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PLC Global Finance Q&A Guide to the Financial Crisis: China
Practical Law UK Articles 1-385-1935 (Approx. 17 pages)
PLC Global Finance Q&A Guide to the Financial Crisis: China
by Fred Chang, Wang Jin, Xu Liang, Kurt Tiam, Wang Liang, Gaston Fernandez, Lovells LLP
| Published on 04 Mar 2009 • China |
A Q&A guide on the causes, effects and regulatory impact of the financial crisis in China.
Section 1. Financial markets
The headline direct market impact of the global crisis were:
- The decline in private equity and other foreign direct investment (FDI) into China (37% decline between 2007 and 2008, as well as liquidation of existing investments).
- The capacity overhang in the export sector.
- The havoc wrought on Chinese corporate balance sheets and profitability as a result of commodity price volatility (many Chinese processors of raw materials have been badly damaged by the global fall in demand for goods, and have also lost money on commodity hedges).
Indirectly, the headline market impacts were the severe price declines in domestic real estate and stock markets in which much of the public's savings had been invested.
For some background information about the Chinese economy, see box, The Chinese economy: some background information.
The Chinese government has used three principal tools to revive the economy, with details of the fourth (fiscal stimulus) yet to emerge. These tools are:
- Tax policy.
- Monetary policy and loosening of restrictions on the extension of credit.
- The ability of financial institutions to raise liquidity (see Question 8).
Various VAT rebates were enacted in 2008 to stimulate consumer- and export production-oriented industries. Also in 2008, the People's Bank of China (PBOC) (the central bank) announced a series of reductions in interest rates for bank lending, reserve rates, and deposit rates.
Further, the China Banking Regulatory Commission (CBRC) (formerly part of the PBOC until regulatory functions were stripped away from monetary functions) and the State Council (the highest organ of government in China) laid down a number of directives and guidelines in December to encourage the extension of credit in a number of areas:
- CBRC announced the repeal of the prohibition against Chinese bank lending to finance company acquisitions, provided adequate risk management was in place at such banks.
- The State Council issued a policy statement encouraging relaxed credit towards rural and SME borrowers.
- The State Council issued various directives to promote increased lending to the flagging residential real estate sector, particularly low-income housing.
There is also a RMB4 trillion stimulus plan. This is reportedly to be allocated, under the joint administration of the Ministry of Finance (MOF) and National Development and Reform Commission (NDRC), to:
- Transportation and power infrastructure (RMB1.8 trillion).
- Disaster reconstruction (RMB1 trillion).
- Rural development (RMB0.37 trillion).
- Environmental protection (RMB0.35 trillion).
- Low-rent housing (RMB0.28 trillion).
- Technology (RMB0.16 trillion).
- Health care and education (RMB0.04 trillion).
In the interim, the government has intervened to support the airline/manufacturer sector, by passing on reductions in the prices of diesel, jet fuel and gasoline to the airlines and manufacturers. On 9 December 2008, the Civil Aviation Administration of China issued a directive to airlines to cancel or suspend pending aircraft orders, ground parts of their fleets, and return rented aircraft.
In addition, the government has supported the SME sector with tax incentives, licensing incentives and enhanced financing alternatives, highlighted in the 22 September 2008 memorandum issued by 11 ministries and commissions (Guidance Opinions on the Promotion of Entrepreneurship to Drive Employment).
China has witnessed a decline in the power of its export engine, as well as in the valuations of their various overseas investments resulting from concurrent devaluations of foreign currencies and foreign equity indices. The basic thrust of the government response to the financial crisis is fiscal and monetary stimulus, without the added complexity of reform and restructuring required in many Western economies (Chinese reforms and restructurings have been proceeding for decades independently of the current crisis).
The likely result is an upgrade in domestic investment and domestic consumption. An additional technical result may be a re-examination of foreign participation in selected types of cross-border transactions, which in recent years came under increasing scrutiny (Guangdong Development Bank, Xugong, the sell-off of "strategic investments" in Chinese banks, suspicion of hot money invested into China by private equity firms and hedge funds). To maximise the potential for consolidating transactions, financed by bank loans, it may be necessary to re-welcome certain types of foreign advisory and/or investment. Some consolidating transactions will be purely among domestic parties, but others will involve a Chinese buyer and foreign target and a few may even involve a foreign buyer and a Chinese target.
In view of depressed prices in the global recession, such re-examination may focus on the greater value an industry player may be willing to pay for a controlling or co-investment stake, compared to what a financial sponsor may be willing to pay.
Corporate loans
In the latter part of 2008, to control inflation the banking regulators reversed course from the tight credit policy on which they had embarked in late 2007 and early 2008. Because of foreign capital looking for exits, and exchange rate and commodity price swings and rising labour costs causing severe profitability and liquidity issues for a large number of companies, it was necessary to find new methods to restore liquidity.
