Trialed in 1986, expanded in 1991, and updated in 2006, China's Enterprise Bankruptcy Law has only this year become important to international investors. The trigger: precedents set by landmark defaults involving U.S. dollar bonds, and growing recognition in the country that court action may be preferable to out-of-court negotiations that drag on for years.

S&P Global Ratings sees these cases as positive for China's credit markets. They raise transparency, facilitate resolutions, and make outcomes more predictable. We anticipate more such cases as defaults rise in China.

The highest-profile debt events this year shed light on what to expect on Chinese defaults. They establish a key template for debt workouts as China improves its restructuring, resolution, and recovery regimes. International investors will find these changes encouraging as more enter the country's bond market, the world's second largest with about US$15 trillion outstanding.

Why Post-Default Events Vary Widely

China's debt market is huge, but international investors only hold some 2.4% of the country's onshore bonds. This low participation, despite the opening of Bond Connect three years ago to encourage foreign buying, is partly due to high uncertainty and poor outcomes in default cases. The recovery process is slow and unpredictable. Transparency on debt resolutions would give international investors more confidence to enter this market.

Chinese defaults have had widely varying outcomes. This is not because the legal framework lacks specificity. Rather, creditors and officials have pushed for different options, often seeing bankruptcy courts as a last resort.

In our view, this is due to the limited experience of lenders and investors, given the short history of China's bankruptcy law and of defaults in the country's bond market, which saw its first case only five years ago.

Fear of a low recovery is also a likely cause, given courts that administer liquidations are not required to maximize the sale price of the assets to be liquidated. This motivates creditors to seek out-of-court settlements that they believe will provide a higher recovery.

Chart 1

Differences Arise Between State-Owned And Privately Owned Entities

State-owned enterprises (SOEs) appear to be adopting more structured debt workouts than privately owned enterprises (POEs).

This could be due to the example set by Peking University Founder Group Co. Ltd. (PUFG), China's biggest SOE defaulter. Investors are following the case closely, due to its ownership by China's oldest university and the direct involvement of central authorities (see "Landmark China Default Tests Two Popular Bond Structures," published Sept. 18, 2020, on RatingsDirect).

The People's Bank of China and the Ministry of Education are leading the restructuring. Investors believe the PUFG case will set a standard for legal claims on state-owned issuers after a default.

Just months after PUFG entered court-administered restructuring in February 2020, court actions emerged for other high-profile SOE cases, including Qinghai Provincial Investment Group Co. Ltd. (QPIG) and Tewoo Group Co. Ltd. (see table 1 in the Appendix).

By contrast, well-known POE cases such as China Minsheng Investment Group (CMIG) and Wintime Energy Co. Ltd. and its subsidiary Huachen Energy Co. Ltd. have seen little legal progress following their defaults two years ago (see table 2).

Mixed Messages Create Confusion

Defaults in China are typically--but not always--preceded by news of financial or operational distress. As many companies do not comment on such news, the situation can confuse investors, especially if positive developments are mixed in with negative headlines.

For example, PUFG issued a Chinese renminbi (RMB) 1.55 billion bond, then defaulted less than two months later. QPIG repaid a US$300 million bond in each of the two quarters prior to its default. Such actions may have assured investors, but the signals were ultimately misleading.

Wavering government support, typically in the absence of official statements, adds to the confusion for distressed SOEs. Reports that the state may step in with support might be denied soon after, as was the case for QPIG months before it defaulted.

Ambiguous Reporting Precedes Decisive Defaults

China has limited experience with bond defaults, which are often not reported as such in the media.

International investors view a failure to pay interest or principal on time and in full, or a distressed bond exchange, as a default. However, reporters in China often call these events delayed or partial payments, or agreements to defer or reduce payments.

The language is ambiguous, but the defaults that follow are not. For example, media reports on Tewoo noted discussions with creditors to "convert" short-term debt (below one year) to something longer term. Three months later, the entity simply defaulted.

