Wu Jiejie Fu Taiming / Dagong Credit
Cross defaults are provisions in which a borrower with multiple debt obligations defaults on one of the debts, triggering an automatic default on all other debts held by the same lender. Cross default is generally limited to financial liabilities that arise from borrowing or other financing methods and is commonly seen in the debt financing document. In the event of a default, the lender has the right to cancel the credit, announce immediate maturity of the existing loan and ask for repayment promptly. Therefore, the cross default provision may trigger a chain reaction, the purpose of which is to put the creditors of the contract that has not yet default under the same protection with the creditors of the contract that has.
The cross default provision takes effect in two aspects. For one thing, when faced with risks, investors could seek timely remedies and gain the same position as other creditors. In general, when a debtor defaults, it indicates that the debtor may have solvency problems, so cross default is often seen as “the most important sign of default”. Cross default provision allows creditors to seek remedies before this contract expires and therefore to avoid the undesirable consequences. For another, the cross default provision requires excellent debt management capacity of the issuer. Issuers with inadequate liquidity may suffer from debt crisis due to the domino effect triggered by cross default. If several contracts of a debtor have introduced cross default provisions that would be invoked simultaneously in the event of cross defaults to claim rights, there might be a liquidity crisis for the debtor due to the accelerated debt maturities.
1. Status quo of cross default
The cross default provision is more common in oversea bond market. About 49% of America’s active corporate bonds have such provisions. 45% of Chinese enterprise’ overseas bonds have cross default provisions, mainly in energy and manufacturing industries. However, the domestic investor protection system is not complete.
March 16, 2016, “16 Sichuan Honghua CP001” mentioned detailed “early sell-back trigger by change of control” and cross default provision in its prospectus for the first time. It’s the first bond with such kind of investor protection provision in Chinese bond market. Nevertheless, there are two major shortcomings in that mechanism. First, the prerequisite for an early sell-back is limited to change in control, greatly reducing the chance of triggering a sell-back. The protection of investors is not enough. Second, cross default relief measures are limited to additional guarantee, and the holders don’t have the right to declare early maturity of the bonds, disabling the investors to take active measures in unfavorable situations.
Due to investors’ enhanced awareness of seeking protection and the active promotion of regulators, there are more and more domestic bonds adding protection clause. According to statistics, since September 2016, there have been 101 short-term financing bonds and 49 mid-term notes that have cross default provisions, accounting for 11.9% and 16.6% of newly issued short and midterm bonds, respectively.
Domestic issuers with protection terms have the following characteristics:
(1) Low credit rating, mostly AA and below;
(2) Mainly in industries with overcapacity, such as steel, mining, commercial trade, transportation, building materials and other cyclical industries;
(3) Municipal bonds accounting for more than 1/3.
2. Analysis on the default case of Dalian Machine Tools Group (DMTG)
2.1 The cross default of DMTG
Default Review: November 18, 2016, DMTG triggered a cross default of “16 DMTG SCP002” because of advance payment of bank acceptance bills. Due to tight capital chain, DMTG failed to pay the full amount of “16 DMTG SCP001” principal and interest on December 12, 2016, constituting an actual default, which triggered a cross default of “16 DMTG SCP002” and “16 DMTG SCP003”. And it failed to remedy the default of the “16 DMTG SCP001” within 10 business days. As a result, by December 26, 2016, “16 DMTG SCP002” and “16 DMTG SCP003” constituted an actual cross default. On December 29, 2016, DMTG failed to pay the full amount of principal and interest of “15 DMTG CP004”, and did not remedy the default within 10 business days, which once again led to another actual cross default of “16 DMTGSCP003”on January 13, 2017.
At the holder’s meeting after “16 DMTG SCP002” cross default, an exemption was proposed on condition that DMTG had to provide either of the following relief plans for “16 DMTG SCP002” before January 20, 2017. Plan A: DMTG could increase mortgage, pledge or collateral as backstop measures, whose value overweighs that of the bond’s principal and interest. Plan B: it could also repurchase the bond “16 DMTG SCP002” before the maturity date of January 20, 2017.
