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INTERNATIONAL FINANCIAL LAW REVIEW

 

THE EAST IS IN THE RED

March 1999

By T.K. Chang*

 

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.

China's leaders appear to be taking a calculated risk that in cleaning up its financial act quickly and early -- unlike the procrastination and denial that exacerbated the financial crises in Japan, Korea and elsewhere in Asia -- the repercussions in the international financial markets will be only short-term. In the long term, China has established clearly that it will not fall into the moral hazard trap of rescuing badly-run companies just because they are too big to fail. In the future, Chinese companies will no longer be able to obtain easy credit on the basis of opaque financial statements, personal connections (guanxi) and vague comfort letters from their parent governmental authorities.

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, China may have actually improved its sovereign risk profile by delineating clearly the liabilities which will be backed by the full faith and credit of China's $140 billion plus of foreign exchange reserves.

                                                The PRC Bankruptcy Law

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 China previously had a bankruptcy law under the Qing Dynasty passed in april 1906, and a bankruptcy law under the Republic of China government passed in July 1935, the 1986 Bankruptcy Law was the first national law on bankruptcy to be passed since the founding of the PRC on October 1, 1949. Until the GITIC bankruptcy, the Bankruptcy Law had been used mostly for the bankruptcies of small state-owned enterprises, and had never been used in the case of a large financial institution, or for a debtor which had significant foreign indebtedness.

 

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 China.

 

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 Guangzhou on January 10 1999. Foreign creditors and domestic creditors were summoned to separate meetings. It was at these meetings that it was announced that GITIC and three of its subsidiaries would be put into bankruptcy under the Bankruptcy Law. The formation of an official liquidation committee for GITIC was announced, comprised of representatives from PBOC, GITIC, the Guangdong provincial government, the Bank of China, Guangfa Securities, as well as Peat Marwick Huazen and a PRC law firm. In addition, it was announced that the more than 27,000 individual depositors of GITIC would be repaid in full on their principal, but not on their interest.

 

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.

                                                Previous Closures of Financial Institutions

Prior to the GITIC bankruptcy, the People's Bank of China (PBOC), China's central bank, had closed a number of financial institutions under authority of the Provisions for the Administration of Financial Institutions, promulgated by the PBOC on August 9, 1994, and other related regulations. Under Article 42 of these provisions, the PBOC had the authority to close down a financial institution if, among other things, losses had reached 10% of capital of the previous three years of losses had reached 15% of capital, or if such financial institution had failed its annual examination two years in a row or failed to improve after failing its annual review, or under any other circumstance deemed appropriate by the 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 Guangdong provincial government, which is technically the owner of GITIC, as well as members of the former management of GITIc, all of whom arguably have conflicts of interest.

 

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 China to foreign lenders is required to be registered with the State Administration of Foreign Exchange (SAFE), China's foreign exchange control authority. Since the part of the promise concerning the repayment in full (at least of principal) of individual depositors has already been honoured, foreign creditors argue that the rest of the promise should also be carried out. However, given that there is no explicit basis for such priority in the Bankruptcy Law, domestic creditors, who have already protested the unfairness of such priority in the previous liquidations of China Venturetech and other financial institutions, are likely to mount a legal challenge to overturn such priority in the GITIC court proceedings.

 

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 Guangdong provincial government. Unregistered foreign creditors argue quite legitimately that they should not be penalized for relying in good faith upon such legal opinions.

 

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 Guangdong provincial government had given so-called comfort letters. The Guangdong provincial government would typically state in such comfort letters that it would provide the necessary support with respect to the payment of principal and interest. Such comfort letters were often also accompanied by legal opinions from PRC law firms, including the Guangdong International Commerce Law Office.

 

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 Hong Kong, the PRC Bankruptcy Law also contains a Chapter 4 on Conciliation and Reorganization, and places a two-year limit on such reorganizations. GITIC creditors have pointed out that it is probably unwise to liquidate the assets of GITIC immediately (a great deal of which is real estate) given the current market trough, and that they are likely to obtain a much higher recovery if GITIC could be maintained under a reorganization until the market turns around. To date, however, the Chinese authorities have not given any indication that a reorganization of GITIC under the Bankruptcy Law is contemplated as a possibility.

 

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 Hong Kong dollar and other imponderables that the GITIC bankruptcy was originally meant to prevent. It is a difficult dilemma, to try to balance, on the one hand, the clear and present need to reform the financial and state-owned sectors, and on the other hand, the vagaries of fickle market sentiment and the herding psychology of lenders and investors. But China has surprised and defied its critics many times in the past twenty years, and perhaps it will be able to do so again.

 

*Mr. Chang participated in consultations with the drafters of the PRC Bankruptcy Law prior to its promulgation. For more information concerning Mr. Chang, please go to: http://www.zhonglun.com/en/lawyer_246.aspx