FINANCIAL DISTRESS RESOLUTION IN CHINA

TWO CASE STUDIES

Amy Kam

Augustus Asset Managers Limited

David Citron
City University London - Sir John Cass Business School

Gulnur Muradoglu
City University London - Sir John Cass Business School

Abstract
This paper examines two financially distressed companies and their restructuring strategies. The
existing distress literature focuses on developed economies such as U.S. and U.K. This paper is a
pioneering work in an emerging market context. The main purpose of the case studies is to
provide rich in-depth evidence on complex events which large-scale empirical studies of
necessity ignore. To achieve this, the paper first analyses the firms accounting-based
performance, both pre- and postdistress, to understand the nature of the firms difficulties. It then examines the series of
complex restructuring procedures each firm initiated and uses an event
study approach to evaluate the stock markets reaction to these strategies. We provide an indepth
understanding of the special features of the Chinese situation, such as the role of government and
other more commercially driven shareholders; the subsequent importance of social policy issues;
the protracted and complex nature of the restructurings; and the frequent use of mergers, share
transfers, asset swaps and asset sales.
The analysis provides new hypotheses for further empirical study on a large-scale basis.
JEL classifications: P27, G34, L10, G33.
Keywords: Distress, Restructuring, Emerging Markets, Case Studies.

Corresponding author. Augustus Asset Managers Limited, Bevis Marks House, 24 Bevis Marks, EC3A 7NE.
Tel. +44 (0) 207 711 6718. Email. akam@city.ac.uk.

Page

1. INTRODUCTION
This paper examines two financially distressed companies in China. It discusses details of their
motivations, the distress resolution strategies they employed and the valuation effects of their
restructuring announcements.

Both

companies

choose a combination

of restructuring strategies for recovery prior to and during distress. Financial distress and
related

recovery

attempts

are

complex

processes by their very nature.

By examining two representative Chinese cases in detail, this paper provides rich in-depth data
on those complex events, a thorough understanding of unique features for China as an
emerging market, and an essential platform for further investigation of the topic using
large sample sizes.
The effects of distress resolution have been studied extensively in developed economies. To
name a few, Asquith et al (1994), Franks et al. (1996), Franks and Sussman (2000), Weston et al.
(2001), Kahl (2001), Franks and Sanzhar (2003). However there are very limited studies in
the

emerging market context.

In China, where bankruptcy law is in its infancy and where the state is
still heavily involved as a shareholder, the process of distressed company restructuring is likely t
o differ markedly from that observed in the U.S. and the U.K. The conditions are similar in
other emerging markets that are in the process of liberalisation. In that sense the Chinese
cases are important for a thorough understanding of company distress and possible recovery
attempts in emerging economies where firms find themselves in a competitive
environment

and

yet

developing legal and regulatory frameworks. Case study methodology has been widely employe
d in finance research literature (Ruback 1983, DeAngelo et al. 2002, Baldwin and Mason
1983).

We adopt this methodology as it allows us to explore the less well-

known features of the distress resolution process in the Chinese institutional context and to
investigate how it differs from the process in more developed economies on an in-depth basis.
The first case, Shandong Jintai is a non-government controlled pharmaceutical company
operating in a growing and liberalised industry consisting of 60 listed firms. The second, Sichua
n Joint-WIT Medical, on the other hand, is a state-owned enterprise (SOE) in the statecontrolled clothing and fabric industry consisting of five listed SOEs. These two companies
were chosen for three main reasons. Firstly they are representative of state-controlled
versus liberalised industries and ownership structures, and therefore provide insights into

the different ways in

Page

which a privately owned company and an SOE cope with distress, and how the market reacts to
their turnaround strategies. Secondly a comparison of the two cases sheds light on the role of
government in distress resolution. Finally they provide an informationrich context to understand the use of various forms of mergers and acquisitions (M&A), asset
sales, asset swaps and debt restructuring in comparison to what has been documented in the
literature to date.
As the existing literature shows, firms suffering from performance decline may choose a variety
of financial and non-restructuring strategies to reverse the decline. Financial strategies include
debt and equity restructuring, while non-financial strategies can entail asset, operational and
managerial changes. These restructuring strategies have been studied extensively in the U.S. an
d
U.K. frameworks, and in other developed economies such as Germany, Japan and France (see fo
r example Gilson et al 1990, Clark & Ofek 1994, Asquith et al 1994, Franks & Sussman
2000, Franks & Sanzhar 2003, Lai & Sudarsanam 1997, Furtado & Rozeff 1987, Denis
& Denis 1995, Dherment-Ferere & Renneboog 2002).
In the Shandong Jintai and Sichuan Joint-WIT cases studied here, four well-documented
restructuring strategies are observed: asset restructuring including M&A and asset
sales/swaps;
managerial restructuring (changes of board members, CEOs and general managers); operational
restructuring; and, to a small extent, debt restructuring. There are, however, a number of key
features in these cases that significantly differentiate them from restructuring processes observe
d

in developed economies.

Firstly, the process is highly complex and long-

drawn out. Secondly, the (non-tradable) shares and underlying assets of the distressed firm are
sometimes

transferred

to

other entities without payment being made in return.

In addition social considerations play a role, in particular the states need to maintain
employment levels.