First, high level pressure from the CBRC has increased available credit from the banks. Second, increased access has been afforded to new corporate bond issuers in the current so-called "inter-bank" market in which institutional investors and financial institutions trade money market and longer term debt securities of government-linked enterprises and listed companies. In a related development, in January 2009, the China Securities Regulatory Commission (CSRC) and the CBRC jointly issued a memorandum announcing that listed commercial banks could now engage in trading on the inter-bank market, adding a huge source of liquidity. Third, acquisition finance, SME finance and other forms of financing have been encouraged by the CBRC.
Trends in loan documents
Some trends can be perceived in loan documents, such as:
- Increasing inclusion of cross defaults.
- Increasing inclusion of other events of default triggered by specific indications of credit deterioration.
- Increasing inclusion of debt coverage and fixed charge ratios.
- Increasing lender discretion rights to invoke material adverse change clauses.
Initiatives by the CBRC
Below are some of the leading initiatives taken by the CBRC in 2008 to stimulate the flow of credit throughout the economy.
On 6 December 2008, the CBRC issued the Guidelines for Risk Management for Commercial Banks Providing M&A Loans. Various requirements for managing related risks are set out. For example:
- The loan term must not exceed 5 years and must be less than 50% of the transactional value.
- Debt incurrence restrictions, prepayment from excess cash flow, and restricted payment provisions must be included.
To provide M&A loans, commercial banks must have:
- Sound risk management and internal control mechanisms.
- Reserves for impaired loans no lower than 100% of required minimum reserves.
- A capital adequacy ratio no lower than 10%.
- A general reserve no lower than 1% of the aggregate outstanding loan amount.
- A professional group performing due diligence on M&A loans and appraisal of related risks.
On 1 December 2008, the CBRC issued the Guidance Opinion on Banks Establishing Specialised Institutions Providing Financial Services for Small Businesses, specifying the business scope of special institutions established by banks and providing finance services for small businesses. These institutions are permitted to apply for finance certificates and business licences, distinct from those granted to larger commercial banks.
If a bank intends to set up such institutions to lend to small businesses, their financial statements must be tallied separately when calculating profits and costs. They must also establish an efficient and independent credit/loan examination and approval system. In addition, such institutions must establish effective risk management, loans impairment reserves and a loan classification system. It is thought that these institutions will specialise in granting loans to small enterprises and provide credit more willingly than the larger banks, which focus on larger enterprises.
This Opinion continues CBRC's policy of encouraging lending to small enterprises. In a previous Guidance Opinion on Banks' Lending to Small Enterprises (effective from 29 June 2007), CBRC provides incentives for banks and local financial institutions to grant more credit to small enterprises, such as approving an increase in the number of branches they can open.
On 4 May 2008, the CBRC issued the Guidance Opinion on Pilot Operation of Microfinance Loan Companies. Micro-finance loan companies are companies providing small-sum loan services and are not allowed to accept public savings. The target customers of micro-finance companies are farmers and small enterprises. A micro-finance loan company cannot be financed by more than two banking financial institutions, and the fund contribution from banking institutions cannot exceed 50% of its net capital. Establishing a micro-finance loan company requires less minimum capital (RMB5 million for a limited liability micro-finance loan company, and RMB10 million for a joint stock micro-finance loan company) and is more quickly approved than a bank.
On 24 January 2008, CBRC issued the Administrative Measures for Vehicle Finance Companies, clarifying the requirements to set up a vehicle finance company and the necessary qualifications for investors in such companies. A vehicle finance company is a non-banking company, but its incorporation is subject to CBRC approval. The "major shareholder" (the largest shareholder having over a 30% shareholding in the vehicle finance company) must be a trader or manufacturer of complete vehicles, or a non-banking financial institution. Vehicle finance companies must comply with the following requirements:
- Their capital adequacy ratio must not be lower than 8% and their core capital adequacy ratio not lower than 4%.
- A line of credit to any given borrower must not exceed 15% of the net capital.
- A line of credit to a given group must not exceed 50% of the net capital.
- A line of credit to one shareholder and its related parties must not exceed the contribution amount of that shareholder.
- Self-owned fixed assets must not exceed 40% of the net capital.
The bankruptcy of a bank is different from the bankruptcy of a non-financial company in several aspects. First, in addition to the debtor and its creditors, the CBRC may apply to the court for the reorganisation or liquidation of a bank. Second, the declaration of bankruptcy of a commercial bank must be pre-approved by the CBRC. Third, the obligations a bank owed to the depositors take priority to taxes and debt payments. Last, the CBRC may seize control of a bank when the bank is deemed to face severe operational risks.
As a Chinese bank has never entered bankruptcy, it is difficult to foresee the manner in which a bankruptcy proceeding for a Chinese bank would unfold. Particular regulations governing financial institution bankruptcy are being drafted to supersede earlier regulations that were drafted before the 2007 Bankruptcy Law.
Capital markets
2008 saw the promulgation of a number of measures designed to enhance disclosure and corporate information in the marketplace. On 25 July 2008, the CSRC issued periodic reporting requirements for listed commercial banks in respect of:
- Capital adequacy.
- Asset quality.Off balance sheet items (including OTC derivatives)
- Market, credit and liquidity risk levels.
