China's Bank Asset Management Companies: Gold in Them Thar Hills?

In addition to the challenge of finding attractive assets in China's Bank AMC portfolios, foreign investors face some formidable legal obstacles in purchasing, restructuring and liquidating them. This article discusses some of the principal challenges, following a review of the background of the Bank AMCs and their progress in divesting assets to date.

Background

During the economic reforms of the last 15 years, most of China's tens of thousands of state-owned enterprises (SOEs) came increasingly to rely on SOCB policy loans made on a non-commercial basis. By the late 1990s, the four major SOCBs were reportedly each holding huge portfolios of bad or distressed assets, in some cases believed to amount to more than half of total assets, mainly comprising non-performing loans (NPLs) made to SOEs.5

In order to facilitate the divestment of these assets by the SOCBs, China's State Council in 1999 approved the establishment of the four Bank AMCs, which are wholly state-owned, non-bank financial institutions. Each of the Bank AMCs has registered capital of Rmb10 billion, directly funded by China's Ministry of Finance (MOF). In 2000, the Bank AMCs each issued ten-year bonds, guaranteed by the MOF, to their respective partner SOCBs in order to finance the purchase of the SOCB assets transferred to them.6

Following their establishment, the Bank AMCs rapidly acquired a significant proportion of the big four SOCBs' NPLs and other troubled assets.7 Relevant legislation8gave the SOCBs responsibility for arranging the valuation of each transferred asset by a "competent independent intermediary," subject to MOF approval.9 The logistical nightmare implied by this process was avoided in practice by the expedient of transferring all assets at the SOCBs' book values, which has led to other issues discussed below. With respect to NPLs, the Bank AMCs purchased the principal amount and all interest chargeable to the profit and loss account associated with those loans.10 A comparatively small proportion of the debt acquired is secured.11

Equity in SOEs, acquired primarily by swapping debt for equity, makes up a significant part of the Bank AMCs' portfolios. The determination of which SOEs were suitable for debt-equity swaps, as with so many things in China, rested with governmental authorities.12 Given the lack of experience with such transactions in China, it is remarkable that several hundred debt-equity swaps have reportedly been accomplished since the Bank AMCs were established.13

The law requires the Bank AMCs to hold equity derived from a debt-equity swap for a "fixed period," during which time they should try to make the enterprise profitable by means of various restructuring measures.14 So far, experience with SOE restructuring appears to have been limited, although in 2000 the Bank AMCs reportedly signed agreements or letters of intent with 580 medium and large-sized SOEs for additional debt-equity swaps worth about Rmb405 billion.15

Disposition of Assets by the Bank AMCs

It has been reported that in 2001-2002 the Bank AMCs will attempt to sell more than 100 assets with a total value in the region of Rmb23 billion.16 To do so, the Bank

AMCs have taken a number of steps to tackle more complex dispositions, to seek foreign investment and to enlist the help of foreign companies with asset management expertise.

For example, Cinda AMC announced formation of joint ventures with a US-based distressed assets specialist and a European bank, which it claimed would be involved in managing and liquidating part of Cinda AMC's portfolio. Cinda AMC has also signed up international accounting firm Deloitte Touche Tohmatsu to assist in its activities.17

For its part, Huarong AMC has reportedly retained the international accounting firm Ernst &Young and the Korean Asset Management Corporation (Kamco) as financial advisers. Huarong has recently taken selected assets deemed suitable for foreign investors on an overseas road show, to be followed by an auction of assets later this year after completion of various qualification certifications and due diligence procedures.18

In addition, although China has little regulatory or legal framework to support asset-backed securitizations, all four Bank AMCs have reportedly retained Kamco to assist with the possible securitization of parts of their loan portfolios.19

Obstacles Facing Foreign Investors

While the Bank AMCs and foreign investors have expressed considerable interest in finding ways for foreigners to invest in the portfolios acquired by the Bank AMCs, there are some formidable barriers to foreign participation. Among the many business issues will be the willingness of the Bank AMCs to accept significant discounts to the book values at which they have acquired their assets. There will likely also be issues arising from the Chinese government's concerns about social and political disruption resulting from overly aggressive restructuring and liquidation of moribund SOEs. And finally there are legal and bureaucratic obstacles, to which we now turn.

