24 November, 2015
Caveat emptor applies to more than just goods one buys off the shelf, but to stocks as well, as offshore investors in the People's Republic of China ("PRC") have learned. As the world has seen this past year, China's once booming stock market is not shatterproof. In fact, its remarkable growth slowed at alarming rate this year, so much so that the market took an abrupt nosedive and crashed spectacularly in August 2015. As a result, there are many foreign investors who increasingly may be concerned about protecting their onshore PRC investment. We had a chance to speak with Neil McDonald, Partner at Kirkland and Ellis and Head of its Restructuring Practice in Asia, about the concerns shared among offshore investors and what they can do to minimize loss and maximize investment security, and here's what he had to say.
Conventus Law – What recourse do foreign investors have in the PRC when the debtor company faces financial distress?
Kirkland & Ellis – The answer to that depends on the type of investment structures these investors have in the PRC. Most of the deals we work on are called ‘offshore bond structures’, where a company typically issues debt through a Cayman Island or Hong Kong vehicle and the bonds are issued to offshore investors, typically hedge funds or asset management companies. Unfortunately, the way these products are structured means that the investors don't normally have any recourse directly to onshore assets. What they have is some sort of collateral over offshore shares, but what they don't have is real security in the form of mortgages or other fixed charges over the actual assets which are almost always owned by the on-shore subsidiaries in the PRC.
What that results in is called ‘structural subordination’ – from a capital structure perspective the recourse of the off-shore lenders is really just to holding companies and not to the underlying value, which is always in the operating subsidiaries who actually own the factories, the real estate and the business you’ve ultimately lent to. If those on-shore assets have been collateralized or mortgaged to onshore lenders, as is increasingly the case, it means the assets are very hard to get to in a distressed situation. This is because the onshore lenders will usually take some sort of enforcement action to realize their security and get value for themselves. Therefore, the outcome for the offshore creditors at that time can be problematic.
CL – What measures can the PRC introduce that will give some relief to offshore subordinate creditors?
KE – I’m not aware of any specifically, but I do think that this is a big issue for the market as a whole. Given the recent volatility of markets, I would hope that the bond community will lobby for better structures that will give them at least equal recourse to assets onshore as that available to onshore lenders. Unfortunately, I don't see any regulatory changes on the horizon, so offshore bondholders will continue to potentially suffer as a result of defaults in this market. They will have to learn quickly that their recourse to onshore assets can be problematic in these types of circumstances.
CL – Are there contractual preventative provisions that can help protect offshore lenders and creditors who invest in or loan to PRC companies?
KE – It’s difficult to work directly around the structural issues, in terms of the regulatory environment, which doesn't permit onshore security to be given for offshore debt. However, the market has been looking at various forms of quasi-security – what have become known as ‘keeproll’ structures. I am a big fan of seeing ‘personal pressure points’ being taken by offshore lenders. For example, people who are investing in these situations should be insistent on getting personal guarantees from the owners or family members of the business and taking real offshore security so that this collateral can be utilized in the event of a default.
However, I believe the key to being truly successful in these structures is knowing at the outset who you are dealing with. People who are successful in private deals in this space invest in companies they know and trust and when they commit the funds it is viewed as the start of a relationship, not the end – they get close to management and stay in touch with the business on a regular basis so they don't find any ‘unwanted surprises’. The lesson here is that “prevention is better than cure” and being diligent at the outset through your credit process and maintaining vigilance throughout the history of the relationship is the best way to avoid problems. Unfortunately, the legal recourse is still imperfect and it is best to avoid that at all costs.
CL – The Enterprise Bankruptcy Law enacted in 2007 by the PRC is available to lenders and offshore creditors. However, it does not seem that many seek recourse under it. Why is this the case?
KE – The answer lies in the politicism of the Bankruptcy Law. In China, there is, culturally, still a stigma associated with bankruptcy so companies are worried about going into bankruptcy and using it as a tool to deal with their debt situation. Also, the Government is worried about enforcement actions for bankruptcy which may affect the rights of individuals, such as employees who work for a large state-owned enterprise, given that the employment relationship is more holistic in China and provides welfare for the employee, such as healthcare and housing, and not just a wage. Because of this the perception is that if a company goes into bankruptcy and there is a threat to the well-being of the broader stakeholders, such as employees, that is of great concern to the Chinese government who don't want to see instability associated with people out of jobs.
Also, a law is only as good as the infrastructure that supports it. For example, Chapter 11 in the U.S. is very successful, because we have a very experienced court system in the U.S. that administers the law and there’s a very experienced group of practitioners who help the courts administer the law. The situation in China is definitely improving, as this is a new law and the legal system itself is still developing, there is unfamiliarity with the benefits a law such as this can bring to companies that are in distress. Until such time as the lawyers, accountants and the judges who are administering this law start to have comfort and an understanding of its benefits, rather than the possible threats that it brings, we won’t see it really working usefully.
I think we need to give it time, it is definitely a good law and has all the structures and tools we would like to see. People just need to have confidence in it and hopefully over time we will see it used beneficially for all stakeholders – companies, onshore lenders and, hopefully, offshore lenders as well.
For further information, please contact:
Neil McDonald, Partner, Kirkland & Ellis
neil.mcdonald@kirkland.com