On 31 October 2008, CSRC issued a list of 21 items required to be separately disclosed in periodic filings and in any offering prospectus, including certain items of non-recurring profit/loss and results from debt restructuring, corporate reorganisation, financial investments, and real estate investments.
Also in 2008, the CSRC increased substantive regulation of broker-dealers in the form of more stringent net capital and reserve requirements in relation to proprietary investments in equity and fixed income securities.
Primary markets
During 2008, 76 companies listed in China (4 in Shanghai and 72 in Shenzhen), with an aggregate value of RMB103 billion (the lowest in five years), with no IPOs since September 2008. It is reported that the CSRC is delaying actual listing of some issuers even after they have obtained the listing approval. One step taken to adjust new issue pricing to the market was the repeal by the CSRC of a previous requirement that the listing price could not be less than the 20 day average trading price before the board resolution approving the terms of the listing.
Secondary markets
In 2008 the CSRC was active in promoting liquidity in the secondary equity market. Detailed rules were issued in relation to securities firms engaging in securities lending and margin lending to implement earlier in-principle rules passed in 2006. A specific CSRC licence is required for these activities, which remains to be issued to any securities firm (we understand the first will be issued early in 2009), although "trial" runs of margin trading were begun by 11 securities firms beginning in October 2008. This has always been a sensitive area due to previous incidents of misappropriation of customer cash and securities accounts, and, of course, the potential for manipulative activity. Accordingly, the following conditions apply:
- No use of customer funds or securities.
- Securities loans can only be on proprietary inventory or other legally obtained stock, where the stock, bond, securities investment fund interest, or other security is on an approved list for securities lending/margin lending.
- The securities borrower must put up cash or specified securities collateral at specified ratios or be closed out.
- Subject to further State Council rule making, a central securities finance company will be created to lend securities to securities firms.
- The required margin is 50%, with haircuts (that is, the amount a lender will reduce its valuation of collateral from the market value to take into account any risks that that value may not be realised on sale) on collateral ranging from 35% for stocks to 5% for government securities.
- Margin trading on a stock is only permitted if:
- such stock has a three month trading history;
- the tradable float of such stock is not less than 100 million shares or tradable market capitalisation of such stock is not less than RMB500 million;
- such stock is held by at least 4,000 persons;
- such stock has not had abnormal volatility in the past 3 months; and
- such stock is not "special" (for example, issued by a company with recent loss-making history).
Other developments included:
- A facilitated approval process for shareholder issuances of exchangeable bonds to avoid outright sales of their holdings.
- Repeal of the previous requirement for CSRC approval of listed company share buybacks.
- Repeal of the previous requirement for general tender offer or CSRC waiver in relation to open market purchases of listed shares by a shareholder causing its holding to exceed 30% of the float.
- A directive to listed issuers to meet certain cash dividend yield requirements.
- A compliance measure directed at "qualified foreign institutional investors" regarding their use of quota, disclosure and the appointment of supervisory personnel.
The OTC derivatives market in China is embryonic and dealers are limited to commercial banks that obtain special derivatives licences from the CBRC based on capital, risk management and other criteria with respect to structure and derivative use. As a result, the onshore markets have not been significantly affected by the melt-down in mortgage-, credit- and other asset-linked derivatives. (Offshore, some Chinese banks have had exposure to Lehman and other bankrupt counterparties on certain OTC derivatives, and some Chinese corporates have suffered major losses on commodity hedges.)
Chinese banks have started to focus on the precise terms of ISDA documents, particularly those relating to the bankruptcy of, and closeout of transactions with, defaulting counterparties. While historically the State Administration of Foreign Exchange (SAFE) and the National Association of Financial Market Institutional Investors supervise and administer Chinese OTC derivatives market, since June 2007 (when it issued Notice on Establishing the Banking Communication Mechanism of Derivatives Businesses) the CBRC has taken a more active role in shaping the agenda of the development of the market and documents for OTC derivatives.
The regulators and scholars of the nascent credit derivatives market have not been deterred by the financial crisis in their determination to cautiously progress the prudent use of credit derivatives. An article published on 2 February 2009 suggests Tianjin as the pilot venue for a credit derivatives exchange. This pilot would unfold in three stages for eligible banks:
- Single name trades.
- Basket trades.
- Securitisation.
Those responsible in China for the development of this product have drawn a lesson from the crisis outside China that credit derivatives can be beneficial if harnessed by the government, but a harmful if left completely alone by it. The harnessing, according to the article, lies in the potential utility of credit derivatives in the development of yield curves and credit spreads for China's credit and capital markets.
Financial institutions
Several trends in financial institution regulation can be discerned, which are in part in reaction to the financial crisis and in part a continuation of an ongoing set of reforms that had been unfolding before the onset of the crisis.
One trend is for the implementation of measures that are intended to stabilise financial institutions (capital adequacy, protection funds, risk management). Another trend is the liberalisation of product offerings by financial institutions to enhance their profitability and also their ability to raise funds. Limiting the second trend, however, is the increased sensitivity of regulators to complaints (as to pricing and risk disclosure) from the retail investing public about investment products linked to equities, which have been falling throughout the world, not excluding the domestic exchanges.
