By T.K. Chang*
In December, the first
distribution of the bankruptcy assets of the Guangdong International Trust
& Investment Corp. was sent out to creditors, marking the beginning of the
end of the largest bankruptcy in the history of the People's Republic of
No company is too big to fail.
Gitic's bankruptcy refuted the moral hazard fallacy that any
Chinese companies would be too big to fail. Even if a company is owned directly
by a provincial government, it remains a stand-alone limited liability entity
whose debts will not enjoy the full faith and credit of the Chinese government.
A loan to such company must be based strictly upon its balance sheet and
financial condition, and not upon any implied connection to, or shareholder
relationship with, the government. Full faith and credit will be enjoyed only
by government bonds and corporate debts that are explicitly guaranteed by the
Chinese government.
Foreign creditors do not have
preference.
Previously, when the People's Bank
of China closed down insolvent financial institutions, such as China Venturetech Investment Corp., foreign creditors were assured that they would be repaid in full. The PBOC had
initially closed down Gitic under similar procedures
and with a press announcement that foreign creditors would have priority. But
after realizing the full extent of Gitic's debts, the
Chinese government decided to apply the PRC Bankruptcy Law, probably as a test
case. Under the Bankruptcy Law, all unsecured creditors are treated equally,
regardless of whether they are foreign or domestic.
All foreign debts must be
registered.
Gitic's bankruptcy confirmed that all foreign debts and guarantees
of Chinese borrowers and guarantors must be registered with the State
Administration of Foreign Exchange . And if the
borrower is a Chinese company that is not a foreign-invested entity, then the
loan or guarantee must also be approved by SAFE. Registration with SAFE,
however, is merely a necessary requirement, and does not guarantee a debt's
validity or repayment.
Comfort letters are not enforceable.
Comfort letters have often been
used in financing transactions in China as a substitute for guarantees. Comfort
letters are side letters in which the signatory, usually the borrower's parent,
makes certain assurances, such as that it would continue to hold a certain
percentage of the borrower' equity, or that it would "support" the
borrower and provide "necessary funds" for its
"operations".
Comfort
letters are actually commonly used in business transactions in the US and
elsewhere. Although they may not always be legally enforceable, they function
by force of moral obligation, and public relations embarrassment if reneged
upon. Comfort letters are enforceable in certain cases under English law. Gitic's bankruptcy confirmed that under Chinese law,
comfort letters that are really disguised guarantees, which have not been
registered with and approved by SAFE, are unenforceable.
Treat Chinese legal opinions with
caution.
Gitic's bankruptcy was perhaps most unjust for foreign lenders
which had made loans to Gitic's Hong Kong
subsidiaries that were guaranteed by Gitic's
unincorporated branch in Hong Kong. The lenders had prudently obtained legal
opinions from well-known Chinese law firms in
The
1/2 and 1/3 rules for allocating fault.
Gitic's bankruptcy has developed rules for allocating fault and
economic loss that are likely to become precedents in future bankruptcy cases.
In accordance with Chinese jurisprudence, the precedents may also apply by
analogy to similar transactions or circumstances. If, as described above, the
primary loan to Gitic's subsidiary is deemed valid
but the secondary guarantee by Gitic's
Substantive
and procedural precedents.
Gitic's bankruptcy has resulted in many significant substantive
and procedural precedents, such as the establishment of the creditors' meeting,
the formation of a chairman committee of creditors and filing deadlines and
procedures. The 1986 Enterprise Bankruptcy Law (Trial Implementation), under
which Gitic was declared bankrupt, is vague in many
of its provisions and a draft of a revised Bankruptcy Law has been under
discussion for many years. But significant disagreements over fundamental
principles, such as workers' rights and other key socialist tenets, have
prevented its promulgation.
Foreign
law and accounting firms.
Although the Bankruptcy Law is a
domestic law applicable only to Chinese enterprises, Gitic's
bankruptcy was the focus of such intense international scrutiny that the
Chinese government spared no expense in hiring top foreign law and accounting
firms to handle the bankruptcy. As with the initial public offerings of the
H-shares and B-shares of Chinese companies, foreign professionals seemed to
have succeeded in carving out a role for themselves in Chinese bankruptcies
involving foreign creditors, which the Chinese government is likely to continue
to regard as being mutually beneficial to
Outdated window company model.
Gitic was one of the 10 financial "window companies"
that had been officially designated by the Chinese government as intermediaries
for borrowing funds internationally that would then be on-lent to Chinese
borrowers. Other financial window companies included the international trust
and investment corporations of Hainan,
Ironically,
Gitic itself has had great difficulties trying to
collect on the loans to its borrowers, in the classic example of China's
intractable "triangular debt" problem, in which a Chinese lender
cannot repay its own loans because its borrowers are unable to repay their
debts. Gitic had loaned more than 12 billion yuan to
more than 240 borrowers, including many of its subsidiaries. Gitic had 240 subsidiaries and joint ventures, of which 108
had been undisclosed prior to its bankruptcy.
Empirical
and result-oriented approach to reform.
Since Gitic's
bankruptcy, the Chinese government has effectively forbidden any other major
Chinese company from going bankrupt. It has also tried to appease the
international banking community with offers of more favorable out-of-court
restructuring settlements, such as that for the Guangdong Development
(Holdings) Ltd. group, in which the
The
concept of bankruptcy, like its mirror-reflection concept of limited liability,
is fundamental to the modern economic model. Yet, bankruptcy may not be the
most politically palatable, nor the most effective, means for solving
*Mr. Chang has worked
extensively on major bankruptcies and restructurings in the U.S. and in Asia. For
more information concerning Mr. Chang, please go to: http://www.zhonglun.com/en/lawyer_246.aspx