Revelation of Bond disputes (III)——Disposal mechanism under the background of bond default

Dehehantong financial dispute resolution team combined with practical experience, launched the “Bond dispute Revelation” series of articles, around bond governance, bond default disposal, bond misrepresentation and other aspects, focusing on the current core issues in the field of bond disputes, and put forward practical suggestions.

In 2014, “11 Chaori bonds” announced in a paper announcement that the second phase of interest could not be paid in full on time, becoming the first substantive default in China's bond market, so 2014 is known as the “default year” in China's bond market. Since then, bond default has gradually entered a normal mode, and the disposal paths for bond default have become increasingly diversified.

This is the third article in the “Bond Dispute Revelation” series, and we will discuss the criteria for the identification of bond default and the disposal path.

1. Overview of bond default types

Different from the general creditor's rights in the non-financial field, bonds have both the attributes of contract and securities, which determines that “bond default” is a relatively complex concept. The premise of discussing bond default is to clarify the types of bond default and its identification criteria.

According to Article 21 of the Supreme People's Court's Symposium on the Trial of Bond Dispute Cases in National Courts (Law [2020] No. 185, hereinafter referred to as the “Bond Dispute Summary”) : “The scope of the issuer's liability for breach of contract. Where the bond issuer fails to pay the current interest or the principal and interest at maturity as agreed, and the bond holder requests the issuer to pay the current interest or the principal and interest at maturity, as well as the overdue interest, liquidated damages and reasonable expenses for the realization of the creditor's rights, the people's court shall support it. Where a bond holder requires the issuer to repay the principal and interest in advance on the grounds that the issuer has defaulted as agreed in the bond offering documents, the people's court shall make a judgment by taking into account the specific agreement on expected default, cross-default, etc. in the bond offering documents and the specific circumstances of the incident.”

Therefore, bond default can be divided into three types: actual default, expected default and cross default.

01. Material breach of contract

A substantial default is when the issuer fails to pay the interest and/or principal due on the contract.

In this case, the issuer has clearly failed to fulfill the payment obligations agreed in the offering prospectus, subscription agreement and other transaction documents, the breach of contract is relatively clear, the legal relationship is relatively straightforward, and there will not be too much dispute over the fact of breach in judicial practice, and the focus of dispute between the two sides will be more on the calculation methods of interest and liquidated damages.

For example, in the case of default of the “two of 18 leases” bond in the first instance of Shanghai Financial Court and the second instance of Shanghai Higher People's Court [1], the issuer, CMIG Leasing Holdings Co., Ltd. did not honor the contract after the maturity of the disputed bond, and the issuer did not make too many defense against the fact of default during the litigation process. But around the calculation method of interest and liquidated damages, attorney fees and case handling fees and other costs to bear the defense, and finally the court also supported the main litigation request of the holder, ordered the issuer to fulfill the obligation of repayment of interest.

02. Expected breach

The system of anticipatory breach of contract is clearly stipulated in the Civil Code of the People's Republic of China (hereinafter referred to as the “Civil Code”). According to Article 578 of the Civil Code, “Where a party explicitly states or indicates by its conduct that it will not perform its obligations under the contract, the other party may request it to bear the liability for breach of contract before the expiration of the time limit for performance.”

According to the above clauses, expected default can be divided into two situations: express expected default and implied expected default. Meanwhile, in practice, expected default of bonds is usually accompanied by accelerated maturity and early repayment of bonds.

As far as the express expected default is concerned, if before the maturity of the principal or interest of the bond, the issuer has clearly indicated that it will not be able to fulfill the obligation to repay the bond and there is no valid reason, the holder can claim that the issuer constitutes an expected default, and then require the bond to mature earlier and require the issuer to bear the obligation to repay. For example, in the “14 Shanshui MTN002” bond default case heard by the Supreme People's Court, the Supreme People's Court held that: “Whereas Shanshui Company made it clear to China Merchants Bank on December 20, 2015 that it could not fulfill the obligation to pay off the litigant bonds in this case, and at the same time recognized that China Merchants Bank had reason to announce the early maturity of the litigant bonds in this case, in this case, even if the parties did not agree in the prospectus for the litigant notes to mature earlier, However, China Merchants Bank, in accordance with the provisions of Article 108 of the Contract Law of the People's Republic of China (basically consistent with Article 578 of the Civil Code), claims that the redemption date of the litigated bonds is due earlier and should be supported [2].”