Finally, while the business operations of a company may be

transferred into new ownership, care is taken to retain the original company shell as it
provides

ready

entry

to

much-valued

Related to this last point, equity restructuring such

stock

exchange

listing.

as spin-offs, equity carve-

outs, tracking stock, and split-ups are not observed. Because the two Chinese stock exchanges
impose strict rules on firms wishing to issue further equity, it is very difficult even for
profitable firms to issue additional equity, let alone the distressed ones (Chen and Yuan,
2001).

Page

The paper is organized as follows. Section 2 discusses the institutional features of China; section
3 describes our data source and the event study methodology; section 4 presents our case
study analyses; section 5 discusses the findings; and section 6 concludes.

2. THE INSTITUTIONAL BACKGROUND

China is the most important emerging market and is in the process of financial liberalisation fro
m a closed economy to a market oriented and an open economy. This section discusses the
role of banks as a main source of finance for listed companies; role of the stock exchanges
and the continuing role of government in the economy. In addition, we also briefly discuss
the key features of the existing bankruptcy laws and their role in firm distress resolution.
2.1 Bank lending
Due to historical reasons, banks are the main channel of funds from savers to borrowers.
According to Tian (2004) and Allen et al. (2004), China is a bank economy. The Chinese
financial landscape is dominated by the big four state owed banks: Industrial &
Commercial
Bank of China (ICBC), Bank of China (BoC), Construction Bank of China (CCBC) and
2

Agricultural Bank of China (ABC), and they are highly inefficient . There was also significant
government intervention in bank lending prior to 1994.
Such government intervention could take place either ex ante or ex post of bank lending
being made (Lu et al 2001). Since 1994, the Chinese State banks have been granted
increasing autonomy in their lending decision-making. Despite this evidence suggest that the
banks lending decisions are systematically biased in favour of SOEs (Lu et al 2001).
2.2 Role of stock exchanges and the government in the corporate sector
Chinas privatisation process in the past two decades has dramatically transformed the
structure of its corporate ownership. In particular, Chinas share issue privatisation (SIP) of
SOEs was a catalyst for the development of its two stock exchanges
- Shanghai Securities Exchange (SHSE) and Shenzhen Stock Exchange (SZSE) in 1990 and
1991 respectively. At the outset the stock exchanges were used primarily to supply
capital to SOEs.

By 2003, the total market

The cost/income ratio of mainland Chinese banks is among the highest in the
world, averaging close to 80%, versus 35-45% in Asia and 40-55% internationally (Bank of China International

2002).

Page

capitalisation of the two stock exchanges was 43.5% of GDP. Together the two stock
th

exchangeswere ranked as the 12 largest in the world. Despite their rapid growth, in 2000
total capital raised in these stock markets accounted for the equivalent of only 15.8 % of new
bank lending over the whole economy in the same year, and total market capitalisation of
stocks was 48.4% of the total loans outstanding in China (McKinsey 2003). In addition,
Tian (2004) documents that listed companies total liabilities are 43% of total assets, and
bank loans are approximately 22% of total assets.
Although Chinese publicly listed companies (PLC) are organised and operated under the model
of modern western firms, their shareholding structures are different from those of western
firms in order to allow for continued state control of these listed firms.
In other words, one of the main
characteristics of Chinese listed companies is that the State remains in control of many
3

enterprises that were formerly wholly State-owned enterprises. Therefore the Chinese
government has keen interest and critical role in the process and issues of Chinas transition fro
m a planned economy to a market-orientated economy. Underpinning the social contract is
the belief that the state would continue to look after the welfare of the individual. The
government now has to delicately balance the often antagonistic tensions of rapid
economic reform and sustaining social stability.
Due to the popularity of the equity market as a source of capital for Chinese firms, coupled
with limitations on the capacity of the two exchanges to absorb large numbers of new
listings,

the

stock exchanges impose strict listing requirements on company size and profitability. In additio
n they impose even stricter rules on firms wishing to issue further equity, as a result of which
it

is

very difficult even

for profitable firms to issue additional equity,

let alone the

distressed ones. In addition, according to the Company Law (Article 157 & 158), firms which
have

been

making

losses for two consecutive years are categorized as special treatment (ST) and are limited to 5
% share-price movements up or down daily; whereas firms that have been making losses for
three

Strictly speaking, an SOE is a

wholly State-Owned Enterprise (100%).
Here we extend the definition to include all state-controlled enterprises (i.e. the state holds less than 100% shares)
as SOEs. By construct, all listed SOEs have less than 100% state-owned shares as at least a portion of the
shares are listed and held by individuals and institutions. In addition, if an SOE has over 50% state-

owned shares, we consider it under the absolute control of the state. If, however, the state holds less than 50% of
the shares but is still the largest shareholder, the enterprise is under the relative control of the state and is also
classified as an SOE. For a thorough discussion of the difference between relative and absolute state control, see
Kam et al (2005) and Clarke (2003).

Page

consecutive years are placed in Particular Treatment (PT) status and are suspended from the
Exchange. These PT firms are given a maximum of a one-year grace period to return to
profitability, failing which they are de-listed from the Stock Exchange.
This feature is taken into consideration when designing our event study methodology.
2.3 Bankruptcy law
Chinese Bankruptcy Law was initially promulgated to restructure or liquidate insolvent SOEs.
4

As China began to move towards a more market driven economy additional bankruptcy
legislation was enacted.

