Preface

Since the outbreak of the pandemic, the economic downturn has led many enterprises to operate poorly and face bankruptcy. However, bankruptcy does not mean the end of an enterprise's life. For many valuable enterprises, bankruptcy reorganization is a win-win opportunity for investors, operators, creditors, and bankruptcy administrators.

In bankruptcy reorganization investment, investors expect high returns but also face relatively high risks. Failure to anticipate and guard against these investment risks is likely to result in the failure of reorganization investment.

Luheng will start a serialized analysis from this article on [Practical Issues Faced by Investors After the Ruling of the Reorganization Plan and Corresponding Solutions]

I. Risk that the Reorganization Plan Fails to Obtain Approval from Relevant Industry Administrative Regulatory Authorities

In practice, the ruling of the reorganization plan is implemented by the court. However, during the operation after the ruling of the reorganization plan, some industries may require approval from administrative regulatory authorities. Industry regulatory risks should be analyzed in advance when formulating the reorganization plan; otherwise, the entire reorganization plan or investment returns may not be realized.

Typical Scenarios:

• Reorganization plan of listed companies is rejected by the CSRC
• Mining enterprises fail to complete construction commencement procedures or obtain mining permits after reorganization
• Coking enterprises are ordered to suspend production due to non-compliance with environmental protection policies after reorganization
• Real estate enterprises fail to complete relevant land and sales procedures during the implementation of the reorganization plan

Preventive Suggestions: Policies change unpredictably. Investors must have sufficient and effective information channels to reasonably judge market trends and keep abreast of the latest developments in government regulation in advance. It is recommended to conduct in-depth communication with regulatory authorities before signing investment agreements to ensure that they will not become obstacles to the reorganization.

II. Risk of Inability to Execute the Reorganization Plan

Reorganization investment may also face the risk of execution failure.

Specific Manifestations:

• Failure of reorganization funds to arrive in a timely manner affects debt repayment, leading to the failure of reorganization and the debtor being declared bankrupt and transferred to liquidation proceedings

• Investment plan cannot be executed due to objective reasons, and the creditors' meeting refuses to modify the reorganization plan or there is no need for modification (e.g., adjustment of national industrial policies, shutdown of the industry, etc.)

III. Risk of Excessively High Tax Costs

At present, the tax authorities have not formulated special tax policies for enterprise bankruptcy reorganization. In accordance with general tax treatment rules, if an enterprise reduces a large amount of debts through the bankruptcy reorganization procedure, it is deemed to generate income, and the tax authorities may require the enterprise to pay income tax on the debt restructuring gains.

Involved Tax Types:

• Enterprise Income Tax (Debt Restructuring Gains)
• Value-Added Tax (Asset Transfer)
• Land Appreciation Tax (Land Appreciation)
• Deed Tax (Change of Asset Ownership)

Preventive Suggestions: Before signing the investment agreement, investors should research and collect relevant preferential tax policies for the target project, and negotiate with local tax authorities to obtain effective tax incentives or reductions/exemptions.

IV. Risk that the Common Benefit Debts from Financing for Project Construction Are Insufficient to Guarantee Enterprise Operation

During the implementation of the reorganization plan, to maximize the value of the reorganized enterprise's assets, the administrator may have realized the resumption of project construction through creditor's rights financing and signed resumption agreements with relevant construction units. The debts incurred therefrom are all common benefit debts. However, common benefit debts may be insufficient to guarantee the full completion of the resumption, and the costs incurred to achieve completion acceptance shall be borne by the investor. This may, however, affect the investment cost or investment returns.

V. Risk of Unfiled Claims

According to the provisions of Article 92 of the Enterprise Bankruptcy Law:

A reorganization plan approved by the people's court with a ruling shall be binding on the debtor and all creditors. A creditor who fails to declare his claim in accordance with the provisions of this Law shall not exercise his rights during the implementation of the reorganization plan; after the completion of the implementation of the reorganization plan, he may exercise his rights in accordance with the repayment conditions for the same category of claims as stipulated in the reorganization plan. The rights enjoyed by a creditor against the guarantors of the debtor and other joint and several debtors shall not be affected by the reorganization plan.

