The use of a parent company guarantee (PCG) can be a valuable tool for securing the performance obligations of a counterparty to a contract. A PCG is often used in the construction industry where parent companies give guarantees to bolster the financial credibility of their subsidiary contractor companies. PCGs are often used in commercial contracts for the sale of goods to insure payment obligations. PCGs are frequently offered as security by Chinese companies in transactions offshore.
PCGs will continue to be used as a form of security as Chinese companies go abroad. China’s Belt and Road Initiative (BRI) has already begun to see huge amounts of offshore investment and cooperation. Ministry of Commerce statistics released in January 2018 stated that as of the end of 2017 “7,217 overseas contractual projects were signed by Chinese enterprises with 61 countries along the Belt and Road routes, and the value of the newly-signed contracts amounted to US$144.32 billion”. With each BRI project comes the uncertainty of financial exposure and a risk of cross-border disputes. The PCG is often proffered as the way to minimize risk. You need to understand what you bargain for in entering a PCG and insure that the PCG’s terms address the nuances of the law and practice in relation to on-demand PCGs in China.
SAFE Registration of Guarantees in China
In China, cross-border guarantees are regulated by the “Provisions on the Administration of Foreign Exchange for Cross-border Guarantee” (Provisions) and the “Operation Guidelines of the Provisions” (Guidelines) both of which were promulgated by the PRC State Administration of Foreign Exchange (SAFE) on 12 May 2014, and were effective 1 June 2014. In response to capital outflows, SAFE tightened capital controls and promulgated the “Notice on Improvement of Banks’ Foreign Currency Management on Overseas Loans Guaranteed by Domestic Entities (Hui Zong Fa No. 108)” (Notice) on 5 December 2017.
Pursuant to the Provisions, cross-border guarantees fall into the following categories:
- Overseas loans guaranteed by domestic entities (内保外贷);
- Domestic loans guaranteed by overseas entities (外保内贷); and
- Other forms of cross-border guarantees.
A guarantee may be in the form of a contractual guarantee, mortgage, pledge, lien, or deposit. If a guarantor is incorporated in China, and both a debtor and a creditor are overseas entities, the guarantee will be classified as an “overseas loan guaranteed by a domestic entity” under the Provisions. If the debtor and guarantor are both onshore entities and the creditor is offshore, the guarantee is considered to be another form of cross-border guarantee (the last category above). This is a significant distinction because when the guarantor is the only PRC company involved, the guarantee must be registered with SAFE as discussed further below. If the debtor and the guarantor are both onshore and the underlying obligation is a service agreement (including a license agreement), or a sales agreement, then no SAFE registration is required. This article thus addresses situations where the guarantor is onshore and the debtor and creditor are both offshore.
Principle clauses of a PCG typically include the name of the creditor and debtor (beneficiary of the guarantee), the amount of the debt; the amount subject to the guarantee, the term of the underlying contract, and the term of the guarantee. If a PCG does not include the value of the guarantee, this could substantially reduce the likelihood of a successful SAFE registration. In practice, SAFE usually will not approve a registration unless the amount of the guarantee is specified in the PCG. SAFE is charged with monitoring and controlling the outflow of currency. A guarantee has to have a fixed amount for SAFE to effectively exercise oversight over the flow of currency across the Chinese border.
Application for registration
A PCG must be registered with SAFE in the place where the guarantor is domiciled within 15 working days of the PCG being signed. Registration requires submission of an application, the PCG, any underlying contract(s), any term sheets for complex transactions, and translations of non-Chinese supporting documents.
Under the Notice, SAFE is required to substantively review the application, which involves considering the liquidity of both the guarantor and the underlying contract debtor. The Notice allows SAFE to require a written explanation about the intended use of the funds. The Notice only applies to bank guarantees; but in practice, SAFE applies the same rules to PCGs. In fact, SAFE may exercise more stringent review of non-bank guarantees.
After a PCG has been registered, the guarantor must update the PCG registration with SAFE within 15 working days of any amendment to the PCG or the underlying contract.
Time for application
SAFE may require the guarantor to provide further detail about the underlying transaction or the commercial reasonableness of the PCG. PRC law is silent on the timeframe in which SAFE must complete its review of a registration application. In our experience, it is common for SAFE to register a cross-border guarantee within three working days of receiving the complete registration application, assuming there are no questions or issues that delay the registration.
A guarantor must apply for cancellation of a cross-border guarantee registration within 15 days after the transaction it guarantees is completed, or the guarantee is called.
Upon registering the PCG, SAFE will provide the guarantor with a registration certificate (Certificate) and an identification number for the registration. When presented to a PRC bank, the Certificate allows the guarantor to pay the creditor in USD or other foreign currency when the PCG is called. Failure to obtain registration and a Certificate means that the guarantor is not authorized to remit funds outside of China when making a payment under the PCG. If the guarantor never registers the PCG, an overseas creditor must enforce the PCG through litigation or arbitration before an offshore payment in foreign currency can be remitted. Guarantors who fail to register with SAFE may incur a penalty of thirty percent (30%) of the value of the guarantee. Thus, there is an incentive to register if the guarantor believes the guarantee could be called. However, a guarantor may also take the risk of not registering the guarantee if the risk of call is deemed low and the guarantor is guaranteeing multiple offshore contract payments.
