14 August, 2015
Much has been written and discussed regarding the structural subordination of an offshore lender and investor. Yes, it is much harder to participate in an onshore restructuring for any investor/lender that has their exposure through an offshore vehicle. That is hardly new news.
What is new however, is the steps that many offshore parties are taking to leave themselves better placed if there is a default, the lessons that can be learned from past strategies employed and what experience shows is the best way to achieve results.
In this article we explore the enforcement environment in China from the angle of the foreign investor or lender and the key lessons that have been learnt.
Gaining Control in China — It Is Getting Better
The bane of the existence of the insolvency practitioner appointed to an offshore company is often getting control of the onshore business following the occurrence of a default. This has often been difficult and problematic where the existing Legal Representative refuses to hand over the chops and business license of the onshore company. Faced with such resistance, the insolvency practitioner is generally forced to apply to the relevant Chinese Court to have resolutions they have passed appointing a new Legal Representative declared valid by the Court and seek to have new chops made.
However, in recent times, the process does seem to be getting better. Why is that? It could be because after all these years, the Chinese Courts have become more accustomed to the types of applications being made by the foreign insolvency practitioner. Or maybe it is because the insolvency practitioner and their PRC legal counsel have become better at making the applications. Or maybe the policy makers often hidden away in the background are finally accepting that the insolvency practitioner is better placed to restructure the debt laden onshore company. Or is it a temporary blip in the application of common sense (and the law)? The truth is we don’t really know but it is probably a combination of all these factors — hopefully not too much of the latter.
It certainly is the case that the foreign practitioner and their onshore legal counsel are more experienced in seeking to take control and are working the system better. That is not to say all such applications go smoothly, that they won’t be subject to frustrating delays or that they are all successful. But recent experience does show that the tide has turned in favour of the insolvency practitioner. Long may it continue.
Too Many Parties Aren’t Paying Attention to Their Exposures in China
It is a difficult environment in which to find good deals to do. Competition for the best deals is tough; parties need to move quickly; they need great connections. Yes, doing the deal is tough but it is often amazing how little attention the deal receives post completion. It isn’t good enough simply to receive, or wait quietly for, the annual accounts from the Chinese business partner. Or to ask some questions by email and be mildly accepting of a vaguely informative response to some of the many questions asked.
Investors and lenders must actively monitor their investments. This means if it was agreed to put in place certain governance structures post investment, that these rights are actively and promptly pursued. It means regular meetings with Chinese business partners, ensuring regular access to information and obtaining satisfactory answers to all questions asked.
If there is one lesson above all others we want investors and lenders to heed, it is that doing nothing, gets nothing. If there is a problem, it almost never gets better by doing nothing.
Substantial value can be destroyed by sitting idly, by wanting to believe management will do the right thing and by believing the next promise will be acted on after the previous half dozen broken promises.
If there is one lesson above all others we want investors and lenders to heed, it is that doing nothing, gets nothing. If there is a problem, it almost never gets better by doing nothing. Proactive, assertive action might bring forward a loss, but it will be a smaller loss than the one suffered two or more years later after taking no or very little action.
Fraud — Same, Same But Different
First of all, don’t let anyone make you believe there isn’t much fraud occurring in Chinese companies. Sadly, the position is probably far worse than you can imagine. A low interest rate environment, companies desperate for access to cash and management needing to show results in a slowing economic environment, creates a perfect platform for fraud. And with there being more corporate debt in the PRC than among even U.S. companies, it is a sure bet that a meaningful enough proportion of that debt is funding fraud or losses connected to that fraud.
So, no change there. But the types of frauds that are occurring are a bit different. The frauds of Moulin Global Eyecare and Peace Mark Holdings are different than the alleged frauds of Sino Forestry and those alleged by short sellers. The fraud seems to be growing in sophistication. Or is it? Maybe there is less “bad fraud” (outright fake businesses) and more “good fraud” (accounting manipulations) although the low interest rate environment is likely helping to hide the extent of bad fraud that is occurring.
One thing is for sure, there are warning signs to fraud if you know where to look. We do. A key starting point is actively monitoring the investment or loan and being proactive if the situation is not going to plan.
The Best Results Will be Consensual
Let’s face it, in an enforcement type scenario in relation to offshore exposures and an onshore business, returns can often be poor. This is usually a function of the offshore lender/investor’s position in the capital structure, the often alarming levels of onshore debt that have built up and the poor underlying performance of the onshore business.
It will also be a factor of the position of the foreign investor or lender in the capital structure. As such, the best success stories in relation to Chinese restructurings with offshore exposures, are consensual outcomes. This requires compromise by both parties, and whilst onshore litigation might ultimately prove successful for the offshore party or their appointed practitioner, the one to two years it might take to win in a Chinese court could have destroyed a lot of value in the meantime.
Find Some Leverage
If a lender or investor is struggling to achieve that consensual restructuring, it is essential to find some leverage to use to either help find a way to achieve a consensual restructuring or to improve returns. What are the pressure points that each party can bring to bear to help get a result they want, or at least are comfortable with.
And if an offshore party seemingly has limited leverage, how can they identify pressure points they can bring to the table. The use of investigative due diligence to find weak spots in the other side’s position can be incredibly valuable and is something we have frequently done using FTI’s Global Risk and Investigations Practice.
Having a structure in place that can help swift action to be taken is also essential. For example, ensure a share pledge or offshore security is taken to enable the prompt appointment of a Receiver rather than relying on pursuing an unsecured claim through an offshore court. What offshore assets are there that could prove to be valuable security if things go wrong e.g. security over offshore receivables, requiring cash to be held in offshore bank accounts, pledges over intercompany loan accounts and even personal guarantees can be useful areas of leverage to apply. The existence of offshore assets might also allow for a mareva injunction to be applied for to freeze those assets in the right circumstances.
As such, the best success stories in relation to Chinese restructurings with offshore exposures, are consensual outcomes. This requires compromise by both parties.
Offshore Investors/Lenders Aren’t Using the Enterprise Bankruptcy Law
In 2007, the PRC Government enacted the Enterprise Bankruptcy Law. It was and still is a gleaming example of progressive bankruptcy law. On paper, the application of the law however has been a bumpy ride with inconsistent results, a lack of understanding of its operation and many judges refusing to accept applications on spurious grounds. Whilst there have been some high profile examples of use of the law, it can hardly be said to be a success to date, especially from the perspective of the offshore investor/lender. And the reality is very few offshore lenders or investors will be advised to or be prepared to seek to use the Enterprise Bankruptcy Law.
For further information, please contact:
Nick Gronow, Managing Director, FTI Consulting
nick.gronow@fticonsulting.com