Some of the noteworthy regulatory developments in 2008 are described below.
Regulatory capital guidelines
CBRC released Implementing Regulatory Guidelines of New Capital Accord on 18 September 2008, which included:
- Guidelines for Classifying Banking-Book Credit Risk Exposures of Commercial Banks.
- Guidelines for Supervising Internal Ratings Systems for Credit Risk of Commercial Banks.
- Guidelines on Measuring Regulatory Capital of Specialised Loans of Commercial Banks.
- Guidelines for Measuring Regulatory Capital for Credit Risk Mitigation in Commercial Banks.
- Guidelines for Measuring Operational Risk and Solvency of Commercial Banks.
These Guidelines are based on the International Convergence of Capital Measurement and Capital Standards: A Revised Framework released in June 2004 by the Basel Committee on Banking Supervision (Basel II).
The Guidelines deal with the:
- Regulatory requirements and technical criteria for classifying banking-book credit risk exposures.
- Use of the internal rating systems for credit risk.
- Measurement of regulatory capital for specialised loans.
- Measurement of regulatory capital for credit risk mitigation.
- Measurement of operational risk and solvency.
The CBRC's goal is implementation of the New Capital Accord by large commercial banks by 2010.
Measures for insurance companies
The Measures for Administering Insurance Protection Funds, effective from 11 September 2008, establish insurance protection funds to protect policyholders if an insurance company goes into bankruptcy. The insurance protection fund will be created with funds paid by insurance companies based on a certain percentage of retained premiums. The amount payable to the insurance protection fund varies depending on the type of insurance company and policy.
The fund's investments are limited to bank savings, government bonds, and other instruments prescribed by the China Insurance Regulatory Commission (CIRC). In addition, the CIRC will establish an Administrative Committee on Insurance Fund Protection to supervise the management and use of the fund. The CIRC will submit a financial report on the fund's status to the Administrative Committee and contributing insurance companies within five months of the end of each fiscal year.
Policyholders are guaranteed full compensation from the fund for any amounts below RMB50,000. For any amounts beyond the guaranteed RMB50,000, the fund will compensate individuals 90% and will compensate institutions 80%. In addition, a policyholder can obtain a priority right to compensation from the fund by assigning any of its creditors' rights to the insurance protection fund.
On 30 December 2008, the CIRC issued the Notice on Classifying and Supervising Insurance Companies. Insurance companies are classified into four categories, from A to D, with category A including the safest companies and category D the most risky companies. Depending on a company's classification, the CIRC is authorised to take different measures to supervise and regulate an insurance company.
Property and life insurance companies are classified according to five criteria:
- Solvency margin.
- Corporate governance.
- Fund management.
- Business operations.
- Financial risk.
For each criterion, the standards for evaluation are listed in the Notice. Reinsurance companies are evaluated solely on the basis of their solvency margin.
For companies in category A, the CIRC will exercise no remedial supervision measures. Companies in category B may be subject to a series of preventative measures, such as requirements to send risk notifications, to remedy existing problems by a prescribed date, or to draft and submit plans to the CIRC on precautionary measures to avoid falling below mandated solvency margins.
Companies in categories C and D are subject to more drastic regulatory measures from the CIRC which may, at its discretion:
- Require a capital increase.
- Restrict or prohibit share dividends.
- Limit the salary of directors and senior management.
- Restrict commercial advertisements.
- Restrict the company's business scope.
- Order a change in management.
- Order changes in fund management practices.
The CIRC can even order reorganisation or take control over companies classified in category D.
The Administrative Provisions on the Solvency of Insurance Companies (effective from 1 September 2008) provide for a variable level of supervision based on an insurance company's solvency level. Different supervision measures apply to insurance companies with solvency rates: lower than 100%; over 100% but below 150%; and above 150%. The Solvency Provisions improve solvency supervision mechanisms by clearly allocating responsibilities between the central CIRC, local CIRC branches and the insurance companies themselves.
On 3 December 2008, the CIRC issued the Draft Insurance Company Solvency Reporting Principles No. 15: Reinsurance Business. The Draft both:
- Determines which assets may not be admitted.
- Specifies the book value ratios for assets and liabilities that may be factored into the solvency ratio for a reinsurance business that transfers "material" risks as well as for a reinsurance business that does not.
Securities fund management companies
On 24 November 2008, the CSRC released the Decision Amending Risk Reserves Levels of Securities Fund Management Companies, which became effective on 1 January 2009. Under the Decision, the minimum proportion of risk reserves was doubled to 10% of securities fund management revenues.
Banks and trust funds
The Guidelines on the Business Cooperation between Banks and Trust Companies, released on 4 December 2008, permit banks to entrust the funds it has raised from customers to a trust company to manage. This is among the measures designed to facilitate bank fund raising. By outsourcing investment sub-management to trust companies, banks can use their customer lists and earn management fees, while trust companies hold title, for the beneficial ownership of the customers, in investment products a bank is not permitted to hold directly.
