Fair adjustments to shareholder interests in reorganisations

Under China’s Enterprise Bankruptcy Law, adjustments to shareholders’ equity under a debtor’s reorganisation plan should be fair and equitable. In practice, however, most reorganisation plans only briefly describe these adjustments, making it difficult to assess whether they are fair or otherwise.

The standard statement goes: the debtor is deeply insolvent. Asset valuations, audits and/or solvency analyses confirm that the value of shareholders’ equity is nil. To avoid liquidation, shareholders should join creditors in bearing the cost of the rescue, transferring their shares for zero or RMB1, or by court order.

The reasoning is simple. If creditors cannot be paid in full, and shareholders would get nothing in a liquidation, then shareholders’ equity should also be written down to zero in the reorganisation.

In practice, most zero-equity adjustments have specific causes. Shareholdings may be concentrated, with mutual distrust between existing shareholders and the reorganisation investors. The debtor may have entered reorganisation too late, with assets insufficient to cover all debts, wiping out equity value. Shareholders may be personally burdened by heavy joint debts and unwilling to retain their stake, or they may have breached their fiduciary duties, leaving them no claim to keep anything.

Yet none of these circumstances necessarily justifies writing equity down to zero. In some cases, the adjustment looks suspiciously unfair.

This article focuses on the fairness and legitimacy of retaining shareholders’ equity in the reorganisation of private, unlisted companies. Unless stated otherwise, “debtor” refers to an unlisted company in reorganisation proceedings.

Reasons to retain

In adjusting shareholders’ equity, the rules of best interest and priority under the Enterprise Bankruptcy Law must be met. Creditors should gain greater value from reorganisation than they would in liquidation; and while ordinary creditors are not paid in full, shareholders may not obtain any profits from the debtor. If these conditions are satisfied, the debtor’s shareholders are entitled to keep a stake in the reorganised company. The reasons are as follows.

Retained stake reflects the value created by the debtor’s turnaround. If the original shareholding had zero value in bankruptcy, retaining a small percentage of the reorganised company does not breach the priority rule. Whether that stake rises in value will depend on the debtor’s management and ability to recover, not on how much debt has already been repaid.

There is more than one way to value a company’s equity. Static financial indicators from valuations and audits can give parties in reorganisation proceedings a basis for concluding that equity value is nil. But the reorganisation investor should also be free to value the debtor from a dynamic standpoint, and to negotiate that valuation with the original shareholders.

Certain elements critical to company survival do not appear in valuation or audit reports. Brands, licences and goodwill, all essential for operation, are not captured in valuations, nor can they be sold to pay creditors. The value of such “shell resources” should not be overlooked, although they only hold value if the debtor remains a going concern.

Retaining equity encourages and protects venture capital. Equity investment funds are an engine of economic growth and deserve protection. Many hold only a single-digit percentage stake, play no part in management, and are effectively creditors. Just as creditors accept a reduced recovery under a repayment plan, scaling down their stake proportionally rather than writing it to zero protects their interests.

Furthermore, where the debtor’s value lies in personal relationships among its owners, retaining the original shareholders may help the investor integrate its assets, staff and operations. Keeping some equity also demonstrates to shareholders how reorganisation differs from liquidation in terms of their own interests, thus improving the chances of securing the investor group’s approval.

Fair amount, fair play

The retained stake should differ between controlling shareholders and others. Controlling shareholders should be examined for breaches of fiduciary duty, and for responsibility for poor business decisions. For other shareholders, the analysis should weigh the timing and valuation of their investment rounds.

Creditors should be given the option to convert their claims into shares. To ensure fairness, the reorganisation investors could divide the company’s equity into three parts: the portion held by the investors; the portion retained by existing shareholders; and the piece available for creditors to convert into. If creditors believe the debtor can be turned around, they may swap their claims for equity to reap the rewards of its recovery.

The amount of equity to be retained should also reflect the contribution shareholders are expected to make to future operations.

Advice to investors

With professional institutions becoming more involved in reorganisation deals, investors have grown more sympathetic to the position of original shareholders and more willing to work with them. That said, the reorganisation investor should still retain control and impose restrictions on any shareholders whose equity is preserved.

Set up a special purpose partnership to hold the retained equity on behalf of the original shareholders. By controlling the partnership, the investor can prevent the original shareholders from interfering in corporate governance and strategic decisions.

Tie the retained equity to contribution to the debtor’s turnaround. Place the shares in an incentive pool and transfer them only when the original shareholders have successfully helped improve the debtor’s performance.

Wang Zhenxiang is a partner at Jingtian & Gongcheng