The PRC economy has now entered into a period, alongside a gradual decline in the proportion of social leverage, leading to a slowdown in the overall growth rate of China's social financing and various financial institutions, shadow banks, government departments and enterprises are beginning to be affected. More specifically, banking and financial institutions and shadow banks have begun to reduce the amount of facilities granted to corporate borrowers, bond issuance is facing various difficulties, bond subscribers are more inclined to accept high-rated bonds and corporate defaults and bankruptcies have increased.
As a result, there has been a rise in non-performing loans in commercial banks and a number of banks, including state-owned establishments, are transferring non-performing loans to asset management companies; there has been increased interest among foreign investors in the non-performing loans market. In addition, as the reliability of collateral is tested in the new economic cycle, banks are taking stricter control over risks and collateral requirements.
There has been a significant recent development in the interest rate mechanism in China. On 16 August 2019, to promote the interest rate marketisation and lowering financing costs for the real economy, the People’s Bank of China (“PBOC”) issued Circular No 15 (“Circular 15”), announcing its improvement and reform to the loan prime rate (LPR) mechanism. According to Circular 15, the National Interbank Funding Center will provide the new LPR at 9:30 am on the 20th day of each month based on the quotation from an expanded group of quotation banks (from 10 to 18). PRC banks shall use the LPR as the major lending rate reference for future loans, and use the LPR as the basis for pricing for floating interest rate loans. The new LPR mechanism will have a substantial effect on future financings on PRC market. The parties to the existing financings may also re-visit its financing arrangement to see if any pre-cautious actions need to be taken.
There are also developments in the National Development and Reform Commission’s (“NDRC”) control over the issuance of foreign debt by domestic enterprises or its foreign subsidiaries. In short, the NDRC has tightened its control over the foreign debt issuance and the relevant filing (commonly known as the NDRC 2044 Filing). In June 2019, the NDRC issued the Notice on the Relevant Requirements for the Application for Filing and Registration of Foreign Debt Issuance by Local State-owned Enterprises (关于对地方国有企业发行外债申请备案登记有关要求的通知), requiring all NDRC 2044 filing to be reviewed by the NDRC at the national level. Subsequently, the NDRC announced its “three warnings” policy in respect of the filing – the enterprises (together with the relevant intermediary agencies) may be subject to different level of warnings/penalties for the first, second and third time it violates the filing requirement. Furthermore, in July 2019, the NDRC issued a notice, enhancing the control over and imposing certain restrictions on the foreign debt issuance by real estate enterprises.
The State Administration for Market Regulation has revised the Measures for Movable Assets Mortgage Registration (动产抵押登记办法) (“Movable Mortgage Registration Measures”) in April 2019. The revised Movable Mortgage Registration Measures provide clearer guidance on the registration of mortgage over movable assets (including the procedures and application documents). The improvement of movable assets mortgage registration system provides more choice to medium and small-size enterprises in choosing collaterals during their financing activities. With such improvements, movable assets mortgage could play a more important role in financing activities for medium and small-size enterprises.
There is currently no mature high-yield market in the PRC.
The lending business is highly regulated in China. Only banks, trust companies and microcredit companies can be approved to conduct lending business, although occasional lending transactions may be permitted from a lender without a permit for lending business, so long as the lender does not perform occasional lending transactions as its business.
There has been a boost in the peer-to-peer lending industry in China in recent years, but this industry has been subject to increasingly stringent regulations. Regulatory bodies have reinstated the need for all lending business to have a licence in order to operate and made clear that peer-to-peer lending platforms are only “information intermediaries” and shall not engage in any financing activities themselves. Approval for incorporating new internet micro-lender companies has also been suspended.
Shadow banks have experienced rapid growth in the unregulated environment of the past few years. With the introduction of the guiding opinions jointly promulgated by the PBOC, the China Banking and Insurance Regulatory Commission (“CBIRC”), China Securities Regulatory Commission (“CSRC”) and State Administration of Foreign Exchange (“SAFE”) in early 2018, and the corresponding operation guidelines promulgated by the CSRC in late 2018 (both of which aim to supervise the operation of the shadow banking regime), it is foreseeable that shadow banks will operate at a more compliant level in order to control financial risks which are growing in prominence.
The development of financial technology has brought some changes to the financial market. Traditional banks and other financial institutions have begun to embrace new technologies in order to provide their customers with better services. For example, HSBC used blockchain techniques to complete a trade finance transaction, which helps to enhance deal efficiency and reduce fraud risks, and complete the first cross-border RMB SBLC.
Bank of China’s new digital banking was built with the assistance of new financial technologies. Additionally, the development of financial technologies has brought up a new financial form (ie, Internet finance) that provides customers with a fast and convenient financial service, different from the service provided by traditional banks. Ant Financial and WeChat are typical representatives of Internet finance.
Please see 1.1 Impact of Regulatory Environment and Economic Cycles.
Only banks, trust companies and microcredit companies can run a lending business as their main business, although occasional lending transactions from a lender without a permit for lending business are allowed, so long as the lender does not perform such occasional lending transactions as its business. In addition, entities established outside the PRC can provide loans (ie, foreign debt) to PRC companies, but the foreign debt quota of the borrower is subject to the relevant PRC laws.
The following requirements, among others, must be met when establishing a bank:
The following requirements, among others, must be met in establishing a trust company:
Before banks and trust companies can provide loans to borrowers, they need to complete due diligence procedures in accordance with the relevant PRC laws and regulations, complete internal credit approval procedures, and sign a facility agreement with borrowers in compliance with PRC laws and regulations; the relevant condition requirements specified in the facility agreement shall be satisfied by borrowers in advance.
Before offshore lenders can provide loans to onshore borrowers, they need to sign the facility agreement with the borrower, and the borrower needs to complete the foreign debt registration with SAFE.
The amount of loans that can be provided by a foreign lender to an onshore borrower is subject to the foreign debt quota of the onshore borrower.
