China's foreign exchange administration authority, the State Administration of Foreign Exchange (SAFE) has substantially relaxed rules that have, for many years, imposed onerous restrictions on the ability of companies inside China to grant security in favour of foreign entities.

Details of the new regime are set out in the Notice on Issues in the Administration of the Provision of Security to Foreign Entities by Domestic Institutions (Notice) which was issued and became effective on 30 July 2010.

The move is expected to be widely welcomed in the market as it will allow Chinese domestic entities and foreign-invested enterprises (FIEs) easier access to financing. It will also ease the administrative burden on the providers of the finance, whether a financial institution or a non-financial institution.

Old regime

Case-by-case approval and registration

In the old regime, if a domestic entity in China provided security to a foreign party (by way of guarantee, mortgage or lien), the security would be unenforceable unless it was first approved and registered with SAFE1. The main consequences of this rule were two-fold:

  • as domestic entities had to pass the SAFE approval hurdle before they could provide security, their access to offshore financing was restricted because SAFE imposed stringent requirements on PRC security providers and security takers; and
  • offshore lenders taking security from PRC domestic entities had to make sure the security was properly approved and registered, or they would not be able to enforce the security2.

This rule applied to all security provided to foreign parties, with a few exceptions for performance bonds and security provided by wholly foreign-owned enterprises established in China.

Loan and security documents had to be carefully drafted in order to ensure the rights of the foreign lenders and security takers.

Quota balancing

The regime was modified in 20053 to make it easier for domestic entities to access financing when making outbound investments. By distinguishing 'financing-type security' from 'non-financing-type security' provided to foreign parties and introducing a 'quota balancing system', the rules on security approval and registration in the context of outbound investment were somewhat relaxed.

Domestic banks were awarded annual quotas within which they were free to provide financing-type security to foreign parties without the need to obtain case-by-case SAFE approval. The quota system was only available for outbound investment related financing. The participating banks had to comply with certain foreign exchange balance requirements and could only provide security to foreign debtors satisfying a specified set of requirements.

New regime

Three systems

The new regime essentially maintains the distinctive regimes of case-by-case approval and quota balancing for security provided to foreign parties. A key innovation is that some types of security do not require case-by-case approval nor quota balancing. Administrative control is now exercised as follows:

  • case-by-case approval applies when non-bank financial institutions and ordinary enterprises inside China provide security to foreign parties;
  • quota balancing applies when banks inside China provide financing-type security to foreign parties (it is no longer restricted to security provided in the context of outbound investment); and
  • no approval or quota balancing is required when qualified banks provide non-financing-type security to foreign parties.

Non-bank financial institutions and ordinary enterprises meeting certain conditions can apply to implement quota balancing administration. If they are approved by SAFE they can provide security to foreign parties without first seeking SAFE approval, except for certain types of security that will remain subject to case-by-case approval.

Financing-type v non-financing-type security

The Notice provides clear definitions of 'financing-type security' and 'non-financing-type of security':

  • financing-type security: where the underlying principal contract is of a financing nature, such as a loan, bond issue and lease financing
  • non-financing-type security: any security other than financing-type of security, such as a guarantee, payment guarantee and tender bond.

Restrictions on security providers

The Notice requires banks, and non-bank financial institutions and ordinary enterprises implementing the quota system, to apply annually to the local SAFE branches for confirmation of their quota. SAFE will consider factors such as their RMB and foreign exchange paid up capital, working capital, and net foreign exchange assets when assessing their quota applications. In principle, quotas should not exceed 50 per cent of the combined RMB and foreign exchange paid up capital or 50 per cent of the working capital or 50 per cent of the net foreign exchange assets of the applicant.

Where a security provider is a non-financial institution enterprise, its net assets and gross assets ratio may not be less than 15 per cent and the total amount secured may not exceed 50 per cent of its net assets.

The Notice has removed the previous restriction which limited the maximum secured amount to the extent of the foreign exchange income of the relevant security providers.

Restrictions on offshore debtors and security beneficiaries

There is no need for a debtor to satisfy any specified requirements before a bank can provide financing-type security to a foreign party.

As discussed above, when banks provide non-financing type security to foreign parties, they are not subject to case-by-case approval or quota balancing. There is, however, a requirement with respect to the debtor or the beneficiary of such security. At least one debtor or beneficiary must be either a legal person registered in China or an offshore entity set up by a domestic institution, or in which a domestic institution directly or indirectly holds equity.

