INTERNATIONAL FINANCIAL LAW REVIEW
THE EAST IS IN THE RED
March 1999
By
On January 16, 1999,
the biggest bankruptcy in the history of the People's Republic of China (PRC)
was declared, when the Guangdong International Trust and Investment Corporation
(GITIC) sought protection from its creditors under the PRC State Enterprise
Bankruptcy Law of 1986 (Bankruptcy Law). This is the first time that the
Bankruptcy Law has been used in the insolvency of a leading financial
institution. Whereas previous liquidations of insolvent financial institutions
had been carried out under central banking regulations, where foreign creditors
were repaid in full, foreign creditors in the GITIC bankruptcy, which are owed
$3.7 billion of GITIC's $4.37 billion in total
liabilities, face the prospect of only a partial recovery under uncertain and
largely untested bankruptcy procedures.
In the wake of the
GITIC bankruptcy, foreign banks have severely contracted credit to PRC
companies, in some cases pulling credit lines and demanding early repayment.
International capital market financing has virtually come to a standstill, with
several abortive listings of PRC companies on the Hong Kong Stock Exchange,
including the proposed listing for Shandong International Power Development
Corp, led by Goldman Sachs.
Foreign banks and investors
will increasingly become the enforcer of the market discipline that China's
leaders had been unable to impose by administrative fiat, thereby helping to
restructure and reform China's ailing state-owned sector. At the same time,
The PRC State
Enterprise Bankruptcy Law (Trial Implementation) was adopted on December 2,
1986 by the 18th Session of the Standing Committee of the 6th National People's
Congress. In accordance with Article 43, theBankruptcy
Law came into effect on November 1, 1988, three months after the implementation
of the PRC State Industrial Enterprise Law. Although
Closure
of GITIC
Given
the unprecedented nature and historic importance of the GITIC bankruptcy, which
may serve as a template for future bankruptcies and fill out the many
procedural lacunae in the Bankruptcy Law, the chronology of the GITIC
bankruptcy, based on actual experience, will be laid out here in some detail.
The closure of GITIC was initially announced by the People's Bank of China
(PBOC) in much the same way as China Venturetech [see
box], by a public announcement from the PBOC, dated October 6 1998, which cited
the 1994 PBOC Provisions on Financial Institution, but made no mention at all
of the Bankruptcy Law. Thus, the Chinese authorities probably had originally
intended to close GITIC in much the same way that China Venturetech
had been closed, under the administrative procedures of the PBOC. It has been
suggested that it was only after the Chinese authorities realized the full
extent of GITIC's insolvency that they decided to
resort to the Bankruptcy Law.
Unlike
the China Venturetech announcement, however, the PBOC
announcement did not promise that foreign creditors were going to be repaid in
full. The PBOC announcement stated only that "overseas liabilities
registered with the foreign exchange administration authorities and the legal
principal and interest of deposits of domestic natural persons shall have
priority for repayment".
According
to the PBOC announcement, all claims and liabilities of creditors against GITIC
would be entrusted to the Bank of China, one of China's four principal
commercial banks, which would be responsible for registering the debts of all
creditors during the three-month period from October 6 1998 to January 6 1999.
The actual debt registration form is a one-page printed form with various
blanks to be filled in concerning the debt in question, and contemplates that
the creditor would attach any necessary attachments to the form. PBOC also
announced that the securities trading business of GITIC would be transferred to
Guangfa Securities, one of the leading securities
firms in
Creditors'
meetings
Creditors
of GITIC were notified at the expiration of the three-month debt registration
period to send one representative per creditor to meetings in
Misstatement
of financial condition
At
the creditors' meetings, the creditors were given the preliminary results of
the verification of the assets and liabilities of GITIC, which showed that
GITIC had liabilities of RMB36.165 billion ($4.37 billion), which exceeded its
assets by a shortfall of RMB14.694 billion ($l.77 billion). To the shock and
surprise of the creditors, there were significant discrepancies between what
the financial condition of GITIC was thought to be prior to, and after, the
verification period. Prior to such verification, GITIC was thought to have assets
of RMB35.878 billion ($4.33 billion), whereas after verification, it turned out
that GITIC had assets of only RMB21.471 billion ($2.59 billion). Furthermore,
prior to verification, GITIC was thought to have 66 domestic subsidiaries and
66 overseas subsidiaries, whereas after verification, GITIC was discovered to
have as many as 105 domestic subsidiaries and 135 overseas subsidiaries.
