Relaxation of PRC regulatory restrictions on cross-border security and guarantees

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1 May 2014 Relaxation of PRC regulatory restrictions on cross-border security and guarantees 1 Introduction After much anticipation 1, SAFE has finally published the Regulation on Foreign Exchange Administration of Cross-border Guarantee and Security together with its operational guidelines (collectively the New Regulation ) on 19 May The New Regulation will come into effect on 1 June 2014 and bring about sweeping changes to the existing regime by removing most of the restrictions on cross-border security and guarantees in respect of loans. 2 Changes from draft Regulation Contents 1 Introduction Changes from draft Regulation Key Methodology in the New Regulation Application to Bonds and Derivative and Other Transactions Conclusion... 6 Most of the provisions we described in our March 2014 note have been preserved and some have been further loosened. The key provisions are discussed in more detail below. The principal changes from the draft regulation are: (i) removal of any financial limit on guarantees and security by financial institutions (which are therefore subject to the same regime as companies); and (ii) further clarification that other guarantee and security structures which are neither outbound nor inbound are freely permitted. 3 Key Methodology in the New Regulation A key approach in the New Regulation is to divide all cross-border guarantee/security transactions falling within SAFE s jurisdiction into three broad categories of transactions (i) onshore guarantee/security for an offshore loan ( Nei Bao Wai Dai or Outbound Security ); (ii) offshore guarantee/security for an onshore loan ( Wai Bao Nei Dai or Inbound Security ) and (iii) other cross-border security or guarantee. Each category is subject to a separate set of rules, which we set out in turn below. Importantly, the New Regulation clarifies that the approval, registration or filing requirements of SAFE in relation to cross border security arrangements and various requirements under the New Regulation are not pre-conditions to the cross border security arrangements coming into effect. 1 Click here for our previous note in March 2014 on SAFE s proposed reform in respect of the regulatory regime on cross-border security and guarantees. New SAFE Regulation 1

2 3.1 Outbound Security Unlike the narrow meaning that is usually ascribed to this term currently in the market (i.e. the SBLC structure), the term Nei Bao Wai Dai has a very broad scope under the New Regulation and comprises all transactions where an onshore PRC entity provides a guarantee and/or security in support of a debt owed by an offshore debtor to an offshore creditor. The main rules on Outbound Security are summarised as follows: PRC companies can freely provide Outbound Security: Subject to the restrictions on the use of debt proceeds referred to in paragraph 3.1(d) below and the registration requirement referred to in paragraph 3.1(c) below, onshore companies can freely provide guarantees and/or security in support of a debt owed by an offshore debtor to an offshore creditor. This means that all of the following restrictions under the existing regime on Outbound Security will be removed with effect from 1 June 2014: - requirement for prior case-by-case SAFE approval or SAFE quota; - requirement that the onshore guarantor/security provider has to be a shareholder of the foreign debtor (currently only downstream guarantee/security and no upstream or crossstream guarantee/security is permitted); and - certain financial criteria which the onshore guarantor/security provider and the foreign debtor must satisfy. Under the New Regulation, there is no mandatory requirement for any shareholding or common ownership relationship between the onshore guarantor/security provider and the foreign debtor. This position, coupled with the fact that the corporate benefit concept is very loosely implemented under PRC company law, means that a PRC company is able to grant a guarantee of the debt 2 of an entirely unrelated foreign debtor. (b) PRC financial institutions can also freely provide Outbound Security: Unlike the existing regime under which a bank may grant external security or guarantee subject to an annual quota allocated to it by SAFE, under the New Regulation the quota regime for banks will be abolished and each PRC financial institution (including banks and nonbank financial institutions) can, subject to paragraphs 3.1(c) and 3.1(d) below and such financial institution having the business qualification for providing such security and guarantee, freely provide Outbound Security. 2 Save in relation to an Outbound Security given to secure a bond issuance see paragraph 5 below. New SAFE Regulation 2

