On May 19, 2014, the PRC1 State Administration of Foreign Exchange (“SAFE”)2 formally issued and published the Foreign Exchange Administration Regulations on Cross-Border Guarantees and Security (the “Regulations”), which came into effect on June 1, 2014, superseding the previous regulations established by SAFE.
Amongst other provisions, the new Regulations — for the first time ever — allow onshore3 companies to guarantee offshore debt without prior regulatory approval4. In the event of an onshore company entering into a debt default, investors are granted direct access to the onshore company’s assets in Mainland China5.
Background
Previously, only state-owned enterprises (“SOEs”), such as China Petroleum & Chemical Corporation — the largest refiner by capacity in Asia — and the China National Cereals, Oils and Foodstuffs Group — the largest grain trader in the PRC — were allowed to pledge domestic assets or provide guarantees against offshore debt subsequent to regulatory approval6.
Restrictions on cross-border capital transfer meant that investors ran a higher risk of losing money if the domestic parent company entered into default. As a consequence, in the event of financial distress, offshore investors were structurally subordinated to domestic creditors in accessing a company’s assets in Mainland China. In 2013, when Suntech Power Holdings Co. — the world’s largest solar panel producer — defaulted on its overseas debt, bondholders were structurally subordinated to domestic creditors in claims against the company’s assets in Mainland China, which highlighted the risk facing investors in the event of a Chinese company entering into default.
In view of and to remedy these problems, Chinese firms have tried to provide assurance to offshore investors by the following means:
- issuing “keepwell agreements”, i.e., written promises that a company will repay overseas creditors and pledge to keep its offshore units afloat;
- offering liquidity support covenants7, as in the case of the Baosteel Group;
- issuing deeds of equity agreement; and
- warranting to buy equity stakes in offshore units to inject cash for debt repayments.
However, institutional investors remained wary of the effectiveness of the aforementioned measures, not without good reason. First, offshore investors were not recognised by Chinese regulators. Second, similar issues had yet to be tested in Chinese courts8. Risk and uncertainty, therefore, largely remained unaddressed.
The Reform
The new Regulations were designed to alter, indeed improve, the position of offshore investors by allowing Chinese companies to provide guarantees or security in support of debts owed by an offshore debtor to an offshore creditor, known as an outbound security.
There are four key changes to the outbound security regime: 1) qualification; 2) registration and enforcement; 3) use of proceeds; and 4) provision of new security (in the event of a default in the company group).
Qualification
Under the new Regulations, banks, non-financial institutions, companies and individuals may provide outbound security for offshore debts. Whereas the previous pre-approval system effectively reserved the ability to provide onshore guarantees or security for SOEs only, entities seeking to provide outbound security for offshore debts may now register with SAFE after an outbound security has been created. The previous quota allocation system for banks providing outbound security has been abolished, and onshore guarantors are no longer required to have a shareholding interest in the offshore debtors.
Registration and Enforcement
Under the new Regulations, all onshore Chinese entities are required to register cross-border guarantees and security post signing with SAFE9. Whereas banks must register outbound security through a pre-established online SAFE platform, non-bank financial institutions, companies and individuals are required to register any outbound security with SAFE within 15 working days from the date of the agreement10.
Meanwhile, the validity and enforcement of cross-border guarantees and security agreements are no longer subject to SAFE approval, registration or filing11. It is worth noting, however, that, although registration with SAFE is no longer required, certain provisions of the Judicial Interpretation of the Supreme People’s Court on Certain Issues Concerning the Security Law of the People’s Republic of China remain effective, in that an outbound security or guarantee agreement will be held invalid if it fails to obtain approval from or complete registration with the relevant authorities12. In view of the hierarchy of legislation, creditors should take steps to ensure that the onshore entity does duly register the cross-border guarantee or security arrangement with SAFE.
The bond markets have reacted to this risk in recent bond issues, such as Shanghai Electric Group’s recent U.S.$500 million bond issue by an offshore subsidiary and guaranteed by the Chinese parent company. The parent company has undertaken to the bondholders to register the guarantee of the bonds with the relevant local branch of SAFE within 15 working days after execution of the guarantee. If the parent company fails to complete the SAFE registration within 45 working days of execution, the bondholders have the right to put the bonds back to the issuer for early redemption.
Use of Proceeds
New restrictions have been imposed by what is generally seen as a liberalising set of regulations, the most important of which are as follows:
- debt proceeds can be used only within the debtor’s ordinary scope of business and not for speculative purposes13; and
- debt proceeds cannot be used for equity investment or shareholder loans into PRC entities without SAFE approval14.
