The Topsoft Cases: The Perils of Loan Guarantees

The Root Causes

As incredible as the Topsoft cases may seem, Topsoft is not alone in the reckless issuing of loan guarantees. Even though the China Securities Regulatory Commission ((CSRC) prohibits listed companies from issuing guarantees that exceed 50% of its net asset value as measured at the end of the most recent accounting year, according to a recent news report, about 40 listed companies are known to be violating this 50% limit rule, and 27 out of these 40 companies have issued guarantees that exceed their respective net asset values. What are the root causes of such abuse?

The Piggy Bank Syndrome

Some Chinese listed companies, such as Topsoft, have been used as piggy-banks by controlling shareholders that cause such listed companies to provide funds or loan guarantees to affiliates. In fact, it is not uncommon for private firms to have their listed subsidiaries to provide loan guarantees for easier access to bank loans for the parent company or the affiliates.

Ignoring the Watchdogs

According to the separate statement issued by Topsoft's independent directors in the 2004 annual report, most of the guarantees were issued before 2004 without the approval of the board of directors, without the approval of the independent directors, in violation of the standard corporate decision making process, and without fulfilling the duty of public information disclosure. Additionally, as mentioned above, the sheer size of these guarantees violated the CSRC's rule limiting the amount of the guarantee to 50% of net asset value. Does it really take a daredevil to ignore the watchdogs? As some scholars have pointed out, currently the penalties for violating the securities laws are low (with limited fines and a maximum of five years of jail time in most cases) and the perceived risk of detection is also relatively low. The potential financial reward, however, can be very high¡Xthis calculation has indeed made the temptation to abuse the system too great to resist for some controlling shareholders.

Blind Faith

If the shareholders and creditors cannot have complete faith in the information disclosures made by listed companies, then the situation is made even worse because of the lack of a nationwide corporate credit-rating system. When a well-known listed company that also happened to be a darling to the media (such as Topsoft in 2002) approaches a bank or a trading partner for business, how could such bank or trading partner say no? After all, most banks want to offer products beyond secured debt and most businesses operate in ways other than "cash on delivery". However, without reliable public information disclosure and credit ratings, the banks that accept guarantees are indeed partly relying on blind faith.

The Implications

After discussing some of the root causes, the prescriptions for the cure seem to be straight forward¡Xcorporate governance reform, toughening the laws against abuse and strengthening the enforcement of the existing laws by the regulators, the establishment of a nationwide corporate credit-rating regime, and also bank reforms. Of course, most people would agree that these measures are all a lot easier said than done, and it will take some time to implement them. Nevertheless, it seems apparent to many observers that substantial banks with professional staff, such as those that were involved in the Topsoft cases, have the resources to deal with these problems and improve the standards of corporate governance by demanding more through their own financing procedures. The Topsoft cases have provided important lessons in raising foreign investors' awareness of the risks associated with the reckless guarantees of loans.