As the Chinese economy enters the “new normal”, the Chinese government has been adjusting its industrial and credit-related policies and strengthening regulation of Chinese financial institutions. A large number of non-performing loans (NPLs) as well as actual loan defaults have started to surface. The risks associated with rising levels of NPLs require Chinese banks to enhance their ex ante and ex post credit risk management practices. They also need to strategically and effectively navigate complex domestic and cross-border loan recovery, debt restructuring and insolvency processes.

Careful planning and effective decision-making is required for banks to manage their NPLs and strategically engage in debt restructuring and insolvency processes. Our recent experience in advising Chinese banks in connection with NPLs indicates that, while insufficient cash flow is the main cause of a borrower’s inability to repay its debts, certain other events may also adversely affect the borrower’s overall business and financial condition, such as:

  • misappropriation of the borrower’s funds by its controlling shareholder;
  • poor local management; and
  • domestic or foreign government investigations involving the controlling shareholder or the borrower’s other affiliates.

Although these events may not immediately result in a payment default, they may constitute breaches of representations or undertakings under the finance documents, which may trigger defaults under the loan in question or cross-defaults under other financing arrangements.

Drawing on our extensive experience in domestic and cross-border NPL recovery, security perfection, enforcement, debt restructuring and insolvency matters, this article provides a high-level, step-by-step guide on how Chinese banks can effectively manage their NPLs, develop a strategy for loan recoveries and navigate complex multi-jurisdictional debt structuring and insolvency processes.

Step 1: Review finance documents

Banks should actively monitor their outstanding loans and, at the first sign of trouble in respect of a particular borrower, guarantor, security provider (each an “Obligor”) or any of their material affiliates, a bank (hereafter referred to as the “lender”) should assess:

  1. the amount of all outstanding debts including how much has become due and payable and how much is not yet due for payment;
  2. whether all finance documents were duly executed and whether the existing deal structure and security package are sufficient to protect the lender’s interests as a creditor;
  3. whether the relevant signatories of the finance documents were duly authorized at the time of execution;
  4. cross-default clauses in the finance documents;
  5. whether an event of default has occurred and if so, whether to immediately send an event of default notice to the Obligors and to accelerate some or all of the outstanding debt;
  6. whether the lender is entitled to (and whether it should) prevent:
    1. further drawdowns under the facility; and/or
    2. further dealings with the secured property (such as preventing withdrawals from the relevant bank accounts); and
  7. in cases involving a syndicated loan, the lender’s voting rights and voting percentage and whether it needs to work with other lenders in order to instruct the agents as the majority lender.

Step 2: Assess the existing security package

The lender should assess:

  1. whether it has effective control over the secured property under existing security arrangements;
  2. whether the securities have been duly perfected under applicable laws;
  3. whether any security has not yet been registered, and if so whether the lender has everything it needs (including any power of attorney granted to the lender) to complete such registration under applicable laws; and
  4. whether the lender should immediately notify banks, securities brokers and other custodians to freeze relevant bank accounts, securities accounts or other secured property belonging to each Obligor.

Step 3: Actively monitor the Obligors and conduct due diligence on their assets and current financial position

The lender should:

  1. consider the extent to which each Obligor’s controlling shareholder or authorized signatory is cooperative and able to sign additional documents, and whether the relevant company seal is readily available and accessible to that person;
  2. assess whether the controlling shareholder or authorized signatory can travel abroad to execute foreign securities documents and attend foreign securities registration (where onsite and in-person signing and notarization are required under applicable foreign laws);
  3. determine whether any Obligor intends to convene a board meeting or shareholder meeting and pass resolutions to dispose of material assets (if so, the lender should consider notifying the attendees or attending the meeting to state its rights); and
  4. conduct litigation and insolvency searches as well as other legal and financial due diligence in respect of each Obligor and its material assets.

