Tag：dispute resolution and litigation-financial disputes, banking and finance-debt capital markets
In recent years, China's bond market has been expanding, the level of opening-up has been rising and the regulatory system of the bond market has been increasingly perfected. However, under the backdrop of the strong impact of international politics, investment, trade frictions, and the COVID-19 pandemic, funding liquidity problems have come to the fore, which results in frequent bond defaults. The scale of defaults grows rapidly, bond disputes increase significantly, and legal disputes regarding cross-border bonds are also increasing.
How to quickly adapt to the new trend of bond disputes under the strong financial regulation and the wave of defaults, and how to properly deal with the credit risks and dispute resolution of cross-border bonds have currently become the challenges and major concerns for all interested parties in the financial market.
On January 10, 2023, China's Supreme People's Court held the National Court Conference on Financial Trials, at which it was highlighted that courts should, "adhering to the fundamental people-centered philosophy, protect the legitimate rights and interests of financial consumers and small and medium-sized investors through strict and fair judicial practices, and safeguard social fairness and justice." Based on this, the conference repeatedly stressed the importance of "fairness" and the "legitimate rights and interests of small and medium investors". In terms of judicial practice, it was pointed out that "the task of unifying the adjudication standards for bond default disputes with similar claims is more urgent", which reveals the trend of "treating like cases alike" and "unifying the adjudication standards for bond disputes".
In March 2023, the Shanghai Financial Court released the Report on Legal Risks of Bond Disputes (the "Report"), which provides a statistical analysis of the bond dispute cases accepted by the courts in Shanghai from 2018 to 2022, and highlights the legal risks related to cross-border bond disputes, including disputes arising from the exercise of the right of action by onshore bondholders, the jurisdiction and governing law for cross-border bond disputes, recognition and enforcement of offshore bond dispute judgments, and regulation of cross-border bonds.
According to the information above, in the current context of strong regulation on finance, it is likely that the PRC courts will continue to concentrate on and strengthen the examination of cross-border bond disputes, focusing on the prevention and control of systemic risks, and curb risky trading activities, which may expose cross-border bondholders to new potential legal risks.
We will write articles focusing on various key areas of cross-border bond risks and dispute resolution such as the jurisdiction and governing law for cross-border bond disputes, confirmation of the principal creditor's rights, and validity of credit enhancement measures, making in-depth analysis of specific legal issues in practice, and exploring the courts’ thinking and positions in trail and adjudication, so as to provide reference and tips for the resolution of such disputes and the prevention and control of relevant legal risks.
I. Types of Cross-Border Bonds
“Cross-border bonds” is a broad concept. Depending on the issuer and the place of issuance, cross-border bonds can be classified into bonds issued abroad by onshore entities and their controlled offshore enterprises or branches (including but not limited to "Dim Sum Bonds" and "Lotus Bonds" issued by onshore entities in Hong Kong SAR and Macao SAR; such bonds are hereinafter collectively referred to as "Offshore Bonds"), bonds issued by onshore entities in China (Shanghai) Pilot Free Trade Zone (i.e., “Pearl Bonds”), and "Panda Bonds" issued by offshore entities in Chinese mainland.
In practice, Offshore Bonds issued by onshore entities and their controlled offshore enterprises or branches may easily cause controversies and disputes in China. The offshore issuance of bonds by Chinese onshore enterprises is conducted mainly through two models: direct issuance and indirect issuance. Under the indirect issuance model, onshore enterprises or other institutions provide credit enhancement measures to ensure the proper performance of the bonds concerned. The common credit enhancement measures include i) keepwell deed plus equity interest purchase undertaking (“EIPU”); ii) onshore guarantees for offshore debts, mainly including cross-border guarantees by onshore parent enterprises and standby letters of credit (“SBLC”) provided by onshore and offshore banks.
1. Direct Issuance
“Direct issuance model” refers to the direct issuance of bonds outside of China by enterprises registered in China, in which case, the issuer is an enterprise registered in China and directly holds the main business and core assets.
Onshore Enterprise Issues The Bond Directly
The advantage of the direct issuance model is that the issuance structure is simple and clear, while its disadvantage is that it sets a higher threshold for the issuer. Usually, the issuers are state-owned or government-owned enterprises in good standing and with stable business performance. In addition, when the issuer pays interest to offshore investors, the issuer needs to pay 10% (or at such other rate as required by the relevant tax treaty or arrangement) of the interest payable to the offshore investors as withholding tax, which will increase financing costs.
2. Indirect Issuance
Onshore enterprises or other onshore and offshore institutions such as banks provide credit enhancement measures, including but not limited to providing keepwell deeds, EIPU, cross-border guarantees and SBLC to ensure the proper performance of the bonds.
i) Credit enhancement model 1: keepwell deed plus EIPU provided by onshore parent enterprise
Under this model, an offshore subsidiary or an SPV established under an offshore subsidiary will be the bond issuer to issue bonds to offshore investors, and the onshore parent enterprise will provide credit enhancement support to the bond issuer by providing a keepwell deed or an EIPU. In the event that the bond issuer becomes insolvent, the onshore parent enterprise will provide liquidity support to the issuer or purchase its assets to ensure the proper performance of the bonds.
Keepwell Deed/Equity Interest Purchase Undertaking
Generally, a keepwell deed will stipulate that the onshore enterprise shall hold at least a certain proportion of the shares of the offshore issuer and provide liquidity support for it. Theoretically speaking, unlike in the case of guarantees, the creditors may only require the keepwell deed provider to provide liquidity support for the issuer, so as to ensure that the issuer can maintain appropriate assets, equity and working capital and will not become insolvent or subject to other similar circumstance. However, it should be noted that, in practice, many keepwell deeds have provided for compensation liability for breach, imposing the obligation and liability on the deed provider to directly compensate the creditors.