3 (c) (d) SAFE registration/reporting requirements: After having entered into a contract providing external guarantees or security, an onshore company or non-bank financial institution or individual is required to register the transaction with SAFE whilst an onshore bank can register by reporting the transaction to SAFE via a pre-established reporting system. The New Regulation also clarifies that SAFE will conduct a procedural review of an application by a non-bank entity for registration of an Outbound Security. Restrictions on use of proceeds: The use of Outbound Security debt proceeds will need to comply with the following requirements: - the debt proceeds can only be used within the debtor s ordinary scope of business and not for speculative purposes; and - absent SAFE approval, the debt proceeds must not be remitted into the PRC (whether directly or indirectly and whether by way of debt (whether it is new financing or refinancing), equity investment or any other means (including using the debt proceeds directly or indirectly to acquire an offshore target if the target s assets located in the PRC represent more than 50% of the value of the total assets of the target)). (e) Onshore individuals can freely provide Outbound Security: The rules applicable to Outbound Security granted by PRC nationals will be the same as those applicable to PRC companies. Therefore, obtaining a personal guarantee and/or security from a PRC national will be straightforward under the New Regulation, subject to SAFE registration as noted under paragraph 3.1(c) above. By contrast, under the existing regime only in very limited circumstances will SAFE recognise the effect of personal guarantees provided by PRC individuals (i.e. only when the PRC individual is acting as a co-guarantor with an onshore company which itself is permitted to be a guarantor). 3.2 Inbound Security As its name suggests, this type of transaction envisages a situation where the creditor is a PRC financial institution, the debtor is an onshore company and the guarantor/security provider is an offshore entity. The key rules in the New Regulation in relation to Inbound Security are as follows: Subrogation Debt subject to cap: Upon an offshore guarantee and/or security provided under an Inbound Security transaction being performed or enforced, by way of subrogation there will arise a foreign debt (a Subrogation Foreign Debt ) owing by the onshore debtor to the foreign guarantor/security provider. The onshore debtor is required to ensure that the total outstanding principal amount of all its Subrogation Foreign Debt will not exceed the amount of the onshore debtor s net assets as shown in its audited financial statements for the previous financial year. New SAFE Regulation 3

4 (b) (c) SAFE registration required for Subrogation Foreign Debt: Once a Subrogation Foreign Debt has resulted from the performance of the offshore guarantee/security, the onshore debtor must register it with SAFE. Restriction on new Inbound Security where there is outstanding Subrogation Foreign Debt: Before any Subrogation Foreign Debt that has become due is fully discharged by the onshore debtor, the onshore debtor shall not enter into any new Inbound Security arrangement. So long as the rules set out above are complied with, the onshore debtor and the onshore creditor can freely enter into Inbound Security transactions. Compared to the rules under the current regime, the main liberalising effect under the New Regulation would come from paragraph 3.2 above. Under the current regime, the most significant hurdle in relation to guarantees of offshore entities in respect of onshore debtors is the uncertainty as to whether the resulting Subrogation Foreign Debt, once it arises, would cause any problem for the performance of such guarantees. If the resulting Subrogation Foreign Debt fell outside the permitted foreign debt but came into existence in any event, such non-compliance with SAFE rules could have potentially impeded the foreign guarantor/security provider s ability to convert foreign currency into RMB in order to perform its obligations under the guarantee/security. This is the reason why, to date, only FIEs with sufficient unutilised borrowing gap have generally been onshore debtors under Inbound Security transactions since, in this case, there is more certainty that any future Subrogation Foreign Debt can be duly registered with SAFE and will not impede the performance of the offshore guarantee/security (and the lenders would usually require the FIE to undertake to maintain a sufficient borrowing gap throughout the term of the loan). Under the New Regulation, this problem will be significantly alleviated, by virtue of the provisions that: (i) so long as the limit on the maximum amount of Subrogation Foreign Debt referred to in paragraph 3.2 above is complied with, any Subrogation Foreign Debt is capable of being registered with SAFE irrespective of whether the debtor is a FIE or has the ability to borrow other types of foreign debt; (ii) even if such limit has not been complied with, the performance of the relevant Inbound Security would not be affected and it is only the onshore debtor who will be penalised after the performance of the Inbound Security. 3.3 Other types of Cross-border Security and Guarantee Under the New Regulation, other than Outbound Security and Inbound Security, PRC persons can freely enter into other types of cross-border security/guarantee transactions with no need for approval or registration (but still subject to the underlying debt s compliance with foreign exchange rules in general). According to the New Regulation, such other types of transactions include without limitation the following: the guarantor/security provider is onshore, either the creditor or the debtor is onshore and the other is offshore; New SAFE Regulation 4

