Fifteen years ago, the city of Zhuhai, a coastal enclave across the Pearl River Delta from Hong Kong, created the Zhu Kuan Group. Zhu Kuan is 100% owned by Zhuhai, and like other so-called "window" companies across China, its purpose was to borrow money abroad, invest it in enterprises linked to the local government, and then repay foreign lenders and bondholders as these enterprises prospered. The implicit government guarantee of the loans gave great comfort to lenders. As Zhuhai's commercial arm, Zhu Kuan played a key role in financing the roads, bridges, airport, stadiums, and other facilities that helped the city grow at breakneck speed. Along the way, the company borrowed more than $750 million from big financial institutions, including Britain's Standard Chartered bank, the U.S.'s Morgan Stanley and Lehman Brothers, France's Crédit Agricole Indosuez and Société Générale, and local banks like the Bank of China (Hong Kong). No doubt about it: The banks liked the Zhu Kuan story.
They sure don't like it now. Zhu Kuan for years has largely failed to service its debt, and bankers are locked in bitter talks with local government leaders over restructuring the company and recovering at least some of their money. In a bizarre twist to this fight, creditors allege that Zhu Kuan and Zhuhai engaged in a blatant act of asset-stripping. This summer the outraged creditors discovered that the Zhuhai government had transferred land worth $125 million out of Zhu Kuan's control and back into the hands of the city -- land the creditors assumed would be theirs to sell. "At that stage we recognized that all negotiations were being done in bad faith," says a source close to the creditors' steering committee. Since then the creditors have filed suit in the Hong Kong courts to liquidate the company, now a sprawling enterprise with more than 50 subsidiaries, 17 of them in Hong Kong.
Do Zhu Kuan officials deny the land transfer? Not at all. But they do have an entirely different explanation. Liu Ke, a senior debt negotiation official for Zhu Kuan, says the land transfer was part of a legitimate change in Zhuhai planning policy. "Outside parties have questioned whether there is now a plan to strip Zhu Kuan assets," Liu told BusinessWeek via fax. "This is an accusation completely without merit and is also irresponsible." Liu does acknowledge that Zhu Kuan's debt exceeds its assets by $500 million.
A PERILOUS PLACE
What's clear is that the fight over Zhu Kuan's assets is turning into one of the most memorable financial fracases the mainland has ever produced -- and it's produced some classics, including the $4.7 billion collapse of the Guangdong International Trust & Investment Corp. (GITIC) -- a fiasco that is still the subject of litigation. Because many of Zhu Kuan's subsidiaries are located in Hong Kong, and one is listed there, the fight is shaping up as a test of the former British colony's ability to enforce its standards on assets controlled by mainland companies. There are potential repercussions for business too: One of the disputed parcels may anchor one end of a planned bridge-causeway across the Pearl River Delta to Hong Kong. Whoever controls that tract will be a lot richer if that bridge ever gets built.
But the most important lesson of the Zhu Kuan affair is this: Doing business in China remains as perilous as ever, booming economy or no. When things go right, the payoff can be immense. When they go wrong -- as they did so egregiously in Zhu Kuan's case -- the losses can be huge. That's especially the case when outsiders run up against powerful local interests, as they have done in Zhuhai. China has moved a long way from the roaring years of the early 1990s, when companies like Zhu Kuan were at their peak. But the institutional problems that are so glaringly obvious in this case -- especially the lack of an independent legal and regulatory system and the lack of transparent corporate accounts -- are still far from being resolved. When China's boom cools, as it inevitably will, expect to see new Zhu Kuan-type conflicts.
To piece together this tale, BusinessWeek has examined numerous documents related to Zhu Kuan Group's difficulties, including: reports prepared by PricewaterhouseCoopers, which was retained by Zhu Kuan as a restructuring consultant; documents that discuss Zhu Kuan's financial status and business practices; and correspondence among creditors, the company, and the Zhuhai city government. BusinessWeek also has communicated by phone, fax, or interview with more than a dozen individuals involved with the case, including creditors and their lawyers, representatives of Zhu Kuan, and executives of RSM Nelson Wheeler, a global accounting and workout firm appointed by the High Court of Hong Kong as provisional liquidators, and whose job it is to protect the remaining assets of Zhu Kuan.
The angry creditors aren't pulling any punches. As late as last spring they were willing to admit they made a bad bet and quietly swallow their losses in a negotiated settlement. But then in July, lawyers for the 28 plaintiff banks and other institutions learned that the Zhuhai government had quietly taken back Zhu Kuan's prime assets -- the two parcels of land, totaling more than 100 hectares. Not long after that, creditors filed their petition to liquidate the company. They have even made appeals to Beijing, which so far has kept quiet about the legal battle. The last Hong Kong court hearing on the case was in October, with new proceedings put off until early next year. Creditors say they need the recess to examine company records. Zhu Kuan has asked the court to dismiss the case for lack of jurisdiction.
Even RSM Nelson Wheeler, the liquidator, is expressing frustration with Zhuhai and Zhu Kuan officials. "Zhuhai authorities are not making company records and public documents available," says John T. Kuzmik, a lawyer with the American firm White & Case LLP, which represents RSM. "We would invite Zhu Kuan to engage in real discussions that would advance a restructuring."
