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China – Cold Comfort: PRC Supreme Court Reaffirms Distinction Between Comfort Letters And Enforceable Guarantees.

15 April, 2015

 

Legal News & Analysis – Asia Pacific – China – Banking & Finance

 

A recent ruling published by the People’s Republic of China (PRC) Supreme People’s Court (SPC)1 has reaffirmed the SPC’s longstanding position that letters of undertaking (LOU) must include an express assumption of guarantee obligations in order to constitute an enforceable guarantee under PRC law. This requirement may seem selfevident, but it can be easily overlooked during the intensity of transaction negotiations and routine internal approval processes of financial institutions.

 

The SPC Rulings

 

As early as 2005, the SPC had already ruled that a LOU issued by a local government in Guangdong province was not an enforceable guarantee (2005 LOU). The operative provision of the 2005 LOU was as follows:

 

“If the [borrower] delays or defaults on its payment of principal and interest due under the facility, we [the Guangdong provincial government] will be responsible for resolving the default such that [the bank] does not suffer any economic loss.”

 

Similarly, in the recent ruling in February 2015, the SPC found that there was no enforceable guarantee provided by the Liaoning provincial government in accordance with the terms of the LOU that was issued to a Hong Kong bank (HK Bank) that was providing a letter of credit facility to an affiliated entity of the Liaoning provincial government (2015 LOU). The operative provisions of the 2015 LOU were as follows:

 

“We [Liaoning provincial government] are aware that you [the HK Bank] have agreed to provide, or continue providing, a banking facility/loans (Facility) to [the Borrower]: a general letter of credit facility in an aggregate amount of HKD 50m, including advances against trust receipts thereunder in an aggregate amount of HKD 50m. We hereby undertake as follows:

 

(a) we agree to the above financing arrangements being provided, or to continue to be provided, by you to the Borrower;

 

(b) we will use our best endeavours to maintain the existence and normal operations of the Borrower;

 

(c) we will use our best efforts to ensure that the Borrower performs its responsibilities and obligations in respect of the Facility utilised by it; and

 

(d) if the Borrower becomes unable to pay any of its obligations under the Facility as required by you, we will provide assistance in dealing with the debts owed by the Borrower to you such that you do not suffer any economic loss.”

 

In reaching its findings in respect of the 2015 LOU, the SPC ruled that it was not an enforceable guarantee due to the following considerations:

 

(a) in accordance with the terms of the LOU, the Liaoning provincial government only undertook to “provide assistance in dealing with” the defaulted debts, without expressing any intent to discharge those debts on behalf of the Borrower; and

 

(b) in its written correspondence with the Liaoning provincial government, the HK Bank did not request the Liaoning provincial government to discharge the defaulted debts on behalf of the Borrower. Instead,the HK Bank merely required the Liaoning provincial government to perform its undertaking in the LOU, such that the HK Bank “does not suffer any economic loss”. This implied that both parties’ intention was for the Liaoning provincial government to provide an undertaking in the form of a comfort letter, rather than an enforceable guarantee of the underlying obligations.

 

Implications Of The SPC Rulings For Lenders

 

Banks that rely on LOUs from PRC entities as credit support for facilities should take note of the importance placed by the SPC on a strict interpretation of the relevant contractual terms.

 

Review of existing credit support arrangements involving LOUs (or similar documents) given by PRC entities should be undertaken, in particular in light of the response of the Hong Kong Monetary Authority (HKMA) to the SPC rulings.2 Such review should take into account the following:

 

(a) Lenders should note that the PRC Government (whether national, provincial or local) is – subject to narrow exceptions – generally prohibited from providing guarantees.3 Guarantees provided by the PRC Government in violation of this prohibition are void.4

 

(b) All LOUs obtained as credit support should include clear and express provisions that operate as a guarantee of the primary obligor’s underlying obligations. Imprecise references to “providing assistance in dealing with defaulted debts” or ensuring that the creditor “does not suffer any economic loss” should be avoided.

 

(c) LOUs should specify:

 

i. the circumstances under which the guarantee obligation will be triggered;

 

ii. the consequences flowing from the guarantee obligation being triggered (including the ability of the lenders to demand payment under the LOU); and

 

iii. details for quantifying payments under the LOU. Where losses under the underlying transaction are difficult to quantify, lenders may consider including liquidated damages provisions in the LOU.

 

(d) For the purposes of both credit risk assessment and Basel III capital risk weight requirements, it is advisable to seek an independent, written and reasoned legal opinion as to whether a LOU issued by a PRC entity (whether State-owned, governmental or privately owned) is enforceable as a guarantee under its governing law, bearing in mind that “clean” opinions in respect of LOUs issued by the PRC Government may not be forthcoming.

 

(e) An enforceable LOU provided by a PRC entity in favour of a non-PRC lender that is guaranteeing a nonPRC borrower’s debt constitutes “outbound security” under the current PRC cross-border security regime that must be registered with the State Administration of Foreign Exchange within 15 business days after the LOU is issued.5

 

(f) When managing a default situation, all written correspondence sent by lenders to the defaulting party and LOU issuer must make clear that the lender regards the LOU as constituting enforceable guarantee obligations under which the LOU issuer is required to make payment.

 

(g) Care will need to be taken in making demands under the LOU to ensure that the demand complies strictly, both in form and in substance, with the terms of the LOU under which it is being made. The terms of the LOU relating to demands should therefore be made as clear and straightforward as possible.

 

End Notes:

 

1 Full text of the ruling is available at http://www.court.gov.cn/zgcpwsw/zgrmfy/ms/201502/t20150204_65 46636.htm.

 

2 While no announcement has been made publically by the HKMA, we understand that authorised institutions have been contacted following the latest SPC ruling and the HKMA: (i) has made clear that credit and risk management functions (including, where appropriate, boards of directors) must be aware of the ruling and its implications; (ii) has directed authorised institutions to review the extent to which letters of undertaking have been a factor in credit decisions to date; and (iii) where they have been a factor, is requiring authorised institutions to take immediate action to mitigate the implications for existing credit facilities. The HKMA also intends, we understand, to review authorised institutions’ responses to the ruling as part of its programme of supervision.

 

3 Article 8 of PRC Security Law issued by the National People’s Congress Standing Committee on 30 June 1995 and became effective on 1 October 1995.

 

4 Article 3 of Supreme People’s Court Interpretations on Application of PRC Security Law issued by the Supreme People’s Court on 8 December 2000 and became effective on 13 December 2000.

 

5 The Foreign Exchange Administrative Provisions on Cross-border Security (跨境担保外汇管理规定) issued by SAFE on 19 May 2014 and became effective on 1 June 2014.

 

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For further information, please contact:

 

Patrick Phua, Partner, Ashurst

patrick.phua@ashurst.com

 

Ben Hammond, Partner, Ashurst

ben.hammond@ashurst.com

 

Doo-Soon Choi, Partner, Ashurst

doo-soon.choi@ashurst.com

 

Angus Ross, Partner, Ashurst

angus.ross@ashurst.com

 

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