By Zhang Wenkui　　

I. Initial Effect of the Debt-to-Equity Policy

In the early 1990's, to solve the problems of heavy debt of China’s state-owned enterprises (SOEs) and the resultant huge amounts of non-performing assets of national banks, some programs were put forward for restructuring the debts of banks and enterprises, including the debt-to-equity swap program with great influence (by Zhou Xiaochuan et al., 1994). After a few years of deliberation, the debt-to-equity swap program was accepted by the decision-making authorities in 1999 and put into implementation from 2000. It has become a policy of significant influence in recent years.

The debt-to-equity swap policy in implementation is some different from the initial program. According to the initial program, an investment department was to be set up in each commercial bank, what is actually adopted is to form 4 assets management corporations correlative to 4 commercial banks. The assets management corporations (AMCs) receive re-loans from the central bank and purchase the creditor's rights to enterprises at face value from respective commercial banks, and transfer them into equity of enterprises, finally, all the AMCs shall exit from enterprises and repay the re-loans by selling equity and other means. The operation period of AMCs is temporarily set at 10 years, that is to say, they should within 10 years accomplish the expected goal of transforming debts into equity and exit from enterprises.

Viewed from its current progress, the debt-to-equity swap policy is being implemented smoothly with initial results. After strict and careful screening, the relevant departments recommended 601 enterprises for carrying out debt-to-equity swaps, with the suggested equity right reaching RMB459.6 billion. By the end of 2000, the majority of the recommended enterprises had concluded an agreement on debt-to-equity swap with AMCs and launched this policy. Among the 601 enterprises, the general enterprise survey team of the State Statistics Bureau conducted an overall survey of 504 enterprises that had signed official and framework agreements with AMCs, it shows that in the first year (2000) of debt-to-equity swaps, the enterprises involved in the swap would lighten their bank interest burden and most of them were expected to make profit. Published results of the survey indicate that, after completing the debt-to-equity swap, the average asset-liability ratio of each enterprise would fall from 68.68 percent to 45.62 percent, and their interest burden could be reduced by RMB3.723 billion monthly, enterprises expected to gain profit in 2000 amounted to 439, accounting for 87.1 percent of the total, of which, 92 could make a big profit. The asset-liability ratio of debt-to-equity swap enterprises even went down by a still larger margin in some localities, take Beijing for an example, in 2000 there were 17 SOEs that concluded a debt-to-equity swap agreement with AMCs, and after completion of debt-to-equity swap, their asset-liability ratio fell drastically to 38 percent from 77.3 percent, and likewise, most of them would benefit from a drastic fall of interest payment and make profit.

The asset-liability ratio has fallen, the debt is lightened and the loss-making enterprises began to make profit immediately. Does this mean that the expected target for debt-to-equity swap policy can be reached in 10 years and that the debt-to-equity swap policy is advancing towards the expected goal? As a matter of fact, the immediate emergence of profit was basically not brought about by the deep-rooted change in the enterprises, instead, the major part of profit was attributed to the change in their financial structure, in other words, less debt and interest payment has made their books look "better" than before. Temporary improvement in financial performance can not necessarily lead to any fundamental change in their situation, what is more important than the financial structure is the change in the structures of operation, property rights and governance (Zhang Wenkui, 1999).

In order to determine whether the implementation of the debt-to-equity swap policy is conducive to reaching the expected goal, we cannot but study the impact of this policy on the governance structure of enterprises. The impact of any kind of debt restructuring program on the governance system of enterprises is worthy of our attention, because it not only involves whether the restructured enterprises are able to fulfill their debt obligation in the future, but also has a bearing on whether they will establish a sound mechanism in a farther future under which all the responsibilities can be fulfilled and the interests of all parties be protected. International experience also shows that a perfect governance structure is of vital importance to the success of debt restructuring while an unhealthy governance structure will not be conducive to debt restructuring. According to a sample survey conducted by the World Bank to the debt-restructured enterprises in Hungary and Poland, it was not the creditors but the insiders of the enterprise who guided restructuring. Imbalance of information made it difficult for the creditors to understand the internal situation of the indebted enterprise, the creditors were usually put into the position of figureheads, therefore, not much improvement was made in the business performance of most debt-restructured enterprises (Zhang Chunlin, 1999). China's debt-to-equity swap policy introduced AMC as the new shareholder of a debt-restructured enterprise. This has directly led to the change in the equity structure, and the interest and behavior-orientation of the new shareholder will exert an impact on the governance structure of the enterprise, and this is very important to our judgment on the prospect of debt-to-equity swap policy.

II. Debt-to-equity Swap and Governance Structure: International Perspective and Theoretical Probe

Modern capital structure theories believe that equity capital and debt capital play different roles in enterprises, and an appropriate capital structure is beneficial to both the increase in equity yield and the improvement of corporate governance. If, however, the capital structure deviates from the reasonable limit with too high a debt ratio, financial risks would be increased to the enterprise. When the enterprise incurs a debt service crisis, debt restructuring is usually more acceptable to all the parties concerned than liquidation after bankruptcy.