Property insurance companies
The Circular on Strengthening the Administration of Investment-type Insurance Business of Property Insurance Companies (effective from 20 November 2008) provides that property insurance companies managing investment-type insurance products must have a solvency ratio above 150% in the last four consecutive quarters, and not have been subject to any administrative penalties for the last three years. According to the Circular, investment-type insurance products developed by property insurance companies are subject to CIRC examination and approval, and the rate of return (exclusive of the insurance benefit) on these products must not exceed 80% of the interest rate of the deposit rate for an equivalent term.
Consumer protection
The Notice on Informing Customers of Risks in Purchasing New Types of Life Insurance Products (issued by the CIRC on 18 May 2008) seeks to prevent insurance salesmen and agents from misleading consumers by exaggerating the rate of return on new types of life insurance products, and requires companies to inform consumers about the major features and risks of new types of life insurance products.
Banks have been subject to similar pressure from the CBRC regarding structured products issued to depositors and customers.
Section 2. Restructuring and insolvency
Since failure to reorganise (or compromise) means liquidation, and since a reorganisation in which secured claims do not receive full value will not be feasible without the consent of the secured class, a creditor of a major customer or supplier in financial difficulty considering bringing bankruptcy proceedings needs to have solid information on the debtor's assets and cash flow position.
In all likelihood, pro-active and early monitoring of the counterparty's situation, and working out and/or setting off claims, will be the best strategy, for example, for trade claims against troubled customer's or suppliers.
Once the court accepts a bankruptcy petition, any individual settlement entered after the date of acceptance will be void. All enforcement or litigation proceedings must also be suspended and consolidated into the bankruptcy process when it is initiated.
For information about the Bankruptcy Law, see box, China's new Bankruptcy Law.
Typical restructuring options include:
- Roll-over and/or amendment of borrowed money debt (or conversion of some or all of such debt into equity stakes)
- Sale of non-core assets including spin-offs of subsidiaries.
- Where the liquidation of the debtor is "not an option", local government support to the debtor and/or restructuring its borrowed money and trade creditors in the form of:
- tax incentives;
- subsidised funding or debt buyouts;
- procurement; and/or
- asset injections.
For information about the Bankruptcy Law, see box, China's new Bankruptcy Law.
11. What steps should a company take when entering into a new customer or supplier agreement to protect against the risk of the customer or supplier having financial difficulty?
12. What special considerations apply in relation to a company's dealings with:
- A company already in financial difficulty?
- The person responsible for winding-up an insolvent company's affairs?
See Question 18 and box, China's new Bankruptcy Law.
The Supplemental Provisions Governing Share Repurchase by way of Centralised Trading on the Stock Exchange (effective from 9 October 2008) has removed the CSRC approval requirement for share repurchases, so encouraging issuers to buy back their stock on the market, subject to certain disclosure and other requirements. A number of listed issuers have, accordingly, repurchased varying proportions of their outstanding stock on both the domestic currency A share exchange and the US dollar B share exchange.
Section 3. Dispute resolution
The financial crisis has spawned primarily debt recovery litigation, as follows:
- Banks initiating actions against borrowers (both individuals and companies) who have defaulted on their loan obligations.
- Creditor- and customer-initiated lawsuits and bankruptcy filings against securities companies that have lost assets during the precipitous fall of the domestic stock markets during 2008.
- Actions initiated by unpaid employees and creditors of manufacturers which have collapsed as a result of the drop in demand for products made in China because of the reduction in consumer spending.
- Actions by creditors, customers and employees against small to medium- sized real estate developers that have collapsed because of poor housing sales.
- Labour disputes between employers and employees regarding compensation amounts arising from termination of employment.
Examples of major litigation that has arisen as a result of the financial crisis include:
- Bankruptcy application by Yunnan Shou Li Securities Company to the Kunming Municipal Intermediate People's Court.
- Bankruptcy application by Huaxia Securities Company to the Beijing Municipal Second Intermediate People's Court.
- Liquidation of Smart Union Group (Holdings) Limited, one of the world's largest toy manufacturers, in Hong Kong proceedings (Smart Union has 7000 employees in PRC subsidiaries in Guangdong).
- Bankruptcy application of Jiang Long Holdings Co. Ltd., one of China's largest printing companies.
China has yet to experience having any of its large enterprises involved in significant litigation due to the financial crisis. As China feels the full brunt of the financial crisis and slowing domestic and international demand, it is likely that SMEs without the support of the government will be the first ones to be involved in any significant litigation.
Section 4. Acquisition finance and private equity
The financial crisis has had a significant adverse affect on the amount of cross-border private equity transactions in China, with a mere US$8.9 billion having been invested in 128 deals in the first 11 months of 2008 (compared to a 2007 figure of US$12.8 billion in 177 deals). The investments focused on agriculture, food and beverage, automotive, electronics, and energy.
On the other hand, domestic private equity grew from 2007 to 2008, with special funds being established in Tianjin, Shanghai and Beijing. 20 domestic funds were established in the first 11 months of 2008, raising the renminbi equivalent of US$21 billion, of which over 15% was invested in 30 deals.
