In a significant development, the Shanghai Financial Court has announced its ruling in the first case in China involving an application for recognition and enforcement of a Hong Kong court judgment relating to the enforceability of so-called keepwell agreements, a form of credit enhancement instrument for U.S. dollar-denominated debt issued offshore by Chinese corporates and which, while falling short of a formal guarantee, were designed to provide noteholders with some level of comfort in the situation where the borrower gets into financial difficulty. The ruling contains useful lessons for noteholders concerned as to how well their security will hold up in front of Chinese courts in the context of the People's Republic of China (PRC) Enterprise Bankruptcy Law.

Keepwells 101

In the context of Chinese-funded U.S. dollar-denominated debt, a keepwell agreement usually refers to a type of "gentleman's agreement" between an onshore parent company and its offshore subsidiary, in which the parent company promises to maintain the liquidity and solvency of the subsidiary without formally guaranteeing repayment in the event of a default. Where there is an offshore guarantor, the keepwell agreement may provide for the onshore parent to continue to maintain a significant equity interest in the offshore guarantor.

Such agreements came into being as a way for Chinese corporates to provide a form of quasi-security whilst observing restrictions that may make it difficult for them to provide formal guarantees.

A keepwell agreement may be viewed as a form of credit-enhancement that is distinct from a guarantee. Under Article 6 of the People's Republic of China Secured Interests Law, a guarantee, "refers to an agreement between a guarantor and a creditor that when a debtor fails to perform a debt, the guarantor will, in accordance with the terms of the agreement, perform the debt or assume responsibility."

In Article 91 of its November 2019 release of the Minutes of the National Court Meeting on Civil and Commercial Judgments, the Supreme People's Court gave some guidance as to whether a credit enhancement document should be considered a guarantee in nature. In essence, what this says is that where the agreement contains a promise to perform the repurchase agreement and provide liquidity support, it can constitute a contractual relationship amounting to a guarantee.

A keepwell agreement often contains a clause such as, "the keepwell agreement does not and cannot constitute a basis for the maintaining party to guarantee the debt of the issuer, nor will it become a mandatory legal obligation or restriction." Even where the provisions are seemingly clear, whether a mainland court will recognize them in practice has become a source of concern for noteholders, particularly given the large amounts already invested in debt instruments which contain this form of credit enhancement.

If the keepwell agreement is found to be in the nature of a security contract, it may be rendered invalid if it is found to violate the mandatory provisions of the law. Pursuant to Article 6 of the Supreme People's Court Interpretations on Several Issues Concerning the Application of the People's Republic of China's Secured Interests Law:

A contract for the provision of security to a foreign institution will be null and void if (amongst other) the security has not been approved by, or registered with the competent department of the state.

It is however, arguable whether this requirement still applies in practice. Cross-border security interests and guarantees are regulated by the State Administration of Foreign Exchange (SAFE). The more recent SAFE Provisions on Foreign Exchange Administration in relation to the Provision of Cross-Border Security (SAFE Cross-Border Security Provisions) requires registration for offshore security given by a Chinese entity and expressly states that failure to register does not invalidate the underlying security.

The Secured Interests Law is one of several laws that will be invalidated on 1 January 2021 when the PRC Civil Code takes effect: the argument runs, therefore, that if the law on which the interpretation was based falls away, so does the interpretation. It could be argued that the more recent SAFE Cross-Border Security Provisions represent the more recent and hence definitive view. For keepwell agreements, therefore, the requirement is to register the agreement with SAFE and file the registration. Yet in a number of judgments we have reviewed, the courts have endorsed the validity of cross-border security contracts that have not been registered with SAFE.

In the 2017 Zhejiang Final Civil Judgment No. 716 issued by Zhejiang Higher People's Court, the court held that:

…in this context, the provision of a cross-border guarantee without prior approval did not affect the functioning of the State's foreign exchange controls and did not constitute a violation of the public interest…As such, the security contract in question should no longer be considered invalid.

In the event of insolvency, creditors may still file their claims directly with the insolvency administrator based on the relevant bankruptcy law provisions. If the insolvency administrator does not accept the filing of claims under a keepwell agreement, bondholders should file proceedings with the bankruptcy court, even if the keepwell agreement provides for the jurisdiction of a foreign court. It is our view that the bankruptcy court will accept the case and determine it by interpreting the provisions of the foreign law governing the contract.