The parties to a PCG are free to negotiate the terms of the PCG without reference to any SAFE requirements for content beyond the basic terms mentioned above. However, following the release of the Notice, SAFE will thoroughly review the terms of the PCG and may also consider such other factors as the credit-worthiness of the guarantor, the size of the amount guaranteed, and the guarantor’s other obligations.
Below, we outline a few terms that we suggest should be considered by any foreign party negotiating a PCG with a Chinese party.
1.Incorporate requirement to register
To ensure that payment is swiftly made under the PCG, and that the funds can be transmitted offshore, we suggest that the underlying contract and the PCG incorporate an express requirement to register the PCG with SAFE. The registration does not impact the validity of the PCG, which is still a contract to pay a debt. Registration simply insures ready payment upon demand. In the absence of registration, the payee may need to seek enforcement of the guarantee through litigation or arbitration.
2.Incorporate prohibition to deregister
There is a risk that the guarantor may apply to cancel the SAFE registration before the PCG expires. We recommend that the underlying contract and the PCG incorporate a requirement that the guarantor provide the creditor with original copies of the SAFE registration certificate and a promise or covenant not to cancel the SAFE registration without prior written consent. The underlying contract and PCG should also set forth the consequences for the guarantor if it prematurely cancels the SAFE registration. This situation could arise where the onshore guarantor is pressed to undertake additional guarantees that secure obligations that are more urgent and lucrative for the group companies.
3.Representation that there are no outstanding guarantees
SAFE will not register a new cross-border guarantee if a prior guarantee in favour of the debtor was called and the debtor has not repaid the prior guarantor all monies owed under that prior guarantee. Given that guarantors in the trading industry (i) are usually non-bank guarantors, and (ii) might have substantial ongoing overseas projects, you should consider requiring the guarantor to confirm that it has no outstanding guarantees that would preclude SAFE registration of your guarantee.
4.An Independent or Dependent Obligation?
Over the past few years, we have encountered some PCGs with no dispute resolution clause, and an underlying contract with offshore governing law and offshore international arbitration. Those PCGs contained on-demand language. The foreign party assumed that this arrangement allowed it to make an immediate demand without proof of the underlying contract breach. And further, the foreign parties believed that courts would honour the on-demand language regardless of the status of the underlying contract. In practice, this has not always proven true. Many foreign parties have had to resort to litigation to enforce on-demand PCGs and have found the courts reluctant to order payment.
Even where a PCG has been registered, we have found instances of Chinese parties filing actions in PRC courts alleging a wrongful call of the guarantee and seeking a stay of the guarantee in favour of arbitration of the underlying contract. As Chinese courts commonly treat a guarantee as a dependent obligation, they generally prefer a definitive ruling on the underlying contract dispute before enforcing the guarantee.
The benefit of a PCG dispute resolution clause submitting to the exclusive jurisdiction of PRC courts (or silent on the dispute mechanism) is that the party seeking to enforce the guarantee can apply to the court for an asset preservation order (APO). An APO must be secured by a bond valued anywhere from fifty to one hundred percent of the value of the assets to be preserved. When deciding whether to issue an APO, courts generally consider the risk of non-payment and the liquidity of the guarantor. Our Firm, KWM, has generally been successful in obtaining APOs as security for the enforcement of guarantees.
If the creditor believes that suing in court and obtaining an APO will result in early settlement, then the creditor should incorporate terms in the guarantee to effectuate that end:
- State that the guarantee is an independent obligation not tied to the underlying contract;
- State that the guarantee is payable “on demand”;
- Emphasize that no proof of breach of the underlying contract is required;
- State that the PRC courts have exclusive jurisdiction to enforce the guarantee;
- State that the guarantor consents to the court entering an asset preservation order;
- State that the guarantee must be paid even if there is a pending arbitration in relation to the underlying contract;
- State that the guarantor agrees to make payment before any arbitration award is issued; and
- State that the guarantor will recoup any loss from the debtor regardless of the outcome of any litigation or arbitration in relation to the underlying contract.
In the alternative, the creditor might draft the PCG with the same governing law and dispute resolution clause used in the underlying agreement. This would increase the likelihood of being able to arbitrate the two contracts in the same venue, assuming the venue allows consolidation or joinder.
Under Chinese law, a contract between a Chinese party and a foreign party or a “foreign-related” contract can be submitted to offshore arbitration. Therefore, foreign parties contracting with Chinese parties should consider subjecting the PCG dispute to the same dispute resolution mechanism as the underlying contract. Foreign arbitral awards are enforceable against the assets of the debtor and the guarantor in China and overseas, under the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (New York Convention). In using an arbitration clause in the PCG, the foreign creditor is agreeing to a decision on the merits of the underlying contract before the PCG will be enforced. Be mindful that practically speaking, even if the creditor could seek an early interim order from an emergency arbitrator or arbitral tribunal for payment under the on-demand guarantee, an interim arbitration award is not a final award under the New York Convention and will not be enforceable in China.
Creditors need to understand the law and practice surrounding on-demand parent company guarantees in China. The purpose of an on-demand PCG is quick satisfaction of a debt owed. For now, in China, this expectation might be difficult to realize without a well-considered strategy. If you have questions about how best to position yourself in these transactions, please reach out to us for more information.