Distressed asset purchases carry legal risks in China

By Zhong Zhifen and Jeffrey Quan, ETR Law Firm

An increasing number of institutional investors are investing in China’s distressed assets. However, due to the special nature of distressed assets, the long period required to dispose of them, and the variety of disposal factors, investors need acute risk identification and operational capabilities. This column analyzes issues requiring investors’ attention.

钟智芬  ZHONG ZHIFEN  广信君达律师事务所合伙人  Partner  ETR Law Firm
ETR Law Firm

Validity of claim transfer contracts. It often happens that a state-owned enterprise (SOE) debtor, or the acquirer of distressed assets, claims that the claim transfer contract is invalid. The courts will hold that an SOE debtor has the right to claim that the contract is invalid, but will require it to institute a separate legal action and provide litigation security.

Many plaintiffs claim that the contract is invalid on the grounds that there were defects in the disposal procedure, for example: the claim transfer announcement violated relevant regulations; no valuation was carried out, or it lacked fairness; the public bid invitation or auction procedure did not comply with regulations; and the approval or recordal procedure was not carried out.

If the claimed assets are acquired from one of China’s four large asset management companies, the chances of the above-mentioned grounds standing up are limited. The reason is that, in the close to 20 years since their establishment, these four companies have been compliant in their procedures and strict in their systems for asset disposal operations. Also, in terms of compliant adducement of evidence, the financial asset management companies stand in an absolutely dominant position, making it almost impossible for a plaintiff to show a defect in the asset disposal procedure.

Accordingly, if a claim that a claim transfer contract is invalid is to be made on the grounds of a defect in the claim transfer procedure, the author recommends that a thorough evaluation of the evidence be carried out to avoid losing the case due to a rash decision.

Change in mortgage rights. Once the master claim has been transferred, is registration of the change in the mortgage rights required? The mainstream judicial perspective tilts towards protection of the rights of the mortgagee, holding that carrying out such re

全朝晖 JEFFREY QUAN  广信君达律师事务所高级合伙人  Senior Partner  ETR Law Firm
Senior Partner
ETR Law Firm

gistration is not a condition precedent to the acquirer securing the mortgage rights. However, a minority of courts still hold that the validity of a mortgage is dependent on the registration of other rights certificates. The failure to register a change in mortgage does pose certain risks. For example, the original creditor and debtor could collude in releasing the collateral, resulting in the released collateral being otherwise mortgaged to a third party, or being placed under seal by a court.

In practice, the author recommends: (1) a strict review of the original mortgage contract, clarifying and defining whether, at the time of the various transfers of the claims, the transferors had an express and genuine intent to transfer the mortgage rights, e.g., whether the bank only transferred claims not secured by a mortgage while retaining those claims secured by mortgages so that it could itself dispose of them; (2) notification of the debtor of the transfer of the mortgage rights, and requiring it to co-operate in registering the change, and retaining such evidence, can provide a factual basis for a subsequent claim for exercising the mortgage rights; (3) where such registration is not possible, consideration may be given to securing the consent of the original creditor bank or asset management company to co-operate in instituting or continuing a legal action in its name; and (4) expressly specifying in the claim transfer contract that, when the mortgage rights are cancelled, the transferor is obliged to co-operate in the cancellation, and to co-ordinate with previous transferors to co-operate in carrying out the cancellation.

Change in enforcing entity. The Supreme People’s Court and local Higher People’s Courts have issued numerous detailed guidelines and attention still needs to be paid to the following.

First, conducting due diligence on the following matters before acquiring the claims: whether the claims are involved in a legal action; whether an enforcement procedure has commenced; whether the basis of enforcement is a civil judgment or a notarial deed of enforcement; whether enforcement has been tolled; whether a claim voucher has been secured; and whether the enforcement applicant recorded with the enforcing court is still the original creditor bank. If claims have undergone a series of transfers, the author recommends that the claim transfer contract expressly specify that, “the transferor must have an obligation to co-operate by appearing in court and participating in the court investigation, and must perform its co-ordination obligation to procure the appearance in court and participation in the investigation by the previous transferors”.

Second, practice among courts varies when confirming the holding of the claims by the acquirer, with some courts only examining original claim documents, claim transfer documents, etc., and rendering a supporting judgment after doing only the necessary investigation. The adjudication division of some courts requires the acquirer to obtain a ruling from the enforcement division of the court to the effect that the previous successive acquirers have been replaced by the acquirer. Some courts require the original creditor bank and successive acquirers to appear in court and participate as third parties.

Finally, if the acquirer proposes changing the litigation entities for only one or certain claims in the entire asset bundle, as the current measures for court costs are silent on how to charge such costs, the practice of different courts in determining the case acceptance fee is inconsistent. Some courts take the principal of the claims (or the principal and interest) as the basis for calculation and some courts take the transfer price for the entire asset bundle as the basis, resulting in a massive difference between the case acceptance fee charged on this basis and the previous charge rate of only RMB100 (US$16), far exceeding the claim acquirer’s cost expectations. The author recommends that a claim acquirer ascertain in advance the competent court’s practice for court costs before purchasing the asset bundle.

The era of easy pickings in China’s distressed asset disposal industry is in the past. As the market is approaching maturity and pricing is increasingly transparent, the space left to investors for making a profit has shrunk. Achieving good results severely tests the overall capabilities of investors, who are strongly recommended to carry out a comprehensive evaluation and make full preparations before entering the industry.

Zhong Zhifen is a partner at ETR Law Firm. She can be contacted on +86 20 3718 1333 or by email at 355345330@qq.com

Jeffrey Quan is a senior partner at ETR Law Firm. He can be contacted on +86 130 0517 0192 or by email at qzh@etrlawfirm.com