China Orienwise's debt default lesson for investors buying into mainland bonds

In the heady boom of the mid-noughties, a US$4 million stake in a newly issued bond by China Orienwise, one of the mainland's fastest-growing loan guarantee companies and a niche play on the country's burgeoning credit markets, must have looked a sure-fire bet. Eight years later and that bet is now a cautionary lesson for investors studying the vagaries of the Chinese offshore debt market.

That is because foreign bondholders get short shrift on the mainland when it comes to defaults.

Foreign investors are "essentially taking equity risk", when they buy a Chinese offshore bond, says Ying Wang, a director of corporate ratings at Fitch, as "offshore creditors are structurally subordinate to onshore creditors" and need to negotiate a local court system that favours local parties and is inexperienced at handling international bond defaults.

It is a warning that comes too late to Orienwise bondholders.

Backed by private equity giants General Electric and Carlyle Group, Orienwise made money by guaranteeing loans between state-run banks, used to lending against fixed assets rather than future cash flow, and fast-growing but asset-poor small and medium-sized enterprises. The strategy worked well for a while, helping propel company founder Zhang Kaiyong into the Forbes rich list, and gave credibility to a Morgan Stanley-backed US$100 million bond issued on the Singapore stock exchange in 2006.

One company to snap up 40 tranches of the US$100,000 senior notes, yielding 10.5 per cent, was LIM Advisers, a Hong Kong hedge fund group with US$2 billion under management.

In June this year, LIM applied to the high court in the British Virgin Islands to wind up what is left of Orienwise's offshore operation, according to court filings, in a belated effort to claw back more than US$3 million in unpaid capital and interest.

LIM had earlier sold half its debt holding in September 2008 shortly after Orienwise announced it was investigating an alleged fraud. The cause of the fraud was not publicly revealed but the foreign private equity backers quietly took a hit and left. One year later and Orienwise formally defaulted on its payments.

"Unravelling the structures behind this liquidation is a learning experience that will inform LIM's future investments in Chinese entities with offshore structures," said a source with knowledge of the court case who spoke on condition of anonymity.

LIM declined to comment, citing the continuing court action.

Pairing international investors hungry for China exposure with Chinese firms seeking onshore-beating lending rates, Chinese offshore debt issuance has grown 25 per cent a year since 2009, and now totals US$332.4 billion, according to data from Thomson Reuters.

While it is not clear if LIM expects to be successful in its court action or if this is simply an exploratory exercise, the hedge fund chose to walk away from a five US cents on the dollar debt for equity swap that was offered to bondholders in 2009.

It is a paltry sum by international standards, where the average recovery rates on unsecured or subordinated bonds between 1982 and 2010 ranged from 24.7 to 36.7 US cents on the dollar, according to one Moody's study.

Attempts to contact Orienwise for this article were unsuccessful. The company was cited in court filings telling LIM: "We are regretting to tell you that currently we are still incapable of handling the creditor's request of settlement of debt."

A look at Orienwise's original prospectus highlights one challenge for LIM. A diffuse holding structure that includes eight offshore and nine onshore entities makes it difficult to identify where assets may be hiding, or indeed, if the original structure still exists.

It is a problem that confronts administrators worldwide when they wind up a company and stake claims for the various creditors, but what makes China especially galling for investors is the obfuscation used to mask assets from a courts system inexperienced in handling complex bond defaults.

Creditors of Suntech Power Holdings, a Cayman Island-registered Chinese solar panel manufacturer, which defaulted on a US$541 million offshore bond last year, are wondering what happened to their assets after a restructure and eventual sale of several Suntech units to Hong Kong-listed Shunfeng Photovoltaic International in April, reportedly without the approval of PwC, Suntech's court-appointed provisional liquidator.

Additional Suntech assets were also sold in February without PwC's blessing to a newly incorporated BVI entity called Fast Fame Global for US$1, according to court documents.

Shunfung has denied any wrongdoing. It is not clear who owns Fast Fame.

Since then, PwC has filed injunctions in Singapore, where some of Suntech's onshore Chinese assets are registered, and a BVI lawsuit against Suntech's Japanese business, in an effort to halt further transfers. Claims have also been filed in Shanghai where PwC had some success in getting the court to accept the cases pending court hearings.

Creditors will continue to stumble until the market has more orderly restructurings, argues Vijay Chander, an executive director of the fixed income department at Asia Securities Industry & Financial Markets Association, a industry trade group.

Without immediate recourse to onshore assets, overseas bond holders can only take comfort in a range of hard-to-enforce commitments - including equity injections, letters of credit, and keep well deeds - all designed to encourage the issuer not to default on its obligations.

"They fall well short of guarantees … but equally, there is a measure of comfort that can be derived from some of these structures," Chander said, "but they need to be tested."

A well regarded but rarely tested bankruptcy law means Chinese courts have little experience handling either corporate or bond defaults. Last year, there were only 2,000 corporate bankruptcies proceedings filed in the courts, says Ying.

Attempts to navigate the local courts system can also fall foul of local politics. In 2009, Guangdong-based Asia Aluminum Holdings defaulted on offshore debt worth US$1 billion but a plan by international hedge funds to structure a rescue buyout by Norweigan aluminium giant Norsk Hydro fell flat after local officials expressed preference for a local management buyout - and so keep the assets under Chinese control.

"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," Rod Sutton, the Asia-Pacific chairman of restructuring advisory FTI Consulting, said at the time.

Foreign bondholders received 20 US cents on the dollar and "just got screwed up", said Ying. Holders of higher-risk instruments known as payment-in-kind notes got just one US cent on the dollar.

"I don't know when we will see the system being more developed," said Ying. "That's the question everyone wants to know the answer to."