If a security or guarantee constitutes a Nei Bao Wai Dai Transaction (ie, the provider of the security or guarantee is incorporated in the PRC or is a PRC resident, while both the debtor and the creditor (ie, the beneficiary of the security/guarantee) are incorporated outside the PRC or are foreign residents), it shall be filed with SAFE by the onshore security provider or guarantor within 15 working days of the signing of the relevant security or guarantee document. In addition, the SAFE rules impose certain restrictions on the purpose, repayment etc, of the underlying facility.
The security or guarantee in favour of foreign lenders that does not constitute a Nei Bao Wai Dai Transaction does not need to be registered with SAFE but shall comply with PRC laws, in general.
Foreign currency exchange and payments under the capital account (资本项目) are still subject to approval, registration or filing (depending on the various purpose and types of the foreign currency exchange and payments).
Foreign exchange and payments under the current account (经常项目) are free. Parties to a trading can exchange and pay foreign exchange if the trading is genuine.
For individuals, the rules on foreign currency exchange are not the same.
According to PRC laws and regulations, and relevant regulatory requirements, the use of proceeds from loans should comply with the requirements of the relevant laws and regulations and the provisions of the facility agreement. The borrower must not use the loan beyond the relevant purpose provisions and, in particular, the loan should not be used for areas or purposes where production or operation has been expressly prohibited by the laws or regulations.
In general, loans in the PRC market (excluding interbank markets and personal loans) can be classified into working capital loans, fixed asset loans and M&A loans, according to their purposes:
For a PRC law-governed syndicated loan, syndicate banks will normally authorise a bank to deal with the perfection of security and other administrative matters as an agent bank. The agent bank does not conduct business on its own account but will be appointed by other syndicate banks on a case by case basis consistent with an agency entrustment relationship which is distinct from a trust business. The security trust concept is not often used and it’s uncertain how the judicial practice would recognize this concept.
According to the Notice of the China Banking Regulatory Commission on Matters Regarding Standardising the Transfer of Credit Assets and the Financial Services Related to Credit Assets (中国银监会关于规范信贷资产转让及信贷资产类理财业务有关事项的通知), the Notice of the China Banking Regulatory Commission on Further Regulating the Credit Asset Transfer Business of Banking Financial Institutions (中国银行业监督管理委员会关于进一步规范银行业金融机构信贷资产转让业务的通知) and other relevant PRC laws and regulations, the following requirements must be satisfied before a lender can transfer its credit assets:
If a banking financial institution wants to transfer its credit assets to another party, the transferee must also be a banking financial institution and, when the transferee and transferor enter into a credit asset transfer agreement, this agreement shall specify the rights and obligations of both parties. The transferor shall provide the transferee with the legal papers and other materials related to the asset transfer, while the transferee shall perform the routine post-loan management duties for the credit assets.
After the competition of the transfer, the transferor shall notify the borrower in accordance with the relevant PRC law.
If there is any collateral for the credit asset to be transferred, the modification registration of the collateral shall be conducted, or the pledged property shall be delivered for possession by the transferee or delivered to the transferee to ensure the valid transfer of the security interest.
There is no buy-back in the PRC loan market. Usually, only the borrower or sponsor can prepay the facilities.
“Certain funds” is still a commercial issue and requirement in the PRC loan market. Lenders are required to issue a commitment letter (in Chinese: 贷款承诺函) to meet the requirement of “certain funds” in acquisition finance. The terms and length of such commitment letter may vary for different transactions or parties.
No withholding tax is required if the lender is an onshore financial institution or an onshore branches of offshore financial institutions. If the lenders are located outside the PRC, the payment of interest or other fees (other than the principal) to lenders is subject to withholding tax.
Apart from VAT in respect of the amount (other than the principal amount of the loan) paid by the borrower to the lender, no other taxes, duties, charges or tax considerations shall be paid by the lender for a separate financing transaction.
It is generally understood that there is no rule limiting the amount of interest that can be charged by a bank, but some PRC courts hold the opinion that the interest limitation stipulated in the Provisions of the Supreme People's Court on Several Issues concerning the Application of Law in the Trial of Private Lending Cases (最高人民法院关于审理民间借贷案件适用法律若干问题的规定) shall also be applicable to financial institutions, as follows:
The followings are typical types of collateral and the forms of security taken over them:
Generally, security cannot be created over land that is state or collectively owned, nor over real estate that is:
In general, the courts in China do not recognise any security created over future collaterals, except for buildings, ships and aircrafts under construction and account receivables, nor any security created over a floating pool of assets, except for future production equipment, raw materials and semi-finished products.
The perfection requirements of the security are as follows:
Costs and timing
The costs and timing in taking security are decided on a case-by-case basis, depending on the type of security, the place where the security is created, and the perfection requirement applicable to the security.
The costs are usually nominal compared with the amount secured by the security and are either subject to a capped amount or proportionate to certain factors, for example, the amount of secured liabilities or the value of the collateral.
Generally speaking, there is no mandatory timeline for the completion of perfection by the governmental authorities. If all the application documents are in good shape, the perfection of security could generally be completed within one month. Certain security can be perfected quite quickly – ie, a pledge over account receivables can be registered with the online registration system of the PBOC on the date of submission of the application. Certain securities may take a couple of months to be perfected – ie, a pledge granted by a foreign shareholder over its equity interests in its PRC subsidiaries.
Under PRC law, there is no concept of “Debenture” or an equivalent that permits universal security interests over all present and future assets of a company.
PRC law allows for the provision of downstream, upstream and cross-stream guarantees that comply with the articles of association of the guarantors. In particular, if the amount of the guaranteed obligations is limited by the articles of association, such limitation shall not be exceeded.
In terms of upstream guarantees, shareholder approval is required for the guarantor to provide the same, and the direct shareholder(s) concerned shall be excluded from the vote.
There is no clear definition of financial assistance under PRC law, and the concept of financial assistance applies if the target being acquired is a listed company or a state-owned enterprise. There is no particular prohibition on private companies providing financial assistance.
