Courtroom dramas

Distressed and credit funds have emerged as the latest trend in Asia, with firms like Apollo Global Management, Oaktree Capital Management and PAG all raising substantial funds for the opportunity.

Oaktree, in particular, has honed in on Asia’s largest and most prominent private equity market, teaming up with state-owned China Cinda to allocate $1 billion to distressed debt opportunities in China.

But while the macroeconomic and private equity trends point to more distressed opportunities in the coming years, one likely corollary is that there will be more fires for the lawyers to put out – because the number of disputes is likely to rise, too.

“We anticipate that over the next year there is likely to be an uptick in insolvencies, defaults and disputes over payments because you are getting tightening credit conditions and you’re in an economy where the growth is slowing,” says Jason Wright, managing director in risk consulting firm Kroll’s Hong Kong office.

Whether they’re acting as minority equity investors or as debt providers seeking collateral, private equity firms are wading into untested and traditionally unpredictable waters when it comes to sorting out disputes with entrepreneurs.

“Up to now, there haven’t been a huge number of defaults and insolvencies [in China], so there is a lot still to be tested. In theory the system is there for international private equity funds and investors to process those disputes, but we’re [yet] to see how it all works out in practice,” Wright warns.

Trust issues

Historically, China has invited skepticism from foreign investors when it comes to securing fair and reasonable judgments in court. This remains a worry for both equity and debt investors.

“We don’t frankly trust the courts system [in China],” Jake Williams, deputy group chief risk officer at Standard Chartered Bank, declared at a recent event in Hong Kong run by pfm’s sister title, Private Debt Investor.

Williams’ sentiments are echoed by other industry sources; most argue that China’s court system is at best unreliable, if not downright untrustworthy.

When looking to enforce contracts or minority rights, either in bankruptcy situations or disputes, foreign GPs have often battled against local courts whose judges have been known to have a local bias.

“It is difficult to get enforcement against a Chinese client in a city where his assets are located, [because] that person may be employing quite a lot of people in that city or province and may well have a local advantage with the local courts,” explains one Hong Kong-based lawyer.  “So a private equity fund may encounter difficulties.”

Another factor that hinders the enforcement process, he adds, is that by the time any arbitration is concluded, the defendant may have lost all his assets or tactically transferred them elsewhere. “In a loose legal environment like China, it is possible for this to happen.”

Taking precautions

In practice, firms must take additional precautions before they invest in case a dispute arises later on, industry sources advise.

The selection of a partner in China is paramount, one Hong Kong based GP says, adding: “It is almost like dating and getting married”.

He explains that pre-investment, during the “courtship” phase, investors should look at a potential partner’s previous business relationships and assess how they have reacted to stressful situations in the past, in order to gauge how the entrepreneur might react if something goes wrong.

Kroll’s Wright adds: “There are a variety of things you can do upfront. There is insurance and various warranties you can put in place around deals. But that is actually tremendously expensive to do with Chinese deals, because the perceived risk is pretty high.”

Some private equity investors even add an extra layer of protection by building an international legal structure into the agreement, so matters can be settled out of China in the event of a dispute.

Barry Lau, managing partner at private credit fund Adamas Asset Management, says that with each deal, the firm will employ two sets of contracts – one under Chinese law and one under Hong Kong or international law.

“The legal cost is quite high, but at least we have both forums,” he explains. “Subject to size, we try to do it as much as possible. If it is a big deal, then definitely.”

Misplaced optimism?

While there are options to protect investors, they are pricey and far from foolproof. Some industry players have just resigned themselves to the notion that China’s courts are not a trusted means of getting to any sort of resolution.

Anthony Holmes, principal at LVF Capital, told delegates at the PDI event that his firm doesn’t even bother with enforcement processes in China. “Our approach has been never to attempt to enforce by the courts. If you end up in that situation, we think you’re in a lose-lose position,” he said.  

However, there are some optimists who believe that the situation is changing for the better.

“There definitely has been an improvement. Shanghai Arbitration Centre has been trying to market itself as an alternative place to go for arbitration, as typically it has been written into contracts that you would go to arbitration in Hong Kong or Singapore,” one source says.

Nevertheless, even though the majority of contracts will have a clause specifying that any dispute will seek international arbitration in (more often than not) Hong Kong or Singapore, GPs then have to go back to local provinces to have the arbitration enforced.

“The problem is not really in the arbitration process, which is certainly very straight forward in Hong Kong and Singapore, and improving in the PRC,” explains Wright. “The problem is often [that] when you have that arbitration award, you then have to separately enforce that.”

There have been improvements at the local level, however, he adds, where the legislation and process is advanced and often of an international standard. Courts in China have seven days to accept or reject an arbitration award, and if they reject it, have to provide a judgment that explains why.

Compare that to Indonesia, where there is an indefinite period for the court to make a decision. This means you can “get trapped in limbo forever”, Wright explains.

The catch is that local Chinese courts can’t always be trusted to follow these procedures, sources say.

But this is changing, slowly. “There are certainly areas where it has improved – Shanghai in particular – where you’ve got young judges, many of whom speak good English and are keen to do the right thing and adopt the principles in [for example] the Enterprise Bankruptcy Law,” suggests Neil McDonald, a partner at law firm Hogan Lovells.

However, while judges may be more open-minded, there are many stakeholders in distressed situations in China – and inevitably the local government will be one of the most significant. That can be a problem, especially in the less developed parts of the country.

“You end up with courts in the better jurisdictions who may be willing to try to do something a little bit better, but are frankly and bluntly told, ‘Sorry, you can’t do this – you need to toe the party line’. Access to justice in the more remote areas, where we are doing deals more and more, remains very problematic.”