5 (b) (c) (d) the guarantor/security provider is offshore, either the creditor or the debtor is onshore and the other is offshore; all three parties are onshore, but the collateral is offshore; and all three parties are offshore, but the collateral is onshore. 4 Application to Bonds and Derivative and Other Transactions The relaxations envisaged by the New Regulation extend to the provision of Outbound Security in respect of bonds and derivative transactions with the following additional restrictions: Bond issuances: The New Regulation requires that (i) the onshore guarantor/security provider must have a direct or indirect ownership interest 3 in the bond issuer, (ii) the bonds proceeds must be used for an offshore investment in which the onshore guarantor/security provider has an equity interest and (iii) either the project or the relevant offshore entity must have been approved, registered, recorded or acknowledged by competent PRC authorities for overseas investments according to relevant regulations. Under the existing regime, the approval authority for an Outbound Security is Central SAFE and approval is only granted for an Outbound Security given in relation to a project of a capital nature approved by the National Development and Reform Commission or the Ministry of Commerce. Whilst the bond issuance restrictions under the New Regulation represent a substantial relaxation of the existing requirements and come under the administration of local SAFE, it remains to be seen how liberally the local SAFE will interpret these restrictions (for example, will an offshore bond offering by an offshore vehicle set up by an onshore entity to raise financing for its offshore business and for which a filing has been made with the Ministry of Commerce satisfy the requirements referred above, particularly (iii)). Thought will also have to be given as to whether and how structured note, certificate of deposit or commercial paper programmes of banks could be structured to benefit from Outbound Security. (b) Derivative and other transactions: The derivative transaction must be for the purpose of stop loss or preservation of value, must come within the principal business scope of the debtor and be duly authorised by its shareholders. Whilst hedging transactions of corporates could satisfy these requirements, query whether derivative transactions entered into by banks (such as back-to-back ( dai ke ( 代客 ) ) derivative transactions) would be able to benefit from Outbound Security. 3 Not necessarily a controlling stake. This represents a relaxation of the ownership requirements proposed at the consultation stage which required onshore entities to have a controlling stake in the bond issuer. New SAFE Regulation 5

6 Bearing in mind the distinction made in China between bonds (including structured notes) and OTC derivative transactions, a pertinent question would be whether structured note issuances will be required to comply with the restrictions applicable to both bond issuances and derivative transactions. As the New Regulation envisages that a cross border guarantee or security could secure obligations under a contract for the sale and purchase of goods, commodity repo transactions could also potentially benefit from Outbound Security. The New Regulation requires the secured obligation benefiting from Inbound Security to arise under a loan or a credit facility and therefore do not expressly apply to bonds and derivatives transactions. 5 Conclusion The New Regulation represents a significant step towards liberalisation of security and guarantees provided by PRC companies. One hopes that SAFE will eventually bring about full liberalisation for bonds and relax the restrictions on use of proceeds. New SAFE Regulation 6

7 Contacts For further information please contact: Nathalie Hobbs (+852) David Irvine (+852) Andrew Malcolm (+852) Chin-Chong Liew (+852) Victor Wan (+852) William Liu (+852) Author: Linklaters This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors. Linklaters. All Rights reserved 2014 Linklaters Hong Kong is a law firm affiliated with Linklaters LLP, a limited liability partnership registered in England and Wales with registered number OC It is a law firm authorised and regulated by the Solicitors Regulation Authority. The term partner in relation to Linklaters LLP is used to refer to a member of the LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP and of the non-members who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ, England or on Please refer to for important information on our regulatory position. We currently hold your contact details, which we use to send you newsletters such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this newsletter or other marketing communications, please let us know by ing us at marketing.database@linklaters.com. A Hwang Hwa Sim (+852) hwang_hwa.sim@linklaters.com Frank Cui Managing Associate (+852) frank.cui@linklaters.com 10th Floor, Alexandra House Chater Road Hong Kong Telephone (+852) Facsimile (+852) / Linklaters.com New SAFE Regulation 7