Exchange Controls

China has a fairly comprehensive and strict foreign exchange control regime. The conversion of currency and remittance of foreign exchange to offshore companies is supervised by the State Administration of Foreign Exchange (SAFE), and capital account items remain strictly controlled.20 In order to hold a business license, receive renminbi revenues, establish an operating bank account in China and convert renminbi income into foreign currency, a foreign investor must at present establish a corporate entity in China in the form of a foreign-invested enterprise (FIE). There is currently no law that would permit a foreign buyer of Chinese debt to convert the proceeds of a domestic currency loan into foreign exchange and remit the funds out of the country. This is a major obstacle to the acquisition by foreign financial investors, such as distressed asset investment funds, of debt from the Bank AMCs.

Investment Guidelines

China's legal framework for foreign investment generally does not contemplate the sort of structures that would readily facilitate the acquisition of assets from the Bank AMCs, even where foreign investors are willing to establish an FIE for this purpose. All FIEs must undergo examination and approval by the Ministry of Foreign Trade and Economic Cooperation (MOFTEC) or its local agencies before they can be lawfully established. In examining an application for foreign investment, MOFTEC will refer to China's formal Investment Guidelines.21

The Investment Guidelines make it clear that projects involving "finance and related industries" are restricted,22 which means in practice that proposals to invest in enterprises that intend to conduct business within the finance industry will likely be subjected to greater scrutiny by the relevant MOFTEC agency. In addition, China's central bank, the People's Bank of China (PBOC), must also give its approval to a foreign investment in the financial services industry. To date, MOFTEC and the PBOC have been extremely reluctant to permit foreign investment in this sector.23

Investment Vehicles

China's policies on foreign investment were created with direct investment in mind, primarily direct investment in manufacturing. The legal framework has evolved over the years, but it is still relatively inflexible. A foreign investor seeking to create an FIE through which to acquire assets from a Bank AMC will have many obstacles to overcome, although these vary depending on whether the assets are debts, equity or real property.

With respect to debts, the first obstacle will be obtaining the requisite investment approval. The Investment Guidelines and other regulations permit the establishment of foreign-invested non-bank finance companies.24 Under applicable regulations, finance companies may be authorized to engage in "such local currency and foreign exchange business as the PBOC may approve".25 Accordingly, it appears at least theoretically possible for a foreign investor to establish an FIE to conduct a domestic currency financial services business, but it is far from clear that the PBOC would interpret these regulations so as to permit such an entity to acquire NPLs from the Bank AMCs. As for securitization of debts, arrangers of such transactions in China must overcome numerous difficulties, among them being the inability to incorporate the requisite special purpose vehicle.26

With respect to equity, there have been a few cases of foreign investors taking a direct equity stake in a domestic Chinese "company limited by shares". But Chinese law offers little direct guidance for this type of investment. Moreover, there is only limited protection for minority or passive investors in Chinese corporations generally, so this route is only suitable for very active investors willing to go to China to take control, or at least participate in the daily management of the investee company. Even for such investors, restructuring of the enterprise is likely to be fraught with difficulties.

There are also difficulties in the structuring of an investment vehicle through which to acquire and hold such equity.27 It is possible for existing FIEs both to establish new limited liability companies, or companies limited by shares, and to buy the interests of one or more investors in a domestic Chinese company, but such investment may be made only in operating companies within economic sectors for which the investing FIE is licensed to do business. In addition, an FIE may invest no more than 50% of its net assets in such companies.28 Accordingly, while operating FIEs may be able to acquire equity in Chinese enterprises from the Bank AMCs, current law places formidable obstacles in the way of the very financial investors, such as distressed asset investment funds, most likely to be interested.

