News Analysis
International investors who own Chinese dollar-denominated bonds are on high alert.
The bankruptcy and restructuring of Peking University’s Founder Group, a Chinese state-backed technology conglomerate, currently playing out in Chinese court could upend the entire offshore dollar bond market.
At the heart of the issue are so-called “keepwell” deeds, a quasi-guarantee issued by Founder Group designed to protect foreign investors who invested in bonds issued by Founder’s offshore subsidiaries. But that structure is being challenged in court as part of Founder Group’s restructuring proceedings, as administrators overseeing its bankruptcy are looking to tear up such “keepwell” bonds.
If the Beijing court deems the provision—akin to a “gentlemen’s agreement”—as non-enforceable, more than $100 billion of offshore dollar-denominated Chinese bonds would suddenly be worth a lot less.
And foreign investors could stand to lose most if not all of their investments.
High Profile Bankruptcy
Founder Group is owned by Peking University and engages in technology services, health care, real estate, and securities trading. It’s one of a handful of conglomerates owned by China’s high-profile research universities.
It began having financial difficulties late last year, when it missed payment on a 2 billion yuan ($280 million) onshore bond. Founder’s default on its onshore bonds initially shocked investors, since it was rated AAA (the highest possible credit rating) by domestic Chinese credit rating agencies. Ostensibly, Founder’s lapsed payment was part of a larger trend of Chinese bond defaults during 2019.
Creditors of the company then extended the deadline for payment to February 2020. In February, as the CCP virus began to ravage much of China, creditors asked a Beijing court to restructure Founder Group through bankruptcy proceedings. According to a report by Chinese business magazine Caixin, as of February, Founder Group had 34.5 billion yuan ($4.8 billion) in outstanding onshore bonds, and $3.2 billion of outstanding offshore dollar bonds.
Validity of ‘Keepwell’ in Question
Founder Group and many other Chinese companies binged on dollar-denominated bonds to raise funding from foreign investors. As part of selling these bonds, Founder Group issued so-called “keepwell” deeds to implicitly offer a level of assurance that the Chinese company wouldn’t default on its offshore dollar debt.
The keepwell is an instrument in which the onshore issuer company seeks to maintain the solvency of the offshore subsidiary (technically unrelated to the onshore operating company). That’s accomplished via a series of agreements that could include asset-purchase agreements or equity interest purchase agreements, in which the Chinese issuer promises to transfer cash to the offshore entity to support the bond. Unlike a direct guarantee, this “keepwell” structure doesn’t require the explicit approval of China’s State Administration of Foreign Exchange, which regulates transactions in foreign markets and foreign currencies. Many Chinese companies adopted this structure because of its expediency and low regulatory hurdle.
But these “keepwell” deeds aren’t guarantees and have never been tested in court during a business bankruptcy—until now.
In Founder Group’s case, the administrator overseeing the restructuring—which is in charge of proposing which claims of the company are valid—has said that it wouldn’t recognize Founder Group’s keepwell bonds, which amount to around $3.1 billion, according to Bloomberg.
Foreign investors could lose their principal if the court decides in the administrator’s favor.
Fitch Ratings, a major U.S. credit rating company, isn’t optimistic about foreign bondholders recouping their funds.
“There has previously been no precedent on enforcements of keepwell structures,” according to a note by Fitch, which rates some of Founder Group’s offshore bonds. Fitch data suggests that approximately 16 percent of the $96 billion in outstanding offshore bonds issued by Chinese companies contain such “keepwell” provisions.
Another Peril of Owning Chinese Securities
International investors owning Chinese stocks and bonds already have to contend with a slew of uncertainties outside of economic and financial worries.
Chinese companies have questionable governance structures and all must implicitly answer to the local CCP bosses and Party cells. Many have a high volume of related Party transactions whose terms often aren’t properly disclosed. Offshore equity investors in Chinese stocks must go through a so-called VIE (variable interest entity) structure, in which investors don’t actually hold ownership in the Chinese company.
The “keepwell” deeds attached to offshore bonds represent another little-known but highly risky quirk that foreign investors must confront.