On December 16, 2016, “16 DMTG SCP001” defaulted, triggering a cross default of “16 DMTG SCP002” and “16 DMTG SCP003”. After the company held a holders’ meeting, “16 DMTG SCP002” obtained conditional exemption and got extended after the expiry of the exemption. DMTG would continue to implement the last relief plan. The exemption was extended to February 10, 2017. If legal procedures were not completed by that day, the bond would mature on February 13, 2017.
After “16 DMTG SCP003” cross default, the holders’ meeting decided to repurchase the bond. If the legal procedures were not completed by February 6, 2017, the bond would mature on February 7, 2017. DMTG failed to pay the principal and interest of “16 DMTG SCP002” and “16 DMTG SCP003” by the expiration dates. Therefore, the two bonds above also constituted actual cross defaults.
2.2 Analysis on cross default
2.2.1 Cross default provisions intensify pressure on capital chain.
If issuers with lower liquidity are faced with cross defaults, they may get into trouble because of the domino effect. Only “15 DMTG CP002” was a technical default at the beginning and DMTG had been postponed to pay principal and interest. But the advance payment of the bank acceptance bill triggered “16 DMTG SCP002” cross default, exacerbating the company's capital chain pressure. The actual default of “16 DMTG SCP001” led to the cross default of “16 DMTG SCP002” and “16 DMTG SCP003”. The actual default of “15 DMTG CP004” again triggered the cross default of “16 DMTG SCP003”. Therefore, debt repayment pressure increased rapidly within a very short time, and ultimately led the company into liquidity dilemma.
2.2.2 Timely and effective information disclosure affect the implementation of cross default provisions.
In DMTG’s default, the advance payment of the bank acceptance bill actually occurred on November 3 and 4, 2016. The issuer didn’t take the initiative to announce, and the default was at last discovered by the main underwriter Industrial Bank on November 25, 2016 when they queried DMTG’s credit report through the banking system. The issuer lacked motivation to disclose negative information, which led to delayed discovery of cross defaults and hurt the interest of investors.
2.2.3 Different cross default provisions lead to different investor protection.
The two core elements of cross default provisions include cross-default-triggering conditions and remedy measures afterwards. More triggering conditions and remedies could offer better protection and more flexible choices to investors. Besides, there should be an accelerated maturity option. The flexibility of the issuers in terms of the design of the provisions leads to different degrees of investor protection. For example, although “16 DMTG SCP002” and “16 DMTG SCP003” were both equipped with cross default protection. The triggers of the former bond included bank loan, while the latter did not. So when DMTG paid the bank acceptance bill in advance, it only triggered the cross default of the former bond. In addition, as to remedies, “16 DMTG SCP002” stipulated that the holders’ meeting could only choose unconditional or conditional exemption. But “16 DMTG SCP003” had sell-back options. As to the conditions of conditional exemption, “16 DMTG SCP002” provided additional guarantee and redemption. But “16 DMTG SCP003” provided only additional guarantee and promised not to issue new debt before the expiration of this one. The difference in remedies made the investors tend to choose sell-back rather than conditional exemption after “16 DMTG SCP003” cross default.
2.2.4 Though there are cross default provisions, the final claim is still uncertain.
The provision of cross default does not mean that investors can get the appropriate protection. In practice, the claim after cross default is still uncertain. At present, the cross default provisions of domestic bonds stipulate that after a cross default is triggered, the holders' meeting should be convened to decide whether or not to exempt the issuer. The advantage of this provision is that those issuers, who have short-term liquidity problems or unexpected factors caused by cross default, can provide additional guarantee and adopt other relief measures and seek the consent of investors to buy themselves more time. But in practice there’s waiting time to hold the meeting, and greater uncertainty. In addition, some of the cross default provisions of the bond descriptions are too vague, making the negotiation more difficult for the holders’ meeting
