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China – Hot Topics In Debt Marketing: Potential New Boom Of Offshore Bonds.

26 June, 2014

 

Legal News & Analysis – Asia Pacific – China – Regulatory & Compliance 

 

How Onshore Enterprises’ Decision on Issuing Offshore Bonds Will Be Influenced When “Re-approval” Requirement Becomes “Post-registration” Requirement for Cross-border Security

 

On June 1, 2014, the Circular on the Administration of Foreign Exchange for Cross-border Security and its implementation guidance (the “Circular 29”) promulgated by State Administration of Foreign Exchange (“SAFE”) is formally brought into force. Since 2010, more and more onshore enterprises have been vigorously issuing offshore bonds, making it one of the major channels for onshore enterprises, especially real estate enterprises, large state-owned enterprises and financial institutions, to obtain financing at a relatively low cost. The relaxing control on cross-border security as endowed by Circular 29 is likely to further foster the enthusiasm of onshore enterprises in issuing offshore bonds.

 

Under Circular 29, in light of the place of business registration of security providers, cross-border security is categorized as (i) a security provided by an onshore security provider for a debt owed by an offshore debtor to an offshore creditor (“Outward Security for Offshore Lending”), (ii) a security provided by an offshore security provider for a debt owed by an onshore debtor to an onshore creditor (“Inward Security for Onshore Lending”) and (iii) other types of cross-border security. This review will mainly focus on the influence of Circular 29 on onshore enterprises in their issuing of offshore bonds. The Circular 29 changed the “pre-approval” requirement into the “post-registration” requirement for the Outward Security for Offshore Lending by non-bank financial institutions, and changed the mode of “beforehand quota control” into “afterwards voluntary filing” for banks in handling business of Outward Security for Offshore Lending. Such changes are highly favorable to onshore enterprises intending to issue offshore bonds by means of Outward Security for Offshore Lending. On the other hand, onshore institutions will possibly find themselves less enthusiastic in providing credit enhancement 1 by means of Outward Security for Offshore Lending in a large scale for their offshore subsidiaries in issuing offshore bonds, because of the blurry requirements in Circular 29 in terms of the shareholding relations between the security provider and the secured party (namely, the debtor or the issuer), the tight restrictions on use of fund raised by offshore bonds, and the inconsistent understanding among local counterparts of SAFE on the requirement of “post-registration”.

 

I. Main Provisions Of Circular 29 In Cross-Border Security For Offshore Bonds

 

(I) Registration Procedure

 

Prior to the implementation of Circular 29, all onshore institutions (including banks, non-bank financial institutions and enterprises) intending to provide security for offshore institutions issuing offshore bonds, were required to obtain SAFE’s approval through the local counterpart of SAFE on a case-by-case basis. Circular 29 removes such approval requirement and instead, stipulates that Outward Security for Offshore Lending are to be managed by means of registration in the following specific procedures:

 

1. Registration For Contract Conclusion

 

Where the security provider is a bank, the security provider shall report to the SAFE the data relevant to the business of Outward Security for Offshore Lending through data interchange program or by other means.

 

Where the security provider is a non-bank financial institution or an enterprise (the Non-bank Institution”), the security provider is required to proceed with the registration formalities for Outward Security for Offshore Lending at the local counterpart of SAFE at the place of its location within 15 business days upon the conclusion of the security contract. Please refer to Exhibit I for the details of registration formalities.

 

2. Change Of Registration

 

Where there are changes to the major clauses of the security contract (including extension of the term of the loan contract, or any changes in the amount secured, the term of loan, the period of security, and the creditor), the procedures for change of registration of the contract for Outward Security for Offshore Lending shall be handled within 15 days.

 

3. Cancellation Of Registration

 

Upon the settlement of liabilities under security by the debtors, the expiration of payment liabilities of the security provider, or occurrence of contract performance for security, security providers as Non-bank Institutions shall handle the registration cancellation procedures for Outward Security for Offshore Lending at the SAFE within 15 business days.

 

4. No Need To Register For Realization Of Security

 

When a bank performs its security obligations for Outward Security for Offshore Lending, the bank may make outward payment for the realization of the security on its own.

 

When a Non-bank Institution performs its security obligations for Outward Security for Offshore Lending, the Non-bank Institution shall directly proceed with the foreign currency purchase and outward payment at a bank by showing its security registration documents with the stamp of SAFT affixed thereon. In case the security is to be performed where no registration on contract conclusion has been proceeded with, the security provider is required to complete the registration.

