Moody's announced in October 2014 that the detainment of Agile Property Holdings' chairman, Chen Zhoulin by government authorities was credit negative, in Moody's view, "similar incidents would adversely affect developers' borrowing costs and/or their access to offshore funding". The events that have unfolded since show that Moody's were right on the money.
A number of investigations into the allegedly corrupt activities of high-level real estate executives in China have recently taken place. To give just two examples, Agile Property Holdings’ chairman, Chen Zhoulin, was recently detained by government authorities (though he later resumed his duties), and another property developer, Kaisa Group Holdings Limited, was blocked by the Shenzhen government from selling property in 11 projects in the city. Shortly thereafter, the chairman Kwok Ying Shing resigned quoting health reasons closely followed by most of the senior management team.
Onshore / offshore lending
Many PRC developers operate under a substantial debt burden. PRC restrictions on borrowing and land purchase, coupled with the huge domestic demand for sales, have encouraged PRC developers to fund their working capital requirements offshore and the high-yield market has been a very willing provider in recent years. Ratings agency Standard & Poor’s, reports that offshore bond maturities will surge to about US$8 billion in 2017 and US$10 billion in 2018.
The typical onshore/offshore lending structure involves a separate Cayman or BVI incorporated parent company (which may or may not be listed) either borrowing funds from offshore credit providers or issuing notes or bonds subscribed by offshore investors. The proceeds are then passed down through the corporate chain by way of equity or shareholder loans to the mainland operational companies where the funds are used.
The onshore/offshore funding model works well until there is a default and offshore creditors require repayment. Unless the offshore creditors have guarantees or direct security from the operating companies, they will have to wait until onshore, generally domestic creditors have been repaid before any surplus can be passed up to the immediate parent company.
Offshore creditors are typically left to rely on any security that may have been granted at the offshore level, whether debenture or share charge security, allowing them to appoint a receiver and manager. In the absence of any security, the options can be limited to seeking the appointment of provisional liquidators or liquidators over the offshore entity and then trying to gain control of the PRC subsidiary.
Gaining control of a company and changing the legal representative (akin to a director) in a scenario where the local management is not co-operative can be a long and frustrating process. However some assistance has recently been provided following a 2014 decision in the Supreme People’s Court in Beijing in the case of Sino-Environment Technology Group Limited (in liquidation). In this case, the court confirmed that once a valid shareholders’ resolution to remove the legal representative has been passed, the existing legal representative no longer has the authority to represent the company or conduct the affairs of the company. Even so, there is still the hurdle of negotiating with the local State Administration of Industry and Commerce to register the change of legal director and issue a new business permit effecting the change.
Kaisa restructuring terms
On 6 February this year, Kaisa and another PRC developer, Sunac China Holdings Limited, jointly announced a proposed deal involving the acquisition of approximately 49.25 per cent of the shares in Kaisa conditional upon a number of terms, in particular the restructuring of the offshore debts being completed by 31 July 2015. The headline terms involve extending the maturity dates on all offshore notes and bonds and lowering the interest coupon and similar but generally improved terms for onshore creditors. At the timing of writing, a deal with Sunac now appears unlikely so creditors will have to wait a while longer to understand how this restructuring is going to play out. The liquidation analysis provided by the company to its creditors at the outset of the restructuring showed an estimated return of only 2.4 cents in the dollar so it seems unlikely the offshore creditors will be taking enforcement action anytime soon.
Changes to restructuring provisions have resulted in some improvements but uncertainty for the company, investors and shareholders remains. The importance of good corporate governance cannot be overstated. To avoid the risk of government investigation, and the potential consequences this can bring, it is crucial that government land approvals are obtained in a transparent and demonstrably law-abiding way.
While Moody’s report that offshore bond issuance has significantly slowed this year, they consider the risk to the sector’s overall refinancing risk to be manageable. The continuing interest rate cuts by the People’s Bank of China and easing of mortgage lending terms and housing taxes are expected to support property sales and reduce domestic borrowing costs for lenders.
It remains to be seen whether high-yield investors will be able to insist on greater protections in future bond covenants. Where transactions concern a company’s founder-chairman and first-generation management, particularly where they have strong links to government, we might anticipate investors in certain development projects to insist upon some additional protections. A default or mandatory prepayment event arising on the departure of a key individual could well be sufficient to give investors an earlier seat at the restructuring table. But it remains to be seen whether that makes any difference in circumstances where the reasons for the key individual departing are less than transparent.