The State Administration of Foreign Exchange of the PRC ("SAFE") published the long awaited "Regulations on Foreign Exchange Administration of Cross-Border Guarantees and Security" (the "Regulations") and the related "Operational Guidelines on Foreign Exchange Administration of Cross-Border Guarantees and Security" (the "Guidelines") on 19 May 2014.
As part of the PRC government's continued efforts to liberalise foreign exchange controls, the Regulations mark a significant reform of PRC's foreign exchange administration system, streamline and relax the approval procedures for all kinds of cross-border guarantee and security structures and regulate fund flows under cross-border guarantees and security transactions. The Regulations and the Guidelines will come into effect on 1 June 2014.
This article summarises the key changes introduced by the Regulations.
The Regulations will, after they become effective, repeal 12 existing regulations and notices, including the "Notice on Issues Relating to the Administration of Foreign Security by Domestic Institutions" promulgated by SAFE on 30 July 2010, and substantially relax the current restrictions on the giving of cross-border guarantees and security.
Framework of the Regulations
The Regulations classify cross-border guarantees and security into three categories according to whether the guarantor/security provider, debtor and creditor, is an offshore or onshore entity, namely:
- guarantee/security provided by an onshore guarantor/security provider for a debt owed by an offshore debtor to an offshore creditor ("Nei Bao Wai Dai" or "内保外贷");
- guarantee/security provided by an offshore guarantor/security provider for a debt owed by an onshore debtor to an onshore creditor ("Wai Bao Nei Dai" or "外保内贷"); and
- any cross-border guarantee/security other than (i) and (ii) above.
A separate set of regulations is provided for each of the above three categories of cross-border guarantees and security.
I. Nei Bao Wai Dai
A. Registration instead of Approval
Under the current regulatory regime, the giving of cross-border guarantees and security by an onshore entity is subject to SAFE approval which can be a stringent and, in most cases, lengthy process. In addition, the regulations are different depending on whether the onshore entity is a bank or a non-bank entity.
Under the current regulations, an onshore bank may provide foreign guarantees or security subject to an annual quota pre-approved by SAFE. Pursuant to the Regulations, this quota regime will be abolished and onshore banks may freely provide foreign guarantees and security provided that they have been approved to engage in the business of providing guarantees/security and they are required to report the guarantee or security to SAFE via the capital account information system after the guarantee or security is executed.
Onshore Non-bank Entities
Under the current regulations, an onshore non-bank entity is generally required to apply to SAFE or its local branch for approval (either on a case-by-case basis or for an annual quota) before it can provide a foreign guarantee or security. Pursuant to the Regulations, pre-approval from SAFE is no longer required to provide foreign guarantees and security. Instead, onshore non-bank entities are only required to register the guarantee or security with the local branch of SAFE within 15 business days after the guarantee or security is executed. The Guidelines set out a detailed list of the materials and information that are required to be submitted to SAFE for registration.
B. No Shareholding Requirement
Under the current regulations, an onshore non-bank entity providing a foreign guarantee or security must be a shareholder of the offshore debtor. SAFE or its local branch will approve or disapprove the application on the basis of, among other factors, the financial status of the applicant and the offshore debtor. This shareholding requirement will be abolished by the Regulations. An onshore non-bank entity may therefore provide a foreign guarantee or security to secure an offshore debt of an entirely unrelated offshore debtor (save in the case where the foreign guarantee or security is provided in respect of an offshore bond issuance - see "D. Specific Provisions for Offshore Bonds Issuance" below).
C. Restrictions on Use of Funds
It is important to note that the Regulations impose a number of restrictions on the use of funds raised offshore under a Nei Bao Wai Dai structure, including:
- the funds can only be used within the offshore debtor's ordinary scope of business. In particular, the funds cannot be used for pure arbitrage trades or for other types of speculative transactions; and
- the funds cannot be directly or indirectly repatriated onshore by way of debt, equity investment, securities investment or any other means unless specifically approved by SAFE.
The Guidelines further elaborate on the second restriction by setting out a few examples of prohibited activities, which include using the funds raised offshore to:
- directly or indirectly invest in an onshore entity by way of debt or equity investment;
- directly or indirectly acquire the shares of an offshore entity, where over 50% of the assets of such offshore entity are located onshore;
- refinance the existing debt of the offshore debtor or another offshore entity, where the funds raised from such existing debt were directly or indirectly repatriated onshore by way of debt or equity investment; or
- make an advance payment to an onshore entity for goods or services to be delivered over one year later where the payment exceeds USD1 million and 30% of the total consideration of the relevant purchase agreement.
