China Ting’s Entrusted Loans and China’s New Bankruptcy Law
June 25, 2014
Earlier this week, China Ting Group Holdings (China Ting) notified the HKSE that there had been an event of default on its entrusted loans to Zhongdou Group Holdings and Hangzhou Zhongdou Shopping Centre, two mainland companies with a common owner. The amount involved is USD 26 mn, which in the whole scheme of the financial system is immaterial. We take this opportunity, however, to highlight: [1] how a section of the shadow-banking system operates; [2] risks taken by companies with no expertise in commercial lending; & [3] our understanding of the current bankruptcy regime in China.
Entrusted loans are facilitated by a mainland bank matching willing lenders to willing borrowers, booking a fee for the service. In the above case, the banks involved are Ningbo Bank Corp. and the Bank of Communications. The Central Bank reported that entrusted loans by public companies rose to almost 400 in 2013, a rise of over 40% from 2012.
China Ting, headquartered in Hong Kong, was founded in 1992 and is a vertically integrated garment manufacturer, exporter and retailer. The company’s main region of operation is the Yangtze River Delta. China Ting is one of the largest manufacturers and exporters of silk products in China. The company made HKD 2.4 bn in revenue in FY 2013 and its asset base was HKD 3.9 bn as at FYE 2013.
The following is an excerpt from China Ting’s 2013 annual report: “As of 31 December 2013, the cash and cash equivalents were approximately HKD 179 mn, representing a decrease of approximately 44% from HKD 320 mn as of 31 December 2012. The decrease in the cash balance was primarily due to the entrusted loans entered with the borrowers, which are companies established in the PRC, through the lending agent, a commercial bank in the PRC. The entrusted loan arrangements would, in the opinion of the Directors, have a better utilisation of the financial resources of the Group.“
This was a bold statement and, as it now appears, naive. We note that Mr Leung Man Kit, one of four independent non-executive directors, previously worked in corporate finance for Peregrine Capital and Swiss Banking Corporation. We further note that the rate of interest on the entrusted loan was reportedly 18%, seemingly a warning sign within itself. We would recommend investors critically assess companies that invest material sums outside their main line of business for returns that appear to be too good to be true. Possibly the monies could have been returned to shareholders if deemed to be surplus to requirements.
The borrowers are companies controlled by Mr Yang Dingguo, somewhat of a local identity in Hangzhou. The Zhongdu Group was established in 2002 and has been in the businesses of real estate development, shopping mall operation, hotels and property management. We note that the property development arm and shopping malls are no longer operational. The group reportedly has CNY 2 bn outstanding debt as of 20 June 2014, not including amounts owing to Zhongdu employees. Total assets amounted to roughly CNY 1 bn. Ironically, Zhongdu Group has been rated AAA for many years by one of the rating agencies. The company is now being sued by banks, trusts and Mr. Yang Dingguo’s relatives and friends. Mr Yang disappeared on June 17 but was apprehended by police on Wednesday.
The Enterprise Bankruptcy (New Bankruptcy Law) took effect on 1 June 2007, replacing the previous legislation enacted in 1986. The new law contains a number of fundamental changes with establishment of new regulations covering, among other issues: [1] restructuring plans; [2] priority of secured creditors; [3] establishment of an administrator; and [4] enforcement of cross-border bankruptcy judgments. The law contains many features of insolvency laws in other countries, including the concept of reorganisation and is meant to provide legal protection for economic stability. We believe that the effectiveness of the new law has yet to be established.
In 2012, Messrs Tomasic & Zhang published a paper examining the effectiveness of the new law. Their findings included:
- Courts had considered a relatively low number of cases (circa 100);
- Two thirds of these arose in three provinces (Guangdong, Jiangsu, & Zhejiang); and
- Consideration by a court of a reorganisation is unlikely to occur unless supported by the local government where the company is based.
The paper highlighted that local governments are concerned about the impact on their community of a failed company. In addition, local creditors may pressure local governments to ensure their claims are met. Interestingly, the fear of mass shareholder meetings causing unrest also was a consideration, somewhat destroying the concept of priority of claim. We understand that the Central government has taken an interest in the issue and may become more involved in the local court system.
In our view, the situation facing a creditor of an offshore company is even direr. Almost all USD HY bonds associated with Chinese enterprises are issued by offshore companies, generally incorporated in the Cayman Islands. Funds are then down streamed to holding companies in Hong Kong, which subscribe to capital in mainland registered entities. Hence, a USD bondholder must first establish a claim with a court in the Cayman Islands before being able to access assets held by the Hong Kong entity. Thereafter, the challenges escalate exponentially. In our view, a Hong Kong receiver would face an uphill battle to access a court and fight for mainland assets. In addition, we believe the mainland court would be more inclined to protect the rights of mainland creditors and employees.