 

Counter security provider may directly purchase foreign currency and make outward payment at a bank by showing documents evidencing the realization of counter security.

 

5. Registration Of Offshore Debts

 

After realization of security, onshore security providers or counter-security providers becoming creditors to offshore debts shall handle registration formalities for offshore debts. 

 

When the creditor to an offshore debt is a bank, the relevant information regarding the offshore debt is to be reported to the capital project information system.

 

When the creditor to an offshore debt is a Non-bank Institution, the creditor is required to handle the offshore debt registration at the local counterpart of SAFE at the place of its location within 15 business days, and proceed with the change and cancellation formalities as required for the offshore debt.

 

6. Circumstances No Need Registration

 

(1) For Outward Security for Offshore Lending in which security providers are unable to reasonably assess the upper limit of the scope of security obligation, for example, security for project completion obligation issued by onshore enterprises with unspecified amount of security liability, no registration is required, provided that the realization of security shall be approved in advance by the SAFE.

 

(2) For other forms of cross-border security provided by onshore institutions, the security providers may enter into cross-border security contracts by itself with no need to go through registration or filing procedure, and no need to report data to the capital project information system, unless otherwise specifically provided by the SAFE; provided, however, when creditor’s right for offshore debt is formed after the realization of the security, registration for offshore debts shall be handled.

 

(II) Qualifications For Security Providers And Secured Parties (Debtors)

 

1. Circular 29 removed the various criteria for security providers and secured parties, such as:

 

(1) Generally, the quota of offshore security for a single bank and non-bank financial institution shall not exceed 50% of its paid-in capital or working capital in both RMB and foreign currency, or exceed its foreign exchange net asset value;

 

(2) If the security provider is an enterprise, as a general requirement, the proportion of its net assets to its total assets shall not be lower than 15%, and the balance quota of the enterprise or the balance of its external guarantee approved on a case-by-case basis shall not exceed 50% of its net assets;

 

(3) The net asset value of the debtor shall be positive; and the debtor shall make profits in at least one of the past three years (or in at least one of the past five years for enterprises engaging in resources development), etc.

 

2. Circular 29 provides that banks and non-bank financial institutions that serve as security providers shall have the corresponding security business qualification in accordance with the provisions of the competent industrial department; security providers acting as branches of onshore institutions shall obtain authority from the headquarter. Circular 29 is silent about the qualification requirement for enterprises as security providers; but Circular 29 stipulates that any onshore institutions may only provide security for an offshore bond issued by an offshore issuer whose shares are directly or indirectly held by such onshore institutions.

 

3. Circular 29 further provides that, for security providers that are non-financial institutions, where the security is to be realized, and prior to the repayment of debts of offshore debtors to security providers, security providers shall suspend the conclusion of new contracts for Outward Security for Offshore Lending without the approval of the SAFE, unless the debtor is unable to pay off the debt due to bankruptcy, liquidation or similar reasons.

 

4. Security providers and debtors shall not sign a cross-border security contract when they clearlyknow or should have known the contract realization for security definitely occurs. Please see Exhibit II for specific standards.

 

(III) Usages Of Fund Raised

 

Circular 29 reiterates the principles of using the fund raised by offshore bond as previously provided in its predecessor regulation, which are to prevent the fund raised offshore from “flowing back” to the onshore market, to stipulate that the fund raised by offshore bond will be used in offshore investment projects with shareholding relations with the onshore institution, and to make sure that for the relevant offshore institution or project approval, registration, filing or confirmation has been obtained from the offshore investment authority in China according to relevant requirement. Please see Exhibit III for the specific requirements.

 

II. Major Issues Unsettled In Circular 29 Regarding Cross-border Security For Offshore Bonds

 

1. Are Onshore Real Property Enterprises Allowed To Provide Cross-Border Security For The Offshore Bond To Be Issued By Its Offshore Subsidiaries?

 

In the Notice on Relevant Issues Regarding Remaining Quota of External Security for Financing Purposes for Approved Domestic Banks in 2011 (Hui Fa [2011] No. 30), which is now annulled by Circular 29, it was expressly provided that “any application made by onshore real property enterprises for providing offshore security for their offshore subsidiaries in issuing offshore bonds will be rejected for the time being”.

 

Circular 29 only provides that banks and non-bank financial institutions shall have relevant qualification for operating security business, but the security qualification for enterprises are not required. However, such possibility could not be ruled out that SAFE will promulgate implementation rules for qualification requirement for real property enterprises or enterprises in other industries in cross-border security business.

