The continuous deterioration of China-USA relations, fuelled by the outbreak of the COVID-19 pandemic, has cast a shadow on the fate of the phase 1 US-China Economic and Trade Agreement which, upon its execution on 15 January 2020, was deemed a tentative truce in the trade-war between these two nations in the past two years. The potential economic decoupling between China and the USA would bring about great challenges and uncertainties for China both now and henceforth in its external economic dealings.
Against this backdrop, China has elected to further opening up its financial market, in a bid to, inter alia, protect it from capital outflow and decoupling from the international supply chain, and gain new momentum for its economic growth. All restrictions on the ownership of foreign investors in China’s financial sector have been eliminated, the record-filing regime for foreign direct investment in China was replaced by a foreign investment information reporting regime, a Chinese company can apply for an overall foreign debt quota so that it no longer needs to register its borrowings from overseas lenders with the State Administration of Foreign Exchange case-by-case, and the master plan for the building of the largest free trade zone in the world, the Hainan Free Trade Port, was rolled out.
It was believed that China’s deeper and better integration in the global value chain would gain it a new competitive edge in the international market, which would in turn create more opportunities and provide external impetus to stimulate China’s domestic economic growth.
China was first nation hard-hit by the COVID-19 outbreak which has taken a significant toll on Chinese economy. The growth seen in the last quarter of 2019 came to an abrupt halt in February when the outbreak triggered a combined supply and demand shock, and GDP contracted by 6.8% in the first quarter of 2020. Output in the service sector declined by 5.2%, while agricultural output dropped 3.8%.
The decline in consumption accounted for almost two thirds of China’s GDP contraction in the first quarter of 2020. The private sector investment dropped by 24.4%, while fixed asset investment in the manufacturing sector saw the most sever contraction of 27.4%.
Scaling Back Restrictions
As the impact of the pandemic began to recede, China started to roll back restrictions, allowing economic activity to resume from late February. China’s economy returned to a pattern of growth in the second quarter, during which GDP expanded by 3.2%. In the meantime, China has continuously stepped up economic policy measures to rein in the risk of the pandemic-induced downturn.
The initial policy response aimed to bolster market confidence, relieve near-term cash flow problems, and mitigate more permanent economic damage in the form of bankruptcy, unemployment, and rising non-performing loans. As the lockdown measures were rolled back, the policy focus shifted toward supporting the recovery and pledging accommodative monetary policy and additional public investment, tax relief, and social transfers. The government policies have emphasised job creation as the main economic policy objective, aiming to create nine million additional jobs and keeping the urban unemployment rate target at 6%.
China's central bank, the People’s Bank of China (PBOC), has ensured ample liquidity to bolster market confidence and relieve banks’ near-term liquidity constraints. The PBOC only modestly lowered short- and long-term policy rates. Since February, both repo and medium-term facility rates have declined by 30bps. PBOC also lowered the one-year and five-year loan prime rate by 30 and 15bps to 3.85 and 4.65%, respectively, leading to a drop in interbank market rates and bond yields by 20-50bps since February. While the cut in policy interest rates was relatively modest, cuts in reserve requirements have released significant liquidity. The PBOC has cut the required reserve ratio three times, unlocking about RMB1.75 trillion in liquidity, some targeted to specific banks, including those lending to SMEs.
Targeting Sectors and Firms
In addition, special refinancing facilities by the PBOC and policy banks have provided banks with the funds to extend subsidised lending to targeted sectors and firms. PBOC has extended about RMB2.2 trillion in re-lending and re-discount facilities for banks to increase credit to affected businesses and SMEs. In addition, policy banks were offered an increase of RMB1,350 billion credit and bond quota to offer lending to private enterprises, including SMEs with preferential interest rates. Preferential loans were extended to firms involved in the production, transport, and sales of epidemic-related medical supplies and daily necessities.
China has emphasised repeatedly that banks shall use all the efforts to make sure lending was supplied to real economy, a lesson learnt from 2008 when China introduced a RMB4 trillion stimulus package to deal with the global financial crisis but found that a substantial portion of the lending ended up in housing and stock markets. On 4 September 2020, the China Banking and Insurance Regulatory Commission (CBIRC), the Chinese bank regulatory authority, sent a warning to all market players by announcing punishment of four banks and one major asset management company, with a total fine of RMB320 million, for, inter alia, providing financing for real estate projects and companies in violation of banking regulations.
Partly due to the prevalence of high credit ratings of bonds, China has not formed a mature high-yield market resembling its counterpart in the USA, in which low ranking bonds are issued at high interest rates to reflect the risks they bear. That said, similar terms do exist in China.
As of the end of 2019, it’s estimated roughly 1,500 outstanding credit bonds are classified as high-yield bonds in terms of their high interest rates. Most of them are issued by municipal investment enterprises (also known as local government financing platforms) and real estate developers, which accounts for 37% and 17% of the total issue amounts respectively. High-yield bonds in strict sense in China could be dated back to 2012 in which a pilot for SMEs private placement bonds was launched but ended up with bleak returns and high default rate.
