Bankruptcy law's failings cut both ways
Offshore investors are poorly protected on the mainland and debt issuers across the border pay the price with higher funding costs
The provisional liquidation of China Metal Recycling (CMR) initiated by the Securities and Futures Commission opens up an intriguing possibility: could this end up in mainland bankruptcy court?
If so, it would be an important test case for offshore creditors in terms of their ability to recover money from a defaulted mainland issuer. That would give offshore investors a lot more confidence to lend to mainland firms, and that would lower these firms' costs of cross-border funding.
There are a handful of reasons to expect that CMR may go to mainland bankruptcy court: the SFC triggered the provisional liquidation in Hong Kong courts and may have the clout to expand the action to the mainland court system; the firm's main creditors are large banks, foreign and domestic, that could also put some pressure on the local government to let this go to court; the mainland's bankruptcy law was revamped in 2007 explicitly to recognise foreign bankruptcy proceedings and claims on onshore assets, and the law is overdue for a test. But that's all hypothetical. Foreign investors currently feel poorly protected by mainland bankruptcy court, and issuers pay the price.
Thomson Reuters data shows that mainland issuers pay substantially more than US firms for unsecured bonds of equal ratings and tenor (see table).
"A double-B rated Chinese real estate bond trades a lot higher than an equivalent double-B real estate credit from the United States. The US bond would yield 5 to 6 per cent compared with a 10 to 12 per cent yield for the Chinese bond," said John Wade, head of debt capital markets, Asia-Pacific, at RBS.
This premium rises the more lowly rated an issuer is. With firms rated below investment grade, where default is a real risk, investors will demand a hefty yield boost from mainland firms to compensate them for the risk that they would recover little cash if the firm became insolvent.
For example, mainland bonds issued this year rated C-minus (implying imminent default) yield an average of 34.17 per cent, while equivalent bonds issued by US firms only yield 13.05 per cent, according to Thomson Reuters.
"It can be difficult for foreign investors to get recourse in courts [on the mainland]. There is no rule of law and no precedents that the various courts are obliged to follow. There is on paper a modern bankruptcy law, but it is largely untested," said Donna Wacker, an insolvency specialist at the law firm Clifford Chance.
One firm did look set to test this bankruptcy law. In 2009, Guangdong-based Asia Aluminum defaulted on more than US$1 billion of debt. Offshore bondholders went after their money. Hedge funds Och Ziff Capital and Stark, working with investment bank Merrill Lynch, went as far as organising a bid for the firm from Norwegian aluminium giant Norsk Hydro, which would have seen all creditors getting all or most of their money back.
However, local political considerations took over. Guangdong government officials favoured a buyout from the former management team that kept the assets firmly in local hands.
The liquidator then decided against taking the firm through bankruptcy proceedings on the view that the Guangdong courts would be mainly interested in seeing the plant staying operational with jobs protected.
"It was made clear to us by the local government that they preferred the management team's bid. We invited other purchasers to go to the local government and promise investment and promise jobs. But there was no other credible alternative offer," said Rod Sutton, Asia-Pacific chairman of restructuring advisory FTI Consulting.
Sutton was previously head of Ferrier Hodgson, which was the court-appointed liquidator of Asia Aluminum.
Asia Aluminum was notable in that offshore investors had a clear claim, but, after weighing up their chances in bankruptcy court, they blinked. "We did not let the firm do a Chinese bankruptcy proceeding, because then there would be nothing for overseas investors. For any bankruptcy so far, there has been no return for offshore investors," Sutton said.
As it was, the management buyout meant that local and offshore banks were repaid in full, but bondholders got only 20 cents on the dollar. Holders of higher-risk instruments known as payment-in-kind notes got just one cent on the dollar.
Investor concerns are compounded by the fact that capital controls require mainland firms to use an offshore vehicle when raising funds in foreign markets. Firms may issue through their Hong Kong-listed subsidiary, or they may set up a special purpose vehicle for the transaction.
The practical implication is that offshore investors, in the event of a default, are subordinate to onshore lenders. Mainland banks would get their loans repaid long before offshore bondholders got their money, as was seen in the Asia Aluminum case.
Likewise, capital controls mean the subsidiary cannot pledge mainland assets against the offshore fundraising, effectively making almost all such issuance unsecured. The local lending is typically secured, however, meaning that domestic lenders get first dibs on assets in a bankruptcy.
"If there is any liquidation or default of offshore obligations, onshore creditors are likely to be in a better position to recover their lending, because onshore credit is often extended on a collateralised basis," Bei Fu, a Standard & Poor's credit analyst, said of a mainland default situation.
The rating agencies explicitly address this subordination issue with their notching criteria. For example, S&P will rate a senior unsecured note one notch below the mainland issuer of the security if the firm's onshore obligation exceeds more than 15 per cent of assets. If the issuer was a non-investment grade entity, S&P would downgrade the security by two notches if that number exceeds 30 per cent, Fu said.
S&P says onshore creditors are likely to be first in line for a repayment in a default. So their view is that, the greater the domestic obligations, the less likely there will be any money left for offshore unsecured lenders.
Mainland firms, in other words, typically have to pay more to borrow than issuers of equally rated credits from other markets.
The CMR case could plausibly wind up in a mainland bankruptcy court and provide a test for mainland bankruptcy law. The firm declared total borrowings of HK$7.2 billion in its last interim statement, of which bank loans comprised HK$5.6 billion.
CMR lists as its principal banks DBS, Standard Chartered, Bank of China, China Construction Bank, China Minsheng Banking and ICBC.
If the case went to court and the banks - including the offshore ones - were able to exercise claims on the issuer's mainland assets and thus get all or most of the money back, it would mark a leap forward in mainland bankruptcy law. The main beneficiary would be issuers, who would see an immediate boost to their ratings and a cut in their offshore cost of capital.