The Anatomy of a Bankrupt State Firm’s Liquidation

For at least the first half of 2017, the ninth floor of 22 Jinpu Rd, an office tower in downtown Nanning, was turned into a makeshift warehouse. Dozens of desks, office chairs, and cabinets—360 pieces in all—that had been used by staff at what had once been corporate headquarters for one of Guangxi province’s biggest manufacturing companies, had been haphazardly piled upon each other, waiting for someone to buy them at auction. The shredders, computers, air-conditioning units, fax machines, safes, and printers that had previously been stacked alongside them, were sold off in April.

The company that had formerly occupied the premises was declared bankrupt early in 2016, and in September that year had been forced into liquidation by the courts. What made the case so unusual is that the company, Guangxi Nonferrous Metals Group, was the first major state-owned firm to be placed into involuntary liquidation, at a time that the embedded political preference—especially local levels of government—is to keep distressed state firms alive.* While there has been a spate of bankruptcies by state firms over the last two years, those companies have typically continued operating after being restructured. Consequently, when Guangxi Nonferrous entered liquidation, there was widespread skepticism about whether the company would, in fact, be taken apart and sold off to pay its debts.

And yet, a year after the court’s decisions it appears as though Guangxi Nonferrous is undergoing a bona fide liquidation, so far raising more than a billion yuan from auctioning off assets ranging from office equipment to equity in major subsidiaries. And while the government has seemingly swooped in to preserve certain assets, for the most part the process has been transparent, open to the private sector, and singularly focused on raising money for debtholders, setting an encouraging precedent for an economy that needs to explore all possible options in dealing with a rising number of bankruptcies.

Selling Off the Family Silver

Figure 1. Relative Size of Guangxi Nonferrous’ Major Subsidiaries, And Their Relationship to Parent as of mid-2017

Note 1: Due to inconsistent availability of data, the relative size of each subsidiary is based on either 2014 or 2015 total assets. Only those subsidiaries with total assets greater than 100 million yuan are included.
Note 2: The relative size of each circle is based on Guangxi Nonferrous’ share of each subsidiary, not the subsidiary’s total size.
Note 3: Controlled subsidiaries refers to companies in which Guangxi has a majority stake; joint ventures refers to companies in which Guangxi Nonferrous’ equity holding is between 20% and 50%; chart does not include companies in which Guangxi Nonferrous merely has a financial investment.

Sources: Beibu Gulf Equity Exchange; SAIC; Guangxi Nonferrous; Dagong Global Credit Rating.

China is no stranger to the liquidation of overly-indebted state firms. Between the late 1990s and early 2000s, thousands of SOEs were shut down or privatized as part of a nationwide effort to clear the banking system of bad loans, and to make the economy more efficient. However, starting around 2005, tolerance—from the public and among officials—for such reform began to wane. Today, the pendulum has swung so far in the opposite direction that distressed SOEs are typically kept alive at all cost.

However, with zombie companies dotting the corporate landscape, and the share of bad loans on banks’ balance sheets on the rise, propping up distressed companies indefinitely is becoming less feasible. That’s created the impetus for China to start experimenting with bankruptcy and liquidation, in part to help free state banks—who bear the brunt of keeping distressed firms alive—from the burden of nonperforming loans. But it’s also the result of a financial system that has changed in ways that makes it more difficult for authorities to ignore defaults.

Traditionally, state banks were the only source of credit for most state firms, which meant defaults could be hidden inside the banking system. But over the past decade, new avenues of credit have opened up that directly link non-state owned financial institutions, and the public in general, with borrowers. Companies like Guangxi Nonferrous have borrowed extensively from the bond market and from trust companies, which means they owe money to the general public, a group that is highly intolerant of defaults, and expects to be paid what they’re owed.

Still, defaults on bonds or other forms of non-bank debt typically don’t end up in bankruptcy. Instead, a white knight usually appears to take over the distressed company and pay out money owed to members of the public. Only when the debts are too great will a state firm slide into bankruptcy, at which point company executives, local officials, and debt holders come together to work out an arrangement whereby the company stays alive, and debt holders get paid a portion of what they’re entitled to.

That’s what happened with Dongbei Special Steel Group (DSS), which, alongside Guangxi Nonferrous, has been one of China’s most high-profile bankruptcies. According to Caixin, in August DSS debtholders agreed to a restructuring agreement under which they received about 22% of what they were owed in return for allowing China’s biggest non-state-owned steelmaker to take over DSS.

Guangxi Nonferrous initially went through a similar process. According to another report by Caixin, when Guangxi Nonferrous entered bankruptcy, the court gave a group of local officials six months to come up with a restructuring plan for the company. During that time, the group reached out to more than 100 potential investors, and while five expressed interest in taking over the company, ultimately no deal emerged that satisfied debtholders. That’s likely because any restructuring deal that could conceivably return the company to health required such a massive write-down in debt that debtholders hoped to get more of their money back by simply selling off the company’s assets. According to Caixin, the company’s debt-to-equity ratio was formally 121% prior to bankruptcy, but an independent audit carried out as part of the bankruptcy procedure put the ratio at a debilitating 217%.

Since the end of 2016, Guangxi Nonferrous has been aggressively trying to raise money by selling assets—ranging from office equipment to equity in its subsidiaries—at auction. After most of the items for sale were passed in at the first major auction in February, prices were cut 20% before being auctioned a second time. When most of the docket went unsold again, prices were cut by another 20%. Consequently, at most recent auction in May 2017, most of the items found buyers, allowing Guangxi Nonferrous to completely sell out of nine of the fourteen subsidiaries it put on the block.

