“Foreign Investors Face Critical Test Over Chinese Bonds” Part 2

I bought US$10 Million in PUFG Bonds
And all I actually got back was this cheap T-shirt

Part 2:  More on the "Critical Test" facing PUFG bondholders. 

I’ll take a close look at the transaction structure quoting chapter and verse from the Offering Circular (prospectus).

I’ll break with what is sadly usual investment process by actually referring to the most important but usually least read section of the prospectus: Risk Factors. 

And in so doing “force” you to read along as well.

In this “exercise” I’m going to focus on structural/legal factors to the exclusion of other risk factors.

Why?

Because if the transaction structure is weak or the market has fundamental legal problems, you need to walk away.

Page 44 

It may be difficult to enforce any judgments obtained from non-PRC courts against the Group or its directors and senior management who reside in the PRC.

Page 48 

Additional procedures may be required to be taken to bring English law governed matters or disputes to the Hong Kong courts and the Bondholders would need to be subject to the exclusive jurisdiction of the Hong Kong courts. There is also no assurance that the PRC courts will recognise and enforce judgments of the Hong Kong courts in respect of English law governed matters or disputes.

These two items do not sound “promising”.

Page 45 

However, any claim by the Issuer, the Guarantor and/or the Trustee against the Company in relation to the Keepwell Deed or the Deed of Equity Interest Purchase Undertaking will be effectively subordinated to all existing and future obligations of the Company’s subsidiaries (which do not provide a guarantee in respect of the Bonds), particularly the Company’s subsidiaries in the PRC, and all claims by creditors of such subsidiaries in the PRC will have priority to the assets of such entities over the claims of the Issuer, the Guarantor and the Trustee under the Keepwell Deed and the Deed of Equity Interest Purchase Undertaking.

If you’ve read my earlier post about consolidated financials and what they mean, you realize that the holding company’s primary assets are equity in subsidiaries. Absent a guarantee from those operating entities, you’re already effectively in a “junior” position.

And, if by chance, you’re wondering about the PUFG guaranteed bonds, well the guarantee there is by the holding company only. There are no cross guarantees by subsidiaries. So it is limited to the assets of the holding company, which largely consist of stock in the subsidiaries.

Thus, while the PUFG “guarantee” is better than a keepwell deed of equity interest purchase undertaking, it still falls short of the sort of guarantee you would want. Another lesson from the tale of consolidated financials.

Here is the offering circular for the PUFG guaranteed US$250 million 7.875% 24 June 2021 bond if you’d like to check my analysis.

Page 46 

Performance by the Company of its undertaking under the Deed of Equity Interest Purchase Undertaking is subject to approvals of the PRC governmental authorities. (Five are listed)

No approval = legal bar to PUFG’s compliance.

Request for approval will come when the payment crisis has occurred. Not before. That seems a less than ideal situation. You don’t know if the Company is legally bound until default.

Page 47

Performance by the Company of its undertaking under the Deed of Equity Interest Purchase Undertaking may be subject to consent from third-party creditors and shareholders, and may also be restricted if any of the equity interests are secured in favour of third-party creditors.

That’s what we “professional” investors call “cold comfort”.

Page 47 

The Relevant Transferors have limited assets which can be sold to the Company pursuant to the Deed of Equity Interest Purchase Undertaking.

This sounds even less promising. If there’s nothing to purchase, the Company has nothing to buy.

Given all this, there seems little justification for bondholders’ complaints.

Or claiming there was a guarantee when there was not. 

Or even an “impression” of a guarantee as demonstrated by the quotes above.

They were warned in the prospectus.

As well, this isn’t foreign investors’ first “bad” rodeo in the PRC. 

If you’re planning to invest in a country, it’s probably a “smart” move to do a bit of due diligence on how other investors have fared with respect to laws, the legal system, legal structures, etc. 

However, on a positive note, this case does prove my version of the Efficient Markets Hypothesis.

The market is very efficient in separating the financially illiterate, the gullible, or the heedless from their money. And does not discriminate between the retail investor, the professional investor, and institutional investors.

H/T to AA's older wiser august and revered brother, expert in many things Asian, for the quote above as well as the T-Shirt picture.  "If you don't do stupid things, you won't end up in tragedy".

Market Commentary: Greensill -- The Critical Difference between Insurance and a Guarantee and Why It Matters

 

An Unhappy Outcome

Since I haven’t seen anything on this topic in re Greensill, I thought I’d offer a few thoughts on how the fundamental difference between (1) a guarantee of payment and (2) an insurance policy affects the Greensill “situation”. 

And how it might motivate actions by participants in this unhappy event.

The difference between these two instruments is frequently misunderstood, including by supposed finance professionals. Hopefully, this post will fill in any extant knowledge gaps.

A guarantee of payment (as opposed to a guarantee of collection) is a legally binding obligation by the guarantor to make payment to the guaranteed party if the debtor does not make a scheduled payment. Proof of the debtor’s non payment is generally fairly “easy” to make. Usually then the guarantor makes payment without undue delay.

An insurance contract is a legally binding obligation by the insurance company to pay the policyholder if the policyholder submits a valid claim.

Keep those last two words in mind. 

The insurance company reviews the policy conditions, the insured’s (or policyholder’s) actions, and makes the initial determination of the validity of the claim. Some policyholders have been known to complain that such assessments seem to move at a glacial pace.

As that should imply, the insurance company has more legal defenses against payment than a guarantor. And its payment is not as fast given the time to review the claim.

The insurance policy spells out the conditions for validity.

For example, in obtaining the policy, did the policyholder make a material misrepresentation or fail to disclose material information that would reasonably have caused the insurance company to refuse to write the policy? In such a case the entire policy is invalid.

Did the policyholder fail to take reasonable steps to prevent the loss?

For example, if he left his Maybach unlocked with the key in the ignition and his insurance company knew this fact, they would likely decline the claim for theft.

If she routinely stored gasoline in her villa and filed a claim for fire damage and the insurance company knew this fact, the result would be the same.

Did the policyholder take reasonable steps to mitigate damages?

When the fire broke out, did she call the fire department? Or just let the villa burn down?

If his trade counterparty was in financial difficulty and he should have been aware, did he shorten payment terms, ask for collateral, lower his credit limit for aggregate outstandings?

There may also be other specific policy exclusions: strike, riot, civil commotion, actions of political entities, foreign exchange controls, etc.

We can therefore expect that Tokio Marine and other insurance companies will be carefully reviewing their obligations under any outstanding policies on Greensill related debt. 

I saw in today's FT (23 March) that Tokio Marine had opined that the policies might not be valid. 

Today (2 April) the FT reported that Grant Thorton acting as administrator for Greensill had been unable to verify certain invoices underpinning loans to Liberty Commodities - part of Mr. Gupta's group.  

Actually, the article says that several firms whose names appeared on invoices denied any commercial relationship with Liberty.  You can guess that this means that any "insurance" on these invoices is invalid.

One would of course have to review the actual policies and the respective governing laws to determine the defenses the insurance companies might have.

But I wonder if it’s possible that policies issued in excess of underwriting limits might be one? 

Part of that might turn on whether Mr. Brereton was working for Greensill (as an insurance broker) or for Tokio Marine (as its employed underwriter).

As well one can imagine Credit Suisse fund managers' angst over the difference between insurance and a guarantee as well as potential liabilities that might arise from potential "defects" in disclosures in selling documents vis-a-vis disgruntled clients whose attorneys will be going over said documents carefully.

Keep up to date on developments.  

The FT continues to follow the Greensill saga with an interesting article on Mr. Brereton earlier this week.