The Asian Wall Street Journal

Ten Lessons of the GITIC Bankruptcy

January 12, 2001

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 China. Gitic's bankruptcy offers many important lessons and precedents for foreign lenders and investors.

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 Beijing and Guangzhou opining that guarantees made in Hong Kong need not be registered with or approved by SAFE. One of these law firms has since seemingly vanished, leaving no forwarding address or phone number. The lawyer who had signed one of the other opinions has since left his law firm, and when finally reached by phone, has disavowed responsibility for the opinion. Meanwhile, the innocent foreign lenders are left holding legal opinions that are not worth the paper on which they were written.

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 Hong Kong branch is deemed to be invalid, then fault and responsibility for the resulting economic loss are shared equally by the foreign lender and Gitic, and the foreign lender's claim is reduced to 1/2 of its original amount. If both the primary loan and the secondary guarantee are deemed to be invalid due to the absence of SAFE's registration and approval, then the foreign lender's claim is reduced to 1/3 its original amount.

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 China and its economic reforms.

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, Tianjin, Dalian, Shanghai and Fujian. Of the 10 financial window companies, only the Bank of China, the Bank of Communications and China International Trust & Investment Corp. are likely to remain strong international credits.

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 Guangdong provincial government voluntarily injected a water plant supplying water to Hong Kong as part of the restructuring.

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 China's triangular debt conundrum. The Chinese government is likely to continue to experiment with bankruptcy as one instrument of economic reform, along with asset management companies, debt-equity swaps, mergers and acquisitions and other devices, in order to see which works best, or to paraphrase Deng Xiaoping, which cat can best catch mice.


*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: