By Andrew Minear
On November 17,
2014, Shanghai-Hong
Kong Stock Connect, known as Stock Connect, went live. Stock Connect is a
government-sponsored investment mechanism that aims to radically expand foreign
investment in China with a daily quota of $2.2 billion. Before the formation of Stock Connect, companies in China attracted
foreign investment through notoriously
risky indirect investment structures
because China’s Qualified Foreign Institutional Investor program, or
QFII, set strict quotas on direct
foreign investment into China. By way of
comparison, under QFII, foreign direct investment totaled $110 billion over the
past 10 years. Nevertheless, the
roll-out of Stock Connect (which is intended to afford foreign investors the
opportunity to invest directly in
Chinese companies), will do nothing to ameliorate the risk in recovery of the foreign investment in
the event of insolvency.
Even if direct foreign investment through Stock
Connect is successful in increasing the infusion of foreign capital, direct
foreign investment will likely not reach the historical levels of traditional
foreign investment in China - indirect
foreign investment, which is structured in China in one of two ways. In the traditional structure used to access
foreign capital markets, known as a Variable Interest Entity or VIE, and used
by e-commerce giants Alibaba
and Baidu, the offshore holding company does not hold a “direct” ownership in the operating subsidiary, but instead the
offshore holding company enters into a series of contracts with the operating
subsidiary which allow it to exercise control over the operating subsidiary and
receive a portion or all of the subsidiary’s profits.
In the
increasingly common “pass through” structure, the equity holders or owners of
the operating company in China create or acquire an offshore holding company
that owns the operating company in China.
The offshore holding company is often domiciled in a permitted domicile
for Chinese companies, often the Cayman Islands or British Virgin Islands. The profits of the operating subsidiary “pass
through” the offshore holding company to the indirect foreign investors.
In both the
pass-through and VIE structures, the offshore holding company infuses cash
raised in the foreign market into the operating subsidiary in China by taking
on debt or issuing equities on a major foreign stock exchange. Alibaba chose the New York Stock Exchange
while Baidu chose NASDAQ.
Direct (e.g. Stock Connect) and indirect (e.g. through a VIE or “pass through” structure) foreign
investment in China offer opportunities for investors in the robust Chinese
economy. But every economic opportunity is accompanied by risk. Despite the emergence of Stock Connect and
recent bankruptcy reforms, the risk of recovery on all Chinese investments
remains high because local governments with political ties retain significant
influence over the restructuring process.
Historically, China
approached financial distress as a matter of public concern, not a purely
financial issue to be resolved by a distressed company and its
creditors/stakeholders. For example, China’s
restructuring law, known as the Enterprise Bankruptcy Law or EBL, prioritizes
employees by subordinating almost all creditor claims to employee claims.
More
significantly for direct foreign investors infusing cash through Stock Connect,
the government and judicial authorities wield substantial control over a
debtor’s reorganization efforts under the EBL.
Under Chapter 8 of the EBL, the parallel to Chapter 11 of the Bankruptcy
Code, a debtor may manage its assets under the supervision of an administrator,
or the administrator may operate the business and administer assets by engaging
existing management. Court-appointed
administrators take an active
role in reorganizations in China, even forcing liquidation over the objections
of creditors and the debtor. The
administrators are frequently government officials from the local bureaus and
departments with political ties to labor groups. Thus, coordinating with the local government is
an essential element to any restructuring in China.
The indirect
foreign investor must also overcome challenges related to pass-through or VIE
structures. Courts in China have ruled
that certain VIE structures are illegal. Alibaba’s prospectus concedes that “the [Chinese]
government may not agree that these arrangements comply with [its] licensing,
registration or other regulatory requirements, with existing policies or with
requirements or policies that may be adopted in the future.” But, the risk of a government crackdown is decreased
if there is no threat to national security and the government has an interest
in seeing the financing completed. However,
in some cases, the operating subsidiary has used political connections with
local officials to successfully nullify the VIE agreements, making enforcement
of legal rights by foreign investors virtually impossible.
In many VIE and
pass-through structures, the foreign investor obtains (or seeks to obtain) security
for the investment, usually in the form of a guaranty or pledge of shares. The effectiveness of the security, however, has
depended on the approval of local government agencies. For example, until recently, a guaranty by
the operating Chinese entity required prior approval from the State
Administration of Foreign Exchange (“SAFE”).
SAFE recently relaxed its regulations by removing the approval
requirement, and replacing it with a requirement that onshore subsidiaries
merely notify SAFE of any guaranty to a foreign investor. In many pass-through structures, the offshore
holding company pledges its shares in the onshore operating subsidiary to the
foreign investor. Share pledges,
however, are similarly subject to approval by the local Ministry of Commerce. In an EBL restructuring, the shares held by
the offshore holding company in the onshore operating subsidiary are
structurally subordinated to the operating subsidiaries’ creditors.
In the past, the
local State Administration of Industry and Commerce (“SAIC”) and local courts often
rejected a foreign investor’s use of its security to remove the legal representative
of the operating subsidiary, even if the foreign investor obtained prior
approval for the security from SAFE or the Ministry of Commerce. Recently,
foreign investors have seen more success with attempts to effectuate
reorganizations. In June 2014, the
Supreme People’s Court enforced a shareholder resolution to remove the legal
representative without updated records from the SAIC. In another recent case, a local court refused
to compel the legal representative to surrender the operating subsidiary’s
legal seal, known as its “chops,” and business licenses. The liquidators appealed to the Suzhou
Intermediate People’s Court where the onshore shareholder had less influence,
and the shareholder agreed to a settlement pending a ruling by the court of appeal.
As China opens
its markets to foreign investors through enhanced direct investment, like Stock Connect, it should undertake three additional
modest reforms to its restructuring laws to attract and protect those investors. First, the role of the bankruptcy administrator
must be transparent, and its authority should be subject to greater limits and
creditor oversight. Second, offshore and
onshore creditors should be treated equally under the law. Third, political collusion among local
interest holders and governments should be reduced (its elimination is an
unrealistic first step, but is an ultimate objective). For the latter, China’s recent campaign
to crackdown on local corruption brings hope, but additional legal reforms are
necessary to create a more certain investing environment.
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