SHANGHAI - Chinese investors caught out by the country's first default of a domestic bond face formidable obstacles to ever recovering any funds from the deeply indebted solar equipment maker.
Shanghai Chaori Solar Energy Science and Technology Co Ltd failed last Friday to pay an 89 million yuan ($14.6 million) interest payment on a 1-billion-yuan, five-year bond it issued in 2012.
Market participants hailed the default as a landmark for Chinese financial markets, turning on its head the assumption that bonds enjoy an implicit government guarantee, which for years had left investors oblivious to the notion of risk.
"The marketisation of defaults constitutes progress," said Chen Dongming, chief credit officer at China Lianhe Rating Co Ltd in Beijing. "It can support the development of both our industry and the bond market as a whole."
While the default could be a turning point in how Chinese markets price risk, investors are also looking at how bondholders in the loss-making firm will be treated since a massive buildup in corporate debt in China has raised the prospects of more defaults to come.
The underwriter and the trustee of the bond, China Securities Co Ltd, is convening a bondholders' meeting on March 26 and has promised to support legal action against Chaori. The bond was issued with a fixed coupon of 8.98 percent.
But Chinese courts are unpredictable and lack legal precedents for handling the case. Importantly, the bonds were not guaranteed, leaving the bondholders low down the pecking order of seniority among Chaori creditors, who have already filed a stack of lawsuits demanding payment of other outstanding debts.
"In our experience - and we've been doing this for 10 years - the courts are getting better in terms of enforcing creditors’ rights," said Benjamin Fanger, founder of Shoreline Capital, a China-focused distressed debt fund in Guangzhou in southern China.
"There's not nearly as much predictability in a court in China as in more developed legal systems; that being said, I think Chinese courts have a much worse reputation than they should."
Banks and other institutional creditors regularly use China's legal system to seize assets from delinquent borrowers. But the Chaori bond is listed on the Shenzhen Stock Exchange, a market dominated by retail buyers and sellers, suggesting a disparate group of investors.
"It's much more difficult to come up with a consensual plan if you have a wide creditor base. That's what makes a bond deal more difficult," said Neil McDonald, head of Hogan Lovells insolvency practice in Hong Kong, who worked on the offshore bankruptcy of another struggling solar company, LDK Solar Co Ltd.
"A lot of these people won't have any experience with this kind of process. It's likely to be very disorganised."
Chaori is a casualty of China's massive investment in solar energy, which has led to a surplus of solar panel production capacity and falling prices.
The firm has reported a net loss for three years in a row and it said on Tuesday its shares could be delisted from the Shenzhen Stock Exchange if it fails to make a profit in 2014. Trading in Chaori's bonds were suspended last July, while its shares were halted in February.
It had 6.5 billion yuan in outstanding liabilities at the end of September, its latest balance sheet filing shows. As of late August, more than 50 banks and suppliers had filed lawsuits seeking payment of unpaid debts totalling 2.2 billion yuan, Chaori stock exchange filings show.
One investor hoping for redress is Shen Wenjie, a 53 year-old Shanghai resident who works in the finance department of a local company.
"My father had bought bonds before. They all paid interest on schedule," she said.
Since the beginning of last year, Chaori has said in several stock exchange filings that it would sell overseas solar farms to raise funds to meet its obligations. It has not reported any deals.
The Shenzhen Stock Exchange did not respond to faxed questions. China Securities declined to comment and Chaori did not answer several calls seeking comment.
In another ominous sign for those seeking legal redress from the default, the Shenzhen Intermediate People's Court rejected a lawsuit last year by a small group of Chaori bondholders, who sued the Shenzhen Stock Exchange and China Securities, claiming they had violated regulations.
They sought compensation, saying Chaori should not have been allowed to list the bond because it had failed to meet the exchange's conditions on the profitability of an issuer. The bondholders have appealed the case.
The lawyer representing the bondholders, Gan Guolong, is focusing his efforts on recovering funds from the underwriter and the stock exchange because he sees little hope of recovering funds directly from the company.
"We don't believe they have any valuable assets to sell. Most have already been mortgaged to bank creditors or frozen by the courts," he said.
Potential interference by local government officials keen to preserve employment and protect a local champion from collapse could also complicate the bondholders' attempts for compensation.
"If I was a creditor and I wanted to seize and auction a manufacturing plant that employed thousands of people, I think the government would intervene," said Fanger. "Which means that holding a manufacturing plant with a lot of employees as collateral is basically unsecured debt."
In practice, an extra-legal agreement brokered by the local government is the most likely scenario in which bondholders will be able to recoup losses, lawyers say.
"Traditionally what has happened is that the government puts the squeeze on a local bank or someone else to fund a payout," said MacDonald.
Fanger is similarly cautious.
"Even if everything works perfectly, the outcome is never happy for somebody who is a creditor when the borrower defaults," he said.
"Now that there has been a default in the bond market, investors have to ask themselves, is the company I'm investing in the kind of company that's going to default? And that's a question they didn't have to ask themselves before."