A foreign lender is not prohibited by PRC law to hold security over real estate. However, as a practical matter, the relevant real estate registrars (in quite a few localities) may refuse to register a real estate mortgage in favour of a foreign entity (regardless of whether it is a bank, a non-bank financial institution, or another types of entity), which leads to the mortgage not being effective.
Regarding security requiring registration in order to be perfected (ie, real estate mortgage, equity pledge), the release of the security would involve a release agreement or a confirmation of the release by the beneficiary, and de-registration of the security interests from the relevant registrar.
Regarding security requiring delivery of the collateral in order to be perfected (ie, commercial instruments), the release of the security would involve a release agreement or a confirmation of the release by the beneficiary, and a return of the collateral to the security provider/owner of the collateral.
The release of any other type of security would simply need a release agreement or a confirmation of the release by the beneficiary.
Under PRC law, the priority among competing security interests over the same collateral is determined according to the following rules:
Contractual subordination is a common method of subordination under PRC law. However, the priority rules mentioned above cannot be varied contractually. Another method of subordination is structural subordination, with a typical example being the senior/mezzanine arrangement in acquisition financing.
As the insolvency procedure has its own statutory rules in terms of the distribution of realisation proceeds of the insolvency assets, a contractual subordination provision cannot usually survive the insolvency of a borrower incorporated in the PRC. However, as a practical matter, it is still possible for the insolvency administrator to be co-operative if the subordinated creditor expressly consents to the subordination arrangement and agrees to take all the responsibility arising from it.
PRC law provides that a security interest or guarantee would become enforceable when an obligor fails to perform the secured or guaranteed obligation, or upon the occurrence of other triggering events as agreed between the parties. In line with this principle, security documents or guarantees in a financing transaction would usually be drafted in a way that the security or the guarantee will become enforceable upon the occurrence and continuation of events of default specified in finance documents (subject to agreed grace period, if any).
Enforcement of Security
If the lender intends to enforce its security interests, it may firstly negotiate with the security provider with a view to agreeing on the realisation of security by a conversion into value/title transfer, auction or sale (the “Out-of-court approaches”). If an agreement cannot be reached or if the consent or authorisation from the security provider cannot be obtained, the lender may file a lawsuit before the PRC court or submit the dispute to an arbitration tribunal, as provided in the relevant security documents, to enforce its security interest (the “Court approaches”).
For the purpose of security enforcement, a creditor may file a lawsuit before the PRC courts to obtain a court judgment/order to have security interests recognised and enforced, without prior negotiation with the security provider. In general, as the PRC judicial system adopts a two-instance approach for court trial proceedings (ie, a first instance hearing and an appeal), the lender may obtain a final judgment or order in respect of its claim regarding security enforcement after the two-instance trial.
In addition to the traditional approach of “suing and enforcement”, PRC law also provides for a special procedure for security enforcement, which is a single-instance process that aims to achieve a prompt realisation of security. It is available only when parties are not able to reach consensus regarding the “approach” of security enforcement but do not dispute the existence and amount of the secured obligations, the validity and enforceability of security, etc. Consequently, the courts are not supposed to review the merits of the case before granting order to enforce security.
If the creditor obtains a court judgment/order in its favour (either through the general trial proceeding or the special procedure) but the security provider does not perform its liabilities accordingly, the creditor may apply for a court-assisted enforcement procedure to force the sale or auction of the collateral. The proceeds of such sale and auction will be ordered to repay the secured obligations.
In certain cases, secured creditors may find that the collateral has been attached by other creditors. When a first ranking attachment exists, no title transfer of – or creation of encumbrance over – the collateral will be allowed. If the first ranking attachment court announces an auction or initiates the private sale against the attached collateral within 60 days of the date of the first ranking attachment and the collateral is successfully disposed, the secured creditor would be subject to such disposal, though any proceeds realised from the auction or private sale would be applied first to discharge the secured debt and then to the beneficiary of the first ranking attachment. If no auction or private sale is initiated within 60 days of the attachment, any enforcement court with a prior ranking claim may request to take over the attached collateral to facilitate enforcement.
Enforcement of guarantee
The above enforcement approach is also applicable to the enforcement of guarantees in general.
As enshrined in the nature of guarantees, a lender is an unsecured creditor against the guarantor by holding guarantee, and accordingly would be subordinated to any other creditors who have taken security interests over assets of the guarantor. When the guarantee is enforced, the lender may only be repaid from the amounts that are left after the satisfaction of secured creditors from proceeds obtained from the disposal of the relevant assets subject to security interests in favour of a third-party creditor.
During the enforcement proceedings, if the PRC court finds that the guarantor does not have any assets against which any judgment can be enforced, it will suspend the enforcement proceedings. If the enforcement process is suspended, the claimant is entitled to apply to the PRC court for re-initiation of the enforcement proceeding by providing evidence relating to the assets of the guarantor against which the guarantee can be enforced.
Under PRC law, parties to foreign-related transactions are generally free to select the governing law and dispute resolution forum for the relevant contracts, provided that such choice is consistent with PRC law.
A transaction is foreign-related if any one or more of the following elements is present:
Choice of law
Parties to a foreign-related contract are free to choose PRC law or any foreign law to govern the contract, except for the following contracts (the “Mandatory PRC Law Contracts”), which must be governed by PRC law:
Submission to Foreign Jurisdiction
Parties to a foreign-related transaction are generally free to agree to submit their disputes to a PRC or foreign court, provided their choice is consistent with PRC law.
Under PRC law, parties may choose a court at any of the following locations. If one of the places below is located outside China, the parties may select a foreign court to resolve their disputes:
Mandatory PRC Law Contracts are subject to the exclusive jurisdiction of PRC courts if parties choose to submit related disputes to court.
Parties to a foreign-related contract may apply to a PRC arbitration institution or another arbitration institution for arbitration, provided that they have a valid arbitration agreement.
Waiver of Immunity
China adopts the “absolute immunity” principle, which provides complete immunity to the sovereign state. A PRC governmental authority’s waiver of sovereign immunity will not be upheld. State-owned enterprises are considered separate legal entities from governmental authorities, and therefore sovereign immunity does not apply to them.
