Playing the rules, not breaking them

The creditor run

A few days before Chinese New Year in 2021, while most of the city was already thinking about holiday, my team and I were still in a meeting room with a client, a Hong Kong-listed company, and a specialist team rarely seen in the ordinary corporate world: insolvency practitioners.

The company had been hit with a wave of debt-acceleration demands from multiple banks in quick succession. Nothing had changed operationally; it was closer to a bank run than a real deterioration in the business. Frustrated and running out of room, the company brought us in to help.

The usual first move in a panic like this is to open a dialogue with creditors and try to buy some breathing space, like a standstill. But after a few rounds of back-and-forth, it became clear the creditors weren’t interested in breathing space. They wanted the company taken apart, and the file closed, so that they could write it off their books.

The Bermuda manoeuvre

So it was suggested to file a winding-up petition in Bermuda, where the company was incorporated, and ask for a provisional liquidation order on a light-touch basis. It works something like Chapter 11: the order strips out some of the powers a provisional liquidator would normally take over, so as to give management room to negotiate and refinance while a court order stayed all liquidation-related petitions.

The timing was the interesting part. The petition and the request for provisional liquidation were filed right before Chinese New Year, and processed over the holiday. By the time creditors found out, the Bermuda court had already made its order. Because the company was listed in Hong Kong and the loans sat under Hong Kong law, the provisional liquidator still needed a recognition order from the Hong Kong court. Around that time, a new Judge took over corporate matters in the Hong Kong court. The new Judge heavily criticised this practice of leveraging two common-law jurisdictions.

Gaming the rules

Nothing here was illegal, but the process was used to defeat its own purpose. Winding-up and liquidation procedures exist so insolvency gets resolved fairly, with all parties able to participate. In this story, participation was the thing being deliberately engineered around. It is a classic example of what Joseph Heath calls gaming the rules, which is about exploiting the letter of a system in a way that defeats its purpose.

The incentives before distress

But after a decade in the industry, I’ve come to wonder whether the borrower was really the worst actor in this story. I’ve noticed a pattern across many distressed scenarios. Long before the crisis, bank relationship managers had encouraged the borrower to borrow more than it needed. Because origination volume, but not credit quality, is what gets rewarded, bankers pointed to a strong balance sheet in a low-rate environment, often glossing over weaker free cash flow or asset quality.

And when distress hit, I heard proposals for presenting invoices more favourably to unlock additional credit. I do not know whether those proposals were ever acted on. To me, they sounded less like attempts to help the borrower than attempts to protect an earlier lending decision.

The incentives behind this are not unusual in banking. People rationalise them as just how the game is played, and only the ones who get caught red-handed learn the consequences otherwise. Banks also rank ahead of ordinary shareholders in a liquidation, so the downside is asymmetric too. It is understandable that if you do not play dirty like your rivals do, you fall behind. But the costs are more than trust erosion. The borrower, and its minority shareholders if it is listed, are the ones paying for it ultimately.

The harder question

So, was the company gaming the rules for a few weeks of breathing room really more corrosive to the market than years of lending whose risks the banks had little incentive to confront?

Certain details have been omitted or altered to preserve confidentiality.