Earth Research | A Preliminary Analysis of Creditor Rights Protection under the Enterprise Bankruptcy Reorganization "Debt-to-Equity Swap" System

Authors: Chen Xia, Wang Yueyu

As early as the 1990s, China had an underdeveloped capital market, and state-owned enterprises heavily relied on bank loans resulting in high non-performing loan ratios for commercial banks and excessive debt for state-owned enterprises. To address these issues, China began implementing debt-to-equity swaps, namely policy-based debt-to-equity swaps, to prevent and resolve financial risks.

With the launch of China's supply-side structural reforms, debt-to-equity swaps were once again used to rescue financially distressed enterprises. On October 10, 2016, the State Council issued "Opinions on Actively and Steadily Reducing Corporate Leverage" and its attachment "Guiding Opinions on Market-Oriented Bank Debt-to-Equity Swaps." In accordance with the spirit of the above provisions, debt-to-equity swaps were considered the most direct and effective means of reducing the "debt ratio" of debtor enterprises. In bankruptcy proceedings, through bankruptcy reorganization, creditors waive their original right to recover principal and interest upon maturity and convert it into equity investment in the debtor. Thus, market-oriented debt-to-equity swaps have become an important means of corporate bankruptcy reorganization.

However, to this day, China's laws and regulations on debt-to-equity swaps in bankruptcy reorganization are still unclear and are constantly being improved. There are different views in the theoretical community, and practices in the field are not uniform. When creditors participate in debt-to-equity swaps in bankruptcy reorganization, the protection of their legitimate rights and interests faces significant risks.

In practice, courts hold two views: View 1 uses the equity price determined in the reorganization plan as the basis; View 2 uses the actual value of the debt-to-equity swap for determination.

Regarding View 1:

Using the equity price determined in the reorganization plan as the basis has caused considerable controversy in practice. This is because, due to opaque information, creditors may question the pricing method and reasonableness of the debt-to-equity swap. In some cases, the debtor may use a backward calculation to determine the equity price to achieve a nominal repayment rate of 100%, while the actual repayment rate for creditors is far less than the nominal repayment rate. Moreover, with a 100% nominal repayment rate, the creditor-debtor relationship will be extinguished due to full repayment, and the guarantor's guarantee liability will also be extinguished due to the extinction of the principal claim. This method will lead to great uncertainty in the protection of creditors' rights.

Regarding View 2:

In the practice of bankruptcy reorganization using debt-to-equity swaps, if the equity price is not determined based on the actual value and is inflated, then the actual amount of debt repayment cannot simply be calculated based on the equity price determined in the reorganization plan, but should be determined according to the actual value of the debt-to-equity swap. Otherwise, it may seriously harm the legitimate rights and interests of creditors and violate the principles of fairness and good faith.

From the perspective of bankruptcy practice, the equity pricing of debt-to-equity swaps in reorganization plans is usually much higher than the actual value of the debt-to-equity swap. If the equity price determined in the reorganization plan is simply used as the calculation basis, it may seriously harm the legitimate rights and interests of creditors, and guarantors may also not bear the guarantee liability they should bear. Therefore, in the Supreme Court's reference cases, there are the following views: Supreme People's Court (2023) Highest People's Court Min Shen 1500 "Civil Ruling": "In the practice of bankruptcy reorganization using debt-to-equity swaps, if the equity price is not determined based on the actual value and is inflated, then when determining the scope of guarantee liability or compensation liability that the guarantor should bear, it should be determined according to the actual value of the debt-to-equity swap in accordance with the principles of fairness and good faith" [3]; Supreme People's Court (2021) Highest People's Court Zhi Jian 17 "Enforcement Ruling": "Because the actual value of the debt-to-equity swap equity obtained by a branch of a certain joint-stock company according to the "Reorganization Plan" affects the scope of responsibility of a certain group company, the actual value of the debt-to-equity swap equity should be determined through evaluation, reference to market prices, etc., and it should be determined whether a certain group company should continue to bear the guarantee liability and the scope of continued liability. The appellant's claim that it does not need to bear the guarantee liability solely on the grounds that the creditor has received full repayment according to the "creditor repayment plan" is not supported by this court" [4].

