A Chinese national flag flies in front of residential buildings in the Lujiazui district of Shanghai, China, on Sunday, June 30, 2013. China's expansion probably slowed for a second straight quarter, based on the median estimate in a Bloomberg News analyst survey, after export growth collapsed and Premier Li Keqiang reined in record credit expansion to contain shadow-banking risks. Photographer: Tomohiro Ohsumi/Bloomberg
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A court ruling in a fourth-tier Chinese city has exposed legal risks from investment in “fake equity” by shadow banks, carrying potentially broad implications for the $2.6tn industry.

Trusts have emerged as the biggest source of non-bank lending in recent years, with assets under management reaching Rmb18.2tn ($2.6tn) at the end of September. That places trusts second only to commercial banks and ahead of insurance companies and securities brokerages.

Some trust investments are classified as loans but a significant portion is instead labelled as equity. These deals typically involve an “equity” investment paired with a repurchase agreement, which requires the investee to buy back its equity along with a fixed dividend at a specified date. The repo essentially transforms the equity financing into a debt-like arrangement.

The practice allows trusts to evade regulations intended to restrict lending to risky borrowers. In Chinese, the practice is known colloquially as “fake equity, real debt”. Analysts say fake equity is one reason China’s official debt statistics may fail to capture the full extent of credit growth in the country.

In a little-noticed ruling last month, a district court in Wuxing district of Huzhou city, in east China’s prosperous Zhejiang district, rejected a claim by New China Trust that it should be treated as a debtholder in the bankruptcy of a local property developer. 

New China Trust invested Rmb225m in Huzhou Port Land Real Estate Company to finance a residential development called Triumphant Return International. The deal required Port Land to repay the equity plus dividends in three stages over 30 months, but the developer made only partial repayment. In 2015 Port Land entered bankruptcy. 

In a bid to recover its money, New China Trust submitted itself to the bankruptcy administrator as a creditor. This would have granted the trust seniority over equity holders in terms of recovering assets from Port Land. But the administrator disagreed, deciding that New China was in fact an equity holder. In its recent judgment, the district court upheld that decision against a challenge from New China Trust. 

The ruling could have a major impact on China’s trust industry. Growth of trust loans outstanding dropped from 62 per cent in 2013 to only 2 per cent last year, according to data from the China Trustee Association, due in part to tougher regulation. But four other categories of trust investment, all of which potentially include fake equity deals, collectively grew 15 per cent last year.

New China has not said if it will appeal against the decision. If a higher court takes the opposite view — either in an appeal of this case or in a separate but similar case — the precedent could be reversed. 

If the precedent stands, trusts could be forced to return to more traditional lending structures. That would probably lead to less overall lending, due to the tighter regulations.

Alternatively, trusts could continue with equity deals but they would face pressure to change how they deal with clients. Most trusts raise funds by selling high-yielding investment products to investors, who perceive them as carrying the safety of a fixed-income product. If fake equity investors lack the seniority that creditors enjoy, trusts would in principle have to communicate this increased risk investors. 

Twitter: @gabewildau

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