In addition, indirect equity investment and lending is prohibited, such as the refinancing of existing debt which was originally used for equity investment or shareholder loans into PRC entities, as well as the acquisition of an offshore company/group which has more than 50 percent of its assets in the PRC. In short, unless approved by SAFE, debt proceeds must not be remitted into the PRC. As an analyst from Fitch Ratings observed, “the purpose [of the New Regulations] is to facilitate firms with offshore funding needs, especially SOEs as part of the government agenda to encourage SOEs to make outbound investments”15.
Provision of New Security
The new Regulations also provide that, if an existing outbound security becomes enforceable and the guarantor or security provider is not a bank, such guarantor or security provider cannot provide any further outbound security without prior approval, until the offshore debtor has fully repaid the debt owing to such guarantor or security provider arising from the enforcement of outbound security16. Banks are not subject to this restriction, whereas non-banks will need to carefully monitor that offshore subsidiaries and other entities do not default on debts guaranteed by the onshore company.
Conclusion
Regulatory changes to bonds and debts, as encapsulated in the new Regulations, are widely believed to be the PRC’s effort to boost international investor confidence in China’s overseas debt market, estimated to be worth U.S.$204.6 billion at present17, as the world’s second largest economy is showing signs of slowing.
Commentators generally welcomed the recent changes and expected the new Regulations to give impetus to offshore bond markets, thereby reducing funding costs and, most importantly, reducing the risks of structural subordination for offshore investors18.
The relatively high domestic borrowing costs in Mainland China are pushing companies to raise funds abroad, and, with the introduction of the new Regulations in June 2014, companies wanting to raise funds for international acquisitions and expansion have been issuing bonds through offshore subsidiaries, guaranteed by the onshore parent company. Greenland Holding Group Co. has so far made three bond issues, and over 20 other Chinese groups have gained access to the international bond markets through offshore issuers, guaranteed by the onshore parent company or bank.
The new Regulations provide investors with direct enforcement rights against onshore Chinese companies and their assets, and Chinese companies with overseas funding needs have been tapping the international bond markets, in growing numbers and at lower offshore funding costs.
It will be interesting to see the extent to which additional Chinese companies turn to these markets to finance their international acquisitions and expansions.
1 “PRC” in this article refers to the People’s Republic of China, excluding Hong Kong, Macau and Taiwan.
2 SAFE is the government agency charged with regulating the provision of cross-border guarantees and security for capital flows, both in and out of the PRC.
3 “Onshore” in this article refers to the jurisdiction of the PRC.
4 “Rule change lets Chinese firms guarantee offshore debt”, South China Morning Post, May 22, 2014.
5 “Mainland China” in this article refers to the geopolitical area under the jurisdiction of the PRC, excluding Hong Kong, Macau and Taiwan.
6 “Chinese Firm Capitalizes on Bond-Rule Change”, The Wall Street Journal, June 26, 2014.
7 “Baosteel tweaks China bond structure”, International Financing Review Asia, November 30, 2013.
8 “Chinese Firm Capitalizes on Bond-Rule Change”, The Wall Street Journal, June 26, 2014.
9 Art. 9 of Foreign Exchange Administration Regulations on Cross-Border Guarantees and Security.
10 Art. 9 of Foreign Exchange Administration Regulations on Cross-Border Guarantees and Security.
11 Art. 29 of Foreign Exchange Administration Regulations on Cross-Border Guarantees and Security.
12 Art. 6 of Judicial Interpretation of the Supreme People’s Court on Certain Issues Concerning the Security Law of the People’s Republic of China: A foreign security contract shall be invalid if: 1) the security is not approved or registered by relevant administration authorities; 2) the security is provided to a domestic creditor for overseas organs without approval or registration by the relevant administration authorities; 3) the security is created to secure registered capital or the foreign party’s external debt of its investment in a foreign-invested enterprise; 4) a foreign exchange security is provided by a financial organ whose business scope does not include foreign exchange security, or a foreign exchange security offered by a non-financial enterprise legal person without foreign exchange income; 5) the security provider will not assume any obligation if the principal contract is altered or the creditor transfers the right of a foreign security contract without consent of the security provider or approval of the relevant administration authorities, except as otherwise provided by laws and regulations. (Source: Law Info China: http://www.lawinfochina.com/display.aspx?lib=law&id=1776&CGid)
13 Art. 11(1) of Foreign Exchange Administration Regulations on Cross-Border Guarantees and Security.
14 Art. 11 (2) of Foreign Exchange Administration Regulations on Cross-Border Guarantees and Security.
15 “Rule change lets Chinese firms guarantee offshore debt, Companies will be allowed to guarantee offshore debt without prior approval under new rules”, South China Morning Post, May 22, 2014.
16 Art. 14 of Foreign Exchange Administration Regulations on Cross-Border Guarantees and Security.
17 “Chinese Firm Capitalizes on Bond-Rule Change”, The Wall Street Journal, June 26, 2014.
18 “Chinese Firm Capitalizes on Bond-Rule Change”, The Wall Street Journal, June 26, 2014.