In another case, the China Securities Regulatory Commission (CSRC), the securities regulator, has started an investigation into Huachen Automotive Group, which has commenced insolvency procedures which could leave its bondholders empty-handed.
Financial regulators in China have warned they will show "zero tolerance" in situations where financial wrongdoing in state-owned companies brings about bond defaults. Vice Premier Liu He was quoted as saying that the Chinese authorities would clamp down severely on illegal behavior, ranging from misuse of funds to malicious transfers of assets.
China is facing a peak period for bond defaults
Corporate bond defaults used to be rare in China, as bond issuers were largely state-affiliated businesses and the government would often step in to ensure that such failing enterprises never actually defaulted, which was known as the "implicit government guarantee." However, after China's securities regulator, the CSRC, released the Corporate Bond Issuance and Trading Management Rules 1 in 2015 which substantially lowered the threshold requirements for issuance of corporate bonds and expanded financing channels for corporate entities, particularly for non-listed companies, China experienced rapid growth in both bond issuance and trading volumes.
Fast forward to 2020, China's bond market 2 has grown to a staggering size of US$14 trillion, surpassing Japan's and making it the second largest fixed income market in the world after the U.S. 3. At the same time, levels of international investor interest in China's bond markets have reached record highs, with major index providers announcing the inclusion of Chinese onshore bonds in their flagship indices 4.
The fast-growing bond market is also now witnessing an increasing number of defaults. With the uptick in bond defaults in recent years, the said "implicit government guarantee" seems no longer to be a safe bet. Based on data compiled by Bloomberg, bond defaults in China for 2019 hit a record high of RMB130 billion, overtaking the previous record of RMB122 billion in 2018. The damage inflicted on the economy by the global pandemic has led to an avalanche of defaults and raised risk profiles. In the first five months of 2020, 23 Chinese issuers defaulted on 53 bonds, worth a total of RMB66.2 billion (US$9.3 billion), which is equivalent to 45 percent of all the defaults in 2019 and over half of the defaults in 2018 5. This has not gone unnoticed by the regulators, who were alarmed to note that 16 of the 23 issuers this year were not first-time defaulters, indicating that some were serial defaulters or that previous restructurings had not achieved their goals.
New rules to respond to default wave
Alongside soaring bond default rates, bond default-related disputes are flooding the Chinese courts. Since China has only had a relatively short track record in dealing with bond defaults and few disputes involving allegations that bond prospectuses lacked clear arrangements regarding investor protection and dispute resolution had been brought before the courts. For disputes that have since made their way through the Chinese courts, bondholders have found the system to be slow and inefficient. Furthermore, as unified legal guidelines applicable to bond defaults were few and far between, the courts have been using a variety of standards and benchmarks when adjudicating bond-related cases. In a civil law based jurisdiction without a doctrine of binding judicial precedent, that adds up to a pretty inconsistent approach.
Against this backdrop of increased defaults and limited legislative and judicial guidance, Chinese regulators have decided to step up their efforts to establish a more robust settlement mechanism to protect bondholders' investments.
- On 24 December 2019 the Supreme People's Court (SPC) together with the People's Bank of China (PBOC), the National Development and Reform Commission (NDRC), and CSRC held a meeting called "The National Forum on Trial of Bond Dispute Cases" in Beijing to discuss measures to improve the handling of bond disputes through court proceedings. Three days later (27 December 2019), PBOC published the draft Circular on the Disposal of Corporate Credit-type Bond Defaults (Circular) jointly drafted by PBOC, NDRC, and CSRC. The Circular was finalized on 15 June 2020 published by PBOC on its website on 1 July 2020 6 and came into effect on 1 August 2020.
- On 15 July 2020 the SPC published the Conference Summary on the Trials of Bond Dispute Cases by National Courts (Conference Summary) 7 which became effective on the same date.
The Circular
The Circular is a "department rule" promulgated by ministries and commissions under the state council, as opposed to a "law" which refers to legislation promulgated by the National People's Congress and its Standing Committee. Therefore, the Circular does not seek to create new rules outside the existing legal framework governing bond defaults but aims to clarify the basic principles and obligations of the parties concerned, as well as the core functions of the trustee system and the bondholders' meeting system when dealing with bond defaults.