With respect to real property, FIEs are currently restricted by MOFTEC to investing in the development and management of a new property. In addition, a real estate development FIE generally must be a Chinese-foreign joint venture, adding to the complexity of any transaction. Presently MOFTEC's insistence on the development component means that an FIE cannot be established to acquire an existing property on the secondary market, although some authorities have permitted foreign investors to acquire an existing domestic company that owns real property and then convert the entity to an FIE. Other methods may be available, such as the purchase of property by an offshore entity relying on a Chinese manager, but such options do not provide adequate protection of the foreign investor's interests.29

Valuation

Under Chinese law, state-owned assets that are to be transferred must be valued and the valuation confirmed by a competent state assets authority, thereby determining the floor price for the proposed transaction. The MOF has emphasized that Bank AMC assets to be disposed of by means of debt restructuring, debt-equity swaps or sale and lease must be valued by independent asset valuation agencies. Although rules to regulate Bank AMCs' powers in respect of writing down the value of assets before disposal to investors have been promulgated, they have yet to be effectively implemented.30 Problems arising from the lack of guidelines are compounded by the decision, noted above, not to write down losses when the assets were transferred to the Bank AMCs.31

Enforcement of Rights

The lack of an effective Chinese insolvency regime will be a major issue for a foreign investor that is able to acquire, directly or through an FIE, financial assets from a Bank AMC. Problems for creditors arise under Chinese law and policy for a number of reasons.

Some of these problems are essentially political. For example, if an SOE's creditors initiate a bankruptcy, the government administrative department with responsibility for the SOE has the power to veto the bankruptcy, thereby depriving creditors of their rights or at least indefinitely delaying enforcement. Even if an SOE is successfully declared bankrupt and placed in the hands of a court appointed liquidation committee, that committee will mainly comprise government staff who lack the incentives and knowledge to deal effectively with the liquidation of an SOE's assets. The bankruptcy regime places creditors at a further disadvantage by requiring that an SOE's legal obligations to its employees be placed before obligations to creditors.32 Moreover, at all stages of the bankruptcy process there is a tendency for local protectionism to prevail, especially in the context of an SOE, making results unpredictable.

In theory, recourse to China's courts is available. Under Chinese law a creditor can generally request the court to enforce its rights within two years of the date when an unpaid debt falls due. If the debt remains unpaid and the creditor takes the matter to court, it will usually take about nine months for the Chinese court to reach a decision and hand down a judgment.33 Once a judgment is obtained, difficulties may arise with regard to enforcement of such judgment.

Although a Chinese court has a number of sanctions available on an application for enforcement against a debtor, such as ordering the freezing and transfer of the debtor's assets, attachment of the debtor's income, delivery to the court of certificates of title and forced sale or auction of a debtor's property, the enforcement process tends to be protracted and depends heavily on the proper exercise of judicial discretion.34 The present bankruptcy regime, which has rarely been invoked in practice, is subject to administrative interference and a large amount of discretion is vested in judges who may be subject to local influences.35

Exit Scenarios

Exits for foreign purchasers of NPLs, in the form of collection of debts or their repackaging and sale, are entangled with the foreign exchange control, FIE approval, business licensing and creditors' rights issues discussed above. To our knowledge there are no precedents. Exits for foreign investors in the equity of Chinese enterprises and real property in China, while facing many of the same issues, have occurred more often and the mechanisms are better understood.