The main reason for the reduction in deals is the absence of liquidity and credit, as banks shut down lending and investors began redeeming positions in funds. Another concern, however, for private equity firms, has been the absence of exit strategies because of the depressed capital markets and also regulatory changes in China that made it more difficult to identify viable pre-IPO candidate issuers. Whereas 71 exits occurred in 2007, only 23 were possible during the first 11 months of 2008.
Overall, domestic deals continued unabated through the first half of 2008, during which deal values totalling US$47.9 billion were executed, compared to US$31.8 billion in the first half of 2007 and US$44.6 billion in the second half of 2007; however, one deal accounted for US$15.8 billion of the 2008 figure (China Telecom's acquisition of China Unicom's CDMA wireless unit). The first half of 2008 generated 1,305 M&A deals compared to 1,409 M&A deals in the second half of 2007. In the second half of 2008, the number of deals fell sharply.
Inbound acquisition by foreign buyers have been adversely affected as a result of cost saving and more conservative expansion plans by foreign buyers with capital concerns back home (see Question 16).
Outbound investment by Chinese companies, however, rose to US$31 billion for the first half of 2008, exceeding the whole of 2007, buoyed by the stronger renminbi and the greater affordability of foreign assets and companies hit by the financial crisis and desperate for capital. Some of the larger Chinese outbound investments include Aluminium Corporation of China taking a 12% stake in Rio Tinto and China Merchants Bank's acquisition of Hong Kong's Wing Lung Bank. When added to inbound cross border M&A (which includes seven private equity deals (see Question 16)), there were 49 total cross border M&A deals involving Chinese acquirors or Chinese targets through the first three quarters of 2008, compared to 84 cross-border deals for all of 2007.
A potential buyer of assets on sale by a debtor (before or during a bankruptcy) or its administrator should be aware of the possibility that its acquisition could be rescinded or modified if it:
- Was executory in nature.
- Was made not earlier than the date six months prior to the bankruptcy commencement when the debtor was insolvent.
- Was made not earlier than the date one year prior to the bankruptcy commencement for inadequate consideration or in consideration of antecedent debt or as non-mandatory repayment of debt.
Bidding or negotiating for an asset sold by a distressed seller also entails little effective opportunity for due diligence or recourse against the seller, and it is unlikely that deferred consideration structures will be acceptable.
Foreign buyers will, in addition, be faced with the challenges of capital account barriers, as well as restrictions on banks selling loans at less than par.
An interesting case is the recent memorandum of understanding signed in November 2008 between Shandong Steel Group (a state owned enterprise (SOE)) and Shandong Rizhao Steel Group Holding (a privately held company). While profitable, Rizhao had levered itself to such a point that its financial structure was untenable and, under the pressure of falling sales caused by its primary customers in real estate, automobiles and consumer goods reducing capacity, was being forced to lay off huge numbers of employees. It suggests that a template for distressed M&A will involve a non-SOE both:
- Facing liquidity issues with its banks (and suppliers) because of the reduced demand for its products.
- Pushing back on the liability side of its balance sheet either by seeking roll-overs of redemption requirements from its creditors or finding a white knight with a larger, more liquid balance sheet.
For information about the Bankruptcy Law, see box, China's new Bankruptcy Law.
No new restrictions on foreign ownership have resulted from the crisis.
Before the onset of the crisis, the government policy was to prevent inflows of hot money, while after the crisis, the focus is to prevent foreign capital from leaving China. For example, in an effort to monitor better the relationship between national foreign exchange reserves and foreign capital, a number of directives were issued by SAFE during 2008 to more stringently supervise and verify transactions putatively designated as "trade account" (as opposed to capital account) transactions, and the cash flows arising from them, and to limit the use of foreign capital in portfolio investment and speculative investment transactions largely dependent on renminbi movements.
20. Do any special competition/anti-trust considerations apply to distressed deals? Does the relevant authority have power to waive competition/anti-trust requirements in appropriate circumstances ( if so, please give details)?
21. Have the tax authorities introduced any incentives to encourage M&A activity (for example, permitting losses to be carried forward following a change of ownership)?
A new national income tax law came into effect in 2008, and draft rules under it governing M&A activity have been circulated. Under these rules, there are certain incentives on the table for distressed M&A, such as:
- Under certain conditions, spin-offs will be tax-deferred.
- A change of control of a company with net operating losses can, under certain conditions, permit the offset of income against a carryforward of those net operating losses.
In addition, on 29 December 2008, exemptions were provided in respect of property deed tax if a state or collectively owned enterprise is sold in a merger, spin-off or equity purchase, and the purchaser maintains all employee positions for three years; only 50% of the tax is payable if the purchaser maintains at least 30% of those employee positions over the same period.
Section 5. Directors' duties and liabilities
The Company Law provides that shareholders, directors and actual controllers of companies can be liable for the debts of companies in specified circumstances. For example, a director who has taken advantage of a connected-party relationship and thereby caused loss to the company, or who has been working concurrently as a member of the supervisory board of the company, may be personally liable if he is also the company's legal representative.