Similar to many other countries, when a company is in distress, there are two possible routes for
distress

resolution:

1.

Private

workouts;

2.

Bankruptcy

process

during

which the company may be restructured under court supervision or liquidated.

However, despite the existence of a legal procedure for the restructuring and/or liquidation of
corporations, this process is seldom used. According to the World Bank (2000) and to the
5

best of our knowledge, there have been no known cases of in-court restructuring in China .
The inefficiency of the bankruptcy laws, coupled with the pressure for the government to
maintain social stability, contribute toward keeping non-viable firms alive.

3. DATA AND METHODOLOGY

3.1 The case companies
The two distressed cases
were selected from the 100 companies that constitute the full population

of

distressed

companies listed in China studied in Kam et al (2005). A firm is classified as distressed if

its earnings before interest, tax, depreciation, and amortisation (EBITDA) are less than its
reported interest expense. This definition is also consistent with Asquith et al (1994), Kahl
(2001), and Rajan & Zingales (1995).

Further criteria for selection of the two case

companies from the sample of distressed firms are firstly that one should have government
and the other non-government controlling shareholders and, secondly, that between them
they
engaged in all the major restructuring categories, i.e. asset, operational, managerial and financial
..

The term bankruptcy follows the US definition and refers to the corporate bankruptcy process of court supervised

restructuring or liquidation, and is used interchangeably with insolvency in this study.

5

As pointed out by George Nast, principal consultant at McKinsey&Co China, in a communication with the authors,
this situation is not unique to China. Distress resolution tends to be informal in many emerging markets
and distressed firms tend to be kept alive much longer (the so called soft budget constraint syndrome (Kornai
1980)).

Page

Data for the two cases operating performance and capital structure are collected from Thomson
Financial Analytics Database. Industry performance controls, capital structure, and size
comparisons are also collected from this database by matching the sample firms principal
four-digit code with other public firms with the same principal SIC code for the same year.
Shandong

Jintai and Sichuan Joint WITs accounts-

based performance summaries are presented in Table 1 and 3, respectively.

The two distressed companies restructuring announcements are obtained from the two
Chinese stock exchanges official websites. Appendix 1 presents the CSRC official
format of
announcement requirement for listed companies (this has been translated by one of the authors).
Details of the two companies restructuring related announcements
chronologically in Appendix

are presented

2 and 3 respectively.

Further data for the case analyses are obtained from the companies annual reports and from
news articles published on the stock exchanges official websites.
3.2 Market reaction to financial distress and restructuring announcements
In order to investigate markets reaction to financial distress and related restructuring
announcements we used event study methodology. The event day (t=0) is defined as the day
when the firm announces its restructuring event as recorded on the official stock exchange
website. However there might be information leakages before the announcement or drifts
after the announcement in restructuring related events and therefore we use a wider event
window of eleven days ( t=-5,..0,..+5). We calculate expected returns using the commonly
used

market

model.

We select a neutral period to estimate the market model.

In the Shandong Jintai case, the company became distressed in 2002 and the first restructuring
related

announcement

is

on

the

17

th

of December 2001;

we use the estimation period as the first 95 days since listing (23/07/01 30/11/01).

Restructuring related announcements made in a multiple announcement together with other news are excluded.
We also repeat all analysis excluding the first 5 days of listing in the Shandong Jintai case and results do not
change.
7

Page

In the Sichuan Joint-WIT case, since the company became distressed in Year 2001 and the
th

first restructuring related announcement was made on 30 December 2000, we define the
estimation period as 21/03/2000-25/12/2000. There are 200 daily observations in this
estimation period
Abnormal returns (ARjt) for company j at time t are calculated as the difference between the daily
returns and their expected values (i.e the respective market returns), and related Cumulative
Abnormal Returns (CAR) are calculated as follows:
AR jt R jt R mt

(1)

CAR j AR jt

(2)

tTP

CARs are used to fully capture the effect of an event on share prices, and to accommodate
uncertainty over the exact date of the event (Strong 1992).
The test statistics below are used for AR and CAR respectively:
ARt : t

tT
P

S( AR)

N (0,1),

where S( AR)

CARTP : t

(
tEP

tT
P

jt

S(CAR)

where S(CAR)

(6)

T s 2
T s 1

tEP

(7)

N (0,1),

(8)

S(AR)
T s 1

(9)

4. CASE STUDIES
4.1 CASE 1: SHANDONG JINTAI GROUP
Shandong Jintai (Jintai) was formerly a state owned enterprise and was restructured to be a
shareholding company in 1989.
The group's principal activities are the research, manufacture and

sale

of

chemical

raw

material medicines, Chinese and Western medicinal preparations and biological medicines.
Other activities include manufacturing and marketing of biological

Page

products, medical intermediates and medical apparatus, developing and transferring technologies
and providing technical services.
The pharmaceutical industry is a high

growth industry in China.