Step 4: Obtain additional security or initiate debt restructuring

The lender should:

  1. conduct legal and financial due diligence in respect of each Obligor to determine whether it has valuable assets (e.g. shares, real estate, receivables, equipment, other contractual rights and projects which can generate cash flow) that could be used to provide additional security to the lender;
  2. review the applicable legal requirements for perfection of security and any relevant restrictions imposed by the Obligor’s articles of association or agreements to which the Obligor is a party. In some foreign jurisdictions, the process for granting and perfecting security over bank accounts, securities and certain other types of movable property may be relatively straightforward, whereas the process in respect of real property may be more complicated. Notarization and certification requirements may also apply to certain types of collateral;
  3. where an Obligor has valuable assets or projects, the lender may work with the Obligor to dispose of them at a reasonable market price (or even at a premium), and the sale proceeds would be used to repay the borrower’s debt. It may also be possible for a third party to acquire equity or debt interests in the borrower in order to be involved in the borrower’s debt restructuring process; and
  4. assess the risk of insolvency proceedings being initiated against an Obligor and possibility of claw-back or similar claims in relation to any payments received by the lender, any additional security provided by the Obligor or any asset disposals by the Obligor.

Step 5: Develop effective litigation strategies

The lender should, at an early stage, engage its in-house and external legal teams to:

  1. investigate whether an Obligor is engaged in any fraudulent activity, and take preventative measures (including court proceedings) where appropriate;
  2. investigate whether any Obligor is implicated in criminal activities such as loan fraud or money laundering, and take into account the impact of potential criminal proceedings involving the Obligor and their interaction with civil proceedings to recover debt or enforce security;
  3. develop specific litigation strategies with respect to each Obligor, including tailored asset preservation and enforcement strategies; and
  4. prepare relevant litigation materials in advance so the lender stands ready at any time to commence civil proceedings (or report suspected criminal activity to the relevant authorities).

Step 6: Formulate effective insolvency strategies

The lender should:

  1. prepare a list of key jurisdictions where insolvency proceedings may be commenced against an Obligor; and
  2. with the assistance of external counsel, investigate how different stages of an insolvency proceeding may affect the lender’s rights, including:
    1. before the commencement of insolvency proceedings (e.g. whether transactions entered into by the Obligor prior to insolvency might be subject to challenge by an insolvency official, creditor or other third party)
    2. understanding the position immediately after the commencement of insolvency proceedings (e.g. whether creditors’ rights may be subject to a moratorium)
    3. understanding the position during the medium to long-term (some insolvency proceedings can last many years)
    4. In some jurisdictions, courts are not actively involved in the insolvency process, and a group of creditors (e.g. a creditors’ committee) will need to make important decisions. The lender should consider which senior officers within its organization should be authorized to make decisions for the lender and who should represent the lender on the creditors’ committee.
  3. Formulate strategies against potential insolvency proceedings

Step 7: Effectively dealing with other creditors

The lender should:

  1. determine whether the borrower has other major creditors and obtain key information about the borrower’s other debts (e.g. amount, due date, whether in default and the security package);
  2. closely monitor the protective and enforcement measures that other creditors have taken or are taking in relation to the Obligors or collateral, and assess whether other creditors are likely to initiate insolvency proceedings against any Obligor; and
  3. consider whether it is strategically advantageous for the lender to work with other creditors (e.g. similarly situated lenders or other members of the loan syndicate) to achieve win-win outcomes for these creditors (including the lender).

In addition to the steps outlined above, we recommend that lenders consider whether there are instances of non-compliance with respect to its credit and lending processes and conduct internal investigations into relevant procedures and personnel. This may help the lender understand and gather relevant evidence for potential legal proceedings.

Debt restructuring, asset recovery, enforcement and insolvency proceedings are fast-moving and incredibly complex, especially if they involve cross-border elements and multiple legal jurisdictions. These processes require close cooperation and coordination at all levels within the bank. They also demand decisive decision-making from the bank’s leadership and swift execution and implementation of those decisions.

External counsel play a critical role in helping banks navigate these complex processes. In addition to their expertise in banking and finance matters and familiarity with the finance documents, external counsel can also provide strategic and practical advice in connection with domestic and foreign security perfection, enforcement, litigation and insolvency proceedings. With the able assistance of external legal and other advisers, Chinese banks can effectively manage their NPLs, maximize loan recoveries and minimize potential or actual losses.