PRC law provides for the enforcement of foreign judgments in accordance with the international treaties concluded or acceded to by China, or with the principle of reciprocity, provided that they do not violate basic principles of PRC law, state sovereignty and security, or public interest. The application of such statutory provisions is not very common, but foreign judgements are increasingly recognised and enforced in China, especially after the launch of the “Belt and Road Initiative”.
China is a member of the United Nations Convention on the Recognition and Enforcement of Foreign Arbitral Awards (New York, 10 June 1958 – the “New York Convention”). PRC courts’ recognition and enforcement of foreign arbitral awards in accordance with the New York Convention is not rare.
In the context of a cross-border transaction, it is important for foreign lenders to consider and plan the approach of channelling the enforcement proceeds of the loan and the security offshore.
A loan from a foreign lender to an onshore borrower constitutes “foreign debt” under PRC law. The relevant loan agreement for such foreign debt is required to be registered with SAFE after signing. Failure to complete this registration would affect the enforceability of the loan agreement.
A security/guarantee provided by an onshore security provider/guarantor in favour of a foreign lender to secure a debt incurred by a foreign borrower constitutes “Nei Bao Wai Dai” under PRC law. The onshore security provider/guarantor is required to register Nei Bao Wai Dai with SAFE after the signing of the relevant security/guarantee agreement. Failure to do so may lead to the proceeds of enforcement of Nei Bao Wai Dai not being remitted offshore.
Outside of insolvency proceedings, the company or a creditor of the company may apply to the court for restructuring, without initiating an insolvency proceeding.
During the restructuring period, upon application by the company and after approval by the court, the company can manage and operate its assets and business operations by itself under the supervision of the administrator. The enforcement of any security against the company’s assets shall be suspended, provided that a secured creditor may apply to the court to resume the enforcement if the collateral is likely to suffer damage or substantial depreciation in value that will impair the interest of the secured creditors.
The court will take actions to notify (or, in practice, authorise the administrator it appoints to notify) the creditors, make public announcements and verify the schedule of creditors’ claims at creditors’ meeting, etc. Additionally, the company or the administrator, shall submit a draft restructuring plan to both the court and the creditors’ meeting within six months of the date of the court ruling on restructuring (which may be extended for another three months with the approval of the court).
Within 30 days of receiving the draft restructuring plan, the court shall convene a creditors’ meeting to vote on the plan. Creditors of the company shall be divided into different voting groups by the nature, and sometimes the amount, of their claims (ie, secured debts, employees’ claims, unpaid taxes, unsecured debts and, if applicable, small amount claims). If, within a voting group, half or more of the creditors that attend the creditors’ meeting approve the draft restructuring plan, and these creditors represent two thirds or more of the total value of all creditors’ claims within the group, the draft restructuring plan shall be deemed to be adopted by the group. The draft restructuring plan is adopted if it is aapproved by all of the voting groups. If a voting group does not approve the draft restructuring plan, the company or the administrator may meet with the voting group and the voting group may vote again, provided that the results of any negotiation among such parties do not harm the interest of any other voting groups.
Within ten days of the adoption of the restructuring plan, the company or the administrator shall apply to the court for approval of the plan. Within 30 days of the date when the application is received, the court shall approve the plan, terminate the restructuring process and make a public announcement if the court, after examination, believes that the application complies with the law. Where any of the voting groups did not approve the restructuring plan at the first voting and failed again to approve it at the second voting, the company or the administrator may apply to the court for approval of the un-adopted plan, if the draft restructuring plan meets the requirements specified by law. If the court, after examination, concludes that the draft restructuring plan satisfies the requirements of law, it shall, within 30 days of receiving the application, rule to approve the application, terminate the restructuring proceeding and make a public announcement. Otherwise, the court shall terminate the restructuring process and declare the insolvency of the company.
The company shall be responsible for implementing the restructuring plan, and the administrator shall supervise the implementation. If the company is unable or refuses to implement the plan as approved, the court shall, at the request of the administrator or other interested persons (ie, a creditor of the company), rule to terminate the implementation of the restructuring plan and declare the insolvency of the company.
The insolvency procedure commences after the court accepts the application for insolvency, and all existing assets of the company (including any secured assets) form part of the insolvency assets. Consequently, any assets preservation measures attaching the assets of the company shall be released, and court enforcement proceedings shall be suspended. Any civil litigation or arbitration involving the company which has been initiated but not yet completed shall be suspended; the litigation or arbitration may resume when the administrator has taken over the company’s assets.
The administrator shall prepare a plan to realise the insolvency assets and submit it to the creditors’ meeting for discussion and approval. If the creditors’ meeting fails to adopt a resolution to approve the plan, the court shall make a ruling to decide. The administrator shall follow the asset realisation plan as adopted at the creditors’ meeting or ruled by the court, and sell or otherwise realise the insolvency assets in a timely manner.
The administrator shall also prepare a plan to distribute the realised assets and submit it to the creditors’ meeting for review and approval. After the distribution plan is adopted at the creditors’ meeting, the administrator shall submit it to the court for confirmation. The administrator shall implement the distribution plan as confirmed by the court. If the creditors’ meeting fails to adopt a resolution to approve such plan after two rounds of voting, the court shall make a ruling to decide.
Secured creditors enjoy priority rights to the proceeds realised from secured assets. If a secured creditor has not been fully repaid after exercising the priority rights, the un-repaid portion shall become unsecured debt. It is worth noting that, if a secured creditor does not waive its priority rights, it will not be entitled to vote at the creditors’ meeting on the distribution plan or any reconciliation agreement, though it will have the right to vote on these two issues to the extent of the debt that is not fully repaid by the proceeds realised from the secured asset.
In a company’s insolvency, the proceeds realised from the company’s assets will be distributed in the following order.
First. repayments will be made to secured creditors – a secured creditor enjoys priority rights to be repaid by the proceeds obtained from the disposal of the secured assets. If the proceeds are insufficient to repay the secured creditors, the unpaid portion of the debt will become ordinary, unsecured creditors’ claims.
