Unsecured loan, missing CEO add red flags to China lending

Ultrasonic shoe company showroom.
Source: Ultrasonic
Ultrasonic shoe company showroom.

Nomura Holdings and co-lenders spent nine months poring over the books, sizing up management and even checking out the factory floor at China's Ultrasonic AG before deciding in August to give the Frankfurt-listed shoemaker a $60 million unsecured credit facility.

The loan was unsecured in keeping with regulations in China at the time it was structured. Nomura, a Japanese bank, and its partner banks, however, felt they had done their homework.

But within weeks, the 3-year loan had been drawn down in full and two of Ultrasonic's top executives had disappeared - leaving the lenders in a situation that should ring alarm bells for foreign bankers exposed to China.

"You couldn't get onshore security for offshore loans," said a person involved in the loan negotiations. "It was a common risk in offshore borrowing for Chinese companies."

Read MoreAiling Ultrasonic in bank talks to avoid insolvency

The affair is a reminder for offshore banks of the risk of lending to small and mid-sized Chinese firms which have long struggled to access credit. Local banks are more inclined to lend to larger, more established companies as economic growth slows, forcing smaller firms to seek expensive loans in the less-regulated shadow banking industry or from offshore lenders.

Asia-Pacific banks had about $1.2 trillion worth of China-related exposure at the end of last year, including bank and non-bank lending, latest Fitch Ratings data show.

"These mid-sized companies are getting hit the hardest by the slight slowdown in the economy, and that's having an impact on how they view the future ...," said Kent Kedl, Shanghai-based managing director for Greater China and North Asia at consultancy Control Risks.

"This isn't to say that mid-sized companies have any more innately corrupt people in them than do large companies, but large companies can weather storms a little easier."

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China's economy grew 7.5 percent in April-June, a touch quicker than the previous quarter's 7.4 percent - the slowest since the third quarter of 2012.

Disappeared

Ultrasonic on Tuesday said CEO Wu Qingyong and his son, Chief Operating Officer Wu Minghong, had been missing since the weekend, and most of the company's cash reserves in China and Hong Kong had vanished. On Thursday, the company said the pair had withdrawn the cash in two tranches.

Just five weeks earlier, the CEO and Ultrasonic's listed holding company had guaranteed the loan, extended by Nomura's Hong Kong unit after extensive checks on the company and its customers, people involved in the loan talks told Reuters.

CEO Wu was well known in Jinjiang City in the southeastern province of Fujian, where the company's factory was located. He received an award from the provincial government last year in recognition of his contribution to the development of the Western Taiwan Straits Economic Zone, according to a government website.

Read MoreChinese shoe company's CEO, COO, cash go missing

"People have backgrounds which are shady, then you do a lot more thinking about it," said the first person involved in the talks. "In this case, the gentleman had no such background, and was quite well endorsed by prominent figures in the region, so he surprised all the banks and investors that bought shares."

Three people involved in the talks spoke on condition of anonymity. A Nomura spokesman in Hong Kong declined to comment.

Several Taiwanese lenders took part in the loan facility, including Cathay United Bank Co, which will report the matter to the police, the people told Reuters. No one at Cathay United Bank could be reached by telephone for comment.

Shadow banking

Ultrasonic did not provide details of the loan agreement, but in a statement on Thursday said creditors had called in the loan the previous day and entered negotiations to determine if insolvency could be avoided.

Read MoreChina regulator to tighten shadow banking supervision

The company's predicament comes as investors question the corporate governance of other foreign-listed Chinese firms.

A $175 million syndicated loan to Nasdaq-listed 21Vianet Group, for instance, has been "put on hold" because Trinity Research Group has twice challenged the credibility of 21Vianet's financial position. The internet data center services provider rejects the allegations.

"Smaller companies are less likely to have reliable financial statements. They're also more likely to borrow from shadow banking," said Christine Kuo, senior credit officer at Moody's Investors Services. "In addition, their businesses are generally more vulnerable during sector downturns."

Access to funds for small firms could get even more difficult, Kuo said.

Local banks are likely to become increasingly cautious in extending credit, Kuo said, because of an increase in bad loans and because the banking regulator wants banks to increase reserves, tying up cash that could otherwise be lent out.