As at 2003, there were a total of 60 listed companies within the industry. According to China
Economic Information Network (CEINet), a leading industry studies expert, the
pharmaceutical

industry

enjoyed

growth

of

15.5% from 2001 to 2002, with RMB94.55bn output in 2002. In addition, as we can see in Table
1 below, the industrys median asset size more than doubled from RMB608mn in 1999 to
RMB1391mn in 2003.
Using our definition of distress discussed in section 3.1, between 1999 and 2003, five of the 60
firms were in distress in the sector, including Jintai. Of these five, two are non-SOEs, and
three are SOEs. Jintai is a non-SOE firm with zero government shareholding. It is also a
small company measured by total assets.
4.1.1 Accounts-based performance
As shown in Table 1, 2002 was the first year of Jintais distress as measured by our interest cover
indicator, with EBITDA/interest ratio massively negative at 9.83%. Jintais interest cover had in
fact underperformed the industry median in each of the two prior years, though not to a worryin
g extent, so that the accounts are showing a sharp and decisive decline into distress in 2002.
Insert Table 1 here
Regarding operational performance, the accounts show that Jintai was small for its industry
sector, and consistently declining in relative asset size. While its assets stood at 63% of the
industry median in 1999, this ratio fell to 54% in 2000 and further to 43% in 2001, the
year prior to distress. By the end of 2002 Jintais assets were only 27% of the industry median
although, as will be shown below, this 2002 decline was predominantly due to the companys
restructuring strategies in response to distress. Both gross margin and EBITDA/assets
underperformed the industry median in the two years prior to distress, but here too the
sharpest

deterioration

in

performance as indicated by the accounts took place in 2002, with gross margin falling from 53

Page

of industry median in 2001 to only 32% in 2002, and the EBITDA/assets ratio being -37.3% in
2002 compared with the 7.9% industry median for that year. These poor 2002 performance
measures are due to the virtual disappearance of Jintais sales base in that year. Sales in 2002
were only RMB27.6 million, 84% less than the year before, due mainly to the companys
significant restructuring activities in 2002.
The poor operating performance of the years prior to distress was accompanied by signs of weak
financial structure as well. Compared to its industry, Jintai was far more reliant on liabilities
in general and on debt in particular to fund its activities. This had been the case in both 2000
and 2001, and by 2002 the company was funded 81.1% by liabilities (industry median
= 42.0%) and 54.0% by debt (industry median = 26.2%).
This analysis shows that Jintai was exhibiting both operational and financial problems in the
years prior to distress. This conclusion is confirmed by news reports that around the time of
8

Jintais listing in July 2001, it had come to light that the company was starting to become
exposed to a variety of issues, such as a high level of bank debts; obsolete technology due to a
lack of investment over the years; management devoting excessive efforts in its listing
application; and the fact that there were only about 10% potentially realisable accounts
receivables of a total of RMB100mn.
The company employed a number of restructuring strategies since 2002, such as operational and
managerial restructuring, measures which seem to have a longer term strategic nature without
immediate cash flow generating implications (unlike some of the U.K. distressed firms studied i
n Lai and Sudarsanam 1997). One possible explanation is that, due to the absence of an
effective bankruptcy law, distressed firms are not worried about being liquidated when they
default on loans. Below we use event study to gain an understanding of market reactions to
the companys announcements, paying particular attention to restructuring related news.
4.1.2 Market reaction to the restructuring strategies of Shandong Jintai
Figure 1 shows the companys raw (unadjusted) stock return, and its raw return minus the
contemporaneous return on the equally weighted SZ All A-shares Index. Appendix 2 lists a total
8

According to articles published on the official stock exchange website.

Page

10

of 13 restructuring related announcements made by the company between 2001 and 2003. Of
the 13 announcements, four relate to M&A announcements and updates thereon; two relate to
asset sales and operational restructuring; three to managerial restructuring; and four to new bank
loans or bank loan renewal. Event study results of these announcements are reported in
Table 2.
Insert Figure 1 here
Insert Appendix 2 here
Jintai started its application for listing in 1993 and was eventually floated on the Shanghai Stock
Exchange, eight years later, on July 23 2001. This lengthy process is mainly a result of
bureaucracy and the extreme demand for listing status outstripping supply (Jiang et al. 2005).
Consistent with other IPOs, the share price recorded a cumulative equally weighted market
th

th

adjusted return of 8.7% by the 6 day. It then started to drop on the 7 day and the cumulative
th

market adjusted return on the 10 day was -3.6%.

Six months after its listing, the company announced on December 17 2001 that the existing
controlling shareholder, Shandong Medical Research, was selling its holding of 26.99% to
Xin

Hong Ji Group.

Jintai had a dispersed shareholding structure with the second largest shareholder holding only
7.13%. Therefore, although Xin Hong Ji Group only bought 26.99% shares in Jintai, it
became de facto the controlling shareholder. Xin Hong Ji Group agreed to pay RMB52 million
for this transaction, with RMB30 million paid as a first instalment. However before the
remaining RMB22 million was paid, the auditor of Xin Hong Ji Group discovered that Jintai wa
s
facing severe financial problems (see article published on www.cninfo.com dated April 15 2003)
. At the time of the transaction, there was no legal requirement for either Shandong Jintai or
Xin

Hong Ji Group to disclose the details of the transaction.

The abnormal share

price movement on the announcement of this change in control was -2.51%, though not
significantly different from zero.

