China promises clampdown on "debt evaders" as bond defaults shake market

In another case, the China Securities Regulatory Commission (CSRC), the securities regulator, has started an investigation into Huachen Automotive Group, which has commenced insolvency procedures which could leave its bondholders empty-handed.

Financial regulators in China have warned they will show "zero tolerance" in situations where financial wrongdoing in state-owned companies brings about bond defaults. Vice Premier Liu He was quoted as saying that the Chinese authorities would clamp down severely on illegal behavior, ranging from misuse of funds to malicious transfers of assets.

Backdrop of increasing defaults

Since 2015, China's fast-growing bond market has witnessed an increasing number of defaults.  Based on data compiled by Bloomberg, bond defaults in China for 2019 hit a record high of RMB130 billion, overtaking the previous record of RMB122 billion in 2018. 

The damage inflicted on the economy by the global pandemic has led to an avalanche of defaults and raised risk profiles. In the first five months of 2020, 23 Chinese issuers defaulted on 53 bonds, worth a total of RMB66.2 billion (US$9.3 billion), equivalent to 45 percent of all the defaults in 2019 and over half of the defaults in 2018 . Alongside soaring bond default rates, bond default-related disputes are flooding the Chinese courts.

Legislative reactions to bond defaults and disputes

Against this backdrop of increased defaults and disputes, Chinese regulators have decided to step up their efforts to establish a more robust resolution mechanism to protect bondholders' investments, leading to a flurry of legislation in this area.  

On 24 December 2019 the Supreme People's Court (SPC) together with the People's Bank of China (PBOC), the National Development and Reform Commission (NDRC), and the CSRC held a meeting called "The national forum on trial of bond dispute cases" in Beijing to discuss measures to improve the handling of bond disputes through court proceedings. Three days later (27 December 2019), PBOC published the draft Circular on the Disposal of Corporate Credit-type Bond Defaults (Circular) jointly drafted by PBOC, NDRC, and CSRC. The Circular was finalized on 15 June 2020 published by PBOC on its website on 1 July 2020  and came into effect on 1 August 2020. On 15 July 2020 the SPC published the Conference Summary on the Tri¬als of Bond Dis¬pute Cases by Na¬tional Courts  which became effective on the same date.

The Circular

The Circular is a "departmental rule" promulgated by ministries and commissions under the state council which aims to clarify the basic principles and obligations of the parties concerned, as well as the core functions of the trustee system and the bondholders' meeting system when dealing with bond defaults. It ranks below laws and administrative regulations issued by the state council in the legislative hierarchy, and cannot be used by the PRC courts to, by itself, ground a claim to invalidate a contract.

The overarching goal of the Circular is to fend off systemic financial risk as well as sustain bond market financing. In order to achieve this, the Circular spells out rules which address key issues including:

(a)        Encouraging restructuring.

(b)        Toughening requirements for bond prospectuses.

(c)        Enhancing punishments for bad faith debt evasion.

(d)        Strengthening regulation of intermediary agencies.

(e)        Creating disclosure obligations relating to insolvency proceedings.

Whilst the Circular is long on general principles, it is short on implementation details. More concrete implementing measures are expected to be released in the near future.

The conference summary

The conference summary is part of a broad range of documents designed to summarize central legal policies and unify court practices. Although the summary does not have the status of law or even a judicial interpretation, lower courts will generally rule on corporate bond defaults based on its provisions as part of the SPC’s campaign to "harmonize court practice." 

The conference summary sets out the principles for dealing with bond dispute cases, rights of bondholders, responsibilities of issuers, and the duties of the issuer's insolvency administrator.  Key issues addressed by the summary include:

(a)        Qualification of litigants.

(b)        Litigation methods.

(c)        Jurisdiction.

(d)        Loss calculation.

(e)        Intermediary agencies.

(f)        Insolvency administration.

A welcome step

Both the Circular and the conference summary expressly support and promote the use of diversified channels to better resolve bond defaults, such as trading in defaulted bonds, and the use of credit derivatives to manage risks. Furthermore, by strengthening the punishments for deliberately missing repayments on corporate bonds, we expect the Chinese authorities to crack down on bond defaulters who use insolvency as an excuse for evading debt repayment obligations and to see increased pressure on the courts to hold directors, insolvency practitioners, and senior management of issuers personally liable if they are involved in falsifying or omitting material information in the issuer's disclosure documents. The point is that insolvency due to genuine business difficulties is one thing but "fake insolvency" or insolvency due to wrongdoing or misfeasance is another and should have consequences.

While the Circular and the conference summary represent progress of a sort in bringing structure and order to this fast-developing area of the law and hence are very much welcomed, they still leave much to be desired. For instance, the conference summary and the Circular are silent on the scope of their application, such as whether they are applicable to offshore bonds where the issuer or guarantor is a Chinese company.

Both documents encourage investors to file lawsuits collectively and have trustees manage these filings to improve efficiency. This may have the unintended consequence that individual bondholders' ability to sue issuers may be limited, especially in situations where the issuer has deep ties with the trustee. Above all, legislation at a higher level within the hierarchy of legislation and that gets more "into the weeds" on bond defaults will clearly be needed going forward.

A longer version of this article is available here.

Authored by Jonathan Leitch, Andrew McGinty, Wensheng Ren, and Nigel Sharman.