Second is the payment of insolvency expenses and debts for common benefit – insolvency expenses and certain debts for the common benefit of all creditors are to be paid out of the company’s assets as and when they are incurred. If the assets of the company are insufficient to pay all such expenses and debts, the insolvency expenses shall be paid first. If the assets of the company are insufficient to pay all insolvency expenses or (after payment of all insolvency expenses) all the debts for common benefit, payment shall be made pro rata. If the assets of the company are insufficient to pay the insolvency expenses, the administrator shall apply to the court for conclusion of the insolvency proceeding.
Insolvency expenses consist of the following, incurred after the court’s acceptance of the insolvency application:
Debts for common benefit consist of the following, incurred after the court’s acceptance of the insolvency application:
Finally, other distributions shall be made – after payment of the insolvency expenses and the debts for common benefit, the proceeds realised from the company’s asset shall be distributed in the following order, and if the assets of the company are insufficient to pay all claims ranking in the same order, the proceeds shall be distributed on a pro rata basis:
Under PRC law, there is no concept that allows bankruptcy courts to lower the priority of a claim if the creditor holding it is guilty of inequitable or wrongful conduct (ie, fraud, illegality, breach of fiduciary duties) and delay the claim’s payment until other creditors are paid. If a bankruptcy court determines that the creditor is indeed guilty of inequitable or wrongful conduct, it will invalidate the claim rather than subordinating it.
If a company goes into insolvency, any of its transactions that conceal or remove assets for the purpose of avoiding debts, fabricating debts or acknowledging untrue debts will be declared void, regardless of when they occurred. In addition, the insolvency administrator may petition the court to set aside selective payment by the company to some but not all of its creditors, if such payment is made within six months prior to the court’s acceptance of the insolvency application and the company meets insolvency tests at the time of the payment, unless a selective payment benefits the company’s assets as a whole. Moreover, the administrator may petition the court to set aside certain transactions that occurred within one year prior to the court’s acceptance of the insolvency application, namely the gratuitous transfer of assets, any transactions at an obviously unreasonable price, the creation of security for an unsecured debt, advance payment of a debt that is not yet due, and waiver of the company’s rights as a creditor.
Project financing was introduced to China in the mid-1980s and has developed rapidly since the 1990s, with various project financing models (eg, BOT, banking project loans) being widely used and promoted.
After more than 30 years of development, the model of project financing transactions with Chinese banks involved has changed a lot. Project financing in the PRC has the following characteristics:
There is also tendency that Chinese banks become active in the project financing transactions outside the PRC.
According to PRC law, “PPP” refers to the benefits sharing, risk sharing and long-term co-operative relationship established by the government with social capital through franchising, purchasing services and equity co-operation.
In the PRC, the operation mode of PPP projects mainly includes entrusted operation, management contract, construction-operation-transfer, construction-ownership-operation, transfer-operation-transfer and alteration-operation-transfer. The application of the PPP model is wide and the project scope of PPP mode includes:
The main legal instruments in respect of PPP under PRC law include:
Under the above legal instruments, the following items shall not adopt the PPP model:
The following requirements need to be met before the lender can provide project financing to a borrower:
PPP projects need to enter the PPP project library, but banking project financing transaction documents do not need to be filed or registered with government agencies.
The responsible government bodies include:
The primary laws and regulations are as follows:
The following issues need to be considered when structuring a project financing, among others:
The common legal form of the project company is a limited liability company. Foreign investors investing in projects in the PRC are subject to relevant PRC laws and regulations on foreign investment, including but not limited to the Special Management Measures (Negative List) for the Access of Foreign Investment (2018) (外商投资准入特别管理措施(负面清单)(2018年版)).
For project financing provided by a Chinese bank, the basic structure is as follows:
For the issuance of corporate bonds in China, the basic transaction process is as follows:
For foreign investors, the acquisition of natural resources in the PRC will usually be approved by the relevant authority in advance, subject to the relevant regulations. For example, according to the Special Management Measures (Negative List) for the Access of Foreign Investment (2018) (外商投资准入特别管理措施(负面清单)(2018年版)), foreign investors can only explore opportunities in oil and gas by setting up joint ventures or co-operative companies with Chinese companies, and are not allowed to conduct exploration, mining and mineral processing of rare earth minerals.
For the export of natural resources, according to the Regulation of the People's Republic of China on the Administration of the Import and Export of Goods (中华人民共和国货物进出口管理条例), if a natural resource is included in the list of prohibited exports or restricted exports, its exports will be subject to customs restrictions. In addition, according to the PRC customs regulations, the export of any goods requires formalities such as customs declarations, inspections and tax filings.
There are plenty of environmental, health and safety (EHS) laws, including the following:
According to the Plan of Deepening Party and State Institution Reform, issued 21 March 2018, the primary regulatory bodies that oversee environmental, health and safety issues at state level are as follows:
In addition to the laws at state level, each province or self-governed unit has specific regulatory authorities for different environmental and health and safety issues. These need to be identified when the content of the project is provided.
There is no Islamic finance in the PRC.
There is no Islamic finance in the PRC.
There is no Islamic finance in the PRC.
There is no Islamic finance in the PRC.
There is no Islamic finance in the PRC.
In response to both the need to rein in the proliferating risks in the financial sector, and the pressures from economic slowdown and trade tensions with the United States (the US), China’s banking system has undergone a fundamental change. One major step taken was the creation of the Financial Stability and Development Committee. Numerous actions were also taken with the view to, inter alia, reducing risk and increasing stability in China’s financial sector, opening-up of China’s financial market to private and foreign direct investments, and cutting financing costs and channelling financing for the real economy.
In the meantime, Chinese banks and financial institutions will have to face more challenges from regulators of other countries, in particular the US.
Reform of Banking Regulatory Architecture
China’s financial regulatory structure was historically called “one bank and three commissions”, comprising the People’s Bank of China (PBOC) acting as the central bank, and the China Banking Regulatory Commission (CBRC), the China Insurance Regulatory Commission (CIRC) and the China Securities Regulatory Commission (CSRC) playing the roles of regulators for banking, insurance and securities industries, respectively.