The overarching goal of the Circular is to fend off systemic financial risk as well as sustain bond market financing. In order to achieve this, the Circular spells out rules covering, amongst others, the following key issues:
Encouraging restructuring
The Circular sets out a number of principles which appear to encourage debt restructuring using market mechanisms to avoid outright defaults. For example:
- Improving the trustee system and recognizing that a trustee can apply on behalf of bondholders to participate in insolvency proceedings.
- Where the trustee fails to perform its duties, a bondholders' meeting may decide to replace such trustee.
- Improving the bondholders' meeting system and its decision-making efficiency, such as by encouraging the establishment of a hierarchical voting mechanism based on the extent to which bondholders' meeting proposals impact on bondholders' interests.
- Encouraging issuers and bondholders, through voluntary negotiations, to restructure their debt through bond swaps or maturity extensions.
- Enforcing information disclosure obligations to enhance the quality of information disclosure and investors' right to know.
Toughening requirements for bond prospectuses
The Circular specifically requires bond issuance prospectuses to include provisions on trustee responsibilities and obligations, rules on bondholders' meetings, bond-default disposal mechanisms and other material matters in relation to the rights and interests of investors – this is to address issues around unclear arrangements regarding investor protection and dispute settlement in bond issuance prospectuses, giving issuers scope for evading their debt repayment obligations.
Enhancing punishments for bad faith debt evasion
The Circular has included the following measures to strengthen punishments for bad faith misbehaving defaulters:
- Promoting a unified legal enforcement mechanism – for example, establishing a cross-department joint punishment mechanism for misbehaving defaulters.
- Significantly increasing the cost of unlawful behavior to diminish the likelihood of defaults.
- Limiting to a certain extent the financing capability of enterprises that have evaded their debt obligations in bad faith.
- Uploading to the national credit system and shared information platform enterprise default information and their persons-in-charge who have engaged in serious unlawful behavior that has led to material losses and has had a negative social impact.
Strengthening regulation on intermediary agencies
In addition, the Circular strengthens regulation of intermediary agencies such as bond underwriters and credit rating agencies and requires them to effectively carry out due diligence, improve credit risk assessment and management capabilities, establish conflict of interests mechanisms, and enhance risk discovery capabilities.
The Circular also encourages specialized security providers and bond credit enhancement institutions to provide security and credit support to issuers. These intermediaries are required to follow the contractually agreed terms and implement credit enhancement measures in a timely fashion, pay when required to pay and provide liquidity support as contractually agreed. In addition, they are required to exercise self-discipline to maintain market order and avoid providing "fake security" 8.
Creating disclosure obligations relating to insolvency proceedings
One of the noticeable changes compared to the draft version released last December was the way in which the Circular has incorporated detailed disclosure obligations in relation to insolvency proceedings – the administrator is under an obligation to disclose the status and progress of insolvency proceedings and provide material information about the enterprise in insolvency, including but not limited to the verdicts and the judgments issued by the court, property status report of the insolvent enterprise, relevant proposals tabled at creditors' meetings, and resolutions made by the creditors and any other material information that will influence the decisions of investors.
As the Circular is long on general principles, but short on implementation details, concrete implementing measures are expected to be released in the near future.
The Conference Summary
In addition to judicial interpretations, the SPC has issued a broad range of documents to translate central legal policies and unify court practices. One of the documents issued by the SPC is entitled "Conference Summary/Meeting Minutes." The Conference Summary falls under this category of judicial guidance documents.
Although the Conference Summary does not have the status of law or even a judicial interpretation, lower courts will generally rule on corporate bond defaults based on its provisions as part of the SPC's campaign to "harmonize court practice."