After a long period of stagnation, recent regulatory development on financial infrastructure signals positive forces for unleashing high-yield market. On the supply side, regulatory authorities have stepped up efforts to crack down structural issuing, enhanced information disclosure and eased requirements on bonds issue. On the demand side, it is believed investors’ appetite for high-yield bonds will be boosted against the backdrop of low return on investment of safe assets and inflow of foreign institution investors.
Alternative credit providers, fuelled by fintech, especially the big data in credit scoring of thin-file customers, are gaining vast momentum in providing credit to underserved populations and engendering financial inclusion in China. A notable trend is the market is evolving in a progressively regulated manner.
The once-hot peer-to-peer (P2P) lending is withering under heavy-handed oversight for the financial risks as well as moral hazard resulting from incompetent risk control and unproportionate guarantee for investment returns by platforms. P2P platforms received the ultimatum from the Leading Group of Internet Financial Risks Remediation, the top internet finance regulator, in the end of 2019 to exit the industry, with qualified firms to be transformed into licensed micro loan lenders.
Traditional banks are also deploying services in this emerging market. Development in securitisation help refinancing the underlying debts thus buffers fund raising for alternative credit providers. But the regulatory outlook is not fair straightforward.
In a recent judicial interpretation released in August 2020, the Supreme People's Court has significantly lowered interest cap for private lending with the view to slashing usurious loan pricing. This have sparked industry concerns over its ripple effects on alternative credit providers who charged high interests to mitigate risks. Besides, the tightened regulations on personal data may burden alternative credit providers with compliance requirements.
Originating from basic IT systems to online financing, the banking and finance techniques in China have entered the era of fintech.In August 2019, the PBOC released a three-year plan outlining the government’s holistic approach on strengthening the development of fintech sector. A survey by PWC and China Banking Association in 2019 shows around 100 banks in China have partnered or will partner with fintech firms on capacity building in this regard.
The most appealing finance techniques includes big data, artificial intelligence, cloud computing, blockchain, IoT, etc. Many financial institutions are seeking to deploy fintech to enhance their ability on providing customised services, targeted marketing, retaining customers and risk control and management. Fintech has great potential of leveraging a financial institutions' ability to serve clients in an agile manner. For instance, consumer credit services are embedded in many e-commerce platforms like Suning, JD and Taobao.
The containment measures for COVID-19, especially as it is becoming a new normal, engender contactless finance solutions, which is an important playfield for fintech sector. Fintech-backed supply chain finance is also a hit in the finance market for being an effective tool for data verification and risk control.
The Civil Code newly enacted on 28 May 2020, although not built from scratch, revised some long-established rules (eg, relating to the transfer of mortgaged property) and introduced certain new concepts (eg, purchase-money security interests) that may have profound impacts on the lending market.
Both banks and non-bank financial institutions holding a lending license issued by CBIRC can provide loans to companies organised in China. Occasional lending between companies is also permitted, as long as the lending company does not carry out lending of money as its ordinary business. However, foreign lenders, whether banks or non-banks, can provide loans to companies organised in China.
A foreign lender providing financing to Chinese company does not need to be registered or licensed in China, or even in its own jurisdiction to do so, provided that all loans provided by foreign lenders to Chinese companies are be registered with the State Administration of Foreign Exchange (SAFE) as “foreign debt” and subject to a “foreign debt quota”, which is currently 2.5 times the net asset value of such Chinese companies.
Foreign lenders are not required to have a presence or be licensed in China to grant loans to Chinese companies, provided that such lending shall be made known to the authorities by record-filing with the National Development and Reform Commission (NDRC) and/or registering with SAFE. Government agencies in charge of foreign debt administration include PBOC, NDRC and SAFE, each undertaking different but in no way distinctive roles.
All companies established in China other than real estate companies and governmental financing platforms can get access to foreign debt within the upper limit calculated by a formula referring to the company’s capital/net asset, a pre-set loan leverage rate and a macro-prudential adjustment parameter fixed by PBOC. A Chinese borrower shall complete a foreign debt registration with SAFE each time it borrows a loan from a foreign lender, at least three business days prior to disbursement. Foreign-invested enterprises, however, may alternatively choose to borrow foreign debts within the cap determined by the discrepancy between its registered capital and total investment amount, both registered with the State Administration for Market Regulation (SAMR).
In addition, any loans granted by foreign lender to a PRC company or a PRC company’s offshore subsidiaries shall also be record-filed with NDRC.
Recently, PBOC increased the aforesaid macro-prudential adjustment parameter from 1 to 1.25, so that the maximum amount that a Chinese company can borrow from foreign lenders went up to 2.5 times its net asset value, with a view to bolstering cross-border lending amid the uncertainties caused by the pandemic. To address the financial needs of small and medium sized high-tech enterprises whose net assets are rather small to obtain substantial foreign debt quota, some local offices of SAFE have rolled out policies to grant sizable quota to such enterprises.