There were also seven multiple announcements relating to managerial restructuring, M&A completion, share

suspension from the stock exchange and ST status, loan renewal and court order of due payments. We
excluded these announcements from our event study as we cannot isolate one event form the other.

Page

11

This change in control was followed on very quickly by a number of significant further
restructuring activities. Three days after the announced change in control a major operational
restructuring was announced. This involved Shandong Jintai firstly selling one of its product line
s for RMB330000, and also establishing a joint venture with the buyer of the product
line. Shandong Jintai transferred fixed assets to this joint venture giving it a controlling 78%
share in the operation. Although the market reacted negatively to the announcement on the
day with an abnormal movement of -1.65%, the 10-day cumulative abnormal return was
+2.71% (although these results are not significant). These transactions were followed
shortly by a major management change, the first of many such changes which are more
characteristic, as in this case, of non-SOEs than SOEs. Thus on January 7 2002 three
managers, including the general manager and chief financial officer, resigned and were
replaced. This triggered a large negative share price movement of -9.13% (significant at the
1% level) on the day of the announcement. Further management changes were announced on
February 8 2002 when three additional board directors were appointed (accompanied by a nonsignificant -0.56% abnormal price change) and on March 4 2002 when a new Chairman was
elected and deputy general managers appointed (with a non-significant positive abnormal
price

change

of

3.32%).

It

should

be

noted

that,

as

disclosed in multiple news announcements, further management changes took place in February
2003 (including appointment of a new general manager) and April 2003 (when the deputy
general manager and chief financial officer resigned, with the latters duties taken over by the
existing general manager).
However these changes were only precursors to the major May 24 2002 restructuring which
involved a complex

hive-

off of significant parts of the business. These, according to Jintais 2002 annual report, were
triggered by liquidity and working capital constraints at a time when price competition in the
pharmaceutical sector was intensifying as a result of the sector being liberalised. Firstly
Jintai

announced

that

it

was

transferring

fixed

assets

from

one

of

its

subsidiaries into a newly formed company in which it would have a 20% interest; and secondly i
t was hiving off its retail business into a new pharmacy retail company in which it would have
an
80% interest, with the remaining 20% held by the 80% shareholder in the first announcement. O
f

particular interest these transactions provide evidence of a distressed non-

SOE transferring either complete or partial control of parts of its business without receiving
any consideration, cash or

Page

12

otherwise, indicative that these asset transfers at times of distress are not limited exclusively to
SOEs.
These asset restructurings

were followed by a number of leverage-

increasing announcements. On June19 2002 Jintai announced board level approval of the
decision

to

raise

working

capital

finance from its bank, and on December 13 2002 it announced assumption of an RMB20 million
one-year loan from Jiao Tong Bank. The first announcement was accompanied by a negative
abnormal share price movement of -1.51% on the day and the second by an increase of
1.31%, with neither of these significantly different from zero. Jensen (1986) and Wruck
(1990) argue that debt provides positive disciplinary role and that using exchange offer
announcements,

as

summarised in Weston et al (2001), empirical studies suggest that the market reacts favourably t
o companies when they increase leverage. However Tian (2004) documents that, for
China,
increased leverage increases management entrenchment and perks, concluding from this that de
bt governance is not at work in China.
In order to examine the overall market impact of the different corporate restructuring
strategies,
we calculate the average abnormal returns and the cumulative average abnormal returns using th
e
four different categories M&A, asset sales/operational, managerial and leverage-increasing.
10

The results are reported in Table 2 . Among the four debt-related restructuring announcements,
two events took place on two consecutive days. To avoid confounding effects, only the first
one is included in the calculation of average abnormal returns and cumulative average
abnormal

returns.

Due to the small number of events in each

category, the average abnormal return and the cumulative average abnormal return results in
Table 2 are best treated as exploratory.
Insert Table 2 here
Table 2 shows that none of the average abnormal return on the day of announcement (AAR0) for
the four types of restructuring announcements is statistically significant. Only managerial

restructuring announcements have an economically significant AAR0 of 2.91%. The signs of

10

As a robustness check, consistent with the literature, such as Krivin et al. (2003), we exclude the first 5
returns from the estimation period to eliminate any stock price reaction immediately following the IPO and the
results are identical. In addition, we repeat the analysis using the market adjusted model and also find
conclusions do not change.

Page

13

11-day cumulative average abnormal returns (CAAR+/5)are consistent with AAR0, with the most

economically significant CAAR+/-5 being 2.62%

for asset sales. According to the signs of CAAR+/-5, the market reacted negatively to all
four types of announcements. Different event windows produce results of opposite signs,
except for managerial restructuring announcements. However

neither

the

cumulative

average abnormal returns nor the AAR0 are significant statistically.

The event study results suggest that the companys
M&A strategy is not perceived by the market as an effective restructuring strategy.

Its

frequent use of asset and operational restructuring strategies did not receive significant
market

reaction

either.

