Legal Issues in Acquiring NPLs

Issues in the "Sale+Joint Venture" Structure

"Sale+Joint Venture" is one of the transaction structures in this market. Under this structure, foreign buyers purchase a certain percentage (e.g., 70%) of the NPL portfolio auctioned by the state banks and leave the remaining part of the portfolio with the seller. Both the seller and foreign buyers contribute assets into an onshore joint venture company (the Joint Venture) to be established by them. A separate assets service company (the Service Company) will be formed to manage the NPLs. The proceeds from the disposal of NPLs will be distributed between the Joint Venture partners in a pre-agreed proportion.

Some important breakthroughs have been made under this structure. First, the relevant regulatory authorities have approved the partners of the Joint Venture to make contributions to the Joint Venture in debt assets, which method is not recognized yet under the PRC Company Law(中华人民共和国公司法). Secondly, the State Administration of Foreign Exchange has approved that foreign buyers may fully repatriate their assets disposal proceeds upon the payment of the income tax levied on the Joint Venture, which is totally different from the regular repatriation of dividends of FIEs and the repayment of the principal and interest of external debts. Thirdly, no business tax, which is applicable to other financial institutions in China, will be levied on the Joint Venture. Finally, a special purpose vehicle company focusing on the management and disposal of distressed assets is permitted to be established.

So far, the anticipated external investment right has not been vested in joint ventures in China, which has made the universal "investmentvalue addedsale" mode unworkable for the Joint Venture. However, foreign investment bankers may sell NPLs to overseas strategic investors, who will restructure the debts of the NPLs completely. This is regarded as a new entrance for foreign investment to the Chinese market, by which foreign investors may obtain access to some industries where foreign investment is originally limited or prohibited. In such an approach, foreign investment in China may make faster progress than the time schedule committed to by the PRC government in its WTO protocol.

Issues in the Trust Structure

The trust structure is an NPL disposal structure designed on the basis of the securitization technique and trust law principle and under the Chinese legal framework. Under this structure, the owner of NPLs (the Settler) entrusts its NPLs to a trust and investment company (the Trustee) with the Settler itself as the beneficiary. In light of the Settler's expertise in distressed assets management, the Trustee delegates its power to dispose of the NPLs to the Settler. All the proceeds of the NPL disposal will be part of the trust assets. The beneficiary right of the trust assets is divided into senior and junior tranches, both of which are held by the Settler at the initial stage. Further, the Settler transfers the senior beneficiary right it holds to investors to obtain immediate cash payment and holds the junior beneficiary right to retain the hope to get proceeds from the NPL disposal upon the payment of the senior beneficiary right. The investors may resell their senior beneficiary rights to other investors.

Although China's legal framework does not allow standard securitization (as current PRC law makes the creation of special purpose vehicles, "true sale" and other securitization techniques nearly impossible), some key securitization techniques, including ring-fence, assets-backed securities, cash flow repackaging, and credit enhancement, are adopted under this structure.

With respect to a ring-fence mechanism, as the PRC Bankruptcy Law does not provide enough room for "true sale", the entrustment of NPLs is structured instead to enable the assets to be ring-fenced from the bankruptcy risk of the seller. However, given that a separate and complete entrustment registration system is yet to be developed, uncertainties still lie in the ring-fence effect of the entrustment mechanism.

While in standard securitization deals securities (in the form of bond or equity securities) are issued by SPVs, given that the issue of securities is highly regulated in China, market players have considerable difficulty in trying to offer securities to investors in their securitization arrangement. The innovation of senior beneficiary rights transfers provides the trust structure more flexibility than standard securitizations in China. What the investors have purchased is a kind of senior beneficiary right that enables the investors to have the first priority in the distribution of trust proceeds. It has been argued that the senior beneficiary right in nature is not a kind of securities to be regulated by the PRC Securities Law(中华人民共和国証券法) and the transfer of the same should follow the provisions of the PRC Trust Law(中华人民共和国信托法) and the PRC Contract Law(中华人民共和国合同法). However, considering the transferability and profitability of such kind of senior beneficiary right and the non-sophistication of the purchasers of the senior beneficiary right, it is not easy to say the offering of senior beneficiary rights will not be subject to the PRC Securities Law and the regulation of the CSRC.