Besides this, SAFE also has launched pilot programs to simplify foreign debt registration formalities to allow Chinese borrower to apply for an overall foreign debt quota up front, so that it no longer needs to register its foreign debt on a case-by-case basis as long as the foreign debt borrowed, when aggregated with all its other foreign debts outstanding, does not exceed such quota.
Foreign lenders can take any security or guarantee available to Chinese lenders. In addition to the security registration requirement under Chinese law, in cases where the security or guarantee provided by a Chinese company or individual is for a loan borrowed by an offshore borrower from an offshore lender, such security or guarantee shall be registered with SAFE. As a practical matter, SAFE registration of this kind of security/guarantee is sometimes difficult to do, in particular when SAFE believes that the possibility of the security provider or guarantor to pay off the debt when due is high or the use of proceeds of the underlying debt does not comply with regulations.
For instance, in case of offshore bond issue, the Chinese security provider/guarantor must be a direct or indirect shareholder of the offshore bond issuer in order for the security/guarantee provided by them to be registered with SAFE. In addition, a Chinese real estate developer may not be able to register a security created on the property developed by it in China for a loan borrowed by its foreign shareholder from overseas lenders with SAFE.
The current account and capital account are subject to different rules in China. Monies of capital accounts, including foreign debts, are generally under tight regulations. The proceeds of inbound cross-border lending shall be deposited in China unless otherwise permitted by SAFE.
To deposit the proceeds in China, the borrower (or issuer in case of bonds issue), following successful SAFE registration of the foreign debt, shall open a designated account to receive loan proceeds and/or repay principal and interests. It should be noted that the debt agreed, registered and repaid shall be denominated in the same currency. The proceeds denominated in foreign currency could be converted into RMB prior to or upon use of proceeds in the borrower’s discretion. In the latter case, the borrower is required to set up a foreign exchange settlement account and make payments from the same.
China’s regulations on use of proceeds, either from cross-border lending or domestic lending, is largely shaped by the policy theme prevailing for the time being. In addition to complying with relevant provisions in the loan agreement, the borrower shall also comply with laws and regulations which prohibits using the proceeds of foreign debt for:
The use of foreign debt proceeds denominated in RMB are restricted under separate but similar rules.
Banks act as the gatekeepers to make sure the above rules are properly followed. That being said, banks are no longer required to review evidence supporting the purported use of the loan proceeds before releasing such proceeds from the bank account, but shall conduct a spot checks thereafter.
The agent and trust concepts extensively used in international syndicated loans does not come with the same level recognition in China, especially in terms of security registration. Although China’s trust law could date back to 2001, this concept unfolds in a different direction with its origins under English law.
Similar terms and practices could be found in banking regulations released by CBIRC, where CBIRC recognises the roles of agent bank and security agent bank in syndicated loans.
The newly amended securities law, along with judicial interpretations of such law by the Supreme People’s Court, confirmed the role of trustee in public bond issue to take and enforce security and represent the bondholders in case of disputes.
Notwithstanding the above, there is still considerable uncertainty about whether the role of an agent, security agent or trustee appointed by subscribers for bonds or notes issued through private placement or by lender(s) of a loan other than syndicated loan will be recognised by Chinese court.
Transfer of performing bank loans and non-performing bank loans (NPLs) work in separate trajectories in China. The former is regulated by three batches of regulations issued by the CBIRC in 2009, 2010 and 2016, respectively, setting out the requirements on loan transfer. However, NPLs are generally transferred to asset management companies which may further transfer them to purchasers including foreign investors. Transfer of NPLs to foreign investors is subject to some additional regulatory restrictions. For example, NPLs owed by debtors in industries prohibited for foreign investment, or concerning sensitive information about national security (eg, national defence, military industry) or national security related industries are not allowed to be transferred to foreign investors.
Under PRC law, transfer of a loan shall become effective against the borrower only after the borrower has been put on notice of such transfer. The Civil Code, which was enacted on 28 May 2020 and will come into force on 1 January 2021, confirms that, upon transfer of an underlying debt, the security for such debt shall also be transferred, whether or not the security registration has been updated to reflect such transfer or the collateral has been delivered to and possessed by the transferee. This rule does not apply to guarantee. In accordance with the Civil Code, failure to inform a guarantor of the transfer of the underlying debt shall work to release such guarantor from its obligations.
China does not have a formed debt buy-back market.
The public acquisition rules of China require a bidder to disclose information, such as the aggregate amount of its offer, source and availability of the funds to pay the offer, payment methods and other payment arrangements in the tender offer report it prepared before the offer is announced. In the event that the funds are borrowed from bank, key terms of the loan, such as the parties to the loan, principal amount, interests, tenor, and security arrangement, shall also be set out in the report.
The bidder shall, upon announcing an offer, either deposit in a designated bank account an amount equivalent to at least 20% of the offer price, or obtain a performance bond issued by a bank covering 100% of the offer price. The bidder may otherwise require its financial advisor to commit to being jointly and severally liable for the payment of the offer price. There is no certain funds requirement in private acquisition finance.
