Protecting Chinese Businesses' Financial Position in the UK: Managing Credit Risk (Part 1: Lending)

At one of our recent UK-China Legal Exchange events, we looked into challenging financial situations and how to use legal strategies to manage credit risks with Chinese businesses in the UK. 

We are often asked by Chinese clients to assist with distressed loans, debt recovery and shareholder disputes after a situation has already deteriorated. While legal tools such as asset tracing, freezing injunctions and disclosure applications are available, the costs can be high, and enforcement may be lengthy and challenging. The key to managing credit risk is to start before entering into a loan agreement, transaction or contract.

The UK's litigation and insolvency framework is well established, rules-based and creditor-focused, but navigating it effectively requires early planning, the right legal structures and a clear understanding of enforcement options.

In this series, we explore how Chinese businesses can reduce default risk when lending or investing in the UK, protect their position as suppliers, creditors and shareholders, and maximise recoveries in distressed situations.

These articles bring together key themes from our practice and provide practical guidance for China-headquartered organisations operating or investing in the UK.

Lending Solutions

One of the central themes is that credit risk management begins before a loan is made, not when problems arise.

For Chinese lenders, this means taking an end-to-end approach, including:

• Borrower due diligence and onboarding.
• Structuring lending arrangements appropriately.
• Putting in place robust security and governance measures.
• Planning for enforcement and recovery from the outset.

The structure of a loan can ultimately determine the outcome if a borrower becomes distressed. In particular, the type of security taken over a borrower's assets is critical.

Due Diligence 

Companies House in the UK provides accurate and reasonably up-to-date public information on UK companies, including details of their directors and officers, shareholders and shareholdings, articles of association, registered security interests, insolvency proceedings and, for most medium-sized and large companies, annual accounts. It is also possible to check the solvency status of most UK companies and individuals resident in the UK.

Many other jurisdictions do not provide the same level of publicly available information. We recommend that Chinese lenders obtain sufficient verifiable documentation to understand:

• The borrower's identity and ownership structure, including ultimate beneficial ownership.
• The borrower's authority and capacity to enter into the loan and any related security arrangements.
• The source of repayment funds, payment flows, banking arrangements and key counterparties.
• The security and asset position, including the nature of the assets, where they are located, how they can be secured under the relevant jurisdiction's laws, how security can be enforced, and whether any existing security interests may affect the lender's position.
• The covenant strength (ability to repay) of any personal or corporate guarantors.

Lending Agreement

English law has a long-established approach to loan agreements, the provisions of which have been extensively tested in the English courts. As a result, lenders and borrowers have a high degree of certainty as to how the courts will interpret loan documentation should a dispute arise.

English law loan agreements often follow a well-established structure and will typically include:

• A clear statement of the purpose of the loan, together with conditions precedent and drawdown mechanics.
• Negative pledge provisions.
• Clear representations, warranties and undertakings.
• Appropriate financial covenants and related performance metrics.
• Events of Default and any applicable cure periods.
• Acceleration and enforcement provisions.
• Links to a robust security package through separate security documentation.

Taking Security

In the UK, different forms of security can be taken depending on the assets available and the relative bargaining position of the parties. Common forms of security include:

Fixed charge

A fixed charge attaches to an asset that is, or is capable of being, ascertainable and identifiable, such as real estate, plant and machinery, shares or intellectual property.

On a borrower's insolvency, assets subject to a fixed charge are not available to the general body of unsecured creditors. The fixed charge holder has priority over the proceeds of those assets, subject only to the costs of realisation and certain limited prior-ranking claims.

Floating charge

A floating charge attaches to a class of assets that changes from time to time in the ordinary course of business, such as stock, fixtures and fittings, book debts and receivables.

A borrower is generally free to deal with those assets without the consent of the charge holder until the occurrence of a specified trigger event, at which point the floating charge will "crystallise" and attach to the assets within the charged class at that time.

While floating charges provide flexibility for borrowers, they offer lenders lower priority in an insolvency. Floating charge recoveries rank behind the expenses of an administrator or liquidator, certain preferential creditors and the prescribed part reserved for unsecured creditors.

Qualifying floating charge

Where a lender holds a qualifying floating charge over all, or substantially all, of a borrower's assets, that lender benefits from two significant advantages:

1. The holder of a qualifying floating charge may appoint an administrator using the out-of-court appointment procedure.
2. The holder of a qualifying floating charge has a degree of control over any competing out-of-court administration appointment process commenced by the borrower.

Key Takeaways

The key takeaway for Chinese businesses is that security should be carefully tailored to the assets available and the commercial objectives of the parties, with legal advice obtained at the structuring stage. Failure to take appropriate security, or to properly register it, can significantly reduce a lender's prospects of recovering its debt in the event of a borrower's insolvency.

Our Banking and Finance team has extensive experience advising lenders, including financial institutions and development finance providers, across a broad range of financing transactions. We provide tailored, practical and commercially focused advice throughout the full lifecycle of a lending transaction and have significant experience supporting China-headquartered businesses and investors. If you would like assistance with any type of lending arrangement, please get in touch.