Debt restructuring takes various forms, including extension or exemption of debt, sales of equity, alteration of debt varieties, increase of investment, etc. Transforming debts into stock shares, namely, debt-to-equity swap, is also an option for debt restructuring. In pure theory, some international scholars hold that debt-to-equity swap is better than any other form of debt restructuring. This can be typically represented by the theory of U.S. economist O. Hart, (1998), which is based on some assumptions and the varied debts in the U.S.. First of all, he assumed that the existence of large companies as a whole is better than that of split-offs, but the existing liquidation procedure is more favorable to split-offs, because when any large company is to be sold, few can afford it, even if some have the purchasing capacity, incomplete market competition would unreasonably force down the price, which would in turn affect the payment to the creditors. Therefore, Hart maintained that liquidation should be avoided as much as possible, and it is better to make restructuring. Secondly, in the U.S., debts of enterprises involve many grades and creditors, restructuring negotiation is difficult and time-consuming, and the restructuring procedure is formidable, that is why a great many enterprises were ultimately split off and liquidated rather than survived as a whole through debt restructuring. Therefore, Hart insisted that the restructuring procedure be simplified by debt-to-equity swap. Hart’s theory is in practice only a realistic technical design.

As a matter of fact, in matured market economies, debt-to-equity swap is not a restructuring mode in common use, even if it is adopted occasionally, there are certain restrictive conditions. Firstly, this swap is by large based on the liquidity of securities, that is to say, usually only negotiable securities can be transformed into equity, and more than often into negotiable stocks. Secondly, the swapping procedure and rules are optional, swaps are usually carried out during the bankruptcy proceedings, the debtor can transform part of the securities included in the restructuring program into stocks, but it is subject to the approval by all creditors. If some creditors do not agree to the debt-to-equity swap, the program cannot be passed. And if the restructuring agreement is not ratified, liquidation must be carried out. Thirdly, securities are usually transferred into preference, or even redeemable, re-saleable stocks rather than common stocks, in all, making the stocks similar to the nature of securities as closely as possible. International experience shows that although large-scale debt restructuring guided by the government can be free from the bankruptcy proceedings, it does not go against the basic principle of bankruptcy system.

In the countries in transition from planned economy to market economy, high expectation is placed on the debt-to-equity swap, but in practice, it is only adopted as a supplement with the scale being very limited. In the early 1990’s, Hungary launched a large-scale debt restructuring for banks and enterprises, 90 percent of the enterprises demanded debt extension in the restructuring program, 52 percent preferred to debt write-off, 10 percent suggested to swap stock shares for debts, 6 percent liked to replace the general management, 4 percent intended to purchase new equipment, and 2 percent wanted to increase equity investment. During the same period, Poland conducted similar debt restructuring, too, the major means being debt extension and debt write-off. The banks only agreed to swap stock shares for the debts of 40 among the 800 state-owned enterprises incorporated into the plan, only 9 commercial banks were involved, with the scale of debt-to-equity swap being merely 2 percent of the creditor’s rights. Similarly, Slovenia also set forth extremely rigorous requirements for debt-to-equity swap, the result must be that the creditors hold and take over the shares of the debtor, and furthermore, the prerequisite was that the investor to purchase the equity must be assured before the swap. In Croatia the scale of debt-to-equity swap only involved 2.5 percent of the total assets of banks, and the banks expected to cash assets by selling equity when the stock market picked up.

Debt restructuring, whether by debt-to-equity swap or by any other means, will generally bring about some impact on the governance structure of enterprises, which is reflected in two aspects. One is that the debt-to-equity swap may possibly make the equity structure change, and this will certainly lead to visible adjustment in the decision-making and supervisory institutions of the general management, for instance, change in the composition of the board of directors. The other is that debt restructuring will cause a change in the capital structure, namely, in the ratio of debt to rights and interests, the variety of debts, etc., which will in turn influence the governance structure. Changes taking place in either equity structure or capital structure, the interest of the shareholders and creditors, the guiding principles of their behaviors, and the way they are embodied in the decision made by the enterprises, all are worthy of attention.

