China Essence

[dzwm87]

So the CB is just behaving like a bond, with fixed repayment schedules. The upside potential from share price appreciation is tantalising but simply out of reach.

In this case it is much worse than a normal bond because there is an asset/liability domicile mismatch. The assets are in China, the liability is in the Cayman Islands. That's probably one of the key reasons the bondholders agreed to restructure - because there was no realistic way they could get their money back, nor take over the company.

All they can hope for is either a Ponzi-refinance i.e. a new group of banks/bondholders is dumb enough to lend the company new money so they can get paid, or the stock market goes crazy and they manage to either sell off the CBs or convert the CBs and sell the shares.

This kind of domicile mismatch is extremely common among S-chips as the company is usually incorporated in the Cayman Islands, BVI, Bermuda etc. Of course, few investors think about this until there are signs of trouble, at which point it is often too late.

Hi d.o.g.

Will need your view on incorporation of companies. Does the incorporation of companies subject them to the kind of laws governing them? For instance, S-chips incorporated in Bermuda will not be subjected to Singapore law in any case of a fraud? How about companies who are incorporated in Singapore? I notice China Gaoxian is one which was incorporated in Singapore yet they were still a fraud!

[potatolover]

Hi D.O.G

Would it make any difference if under the trust deed of the old CB, the two parties agreed that it would be governed under the laws of England and Wales.

Extracted from CE's announcement in 2006
Governing Law - The Bonds are governed by, and construed in accordance with, the laws of England and Wales.

Further in CE's case, the two Guarantors, namely (a) Huge Glory and (b) Honour Wealth are incorporated in BVI and Hong Kong respectively. What would be the significance, if any?

[Sfsh12]

The starting point of the negotiations must have been the business prospects of China Essence (CE). My guess is that if bondholders had felt that CE did not have reasonable prospects, they would not have restructured the convertible bond. Bondholders had first assessed CE’s business 5 years ago, when the original CB was issued in Dec 2006. During these 5 years, if bondholders have been keeping tab, they would have noted CE’s strengthening financial position, growth in capacity and expanded product range. Notwithstanding the losses reported by CE in 2Q, bondholders’ confidence in CE was strong enough for them to restructure the CB and extend the maturity by another 3 years.

If bondholders’ conclusion on CE’s prospects had been unfavourable, it would not make sense for them to restructure. Why restructure if there is no prospect of being repaid later? It may be better to have a lose lose situation rather than you win I lose situation. An example of lose lose situation is Celestial Nutrifoods, which is incorporated in Bermudas. Celestial’ s bondholders, having concluded that it’s business was not viable, decided to pull the plug even though getting any money back through legal means would be a daunting task.

Although the terms are generous to CE based on current conditions, the bondholders did not exactly walk away with a bad deal, if CE can perform to expectations. The principal amount of the new CB is increased to HK$260m from the outststanding HK$218m. Although there is a 'haircut' (which comes from part of the accrued interest on the old CB), the new principal of HK$260m and conversion price of $0.7 will entitle the bondholders to more shares than they had before in the old CB, if they choose to convert. The total number of shares bondholders will eventually receive is limited to what was already approved by SGX for listing in the old CB and any excess shares would be received in cash equal to their market value then. In the bondholders’ calculation, a scenario where they can exit their investment profitably by conversion is not impossible.

[d.o.g.]

For instance, S-chips incorporated in Bermuda will not be subjected to Singapore law in any case of a fraud? How about companies who are incorporated in Singapore? I notice China Gaoxian is one which was incorporated in Singapore yet they were still a fraud!

Companies are subject to the laws of the country in which they are incorporated as well as the laws of the countries in which they operate e.g. if a Singapore company is allowed to use slave labour, and Malaysia bans the use of slave labour, then a Singapore company can't use slave labour on its Malaysian plantations.

With regards to fraud, it is important to understand that law enforcement is limited to the arrest of individuals and the seizure of assets. If the crime is not committed in the same domicile as said individuals or assets, then obviously there is very little that can be done.

In the case of China Gaoxian, the fact that the company was incorporated in Singapore means absolutely nothing because the key individuals and assets are all in China. There is no extradition treaty between Singapore and China, so the Chinese police are not going to help you arrest anybody. To seize assets, you need to get a Singapore court order, then convince the local court in China to recognize the order, then you have to arrange for someone to seize and sell/move the assets. I sincerely wish anyone trying this the best of luck, for they will need it.

Further in CE's case, the two Guarantors, namely (a) Huge Glory and (b) Honour Wealth are incorporated in BVI and Hong Kong respectively. What would be the significance, if any?

Guarantees are meaningless unless the guarantor has put up collateral with a local third party that can be seized in the event of default. Without collateral you are fully dependent on the guarantor's willingness to pay, not merely its ability to pay. If neither Huge Glory nor Honour Wealth want to pay then you need to sue them in BVI or HK. Assuming the courts there recognize that the guarantee is valid (which is not always the case) then you can appoint someone to seize the assets - if there are any. If there are no assets, well, too bad. If their assets are somewhere else, then you have to continue the wild-goose chase and hope that the jurisdiction where the assets are eventually found will agree to release the assets.

[potatolover]

Mr D.o.g

well, it may seem that Morgan Stanley have not done their risk assessment properly, 5 years ago and now

How about the DBS loan? still no news of it and investors are very concerned...Understand that it is meant to be unsecured. Why would DBS (deemed to be more conservative) do such a thing?