A non-resident corporate lender without business presence in China shall pay withholding tax for interest and fees acquired from China, at the rate of 7% for lenders from Hong Kong and 10% for lenders from other jurisdictions. However, repayment of principal is not subject to withholding tax.
Lenders (including non-resident lenders) providing loans to Chinese borrowers shall pay VAT and VAT surcharges (eg, urban construction and maintenance tax, the education surcharge and the local education surcharge) for the interest paid by the borrowers. In addition, both the lenders and borrowers shall pay stamp duty for the loan agreement at a rate of 0.005% of the principal unless otherwise exempted by relevant regulations.
There is no limitation under PRC law on the interest rate charged by banks and financial institutions holding a lending license. However, in accordance with a recent judicial interpretation released by the Supreme People’s Court, interest rates for private lending shall not go beyond four times the one-year Loan Prime Rate (LPR) announced by the National Interbank Funding Center, applicable when the lending is made. By way of example, the one-year LPR announced on 20 August 2020 was 3.85%, so the upper limit on the interest rate of all private lending made during the period between 20 August 2020 and 19 September 2020 could be as much as 15.4%.
A broad range of assets are available as collaterals under Chinese law, which can be roughly divided into three categories: real estate, movables and property rights.
Registration of security usually does not take much time if all required documentation is in place and accepted by the registrars, which marks the starting point of the registration process. In light of the ongoing campaign for digitalisation of governmental services and integration of security registration procedures, security perfection is expected to be simplified and more convenient in the future.
Real estate includes land and buildings (including buildings under construction). Security created on real estate shall become valid upon registration. Given the varied ownership status and purposes of real estate, certain land and buildings (eg, land and buildings of hospitals and schools) are not allowed to be secured. This said, the creation of security over Rural land (including farmland) will be allowed after 1 January 2021 when the Civil Code becomes effective.
Movables such as equipment, raw materials, work-in-progress, half-finished products and finished products can either be mortgaged or pledged at the option of the parties. The perfection requirements on movables largely depends on the type of security selected.
Mortgage over movables becomes effective between the mortgagor and the mortgagee upon execution of the security agreement, but the mortgagee can gain priority over a third-party creditor only after such mortgage has been registered with SAMR. Pledge over movables, to the contrary, does not need to be registered. Such pledgee is perfected when the pledgee takes possession of the collateral. Given that the pledgee’s possession or excessive control of the movables may interrupt the business of the pledgor and, therefore, is usually undesirable for both parties, pledge over movables is not a prevailing practice in China except for cash pledge.
Equity interests, receivables, IP rights and deposit certificates and other property rights can be pledged, and most of such pledges shall be perfected by registration with only limited exceptions.
Under Chinese laws, a floating charge can be created only over all of the present and future machinery, raw material, work-in-progress and finished products of a company. Such floating charge will be crystallised into a fixed mortgage and become enforceable upon occurrence of an event of default. A floating charge shall be registered with SAMR. A “floating charge” over other types of collateral is not permitted.
Companies in China are generally free to give downstream, upstream or cross-stream guarantees. However, in case a company is to provide upstream guarantee or security for its shareholder or de facto controller, such guarantee/security shall be approved by the affirmative vote of the other shareholders present at a shareholders’ (general) meeting who hold over half of the shares in such company.
There is no restriction on a target providing financial assistance for acquisition of its own shares, except in cases where the target is a listed company, which is prohibited from providing security or guarantee or lending for the acquisition of its own shares.
Generally speaking, governments or organisations established for the purpose of serving social well-being or the public interest (eg, schools, hospitals) are not allowed to grant guarantees for others. Creation of security interest in certain assets including, inter alia, ownership of land, facilities of schools, kindergartens, hospitals, etc, serving social benefits, assets whose title or use is in dispute, or assets attached or seized by the court, is prohibited. A company cannot take security over its own shares for debts owed by its shareholder to it.
That being said, the State Council of China published a guiding opinion, in which it pledged to support private business in elderly care and education sectors to mortgage their assets such as land use right and facilities for the purpose of obtaining financing.
Security not registered shall be released automatically upon the discharge of the secured obligations. For security requiring registration, it shall be released by an application to the registrar jointly by the security provider and the creditor or by the creditor alone.
Articles 414, 415 and 416 of the Civil Code unified the once scattered and even conflicting rules governing the priority of competing security interests. The priority largely depends on three factors: type of security; time of perfection; and time of registration. If the competing security interests are of the same type, the registered security shall prevail over the unregistered ones.
If none of the security interests are registered, the creditors shall share the collateral pari passu. If the competing security interests are of different types (eg, mortgage and pledge over the same movables), the priority goes to the security interest first perfected.