As far as implied anticipatory breach is concerned, because there is no explicit intention of non-performance of the issuer, the judgment standard of implied anticipatory breach will be more prudent in judicial practice.

In the “11 Tianwei MTN1” bond default case tried by the Shanghai Pudong New Area People's Court, although the issuer of the case has entered the bankruptcy reorganization process, and there have been a number of other bond defaults, the court still emphasized in the judgment: “Although the defendant has defaulted on other bonds, the issuance and payment of each bond are independent performance acts of the defendant, and the loss of the ability to pay any of the bonds does not necessarily extend the payment results of other bonds, and the defendant has been paying interest on the bonds involved on time, whether subjectively or in terms of the externalization of the behavior. Neither has' indicated 'that it will not fulfill its obligation to honor the bonds involved, therefore, the evidence on the record is insufficient to prove that the defendant has an anticipated breach of contract as provided for in Article 108 of the Contract Law, and the defendant's argument that it does not constitute an anticipated breach of contract is valid [3].” This case was subsequently selected as one of the Shanghai High People's Court's “Top Ten Typical Cases of Financial and Commercial Trials in Shanghai Courts in 2016”, and its title was named “Strict Identification of the standard of implied refusal to perform by the issuer of unmatured bonds”, which precisely confirms the prudent attitude towards the identification of implied default in judicial practice.

However, a prudent attitude does not mean that the path of anticipatory default is not feasible. In the well-known case of “11 Kaidi Bonds” [4], the Supreme People's Court found that the issuer “the above behavior of Kaidi Ecology Company is sufficient to show that it is unable to perform its contractual obligations, and it should be determined that it has constituted an anticipatory breach of contract prescribed in Article 108 of the Contract Law of the People's Republic of China”. Specific to the case, the property of the bond guarantor has been frozen several times due to several arbitration cases, and the stock price of the issuer company held by it has fallen below the level line. At the same time, the issuer has released its default on the medium-term notes of more than 690 million yuan and has been investigated by the CSRC for suspected violations of information disclosure. In this case, the credit rating of the bonds involved was lowered, and the issuer was found to have illegally misappropriated funds of 402 million yuan. Based on the above circumstances, the Supreme People's Court finally concluded that: “The above behavior of Kaidi Ecological Company is sufficient to show that it has been unable to perform its contractual obligations”, and determined that the accelerated maturity conditions of the bonds involved in the case were achieved.

03. Cross default

The legal principle of the cross-breach system is rooted in the theory of civil law in anticipation of breach of contract and the right of uneasy defense. Cross-default in the field of bonds means that if the issuer of the bond defaults on other debt contracts, such default will also be regarded as a default under the bond.

The applicable standards for cross-default need to be clearly agreed in bond trading documents. For example, in the Model Text of Investor Protection Clauses (2019 edition) issued by the China Interbank Market Dealers Association [5], cross-default triggering situations for reference are listed, including: (1) The issuer and its subsidiaries within the scope of the consolidated financial statements fail to repay the principal or interest of other debt financing instruments, corporate bonds, corporate bonds or foreign bonds that are due and payable; (2) or the issuer fails to repay the interest on the current debt financing instruments; (3) or the failure of the issuer and its subsidiaries within the scope of the consolidated financial statements to repay the principal or interest of any bank loan due and payable, and the total amounts, individually or cumulatively, meet or exceed certain standards.