[d.o.g.]

How about the DBS loan? still no news of it and investors are very concerned...Understand that it is meant to be unsecured. Why would DBS (deemed to be more conservative) do such a thing?

The image of DBS and its actual behaviour are 2 different things. If DBS had indeed been conservative there would have not been any need to do the rights issue during the recent crisis. The fact that both OCBC and UOB, who compete in essentially the same market, supplying the same commodity, from the same source, to the same customers, did NOT do a rights issue, speaks volumes about who was behaving conservatively and who was not.

DBS is helpless here because the company doesn't have to pay if it doesn't want to. What can DBS do? Its position is no better than that of the CB holders. It can declare a default, but so what? There's nothing to seize in Singapore. If it goes to China, it has to get a Singapore court order, get the local Chinese court to recognize the order, then appoint someone to seize and sell the assets. Again, I wish them the best of luck if they try this route.

The DBS credit team forgot the first rule of lending: only lend to people who will pay you back. The only people who will pay you back are those with something to lose: pledged collateral, future borrowing ability, a sterling personal reputation etc. China Essence did not pledge any collateral, it was not clear if they would need to borrow more in future, and the key executives were unknowns. Even if they can pay, they have no reason to pay, because they have nothing to lose by not paying.

It is sad that such elementary concepts seem to have been forgotten in the rush to "modernize" and "internationalize" the bank.

[potatolover]

Hi d.o.g

Just for the record, Essence has made 3 payments to DBS for its original $60mil USD loan. $10mil, $10mil and $1.5mil (most recent).

But not quite sure why the credit team in DBS agreed to lend to Essence via a unsecured loan originally...

[d.o.g.]

Just for the record, Essence has made 3 payments to DBS for its original $60mil USD loan. $10mil, $10mil and $1.5mil (most recent).

But not quite sure why the credit team in DBS agreed to lend to Essence via a unsecured loan originally...

Yup, they did some good-faith partial repayments. They probably figured they might need to raise capital again in future, and paying something looks better than paying nothing. But ultimately, they paid because they WANTED to. DBS had no recourse if they didn't pay, and still has no recourse. Unless they have connections with some informal "debt collection" teams in China... but being a state-owned enterprise, DBS is unlikely to use such measures, however effective they may be.

As to why the loan was made to begin with, remember that the loan officers are just employees trying to get a bonus. In a bank you get a bonus for making lots of loans and thus booking lots of interest income.

If the loan goes bad later, so what - you've already collected your bonus. Nobody has a long-term incentive to make sure the loan is good, especially when staff turnover is high. You'd probably be working in a different department or even a different bank by the time the problems crop up, so who cares about loan quality?

In good times, managers will tell credit officers to be aggressive and lend at low rates with lenient terms. In bad times, managers will give the opposite directive - no lending except at high rates and stringent terms, or sometimes no lending at all. Thus are we condemned to this collective insanity and the resulting boom-bust economic cycle. Only a bank that is micro-managed by its owner (like UOB) can hope to sidestep these issues. But there is a limit to how large such a bank can grow, and a limit to how long such an owner will live...

[hmwes]

Hi d.o.g.

You mentioned "In good times, managers will tell credit officers to be aggressive and lend at low rates with lenient terms. In bad times, managers will give the opposite directive - no lending except at high rates and stringent terms, or sometimes no lending at all. Thus are we condemned to this collective insanity and the resulting boom-bust economic cycle."

Like to clarify with you the above statement since seem a bit counter intuitive to me from a demand perspective. In good times bank should be able to lend at better rates and terms since demand for capital is high and borrowers have confidence they would earn adequate returns in excess of interest to pay back the bank? In bad time, demand for capital would be low and borrowers have no confidence to earn adequate returns to pay back the bank interest, so won't bank find it hard to push loans at stringent terms?

Would also like to seek your wisdom on how the bankers attitude can lead to resulting boom bust economic cycle? Thanks.

[d.o.g.]

In good times bank should be able to lend at better rates and terms since demand for capital is high and borrowers have confidence they would earn adequate returns in excess of interest to pay back the bank? In bad time, demand for capital would be low and borrowers have no confidence to earn adequate returns to pay back the bank interest, so won't bank find it hard to push loans at stringent terms?

Would also like to seek your wisdom on how the bankers attitude can lead to resulting boom bust economic cycle? Thanks.

In good times the banks are confident that borrowers will be able to repay or be refinanced by other lenders, so they are willing to lend aggressively. In bad times the banks are terrified the borrowers will not be able to repay or refinance, so they do not lend except on very strict terms.

This type of lending pattern amplifies the business cycle in both directions. Good times last longer than they should because credit is too easily available, driving prices too high. Bad times last longer than they should because there is no credit, driving prices too low. This is the basis for central bankers' interference with interest rates - when times are good they raise rates to discourage expansion, when times are bad they cut rates to encourage expansion.

The ideal situation, when companies are expanding and banks can charge high rates, occurs only briefly, when the economy is coming out of a bust. At this point both the companies and the banks are making their best money ever - the companies because so few competitors can get credit, the banks because their high-interest loans are safe (the companies they lend to have little competition). But soon enough, the competitors point out these successes to their lenders, and the previously fearful lenders become greedy at the thought of missing out on easy profits from high-interest loans. By and by, more and more companies get financing, and the terms get looser and looser, and the seeds of the next bust are sown as the economy booms.