Currently a foreign investor in a Chinese enterprise has three exit scenarios: transfer of shares to a third party; share buyback by the invested enterprise; or a listing on an offshore or domestic stock market. None of these strategies is without potential difficulties, but all are feasible under Chinese law and policy. But structuring an investment in China with an exit scenario in mind is of critical importance, especially to a financial investor aiming not only at the best possible valuation but also liquidity in a convertible currency.36

A sale to other foreign parties effected offshore has been the most prevalent form of exit to date and will likely be the most practicable for buyers of enterprise equity from the Bank AMCs.37 The prospect of a share buyback by the invested enterprise seems a more remote prospect for exit, given the nature of the SOEs whose debt has been converted to equity, but it is not impossible and there are no legal (as opposed to administrative) obstacles under current law. Of course, as discussed above the ability to repatriate the proceeds can be an issue.

The nature and condition of the enterprises whose equity is acquired from the Bank AMCs may similarly make a sale of securities on the public markets, whether within China or on another exchange such as Hong Kong, seem rather remote. The authorities have recently indicated that there will be a further liberalization of the capital markets and that more FIEs will be permitted to list their securities, at least B Shares denominated in US dollars, on the Shanghai and Shenzhen stock exchanges. This has been rare to date, however, and even if the liberalization occurs there may be much better candidates for listing than companies acquired from the Bank AMCs. Again, there are no legal difficulties, apart from the foreign exchange issues noted,38 but as an exit route a public offering seems unlikely unless the authorities were to give preference to such entities as part of a package to encourage foreign investment in the Bank AMCs assets.

Conclusion

Foreign investors are clearly eager to participate further in the Chinese economy. At the same time, the Bank AMCs are making positive moves to bring about such participation through the acquisition of their respective assets, in one form or another. These assets may well be "gold in them thar hills". Given the present state of the Chinese legal system, however, numerous problems arise with regard to foreign investment in Bank AMC assets.

Some of the obstacles discussed above can and will be addressed by policy changes.39 Many of the policy changes now in the works because of China's planned accession to the WTO are relevant to the disposition of Bank AMC assets and may prove helpful. Moreover, officials at the Bank AMCs now speak openly of new laws they hope will be promulgated during the next year to address the problems faced by foreign investors wishing to acquire assets from the Bank AMCs.40

China has made great strides in developing its legal system, which barely existed 20 years ago, and it is certain that the government will continue its efforts as it grapples with the issues posed in this article. Whether new policies and legislation will appear and provide an adequate framework for near-term dispositions of Bank AMC assets to foreign investors remains to be seen.

ENDNOTES

1 In this article, we distinguish AMCs formed to deal with bank assets (Bank AMCs) from AMCs that have been established by some Chinese municipalities to hold and dispose of equity interests in certain SOEs.

2 Huarong AMC acquired assets from the Industrial and Commercial Bank of China, Great Wall AMC from the Agricultural Bank of China, China Orient AMC from the Bank of China and Cinda AMC from the China Construction Bank. Cinda AMC also acquired some assets from the China Development Bank.

3 See Peter Wonacott, "China Begins Overseas Push to Sell Nonperforming Loans," The Wall Street Journal, June 11 2001.

4 See the websites of the Bank AMCs, www.coamc.com.cn, www.chinacinda.com.cn, www.gwamc.com.cn and www.chamc.com.cn, which provide considerable information about their assets and activities.

5 See Nicholas Lardy, China's Unfinished Economic Revolution (Washington: Brookings Institution Press, 1998), for an extensive review of the problems of the SOCBs. As Lardy concludes, "[i]n part the rapid buildup of nonperforming loans in the financial system in the 1990s reflects the success of economic reforms in other areas. At the outset of reform state-owned enterprises benefited from a variety of implicit and explicit subsidies. Reforms gradually have closed off most of these subsidies, leaving preferential access to credit as the major policy instrument for supporting state-owned enterprises." Op. cit. p. 220.

6 As an alternative method of finance, loans allocated to SOCBs by the People's Bank of China (the PBOC) may be re-allocated to Bank AMCs to fund their purchases from SOCBs. State Council, Financial Asset Management Companies Regulations [金融资产管理公司条例], promulgated on November 10 2000 (the AMC Regulations), Article 14.