Both contractual and structural subordination are workable under the PRC laws. Specifically, creditors may change the ranking of priority of their claims against the collateral through a contractual arrangement, to the extent that such arrangement will not adversely affect other creditor’s interest in such collateral. There are no explicit rules nullifying the contractual subordination provisions in the context of insolvency of the debtor.
Collateral usually becomes enforceable upon the occurrence of the event of default, in which case the creditor and security provider may discuss and reach an agreement on the methods of disposal of the collateral including conversion into value, sale and public auction. If the parties fail to reach an agreement, the creditor may petition the court for enforcement of the security, and obtain a court order for judicial sale of the collateral. It should be noted that Chinese law does not allow the lender and the security provider to agree before the loan matures and becomes payable that title to the collateral shall be transferred to and vested in the lender when it becomes enforceable and, therefore, a Chinese court may refuse to give effect to a foreclosure clause in the security document.
In accordance with the Civil Code, a guarantor’s obligations shall be conditioned on the creditor’s having first exhausted legal remedies against the principal debtor, unless the guarantor has explicitly agreed that it shall be jointly and severally liable for the underlying debt.
In cross-border lending transactions, the parties are generally free to choose foreign laws as the governing law of their transaction with a few exceptions. For example, security over real estate located in China shall be governed by Chinese laws. In addition, pledges created over securities shall be governed by the law of the jurisdiction where such securities are converted into value or with which such securities have closest connection.
Pledges over property rights shall be governed by the law of the jurisdiction where the pledge was created. It should be noted that the choice of law shall be made explicitly to be effective, with such choice to be subject to China’s mandatory law and public policy. Unless specifically agreed by the parties, the conflicts of law rules shall be excluded from that choice.
As a general rule, parties to a cross-border lending transaction may choose to submit disputes to a foreign court, provided that such court is located in the jurisdiction where the transaction document is signed or performed, or one of the parties is domiciled or the transaction is otherwise connected. That being said, disputes related to real estate are subject to the jurisdiction of the court where such property is located. Other than litigation, arbitration is also a prevailing legal forum fully recognised in China and the parties are given wide discretion to select the seat.
Generally speaking, a waivers of immunity are upheld in Chinese courts.
Although jurisdiction of foreign court is admissible in China, the enforcement of foreign judgements may be a big headache for the parties. Unless the judgement is rendered by a court of a jurisdiction which has a bilateral or multilateral treaty, or otherwise a reciprocal relationship, with China for the mutual recognition and enforcement of court judgments, Chinese courts can refuse to recognise and enforce such judgment in China without a retrial of the merits. Even the judgments from the court in jurisdictions most popularly used in cross-border financing transactions (eg, UK, New York, etc) are not an exception. Judgments rendered by US courts have been turned down in one case while enforced in another. To date, there is still no precedent of enforcing an English court judgement while an unsuccessful try was made in 2004.
The British Virgin Islands have recently enforced, for the first time, a Chinese court judgement which may open a new chapter for the mutual recognition and enforcement of court judgements between the two jurisdictions. Enforcement of Hong Kong judgements is much easier as there was special arrangement between the Supreme People’s Court of China and the government of Hong Kong in this regard, which was reinforced by the Arrangement on Reciprocal Recognition and Enforcement of Judgments in Civil and Commercial Matters between the Courts of the Mainland and of the Hong Kong SAR signed in 2019. Chinese courts are also stepping up efforts on expanding the scope of reciprocity relationships with countries under the One Belt and One Road Initiative to accommodate the rising needs of mutual recognition and enforcement of court decisions between China and these jurisdictions.
As to arbitration awards, as China is a contracting state to the United Nations Convention on the Enforcement of Foreign Arbitral Awards, foreign arbitral awards could be enforced without a retrial of merits pursuant to this Convention subject to the declarations and reservations made by China.
See 3.1 Restrictions on Foreign Lenders Granting Loans and 3.2 Restrictions on Foreign Lenders Granting Security.
Rescue mechanisms available for an insolvent debtor include restructuring and compromise.
If a debtor is unable to pay its debts, and the value of its assets is less than the amount of its liabilities, either the creditor or the debtor may petiton to the court for restructuring. Where a creditor has filed a bankruptcy application against the debtor, the debtor or a shareholder holding more than 10% of the debtor’s share capital can also petition for restructuring after the court has accepted the application and before the court declares the debtor bankrupt. A restructuring plan must be adopted by a majority of the creditors in each voting class present at the creditors' meeting representing at least two thirds in value of total claims in that class.
The creditors are classified according to whether they are secured creditors, employees, agencies with outstanding tax claims, and ordinary claims. If the restructuring plan is adopted by all classes of creditors, the administrator or debtor must file an application to the court for approval within ten days from the date of adoption. A restructuring plan approved by the court is binding on the debtor and all its creditors. Those creditors who have not filed their claims cannot exercise their rights until after the implementation of the restructuring plan and then only in accordance with the discharge conditions for the same class of claims provided in the restructuring plan. The creditor’s rights in respect of any guarantor of the debtor or other joint debtors are not affected by the restructuring.