In fact, cross default is not a “default behavior” in the real sense, but an agreed protection mechanism for investors, which constitutes a cross default in the field of bonds when it is triggered. However, for issuers, the setting of cross-default clauses is very easy to cause a chain reaction - once a debt defaults, other outstanding bonds will also trigger accelerated maturity like dominoes, resulting in the rapid deterioration of the issuer's financial situation and the collapse of the building.

Well-known bond cross-default cases include the “16 Zhongan Quan” case. On April 28, 2018, the rating agency United Credit Management Company Limited downgraded the main rating of Zhonganxiao Company Limited (hereinafter referred to as “Zhonganxiao”) from A to C and removed it from the credit rating watch list; On May 7, 2018, Zhongan Xiao announced that “15 Zhongan Xiao” should pay the bond principal balance of 91.35 million yuan and interest of 3.06 million yuan on April 30, 2018, and the company could not pay the principal and interest of the bond on time, which has constituted a material default. In addition, the issuer still has a period of existing bonds “16 peace”, the balance of 1.1 billion yuan, in January 2018 through the holder meeting added a cross-default clause, April 28 disclosure of the 17-year audit report shows that the company's overdue loans within six months has exceeded 600 million yuan, triggering the cross-default clause, the issuer needs to pay 16 peace in advance within three months.

Subsequently, the holder of “16 Zhongan Consumer” sued Zhongan Consumer to require it to bear the repayment liability, and was supported by the Shanghai Financial Court and the Shanghai Higher People's Court [6].

2. Disposal path of bond default

As mentioned above, bonds have both the attributes of contracts and securities, and there are multiple solutions when holders are faced with the situation that they cannot be repaid at maturity.

01.negotiate the extension

At present, the extension has become the most mainstream bond default disposal path. From the perspective of civil law, the extension of a bond before the maturity date does not strictly constitute a bond default, but from the perspective of financial supervision, taking into account the issuer's credit risk and solvency, the default behavior that cannot be repaid after maturity and the extension behavior before maturity are generally recognized as a bond default in a broad sense.

According to the “2023 Bond Market Default Summary and 2024 Outlook” released by China Bond Credit Rating Co., LTD., in 2023, there will be 21 new default and renewal entities in the bond market, with a default and renewal scale of 2127.735 billion yuan. Considering the broad default rate after the renewal, 0.53% is obtained. During the year, there were 9 new defaulters of public debt bonds, and the default scale of public debt bonds was 75.06 billion yuan. From the perspective of extension, 12 new extension subjects were added throughout the year, and the bond extension scale was 137.675 billion yuan [7].

For example, on September 20, Country Garden Property Holdings Limited issued an announcement on the important matters of corporate bonds, and pointed out that as of September 12, 2023, the company's seven rollover bond renewal proposals were voted by the bondholders' meeting. Including H19 Pidi3, H20 Pidi3, H20 Pidi4, H1 Pidi01, H1 Pidi02, H1 Pidi03, H1 Pidi04.

From the above data, it can be seen that some bonds can be disposed of by negotiation before the expiration of redemption. Issuers facing default risks can negotiate with holders by integrating debt repayment resources, additional credit measures, etc., and pass renewal proposals by holding holders' meetings to postpone the date of bond redemption. Even after maturity, bonds can be extended through negotiation so that issuers avoid the risk of litigation and cross-default.

02. Bond replacement

Bond replacement means that the issuer can realize the replacement of the new bond and the original bond and the normal maturity of the original bond by issuing new bonds and subscribe by the original holder under the premise of obtaining the approval of the new bond.

On July 1, 2020, the People's Bank of China, the Development and Reform Commission and the China Securities Regulatory Commission issued the Notice on Matters Related to the Default Disposal of Corporate Credit Bonds (Yinfa [2020] No. 144, hereinafter referred to as the “Notice on the Default Disposal of Bonds”). It is pointed out that issuers and bondholders can carry out debt restructuring through bond exchange and extension on the basis of equal consultation and voluntary.