7 While some foreign analysts have suggested that the SOCBs still have troubled assets amounting to as much as 40% of their total assets, bank officials have indicated that the figure is around 25%. The Bank of China recently announced that it had NPLs amounting to 28.78 % of assets as of December 31 2000, i.e., even after the transfer of Rmb264 billion worth of assets to China Orient AMC in 2000. Liu Mingkang, chairman of the Bank of China, has reportedly said that currently some 48% of all SOCB lending should be classified as NPLs. See Christine Chan, "BOC chairman admits true non-performing loan level," The South China Morning Post, July 6 2001. See also the Bank AMC websites.

8 Principal laws governing the operations of the Bank AMCs include the AMC Regulations; the Accounting Practices of Financial Asset Management Companies Rules [金融资产管理公司财务制度], promulgated by the MOF on June 30, 2000; and the Disposition of Assets by Financial Asset Management Companies Rules [金融资产管理公司资产处置管理办法] promulgated by the MOF on November 8 2000.

9 See the Questions Concerning Asset Valuation When Carrying Out Debt-Equity Swaps Circular [关于债权转股权工作中资产评估若干问题的通知] issued by the MOF on December 7 1999.

10 Any interest not chargeable to profit and loss is transferred without compensation. The AMC Regulations, Article 12.

11 Reportedly some 22% of total debt is secured by means of mortgaged and pledged property in the form of real estate, other physical property, intellectual property rights and other valuable security, but Bank AMC officials estimate that the true value of this security covers only around 42% of the amount of the secured

By David G Pierce and Lawrence S Yee,

12 The AMC Regulations, Article 18. The State Economic and Trade Commission recommends SOEs deemed suitable by it for a debt-equity swap to the State Council, which approves the transactions along with the MOF and the PBOC.

13 As of July 2000. Information from the Bank AMC websites.

14 The AMC Regulations, Article 10. The duration of the "fixed period" is not clear, however.

15 Information from the Bank AMC websites.

16 International Business Daily [国际商报], May 11 2001.

17 Information from the Cinda AMC website.

18 Bei Hu, "Huarong gears for US$1.9b sale of bad-debt portfolio," The South China Morning Post July 2 2001.

19 "Korea KAMCO Advises China, Russia AMCs on Asset Disposal," Dow Jones Newswires June 18 2001. China does not yet have specific rules applicable to securitization and arrangers of securitization transactions face many difficulties. See Gao Peiji & Paul Kruger, "China Faces Up to the New Challenges of Securitization," International Financial Law Review (August 2000), pp. 29-34.

20 The PRC, Foreign Exchange Control Regulations [中华人民共和国外汇管理条例], effective April 1 1996 and administered and interpreted by SAFE apply to all transactions involving foreign exchange in China. An FIE is entitled under Chinese law to convert and remit the foreign investor's share of profits provided that such profits are derived from activities with the FIE's approved business scope.

21 These are set forth in the Directing of Foreign Investment Tentative Provisions [指导外商投资方向暂行规定], issued jointly by the State Planning Commission, State Economic and Trade Commission and MOFTEC on June 20 1995, and the Foreign Investment Industrial Guidance Catalogue (Revised) [外商投资产业指导目录], approved by the State Council on December 29 1997 and effective January 1 1998 (the Investment Guidelines).

22 Investment Guidelines, Restricted Projects, Class B (XV) Finance and Related Industries.

23 China has committed to opening its domestic market to foreign financial institutions in various bilateral agreements concerning the country's accession to membership of the World Trade Organization. The implementation of these commitments is some way off, however, and unlikely to be of immediate assistance with respect to the disposition of assets by the Bank AMCs.

24 The PRC, Administration of Foreign Investment Financial Institutions Regulations [外资金融机构管理条例], promulgated by the State Council on February 25 1994 and effective April 1 1994.