The debtor may otherwise apply to the court to limit and settle its liabilities with its creditors by submitting a compromise proposal after the court has accepted a bankruptcy petition against the debtor and before the court declares it bankrupt. A compromise proposal must first be approved by a majority of the creditors with voting rights present at the meeting representing more than two thirds in value of the total unsecured claims, and then submitted to the court for approval. A compromise proposal that is approved by the court is binding on the debtor and all its creditors who had no security when the court accepted the bankruptcy petition.
Those unsecured creditors who have not filed their claims cannot exercise their rights until after the implementation of the compromise proposal is completed and then only in accordance with the discharge conditions in the compromise proposal. The unsecured creditors’ rights in relation to any guarantor of the debtor or other joint debtors are not affected by the compromise procedure.
Secured creditors are subject to a moratorium during restructuring, they can apply to the court for enforcing their security if they have reasonable ground to believe that the secured assets will suffer damage or diminution in value that will prejudice their security interest therein. However, the secured creditors are not subject to a moratorium and can exercise their security rights during the compromise procedure.
Once the bankruptcy proceeding commences, any attachment in relation to the debtor’s assets is lifted, and any security or judgment enforcement procedures are suspended. Further, any civil litigation or arbitration against the debtor is suspended until an administrator is appointed.
Claims towards an insolvent debtor shall be paid in the following order pursuant to the Enterprises Insolvency Law enacted in 2006:
China has not yet developed full-fledged rules on equitable subordination, but is no doubt on its way. In 2015, the Supreme People’s Court affirmed a decision of a lower court which held that the claims of a shareholder who failed to contribute all the share capital it subscribed for should be subordinated to the claims of the other creditors. In 2018, the Supreme People’s Court published a judicial guideline which provided that, upon bankruptcy of a debtor, claims resulting from undue influence from such debtor’s related-party shall be subordinated to the claims of other creditors, and security provided by the debtor for such claim shall not be enforceable.
Security provided by the debtor for any previously unsecured debt, or prepayment of any loan before it comes due within one year prior to the court’s acceptance of a bankruptcy petition against the debtor may be avoided by the court. Repayment of a debt to any specific creditor within six months before the court's acceptance of the bankruptcy petition may also be avoided. In addition, where a loan is secured and/or guaranteed by multiple security providers and/or guarantors, in the event one of them goes bankrupt, the other security providers and/or guarantors may file a claim against it which may compete with the claim of the creditor. As such, it is usually advisable to include a non-compete clause in the security documents.
Project finance grows hand in hand with infrastructure projects blooming in China over the past several decades. The political initiative for building new infrastructure for a digital economy in China may heats up a new wave of rise in project finance. As the industry is characterised for being complicated and capital intensive, financial institutions are expected to navigate intricate industry policies and regulations to kick off a deal and provide tailored financial solutions for each project.
Since its explosive growth in 2014, public-private partnerships (PPPs) have become a ubiquitous financing method in China’s infrastructure sector. As of August 2020, the dashboard produced by the China Public Private Partnerships Center, under the Ministry of Finance (MOF) is tracking over 9,000 PPP projects of more than RMB14 trillion across multiple sectors including transportation, environment protection, education, etc. Most of them are still in the early stages and it remains to be seen whether they will live up to the social and financial expectations of multiple parties.
The MOF and NDRC have formulated a number of regulations and guidelines on the development and financing of PPP projects. PPP projects shall meet certain threshold or capital contributions, which was lowered in late 2019 for certain types of projects to ease the financial stress on investors. In addition, there are limitations on the amount of investment received from government.
Project finance is usually used in industry sectors that are highly regulated and, therefore, is often subject to government approvals or licences depending on the type of the project. In most cases, a right to use the land where the project is to be constructed and operated from has to be obtained from the government via a public auction, with a land use fee to be paid up front. For projects in particular sectors, a special permit or licence from the government may be required. For example, for a hydropower project, a permit is required to use or obtain access to water resources.
Large-scale infrastructure or energy projects usually invite a broad range of compliance issues ranging from acquisition of lands, construction of facilities or premises to industry licences, environmental and safety compliance and data compliance amid the new infrastructure political initiative in the wake of digital economy.
There is no special rule for the registration or filing of finance documents under a project finance transaction, so parties need only follow rules generally applicable to lending transactions. For example, finance documents in a project funded by a foreign lender may need to be registered with SAFE.
The oil and gas and power and mining sectors in China are basically under the administration and supervision of two governmental agencies, the Ministry of Natural Resources and the National Energy Administration under NDRC.
The Ministry of Natural Resources takes charge of the registration of mining rights and issuance of mining licences. On 17 April 2020, the Ministry of Natural Resources released a public announcement which very much simplified the once complicated formalities for the registration of mining rights.
The National Energy Administration is responsible for formulating national energy development schemes and industry guidelines and standards. It is also the government body responsible for approving most investments in energy sector.