Thus far, the liquidation has raised far less for bondholders than originally anticipated. Caixin reported that Guangxi Nonferrous had accumulated debts of 14.5 billion yuan ($2.18 billion), of which about half were its direct responsibility, while the rest were in the form of guarantees it had extended to subsidiaries. When Guangxi Nonferrous’ assets were initially posted for sale on the Beibu Gulf Equity Exchange—an online auction house chartered by the Guangxi provincial government—at the end of last year, they were listed at a combined price of 4.49 billion yuan ($677 million) (of which 4.46 billion yuan was to come from selling equity in subsidiaries), based on the evaluation of independent appraisers.

At the end of the May, following three rounds of auction, it had sold most of the items on the docket, but, based on listing prices—Beibu Gulf Equity Exchange has only partially disclosed actual sales prices—raised only 1.38 billion yuan ($208 million), with the remaining assets valued at 1.58 billion yuan ($238 million) (see Figure 2). It’s unclear what will happen to those assets that haven’t as yet been sold.

Diminishing Expectations

Figure 2. Guangxi Nonferrous Assets and Subsidiaries, Sold and Unsold After Three Auctions, in Yuan
Source: Beibu Gulf Equity Exchange.

The Beibu Gulf exchange hasn’t disclosed the names of successful bidders, but the identity of some of the buyers of Guangxi Nonferrous subsidiaries is available from SAIC records. A property developer and glass making company owned by Guangxi Nonferrous were acquired by a state-owned investment company that is majority owned by the Guangxi State-owned Assets Supervision and Administration Commission (SASAC), the same provincial government body that owns Guangxi Nonferrous. In all other cases for which data is available, the buyers were privately owned companies. A private investment fund that specializes in distressed assets acquired Guangxi Nonferrous’ wholly-owned in-house research center. Guangxi Nonferrous’ 40% stake in a mining investment company was bought by an existing shareholder in the firm. And Guangxi Nonferrous’ rare earths subsidiary, which had significantly more liabilities than assets, was valued at zero, and was bought for nothing by a private company that was formed the month of the auction. 

Still, the liquidation process hasn’t been entirely transparent. Guangxi Metallurgical Construction Co. was previously one of Guangxi Nonferrous’ biggest subsidiaries (Figure 1), but according to the State Administration of Commerce and Industry (SAIC) corporate records, it is now owned by Guangxi Construction Engineering Group. However, the SAIC records don’t mention Guangxi Nonferrous as the previous owner, or even note that there was a change in ownership. Guangxi Metallurgical Construction says on its website  that it was absorbed into the provincial engineering group in December 2016, but doesn’t offer an explanation of why the change in ownership occurred, or whether Guangxi Nonferrous was paid anything for the transfer. Guangxi Construction Engineering Group is wholly owned by the Guangxi SASAC.

Guangxi Nonferrous has another six subsidiaries that weren’t put up for auction, whose fate is uncertain. One of those is Guangxi Nonferrous Metals Recycling Co., the parent company’s single biggest subsidiary. In December 2016, the Supreme People’s Court—the highest court in China—ordered Guangxi Nonferrous to sell off the 87% stake it holds in the company. Guangxi Nonferrous had earlier pledged the equity to Minmetals International Trust in return for a 500 million yuan ($75 million) loan. When Guangxi Nonferrous failed to repay the loan, the trust sued for restitution, and the courts found in its favor, ordering the stake to be sold.

However, finding a buyer is likely to prove difficult. Guangxi Nonferrous Metals Recycling entered into its own bankruptcy proceedings at the end of 2015. In 2014, the last period for which data is available, Guangxi Nonferrous Metals Recycling’s liabilities exceeded its assets, and it posted a loss of almost 1 billion yuan ($150 million). Like its parent, since the beginning of the year it has repeatedly tried to raise money by auctioning a collection of plant and inventory, as well as equity in one of its own subsidiaries.

Guangxi Nonferrous’ liquidation sets a precedent, albeit one that will be selectively applied. Most promisingly, with private capital heavily involved, the process amounts to more than just the shuffling of state assets between state institutions. Nonetheless, Guangxi Nonferrous’ experience likely means that liquidation will be a viable course for bankrupt local SOEs in the future, one that is no longer the taboo that it was assumed to be.

*POSTSCRIPT:

As some readers have pointed out, Guangxi Nonferrous is not the first state-firm ever to be put into liquidation. That honor goes to Guangzhou International Trust and Investment Corp (GITIC) which defaulted on its debts during the Asian Financial Crisis, and passed into liquidation in 1999. GITIC was a financial company with wide-ranging investments—albeit concentrated in real estate—that sprawled throughout southern China. According to Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise, by Carl Walter and Frasier Howie, at the time of GITIC’s collapse the company had $2.6 billion worth of assets and $4.4 billion worth of liabilities. Debtholders—including foreigners, who had lent the company billions of dollars—eventually recovered only 12.5% of what they were owed. KMPG was the administrator, and did yeoman’s work to liquidate the company over four years.

GITIC’s liquidation stands as a symbol of Beijing’s ability to take tough decisions in the interests of financial reform when the political will exists. However, in the context of China’s present efforts to clean up its financial system, Guangxi Nonferrous is the first liquidation of the current wave of bankruptcies and should be considered a precedent. While GITIC blazed the trail, Guangxi Nonferrous sets the example for its peers facing similar financial distress.