D. Specific Provisions for Offshore Bonds Issuance
The Guidelines set out additional requirements applicable to offshore bonds issued under a Nei Bao Wai Dai structure, including:
- the onshore guarantor/security provider must have a direct or indirect equity interest (but not necessarily a controlling interest) in the offshore bond issuer;
- the bond proceeds must be used for an offshore investment project in which the onshore guarantor/security provider has an equity interest; and
- either the offshore investment project or the relevant offshore entity has been approved, registered, filed or confirmed by the PRC governmental authorities responsible for outbound investments in accordance with applicable PRC rules and regulations.
E. Restrictions for Other Transactions
Offshore investments: Where the funds raised under a Nei Bao Wai Dai structure are used directly or indirectly to invest in other offshore entities by way of debt or equity investment, such an investment must comply with the applicable requirements for outbound investments in the PRC. Derivative transactions: Where the guarantee/security under a Nei Bao Wai Dai structure is given in respect of the offshore debtor's payment obligations under a derivative transaction, the derivative transaction of the offshore debtor must be (i) for hedging purposes only; (ii) consistent with its principal scope of business; and (iii) duly authorised by its shareholders.
F. Individual as Guarantor/Security Provider
Individuals are expressly permitted to be guarantors/security providers for a Nei Bao Wai Dai structure, which shall be regulated by reference to the provisions applicable to non-bank entities.
G. Enforcement and Consequential Foreign Debt Registration
Provided that the relevant registration requirements have been complied with, if a foreign guarantee or security is enforced against the onshore guarantor/security provider, the onshore guarantor/security provider can make the offshore payments itself (in the case of an onshore bank) or via a financial institution by submitting the relevant SAFE registration documents (in the case of an onshore non-bank entity).
Upon the enforcement of a foreign guarantee or security, a foreign debt owed by the offshore debtor to the onshore guarantor/security provider will arise by way of subrogation. The onshore guarantor/security provider is required to report such foreign debt to SAFE via the capital account information system (in the case of an onshore bank) or register with SAFE within 15 business days (in the case of an onshore non-bank entity).
If the foreign guarantee/security is enforced, the onshore guarantor/security provider cannot enter into any new Nei Bao Wai Dai transaction without SAFE's approval before the offshore debtor has discharged all outstanding obligations owed to the onshore guarantor/security provider under the consequential foreign debt.
An onshore guarantor/security provider is required to de-register the foreign guarantee or security by reporting to SAFE via the capital account information system (in the case of an onshore bank) or de-register with SAFE within 15 business days (in the case of an onshore non-bank entity) if (i) the offshore debt has been repaid in full by the offshore debtor; (ii) the payment obligations of the onshore guarantor/security provider have expired; or (iii) the onshore guarantor/security provider has performed its payment obligations under the foreign guarantee or security.
The liberalisation of the rules on Nei Bao Wai Dai should be well received by market participants as it marks a fundamental reform of the current regulatory regime. In particular, the removal of the requirement to obtain prior SAFE approval for onshore entities to provide foreign guarantee or security could potentially alter the way offshore loans and bond issuances are to be structured.
In light of the difficulties and uncertainties in obtaining SAFE approval under the current regime, the market has in the past few years witnessed the use of creative credit enhancement structures such as keepwell deeds, standby letters of credit and equity interest purchase undertakings entered into by onshore entities (where majority of the assets and business of the group are located) to enhance the credit quality of loans and bonds issued and/or guaranteed by offshore entities (which in most cases do not have sufficient credit to substantiate a good pricing for the deal). However, such credit enhancement structures are often viewed by investors and creditors as a "second-best" option due to the uncertainties relating to enforceability and other regulatory risks in the enforcement process. Issuers and borrowers in those deals therefore usually obtained funding at a higher cost than what would have been the case should the onshore entity be able to provide a direct guarantee or security. The stronger protection of a guarantee or security afforded by an onshore entity should give offshore creditors and investors greater confidence, which in turn will enable the offshore entity to obtain funding at a lower cost. The relaxation of the rules should be seen as a positive development for bond issuers, borrowers, investors and creditors alike.