It is easy to understand the impact of equity change on the governance structure, whereas it would be difficult to grasp the effect of capital structure change in the governance structure. Theoretically, the preferences of debt capital and equity capital are different and so are their requirements for agents and means of control. The theory on agency cost has explained the relationship between capital composition and governance structure. Classical theses of M. Jensen and W. Meckling (1976) hold that an appropriate debt ratio can reduce general agency cost, thereby better guarantee the interests of the trustor. From the viewpoint of allocation of remaining control rights, P. Aghion and P. Bolton (1992) expounded the active role of a rational debt ratio in reducing agency cost and improving the governance structure. E. Fama (1985) also held that expert supervision by the creditors could cut the supervisory work of stock owners and make supervision more effective, and that is the so-called “Enlist the bondholders” in the governance structure. In a milestone thesis on debt contract, C. Smith and J. Warner (1979) noted that covenants in a debt contract could also effectively protect the interests of the creditors and improve the governance structure by their restrictions on the enterprise and its operator in respect of investment, financing, dividend distribution, income of the manager, etc..

This is nothing more than a general description of the relationship between capital composition and governance structure. In practice, however, different types of debt affect the governance structure of enterprises to varied extent. This is true, for instance, of debts of strong or weak liquidity, debts in lump amounts and individual amounts, long-term and short-term debts, negotiable and non-negotiable debt instruments, redeemable and non-redeemable debt instruments, etc. R. Haugen and L. Senbet (1979, 1981) considered that the introduction of redemption and transfer would create important effect on the interest mechanism of enterprises. A. Barnea, R. Haugen and L. Senbet (1980) further analyzed that the redemption of debts was tantamount to shortening the maturity of debts, and this was helpful to protecting creditor’s rights. All in all, lump amounts of long-term debts with poor liquidity and transferability and without terms for redemption would require the enterprises to make more readjustments to their governance structure. What requires special attention is that the governance structure of enterprises in which the creditors provide long-term loans. Long-term loans are often in big amounts, generally used for fixed assets investment projects with high risks. Moreover, such loans lack liquidity and transferability and can hardly be secured by mortgage and guarantee, therefore, the lenders can set more limits to enterprises and their operators by means of protective terms and conditions, for example, restrictions on the working capital percentage, cash dividends, percentage of fixed asset investment, and income of their managers. In addition, the lenders can likely become controlling and guiding creditors from creditors keeping distance from the borrowers, thus having direct impact on the governance structure of the indebted enterprises.

III. Change in Equity Composition and Capital Composition: Preference Shares with Compulsory Redemption Terms

In China, debt-to-equity swap aims to transfer non-negotiable bank loans into non-negotiable equity, and it is, in essence, not optional. More importantly, China’s debt-to-equity swap is basically a scheme of large-scale debt restructuring for avoiding the bankruptcy proceedings, it is very difficult to find any similar international schemes for reference. Special attention should be paid to what impact this restructuring would have on the governance structure of enterprises and how the prospect would be.

In order to study the impact of debt-to-equity swap on the governance structure of enterprises, let us first find out what changes have taken place in the equity composition and capital composition of enterprises that have carried out debt-to-equity swap. After debts transferred into equity, the direct change in the composition of equity is that it has given birth to a new shareholder – an assets management corporation, which holds a large percentage of shares and even is the number one shareholder in some enterprises. Therefore, the first direct change in the governance structure of enterprises brought about by debt-to-equity swap is that these enterprises must transform themselves into shareholding companies and introduce into their board of directors members from the corresponding AMCs. No matter whether the business decision-making power still remains at the hands of their original leading body, their important business decisions, at least in form, must be adopted by the board through which the AMCs impose influence on the decision. One published example is Hunan Artificial Board Factory, after completion of debt-to-equity swap, it was transformed into Hunan Artificial Board (Group) Co., Ltd. Of its total equity capital of about RMB493.97 million, the Great Wall Assets Management Corporation holds shares for RMB282.82 million, Hunan provincial state-owned shares (current net assets of the factory) account for RMB151.37 million, Hunan International Trust Corporation holds shares for RMB 15.90 million, Hunan Trust and Investment Corporation holds shares for RMB 12.69 million, Hunan Provincial Economic Construction Investment Corporation holds shares for RMB8.20 million, Hunan Provincial Economic and Technical Investment Guarantee Company holds shares for RMB4.00 million, and the remaining RMB20.00 million are held by individuals. On the basis of pluralistic equity composition, the new company has set up a board of directors in compliance with the equity composition. Another published instance is Xinjiang Tianlun Chemical Fiber Factory. After its system has been transformed, it is controlled by the Great Wall Assets Management Corporation, and of the 7 new members on its board of directors, 2 are from the Great Wall Assets Management Corporation, 2 are from the Xinda Assets Management Corporation, 2 are from the original factory and one is from Xinjiang Constructive Military Corps.

