equity swaps during reorganizations

By Yang Guang and Wang Yao, Lantai Partners
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A bankruptcy reorganization is conditional on a multifaceted and effective valuation of the enterprise’s property, claims and debts, as the results of such a valuation will directly affect the creditor repayment rate and the enterprise’s reorganization direction.

debt
Yang Guang
Partner
Lantai Partners

Taking a debt for equity swap in the reorganization procedure for a listed company as an example, the appraisal of the value of the equity to be swapped for the debt directly affects the probability of the realization of the claims for which the creditors can obtain repayment during bankruptcy reorganization, and the actual amount realized, and likewise affects the amount of the guaranteed liabilities that secured creditors can claim against guarantors. Such a procedure immediately concerns creditors’ interests, and improper handling can easily trigger disputes, making it impossible to genuinely realize the claims of rights and interests.

debt
Wang Yao
Associate
Lantai Partners

Pricing methods

In the rescue of debt-troubled enterprises, debt for equity swaps have become a normalized legal means. The ultimate outcome of such swaps is the acquisition of equity by the creditors and extinguishment, or reduction, of the debtor’s debts. In a debt for equity transaction, the most crucial issue is how to determine the percentage at which the claims will be swapped for equity, i.e., how to determine the unit price of the equity to be swapped for debt. The determination of this price establishes the shares of the equity that the creditors can acquire, and the repayment rate of the reorganization procedure.

In practice, the pricing of the equity of an enterprise undergoing reorganization is more complex than the pricing of the equity of a normally operating enterprise. The common methods of pricing equity to be swapped for debt used in reorganization procedures include: (1) pricing based on the initial registered price of the debtor’s equity; (2) pricing based on the price of the debtor’s most recent offering of equity; (3) pricing based on the closing market value of the enterprise’s equity before the suspension of trading; (4) pricing based on the weighted average price of the stocks before the suspension of trading; and (5) pricing based on price-to-book ratio/price-earnings ratio.

However, the problem with the above-mentioned pricing methods is the lack of fairness. Taking (5) as an example, such market multiplier methods as price-to-book ratio, price-earnings ratio, etc., apply where there are multiple listed companies that are similar to the appraised enterprise in terms of business nature, size, the enterprise’s phase of operation, profit level, etc., or where there have recently been similar transactions in the same industry.

The reference by an enterprise undergoing bankruptcy reorganization to the price-to-book ratio or price-earnings ratio of well-run enterprises for pricing hardly ensures fairness. The failure of the great majority of reorganization plans to take the discount on non-controlling equity as a factor that affects a valuation also contributes to the lack of fairness.

Impact of lack of fairness

(1) The high creditor repayment rate is inconsistent with reality, causing a second insult to creditors’ rights and interests. The fairness of the pricing is a key element in protecting creditors’ interests. Any unfairness will directly affect the probability of the realization of the claims for which the creditors can obtain repayment during bankruptcy reorganization. The nominal value of the equity acquired by the creditors based on the reorganization plan will be far higher than the actual value that they could obtain by disposing of the equity based on market principles.

Furthermore, looking at the term “repayment” from a legal perspective, it means that a creditor can realize its claim in cash, and regardless of whether such repayment is made in cash, or in shares, or in kind, they all have the function of being exchangeable on the market at the same value. Accordingly, even if creditors accept a debt for equity swap, the actual repayment amount received by the creditors should be determined by the fair value of the equity.

If the repayment is based on a valuation that lacks fairness, then the equity received as repayment cannot truly discharge the claims in question, and such a repayment is in fact a false repayment that harms the creditors’ interests and is an artificial book repayment.

(2) The amount of guarantee liability borne by guarantors is reduced, allowing guarantors to escape part of their liability. Pursuant to article 124 of the Enterprise Bankruptcy Law, where a claim cannot be fully discharged in a bankruptcy procedure, a creditor may additionally seek repayment of the unpaid portion of its claim from the guarantor. However, neither the Enterprise Bankruptcy Law nor related regulations address the issue of how to determine an “unpaid claim”.

If an unfair price is set for a debt for equity swap, the actual value of the equity acquired by the creditors is far lower than the value determined in the reorganization plan. In such a case, should the creditors’ “unpaid claims” be calculated based on the nominal value of the equity acquired by the creditors (i.e., the equity value determined in the reorganization plan), or by the actual value that the creditors would obtain by disposing of the equity based on market principles?

If the answer is the former, the creditors may have already realized full repayment of their claims “on paper”, making the amount of the guarantee liabilities bearable by the guarantors zero, which translates into the guarantors escaping their liabilities to the extent of the false repayment to the creditors.

Conclusion

In judicial practice, such issues as simplistic methods of valuing equity, unfair pricing of the equity, etc., plague debt for equity swaps, with the repayment amount that creditors would actually obtain from disposal of the equity based on market principles differing substantially from the value of the equity acquired based on the reorganization plan.

Based on the flaws in the rules for the valuation of, and repayment with, equity in listed company bankruptcy reorganizations, the authors recommend that the legislative and judicial authorities clarify the method of valuing the assets of companies undergoing bankruptcy reorganization from the perspective of entities and procedures, restrict the abuse of the valuation and repayment methods by bankruptcy administrators and debtors, accord creditors reasonable means of seeking relief, and safeguard transaction order so that debt for equity swaps fully live up to their name.

Yang Guang is a partner and Wang Yao is an associate at Lantai Partners

Lantai Partners

Lantai Partners
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E-mail:
yangguang@lantai.cn
wangyao@lantai.cn
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