2.2.5 The existing old debts without cross default provisions are relatively passive.
The cross default provisions of newly issued bonds also expose problems in the existing bonds. The existing bonds of the same issuer do not have cross default provisions while the new ones have. For example, in DMTG’s case, the company had more than one actual defaults, among which two bonds should adopt debt relief plans. In addition, the company had 1.8 billion existing debt, including two mid-term notes and two PPNs. Despite the holders’ meeting requested a credit enhancement and cross default provision, the issuer refused. Future claims would be more passive.
3. Interpretation of Investor Protection Mechanism
Since 2015, defaults occurred frequently in China's bond market. In March and April, 2016, there were quite some defaults. A series of bond defaults occurred, fully exposing the lack of investor protection mechanism.
September 9, 2016, the National Association of Financial Market Institutional Investors (NAFMII) published “Paradigm of Investor Protection Clause” (hereinafter referred to as “The Paradigm”) on their website. The Paradigm comes up with three categories of investor protection terms. Basic terms are divided into “Cross-protection Clause”, “Pre-constraint Clause” and “Change in Control Clause”, in which the “Pre-constraint Clause” includes the financial indicator commitment and pre-constraint matters. NAFMII hopes to encourage the issuer to include the clause in the bond issuance documents and make certain commitment to investors in advance. If the issuers broke their commitments, there would be penalties.
“The Paradigm” is a great improvement in the investor protection system. “The Paradigm” is committed to solve the problem that holders’ meeting lacks in detailed conditions and the resolution does not have legal enforcement of urgent problems. It’s trying to institutionalize and standardize the investor protection, so as to increase the issuer’s cost of default, promote their corporate management ability and improve self-protection ability. It’s a very positive sign in the Chinese bond market where investors are lack of protection mechanism, and collective action is not complete. But the introduction of “The Paradigm” doesn’t mean that the investor protection has been in place. There are many problems on the effectiveness of the clause, which need our attention:
First of all, the investor protection clause in the prospectus is designed by the issuer and the lead underwriter, so investors can only accept the terms. Therefore, when investing in bonds, investors should pay attention to the issuer's risk characteristics and whether the relevant protection clause can effectively mitigate the risk. Investors need to pay special attention to seven kinds of risks: weak parent company with strong subsidiaries, equity trust, complex ownership structure that tends to cause personnel change in the actual controller, the actual controller under investigation, weak control over core listed company, industry with overcapacity and nominal shares that are debts in real terms.
Second, in order to keep the contagion risk of default in check, matters involving cross default provision or pre-constraint will go directly to holders’ meeting instead of triggering the maturity or repurchase of the bond, when the waiting costs and uncertainty of the resolution need to be taken into account. And different triggers eventually lead to entirely different results, so investors need to carefully read the relevant terms.
Third, since the holders’ meeting can decide whether to accelerate the maturity of the bonds or enhance credit under the new system, investors should participate more actively in the holders' meeting in the future and choose the most favorable resolution, and find out whether there is a relevant clause in the bond issuance documents allowing the issuer to be exempted from the obligations when the meeting fails to deliver effective resolution.
At last, since the investor protection clause is optional, there must be a lot of bonds that will not add it to the terms, and it is even possible that the same issuer's existing bonds do not have the terms but the new ones do. For the issuers with low credit ratings and don’t have the term in the bonds, there may be a certain secondary attribute, so investors need to be more cautious. The investor protection clause can reduce the moral hazard of the issuer in terms of corporate governance, foreign investment and asset transfer to a certain extent, thus benefiting all the existing bonds of that issuer. But once the term is triggered, issuers with protection-clause-added bonds are likely to increase the guarantee or take other measures, and may even face accelerated maturity. This may cause certain disadvantage for the bonds without relevant clause in repayment time, additional credit and so on.