In essence, the bond exchange realizes the renewal in another way, and its purpose is to extend the repayment period. However, different from the whole bond extension, the bond exchange can realize the replacement of some bonds on the basis of equality and voluntary-while the issuer should fulfill the repayment obligation according to the contract for the holders who do not agree to the replacement plan.

Typical successful bond replacement cases such as “16 Suning 01” and “17 Sander Engineering MTN001” -- On February 1, 2021, issuer Suning Electrical Appliance Group Co., Ltd. launched a replacement offer for “16 Suning 01” and successfully replaced it on February 2, 2021, with a final replacement rate of 73.24%; On March 2, 2020, the issuer Beijing Sande Environmental Engineering Co., Ltd. initiated a replacement offer to all holders of “17 Sande Engineering MTN001”, and as of the deadline of the offer period, 11 of the 14 bondholders participated in the replacement, with a total replacement amount of 400 million, accounting for 80% of the issue amount.

03.Contract breach litigation

Extension and replacement are temporary measures, even if the risk of bond default is temporarily alleviated through these ways, but in the long run, whether the bond can be finally repaid is still unknown. A professional team once conducted a systematic study on the redemption situation of bonds after the renewal, and the results showed that only 30% of bonds were successfully redeemed according to the first renewal plan after the renewal [8].

In the face of the narrow sense of bond default, default litigation is the most direct relief path. The advantage of default litigation path is that through the relatively simple and direct rights and obligations under the bond legal relationship, the holder can usually get an effective judgment ordering the issuer to repay the principal and interest. However, the disadvantage of breach of contract litigation is that after investing high litigation economic cost and litigation time cost, the issuer is likely to have no actual solvency, leaving only a paper effective judgment.

04. Bond misrepresentation lawsuit

According to Article 9 of the Summary of Bond Disputes, “Where a civil compensation lawsuit brought by a bond holder or bond investor against the perpetrator of a fraudulent issue or false statement on the grounds that he or she has been infringed upon by a fraudulent issue or false statement complies with the provisions of Article 119 of the Civil Procedure Law, the people's court shall accept it.”

According to the general view in current judicial practice, the acceptance of bond misrepresentation is not premised on the affirmation of relevant facts by the relevant authorities' administrative penalties or effective criminal judgments, but according to the author's experience, if there are no relevant regulatory documents or criminal judgments in such lawsuits, it will greatly increase the burden of proof on the plaintiff for the fact that there is a misrepresentation of securities.

Since the bond misrepresentation case is in essence a special tort dispute, its legal relationship is not as clear and clear as the payment obligation under the default dispute, and the difficulty of the case is significantly higher than that of the default dispute. However, its advantage is that it can break the principle of relativity of contract disputes. By adding intermediaries, real controllers of issuers and directors and supervisors as defendants, the subject of responsibility is greatly expanded to achieve the final payment at the execution level.

For example, the famous “Wuyang Bond” case, as the first case in the field of securities disputes in the country to be tried by the representative litigation system, Hangzhou Intermediate People's Court ruled that the issuer Wuyang Construction Group Co., Ltd. should be liable for compensation for investors' losses. At the same time, the ruling ruled that Chen Zhizhang, the controlling shareholder of the issuer, and the intermediary Deppon Securities Co., Ltd. and Daxin Accounting Firm (special general partnership) should bear joint and several liability for compensation, and Dagong International Credit Evaluation Co., Ltd. should bear joint and several liability for compensation within the range of 10%. Shanghai Jintiancheng Law Firm (Special general Partnership) shall bear joint and several liability within 5% [9].

05.Issuer bankruptcy reorganization

According to Articles 5 and 6 of the Notes of Bond Disputes, when the bond issuer fails to pay the principal and interest of the bonds as agreed or defaults as agreed in the bond offering documents, the trustee may, according to authorization, apply for the bankruptcy reorganization or bankruptcy liquidation of the issuer on behalf of the bond holders in its own name; The bondholders may also apply for bankruptcy reorganization or bankruptcy liquidation of the issuer on their own.