Zhu Kuan denies it is obstructing a settlement. But if a breakthrough is made in reaching a deal, it will have to involve both the city and the company. The Zhuhai Municipal Government established Zhu Kuan Group shortly after the city of 1.3 million people was named a Special Economic Zone by the Beijing government in 1980. That made Zhuhai a tax haven for foreign investors and opened it to free market experimentation. With the help of funds raised by Zhu Kuan, Zhuhai, under the direction of long-serving Mayor and Communist Party Secretary Liang Guangda, embarked on a building spree. The "Mayor of Roads and Bridges," as Liang was nicknamed, and his successors plowed more than $13 billion into civil infrastructure, erecting ports, highways, and stadiums. Liang succeeded in transforming Zhuhai, which now bills itself as a "garden city." It has a gross domestic product of $5 billion, serves as a major export platform, and hosts multinationals like Toshiba, Canon, ExxonMobil, and Flextronics.
Along the way, the Zhuhai government bolstered Zhu Kuan's balance sheet by transferring large tracts of land to the group. This is a common and legal practice among Chinese municipalities and their window companies. In 1998, for instance, Zhuhai transferred $423 million worth of land to Zhu Kuan, according to a 2001 Pricewaterhouse report. Later, additional tracts assessed at $89.5 million were shifted to the company. (Because the state still owns all land in China, what was technically transferred were land-use rights.) At the end of 2001, more than 90% of Zhu Kuan's assets were property-related, Pricewaterhouse found, and more than half of that was undeveloped land.
As Zhuhai and Zhu Kuan continued to work together, Mayor Liang's reach eventually exceeded his grasp. He built a high-performance motor speedway, but the Formula One event he lobbied for never arrived. He constructed an $800 million international airport, but never received Beijing's permission to land overseas flights there. Today, the little-used facility is one of China's most notorious white elephants, serving fewer passengers in a year than Hong Kong does in a week. Under Liang, Zhuhai even started construction on a 30-kilometer bridge and causeway complex to span the mouth of the Pearl River and connect Zhuhai to Hong Kong. In the end, the bridge stopped at an island just 3 km from Zhuhai. (The new plan to span the Pearl River is a different project.)
"By the time he stepped down in 1998, there was a general observation that Zhuhai was in serious economic trouble and Liang's recklessness was part of the cause," says Joseph Cheng, chair professor of political science at the City University of Hong Kong, who has written and consulted extensively about the development of Guangdong province. Liang, now a member of the Standing Committee of the National People's Congress, declined through an aide to comment for this story. The aide points out that Liang hasn't been a member of local government for years. He is not accused of wrongdoing in this case.
Zhu Kuan Group started to unravel as early as the Asian financial crisis in 1997-98, when the flow of new money into its coffers stopped. That left Zhu Kuan with bad investments, big loans of its own, and few assets other than undeveloped land. As early as November, 1998, the group started to default on various interest and principal payments. In March, 2001, Zhu Kuan hired PricewaterhouseCoopers to help with restructuring. In its 2001 report, PWC estimated that in 2002 Zhu Kuan would have a net operating loss of $2 million -- even without making a single interest payment on its debt. Negotiations for a debt workout began.
In June, 2002, the creditors thought they had reached a settlement with Zhu Kuan, in which the city government would hand more than $180 million in cash as well as proceeds from the sale of the two now-disputed plots of land. Under that workout, creditors would have recovered 40% to 60% of their loans, depending on the class of their debt. But that deal was never ratified because, says a source close to Zhu Kuan, it "didn't make sense" financially for Zhu Kuan.
Negotiations continued fitfully until last July, when they came to an abrupt halt after the creditors discovered the land transfers. But creditors allege that asset shifting continues even as court hearings proceed. Zhu Kuan officials recently transferred 42% of the shares in Zhu Kuan Development Co., its listed Hong Kong arm, to a separate company outside control of the group. The new owner is another company controlled by the Zhuhai Municipal Government. The creditors think they have been deliberately deprived of a potentially valuable asset. Zhu Kuan denies that there was anything improper about the share transfer. Liu Ke says in his statement to BusinessWeek that those shares had been pledged as security for another loan. Zhuhai officials, meanwhile, referred all questions to Zhu Kuan.
Nelson Wheeler is attempting to figure out just what happened. It's tough going. The firm complains that the records of many of Zhu Kuan's Hong Kong subsidiaries are not available: Zhu Kuan says they have been temporarily removed for accounting purposes. When the liquidators petitioned the Zhuhai Intermediate People's Court for an administrative review of the land confiscation, the court demanded a fee of $1.2 million before it would take action. The customary fee, creditors say: $12. A Zhuhai court official contacted by BusinessWeek confirms the $1.2 million demand, saying that the fee was high because the land deal is "a complicated case." He added, however, that the matter is under review.
Zhu Kuan Group continues to tell creditors that their best hope is to take the settlement on offer, which company officials say comes to about 37 cents on the dollar. "The Zhu Kuan Group maintains that its most recent offer...should be accepted by creditors because it would provide a better return than liquidation," Liu Ke says. A representative of the creditors says "we don't believe they can pay" even that much. Besides, creditors say that if they are going to take a big haircut, they want to know where all the money went, including $125 million that Zhu Kuan's Hong Kong subsidiary loaned directly to the Zhuhai Municipal Government for unspecified purposes. "There needs to be full transparency of the financial dealings of the group," says the representative. Zhu Kuan counsels patience, again explaining that the records the creditors want have been moved to Zhuhai in the normal course of business. When asked if they will be made available later, a Zhu Kuan official responds that the company "is cooperating" with creditors.
Asked to comment on the legal wrangle, Nelson Wheeler Executive Director Cosimo Borrelli told BusinessWeek: "These matters are all before the courts in Hong Kong and the People's Republic of China, and on that basis I cannot comment in detail. However, it's fair to say, based on what we've seen to date, that anyone considering extending substantial credit in similar circumstances to Zhuhai should proceed with extreme caution." The banks that loaned Zhu Kuan millions for so long might have considered that possibility earlier.
By Matthew Miller and Mark L. Clifford in Hong Kong