Op-Ed Commentary: Chris Devonshire-Ellis
Apr. 19 – The old China bug-bear of due diligence and fully understanding the investment risks has come back to haunt the foreign investors in Hunan Taizinai, in a case that once again explains the difficulties of gaining control over liquidation of companies with assets in China.
Taizinai, backed by Goldman Sachs, Morgan Stanley, Actis, Citi, RBS and DBS has just been declared insolvent and has a winding up order issued against their holding company based in the Cayman Islands. However, the main Chinese subsidiary is refusing to recognize the jurisdiction of the Cayman courts, creating problems as the majority of the group’s assets remain in China.
Taizinai started off with a great business in Mainland China’s dairy industry and are well known for their pro-biotic yoghurt drinks. By 2007, Taizinai had planned to list on the Hong Kong or New York stock exchange, but two things knocked this back: over spending by the board during this period to inflate the value of the company, and the melamine scandal. Taizinai invested in huge new facilities in Zhuzhou, Beijing, Chengdu, Huanggang, and Kunshan ahead of the listing to further leverage their IPO worth. In fact, it was money they could not afford, and they were reliant on the IPO to support the investment. Secondly, the melamine scandal broke, and although Taizinai were not implicated, the scandal did not help with the local market for dairy products collapsing. Taizinai defaulted on loans as income dried up from an already stretched balance sheet loaded up with aggressive expansion debt. By this time, those debts included a combined amount of US$100 million from the banks, and a further US$478 million from JP Morgan and Goldman Sachs, who had acquired 31 percent of Taizinai’s shares. In short, the company had been caught out by a double pincer, the unexpectedness of a major scandal hitting their industry, and sheer corporate greed.
Come 2009, and problems maintaining local payroll and debts, the Zhuzhou city government seized assets belonging to Taizinai, and the process of unraveling the company’s complicated cross border structures began. With the assets of the China entity now in the hands of a Cayman Islands holding company, a tug of war commenced between the legal systems of the Cayman Islands, which are based on British and American corporate and financial laws, and those of Mainland China.
While Taizinai’s liquidators, Borelli Walsh, have applied to the Cayman high court to have the company and its assets placed in the hands of the liquidators, the China end, which controls the assets, is refusing to play ball. In fact, the company spokesman in China has gone as far as to say that the “British or American legal systems do not apply to the Chinese system.” He is correct, and the overseas investors may be left high and dry with worthless offshore paper.
In China, changes of the board of directors and shareholders must be approved by the local government, as must any decision to liquate the business and return to shareholders what assets may be left. This means that Borelli Walsh is unable to gain control of the actual assets of the mainland entities without local government approval. Here, a clash of priorities occurs. Borelli Walsh will want to secure as many assets on behalf of shareholders as it can and return what value it can obtain for them to the investors and creditors. In China, the local government will have a political agenda, the savings of jobs and securing for themselves any government interest in the business. Local investor influences may also come to play within the government’s behavior at the expense of foreign creditors and shareholders. Further legal action in China to force the government to give way and appoint Borelli Walsh staff as liquidators to dissolve the company and its China assets are also likely to fail, if not due to political influence, then as the fact the firm is not licensed China auditors and have no authority to practice on the mainland.
Regrettably, we’ve been here many times before. But while it may be difficult to find current sympathy for the likes of the overseas investing banks who were seemingly prepared to accept the risk of investing via an offshore structure into a business whose primary assets remained in China, the lessons are clear to all who follow such structures: when it all goes horribly wrong, what China due diligence did they really carry out, and what mechanisms were put in place to secure mainland assets in the face of overseas default?
The answers lie in the obtaining of mortgage charges over mainland properties backed against the offshore debt. Clearly, this was not negotiated and Goldman, JP Morgan et al are almost certain to take a haircut. But for other, smaller investors, it may be wise to consider ways such as obtaining guarantees or security against mainland assets prior to folding the entire deal up into a sexy looking offshore package. It may look good, and be beneficial to investors banking in receiving future dividends offshore, but as Taizinai have pointed out, the laws in such holding entities are not necessarily applicable in China. And with different priorities come problems, it may be difficult to gain access to and control over mainland based group assets.
Investing in China by using offshore or other holding entities to acquire them does not by itself mitigate China risk. Such structures, while useful for future dividend dispersal, would do well to consider methods of acquiring some leverage over assets based in China itself. To this end, seats on the China board, the issue of ownership of land use rights, and the placing of mortgages and guarantees over both fixed and moveable assets should all be explored as part of the securitization process when engaging in the financing of such structures.
Chris Devonshire-Ellis is the founding partner of Dezan Shira & Associates and has been involved with the cross-border structuring and liquidation of many Sino-foreign investments over the past 18 years. The firm maintains a significant business advisory division with offices handling offshore jurisdictions and China entities. Please e-mail email@example.com if seeking structuring or liquidation advice or wishing to examine the potential exposure of existing China asset risk.
Chris also contributes to India Briefing , Vietnam Briefing , Asia Briefing and 2point6billion