After a three-month public consultation, the State Administration of Foreign Exchange ("SAFE") released the Foreign Exchange Administrative Rules on Crossborder Security and its operation guidelines (the "New Rules") on 12 May 2014, which will become effective on 1 June 2014. Whilst the New Rules will bring about certain long-awaited changes to taking cross-border security, lenders and borrowers expecting groundbreaking deregulation could be disappointed by the restrictions on financing acquisitions of onshore companies and assets.
The New Rules regulate cross-border security in three categories: outbound security, inbound security, and other types of cross-border security. This note provides a summary of the key rules and an analysis of the implications such rules may have on cross-border financings.
Outbound security is defined as security (in the form of a guarantee, pledge or mortgage) provided by an onshore security provider in favour of an offshore creditor to secure a debt incurred by an offshore debtor.
Under the New Rules:
- Qualification requirement: Financial institutions shall meet the specific qualification requirements imposed by the relevant regulators for carrying on the business of providing outbound security. Other onshore security providers and the offshore debtor are not subject to any qualification requirement. The qualification requirements for granting outbound security under the existing cross-border rules, for example minimum shareholding, meeting certain financial conditions and quotas will be removed. In addition, subject to certain conditions, outbound security can be upstream, downstream or crossstream. Individuals may also provide outbound security.
- Registration: SAFE approval will not be required for granting outbound security, but registration with SAFE is still necessary. A streamlined registration procedure allows banks to register their outbound security through an online platform with SAFE. Nonbank security providers must register any outbound security with local SAFE within 15 business days after the date of the security agreement. Failure to register with SAFE will not invalidate the outbound security although this may delay enforcement.
- Enforcement: The proceeds of enforcement of outbound security may be remitted to the offshore creditor through an onshore bank which will require the production of the SAFE registration certificate. If the outbound security has not been registered with SAFE, late registration is permitted although SAFE may impose penalties on the security provider. Following enforcement, the onshore security provider should register with SAFE its claims against the offshore debtor.
The above changes are good news, in particular the ability for individuals to provide outbound security, the permission of upstream security and the abolition of SAFE approval. However, in practice the impact of these reforms on cross-border financings are likely to be limited by a number of new rules. The key provisions are as follows:
- Purpose restriction: The proceeds of any offshore financing supported by outbound security may be used only for the ordinary business purposes of the offshore debtor, and should not be used for false trading transactions, speculative transactions or any transaction outside the ordinary business of the offshore debtor. The term "ordinary business" is not defined in the New Rules.
- Flow-back restriction: The proceeds from any offshore financing supported by outbound security should not be used for:
- any direct or indirect equity investment in or intercompany loan to a PRC entity;
- the acquisition of any offshore target whose assets located in the PRC account for more than 50% of its total assets;
- the payment of a deposit for the trading of goods or services, where such payment is made more than one year in advance of supply and is in an amount exceeding USD 1 million and 30% of the total consideration; or
- the refinancing of an existing loan which has been used for any of the above purposes.
In practice these restrictions mean that no financing for a buyout or acquisition may be supported by any outbound security over onshore assets or by way of a guarantee where the target business or assets are principally in the PRC. The New Rules largely maintain the status quo in relation to acquisition financing, in that the door remains firmly closed to offshore financers who are looking into security over onshore assets and individual guarantees as a potential credit enhancement for the financing.
- Anticipated enforcement: No outbound security may be given where any relevant party actually knows or ought to know that enforcement of the security is anticipated. The purpose of this rule is to prevent outbound security from being used as a disguised loan or payment to move cash offshore. Unfortunately, in practice it could also create obstacles for an offshore creditor in taking additional security from onshore security providers in a situation where the offshore debtor's financial condition has deteriorated or as part of a financial restructuring.
Inbound security is defined as a guarantee or security provided by an offshore security provider in favour of an onshore creditor to guarantee or secure a debt incurred by an onshore debtor.
- Qualification requirement: Neither the offshore security provider nor the onshore debtor is subject to any specific qualification requirements. As for the onshore creditor, only financial institutions licensed to conduct lending business can legally lend money in the PRC.
- Registration: The onshore creditor must register the inbound security through an online platform with SAFE. Upon enforcement, the onshore creditor may process and receive the enforcement proceeds from the offshore security provider directly. After payment to the onshore creditor, the offshore security provider will become a creditor of the onshore debtor who should then effect a foreign debt registration with local SAFE within 15 business days after payment by the offshore security provider.
- Secured obligations: No express limit is placed on the amount that can be secured by way of inbound security. However, if the principal amount of the debt owed by the onshore debtor to the offshore security provider as a result of the enforcement of the inbound security exceeds the onshore debtor's net asset value in the preceding year, that excess will count towards its foreign debt quota. Where the onshore debtor does not have sufficient available foreign debt quota, any excess will be regarded as unauthorised foreign debt and the onshore debtor could be subject to administrative penalties. Therefore whilst the amount of onshore debt that can be secured by inbound security continues to be limited, the new rule effectively increases that limit from the onshore debtor's foreign debt quota to the aggregate of its net asset value and its foreign debt quota.
- Anticipated enforcement: The restriction set out above relating to outbound security applies to onshore financings supported by inbound security.
Other cross-border security
Other types of cross-border security are defined as any cross-border guarantee or security other than outbound security and inbound security. The regulation of such security is similar to those applicable to outbound and inbound security. SAFE registration of the security is not required, but it is necessary to register the debt owed to the security provider by the debtor as a result of the enforcement of a cross-border security.
After almost 20 years of implementation and development, the existing cross-border security rules can no longer serve the legal and economic development unleashed by the liberalisation of Renminbi. The New Rules are seen as the first major attempt by SAFE to revamp and update its control over cross-border security in line with the PRC government's policy of liberalising Renminbi. The new regulatory regime is certainly less restrictive but falls short of complete deregulation. This is logical from the perspective of, and consistent with, the pace of the PRC government making Renminbi a global currency. It is true that the New Rules are unlikely to lead to a drastic increase in the volume of leveraged crossborder acquisitions, they will however assist lenders in obtaining credit enhancements for corporate lending and may provide room for creative deal structuring. As the market adapts to the New Rules, it is inevitable that new structures will be developed and everyone involved in the cross-border financing market will, we are sure, be watching these developments with interest.