The Bankruptcy Law imposes personal, civil liability on directors, supervisors and senior managers who breach their duty of loyalty or diligence and that breach results in the company's bankruptcy.
The consequences for such breaches include a ban from acting again as director, supervisor or senior manager in any company for three years, as well as a liability to contribute assets to the bankrupt entity. Directors will be held liable if that are responsible for:
- Transferring assets to evade debt obligations.
- Creating false debts
- Transferring assets for inadequate consideration within a certain period of time before bankruptcy.
- Antecedent debts.
- Certain other company acts that diminish the debtor's estate in a bankruptcy.
Also, criminal liability attaches if there is "interference with liquidation" or "illegal acts for personal gains or by fraudulent means".
The Bankruptcy Law also requires shareholders of a bankrupt company to satisfy outstanding capital contribution obligations. A Supreme People's Court ruling imposes further liability on shareholders of an LLC (see Question 23), directors and controlling shareholders of a JSC (see Question 23) and de facto controllers of a company in certain circumstances. These are:
- Failure to form a liquidation group (that is, the convocation of shareholders, directors, management, specialist advisors/experts, and supervisory board members required for an orderly liquidation of the bankrupt company) within the statutory time limit.
- Loss they cause to properties, accounts or documents of the bankrupt company that hinder an orderly liquidation.
- Fraudulent transfers.
- Fabricated liquidation reports.
Listed companies have new obligations when making material asset reorganisations under the Administrative Measures for the Material Asset Reorganisation of Listed Companies (Reorganisation Measures) (effective from 18 May 2008). The Measures state that the CSRC will establish a Review Sub-committee for Mergers, Acquisitions and Restructurings of Listed Companies (under the Issuance Review Committee), which will vote on the material asset reorganisation applications submitted for its deliberation and put forward examination opinions.
The Reorganisation Measures define "material asset reorganisations" and specify the attendant procedures and disclosure obligations. The Reorganisation Measures also apply to asset trading activities conducted by listed companies and their subsidiaries, such as buying and selling assets exceeding a prescribed proportion which cause material changes in the principal business, assets and income of the company. Certain types of transactions, such as the issuance of equity in consideration of asset injections, are made subject to two thirds shareholder super-majority voting requirements.
The Reorganisation Measures reflect an interesting interplay between the Bankruptcy Law, on the one hand, and other features of the Chinese markets (state ownership, listed enterprises, financial institutions) on the other hand. The Bankruptcy Law is always subject to these complexities, and it appears a spate of reorganisations involving distressed listed companies occurred immediately before the effective date of the Reorganisation Measures.
The Provisions of the Supreme People's Court on the Application of the Company Law came into effect on 19 May 2008. The Provisions, together with the Company Law, set up a series of shareholder rights and correlative director liabilities in both limited liability companies (LLCs) and joint stock companies (JSCs).
In both an LLC and a JSC, the following rights are reserved to the shareholders:
- Election, change and compensation of directors.
- Approval of budget, reserves, dividends, changes in capital, issuance of bonds, corporate reorganisations, and the accounts.
- Pre-emptive rights on new equity issues.
- Certain information and inspection rights, although the company can deny access to the accounts if the shareholder lacks "just cause" for such inspection.
- Holders of 10% of the voting shares have the power to sue for dissolution where:
- the company has failed to hold a shareholder meeting for two years;
- the shareholder meeting has failed to reach a decision because the required voting thresholds have not been met for two years;
- "severe conflict" persists between the board and shareholders; or
- other "serious" problems have arisen in the operation of the company.
- In an LLC, shareholders have a right to sell shares back to the company (at a "reasonable" price) under certain conditions where they oppose a shareholder vote, (for example, dissent to a merger or retention of earnings for a fifth consecutive year). The price can be litigated if the two sides cannot agree what price is reasonable.
On 27 March 2008, the CBRC published the Draft Methods for the Supervision and Management of Majority Shareholders of Banks, providing:
- Conditions and procedures for acquiring control of a bank.
- Codified rules on the supervision of banks.
- The criteria which the management of majority shareholders of banks must meet.
The Rules on Qualifications of Financial Managers of Insurance Companies (effective from 1 February 2009) set out detailed requirements on the responsibilities and professional qualifications of financial managers (essentially chief financial officers (CFOs)). For example, financial managers must have an established residence in China, have working fluency in Chinese, and meet various other criteria. Financial managers must report to the board of directors at least once every six months and are responsible for preparing an insurance company's solvency report, risk assessment, and other financial documents.
Similarly, the Guidelines on the Operation of the Board of Directors of Insurance Companies (effective from 1 October 2008) further regulates the operation of boards of directors and sets out decisions which must be made by the board.
The (effective from 5 December 2008) directs five state-owned insurance and certain other majority Chinese-owned insurance companies to observe limits on executive compensation and orders a temporary suspension in implementing employee share or share option plans at those companies.