Parties in project financing deals usually come across the same issues when structuring other financing deals; these issues may need to be viewed from a different perspective taking into account the longer time span the project may stretch. Most notably, as project financing usually involves both debt financing and equity investment, it is critical for the parties to give careful thoughts on how debt and equity investments shall interact over time, and reflect this in the terms of the financing documents (eg, conditions precedent, change of control). Banks may also want to have a clear understanding of the future cash flow and profit model of the project, in order to decide whether to have in place additional protections such as credit enhancement tools and security.
A project company in China is usually organised in the form of limited liability company. Subject to restrictions under the negative list for foreign investment issued by Chinese government, foreign investors are generally allowed to invest in a project company. Free trade agreements or other bilateral or multilateral treaties entered into by China may facilitate the access of foreign investors from jurisdictions covered in such agreements or treaties to Chinese market.
Project financing is typically structured in a combination of debt and equity investments, especially when there is a threshold requirement for capital contribution in PPP projects in China. Bank loans are the dominant source of funding to a project, with syndicated loans being more commonly used given the sheer amount needed and the underlying risks to finance a project. Export credit agency financing is also commonly used, particularly in projects involving foreign financing party. Project bonds are usually seen in projects where the construction has finished and the cash flow could be estimated.
In accordance with the latest negative list for foreign investment unveiled in June 2020, foreign investors are allowed to invest in most areas in the mining sector, with limited exceptions such as exploration, mining and ore dressing of rare earth, radioactive minerals and tungsten. Foreign investment is encouraged in some areas, such as exploration and mining of potassium salt and chromite. Under the Foreign Investment Law, foreign investors may invest in business not restricted or prohibited for foreign investment by such ways as greenfield investment, merger and acquisition, or financing a project individually or in partnership with Chinese parties. Other than capital repatriation out of China, a foreign investor may alternatively enter into a product sharing agreement with its Chinese partner to either share the products produced by the joint venture it established with the Chinese partner, and sell such products to domestic or overseas customers.
The Ministry of Ecology and Environment is responsible for overseeing the environmental compliance of companies. All projects shall go through an appraisal of its impact on the environment.
The Ministry of Emergency Management is the watchdog for work safety in natural resources project, with the authority to, inter alia, review the safety conditions of oil and gas pipeline, give safety production permit to oil and gas business, and review design of safety facilities for mines.
The trade war between China and the USA, which started in 2018 has in the past year escalated to a full-scale geopolitical tension. The outbreak of the COVID-19 pandemic, and the pandemic-induced global recession, has further exacerbated the situation.
The outbreak has exposed significant vulnerabilities to global supply dependence, in particular in certain sensitive areas such as medical supplies, which may trigger some reconfiguration of global supply chains as governments may seek to diversify supply capacities and reduce dependence on single source market like China. The potential economic decoupling between China and the USA, as well as the threatened international geopolitical containment of China initiated by the USA, in a post-COVID-19 world, would cause unprecedented challenges and uncertainties for China both now in its efforts to recover from the COVID-19 shock and henceforth in its external economic dealings.
In response to the shift in the external environment, and in order to ensure a sustainable development and the security of the Chinese economy, China has decided to turn its development pattern towards an increased reliance on its domestic market.
Turning Toward the Domestic Market
From the outset of China’s reform and opening-up in late 1970s, China has adopted an export-driven strategy of internationalisation whereby China imports raw materials and components from overseas, processes them locally and exports the finished goods in exchange for foreign currencies. China became the world’s largest trading nation in goods in 2013, which helped it overtake the USA to become the world’s largest economy in purchasing-power-parity terms in 2014. However, the contribution of net trade to China’s GDP growth has constantly declined, with the domestic consumption becoming the major driver of its economic growth.
In 2018, about 76% of China’s GDP growth came from domestic consumption, while net trade made a negative contribution to GDP growth. With the sudden and dramatic drop in foreign trade demands following the COVID-19 outbreak, and the potential reconfiguration of global supply chains and trading patterns to follow, China decided to rely on its huge and rapidly expanding consumer market to gain its future growth momentum.
A new strategy
In May 2020, Chinese government laid out a new strategy called “domestic-international dual circulation”, which envisaged a new development pattern where “domestic and foreign markets can boost each other, with domestic market as the mainstay”, and fostering “new strengths in international co-operation and competition under the new circumstances.”
The prime objective of the new strategy is to maintain the security of China’s production chain and the stability of its supply chain, against the backdrop of the on-going anti-globalisation movements and the disruptions in the global supply chain, through a complete localisation of its industrial and supply chains. China has the most complete industrial chain in the world, but the weakness of the high-end links of its production and supply chains also exposes it to great risks and uncertainties. China depends on foreign suppliers on core components and high-end products in some strategic industries, which had been utilised by the USA through imposing various sanctions against Chinese high-tech companies to cut off their access to US supplies and technologies. Taking into account the unfavourable external environment, which is not likely to get better in the near future, China has turned towards its domestic consumer market for supporting its upgrading of its industrial and demand chains, and establishing fully indigenised and achieved self-sufficiency in its key value chain such as semiconductor.