These
discrepancies raise disquieting questions about the overall reliability of the
financial statements of GITIC, which had been audited by international
accounting firms, as well as the accuracy and adequacy of the disclosure in the
offering memoranda, prospectuses and placement documents used in raising the
over $4 billion in indebtedness for GITIC. They inevitably also raise issues
relating to the potential liability of underwriters, accountants and law firms
under applicable laws of the relevant jurisdictions, including possibly Rule
10b-5 under the US Securities Exchange Act of 1934.
The
declaration of bankruptcy
Subsequent
to the creditors' meeting, the creditors of GITIC received official notices
from the Guangdong Province High People's Court notifying each creditor to send
one representative to appear at the court on January 16 1999. Foreign and
domestic creditors were summoned to the same session, although they were asked
to sit in separate sections in the audience. The court was presided over by
five judges, including a chief judge, and was not open to the public or the
press. The creditors were required to stand in silence while the announcement
of the bankruptcy of GITIC was read aloud by the chief judge, and translated
into English by two translators. Creditors were not permitted to speak or to
make any statements during the court session, which some creditors had been
rumored to be planning to do prior to the court session. The judge announced
that there would be a formal meeting of the creditors to be held in the latter
part of April 1999, to which creditors would be required to attend.
Prior to the
GITIC bankruptcy, the People's Bank of China (PBOC),
The PBOC had closed
the Zhongyin Trust and Investment Corporation in
1995, the Agribusiness Development Trust and Investment Corporation in 1997,
and Hainan Development Bank and China Venturetech
Investment Corporation in 1998. In the closure of China Venturetech,
a well-known PRC investment bank with significant foreign indebtedness and
foreign assets, the PBOC had published a public announcement dated June 22 1998
in the national press, which stated unequivocally: "The overseas
liabilities and the legal liabilities of domestic natural persons of the
original China Venturetech Investment Corporation
shall be repaid in full."
The closure of
financial institutions by the PBOC under central banking regulations, rather
than under the Bankruptcy Laws, is not necessarily out of the mainstream of
international practice in the US, for example, the US Bankruptcy Code does not
apply to federally insured or chartered banks, or savings and loan
associations.
Although
it may be perhaps premature to speculate as to what will be the important legal
issues in the bankruptcy process, some issues have already been raised by
creditors. Under Article 35 of the Bankruptcy Law, certain actions carried out
during the six month period prior to bankruptcy will be deemed null and void,
including private distribution or gratuitous transfer of property, irregular
underselling of property and repayment of unmatured
liabilities. Challenges will certainly be made by creditors under the provision
concerning the transfer to Guangfa Securities of the
securities trading business of GITIC, probably one of the only valuable
business operations of GITIC. However, the fact that a representative of Guangfa Securities is on the liquidation committee may make
it unlikely that such a challenge would be endorsed by the liquidation
committee.
Conflict
of Interest
Related
to the above issue, the entire composition of the liquidation committee raises
questions concerning possible conflicts of interest and the fairness of the
liquidation process. In addition to Guangfa
Securities, another member of the liquidation committee is a representative of
the Bank of China, which is one of the largest creditors of GITIC, reportedly
with a total loan to GITIC of over $50 million. Furthermore, the liquidation
committee also includes officials from the
One
of the most troubling features of the Bankruptcy Law is the dominant role that
is played by the liquidation committee, and the potential conflicts that are
likely to occur between the liquidation committee and the creditors' committee.
The liquidation committee has broad powers under the Bankruptcy Law with
respect to the valuation, disposition and distribution of the debtor's
property. The Opinion of the Supreme People's Court on the Bankruptcy Law,
issued on November 9, 1991, which sets forth many details on bankruptcy
procedures and was explicitly cited by the chief judge in his statement from
the court, appears to anticipate that there would be conflicts between the
liquidation committee and the creditors' committee. According to the Opinion,
if the plan for the distribution of assets proposed by the liquidation
committee is not approved by the creditors' committee after several votes, the
matter would be decided by the court.
Registered
foreign debt v domestic debt and unregistered foreign debt
Foreign
creditors of GITIC had previously thought that, as with the previous closure of
China Venturetech and other financial institutions,
foreign creditors would be repaid in full. But according to Article 37 of the
Bankruptcy Law, the order of priority for the distribution of unsecured assets
is, first to wages and labour insurance, then to
taxes, and lastly to all unsecured claims. There is no provision in the
Bankruptcy Law that provides for prior distribution to foreign creditors.