Risk Point: After the completion of the implementation of the reorganization plan, unfiled creditors may exercise their rights in accordance with the repayment conditions for the same category of claims as stipulated in the reorganization plan, thereby bringing risks to the debtor.

VI. Risk of Asset Liquidation

In the reorganization plan, the administrator generally packages the accounts receivable on the debtor's books as assets and hands them over to the investor for disposal. However, most of these accounts receivable have a long aging period, and the possibility of actual recovery is small. Investors should pay attention to the corresponding investment costs.

In practice, it is common for debtors to have some houses with ownership disputes. The disposal and liquidation of such assets are difficult, resulting in pressure on investment costs.

VII. Post-operation Risks

In the post-operation process of the reorganized enterprise, it also faces enterprise operation risks brought about by, but not limited to, changes in project administrative examination and approval and policy changes.

Currently, with shrinking demand, supply shocks, weakened expectations, and increased economic uncertainty, the valuation of original financing collateral is highly uncertain. Operational risks should also be a major consideration for investors investing in bankrupt enterprises.

VIII. Judicial Coordination Issues

Bankrupt enterprises will face some unique judicial issues.

Typical Issues:

• Difficulty in Unsealing Assets: Before entering the bankruptcy procedure, enterprises are often involved in numerous lawsuits, and their assets are sealed multiple times by multiple courts. Unsealing must be handled by the original seizing court, and the bankruptcy accepting court finds it difficult to coordinate.
• Difficulty in Credit Repair: Bankrupt enterprises are included in the dishonest list by multiple courts. During the implementation of the reorganization plan, it is necessary to remove them from the blacklist and restore enterprise credit, which is highly difficult to coordinate in practice.

IX. Reorganization Costs Exceeding Expectations

Although in the bankruptcy procedure, the administrator has tried to restore the enterprise's creditor's rights, debts and asset situation through various efforts, it is not foolproof.

(I) Debt Repayment Costs Exceeding Expectations

• Discovery of unfiled illegal guarantees during execution
• Compensation liabilities arising from lawsuits filed by minority shareholders
• Discovery of suspected crimes by original shareholders, which may lead to recovery claims against the enterprise by third parties
• The bankrupt enterprise failed to issue invoices after completing transactions, and the counterparty now requests supplementary invoicing, involving issues of tax deduction and fines

(II) Funds for Restoring and Developing Operations Exceeding Expectations

• Construction cycle is prolonged indefinitely due to various problems, resulting in a substantial increase in construction costs
• Due to market changes, the price of raw materials has risen sharply, leading to a decline in profits or even negative profits

X. Unsuccessful Integration

It is difficult to integrate the cultures of the investor and the debtor, and the businesses cannot be effectively integrated, and even mass incidents involving workers may occur. This is a risk faced by all equity mergers and acquisitions, and it is also a problem that must be clearly considered in the business plan.

Conclusion

Equity investment in reorganization is essentially equity merger and acquisition, but this action is carried out under the regulation of the Bankruptcy Law. Therefore, to effectively prevent these risks, it is necessary to be familiar with merger and acquisition operations and, more importantly, understand bankruptcy practice.

Investing in troubled enterprises is inherently a complex and risky undertaking. Reorganization investors need to build a team that closely combines professional capabilities such as legal, financial, commercial, and investment expertise to potentially avoid risks and obtain high returns.

Preview

Next, we will analyze the following practical issues of reorganization investment:

• Key Points and Difficulties in Asset Handover After Bankruptcy Reorganization Ruling
• Key Points and Difficulties in Operation Right Handover After Bankruptcy Reorganization Ruling
• Tax Issues After Enterprise Reorganization
• Contingent Claims You Must Know About in Bankrupt Reorganized Enterprises
• Main Paths and Practical Cases of AMC Participating in Reorganization Investment Enterprises
• Credit Repair of Reorganized Enterprises
• Equity Restriction Issues That Investors Fear Most
• Disposal of Equity in External Investments by Bankrupt Reorganized Enterprises
• Modification of Reorganization Plan Is Not as Easy as You Think
• Things to Know About Economic Compensation