Almost without exception, property developers plagued by bankruptcy prospects find themselves at the end of their ropes in terms of liquidity. Considering the day-and-night difference in the market value of a property, the costs of and difficulties in its disposal, before and after project completion, as well as the need to maintain social stability, developers are under considerable pressure to acquire funding to continue and complete construction. Such financing needs may be provided by either investors eyeing a healthy return or urban investment companies on a mission of social governance, but both must tread carefully to keep funding risks under control.
COMMUNITY LIABILITY FINANCING
Depending on the stage of debt liquidation, developers' financing is classified into: “community liability-like financing”, which takes place during pre-bankruptcy debt restructuring and pre-restructuring; and “community liability financing”, arising during bankruptcy, which has a clearer legal definition and hence has seen more active legal practice.
The legal basis for community liability financing is primarily found in articles 26 and 42(4) of the Enterprise Bankruptcy Law (EBL), and article 2 of Provisions (III) of the Supreme People's Court on Several Issues concerning the Application of the Enterprise Bankruptcy Law (the provisions III), under which the developer, after the bankruptcy application is accepted and with the approval of the creditors' meeting or the court, may borrow funds to continue operation and enjoy certain priority rights of repayment with reference to regulations on community liabilities.
Accordingly, financially stranded property developers, after entering the bankruptcy procedures, may borrow funds to continue operations, which include selling commercial housing and ensuring a delivery state of acceptable quality. To ensure a favourable position for funding, parties should ensure that the developer meets all the following conditions:
- In terms of timing, the financing legal relationship should be formed and the obligation performed after the bankruptcy application is accepted;
- In terms of procedure, depending on the stage, the financing should be approved by either the creditors' meeting or the court; and
- In terms of common benefits, the raised funds should be used for the completion, acceptance and delivery of its real estate projects.
With the provisions III expanding on the regulations on community liabilities under the EBL, it was clarified that financing in this manner may be placed after community debt in the order of liquidation, a market-stimulating move that is guaranteed on a judicial level. By participating in the community liability financing, investors will be given priority of repayment second only to property-secured creditors' rights. In the end, developers will be allowed to continue their property projects, and when completed the properties will rise in market value and creditors will be repaid from a richer pool of resources.
With property developers experiencing general financial hardships and mounting pressure to guarantee the delivery of properties, investors are adopting a wait-and-see approach. Developers recklessly entering bankruptcy may find it challenging to solicit suitable offers within the statutory time limit for reorganisation (six months from acceptance of the case, subject to three months of extension). To uphold both property value and social stability, urban investment companies and certain investors may need to offer capital support before the developers enter bankruptcy, thus forming “community liability-like financing”.
If the developer has entered pre-reorganisation, and the funds provided by investors meet the second and third of the above-mentioned conditions, it may be regarded as “community liability financing” as defined by the Supreme People's Court and local judicial policies. A dozen local courts, including those in Shenzhen, Zhengzhou and Suzhou, have set out regulations for financing to “make reference to” the settlement order of community liability in their respective pre-reorganisation policies.
If the developer has not entered pre-reorganisation, funds raised at this stage usually cannot be recognised by courts as community liability financing. However, in the civil judgments of Zhejiang Asia Real Estate Development v Songdu Chengye Investment Management (2017), and Jinsailong Industrial v Hehuang Hotel Management & Argos Resort Hotel Management (2018), the Hangzhou Intermediate People's Court and the People's Court of Deqing county, respectively, determined that capital investments that satisfy certain conditions (government designation, ratification by the administrator, etc.) may be repaid akin to community liabilities.
RISKS AND DILEMMA
Currently, laws and regulations on community liability financing are not seamless, which leads to certain risks. First, even if the investment is deemed community debt financing, there are discrepancies between laws and judicial interpretations. While the provisions III favours the repayment of community debt financing over common creditors' rights, the EBL provides that it is secondary only to creditors' rights secured by properties.
Second, judicial interpretations and some judgments have been flexible with the above-mentioned “timing” condition, clouding the procedure with uncertainty. Third, while administrators may lawfully set up property security for debtors' financing, in the case of developers, they have likely by this point exhausted the well of financing attached to their properties, with little left to use as security.
ADVICE TO INVESTORS
If financing before the acceptance of bankruptcy application is absolutely necessary, depending on the exact situation, investors are advised to do the following:
- If funds are needed to satisfy the construction fees, for every creditor's right created since the funding party's entry, and until the acceptance of the bankruptcy, the funding party should enter into separate transfer agreements with each debtor and construction unit. Once the creditors' rights are affirmed between the developer and the construction unit, the funding party may then move the funds to the construction units as payments of construction fees, although one should be mindful of transfer risks;
- Financing should be approved in writing by main general creditors, or in the pre-reorganisation process, approved in writing by the administrator or the court; and
- Community liability financing may be conducted in conjunction with the reorganisation investment, with the former applied first to sustain construction, and the latter at a later phase to assume overall control of the developer, and in turn its project.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.