A non-performing loan (NPL) is a loan where the borrower is unable to service the debt, either through the non-payment of principal or interest payment, or both. Different classifications of loans in default exist, often depending on the estimated percentage of loss of principal and interest after taking into consideration commercial and legal measures. Classification could also be based on simply the number of days that the borrower is in default of the payment. According to the China Banking and Insurance Regulatory Commission, Chinese commercial banks held a total of RMB2.41 trillion of NPLs by December 2019.
The continuous rise of NPLs has contributed to an increasing number of restructuring and financing transactions in the market and, in particular, transfers of NPLs by lenders to potential buyers. The commercial consideration is always complex and diverse, and professional advice should be sought in relation to a number of areas, including due diligence around the valuation of the loan portfolio, structuring and pricing of sales, post-completion loan servicing and recovery, etc. From a legal perspective, the following factors should be looked at carefully:
- Legal analysis on the transferability of NPLs – certain jurisdictions may have restrictions on the transfer of bank loans generally, or specific regulations in relation to the types of loan receivables (e.g. mortgage or consumer loans); these will need to be examined in conjunction with the transfer provisions in the loan documentation. The analysis is further complicated when multiple projects or facility lines are potentially involved.
- How the transfer of NPLs will be carried out – the transfer of NPLs are often carried out by way of assignment or novation of the rights and/or obligations of the banks, which in most cases result in the debts being taken off the balance sheet of the banks. Generally, novation requires consent of the obligors and assignment involves service of notice on the obligors. However this may not be feasible depending on the number of obligors involved. If banks wish to transfer NPLs without the knowledge of the obligors or without removing them from the book, they may consider funded sub-participation to share the risks with other banks which leaves the underlying loan relationship and documentation intact.
- The due diligence and analysis of the existing security package – in addition to the usual legal due diligence on the legality and validity of the security interests, transferability of securities may also require consent of the counterparties or other registrations with relevant authorities. Unsurprisingly, this will result in more emphasis on advising potential buyers on the risks relating to enforcement of security and any applicable registration/filing. This may be further complicated by the number of jurisdictions involved as specific reciprocal of foreign judgement and filing requirements will have to be mapped out, including consideration on the priority of the competing security interests. In addition, it is common for NPLs to be secured on real estate properties, especially in China therefore specialist local legal and tax input is essential.
- Enforcement of offshore security – where loans have been made offshore, there may be charges granted over the shares in one or more offshore companies. The enforcement of such security can be complicated where the defaulting borrower group withholds consent to changes to the registered ownership of the shares. This can result in offshore litigation and it is sometimes simpler to seek the winding-up of offshore entities and appointment of liquidators.
- Bankruptcy and insolvency issues – the parties should seek advice on the potential impact of insolvency laws on the transaction and on the potential enforcement of NPLs. In some jurisdictions, a transaction at an undervalue can be set aside in the event of insolvency; this could affect a transaction if the original lender went into an insolvency process after transferring loans at a discount. Any repayment of a debt by an insolvent debtor might be subject to challenge on the basis that it is a preference given to one creditor. An insolvent debtor may be able to restructure its debt by a bankruptcy process or scheme of arrangement, such that the buyer of NPLs would be unable to recover them at full value.
The transfer of NPLs requires detailed analysis on a wide range of aspects, and the legal considerations outlined in this article are by no means exhaustive. Each sale of a NPL has its own unique features and considerations that may render one structure more suitable than others. Both selling and buying banks and other financial institutions are strongly encouraged to seek professional advice in all aspects in order to maximise the potential value of the NPLs.
Banking & Financial Services businesses find themselves under scrutiny like never before from the general public, the media, politicians and their own clients, putting an increased focus on governance, risk and accountability, tax, executive compensation and capital requirements. Our offices provide easy access for financial institutions looking to conduct transactions with international entities and receive expert multi-jurisdictional advice. In particular our Hong Kong team has been providing expertise on financing and restructuring for over 30 years and are often sought to advise on the offshore aspect of Chinese NPLs in Mandarin, Cantonese or English.
 CBIRC releases supervisory statistics of the banking and insurance sectors 2019 Q4. Dated 17 February 2020. www.cbirc.gov.cn/en/view/pages/itemdetail.html?docid=891703&itemid=983