During

the

companys

distress

period, we also observed

frequent senior management departures, one of which was perceived by the market strongly
unfavourably. We will further analyse these results in section 5.
4.2 CASE STUDY TWO: SICHUAN JOINT-WIT MEDICAL
Sichuan Joint-Wit Medical and Pharmaceutical Industry Company Limited (Sichuan), formerly
known as Sichuan No. 1 Textile Stock Company Limited, was an SOE with 65.6% stateowned shares immediately after listing on the Shenzhen Stock Exchange in June 1998. The
Group's principal activities were the manufacture and sale of yarn, thread, base cloth,
dyed cloth, knitwear, garments, beddings, adornments, machinery equipment, apparatus,
meters

and

spare

parts. Other activities included import and export trade, purchase of raw cotton and manufacture
of chemical fibre yarn. The Groups main products
The textile

were cotton cloth and cotton yarn.

industry included five listed companies, all under the control of the state.

In addition, there was a large number of non-listed non-state-owned small to medium size
companies within the sector. The industry has been growing rapidly and the increased
production and sales were a manifestation of brisk consumer spending and growing
exports. As Table 3 shows, among the five listed companies, the median industry book
value

assets

increased

year-on-year

from

RMB608 million in 1999 to RMB1.39 billion in 2003. Sichuan was the smallest listed company
in the industry in 1999.
4.2.1 Accounts-based performance

Page

14

Table 3 shows that the first year of the companys distress (i.e. the year in which the ratio of
EBITDA to interest expense fell below 1) was 2001. The Table displays key performance
indicators for the two years prior to distress and the two subsequent years.
Insert Table 3 here
In terms of operating performance, Sichuans EBITDA/assets ratio was similar to its industry
median prior to distress, but became negative in 2001 and 2002. However the 1999 gross margin
of 11.8% was already well below the industry median of 18.7%, and this shortfall grew
consistently in subsequent years. In addition the companys capital spending/assets ratio was
already lagging well behind that of the industry median in 1999. This poor operational
performance was all the while accompanied by rapid growth in numbers of employees from 435
0 in 1999 to 9847 by 2001. As a result sales per employee declined from RMB580000 in 1999
to RMB370000 by 2001, well below that of the industry median, even in this sector
which comprised only SOEs.
Turning to Sichuans financial performance, while the ratio of total liabilities/assets was above
the industry median and growing each year, neither the proportion of current to total liabilities
nor the debt/asset ratio were worrying when compared to the industry median, either before or
after entering distress. These points, taken together with the poor operational performance
highlighted above, point to economic inefficiencies
being the main cause of distress for this SOE rather than financial problems such as excessive
debt. In addition it is evident that a number of operational indicators were already showing
that Sichuans performance fell well below the industry median two years prior to entering
distress.
As will be shown in more detail in the next section, in 2000, one year prior to distress, the
government attempted a number of restructuring strategies including transferring state-owned
shares from an asset management SOE to a textile SOE which supposedly had industryspecific

management expertise but in vain.

The new SOE controlling shareholder was not able to turn the performance around either. In
December 2002 the company had to severely cut back operations due to deteriorating cash
flow problems. Eventually, it had to lay off its extremely large labour force, the main source
of inefficiency, and initiate its exit from the labour-intensive textile

Page

15

industry in 2003. While the total number of employees was 6560 in 2002, this figure dropped
sharply to only 709 in 2003 due to large-scale redundancies.
4.2.2 Market reaction to the restructuring strategies of Sichuan Joint-WIT
Figure 2 shows the companys raw (unadjusted) stock return, and its raw return minus the
contemporaneous return on the equally weighted SH All A-shares Index. Thirteen restructuring
related announcements made by the company between 2000 and 2003 were collected and
these are presented in Appendix 3. Although in 2003 the companys interest cover was
back to a healthy 9.2 times, higher than the industry median of 8.6 times, the year 2003 is
included in our analysis as it was during this year that the company completed a
complex strategic asset restructuring process.
Insert Figure 2 here
Insert Appendix 3 here
Among the 13 announcements, four relate to M&A via shares being transferred to a new
controlling owner and without payments; one relates to M&A with payment; two to asset
sales and operations restructuring; and one to managerial restructuring. Of the 13 events,
five took place either during the period when the company share price was capped (due
to special treatment status) or suspended, and therefore we are only able to carry out event
study analysis on eight events, results of which are presented in Table 4.
Year 2000 was the first
year that Sichuan embarked on its first major restructuring strategy. This
was the plan, announced
on January 11 2000, for the controlling state shareholder, Chendu Asset

Management,

to

dispose of its 52% shareholding. While 8.3% of this would be sold to two Haikou (a
coastal city) companies for cash, the remaining 43.7% was to be transferred without any
consideration to another SOE. This amounted, therefore, to the effective acquisition of
Sichuan by another SOE, with a view to its management being transferred from an allpurpose asset management company to a sector specialist company. However the abnormal
share price movement on the day of the announcement was minus 2.32% which, while not
significantly
different from zero, was at the very least indicative of the markets indifferent view of ownership
remaining with the state in a transaction in which the acquirer was not required to make any

Page

16

payment. This form of change of control is characteristic of SOEs, in contrast to the more
11

conventional sale of shares for payment generally found in non-SOEs.

transfer

was, however, not completed.

Then on September 18 2001, the controlling shareholder, Chendu

announced

This proposed

it

was

to

transfer

48%

of

its

holding

Asset
to

another

Management
textile

SOE

company which would be de facto the controlling shareholder.