If an ordinary enterprise or a non-bank financial institution provides security to foreign parties, the offshore debtor must be either a legal person legally registered in China by the security provider, or an offshore entity set up by the security provider, or in which the security provider directly or indirectly holds equity.

Offshore debtors must meet certain net asset and profit requirements in order to get security provided by non-bank financial institutions and ordinary enterprises. Certain exemptions or exceptions to these requirements are available to offshore debtors in the resources industry.

SAFE procedures

The Notice affects the procedures that need to be completed with SAFE and the documentation that evidences compliance with SAFE requirements.

Banks with a quota balancing are not subject to SAFE approval and only need to submit monthly reports to SAFE. SAFE will no longer issue registration proof for any security provided by banks.

Any security provided by banks within their approved quotas takes immediate effect. Security provided beyond the approved quotas is subject to the 1996 Measures. This means that it is not enforceable unless first approved and registered with SAFE.

Non-bank financial institutions and ordinary enterprises that do not implement quota balancing must obtain SAFE approval on a case-by-case basis before they may enter into a security contract. They must register each security with the relevant SAFE branch within 15 days of execution of the security contract.

Non-bank financial institutions and ordinary enterprises with a quota balancing do not ordinarily need to obtain prior SAFE approval before they enter into a security contract. However, they still need to complete a registration with SAFE within 15 days of entering into the security contract. SAFE will issue a registration document for such security after verifying qualification of security takers.

Enforcing security

To enforce security provided by banks within their quota limit no prior SAFE approval is required.

Security provided by non-bank institutions can only be enforced upon verification by the relevant SAFE branch.

Financing-type security intended to support outbound investment

If financing is secured by financing-type security, the funds may not be directly or indirectly used in China by way of loan, equity investment, securities investment, or in another manner through a third party. The security providers or the domestic parent companies of the offshore debtors must ensure that the funds are used for the business operations carried out by the debtors offshore.

This shows that one of the motivations behind the new rules is to enable Chinese enterprises better access to financing for their outbound investments.

Observations

Under the new regime, banks are given a great deal of freedom to provide security in a less restricted way. This liberalised regime will offer domestic and foreign financiers and companies alike improved efficiency and certainty when they take and provide security in China. Security and loan documentation will need to be adapted to the new rules in particular as they need to seek evidence that security is provided within the quota limit or has been properly approved and registered.

Certain major restrictions of the old regime remain in place given that the 1996 Measures and its implementation rules remain in effect to the extent they are not replaced by the provisions of the Notice. There will be little difference in the regime for domestic companies and FIEs seeking to provide security to foreign parties to obtain funds for their operations in China. The main trust of the new regime is to relax security if it is provided to foreign parties in the context of outbound investment by Chinese companies.

The improved regulatory regime no doubt will better serve China's ambitious 'going out' policy by allowing security providers easier access to Chinese credit markets. The Notice is a commendable effort by SAFE to consolidate and simplify the complex regulatory regime on security to foreign parties but does not remove the need for careful due diligence and document drafting when security is provided by a domestic entity to a foreign party.

Disclaimer

The views set out in this publication are based on our experience as international counsel representing clients in their business activities in China. As is the case for all international law firms licensed in China, we are authorized to provide information concerning the effect of the Chinese legal environment. However, we are not admitted to practise Chinese law and are unable to issue opinions on matters of Chinese law. The content of this article is intended to provide a general guide to the subject matter. This publication is only a general outline. It is not legal advice. You should seek professional advice before taking any action based on its contents.

Endnotes

1 Measures for the Administration of Security Provided to Foreign Parties by Domestic Institutions, issued by the People's Bank of China on 25 September 1996 and effective from 1 October 1996 (1996 Measures) and the detailed implementation rules for the 1996 Measures promulgated in 1997.

2 Interpretation of Various Issues in the Application of the Security Law of the People's Republic of China, issued in 2000 by the Supreme People's Court.

3 Notice on Adjusting the Mode of Administration of Financing-Type Security to Foreign Parties Provided by Domestic Banks to Enterprises Investing Abroad, issued by SAFE on 16 October 2005 and effective from 1 September 2005 (Notice No. 61).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.