 

2. Does The Cross-Border Security Referred To In Circular 29 Only Cover Security Denominated In Foreign Currency? Does It Apply To RMB Security?

 

According to the Notice on Share of Administrative Responsibilities on Cross-border RMB Business (Yin Fa [2012] No. 103) issued by the People’s Bank of China and SAFE, the cross-border RMB business will be administered by the Second Monetary Policy Bureau of the People’s Bank of China, and such bureau further once indicated in a letter responding to a bank, that no pre-approval or registration is required for banks to handle the business of RMB offshore security for financing purposes, and the banks are required to submit the security letter and performance status to the the Cross-border RMB Receipts and Payments Information Management System.

 

Circular 29 has not differentiated the cross-border foreign currency security and cross-border RMB security, instead, it provides that when the security provider is a bank, the security provider only needs to submit relevant data to SAFT through data interchange program. In case an enterprise intends to provide offshore security in RMB, it is highly likely to be required to proceed with relevant registration formalities according to the requirement in Circular 29.

 

3. Can Onshore Security Provider Be Enforced To Perform The Cross-Border Security When No Registration Procedure Is Gone Through?

 

It is expressly provided by Circular 29 that “the registration or filing of cross-border security contracts by foreign exchange authorities shall not constitute the essential element of effectiveness of cross-border security contracts.”

 

Circular 29 further stipulates that in case the security is to be performed by non-bank financial institution where no registration on contract conclusion has been proceeded with, the security provider is required to complete the registration. Prior to the registration, the matter shall be firstly referred to the foreign exchange checking authority.

 

In addition, Circular 29 provides that in case any security provider fails to register the Outward Security for Offshore Lending according to the relevant requirements, SAFE has the authority to impose punishment according to the Regulations of the People’s Republic of China on Foreign Exchange Administration (the “Regulations”). Please see Exhibit IV for specifics on punishment.

 

According to the above provisions, though the contract conclusion registration is not an essential element of effectiveness of cross-border security contracts, but it should be a condition precedent to the realization of the security thereunder. In case contract conclusion registration is not completed or requirements in connection with the registration are not satisfied, security providers will not be able to perform the security, and will potentially be imposed fines. Therefore, the parties to a cross-border security will possibly have to communicate with SAFE regarding the possibility of registration before concluding the security contract, which will largely decrease the efficiency of the implementation of Circular 29.

 

4. How Could Security Providers Conduct Due diligence Investigation On The Offshore Debtors And Supervise Them In Their Use Of Raised Fund?

 

Under Circular 29, “where security providers engage in the financing business of Outward Security for Offshore Lending, they shall verify the principal qualifications of debtors, purposes of funds under security and the relevant trading background, conduct due diligence investigation of whether onshore and offshore laws and regulations are complied, and supervise the use of funds under security by debtors pursuant to their declared uses by appropriate means.” If security providers fail to do so, SAFE may impose penalties.

 

Circular 29 is silent about the method and procedure for the due diligence investigation, and registration requirement does not require due diligence report as part of the application package either. But the above provision may become the sword of Damocles placing potential risks on security providers.

 

5. Does The “Shareholding Relations” Between The Onshore Institution And The Offshore Debtor Mean Controlling Relationship?

 

Circular 29 stipulates that “when the security provider performs repayment obligation under the bond issued by the offshore debtor, the equity of offshore debtor should be directly or indirectly held by the onshore institution.”

 

Circular 29 does not expressly provide that whether the “shareholding” is actually “share controlling”. According to relevant previous practices, we believe the “shareholding relations” may not refer to “controlling relationship”.

 

Circular 29 is also blurry about whether an onshore guarantor (an onshore bank) is allowed to provide security for the offshore bond issued by an offshore issuers with whom it has shareholding relations with an onshore institution while has no shareholding relations with the onshore guarantor. From the literal meaning of the provision, the answer should be no. It is more or less irrational, for example, as a commercial bank, providing credit enhancement for customers is one of its inherent business.

 

6. How To Deal With The Inconsistency Between Circular 29 And The Regulations On Cross-Border Security That Are Still In Force?

 

Circular 29 annuls a series of regulations on cross-border security promulgated by SAFE. However, due to the limitation of its authority, SAFE has no power to annul regulations published by other government agencies or judicial authorities, such as the Administrative Measures on Offshore Security by Onshore Institutions published by the People’s Bank of China, and the Interpretation on Several Matters in Application of the Security Law of the People’s Republic of China issued by the Supreme People’s Court. Such regulations still provide that, without approval and registration, contracts for cross-border security are invalid.

