China joins the latest fad in corporate restructuring

Having emerged in the US, numerous other countries are now encouraging debt-for-equity swaps.

Debt-for-equity swaps are the financial equivalent of the childhood pastime of collecting and trading sports cards – creditors and a corporate debtor swap IOUs for new common shares. Except it’s a little more involved than haggling over a piece of cardboard with the face of a famous sports person on it.

Last week, when it was reported that China Construction Bank would be getting new stock in Shandong Energy in return for extinguishing old debt, it became clear – if it wasn’t already – that this tactic was gaining some traction in the world’s most populous nation.

The Shandong transaction was CCB’s fifth large debt-for-equity deal done with a state-owned entity since last month. This one totalled 21 billion yuan ($3.04 billion; €2.88 billion). In October, China approved a programme to allow businesses and banks to execute these types of transactions.

The attractiveness of such deals isn’t hard to spot. While a distressed company’s shareholders normally lose control of the business in a debt-for-equity swap, they often allow the company to remain in business. Shareholders and creditors both avoid a protracted court fight over what, if any, rights each party has.

China is just the latest country to jump on the debt-for-equity swap bandwagon, which has gained traction in multiple countries over recent years. In the period following the 2008 financial meltdown, Italy, Germany, Spain and France each instituted tweaks to their insolvency laws to clear the way for creditors to trade in pre-insolvency proceeding debts for new equity.

In 2012, Italy adjusted its laws allowing for distressed companies to win court protection earlier, aiming to facilitate more reorganisations – which can include debt-for-equity conversions – than liquidations. The same year, Germany instituted rules allowing for an effective cram-down of equity holders, essentially allowing a court-ordered reorganisation to take effect over the objection of dissenting shareholders.

In 2014, Spain passed statutes tweaking the legal relationship between the debtor and the creditor receiving new shares, making it more attractive to execute such transactions. In 2015, France adjusted its insolvency process to allow courts to enforce debt-for-equity swaps through certain measures, including the forced sale of shares, under specific circumstances.

In the US, meanwhile, such deals have long been common, particularly in oil and gas sector-related Chapter 11 cases. Their usage became so prevalent that it became a running joke among bankruptcy reporters that the opening line for seemingly every story ran approximately as follows: “Business A sought protection from creditors with plans to hand control of the company to Lender Group B after succumbing to the recent rout in oil prices.”

Of course, these types of transaction solve just one end of the equation. Aside from the balance-sheet woes and liquidity crunches that distressed companies encounter, there is the operational aspect of the business. But a debt-for-equity trade at least retools the financial state to a manageable position, at least in theory.

China’s allowance of debt-for-equity conversions aims to ease a growing corporate debt problem. While it is not a silver bullet, it opens up one more avenue for companies to restructure, and is a method that multiple sovereigns have slowly but surely embraced.