Choosing a debt-to-equity swap plan can quickly reduce the debtor's debt and significantly improve its operating conditions. In the process of resuming production and operation, it can attract investors to participate in saving the company, thereby obtaining equity dividends or equity disposal proceeds in the future development of the company, so that its own claims can be fully repaid or even profitable. However, it faces the risk that the priority claims are transformed into subordinated equity, and the debt cannot be effectively repaid due to the failure of the reorganization or the deterioration of future operating conditions, resulting in a serious devaluation of the equity; if the debt-to-equity swap plan is rejected, the creditor can realistically obtain part of the repaid claim without having to bear the risks of the debtor's reorganization and operation, but in this case, the proportion of claims repaid by the creditor is low, and therefore, the opportunity to receive a high proportion of claims may be lost.

Article 87 of the People's Republic of China Enterprise Bankruptcy Law stipulates that "If a partial voting group does not pass the restructuring plan draft, the debtor or administrator may negotiate with the voting group that did not pass the restructuring plan draft. The voting group may vote again after negotiation. The result of the negotiation shall not harm the interests of other voting groups. If the voting group that did not pass the restructuring plan draft refuses to vote again or the restructuring plan draft is still not passed after voting again, but the restructuring plan draft meets the following conditions, the debtor or administrator may apply to the People's Court for approval of the restructuring plan draft".

"Cash + Debt-to-Equity Swap" is one of the more popular repayment methods in bankruptcy restructuring today, that is, ordinary claims below a certain amount are repaid in full in cash, and claims exceeding that amount are implemented as debt-to-equity swaps at a certain price ratio. Repayment in this way allows the small creditor group to be fully repaid in cash, which is conducive to the passage of the restructuring plan draft in the voting; secondly, the repayment rate of ordinary claims is increased to 100%, far exceeding bankruptcy liquidation. According to Article 87 of the People's Republic of China Enterprise Bankruptcy Law, "According to the restructuring plan draft, the repayment ratio obtained by ordinary claims shall not be lower than the repayment ratio that can be obtained under bankruptcy liquidation procedures when the restructuring plan draft is submitted for approval, or the voting group has already passed the restructuring plan draft." Through the above method, conditions will be created for the court to compulsorily approve the restructuring plan, thereby increasing the success rate of restructuring. However, due to disputes over the valuation of debt-to-equity swaps and the amount of creditor repayment, court-ordered enforcement in this situation will lead to great uncertainty in the protection of creditors' rights.

In summary, if the "debt-to-equity swap" repayment method is adopted in the bankruptcy restructuring procedure, creditors should pay close attention to the following points:

1. Pay attention to the pricing of equity and the agreement on the handling of secured claims in the restructuring plan draft, and carefully cast a vote in favor;

2. Supervise the third-party evaluation process, communicate fully with the appraisers, and ensure the objectivity and fairness of the evaluation results;

3. Improve the equity exit mechanism to avoid long-term holding of equity without being able to realize it. Equity exit can be achieved through methods such as the restructuring company repurchasing equity or transferring it to others.

4. For secured creditors, firstly, after the implementation of the debt-to-equity swap, if the original claim enjoyed by the secured creditor against the bankrupt enterprise is extinguished due to repayment, resulting in the extinction of the guarantee liability. Actively claim to determine the actual value of the debt-to-equity swap equity through evaluation, reference to market prices, etc., and then determine the scope of the guarantor's guarantee liability; secondly, creditors should carefully cast a vote in favor in the voting on the restructuring plan draft, otherwise, reaching a consensus with the debtor on the debt repayment plan will be deemed to have waived the right to claim against the guarantor.

5. If there is a dispute over the valuation of debt-to-equity swaps and the amount of creditor repayment, carefully cast a vote in favor to avoid the risk of court-ordered enforcement;