However, with the rise of the “shadow” banking industry since 2008, which has produced firms and products that often blur the lines between banking, insurance and securities, it became very difficult to effectively regulate these hybrid institutions which often managed to fall between jurisdictions and industries. PBOC, in its capacity as central bank, does not have authority over the three commissions to coordinate regulatory efforts and handle a constantly changing, more complex financial sector. It was also difficult to take a systemic approach to regulation, which would usually require taking different areas of the financial system and their linkages into account.
In November 2017, the Financial Stability and Development Committee (FSDC) was established, a super financial regulator directly under the State Council. The role of FSDC is to coordinate overall strategy for the financial sector and formulate policy at a high level, including supervising China’s monetary policy and financial regulation, formulating policies on systemic financial risk management and maintaining China’s financial security, and giving local governments guidelines on their financial development.
Another key move of the Chinese government was the merger of China’s banking and insurance regulators, CBRC and CIRC, into one regulator, the China Banking Insurance Regulatory Commission (CBIRC) in 2018. Insurance companies were allowed to invest in many new types of assets, and issue short-term insurance policies that, since 2002, had represented risky investments in China and created serious problems in the financial sector. Chinese banks sold wealth-management products with guaranteed yield to investors, and entrusted insurance companies to invest the proceeds from these products on their behalf. The insurance companies could then leverage and invest in riskier products. This sort of off-balance sheet activity had been expanding very quickly over the years, partly resulting from the difficulty of CBRC and CIRC to co-ordinate and launch an integrated crackdown on these activities. A consolidated banking and insurance regulator would adopt more effective and efficient approaches to bring such activities back under control.
The new financial regulatory framework had streamlined the policymaking and implementation functions within the regulators and been changed into a “one committee, one bank and one commission” structure, with FSDC being the “super financial regulator”, taking the leadership role in co-ordinating the financial regulators and making macroprudential policy, mostly through PBOC, PBOC being the central bank responsible for making and implementing monetary and exchange rate policy, issuing currency, regulating interbank lending and the interbank bond market, etc, and CBIRC acting as the conduct regulator and implementer of the policy formulated by FSDC and PBOC including monitoring compliance, with a particular view to deleveraging and mitigating systematic risks, which had been piling up in the Chinese financial market in the last decade.
Reform of the Interest Rates Setting Mechanism
The loan interest rate liberalisation reform in China was launched in 2013, when PBOC announced that the lending rate floor previously set for bank loans (excluding the individual housing loan), which was 70% of the benchmark rate, as well as controls on the interest rate of bill discounting and the lending rate ceiling of the rural credit co-operatives (which was 230% of the benchmark rate), were all removed. The financial institutions were since then free to set their own loan rate.
On 25 October 2013, the Loan Prime Rate (hereinafter the "LPR") centralised quotation and publishing mechanism was officially launched, which marked the establishment of the self-regulatory pricing mechanism for the market interest rate in China. The LPR was the most preferential lending interest rate a commercial bank offers to its prime clients, calculated through using quotes provided by several panel banks. The LPR was published on a daily basis to provide a reference for the lenders on the loan market to set their own loan interest rates.
The above measures were regarded as a breakthrough for the market-oriented interest rate reform, which drove the banks to establish and improve an independent pricing mechanism for the interest rate. However, banks in practice preferred to use the benchmark loan rate set by PBOC, which was usually higher than the market-led LPR, as the key reference for them to price the loans, with the view to maintaining higher profit margins.
Amid the challenges posed by the slowdown of economy, and following the steps taken by central banks of other countries (eg, the United States Federal Reserves) to cut their financial interest rates, the Chinese government decided to take market-oriented reform measures to reduce real interest rates and ease financing difficulties. further lower the average funding costs in particular for small firms partly through, inter alia, further reforming the banks’ interest setting mechanism with the intention to improve the transmission efficiency of the market interest rates.
On 16 August 2019, PBOC released an announcement for improving the LPR setting mechanism. In lieu of publishing LPR on a daily basis, the National Interbank Funding Center would disclose the new LPR, monthly, at 9:30 am on the 20th day of each month.
The number of quotation banks were increased from ten to 18, and the types of quotation banks included were expanded from national banks to urban commercial banks, rural commercial banks, foreign-invested banks and private banks, to improve the representativeness of the LPR. The two foreign-invested banks currently included in this rate-setting group are Citibank China Co Ltd and Standard Chartered Bank China Ltd.
Banks should take the LPR as the major lending rate reference for their loans, save that loans already executed may stick to the interest setting mechanism in the existing loan agreements.
Banks were prohibited from acting in concert to set any implicit interest rate floor to ensure that the new plan is well implemented. Companies can report such practices of banks PBOC, which would be taken seriously by PBOC. The implementation of the new LPR scheme and loan interest rate competition behaviours would be included in the macro-prudential assessment of banks.
Opening up the Financial Market
With the intention to promote competition and attract foreign capital in China's financial services sector, in 2017 Chinese government offered to further open up China’s financial sector by easing restrictions on foreign businesses. One of the major changes was that foreign firms were allowed to own up to 51% of domestic securities, insurance and fund management firms, with such cap to be lifted in certain years. The Chinese government had also promised to remove limits on foreign shareholdings in banks, which was previously 20% for an individual foreign investor and 25% for a group of foreign investors, and to take similar steps in the insurance and securities sectors in the following few years. The objective was to phase in full-licence, full-ownership operation of overseas firms in China’s financial sector. Foreign-invested banks (ie, banks incorporated in China and wholly or partly owned by foreign investors) were also allowed to engage in treasury bonds underwriting, custodial business, and financial advisory services since 2017 without the need of first obtaining a license from the regulator.
In 2018, CBIRC announced reforms to further relax restrictions on foreign investment in the financial sector including raising the foreign ownership cap in life insurance companies from 50% to 51%, removing foreign ownership limits in Chinese banks, and allowing foreign owned insurance brokerages to expand their business scope to the same as that of domestic insurance brokerages.
