Scott Murdoch, Karin Strohecker

LONDON/HONG KONG – Offshore bond investors are weighing the legal options in order to protect their investments as China Evergrande Group nears its default date.

These are the factors that offshore investors who have some $20 billion worth of Evergrande debt remaining must consider in order to cope with what could be China’s worst corporate default.

EVERGRANDE’S OFFSHORE BANDS DO EVERGRANDE’S GUARANTEE FROM ISUER

Chinese legal rules prevent mainland-incorporated parent companies from guaranteeing their subsidiaries’ offshore debt without going through a registration and approval process.

Offshore corporate bonds can often be issued using Special Purpose Vehicles (SPVs), which feature a keepwell structure.

Market participants used keepwell debts as a way to circumvent the non-existence of a guarantee. These are agreements between the bondholders and offshore SPVs that they will provide guarantees for the SPV’s financial stability and net worth.

Fitch reported that the keepwell structure was created in 2012-2013. They cited data that estimated more than 16% (or nearly $100 billion) of offshore bonds outstanding issued by Chinese corporations in 2020.

IS THE KEEPWELL-STRUCTURE RECOGNIZABLE?

Chinese courts can refuse to enforce a stay of execution based upon public interest, as is widely believed.

“The fundamental question in front of investors is whether the keepwell agreement is enforceable and what difference that may make in the recovery process should the group default,” said Matthew Chow at S&P Global (NYSE:) Ratings.

There have not been many test cases.

Chow cites the Peking University Founder Group Co Ltd case where administrators were appointed by the court and ruled that they would not recognize keepwell deeds for the group’s offshore bonds.

In a different case, however, CEFC Shanghai International Group Limited, an offshore bondholder, filed a claim against CEFC Shanghai International Group Limited for breaching the keepwell deed. CEFC was awarded a default judgement.

Ashurst Law Firm states the court upheld this decision last November because enforcement was not in violation of public interest. It also notes that the decision might have been different had proceedings been contested.

What are the other options?

Evergrande’s ensconcement in China’s economic system has led to some doubts about the willingness of Chinese courts to pay foreign creditors. This could be detrimental to domestic creditors.

David Billington, a restructuring partner at Cleary Gottlieb Steen & Hamilton LLP, said creditors might have some other options.

Billington explained that rather than enforcing keepwells, the bondholders could place the offshore issuer company under liquidation or any other insolvency procedure.

This would effectively mean that creditors would take control of the SPV which issued bonds via a liquidator. They would then pursue vehicle claims against China’s parent company.

Billington stated that such a move would improve the image of the Chinese court.

The Chinese court will not issue a judgment that requires a payment to foreign creditors. Instead, it will uphold a promise made by a parent to its subsidiary.

Karl Clowry from Addleshaw Goddard, London restructuring partner, stated that the complexity of issuers as well as the invisibility of authorities could prove to be a problem.

“Evergrande almost resembles a quasi-sovereign restructuring of debt, where the important stakeholders and the authorities are without doubt dictating the actions to be taken while the sponsor remains in place,” he stated.

“The government’s hand and the authorities are never far away.”

WHAT ARE THE CHANCES FOR OFFSHORE BONDHOLDERS TO MAKE CASH RECOVERY

Chinese restructurings are often complicated and not easily standardised, according to S&P. S&P says that dollar-bond defaults can be complicated and not easily standardised. However, out-of court restructurings allow creditors to make a different deal than the one they have with domestic creditors.

Tewoo Group executed an exchange and tender offering for four U.S. dollar bonds in December 2019, while its onshore debt restructuring process was approved about a year later.

In-court restructuring is not always easy to read when it comes cash recovery rates. These depend on many factors, including asset quality and equity ownership as well as the complexity of the group structure.

Based on a review of nearly 50 defaulters going through in-court restructurings, S&P found investors saw an average recovery of 23.7%.

A Hong Kong lawyer representing a large western law firm said that everyone is monitoring the situation. The outcome of the restructuring process could have an impact on the future.