This latter de facto M&A without payment transfer was eventually approved by the central
government by July 2002.
As can be seen in Figure 2, from early 2002 to September 2003, the stocks cumulative abnorma
l returns started to deteriorate. It seemed the new SOE owner was not able to transform
the company. On January 28 2003, the company announced that the municipal government
would lead the companys restructuring, including its relocation and employee
redundancies. The market embraced this announcement with strong positive response the
event

day

abnormal

return was a positive 5.26%.

The governments involvement in employee redundancy meant that it would subsidise the
companys obligation to settle redundancy payments in order to main social stability. Then
on May 23 2003 the controlling state shareholder signed an agreement to sell its 43.7%
holding to a pharmaceutical company for RMB167 million. The purchaser would become the
controlling shareholder once the deal was completed. This announcement was
accompanied by a 3.76% abnormal return on the day. However shortly afterwards on July 10
2003 it was announced that the entire shareholding of the SOE controlling shareholder had
been frozen by the court in June 2003 for one year because of overdue debts owed to
Chendu Industrial Development Ltd. The abnormal return on this announcement was an
economically
although not statistically significant -3.87%, indicative of the markets disappointment at the
12

cancellation of this deal. As a result of the court order, cancellation of the share sale agreement
to the pharmaceutical company was announced on September 15 2003.
On August 21 2003 the company announced that it would sell its textile business assts net of
related debt to a textile business for RMB26.8 billion, with RMB13.2 billion of redundancy
payments deducted, leaving Sichuan with a net cash inflow of RMB13.6 billion. Sichuan
would then achieve the transformation from being a textile to a pharmaceutical company
which had

11

Although the Shandong Jintai case above does include changes in ownership of subsidiaries achieved via
asset transfers and without any payments changing hands.
12
This price change has not been included in our summary tables as it was not a restructuring event.

Page

17

previously been obstructed by the court order referred to above, by using part of its newly-found
cash to purchase an 81% holding in a pharmaceutical company for RMB0.12 billion. These
transactions were indeed completed on December 31 2003. It should be noted that between
August 28 2003 and December 19 2003 the stock was suspended from the exchange due to
continued deterioration in

profitability,

and the stock price continued to plunge from the first day of relisting, December 23 2003, up
until the end of the year.
The overall share price movements by restructuring category are summarised in Table 4. This
shows the event day abnormal return for two of the M&A without payment announcements in
2001 were positive but were not significant either economically or statistically. However
event day return for the follow-up announcement in 2002 was negative. The average
abnormal return of the four announcements on day 0 is negative but again not statistically
or economically significant, and its CAAR10 is -3.32% but not significant. On average
the market reacted negatively to M&A without payment announcements.
Insert Table 4 here
Although there were five asset sales and operations restructuring related announcements, three o
f these took place during the shares suspension period or when the share price movement
was capped.

Table 4, therefore, shows only the remaining two announcements.

The

average abnormal return on announcement day was 2.73% but this was not statistically
significantly different from zero. The M&A with payment announcement on May 23 2003
as part of the companys 2003 strategic restructuring process resulted in a AR0 of 3.76%, and
CAR(-2, +2) of 10.90%, both significant at the 1% level. This M&A transaction was not
completed

and

on

September 15 2003 the company announced the cancellation of the intended M&A with paymen
t transaction. As the cancellation announcement was made during the stocks suspension
period, event study analysis could not be carried out.
negatively

to

Finally, the market reacted

announcement relate to the managerial restructuring announcement.

These results are in general consistent with those of the first case study, Shandong Jintai. In
addition, this case provides an interesting comparison of market reaction between M&A
with and M&A without payment announcements.In

this

case,

the

market

reacted

negatively to M&A without payment announcements but positively and significantly to

M&A with payment announcement.

Page

18

5. DISCUSSION
The two cases we present here highlight the role of government versus non-government
ownership in distress resolution as an important corporate variable determining the success of
various restructuring methods employed for recovery.
First, mergers and acquisitions are value-enhancing when a payment is involved and
ownership

is

transferred

from

state

to

non-state

shareholders.

However M&A transactions between state companies and without payment being made is not
perceived by the market as value-enhancing.
M&A was employed by both Shandong Jintai and Sichuan Joint-Wit as the major strategy for
recovery. In the SOE Sichuan case, M&A without payment was first employed with
state shares

changing hands between SOEs.

When this transaction failed to turn the companys performance around. Sichuan Joint-Wit then
announced an intended M&A with payment transaction. While the average abnormal return
on the relevant M&A without payment announcements was -0.3%, the abnormal return on the
subsequent M&A with payment announcement, which would have entailed the privatisation
of state-owned shares, was a significantly positive 3.8%. Shandong Jintai, the non-SOE,
engaged in a number of M&A for payment transactions. In contrast to the
significantly positive market reaction to Sichuan JointWits M&A with payment announcement,
the average abnormal return for Shandong Jintai was a non-significant -0.2%. This suggests that
it is the transfer of control

from SOE to

non-SOE that is perceived

most positively by the market as a successful restructuring strategy.

