On June 1 2014, the long-awaited Foreign Exchange Administrative Provisions on Cross-Border Security and its implementation guidelines (collectively the New SAFE Regulations), released by the State Administration of Foreign Exchange of the People’s Republic of China (SAFE), took effect.
The New SAFE Regulations bring substantial changes to the previously existing cross-border security regime (also known to some as the foreign security regime) and supersede a series of regulations previously issued by SAFE. These changes are likely to impact how cross-border financings involving the PRC are structured.
A number of the previous restrictions on PRC onshore entities providing guarantees and security over their assets to support debt incurred outside of the PRC by offshore debtors (内保外贷 – neibaowaidai), and on entities outside of the PRC providing guarantees and security over their assets to support debt incurred within the PRC by onshore debtors (外保内贷 – waibaoneidai), have been removed.
However, certain conditions imposed by the New SAFE Regulations, in particular those on the use of funds benefitting from neibaowaidai, are likely to limit the impact the New SAFE Regulations may have in opening up ways in which PRC offshore financings may be structured.
This article focuses on the impact the New SAFE Regulations may have on the use of onshore security to support debt provided from offshore. The debt from the offshore creditor and which benefits from onshore security may be one that is provided to an offshore debtor (which would fall within the neibaowaidai regime – Diagram 1), or may be one that is provided to an onshore debtor (Diagram 2).
For a fuller discussion on the subject, click here to be redirected to our client bulletin published on 22 May 2014.
For the purpose of this article, security includes both proprietary security and guarantee, and security provider shall be construed accordingly. Onshore means mainland China; offshore means outside mainland China.
What are the changes?
- Neibaowaidai (onshore credit support for offshore debt) –
Before the New SAFE Regulations came into effect, PRC onshore entities providing onshore security to support debt incurred outside of the PRC by offshore debtors (neibaowaidai) required SAFE pre-approval, were subject to quota limitation and financial tests on the debtor, or were allowed only if the security provider was a parent of the offshore debtor, depending on circumstances and in addition to other conditions.
The most commonly seen cross-border credit enhancement tools for offshore debt were limited to standby letters of credit (SBLC) issued by an onshore bank in favour of offshore banks providing offshore credit to offshore borrowers (which are subject to a quota imposed on the SBLC issuer bank) or downstream guarantees provided by PRC parents (often state-owned enterprises) in favour of offshore creditors supporting offshore debt incurred by their offshore subsidiaries (which are subject to SAFE pre-approval or quota).
There were no implementation rules on the registration of security given by PRC individuals to support offshore debt, and security granted by onshore individuals was expressly allowed only under very narrow circumstances. Without registration, the value of any such onshore individual security would be limited (see below), although creditors have taken individual guarantees with a view to potentially enforce against any offshore assets of the individual guarantor and for it to be used as leverage on enforcement.
After the New SAFE Regulations came into effect, the requirements for pre-approval, quota and other conditions on the debtor and shareholding have been removed. Onshore financial institutions qualified to engage in security provision business and onshore corporates are all free to provide neibaowaidai. Onshore individuals are also now expressly allowed to provide neibaowaidai.
Registration is required within 15 business days of signing. Post-enforcement, the onshore security provider must undertake an overseas credit registration in respect of its subrogation claim against the offshore debtor. Enforcement of any properly registered neibaowaidai would, subject to very limited exceptions, no longer require prior SAFE verification.
- Failure to register with Safe
According to a Supreme Court’s Interpretation to Security Law, failure to register with SAFE onshore security supporting an offshore debt would not only prohibit the beneficiary’s ability to remit offshore proceeds from the security offshore. The guarantee or security itself would also be invalid. The New SAFE Regulations, now specifically provides that failure to register with SAFE no longer invalidates the onshore security, although remittance of proceeds from enforcement would continue to be blocked if the onshore security is not registered with SAFE.
- Derivatives – The New SAFE Regulations provide that neibaowaidai can secure a derivative transaction if the transaction is entered into by the debtor for hedging purposes, in line with its scope of business and is authorised by its shareholders.
Under the old SAFE regime, security interest arrangement was not a common option under an ISDA Master Agreement between offshore entities and onshore counterparties, due to difficulties in registering this with SAFE. The SAFE registration required that a secured amount be specified; the mark-to-market nature of the onshore counterparties’ exposure meant that a secured amount could not be specified. The New SAFE Regulations provide that cross-border security arrangements that are not neibaowaidai or waibaoneidai are not subject to SAFE registration. Security interest arrangements created under a CSA entered into between an onshore entity and an offshore counterparty (the structure under Diagram 2) would be categorised as such.
A new dawn?