25 Ibid., Article 18.

26 See Gao & Kruger, supra note 19, for a discussion of the many issues that must be addressed as China embraces securitization. PRC, Trust Law [ÖлªÈËÃñ¹²ºÍ¹úÐÅÍз¨], adopted by the National People¶Þ Congress (NPC) Standing Committee on April 28 2001 and due to come into force on October 1 2001, should prove helpful to arrangers of securitization transactions, but obviously there is no experience with it to date.

27 The Establishment of Companies with an Investment Nature by Foreign Investors Tentative Provisions [关于外商投资举办投资性公司的暂行规定] were promulgated by MOFTEC on April 4 1995, but these poorly understood regulations only deal with the creation of holding companies by foreign investors that already have substantial direct investments in the country. To date, few foreign companies have been able to meet the stringent qualification thresholds to establish such holding companies. The regulations have been supplemented somewhat, on August 24 1999 and again on May 31 2001, but unless substantially further amended they will not be helpful to financial investors in distressed assets acquired from the Bank AMCs. For an analysis of the holding company rules, see Patrick M Norton & Howard Chao, "Mergers and Acquisitions," O'Melveny & Myers Topics in Chinese Law (February 2001), pp. 7-8. For a summary of the most recent changes to these regulations, see "Supplemental Provisions to the 'Provisional Regulations on Foreign-Funded Investment Companies," O'Melveny & Myers China Law & Policy Digest (June 29 2001).

28 See the Investment Within China by Foreign Investment Enterprises Tentative Provisions [关于外商投资企业境内投资的暂行规定], issued jointly by MOFTEC and the State Administration for Industry and Commerce and effective from September 1 2000. These provisions are discussed at length in Norton & Chao, supra note 27, at pp. 8-9.

29 See Howard Chao & David Kitchen, "Secondary Market Property Investments in China," Urban Land (June 2001) pp. 88-91.

30 Asset Disposition by Asset Management Companies Management Rules [金融资产管理公司资产处置管理办法], promulgated by the MOF and effective on November 8 2000.

31 Some commentators have questioned the willingness of Bank AMC managers to accept the steep losses that may be required to divest of overvalued assets. See Mia Trinephi, "China NPLs Have Great Potential - Ernst & Young," Dow Jones Newswires June 10 2001.

32 PRC, State Enterprise Insolvency Law (Trial Implementation)[中华人民共和国企业矿产法（试行）], adopted by the NPC Standing Committee on December 2 1986, Article 34.

33 PRC, Civil Procedure Law [中华人民共和国民事诉讼法], adopted April 9 1991 by the NPC Standing Committee, Articles 136 and 159.

34 Civil Procedure Law, Articles 221 to 233.

35 In April 2001 China Orient AMC reported that SOEs nationwide had avoided about Rmb12 billion worth of debts. A primary means of avoiding debts was to set up a new company "under the guise of reforming the corporate system," transferring all of the assets and employees from the SOE to the new company, and leaving the original debtor stripped of any assets. It was also reported that various local governments were actively obstructing the Bank AMCs pursuit of creditors' rights through the courts. Information from the Bank AMC websites.

36 See Norton & Chao, supra note 27, at pp. 3-7 for a discussion of structuring foreign investments in China generally.

37 Increasingly, such offshore transactions involve entities that are owned and controlled by domestic Chinese interests, a perhaps inevitable byproduct of exchange controls.

38 There would be no such foreign exchange issues with respect to B Shares, which are denominated in US dollars, or to shares traded on overseas exchanges, including Hong Kong.

39 For example, the current restrictions on foreign investment in Chinese commercial real estate could be dealt with by a simple change in MOFTEC's policies. See Chao & Kitchen, supra note 29, for a detailed discussion.

40 See Bei Hu, "Foreign prop for bad loans under review," The South China Morning Post July 4 2001, and Mia Trinephi, "China Huarong's Marketing Efforts Fail to Inspire Investors," Dow Jones Newswires June 20 2001, citing officials from Huarong AMC.