If the bonds do not mature and the issuer enters bankruptcy reorganization proceedings due to failure to pay other debts, the remaining bonds shall immediately accelerate maturity and cease to bear interest in accordance with the relevant laws and regulations in the field of bankruptcy.

At the same time, Article 33 of the “Bond Dispute Summary” stipulates that after the bond issuer enters the bankruptcy proceedings, the issuer's obligation to disclose bond information is borne by the bankruptcy administrator, which is also a special protection path for the holders in the bankruptcy proceedings.

As for the final repayment rate in the bankruptcy reorganization process, there are great differences in practice. According to the research of China Bond Credit Evaluation Co., LTD., the highest repayment rate can exceed 100%, the lowest even less than 10%, and the average repayment level is estimated to be about 30%[10].

3. Conclusion

The scale of bond defaults in China roughly reached a peak between 2018 and 2021, and then there was a downward trend, and the scale of bond defaults declined year by year, reflecting the results of resolving credit risks in China's bond market to a certain extent.

As an increasingly mature and indispensable financing tool, bonds need all parties to jointly maintain their orderly development. For issuers, they should issue bonds appropriately, improve internal control and governance of the company, and fully fulfill the obligation of information disclosure. When enterprises fall into liquidity crisis and face the risk of bond default, it is particularly important to fully communicate with the trustee and the holder. For the holders, before investing in bonds, they should fully understand the product risks and rationally evaluate their own investment capabilities. In the face of bond default, they should use diversified bond disposal mechanisms to safeguard their rights. As for intermediary institutions, they should properly assess the risk of conflict of interest, fully fulfill the duty of diligence and due diligence, and beware of getting involved in the quagmire of joint and several liability.

Footnote:

[1].See Shanghai Financial Court (2022) Shanghai 74 Minchu case No. 2935, Shanghai High People's Court (2023) Huminend case No. 488, Guotai Junan Securities Co., Ltd. and CMIG Leasing Holdings Co., Ltd. bond transaction dispute;

[2].See Supreme People's Court (2016) Supreme Court Case No. 394, Shandong Shanshui Cement Group Co., Ltd. and China Merchants Bank Co., LTD. Corporate bond transaction Dispute;

[3].See Shanghai Pudong New Area People's Court (2015) Pu Min Liu (Shang) Chu Zi case No. 4310, Baosteel Group Finance Co., Ltd. and Baoding Tianwei Group Co., Ltd. other securities disputes;

[4].See Supreme People's Court (2020) Supreme Law Minend 708 case, Kaidi Eco-Environmental Technology Co., LTD., Founder Securities Underwriting and Sponsorship Co., LTD., corporate bond transaction dispute;

[5].See the official website of China Interbank Dealers Association:

https://www.nafmii.org.cn/ggtz/gg/201904/t20190410_198217.html;

[6].See Shanghai Financial Court (2019) Shanghai 74 Minchu Case No. 13, Shanghai High People's Court (2019) Huminend case No. 426, Corporate bond transaction Dispute between Zhonganke Co., Ltd. and Pacific Securities Co., LTD.;

[7].See China Bond Credit Rating Co., LTD. 's 2023 Bond Market Default Summary and 2024 Outlook:

https://www.chinaratings.com.cn/CreditResearch/Industry/TopicReport/143848.html;

[8].Refer to the wechat public account of “CICG”, “A Review of Domestic and Foreign Bond Rollover Situation”, authors Lei Wenlan, Wang Qing, et al.

[9].See Hangzhou Intermediate People's Court (2020) Zhejiang 01 Minchu Case No. 1691, Wang Fang and Wuyang Construction Group Co., LTD., Chen Zhizhang Securities false statement liability dispute;

[10].See China Bond Credit Evaluation Co., LTD., “Technical Depth Series” Bankruptcy Reorganization Cases of defaulted enterprises in the Bond Market, author Default Research Team, Yuan Ye.