On 20 July 2019, the Office of FSDC released 11 measures for further opening up the financial sector of China to foreign investment. It was notable that all these measures were set to open up one of the few sectors that had traditionally been heavily regulated and protected by the Chinese government, the financial services sector.
A broad spectrum of financial services is covered under these 11 measures, to make the financial services sector more open and easier to access for foreign investors.
Foreign rating firms can now rate all bonds traded on China's interbank market and exchanges. Foreign asset management companies are encouraged to invest in wealth management subsidiaries established by commercial banks. Foreign asset management companies are allowed to set up foreign-controlled asset management companies with subsidiaries of Chinese banks or insurers.
Foreign pension funds are allowed to establish or invest in Chinese pension fund management companies, and foreign investors may establish wholly foreign-owned currency brokerage companies in China.
The foreign equity ownership cap (currently 51%) in securities, fund management, futures, and life insurance business would be removed altogether in 2020, one year earlier than the timeframe previously announced by Chinese government in 2018 and set forth in the 2019 negative list.
Foreign investors can now own more than 25% equity stake in insurance asset management companies, as promised by Chinese government in 2017. The market entry requirement for foreign insurers to have 30-year’s operational experience in the insurance business before they can conduct business in China was removed.
Foreign-invested banks can now apply for type-A lead underwriting licenses in the interbank bond market. Foreign institutional investors’ investments in the interbank bond market would be further facilitated.
On 10 September 2019, the State Administration of Foreign Exchange of China (SAFE) announced its decision to remove the investment quota restrictions for Qualified Foreign Institutional Investors (QFII) and RMB Qualified Foreign Institutional Investors (RQFII). The QFII and RQFII schemes were established in 2002 and 2011, respectively, to provide foreign institutional investors with limited access to China's securities markets. After this move, foreign investors seeking to invest in Chinese capital market will no longer be subject to a quota setting limits on the amount they can invest through the QFII or RQFII schemes, and the requirements on countries and regions for those schemes will be scrapped too. although they will continue to be subject to qualification review by CSRC and registration process with SAFE. The purpose of this, as explained by SAFE, was to make it more convenient for foreign investors to participate in China’s domestic financial markets, making China’s bond and stock markets more broadly accepted by international markets.
The above efforts were reinforced by the legislation of the Foreign Investment Law in March 2019, which will come into force on 1 January 2020 (hereinafter the “Foreign Investment Law”). One major leap forward taken by the Foreign Investment Law was the adoption of the pre-establishment national treatment and negative list management system for foreign investment and the national treatment to foreign investment in all industrial sectors not included in the negative list. China, in recent years, has gradually deregulated foreign direct investment in most sectors. In 2016, the old approval system which required government review and approval for all foreign direct investments in China was abolished and replaced with a record-filing regime, under which all industrial sectors were opened for foreign investment except for specific industry sectors included on a “negative list”.
The “negative list” is a list of industries into which foreign investment is either prohibited or restricted and contains restrictions or prohibitions on foreign investment in the relevant industrial sectors. Subsequently, the Chinese government has shortened the negative list every year with the view to easing market access for foreign companies. For example, Chinese government cut the length of the negative list from 63 items in its previous version to 48 in 2018, and further to 40 in 2019. The current negative list was published on 30 June 2019, pursuant to which foreign equity ownership in securities, securities investment fund management, futures, and life insurance business would be subject to a 51% cap until 2021. As we explained above, Chinese government has pledged to remove such cap one year earlier.
The Foreign Investment Law confirmed that all foreign investments will be treated the same as domestic investments, other than foreign investments into industries that are listed in the negative list. In addition, the law highlighted “a market environment of fair competition”, “equal consultations based on the principle of fairness”, and equal application of China’s business development support policies to foreign-invested enterprises in principle. Chinese regulators should handle foreign investors’ licensing applications in accordance with conditions and procedures that are consistent with those applicable to domestic investors. Domestic and foreign investment in sectors not included in the negative list should be treated equally. The purpose was to put foreign investors on equal footing with domestic investors in the Chinese market and giving them equal protections, and to set up and perfect a mechanism for facilitating foreign investment and develop a more open and transparent foreign investment environment.
Minutes of SPC conference released for public consultation
On 6 August 2019, the Supreme People’s Court (SPC) released the minutes of a conference held by SPC on 3 and 4 July 2019 (the “Minutes”) for public consultation. The Minutes provided guiding principles on 123 legal issues frequently encountered by judges when trying civil and commercial cases, some of which related to security rules in China.
The Minutes tried to clarify one issue that had long been subject of controversy. In accordance with the PRC Contract Law, a contract signed by a company shall be binding on a company as long as it has been signed by the company’s legal representative who is registered with the company registry (under PRC law, this shall be either the chairman of the board of directors or the general manager of the company), unless the counterparty knows or has reason to know that this legal representative does not have the authority to sign.
On the other hand, the PRC Company Law requires that any guarantee or security provided by a PRC company shall be approved by its board of directors or shareholders, as required by its charter, to be binding on that company.
There had been a split of authority regarding which law shall prevail when deciding the enforceability of a guarantee or security agreement signed ultra vires by the guarantor or security provider’s legal representative. In the Minutes, SPC provided its view that a guarantee or security agreement not approved by the shareholders or board of directors, as the case may be, of the company providing the guarantee or security shall not be binding on the company, whether or not it was signed by the company’s legal representative and/or stamped with its company seal.
Thus, subject to limited exceptions, all creditors/lenders taking guarantee or security from a Chinese company for a third-party debtor/borrower shall have the obligation to review the resolutions made by the competent corporate body (ie, the shareholders or board of directors) of thecompany pursuant to its charter to decide whether the company has been duly authorised to do so.
The Minutes also provided clarity on issues related to independent guarantee. Chinese courts had historically refused to give effect to independent guarantee except in cases of cross-border transactions. In 2016, SPC issued a judicial interpretation which for the first time explicitly recognised the enforceability of independent guarantee provided by Chinese banks and financial institutions in both cross-border and pure domestic transactions.
