How arbitration tackles disguised debt in trust industry

By Zhang Jiechao, BAC/BIAC

Debt investment in the name of equity investment” (disguised debt) is a way of establishing trust plans in the trust industry. There has been no consensus regarding the exact definition of disguised debt, in theory or in practice. The China Securities Investment Fund Industry Association and the former China Banking Regulatory Commission stipulated some specific rules for regulation. Generally, disguised debt refers to an investment that is classified as equity, but that performs in effect like a debt. Such an arrangement may include a fixed payout and, under the prescribed trigger, a conditional buyout of the shares involved, making the trust investment similar to a guaranteed loan.

Specifically, the route taken to operate disguised debt varies according to its pattern of payout and buyout.

1. The repurchase or transfer of the equity. Parties agree in advance that the original shareholder or the actual owner of the special purpose vehicle (SPV), or companies associated with the investee, will repurchase or buy the equity at a fixed price. This arrangement in an investment contract or in a separated contract guarantees the return of the principal and the margin when the contracts are established.

2. The fixed dividend. Parties agree that, after the completion of the investment, the investors will have priority in the distribution of the dividend, and the dividend will be fixed irrespective of the business performance of the SPV. The cap on the dividend is equal to a prescribed sum of the principal and the margin. The equity that the investors have will be returned to the original owners under prescribed conditions or after certain periods.

3. Independent guarantee. Parties agree that the SPV’s original shareholders, actual owners, or an associated third party, will provide liquidity and guarantee the supplement of any price shortages of the prescribed dividend or repurchase. Such guarantee covers all the loss when the prescribed principal and the margin have not been realized.

Other than the above-mentioned routes, the VAM (value adjustment mechanism) may also be disguised debt when the investors receive a fixed return and not take on any risk associated with the SPV’s business performance.


Based on a study of the BAC/BIAC’s arbitration cases, which involve a validity issue related to disguised debt, the author concludes that, in arbitration, the nature of the investment may not be easily considered as a reason to deny the validity of the transaction.

Arbitral tribunals, the primary subject of the author’s research, repeatedly state that the so-called disguised debt does not violate compulsory laws or regulations, and that the parties’ free will in the contract will be fulfilled. In other words, the “disguised” nature of such a transaction will not delegitimize the parties’ agreement, thus providing arbitral tribunals with no reason to rule differently from the contractual wording.

The following BAC/BIAC cases demonstrate this point.

1. The repurchase case. In this typical repurchase case, a trust company and a real estate company entered into a trust investment agreement and a repurchase of equity agreement. The trust company invested for 90% of the shares of the SPV for a real estate developing project. Parties stipulated that the real estate company would repurchase all the shares at the fixed price (equal to the prescribed principle investment and margin) when the construction was completed, or when a certain period had passed. In this arbitration, the tribunal ruled that the real estate company should fulfill its obligation to repurchase and pay the contractual price.

2. The fixed dividend case. In many cases where the trust companies claimed for a fixed dividend, arbitral tribunals ruled that the equity investment normally followed the dividend distribution rules under applicable laws – the amount of the dividend available would be determined by the performance of the company under the PRC Corporation Law. Although those tribunals acknowledged the difference between a fixed dividend arrangement and the regular shareholders’ dividend, they ruled that such a fixed dividend arrangement did not violate compulsory laws or regulations. The parties’ agreement should be honoured.

3. Independent guarantee. In this type of disguised debt, the BAC/BIAC arbitral tribunals also supported the validity of the parties’ agreement. The rules of solving regular equity transfer issues did not apply to the independent guarantee agreement under the disguised debt scenario. The original shareholders, actual owners, or the third parties who made a guarantee beforehand would be held accountable for the trust companies’ claim.

The reasons for the BAC/BIAC approach to tackling the disguised debt in the trust industry may be twofold. The first is industrial expertise. Arbitrators tend to specialize in certain business sectors and thus comprehensively understand the industrial practice. Trust investments usually are at the high end of investment activities, with a complex structure and varying transactional arrangements. Therefore, arbitrators have to maintain an up-to-date understanding of the underlying industrial interests when dispute resolution takes place.

The second reason is the commercial nature of the dispute and the disputants. Current commercial arbitration emphasizes the parties’ autonomy and honours commercial precedents. “Disguised debt” is jargon and has no clear, official definition. The validity of this practice relies upon the adjudicators’ attitude – conservative or liberal – towards innovation in commercial activities. Arbitrators, as well as arbitrations, are capable of safeguarding the parties’ commercial interests in related disputes and encouraging the development of the trust industry. Industrial expertise and the commercial nature of the commercial arbitration guarantee it.

Zhang Jiechao is an arbitrator with Beijing Arbitration Commission/Beijing International Arbitration Centre (BAC/BIAC), and vice general manager of the Beijing International Trust Company legal affairs department. BAC/BIAC’s senior manager, Terence Xu, also contributed to the article.