China-Related Acquisition Finance: SAFE Confirms The 50% Assets Rule Is dead .

 

13 June, 2017

 

 

On 27 April 2017, China’s State Administration of Foreign Exchange (“SAFE”) published a Policy Q&A Paper (the “April Q&A”) in relation to its Notice to Further Promote the Reform on Foreign Exchange Administration and Improve the Verification of Authenticity and Compliance (国家外汇管理局 关于进一步推进外汇管理改革完善真实合规性审核的通知 (汇发 【2017】3 号)) (“SAFE Notice 3”).

 

The April Q&A has clarified that the so called “50% Assets Rule” has been abolished. This was the rule which prevented lenders from taking any onshore guarantees or security in an acquisition financing of an offshore target if the target group’s assets in China represented more than 50% of its total assets. This is a welcome development which may enhance the credit on China-related acquisition financings going forward. But investors should note that acquisitions involving no injection of proceeds onshore (as would be the case with a typical leveraged buyout) are likely to attract enhanced scrutiny from SAFE in the registration process.

 

Background

 

The current regulatory framework for “Outbound Security” transactions (i.e. transactions involving an offshore loan supported by onshore guarantees or security, a.k.a. Nei Bao Wai Dai) was introduced by SAFE in 2014. At that time, the Chinese authorities were tackling an overheating economy and hence the rules were aimed at cooling down the market for Chinese assets by preventing lenders from taking Outbound Security for loans to fund onshore purposes, including:

 

(i) investment into a Chinese entity by way of debt or equity (the “No Onshore Investment Rule”); 

 

(ii)  acquisition of an offshore target if the target group’s assets located in China represented more than 50% of the total assets of the target group (the “50% Assets Rule”); or

 

(iii)  refinancing any offshore debt the proceeds of which were invested into a Chinese entity by way of debt or equity (the “Refinancing Rule”).

 

These rules – particularly the first two – have significantly shaped the structure of inbound China transactions and limited lenders’ expectations in terms of credit support.

 

Rules overturned

 

By the end of 2016, the economic backdrop had changed, and the focus of concern had shifted to addressing the downward pressure on the renminbi exchange rate and increasing net capital outflows. Rules that made economic and political sense in 2014 no longer did.

 

Hence SAFE Notice 3. This notice (published in January 2017 and discussed in our Client Alert on the topic) completely reversed the No Onshore Investment Rule in a clear bid to encourage inbound investment activity. However, it was ambiguous as to whether the 50% Assets Rule and/or the Refinancing Rule remained in place; and commentators had disagreed as to the more likely interpretation. Some had argued that the abolition of these rules was implied (as both were derivative of the main No Onshore Investment Rule). Others had expected that the 50% Assets Rule would remain, given that its abolition arguably runs contrary to the policy objective by facilitating outbound capital flows (via the enforcement of Outbound Security) on transactions which do not necessarily involve any new direct inbound investment (because all funds flows remain offshore).

 

The April Q&A has now clarified that both the 50% Assets Rule and the Refinancing Rule have been abolished by SAFE Notice 3. This sheds light on the impact of SAFE Notice 3 on typical transaction structures, as summarised in the table below: 

 

 

SAFE Notice 3 preserves (notwithstanding the abolition of the No Onshore Investment Rule) the prohibition against the proceeds of Outbound Security loans being applied towards portfolio investments in Chinese securities, unless SAFE approval is obtained.

 

It is not yet clear whether SAFE will allow lenders to obtain Outbound Security in relation to already completed financings where the rules now allow Outbound Security of that nature to be taken.

 

Enhanced scrutiny where proceeds remain offshore

 

Outbound Security contracts will still need to be registered with SAFE in accordance with the 2014 rules, but the new policy is likely to affect SAFE’s approach to accepting registrations. Now, SAFE should routinely accept registrations where the loan proceeds are to be injected onshore; but conversely, if the loan proceeds are to be retained offshore (as is the case in a typical leveraged buyout), there is likely to be an increased emphasis on SAFE’s duty to verify the authenticity of the underlying transaction. This verification will probably be principally focussed on two aspects:

 

• no round-trip entity: SAFE may require evidence that the onshore guarantor/security provider is a genuine foreign invested entity rather than a round-trip entity ultimately funded by a Chinese investor (as the latter could be indicative of a sham transaction designed to transfer assets out of China without having obtained the requisite consents); and
• genuine source of repayment: SAFE may require evidence that there is a reasonable and genuine source of repayment and that the guarantee is not entered into in contemplation of a default and enforcement.

 

As the policy change is relatively new, however, it remains to be seen exactly how local SAFEs will implement these criteria in practice and whether genuine transactions will fail to pass the verification tests imposed by the relevant local SAFE. 

 

Outbound investments

 

Finally, it should be noted that the April Q&A also emphasises SAFE’s role in scrutinising the use of proceeds of Outbound Security loans made to finance outbound investments. Consistent with the approach taken by the Chinese government authorities, including the People’s Bank of China, National Development and Reform Commission and Ministry of Commerce, financings of:

 

• outbound investments in “special sectors” such as real estate, hotels, cineplexes, entertainment and sports clubs; and
• outbound investments of certain types such as investments made by limited partnerships, investments in subsidiaries larger than the parent and short-term entry-exit investments, 

 

 

will be subject to additional scrutiny by SAFE in the Outbound Security registration process.

 

SAFE is expected to deny registration of Outbound Security contracts if the intended application of the loan proceeds involves any outbound funds flow from China which would be restricted under outbound investment regulations. “Restricted” is not defined in the April Q&A but may include, for example, payments into a territory or sector deemed sensitive under the outbound investment regulations or any investment for which the requisite approvals have not been obtained. 

 

Moving forward

 

The abolition of the 50% Assets Rule is a game-changer for China-related acquisition financings and could significantly enhance the credit and economic viability of such transactions going forward. Onshore security does, however, bring its own problems. In particular, taking security over most types of asset in China involves registration with the relevant asset-based registry (such as the local branch of the State Administration for Industry and Commence for equity interests or the local land resources bureau for land use rights). These processes can be complex and lengthy and, moreover, the relevant registries may still have concerns with registration, regardless of the position adopted by SAFE. This factor coupled with the uncertainty of achieving SAFE registration where the loan proceeds remain offshore is likely to cause some hesitation among investors in the short run, while the market and local authorities move towards finding a new norm. Please get in touch if there are any options you would like to explore with us. 

 

 

For further information, please contact:

 

Jian Fang, Partner, Linklaters

jian.fang@linklaters.com