Caixin | Financial markets have been jolted by a number of defaults on corporate debt in recent weeks, with state-owned Dongbei Special Steel Group Co. missing a 700 million yuan repayment on May 5.
As creditors count their losses, the string of defaults underscores an urgent need for authorities to improve their oversight of the debt market through better risk controls and effective restructuring remedies.
Shenzhen-listed Shanghai Chaori Solar Energy Science &Technology Co. Ltd., which raised 1 billion yuan in the bond market in March 2012, said in a notice on March 6, 2014, that it could not make a repayment due the next day, and authorities then refused to ride to the rescue with a bailout.
The number of defaults involving companies large and small, private and state-owned has been on the rise over the past two years, highlighting the risks in the nation’s fledgling debt market.
A slower growing economy undercutting profitability and a lack of good faith in agreements and contracts are contributing to the problem. The excess amounts of leverage that many businesses assumed during better times are also exposing firms to the risk of default.
The impact of defaults is rippling through the debt market, and a large number of bond offerings have been delayed or put on hold due to a lack of interest and rising costs. In the meantime, investors have sought to offload or shunned bonds held by debt-ridden state-owned companies and businesses dealing with oversupply problems.
Defaults occur in any economy. However, the latest bout of defaults in this country exposes a systematic flaw: corporate governance is all but absent. Many firms are missing due dates because they are hampered by feuding shareholders. Some unscrupulous businesses are also deliberately trying to evade liabilities by providing misleading information or by conducting murky deals with their parent companies. This is done at the expense of creditors and good faith in the debt market.
Investors are now forced to rethink their strategies. In the past, they often worried more about whether a debtor had the backing of the government or was an industry heavyweight than how it was run. Some investors simply built their portfolios on the premise that authorities or big-name backers are certain to come to the rescue when a problem occurs. This might have been the case in the past, but the logic no longer holds because authorities are preoccupied with a weakening economy.
Underwriters, accounting and law firms come in for some blame, too. They are eager to profit from their clients, even if it means not doing their job properly by performing due diligence checks and disclosing information to the public. Some underwriters, themselves creditors who have lent out money to companies, have often sided with their clients over retail investors during defaults.
This will only result in a vicious cycle: irresponsible debtors continue defaulting on their debts, which pushes up the costs for others who want to raise money. To address these issues and restore investor confidence, we must strengthen oversight and close loopholes in the debt market.
The current legal framework is flawed because the punishments on the books do not deter debtors from defaulting, even if they do so on purpose.
To better regulate the corporate bond market, we can look to the Deep Rock Doctrine developed by the U.S. judicial system for inspiration. That principle prevents debtors from hiding their assets via murky deals with their parent companies because it says that a debtor’s parent company lines up behind other creditors when it comes to repayment.
Regulators should also put in place rules obligating a debtor to properly disclose information as well as rules for debt restructuring when a default occurs. These rules make more sense as a growing number of state-owned companies in glut-ridden sectors are ordered to undergo restructuring to shed overcapacity and excess leverage.
It is also time for investors to abandon the illusion that authorities will save the day – and their money – with a bailout. Instead, they should learn to shop for companies that demonstrate sound fundamentals. They must also keep their eyes open for potential risks linked to new businesses and merger and acquisition plans firms might undertake.
For their part, regulators must move to tighten their oversight of underwriters and other intermediaries linked to debtors so that investors have broader access to good information. This would also entail punishing people guilty of insider trading and scams.
The latest problems expose a weakness in the law in terms of protecting investors. For instance, many creditors’ committees set up in the wake of the defaults are dominated by banks that lent money to debtors, meaning retail investors have little say in how debt restructuring proceeds. Meanwhile, now is the time to set up a credit trustee system and a fund to handle debt restructuring so that investors can be better protected.
The amount of China’s outstanding debt reached 14.3 trillion yuan at the end of 2015, second only to the United States. The string of failures in recent weeks is a stark reminder of how the domestic market is prone to risks. As the amount of debt is likely to expand rapidly, it should do so alongside a sound oversight regime that can prevent the problems seen in the period.