The Conference Summary sets out the principles for dealing with bond dispute cases, rights of bondholders, responsibilities of issuers, and the duties of the issuer's insolvency administrator. Key issues addressed by the Conference Summary include:
Qualification of litigants
The Conference Summary clarifies who can initiate lawsuits in bond default cases, such as whether bond trustees have standing as litigants. For example, if an issuer is unable to repay the principal and interest on the bond or there is a default situation as stipulated in the prospectus, the trustee may represent bondholders in its own name in civil lawsuits or apply for reorganization or insolvent liquidation of the issuer.
Litigation method
The Conference Summary promotes collective action as the primary litigation method in bond default cases, as this would make handling a case more efficient than if every bondholder were to file its own case.
Jurisdiction
Where the trustee or bondholders launch a lawsuit against the issuer or the credit ratings agency to request repayment of the principal and interest on the bond or performance of the credit rating obligation, the courts in the place of registration of the issuer shall have jurisdiction over such dispute, unless the parties have agreed otherwise.
In insolvency cases where the trustee and bondholders apply for the issuer's reorganization or liquidation or where the issuer applies for reorganization, reconciliation, or liquidation, the intermediate people's courts in the place where the issuer is registered shall have jurisdiction.
Loss calculation
The Conference Summary provides detailed rules as to how to determine the scope of default liability and how to calculate losses that have resulted from fraudulent bond issuance.
Intermediary agencies
The Conference Summary specifies the scope of duties of trustees, underwriters, and service institutions, such as credit rating agencies and lists out several situations where these intermediary agencies may be held liable to compensate investors to the extent that they are at fault and have failed to perform their duties in a diligent manner.
Insolvency administrator
The conference summary stipulates that once the issuer enters insolvency proceedings, the information disclosure obligation of the issuer will fall on the insolvency administrator, except for information about property self-managed by the issuer and the issuer's business affairs.
In addition, the administrator is prohibited from refusing to confirm valid bondholder claims for compensation without cause. Instead, upon receiving them from the trustee who represents bondholders, the administrator is required to confirm and register creditors' claims in a timely manner.
NAFMII guidance and bond exchange rules
NAFMII guidance
The Circular and the conference summary supplement a series of guidelines issued by China's interbank bond market regulator – the National Association of Financial Market Institutional Investors (NAFMII) – late last year, whose purpose was reducing the risks associated with interbank bond defaults.
Guidelines on Non-financial Enterprise Debt Financing Instrument Defaults and Risks Disposal in Interbank Bond Market 9 (Disposal Guidelines), issued on 27 December 2019 and effective from the same date.
The Disposal Guidelines summarize three disposal methods for interbank bond market bonds, namely adjustment of repayment terms, debt swaps or alternative repayment methods. These disposal methods are not only applicable to defaulted bonds, but also applicable to bonds that are yet to fall due, but where repayment is anticipated to be in doubt.
Guidelines on Bond Trustee for Non-financial Enterprise Debt Financing Instruments of the Interbank Bond Market (for trial implementation) (Trustee Guidelines) 10, issued on 27 December 2019 and effective from 1 July 2020
The Trustee Guidelines bridge the gap between the trustee system and legal proceedings, whereby the trustee is entitled to apply to the court for asset preservation, litigation, insolvency, and other judicial proceedings on behalf of investors holding the same category of debt. The Trustee Guidelines also clarifies that, in addition to the main underwriters, experienced asset management companies, law firms, trust companies, and other professional institutions are allowed to conduct trustee business after duly carrying out record-filing.
Rules for the Bondholders Meeting of the Interbank Bond Market Non-financial Debt Financing Instruments (revised version) ( Bondholders Meeting Rules) 11, issued on 27 December 2019 and effective from 1 July 2020.
The Bondholders Meeting Rules introduce a layered voting mechanism for bondholders meeting proposals to improve the effectiveness of bondholder meeting resolutions. In addition, the rules revamp the convening process to increase the transparency of bondholders meetings and emphasize all participating parties' rights and obligations. The new voting system could help bondholders to reach consensus on an out-of-court restructuring in the event of a default.
Bond exchange rules
On 31 July 2020 Shanghai and Shenzhen stock exchanges respectively published new rules on corporate bond exchanges – the Circular on Issues concerning Corporate Bond Exchange Business of Shanghai Stock Exchange 12 and the Circular on Issues concerning Corporate Bond Exchange Business of Shenzhen Stock Exchange 13 (collectively, Bond Exchange Rules).