Generally, the CSRC regulates issuance of stock and stock options to executive employees under the Measures for the Administration of Equity Incentive Plans of Listed Companies (effective from 1 January 2006). The current regime allows incentive plans to include both options and restricted share sales, and caps the amount of shares which may be used for incentive plans at 10% of the outstanding total of a company's shares. For privately held companies, any employee may take part in a share incentive plan, except for independent directors.
Similar but separate regulations apply to state-owned enterprises, where only directors, senior managers and core personnel with a direct impact on the company's overall performance may participate in share or option incentive plans.
If a company chooses to implement a share or share option incentive plan, it must establish an internal performance evaluation system, and implement its equity incentive plan on the basis of the results. However, there is no clear guide on the specific standards which should be used in the performance evaluation.
The Chinese economy: some background information
The global recession has threatened the viability of a significant number of exporters in China. However, at the same time, China's engineer-like approach to the import of black box financial products (that is, complex and opaque financial products whose inner workings are not easily decipherable) and hot money (that is, money moved frequently between short term investments in search of the highest yield) has insulated it from the more severe shocks experienced elsewhere in the world.
In China, ownership of major companies is not widely dispersed into the hands of competing, independent financial intermediaries but concentrated in organs and subsidiaries of the government. The corporate policy that results from this ownership structure is designed to achieve maximum export growth. Export growth fuels employment and both corporate and fiscal revenue.
The second fundamentally unique characteristic is the capital account, which allows only "foreign invested enterprises" (FIEs) (and on an exceptional basis, certain other domestically incorporated companies) to open to hard currency equity and debt investment. Additionally, the Chinese government is relatively more powerful than other governments with regard to setting interest rates and the supply of credit, as it controls the central bank (People's Bank of China (PBOC)), and only very limited foreign participation in either domestic bond markets or the fledgling domestic credit derivative market is permitted.
Neither Chinese companies nor Chinese financial intermediaries have been permitted, either by regulation or by shareholder mandate, to stray far from what has been considered "traditional" forms of business risk, primarily credit risk and business cycle risk. Although losses have been tallied to date by Chinese companies and financial institutions due to defaults and market losses, the contingencies have by and large been ascertainable and quantifiable at all times. The Chinese government has generally been free to focus on managing the potential crisis for those companies without direct state funding sources. These companies have been severely affected by the strength of the renminbi (RMB), the decline in export growth, and the collapse of investment values in real estate and the domestic stock market. As in other parts of the world, domestic demand has dropped as confidence in the global economy has fallen:
- Export growth has fallen from 20% in the first half of 2007 to 3% as at the end of Q1 2008 (a level last seen in the Asian financial crisis of 1998).
- Real GDP growth has dropped from 10.6% year on year at the end of Q1 to 9.0% at the end of Q3 2008 (conversely, PPI inflation has declined from 10.1% to 6.6% during the same period and tax revenue growth dropped to 3.1%).
The task of the Chinese government, while large in scale, is relatively simple compared to that of other governments, which have to deal not only with solvency in the corporate sector but in the financial sector as well, and an overall failure by the credit and equity markets to bottom out. The government lifeline to this less state-reliant sector of the economy is another breakthrough in China's development from "enterprise" to "corporate" that has gathered apace over the course of recent years. In only a few years, there has been:
- The enactment of new Company, Securities, Bankruptcy, and Property Laws.
- The promulgation by the Ministry of Finance (MOF) in 2007 of a new set of Chinese Accounting Standards that in most places conform to or exceed the rigour of the IFRS but which adapt to the realities of the Chinese economy.
- The rapid development of the exchanges on which equities, money market and other longer-term debt securities, and commodities are traded.
- The increasing awareness of the relationship between capital and risk (including the risks that breed from herd behaviour across separately regulated markets) in financial intermediaries.
- The overall streamlining of the bureaucratic apparatus.
Provided that the Chinese government can maintain relatively low levels of unemployment, it is likely that the chief lesson to be drawn by its leaders from the global crisis is the relative wisdom of the nature and pace of market and legal development in China.
China's new Bankruptcy Law
The new Bankruptcy Law came into effect in June 2007 and consolidates previous laws that applied separately to state-owned enterprises, non-state owned companies, FIEs and listed companies. It established three different processes for dealing with troubled companies that have voluntarily or involuntarily been put into bankruptcy proceedings:
- Liquidation.
- Reorganisation.
- Compromise (which (compared to reorganisation) is a less comprehensive restructuring of the debtor's obligations).
Many concepts, including the role of an administrator, the role of a creditor's committee, priorities, post-petition financing, automatic stay, treatment of executory contracts, avoidance of certain transfers, and cramming down a plan of reorganisation notwithstanding failure of an impaired class to consent provided certain tests are met, will be familiar, but with certain technical and practical adjustments to suit the Chinese economy. Most importantly, the appointment of an administrator, and the proposal of a specific reorganisation plan, are by the debtor or court, not the creditors.
The most important aim of the law is to ensure order and stability following the distress of a debtor. In particular, claims for employee benefits accrued through August 2006 and possibly beyond enjoy super-priority.