Chart 2

Asset Freezes Signal Start of Legal Actions

After the first default event, creditors often apply to local courts to freeze the assets of the debtor.

In Wintime's case, the court froze assets a day after the first default event, while PUFG took four days, and CMIG took a month. These actions were meant to secure the collateral underlying the debt, and they signaled the start of legal actions.

Delayed Payments Are Not A Path To Resolution

Defaulted companies in China sometimes make partial payments on interest or principal after a default. This may happen a few days (in the case of QPIG), a few months (CMIG), or a year (Wintime) after the initial default (see table 2).

While this reflects a willingness to pay, the issuer's inability to pay soon catches up with it. In no case have we seen issuers fully repay bondholders in this way without an organized legal or out-of-court process to restructure the defaulted bond. We see these payments as moderately positive, but not indicative of a path to resolution.

From a rating perspective, any reduced or delayed payments beyond those allowed by the terms of the bond, such as any grace period, constitutes a default.

Creditors' Meetings First Step In Engagement

The first out-of-court creditor or bondholder meetings are typically held within three weeks to three months of the first default event. In cases of extended inaction by stakeholders, such as QPIG, it may take a year or more for the first meeting to occur (see table 2).

These meetings are the first steps in engaging creditors to reach resolution. The meetings may be held to give notice to investors of an issuer's inability to pay, or to seek agreement to extend the date or reduce the amount of upcoming interest or principal payments (see the examples of PUFG and CMIG in tables 1 and 3).

It is important to monitor the developments of all creditor meetings. In out-of-court processes, the two creditor groups--bank lenders and bondholders--typically meet separately and do not coordinate demands. As the two groups' interests may not be aligned, outcomes for one may be negative for the other.

Distressed Tenders Equivalent To Default

An important development is distressed SOEs' increased use of tender offers, or offers to buy back outstanding bonds at discounted prices to reduce their debt burdens. Such offers are typically made months before the first default event, but sometimes months after (Tewoo). In extreme cases, the tender offer may come up to a year after the default (QPIG).

Tender offers after defaults tend to be at steep discounts that reflect the bonds' traded prices rather than the issuers' ability to pay. Tewoo's tender prices ranged from 30-60 cents on the dollar; QPIG offered 30-40 cents. The offers were largely in line with the traded levels of their bonds at that time (see table 1).

Such tenders are typically bad for investors. After a default, issuer transparency and bond liquidity are often low to nil. This may translate into punishing discounts on the bonds' traded price. The issuer's ability to repay the bonds may be substantially better than what the bond price indicates, as a result.

When an issuer is in distress, we see tenders or other forms of payment delays or reductions outside the terms of bonds to be equivalent to defaults. This is irrespective of creditors' willingness to accept the tender terms. The event constitutes a default even if an issuer has not defaulted outright on interest or principal due (see "Rating Implications Of Exchange Offers And Similar Restructurings," published May 12, 2009).

More Cases Will Bring Better Practices

We believe the need for resolution, particularly in the state sector, will motivate issuers and investors to adopt in-court processes laid out by the bankruptcy law.

As such cases cumulate, better practices are likely to emerge in China's domestic and international bond markets. SOEs are increasingly choosing the structured in-court approach, and we anticipate more POEs to follow.

This will provide more predictability in resolutions, and is clearly good for investors at home and abroad. To the extent it builds confidence and stimulates liquidity for China's bond markets, it will be good for issuers too.

Appendix

Table 1

Table 2

Table 3

Table 4

Related Research

• Landmark China Default Tests Two Popular Bond Structures, Sept. 18, 2020
• Peking University Ruling Raises Refinancing Risk On US$93 Billion Of Keepwell Bonds, Sept. 2, 2020
• Rating Implications Of Exchange Offers And Similar Restructurings, May 12, 2009
• Rating Government-Related Entities: Methodology And Assumptions, March 26, 2015