The Bond Exchange Rules allow issuers to offer bondholders new bonds in exchange for debts falling due under an earlier bond, which is, in essence, a debt rollover. While this practice is not uncommon in offshore markets, it has only recently been formalized onshore, and may prove to be a popular device when dealing with onshore debt restructurings in the post-COVID-19 environment.
Under the Bond Exchange Rules, issuers must conduct bond exchanges by means of an offer, which shall be made through an announcement to all bondholders, together with a detailed swap plan. Issuers are required to actively communicate with bondholders and execute the swap on an equal and voluntary basis. For bondholders who reject the swap offer, issuers must continue to perform their payment obligations. It is notable that there is no cram-down or squeeze out mechanism based on achieving a certain percentage of bond holders in favour of the roll-over.
As both Shanghai and Shenzhen stock exchanges are supervised by CSRC, the Bond Exchange Rules are widely seen as a tool to increase bond issuers' liquidity and manage default risks that has the implicit "blessing" of China's regulators.
While the regulators seem to be encouraging public debt swaps, the Bond Exchange Rules fall short of explicitly banning or penalizing other controversial tactics deployed by onshore issuers, such as unilaterally extending maturity dates, reducing coupons, making private repayment arrangements with certain bondholders, or forcing bondholders into debt swaps. Given the non-transparent process and the lack of supervision by the authorities, these tactics often end up prejudicing the rights of certain bondholders. The prevalence of such practices, which notably do not involve giving all bondholders the option to redeem or roll-over, raises questions over whether bond issuers will, in practice, in the absence of an express ban under the Bond Exchange Rules, change their behaviour in a difficult post-COVID-19 market when cash is desperately tight.
Observations and conclusion
Both the Circular and the Conference Summary expressly support and promote the use of diversified channels to better resolve bond defaults, such as trading in defaulted bonds, and the use of credit derivatives to manage risks. This signals a significant change of direction – rather than bailing out failing enterprises for the sake of "social stability," the Chinese government appears now to be working towards establishing a more market-oriented and rule-based environment for dealing with defaults.
Also, by strengthening the punishments for deliberately missing repayments on corporate bonds, we expect the authorities to crack down on bond defaulters who use insolvency as an excuse for evading debt repayment obligations and to see increased pressure on the courts to hold directors, insolvency, and senior management of the issuers personally liable if they are involved in falsifying or omitting material information in the issuer's disclosure documents.
Nonetheless, the Circular and the Conference Summary still leave much to be desired. Both documents encourage investors to file lawsuits collectively and have trustees manage these filings to improve efficiency. The unintended consequence is that this may limit individual bondholders' ability to sue issuers, especially in situations where the issuer has deep ties with the trustee.
Moreover, the Conference Summary and the Circular are silent on their application scope, such as whether they are applicable to offshore bonds where the issuer or guarantor is a Chinese company. This may mean Chinese courts will need to review the bond offering documents, such as their governing law provisions to determine whether the Conference Summary and/or the Circular can apply to such offshore bond defaults. With respect to the scenario where the issuer is offshore but the guarantor is onshore, we think the application will largely depend on whether or not issuance takes place onshore and whether such issuance has been registered with the Chinese authorities. If the bond is issued and registered onshore, it is likely that the Circular and the Conference Summary will apply. In the contrary case, then unless the debt issuing documents specify Chinese law as the governing law, then the Circular and the Conference Summary are unlikely to apply.
Jonathan Leitch, Andrew McGinty, Wensheng Ren, and Nigel Sharman.
2 China’s bond market is a complex ecosystem that can be split into three categories: 1) Onshore RMB-denominated bonds, 2) Offshore RMB-denominated bonds, and 3) offshore U.S. dollar-denominated bonds, each with fundamentally different characteristics. This alert will mainly discuss category 1.
8 In practice, this usually refers to a security provider signing up to provide a guarantee in the contract, where in fact it does not have the ability to pay when the issuer defaults on the bonds.