In the meantime, the new strategy also envisaged a high-quality opening up of Chinese market. A strong domestic consumer market and a stable domestic supply chain will work together to empower China’s deeper and better integration in the global value chain and gain a new competitive edge in the international market, which will in turn create more opportunities and provide external impetus to stimulate China’s domestic economic circulation.
China has already put into motion the new strategy, but there are still a lot to be done. In the wake of the outbreak, China needs to lay the groundwork for the new strategy first by optimising its business environment in accordance with higher standards, so that all businesses, domestic and international, can compete on an equal footing. Notably, China has recently introduced a series of new opening up policies including further liberalising the service sector, shortening the negative list for foreign investment, and speeding up the building of the Hainan Free Trade Port.
Opening Up the Financial Market
China’s opening-up policies started with its manufacturing sector. After many years’ development, China is now playing a central role in the international industrial and supply chain. However, the continuing slowdown of Chinese economy in recent years indicates that the contribution of the manufacturing sector to China’s GDP growth has gradually declined, and China must look for new impetus for its economic growth.
China has been the world’s largest goods trading nation since 2013, but accounted for only about 6.4% of global services sector trade in 2017. A study found that a 50% reduction in service trade restrictions could lead to total factor productivity growth in China of up to 3.55% in certain sectors, and the liberalisation of services sectors could boost total factor productivity in manufacturing firms by 9.2% and increase welfare and household income by 5.3%. Thus, attracting foreign capital and promoting competition in its services sector has become China’s key move to gain new growth momentum for Chinese economy, with the financial sector being the first pick.
Easing restrictions on foreign business
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, China Banking and Insurance Regulatory Commission, the banking authority of China, 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 the Financial Stability and Development Committee, the super financial regulator directly under the State Council of China, 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 was covered under these 11 measures, to make the financial services sector more open and easier to access for foreign investors.
Changes under the 11 new measures
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.
Participation in Chinese banking and insurance
On 15 October 2019, the State Council of China announced its decision to amend the Administrative Regulations on Foreign-invested Banks and the Administrative Regulations on Foreign-invested Insurance Companies. Some substantial limits on foreign investors’ participation in Chinese banking and insurance sectors were eliminated. In respect of the banking sector, one major progress was that the minimum USD10 billion total asset requirement on each foreign shareholder of a wholly foreign-owned bank or a Sino-foreign joint venture bank, and the minimum USD20 billion total asset requirement on each foreign shareholder of a foreign bank’s branch in the PRC, were both removed.
In addition, the approval and licencing requirement for foreign-funded bank engaging in RMB business was also eliminated. In the insurance sector, the requirement that a foreign insurance company must have engaged in insurance business for more than 30 years and have established and operated a representative office in the PRC for more than two years before being allowed to establish a foreign-funded insurance company in the PRC was removed.
Conclusion of phase 1
The conclusion of the phase 1 US-China Economic and Trade Agreement on 15 January 2020 had further reinforced the above efforts. China agreed in this agreement to ease access to most of its financial services for US investors by 1 April 2020. Although the sectors and timetables for such opening up set forth in this agreement were basically identical with what promised by Chinese government under the 11 measures, the inclusion of them in a bilateral agreement made them binding obligation of Chinese government.
On 27 March 2020, China granted approval for both Goldman Sachs and Morgan Stanley to take majority equity interest in their Chinese securities company subsidiaries, the evidence that China had kept its commitment to open up its financial sector. Although the recent tension between China and the USA has cast a shadow on the fate of the phase 1 trade agreement, China has on various occasions reiterated its commitment to continue to open up its financial market to foreign players.
Further Shortening the Negative List
The Foreign Investment Law of the PRC, as well as its implementing regulations, came 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
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 it reduced further to 40 in 2019.
The 2019 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.
New reporting regime
With the implementation of the Foreign Investment Law from 1 January 2020, the record-filing regime was further replaced by a foreign investment information reporting regime. Article 34 of the Foreign Investment Law requires foreign investors or foreign-invested enterprises (FIE) to submit and report investment information to the Ministry of Commerce through the enterprise registration system and enterprise credit information publicity system maintained by the State Administration for Market Regulation. The content and scope of reporting should be determined under the principle of necessity.
Investment information that can be obtained through interdepartmental information sharing is not required to be submitted repeatedly. It’s worth noting that both negative-list FIEs and non-negative list FIEs are subject to such information reporting regime, and the requirement that subjected negative-list FIEs to approval of the Ministry of Commerce was abolished.
China released its current national negative list on 23 June 2020, which further cut the number of industrial sectors on the list from 40 to 33. As was promised in the previous version, the foreign ownership caps on securities, fund management, futures and life insurance companies were all removed from the current list.
By far, all restrictions on the ownership of foreign investors in China’s financial sector have been eliminated, which marked 2020 as the first year of the full opening up of China’s financial sector.