Historically low interest rates resulting from quantitative asing in the developed markets
have afforded relatively easy access
to capital, making it possible for
distressed companies around the globe
to refinance rather than restructure
as capital markets continue to flow.
In China, bank capital adequacy
pressures coupled with alternative
credit providers hunting for yield
in emerging markets continue to
propagate distressed investment
and restructuring opportunities.
However, growth in China has slowed
to a long-term low, and the appetite
for state- and government-backed
bailouts has perhaps been tempered.
Some recent legal and regulatory
changes implemented and proposed
in the People’s Republic of China
(PRC) in relation to foreign investment
provide a backdrop to highlight
where some issues lie in relation to a
foreign investment in China and how
things may develop in the future.
Typical Structural Issues
In most instances, overseas investors
are structurally subordinated in the
capital structure of PRC companies.
Foreign investors generally acquire
no direct ownership rights in the
operating companies that run the
business or otherwise direct recourse
to tangible assets in the PRC or to
Chinese entities that hold them.
Loans originate from both onshore
entities, such as domestic Chinese
banks and other financial institutions,
including shadow banking, and
offshore entities, such as non-domestic
banks, private equity firms, and other
credit providers. Given the competing
interests of these parties and the
structural subordination of most foreign
investors, conflict can arise between
domestic and offshore creditors when
a debtor group runs into trouble.
Strict capital controls have prevented
many mainland companies from
borrowing from foreign lenders
directly, so they have used offshore
structures to channel onshore the
loans received. Offshore loans are
also typically injected into a PRC
business as equity capital and will
therefore often be unrecoverable by
the holding company unless there
is ultimately surplus value available
for distribution to shareholders.
Even before the spectre of collapse
looms, moving money offshore
from PRC entities to service interest
and principal on loans from foreign
investors is a challenge. Onshore
profits and cash flows need to be
sufficient to allow dividends in
amounts to cover such repayments
offshore; otherwise additional
borrowing will be required, potentially
precipitating a downward spiral.
Variable interest entity (VIE) structures
have developed that involve
contractual arrangements intended
to allow foreign investors to enjoy
economic but not legal ownership
and contractual but not constitutional
control of businesses in the PRC.
Foreign investors in a VIE acquire no
direct ownership rights in the operating
companies that run the business. All
they have are contractual claims to
the economic benefits of ownership
and to control the business. The
enforceability of these claims in the
PRC remains uncertain. Investors in
these arrangements must factor in the
risks that the underlying operating
companies, or their creditors, may
simply ignore the VIE control structure.
Two recent developments regarding
foreign investment in the PRC are of
particular interest to investors: (i) a
relaxation of regulatory restrictions
on granting security and giving
guarantees, which has been
implemented; and (ii) a draft new
Foreign Investment Law (FIL).
The security regulations are
likely to impact how cross-border financings involving PRC
entities are structured, but some
conditions imposed concurrently
will perhaps limit the extent of the
potential benefits of the changes.
The draft laws on foreign investment
offer evidence of an apparent
continuing trend that reflects a desire
to shape the PRC’s foreign investment
regime in line with generally accepted
continued on page 22