On 11 May 2018, China’s National Development and Reform Commission (“NDRC”) and Ministry of Finance issued a joint notice (the “Notice”) aimed primarily at preventing foreign creditors having recourse to local government resources, in a further bid to de-risk local authorities. The Notice also imposes higher standards on enterprises engaging in foreign debt financings generally, to ensure such enterprises, and their financing plans, are sufficiently robust and viable. Whilst previous notices have covered some similar ground in relation to corporate bonds, this Notice is drafted more broadly to apply to all types of medium to long term foreign debt incurred by Chinese enterprises (i.e. including loans). In common with previous notices, this Notice is also expected to apply to offshore debt structures – both bonds and loans.
No recourse to local governments for foreign lenders
China’s central government has made very clear, in a string of announcements and measures this year, that reducing local government debt (particularly “covert debt”) is one of its key focal areas for deleveraging the economy.
In further pursuit of those policies, the Notice imposes the following restrictions on enterprises incurring medium to long term foreign debt:
- Enterprises are not permitted to require or accept guarantees from local governments or their subordinate departments. We do not expect this to include state-owned enterprises, but, as this is not explicit in the Notice, at this stage we would suggest checking the point with local counsel on a case by case basis.
- Enterprises may not count public schools, public hospitals, public cultural facilities, parks, public squares, office buildings of government offices, municipal roads, non-toll bridges, non-managed water conservancy facilities, non-chargeable network facilities or any other public assets, or the rights to use land reserves, as assets owned by the enterprise for reporting purposes.
- Enterprises may not publicise any misleading link to government credit in offering documentation or otherwise; where an enterprise is owned by a local government entity, the documentation must make clear that the liability of the local government is limited to the amount of its capital contribution and the debts of the enterprise are to be repaid by the enterprise itself as an independent legal person.
Failure to comply with these restrictions risks the enterprise, the creditors and the professional advisers being blacklisted and prevented from obtaining foreign debt registrations in the future.
Higher standards for enterprises borrowing offshore
The Notice sets out various standards that enterprises should comply with if they intend to incur foreign debt. In particular, the enterprise must:
- have substantial operations, implement market-based financing in compliance with laws and regulations and fully demonstrate the necessity, feasibility, economy and financial sustainability of incurring foreign debt;
- formulate a foreign debt principal and interest repayment plan;
- establish a sound and standardised corporate governance structure, management decision-making mechanism and financial management system;
- consider and hedge its financing risks by utilising swaps, options and other financial products as appropriate; and
- use the debt proceeds on financially sustainable projects, demonstrating stable and reasonable investment returns.
The Notice also encourages investment in innovation and development, green finance, strategic emerging industries, high-end equipment manufacturing and Belt and Road initiatives.
We expect that the NDRC will have regard to these factors when considering foreign debt registrations under NDRC Circular 2044 and may deny registration if it deems they are not met.
Technically any foreign debt with a tenor of one year or more incurred by a Chinese entity, or any offshore branch or subsidiary which it controls, requires registration under NDRC Circular 2044. In practice, local NDRCs do not always require or accept registration for offshore commercial loans. Failure to register should not affect the validity of the offshore loan from a legal perspective but could result in the enterprise being blacklisted.
What does this mean for offshore lenders?
As is often the case, the Notice is drafted somewhat ambiguously and it is not entirely clear how the requirements will impact loan transactions in practice. However, until experience provides more clarity, lenders should:
- be careful to avoid any of the following features when structuring loans (whether direct inbound loans or loans structured offshore) without first obtaining the approval of the relevant local NDRC:
- taking guarantees or security from, or having any direct recourse to, local governments or their subordinate departments;
- counting any public assets owned by the obligor group towards the pool of net assets for financial testing purposes; or
- taking security over any public assets owned by the obligor group; and
- be mindful of the standards that apply for enterprises engaging in foreign debt structures and encourage borrowers to engage with local NDRCs early on to establish whether foreign debt registration under Circular 2044 is required and, if so, whether the borrower group will satisfy the NDRC’s requirements for granting registration.