The Importance of Legal Due Diligence On the Prevention of Bond Default Risks

Since 2020, the offshore Chinese US dollar bond market in Hong Kong has continuously experienced several bond defaults, which have caused significant impacts on the bond market. Among them, the default of Fantasia Holdings Group Co., Limited (“Fantasia”) which occurred in October 2021 had a huge negative effect on the market. Fantasia’s default has also revealed many problems in the offshore high-yield US dollar bond issuance.

On 4 October 2021, Fantasia published an announcement at night and stated that it failed to repay the remaining US$205 million of its US$500 million notes which has already become due. After the default, Fantasia stated that the company was currently experiencing a periodic liquidity stress and an emergency response team has been set up to prepare a risk mitigation plan. After Fantasia’s default, three major international rating agencies, Moody’s, Standard & Poor’s and Fitch, have downgraded Fantasia’s bond ratings. In addition, Fitch has also revealed the hidden corner of Fantasia’s debt situation. According to Fitch, Fantasia disclosed in a recent conference call the existence of US$150 million guaranteed private placement bond which was not reported in its financial statements. Although the company’s management stated that apart from that US$150 million guaranteed private placement bond, there were no other offshore off-balance-sheet borrowings, and the US$100 million private placement bond was redeemed on 28 September 2021. However, the existence of these undisclosed private placement bonds means that the company’s liquidity situation may be worse than previously expected, and casts doubt on the company’s ability to repay its offshore due bonds and loans on time. More importantly, the series of incidents also raised doubts among investors about the transparency of the company’s financial disclosure.

Fantasia’s default revealed potential risks in offshore high-yield US dollar bond market. These risks include not only the credit risk but also the corporate operational risk. A series of bond defaults have also revealed problems such as insufficient information disclosure and weak risk prevention measures in the bond issuance process. In order to prevent the occurrence of bond defaults and to maintain the long-term sustainable development of the bond market, especially the high-yield real estate US dollar bond market, legal due diligence on the offshore bond issuance should be strengthened.

First, lawyers should conduct comprehensive and in-depth legal due diligence on the issuers. The legal due diligence work goes through the entire bond issuance process, including the preliminary bond issuance structure planning, the transaction documents drafting, the bringdown due diligence before pricing, and the bringdown due diligence before closing. Lawyers should not treat legal due diligence as a mere formality but should confirm the authenticity and accuracy of the responses to the due diligence questionnaire through various methods such as conference calls, document review and on-site interviews, etc. At the same time, lawyers should pay particular attention to the issuer’s financial situation during the due diligence process and try their best to have an accurate grasp of the company’s qualification through due diligence.

Second, lawyers should strengthen the comprehensive review of the issuer’s onshore and offshore financing documents. Currently, many offshore US dollar bond issuers conduct various types of onshore and offshore financing methods. Lawyers usually set up a “cross-default” clause in the terms and conditions for the issuer’s offshore bond issuance. If the issuer defaults on its other financing projects, all of its offshore debts will become immediately due. For example, a default on repayment of principal amount by Fantasia in 2021 may trigger a cross-default of its undue bonds and may accelerate the payment of the issuer’s other offshore debts which may result in all its offshore US dollar debts becoming immediately due. This also reflects the high vulnerability of offshore bond issuers’ ability to pay.

Third, lawyers should ensure comprehensive information disclosure. If the lawyers find that the issuer has hidden private placement bonds during the due diligence investigation, then the issuance information of the private placement bonds, including the amount, repayment period, and whether there is

any guarantee, etc., shall be fully disclosed in the bond offering circular to give investors a comprehensive and accurate financial information. At the same time, when drafting legal clauses, lawyers should also set up a reasonable threshold for the triggering amount of cross-default based on the company’s actual loan amount and financial statement. Meanwhile, in relation to the event of default clause, reasonable conditions should be imposed on the issuers according to the actual requirements of the company to reduce the possibility of triggering bond defaults.

Fourth, lawyers should assist the issuers in complying with PRC laws and regulations regarding the legality and compliance of offshore bond issuance. On 19 July 2021, China Banking and Insurance Regulatory Commission (“CBIR”) issued the “Guidelines for Banking and Insurance Institutions to Further Prevent and Resolve Hidden Debt Risks of Local Governments” (Yinbao Jianfa [2021] No. 15) (《銀行保險機構進一步做好地方政府隱性債務風險防範化解工作的指導意見》(銀保監發[2021]15號)) (“Circular 15”). According to Circular 15, all banks and insurance companies shall strengthen compliance management and due diligence process. They shall not create hidden local government debts in any form and shall refine bond issuance plans to properly resolve existing local government debt issues. The document imposes more stringent requirements on the issuance of offshore debt by Chinese companies. Therefore, before the issuance of offshore US dollar bonds of Chinese companies, lawyers should strictly monitor the use of proceeds based on comprehensive legal due diligence, and ensure that the proceeds from the bonds will only be used to repay the principal amount of the debt due, and will not be used to expand the scale of construction and other illegal purposes. Lawyers shall ensure that the use of proceeds will not violate the provisions of Circular 15 and will not increase the hidden debt of local governments.

Since the end of 2020, bond defaults have continuously occurred in the offshore Chinese companies‘ US dollar bond market. This has also urged the lawyers to pay more attention to the prevention of legal risks for offshore bond issuers. Lawyers should not only thoroughly understand the issuer’s qualification and financial status through legal due diligence, but also design reasonable legal clauses for the issuer to prevent bond default risks in the preparation of legal documents, and provide legal protection for the sustainable development of the offshore Chinese companies‘ US dollar bond market. 

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Partner, Jeffrey Mak Law Firm

JI Hui is the Partner of Jeffrey Mak Law Firm. She is a Hong Kong qualified lawyer and has a Master of Law degree. She mainly specializes in corporate finance related legal services, including but not limited to debt offerings of large-scale state-owned enterprises and private enterprises, such as public bond issuance, private placement and perpetual bond issuance, etc. She has much experience in IPO projects of Chinese enterprises on the Main Board or GEM Board of Hong Kong Stock Exchange as well. She also represented Chinese enterprises to deal with various loan transactions and merger and acquisition transactions.