Will these changes revolutionise the way in which offshore financings of PRC underlying credits can and will be structured? The potential impact of these changes needs to be considered in light of certain remaining conditions under the cross-border security regime, described below.
- Due diligence – The New SAFE Regulations require that an onshore security provider providing neibaowaidai must (a) check, among other things, the debtor's credit, funding purpose (as to which see below) and repayment sources, and whether the transaction is in compliance with applicable laws and regulations, and (b) monitors the offshore debtor's use of proceeds from the relevant financing. These requirements create a burden on the onshore security provider. An onshore company is likely to be reluctant to provide security to support the indebtedness of an unrelated offshore third party. Even for an onshore subsidiary providing security to support the offshore indebtedness of its parent (and especially to a parent that does not wholly own the onshore subsidiary), query one should question whether the checks and monitoring are feasible, and – if the onshore security provider attracts liabilities in the event the loan is found to be in breach of the New SAFE Regulations (as to which see below also) – this may complicate the onshore security provider’s consideration of the corporate benefit of providing this security.
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Bonds – Neibaowaidai can secure offshore bond issues. In addition to all of the requirements discussed above, neibaowaidai for bonds is subject to the requirements that:
- the issuer must be directly or indirectly owned by an onshore entity;
- the proceeds of the bond issue must be used for an offshore project in which an onshore entity has an equity interest; and
- the issuer and the offshore project must have been duly approved by, registered and filed with, the relevant authorities in charge of outbound investment.
The removal of quota or approval requirement for neibaowaidai is certainly a welcome change in the context of an offshore bond issuance, as a direct guarantee by the onshore parent of the offshore issuer would be a much cleaner solution than the current market practice of obtaining keep-well letters from the onshore parent. However, it remains to be seen whether the restriction on the usage of funding to a particular project (rather than for general corporate purposes, as is more commonly seen in current offshore bond issues) would reduce issuers’ appetite to adopt this structure. Another question is also whether or not loan-style privately placed structured notes, issued offshore, would be caught by these additional conditions imposed on bonds.
- Repatriation – Market participants who have worked with the SBLC structure referred to above would be familiar with the prohibition, under the old regime, against proceeds of loans supported by permitted neibaowaidai being repatriated back into the PRC. While the forms of neibaowaidai and how they are done have been relaxed, it remains the case that proceeds of offshore credit raised with the benefit of neibaowaidai may not be repatriated, whether directly or indirectly, from offshore to onshore, whether by way of equity investment or lending. This includes direct or indirect equity investment in an offshore company where 50% or more of its assets are located in the PRC. It also includes refinancing of the offshore debtor's or any other offshore entity's existing debt, of which the proceeds have been repatriated, directly or indirectly, by way of equity investment or lending, from offshore to onshore.
The extent to which a transaction is deemed to be repatriation for these purposes has been the focus of much of the discussions amongst providers of offshore loans since the New SAFE Regulations were released in May 2014. The new regime benefits those credits, the proceeds of which are applied towards acquisitions of pure offshore assets, where lenders can now be protected by upstream security provided from onshore subsidiaries. The new regime does not benefit those credits the proceeds of which are applied towards capital injection back into the PRC. As to the extent to which past repatriation could be linked to a current financing benefitting from onshore credit support and therefore offend the repatriation restriction (eg to what extent neibaowaidai could support credits that refinance previous rounds of debt raising, or equity investments, into PRC assets or to fund dividends from those investments), this remains a grey area for which the New SAFE Regulations do not provide guidance, and on which views will continue to be formed.
SAFE will impose a monetary penalty (up to the amount of the offshore financing proceeds which are considered by SAFE to have been repatriated from offshore to onshore) on the onshore security provider if the repatriation restriction was breached. It is reasonable to expect also that remittance of proceeds from enforcement of onshore security, used for offshore debt in breach of the no repatriation rule, may be blocked. Financial institutions are likely to take a conservative approach until there is further clarity on the extent of prohibition on repatriation.
The road ahead
Financing structures will evolve to accommodate or take advantage of the New SAFE Regulations. While the New SAFE Regulations are focused on waibaoneidai and neibaowaidai, as mentioned in the context of derivatives above, the new regulations do not lay out prescriptions on any other forms of cross-border security. It can be reasonably concluded that, from SAFE’s perspective, all onshore entities are free to provide or accept other types of cross-border security, such as the structure shown in Diagram 2 above. Onshore borrowers borrowing from offshore lenders but granting security over its own assets to support the debt, and being supported by security granted by a third party onshore entity, would fall within this category. While cross-border lending with onshore borrowers has inherent limitations – for example, foreign debt headroom would continue to apply, and parties will need to consider withholding tax – this structure may attract more interest as a result of the New SAFE Regulations.
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