The decision 

In its ruling, the Shanghai Financial Court ordered a mainland company, CEFC Shanghai International Group Ltd., to pay substantial sums to the holder of investment bonds valued at more than €29 million issued by a British Virgin Isalnds company, ZY International Ltd., an affiliated entity of Shanghai Huaxin International Group Co. Ltd. (HX). The bonds had been sold to a global investment fund, SPC-Time and Value Investment Fund (SPC), which became the registered holder.

On the day of the sale, HX issued a "maintenance agreement" in favor of SPC, in which HX committed to SPC that it would take steps to enable ZY to maintain a consolidated net worth and sufficient liquidity to protect the interests of the bondholders and assume corresponding liability. HX stated in the agreement that the commitment was not a guarantee but that it would bear corresponding legal liabilities if HX failed to perform its obligations. The agreement also provided for the application of English law and for the jurisdiction of the Hong Kong courts.

On 24 July 2018 SPC sued HX in the Hong Kong Court of First Instance on the grounds that HX had breached the terms of the agreement. HX did not respond to the suit and on 24 August 2018 the court issued a default judgment against HX, ordering it to pay SPC €29 million, being the principal amount of the bonds, together with interest and costs. HX failed to satisfy the judgment and in May 2019 SPC applied to the Shanghai Financial Court for recognition and enforcement of the Hong Kong judgment in mainland China against CEFC Shanghai.

CEFC Shanghai argued that the Hong Kong courts did not have jurisdiction over the agreement and that SFC had deliberately failed to serve the proceedings on HX's registered address, thereby rendering the Hong Kong judgment fraudulent. It also argued that the maintenance agreement was essentially a guarantee, which should have been registered with SAFE. It also argued that the Hong Kong judgment went against the public interest.

In its decision, the Shanghai Financial Court held that the standard of review for the recognition and enforcement of Hong Kong judgments is limited to procedural matters, and that the issue of the substantive law of the maintenance agreement was outside the scope of review of the case.

The Shanghai Financial Court also held that the "public interest" cited in refusing to recognize and enforce a judgment should be strictly construed and normally only includes those cases where recognition and enforcement of the Hong Kong judgment would be contrary to the public interest of the Chinese mainland.

Although the Hong Kong judgment recognized that the nature of the security interest in the agreement represented a potential breach of the law, the Shanghai Financial Court held that the case did not violate the mainland's "social public interest" requirement.

Points to note 

Since keepwell agreements involving Chinese-funded U.S. dollar debt generally provide for foreign governing-law (usually English law) and are typically subject to the exclusive jurisdiction of courts outside mainland China, often in Hong Kong, mainland courts rarely have the opportunity to address the validity of keepwell agreements and related legal issues. A search of the China Trial Documents website using relevant search terms returned only two results.

As such, the decision by the Shanghai Financial Court will have a significant impact on all bond market transactions where keepwell agreements are involved, although it should be noted that each case turns on its own facts and the wording used in the keepwell agreement, and hence you cannot generalize – it is a case-by-case analysis.

When applying for recognition and enforcement of decisions relating to keepwell agreements, bondholders should take note that, under Article 1 of the Arrangement between the Supreme People's Court of the People's Republic of China and the Courts of the Hong Kong Special Administrative Region on the Reciprocal Recognition and Enforcement of Judgments in Civil and Commercial Matters (the Mutual Enforcement Arrangement), the mutual recognition and enforcement of judgments in the mainland and Hong Kong shall be governed by the provisions of the Mutual Enforcement Arrangement. Chinese courts should, therefore, only have discretion to refuse recognition and enforcement within the four corners of the Mutual Enforcement Arrangement.

To qualify for recognition, the judgment must be a "final judgment for payment," a condition that was satisfied here by the Hong Kong default judgment which awarded the payment of €29 million by HX to SPC.

The decision has brought long-awaited guidance for those who have invested in the multi-billion dollar cross-border bond market. It should, however, be noted that the ruling concerned the validity of a Hong Kong default judgment, with CEFC Shanghai declining to appear in the proceedings. Future proceedings, where the governing law is Chinese law and/or where the Chinese courts or an arbitration institution in China has jurisdiction and where the validity of the keepwell agreement itself is contested may still lead to different outcomes.