However,
foreign creditors have clung to the promise in the initial PBOC Announcement of
October 1998 that priority will be given to foreign debts registered with the
foreign exchange authorities. Under existing PRC regulations, all indebtedness
within
Such
a legal challenge may also be joined by those foreign creditors of GITIC whose
debts are not registered with SAFE, since recovery from the assets of GITIC
would be virtually impossible if registered foreign debt is repaid first. Close
to $2 billion of the total liabilities of GITIC consist of guarantees, many
given by the Hong Kong Branch of GITIC. Under the then existing law, guarantees
granted by the Hong Kong Branch of GITIC were considered overseas indebtedness,
and therefore were not required to be registered with SAFE. This legal
interpretation was supported by legal opinion from PRC law firms, including the
Gungdong International Commerce Law Office,
affiliated with
Provincial
government comfort letters
Foreign
creditors have reacted with such vehemence to the bankruptcy of GITIC in part
because in many of the loan and capital market transactions involving GITIC,
the
Foreign
creditors may find it difficult to claim, however, that they were not aware of
PRC regulations which have prohibited government departments from giving
guarantees on foreign debts for many years. According to the Notice of the
State Council Regarding the Strengthening of Control over the Borrowing and
Using of International Commercial Loans, issued on January 12 1989, "no
governmental agency or institution shall provide foreign exchange guarantees to
any foreign party". The State Council Notice is cited in the offering
memorandum of at least one big GITIC bond offering, and is the same Notice that
designated GITIC as one of the 10 so-called window companies in the PRC,
authorized to obtain foreign loans.
Reorganization
Analogous
to Chapter 11 of the US Bankruptcy Code, and in contrast to the
liquidation-based insolvency laws of
Foreign
ownership of GITIC's assets and shares
In
order that creditors can maximize their recovery from the assets of GITIC, such
assets should be permitted to be sold on the open market, in which foreign
parties can also participate as purchasers. However, GITIC holds shares in
numerous PRC companies in the form of state or legal person shares, which
generally may not be transferred to foreign parties. The recovery for creditors
is likely to be much less if the assets of GITIC can only be sold to a
restricted subset of PRC buyers.
Similarly,
if there is the possibility that GITIC can be maintained as a going-concern in
order to maximize the value of its assets, then the creditors would want to
take over the shares of GITIC and take control of the management of GITIC.
Under existing regulations, however, it is generally not possible for foreign
parties to hold such GITIC shares, or at least to have control of GITIC,
because the state must hold an absolute majority (50%) or relative majority
(30%) in all state-owned companies.
It
is hoped that in resolving the issue of the foreign ownership of GITIC's assets and of GITIC's
shares, the GITIC bankruptcy will act as a catalyst for accelerating the
reforms promised during the 15th National Congress of the Chinese Communist
Party and embodied in recent amendments to the PRC Constitution. In this way,
the GITIC bankruptcy can help to realize the vision of a mixed socialist market
economy that has a multitude of forms of property ownership, in addition to the
ownership of the means of production by the state.
The
New Bankruptcy Law
Although
much criticized for the paucity and ambiguity of its provisions, the Bankruptcy
Law was, at the time of its passage, a courageous document that had overcome
heavy conservative opposition during its consideration by the National People's
Congress, (see the author's article "The Making of the Chinese
Bankruptcy Law" in the Harvard International Law Journal
(1987)). Even its drafters concede in its title that it was only for trial
implementation. With the bankruptcy of GITIC, however, which affects more than
170 foreign lenders, trial implementation is no longer adequate, and the
Chinese bankruptcy regime must be brought up to international standards. The
proposed revised Bankruptcy Law, being considered by the National People's
Congress, is a much more comprehensive and well thought-out law, with over 193
articles in 10 chapters in one current draft (against only 43 articles in the
existing Bankruptcy Law). The continuing process of the GITIC bankruptcy is
certain to be studied closely as part of the legislative deliberation for the
revised Bankruptcy Law.
Calculated
risk
The
international reaction to the GITIC bankruptcy and the resulting credit crunch
for PRC companies has been swift and unforgiving. Chinese leaders have taken
the calculated risk that these repercussions are only short-term, and will not
lead to the devaluation of the renminbi and
*Mr. Chang participated in
consultations with the drafters of both the prior and current PRC Bankruptcy
Law prior to their promulgation.
For more information concerning Mr. Chang,
please go to http://ivylawgrp.com