 

The simplification of approval procedure by Circular 29 is a measure responsive to the call of the State Council of to “streamline administration and delegate power to the lower levels”, and the above inconsistencies are only of a matter needing reconciliation between the government agencies, and the effectiveness of Circular 29 is unlikely to be affected.

 

Exhibits:

 

Exhibit I: Formalities For Contract Conclusion Registration

 

1. Non-bank Institutions should provide the following materials to the local counterpart of SAFE for proceeding with contract conclusion registration for Outward Security for Offshore Lending:

 

(1) Written application report regarding the contract conclusion registration for Outward Security for Offshore Lending (containing the basic information of the company, sum of cross-border security already handled but not settled yet, the major specifics about this security business, the source of fund expected to be used as repayment fund, and other matters to be clarified. In case there is a co-provider for security, it should be indicated in the application report);

 

(2) Security contract and contract of the main debt under the security (in case the contracts are too long, summary of contracts with official stamps affixed would be sufficient. In case the contracts are written in foreign languages, Chinese translation thereto with official stamps affixed should be furnished);

 

(3) Relevant evidentiary materials deemed by SAFE as necessary to supplement (such the approval documents issued by National Development and Reform Commission and Ministry of Commerce regarding the offshore investment project).

 

2. SAFE will conduct procedural review from the aspects of truthfulness and compliance on the application for registration submitted by Non-bank Institutions as security providers, and will proceed with the registration formalities. In case any security providers fail to handle the registration formalities within the designated period, they may apply for post-registration.

 

3. Non-financial institutions may apply with SAFE to report data through the capital project system referring to the procedure applicable to financial institutions.

 

4. In case there are multiple onshore security providers for a single project of offshore loan under onshore security, the security providers may appoint one of them to proceed with the registration formalities at the local SAFE.

 

Exhibit II: Standard In Determination Of Intention Of Security Realization

 

Security providers and debtors shall not sign a cross-border security contract when they clearly know or should have known the contract performance for security definitely occurs. The following standard shall apply to determine whether a definite intention to perform a security exists under a security contract:

 

1. When entering into the security contract, whether the debtor has sufficient capability to repay and expected resources of fund to be used as fund for repayment;

 

2. Whether the financing conditions under the underlying loan contract are largely inconsistent with the purpose of fund indicated by the debtor, in terms of the amount, interest rate, term and other aspects of the loan;

 

3. Whether the parties to the security indicate any intention to repay the debt under the security in advance by means of realization of security; and

 

4. Whether the parties to the security have ever maliciously performed the security or committed any loan-related breach, as security provider, counter-security provider or debtor.

 

Exhibit III: Restrictions On Use Of Funds Raised By Outward Security For Offshore Lending

 

The use of funds of Outward Security for Offshore Lending shall comply with the following provisions:

 

1. The funds under security shall be used for the payment of debtors within the usual scope of operation, and shall not be used for businesses outside the scope of business engaged by debtors or for arbitrage or other speculative transactions against fictitious trading background;

 

2. Without approval by SAFE, debtors shall not directly or indirectly transfer funds under security for domestic use by means of offering loans or making investment in equity or securities within the territory.

 

3. The funds under the security may not be used by the offshore institutions to make equity investment or debt investment, directly or indirectly into onshore institutions or individuals, and conducts including without limitation the following are prohibited:

 

(1) the debtor uses the funds under the security to make equity investment or debt investment, directly or indirectly, into the institutions registered within the PRC.

 

(2) the funds under the security are used directly or indirectly to acquire the equity in an offshore target company, more than 50% assets of which is within the PRC.

 

(3) the funds the security are used to repay the debt of the debtor or debts of other offshore companies, and the funds originally raised have been transferred for domestic use by means of investment in equity or debt within the territory.

 

(4) the debtor is using the funds under the security to repay the price for goods or services to the onshore institutions, and (a) the repayment is made at a time 1 year ahead of the time of supply of the goods or provision of services, and (b) the amount of repayment exceeds both USD 1 million and 30% of the aggregate contract price (in case of exportation of complete sets of heavy equipments or contracted services, the completion of work load will be deemed as delivery of goods).

 

4. Where the security obligation for the Outward Security for Offshore Lending is the obligation to repay for the bonds issued by offshore debtors, the gains of offshore bond issuance shall be used in offshore investment projects/institutions with shareholding relations with the onshore institution, and the relevant offshore institutions/projects should have been approved, registered, filed or confirmed by the foreign investment authority of the PRC.