EIPU is a supplement to keepwell deed. Generally, EIPU requires the onshore parent enterprise to have an offshore subsidiary that has been existing and operating for a certain period and owns certain assets under its name, and the offshore subsidiary will issue bonds or provide a guarantee for the bonds of the offshore issuer. Furthermore, to provide credit enhancement to ensure the solvency of the offshore subsidiary, the onshore parent enterprise shall make an EIPU, whereby it undertakes to pay the offshore issuer funds sufficient to cover all of its liabilities, by purchasing the assets of the offshore issuer and its onshore subsidiaries, in case of any actual or potential default under the bonds issued (that is, the purchase price shall not be lower than the sum of the principal, interest and relevant expenses due and payable under the bonds).
The advantages of this model are that the issuance threshold is lower, no guarantee is involved, and the backflow of funds is flexible. While its disadvantages are that the issuance structure is more complicated compared with other models, the issuance cost is higher, and the legal risks are higher. In practice, there are many controversies and disputes arising from such issuance model.
ii) Credit enhancement model 2: cross-border guarantee by onshore parent enterprise
Under this model, an offshore subsidiary, or an SPV established under an offshore subsidiary, will act as the issuer of the bond, and the onshore parent enterprise will provide credit enhancement to the issuer by providing cross-border guarantee for the bond.
Cross-border Guarantees Provided By Onshore Parent Enterprise
The advantages of this issuance model are that the issuance structure is more straightforward, the bond pricing is mainly based on the credit rating of the guarantor, and investors prefer the directly guaranteed bond structure. As a result, this structure can achieve a larger scale of financing. Its disadvantages are that compared to other models, the onshore parent enterprise is required to apply to the foreign exchange administration for registration of onshore guarantees for offshore debts, which is relatively complicated. What’s more, the issuance threshold is relatively high, which means a stricter requirement on the credit rating of the group’s parent enterprise.
iii) Credit enhancement model 3: SBLC provided by banks
Under this model, an offshore subsidiary of the onshore enterprise, or an SPV established under such offshore subsidiary, will act as the bond issuer, and third-party bank guarantee (commonly in the form of an SBLC issued by the guarantor bank) will be provided as credit enhancement. In the event that the bond issuer becomes insolvent, the guarantor bank will be obligated to make the payments on behalf of the issuer. Bondholders may also directly request the guarantor bank to pay on its behalf.
SBLC From Banks
The advantage of this model is that the bond rating is generally equivalent to the rating of the bank providing the SBLC, which can reduce the cost of bond issuance. But this model requires an additional payment of bank guarantee fees.
II. Major Legal Risks and Litigation Issues in Respect of Cross-Border Bonds
In the life cycle of cross-border bonds, there may be different legal risks and potential disputes in different stages. Focusing on the resolution of disputes over cross-border bonds, we will, from the practice of litigation, arbitration and enforcement and following the procedural flow, provide a multi-faceted analysis of the key points in cross-border bond disputes for reference. This series of articles will cover the following four topics:
1. Frist Issue in Cross-Border Bond Disputes: Counterparty, Jurisdiction, and Governing Law
When a dispute over cross-border bonds arises, the first thing to do is to determine the specific counterparty in the dispute. In the case of a bondholder, whether the issuer, the guarantor or the bond administrator is the responsible party will determine the nature of liability and the nature of dispute. In addition, to resolve disputes through litigation or arbitration, the jurisdiction and governing law have to be determined. These are the first issues that must be considered and resolved before initiating the relevant legal proceedings.
2. Second Issue in Cross-Border Bond Disputes: Confirmation of Principal Creditor’s Rights
Proving and confirming its principal creditor’s right is a must-do issue for every bondholder, whether the claim is made against the bond issuer for its liability for the principal repayment and interest payment, or against the guarantor/credit enhancer for its obligation for providing guarantee and credit enhancement. In cross-border bond transactions, the process of purchasing and holding bonds by offshore bondholders is usually quite complicated, the nominal bondholder and the actual bond subscriber may not be the same, and multiple rounds of financing and repurchase arrangements may be made during the period, posing various difficulties in confirming the principal creditor’s right.
3. Third Issue in Cross-Border Bond Disputes: Validity of Credit Enhancement Measures
The validity of credit enhancement measures for cross-border bonds has long been a difficult issue in judicial practice. New and noteworthy changes in this issue are likely to occur in the future, given that the National Court Conference on Financial Trials was held and the Report was issued, and that the courts in the PRC have shown certain tendency in their recent adjudication of the validity of credit enhancement measures. We will analyze the potential adjudication tendency on this issue in light of the cases in recent years.
4. Fourth Issue in Cross-Border Bond Disputes: Asset Preservation, and Recognition and Enforcement of Off-Shore Judgment
While initiating legal proceedings, the holder will often simultaneously apply for preservation of the property of the issuer and the guarantor to ensure the enforcement of the future judgment /award on its claim. After obtaining effective judgment or award against the issuer/guarantor abroad, the holder will have to apply to the court with jurisdiction for recognition and enforcement. In this regard, we will further sort out the major issues and precautions in this process for reference.
Thanks to Yu Renzhou and Liu Qiaoping for their contribution to this article.
Any reference to Hong Kong and Macao should be construed as the Hong Kong Special Administrative Region and Macao Special Administrative Region of the People’s Republic of China.
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