II. Wai Bao Nei Dai
A. Registration instead of Approval
Pursuant to the Regulations, an onshore debtor and an onshore creditor may freely enter into a Wai Bao Nei Dai transaction without having to obtain approval from SAFE provided that:
- the onshore debtor is a non-financial institution;
- the onshore creditor is a financial institution;
- the guarantee/security is provided to secure a loan (which can be denominated in RMB or foreign currency, excluding an entrustment loan) or a committed facility provided by the onshore creditor; and
- the guarantee or security is in compliance with applicable onshore and offshore laws and regulations.
The onshore creditor is required to report the guarantee or security to SAFE via the capital account information system.
Upon enforcement of the guarantee or security under a Wai Bao Nei Dai structure against the offshore guarantor/security provider, the onshore financial institution may directly receive payments from the offshore guarantor/security provider.
B. Enforcement and Consequential Foreign Debt Registration
Upon enforcement of an offshore guarantee or security provided under a Wai Bao Nei Dai transaction, a foreign debt owed by the onshore debtor to the offshore guarantor/security provider will arise by way of subrogation.
The onshore debtor is required to comply with the following requirements in respect of such foreign debt:
- the total outstanding principal amount of such foreign debt shall not exceed the onshore debtor's audited net assets for the preceding financial year;
- the onshore debtor must register and file such foreign debt with the local branch of SAFE within 15 business days; and
- the onshore debtor cannot enter into any new Wai Bao Nei Dai transaction or make any further drawdown under any existing Wai Bao Nei Dai structure without SAFE's approval before the onshore debtor has fully discharged such foreign debt.
Like Nei Bao Wai Dai, the relaxation of the rules on Wai Bao Nei Dai should also be welcomed by the market. The removal of the requirement to obtain prior SAFE approval for onshore entities to obtain offshore guarantees or security under a Wai Bao Nei Dai structure should facilitate cross-border financing transactions to satisfy onshore entities' funding needs.
III. Other Types of Cross-border Guarantee or Security
Under the Regulations, there is no requirement to obtain SAFE approval or registration for cross-border guarantees or security other than Nei Bao Wai Dai and Wai Bao Nei Dai unless otherwise explicitly required by SAFE. Examples of these include:
- guarantee/security provided by an onshore entity for a debt owed by an onshore debtor to an offshore creditor; and
- guarantee/security provided by an offshore entity for a debt owed by an offshore debtor to an onshore creditor.
It should be noted, however, that if the underlying foreign debt requires approval or registration, or if enforcement of the cross-border guarantee or security leads to any change in the foreign debt status, the relevant approval or registration will need to be obtained or made.
The much anticipated Regulations published by SAFE represent a major step undertaken by the PRC government to relax capital controls in the PRC and are well received by market participants. The Regulations signify a fundamental reform of the current regulatory regime relating to cross-border guarantees and security. Of paramount importance is the express stipulation in the Regulations that the validity of a cross-border guarantee or security is no longer conditional upon any SAFE approval, registration or filing of the cross-border guarantee or security or any administrative requirements.
The liberalisation of the rules on cross-border guarantees and security and the shift from the approval system to the registration system will certainly alleviate significant hurdles which onshore entities face under the current regime. The Regulations should allow more onshore entities to raise funds in the offshore capital markets arena and encourage issuers and borrowers who might not have been able to raise funds offshore under the current regime (for instance, due to the time required for approval or other uncertainties) to tap into this funding space and enhance the development of cross-border financing. In the long run, this should result in a more mature market with a broader and more diversified class of issuers and borrowers.
IT'S NOT A COMPLETE DE-REGULATION YET!
It is important to note that the Regulations have not completely liberalised the regulatory regime for cross-border guarantees and security. There are still a number of restrictions and limitations, for example, the restrictive use of funds under a Nei Bao Wai Dai structure, which will not directly benefit onshore entities that require the offshore funds for their onshore operations (as in the case for most PRC property companies). As far as offshore bonds are concerned, the funds must also be used for investment in an offshore investment project in which the onshore guarantor/security provider has an equity interest. Therefore, issuers and borrowers who cannot avail themselves of the benefits afforded by the new Regulations may have to continue to rely on the alternative forms of credit enhancement structures in the offshore capital market (including keepwell deeds, equity interest purchase undertakings and standby letters of credit).