The Minutes reaffirmed SPC’s position that independent guarantee issued by banks and financial institutions for either cross-border or domestic transactions shall be enforceable, but in the meantime emphasised that only banks and financial institutions may provide independent guarantee. In other words, any independent guarantee not provided by banks or financial institutions shall be invalid. In accordance with the Minutes, any provision in a guarantee (other than independent guarantee provided by a bank or financial institution) providing that such guarantee shall not be held invalid or unenforceable as a result of the invalidity or unenforceability of the underlying contract is unenforceable.
Given that, as a practical matter, guarantee agreements signed in almost all cross-border transactions would contain such a provision (or provisions of similar nature), to mitigate such risk it may be advisable for the parties to choose foreign laws as governing law of the guarantee agreements in the future.
The deadline for the public to give comments on the Minutes has passed, but the time for officially issuing the Minutes is still unknown. Once officially issued, the Minutes shall have an important guiding impact on Chinese courts at all levels, and judges could decide cases according to the provisions therein.
Chinese Banks Held in Contempt of US Court
On 30 July 30 2019, the United States Court of Appeals for the District of Columbia Circuit (hereinafter the “DC Circuit”) affirmed two rulings by the United States District Court for the District of Columbia (hereinafter the “DC District Court”) in the subpoena case involving three Chinese banks (hereinafter the “Banks”). The Banks had each been subpoenaed for documents relating to a US investigation into a Hong Kong entity that was accused of laundering money for North Korea’s weapon of mass destruction program.
According to the uncovered facts, there is an ongoing American investigation into a now-defunct Hong Kong front company (hereinafter the “Front Company”) that was acting on behalf of an unspecified North Korea entity.
The Banks – referred to as Bank One, Bank Two, and Bank Three in the court rulings – had been drawn into this case as they were responsible for conducting transactions on behalf of the Front Company. To aid in the investigation into the Front Company, in December 2017, the Banks were served subpoenas by the United States Attorney for the District of Columbia for information relating to the Front Company and its transactions.
The Banks refused to comply, claiming the production would violate multiple Chinese laws and urging US government to take evidence through the legal co-operation channels as provided in the Agreement Between the Government of the United States of America and the Government of the People’s Republic of China on Mutual Legal Assistance in Criminal Matters between China and the United States (hereinafter the “Mutual Legal Assistance Agreement”).
In November 2018, the US government filed a motion to the DC District Court to compel the production of documents.
On 18 March 2019, the DC District Court granted the US government’s motion to compel discovery. However, none of the Banks complied with the subpoena within the given time. On 10 April 2019, the DC District Court held the Banks in civil contempt and imposed a USD50,000 daily fine until the Banks are willing to complete production. The Banks then filed a notice of appeal.
The DC Circuit mainly discussed three issues: whether the Banks were subjected to D.C. District Court’s personal jurisdiction; whether the subpoena to Bank Three exceeded the government’s authority provided in the Patriot Act; and whether compelling the Banks to discovery violated the international comity doctrine.
For Bank One and Bank Two, the DC Circuit held that they had consented to the court’s jurisdiction when they opened branches in the US and the DC District Court can exercise personal jurisdiction over Bank One and Bank Two due to their consent.
Regarding Bank Three, which did not open branches in the US, the DC Circuit concluded that Bank Three’s maintenance of correspondent accounts in the US supplied necessary nexus for the exercise of personal jurisdiction.
The DC Circuit also reviewed the second issue of whether the subpoena to Bank Three exceeded the government’s statutory authority and concluded that all records pertaining to the Front Company’s Bank Three account and its correspondent account are ‘related to’ the US correspondent accounts.
The third issue discussed by the DC Circuit was whether the DC District Court abused its discretion when conducting the comity analysis and concluded in its rulings that the legal co-operation mechanism between China and the US was not an effective way to obtain evidence from Chinese authorities. Based on the facts and statistics given by the DC District Court, the DC Circuit saw no abuse of discretion in the DC District Court’s decision to compel compliance.
Taken together, the DC Circuit affirmed DC District Court’s contempt orders against all three Banks.
The above rulings posed a number of risks on Chinese banks. Given that the Chinese currency, Renminbi, is not freely tradable, almost all Chinese banks engaged in cross-border transactions for their clients usually have to maintain correspondent accounts in the US which activity may subject them to personal jurisdiction of US courts, whether or not they have established business presence in the US. In addition, a subpoena from the US government may compel discovery for not only records related to the correspondent account in the US, but all records related to the client’s accounts maintained with the bank, wherever such accounts were opened.
Complying with this kind of subpoena may result in the violation of a series of Chinese laws and regulations including, inter alia, Article 73 of China’s Commercial Bank Law, Article 40 of the Regulation on Credit Investigation, Article 28 of the Corporate Deposit Regulations, Article 32 of the Anti-Money Laundering Law, and Articles 64 & 66 of China’s Cybersecurity Law, and lead to a number of consequences, including fines of up to RMB500,000 by Chinese authorities. Another risk that may result from such compliance is that if the documents produced show that the banks were negligent in their compliance screenings or violated US sanctions on purpose, they may be exposed to additional investigations, enforcement actions, litigation and/or public exposure if they co-operate.
This is also the first time that the US federal district court denied the first resort to the Mutual Legal Assistance Agreement when taking evidence from Chinese banks. In this regard, the US court considers the legal co-operation with Chinese judicial authority as a futile, even though China’ Ministry of Justice has repeatedly pledged to handle US courts’ request timely manner.
With the debts mounting and the economy slowing, China has to walk the fine line between the national effort to reduce debts and maintain financial stability, and the task of boosting the economic growth. This becomes even more challenging against the backdrop of the intensifying China and US trade conflict. Chinese banks shall get ready for facing more challenges from regulatory authorities of other countries and, if possible, work out methods to align their activities with financial compliance requirements from other jurisdictions without violating Chinese banking regulations. In the meantime, in the wake of more opening-up measures in the financial sector unveiled by Chinese government, more foreign investments in Chinese financial sectors are expected.