In the SOE Sichuan Joint-Wit case, managerial disciplinary events are not frequently observed.
There is only one managerial restructuring announcement following the M&A with payment
announcement. On the contrary, in the non-SOE Shandong Jintai case, as a distressed
commercial company, frequent announcements of departures (both forced and voluntary) of
senior management are observed. The markets reaction to these announcements was mixed.
Events entailing the appointment of additional directors or general managers were accompanied
by positive, although not statistically significant, price reactions.
However the announcement of
the resignation and replacement of key appointments, including the companys general manager

and its chief financial officer, triggered a significantly negative share price change.
This negative

Page

19

result is not consistent with evidence from developed economies (Dennis and Dennis 1995;
Dherment-Ferere and Renneboog 2002). One possible explanation is that this type of
announcement sends a hybrid signal to the market.
Thus, Roland and Sekkat (2000) argue that in
a socialist economy, due to asymmetric information about managerial skills, good managers hav
e little incentive to out-perform others. Following this line of argument, the act of
replacing incumbent management does not bring about the desired result of better
performance for SOE. Future investigation using large scale international data could provide
better understanding on this issue.
Restructuring strategies entailing mere transfers of assets or shareholdings, do not have any
significant impact on firm
values. Such strategies, which were implemented in both these Chinese firms, do not have
immediate

cash

flow-generating

implications.

This

contrasts

with

the

cash-

generating strategies observed in developed economies (Asquith et al. 1994; Lai and Sudarsana
m 1997). Chinese firms do not face the same threat of bankruptcy as firms in say the U.S. and
the U.K. For example, during the first year of its distress, Shandong Jintais management
still had the time to experiment with new operating strategies despite the adverse
circumstances,

further

demonstrating the lack of threat from potential bankruptcy or liquidation. The management was
able to conduct such experiments by selling assets and using the proceeds to invest in other
activities, rather than meeting overdue debt payments.
Both companies frequently employed mergers and asset sales in their effort to restructure. Given
that the nature of distress in China is predominantly economic, as documented in Kam et al.
(2005), this is perhaps not a surprising result. As a result of the difficulties in officially
liquidating economically unviable firms in the Chinese context due to the lack of effective
bankruptcy laws, these observed mergers and asset sales are perhaps a beneficial outcome in
terms of improved use of resources.
Using U.S. data, Kahl (2001) also argues that M&A are used in re-allocating assets to more
efficient

uses

and

that,

although

inefficient firms alive, these distressed firms are not

Chapter

11

tends

to

maintain

tolerated for long by the market.

In addition, Weston et al. (2001) argue that divestitures perform vital economic functions
by

moving

resources from less valued to higher valued uses and therefore contribute to the resource mobilit

y essential to the effective operation of an enterprise economy.

Page

20

We also observe a small number of debt related restructuring announcements in the non-SOE
Shandong Jintai case. In this case the distressed debtor renews existing or obtains further
loans. These events differ from those generally found in the existing literature which
documents more active creditor participation in financial restructuring such as debt for
equity swaps, debt forgiveness and write-downs. This is perhaps not so surprising given
the

lack

of

creditor

protection in the existing formal bankruptcy process in China.

In addition, the event study results show that the market reacts negatively to the companys
announcements on renewing or increasing leverage. This is contrary to the debt governance
theory advocated by Jensen (1986) and Wruck (1990). There are two potential explanations
for these results. Firstly because, as argued by Tian (2004), debt governance is not at work
in the Chinese institutional context, increased leverage may merely increase management
entrenchment and perks. Secondly, the distressed firms attempt to renew existing or obtain
further debt may be signaling to the market its poor performance.

6. CONCLUSIONS
The two case studies provide an information-rich environment to understand how Chinese
distressed firms restructure and how these restructuring strategies impact shareholder wealth.
Asset restructuring, including M&A with and without payment, asset sales, debt and managerial
restructuring strategies

are employed by both firms.

Equity restructuring is not observed in these two cases. This likely because the two Chinese
stock exchanges impose strict rules on firms wishing to issue further equity, making it
very difficult for non-profitable firms to issue additional equity.
Both firms frequently sell assets under distress. The motivation for selling assets does not
seem to be associated with enabling the firms to meet overdue debt obligations as there is no
evidence

of significant debt repayments.

Instead, it is associated with their severe liquidity constraints and

with providing liquidity for working capital requirements and, in the Jintai case, for managemen
t to experiment with new operational strategies.
M&A is employed successfully by the SOE firm. The markets reaction suggests that market
participants view privatisation favourably and that a continuing government role in the distress

Page

21

resolution process is unwelcome. In addition, markets indifference to the non-SOEs M&A with
payment announcement suggests that takeover is not perceived favourably by the market as a
turnaround strategy.
This research has raised a number of important issues throwing light on distressed firm
restructuring in a context where substantial state ownership persists despite on-going market
liberalization and where formal insolvency procedures are absent. Further investigation is neede
d to understand the motivations and mechanisms for distressed firms in such an environment
to
transfer their shares and assets without payment, and for the complex joint venture structures tha
t often result from this process. In addition, the reasons for the negative market impact of
certain

managerial and debt restructuring strategies need further examination. Finally a larger-

scale study

could

test

whether

distressed

SOE

acquisitions

are systematically viewed as more value-enhancing than other M&A strategies.

by non-SOEs

Page

22

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