 

5. When the funds raised under the contract for Outward Security for Offshore Lending are used to acquire, directly or indirectly, the equity or debt of other offshore institutions (including investment in newly-established offshore enterprises, acquisition of the equity interest in offshore enterprises, or increase of capital contribution of offshore enterprises), such investment activities shall be deemed as inconsistent with the relevant regulations on outbound investment set by relevant PRC authorities.

 

6. When the obligation under the contract for Outward Security for Offshore Lending is the obligation to pay for the derivative transaction of offshore institutions, when dealing derivative transactions debtors shall abide by the principle of stop-loss and inflation-proof, act within the scope of its main business, and has been duly authorized by shareholders.

 

Exhibit IV: Punishment On Violations In Connection With Outward Security For Offshore Lending

 

Violations Punishment
Violating item (ii) of Article 11, Circular 29, Debtors directly or indirectly transfer funds under security for domestic use by means of offering loans and making investments in equity or securities within the territory.  According to Article 41 of Regulationswhere any foreign exchange is remitted into the territory of the People’s Republic of China in violation of any legal provision, the foreign exchange administrative organ shall order its correction, and impose a fine of not more than 30% of the amount of violation; or if the circumstances are serious, impose a fine of not more than the amount but not less than 30% of the amount of violation. Where any illegal settlement of foreign exchange is committed, the foreign exchange administrative organ shall order conversion of the illegal settlement funds back into the original currency, and impose a fine of not more than 30% of the amount of violation
Violating Article 8, Circular 29, security providers engage in the business of Outward Security for Offshore Lending in violation of state laws and regulations, the provisions of the competent industrial department and administrative provisions on foreign exchange.  According to Article 43 of Regulationswhere any violation of foreign debt administration is committed, such as unapproved international borrowing, offshore bond issuance or provision of international guaranty, the foreign exchange administrative organ shall impose a warning and a fine of not more than 30% of the amount of violation.
Violating Article 10, Circular 29, security providers engage in the business of Outward Security for Offshore Lending exceeding the authorized scope of business approved by the competent industrial department. 
Violating Article 12, Circular 29, security providers fail to verify the principal qualifications of debtors, purposes of funds under security and the relevant trading background, fail to conduct due diligence investigation of whether onshore and offshore laws and regulations are complied, or fail to supervise the use of funds under security by debtors pursuant to their declared uses by appropriate means. 
Violating Article 14, Circular 29, security providers conclude new contracts for Outward Security for Offshore Lending without the approval of the SAFE prior to the collection of repayment funds from debtors. 
Violating Article 27, Circular 29, security providers and debtors sign a cross-border security contract when they clearly know or should have known the contract performance for security definitely occurs 
Violating Article 28, Circular 29, onshore banks fail to conduct due diligence investigation as to the background of cross-border security transactions to ensure such security contract is in compliance with Chinese laws and regulations and the provisions of Circular 29.  According to Article 47 of Regulations, a foreign exchange administrative organ shall order the financial institution to make correction within a prescribed time limit, confiscate the illegal proceeds, and impose a fine of not less than 200k yuan but not more than 1m yuan; or if the circumstances are serious or no correction is made within the prescribed time limit, it may order the financial institution to suspend the relevant business. 
Violating Article 9, Circular 29, security providers fail to handle the registration formalities for Outward Security for Offshore Lending in accordance with relevant provisions According to Article 48 of Regulations, a foreign exchange administrative organ shall order correction and impose a warning, and may impose a fine of not more than 300k yuan in the case of an institution or 50k yuan in the case of an individual. 
Violating Article 13, Circular 29, security providers fail to handle the registration cancellation formalities for Outward Security for Offshore Lending in accordance with relevant provisions. 
Violating Article 15, Circular 29, security providers or counter-security providers fail to handle the formalities for registration of offshore creditors’ rights in accordance with relevant provisions. 

 

End Notes:

 

1 Subject to the previous control/approval requirement on the offshore security by domestic institutions, the practical ways of credit enhancement available for domestic institutions include: keepwell deed, undertaking of equity interest purchase, and letter of support, etc.

 

Jun He 4

 

For further information, please contact:

 

Yu Yongqiang, Partner, Jun He

[email protected] 

 

Zhang Qi, Jun He

[email protected] 

 

Ma Rui, Jun He

[email protected] 

 

Lei Tianxiao, Jun He

[email protected]


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