Except the visible adjustment in the decision-making and supervisory organs of the governance structure of enterprises after debt-to-equity swap, the change in their interest mechanism is more worthy of our attention. Shares held by the AMCs are quite different from those in general sense, and so are the interest and behavior-orientation between the AMCs and general shareholders, all this would pose decisive impact on the governance structure of debt-to-equity swap enterprises. This difference can be easily seen in the debt-to-equity swap agreement concluded between AMCs and enterprises. In practice, among the agreements signed by AMCs and enterprises, there are three common terms and conditions: Firstly, the agreements universally contain a redemption article, i.e. the enterprise undertakes to redeem all (or a major part of) shares held by AMCs at a set price in a given period of time (up to 10 years), by which way AMCs will exit from enterprises. As this clause does not provide for voluntary redemption, and it is imposed on enterprises by AMCs, therefore, it is a compulsory redemption. Secondly, enterprises generally undertake to pay AMCs a relatively fixed return on the shares held by AMCs, and the return should be normally no less than the interest rate (e.g. 2.5%) at which AMCs obtain re-loans. It can be seen, therefore, that the shares held by AMCs are more like preference shares. Thirdly, local governments grant guarantee for the restructuring program, especially the exit of AMCs. The local governments promise to give priority to the listing of dept-to-equity swap enterprises and the shares held by AMCs, to act as a broker for other enterprises to purchase the equity of debt-to-equity swap enterprises held by AMCs, to take over non-operating and bad assets separated from these enterprises, to implement a preferential tax policy and to make funds available to these enterprises to redeem their shares. Some local governments even undertake to rectify market order to create a favorable competition environment for enterprises. The rectification of market order perhaps actually aims to wipe out the rivals to debt-to-equity swap enterprises. In order to make the commitment more reliable, AMCs even go so far as to conclude debt-to-equity swap agreements with the state-owned assets controlling companies – the superior to debt-to-equity swap enterprises, because they know that these controlling companies are actually re-named governmental departments, and they hold some best assets.

After analyzing the above three terms and conditions, we can determine the nature of shares held by AMCs. Since the shares are basically tantamount to preference shares, and additionally there is a compulsory clause, the shares held by AMCs are most similar to debt instruments from the viewpoint of design of financial products. In this sense, therefore, we can regard the shares held by AMCs as quasi-debts. As such quasi-debt must be “repaid” by the enterprises through redemption and other forms, China’s policy on debt-to-equity swap is close to re-arrangement for debt extension. Besides, with the guarantee of local governments, debt-to-equity swap can be regarded as debt extension secured by local governments.

Why have all the AMCs selected the above three clauses for their agreements with enterprises? Why do these enterprises accept this “debt extension arrangement” and is it secured by local governments? Debt-to-equity swap enterprises and local governments originally intended to transfer debts into equity capital that doesn’t need to pay principal and fixed return, but have ultimately turned debts into quasi-debt. This result is obviously not what these enterprises and local governments would like to see. As a matter of fact, in the negotiation for debt-to-equity swap agreement, the AMC and the enterprise are not in an equal position, the latter without any option. After all, this is much better than continuously paying capital and interest, and it is, anyhow, something like enjoying the benefit of interest suspension policy.

If the shares held by AMCs are defined right, we can anticipate the interest-preference and behavior-orientation of AMCs, which we can say are similar to those of the creditors, namely, AMCs strongly hope that the enterprises will annually pay them a relatively fixed amount of benefits within a number of years and repay them the equity capital duely. This is actually called “paying capital and interest” by the enterprises, and their surviving capability beyond this period is no longer the concern of AMCs. Therefore, AMCs show similar concern with creditors in respect of the arrangement for cash flow, enterprises’ profiting capability and value-addition of assets.

It can be said that AMCs represent strategic shareholders in the debt-to-equity swap enterprises, and their clear strategic goal is to realize the targets of mid-term cash payment and fixed earnings. They show no concern for the long-term goal of the enterprises.

IV. Quasi-active Shareholder: Between Distant Shareholder and Control-guiding Shareholders

The importance of this strategic goal of AMCs to the governance structure of debt-to-equity swap enterprises lies in three aspects: firstly, it imposes relatively tough restriction on their budget, that is, within a given period of time, these enterprises must pay AMCs a set return and redeem their equity with cash payment on expiry; secondly, AMCs are reluctant to concern about the long-term development of these enterprises and will feel all right as long as they can exit on expiry; lastly, AMCs will exercise strict supervision over the financial activities of these enterprises because this has a bearing on the fixed return and the reliability of mid-term cash repayment. All this will improve the trust and agency relationship of enterprises, reduce their agency cost and is of positive significance to their operation as a whole.

As AMCs are concerned about their fixed return and exit, once commitment and guarantee for both are obtained, they will not appear as active shareholders, though they hold most shares of the debt-to-equity swap enterprises. Viewed from the actual situation in China, AMCs are not poised to involve in the decision-making of enterprises, for their understanding of enterprises is not sufficient enough to allow them to do so. From the viewpoint of remaining controlling rights, debt-to-equity swap cannot really transfer a large part of remaining controlling rights to AMCs, nor change the situation that they are under the control of insiders. In reality, after completion of debt-to-equity swap, the controlling rights of the original leaders of enterprises are stabilized in the main. Compared with