Corporate lending market in the People’s Republic of China (China)2 continued to grow steadily in 2017. Pursuant to the statistics published by the People’s Bank of China (PBOC), the outstanding financing amount of financial institutions by the end of 2017 was 176,64 trillion yuan, 12 per cent higher than the previous year.3
Commercial banks are the main providers of corporate lending in China. However, trust companies also play an important role as finance providers in the loan market. The amount of trust loans accounted for 5 per cent of the aggregate financing by the end of 2017. In addition, the widespread peer-to-peer (P2P) lending platforms make it easier to finance small and medium-sized enterprises that have difficulty getting loans from commercial banks and trust companies.
There have been several significant loan transactions in the past year. One of the largest syndicated deals was a 22 billion yuan loan arranged by Bank of China to finance the construction of Hong Kong-Zhuhai-Macao bridge. In addition to domestic transactions, Chinese lenders are also very active in cross-border transactions, in particular finance projects under the Belt and Road Initiative. A high-profile deal is the financing by China Development Bank of the investment by China General Nuclear Power Corporation in the Hinckley Point C nuclear power station in the United Kingdom. Another significant loan transaction in 2017 was China CITIC Bank’s HK$6.6 billion loan facility to finance the acquisition and privatisation of Belle International, which was considered one of Asia’s largest consumer buyouts.
The high level of corporate debt in China has always been considered a major risk to the financial system. In 2016, China started a deleveraging process to reduce heavy debt. However, growing shadow banking in China since the global financial crisis has made such risks harder to reduce. Loans provided by shadow banking are less visible since many financial institutions and non-financial institutions use asset management products, trust products or entrusted loans to finance companies that cannot get credit from banks. As a result, corporate debt piled up, especially in some risky sectors.
II LEGAL AND REGULATORY DEVELOPMENTS
i Financial regulatory reform
A key reform in 2017 was the establishment of a Financial Stability and Development Committee (FSDC). The FSDC is an office of the State Council, China’s top administrative authority and is chaired by a Vice Premier. The FSDC focuses on deliberating major reform and development programmes for the financial sector, coordinating financial reform, development and regulation, coordinating issues concerning monetary policy, and coordinating the making of financial policies, and related fiscal and industrial policies. The FSDC is also responsible for analysing international and domestic financial situations, addressing international financial risks, and conducting policy research on systemic risk prevention, and treatment and financial stability.
In March 2018, the National People’s Congress approved a reform plan for the institutional organisations of the State Council (the Reform). According to the Reform, the regulator of banking industry and the regulator of insurance industry merged into China Banking and Insurance Regulatory Commission. Before the Reform, the banking industry had been regulated by the China Banking Regulatory Commission (CBRC) since 2002 and the insurance industry had been supervised by the China Insurance Regulatory Commission (CIRC) since 1998. The Reform also transfers the roles of drafting key regulations and macro prudential supervision of the CBRC and CIRC to the PBOC.
ii Inspections and sanctions
In order to combat shadow banking, high leverage ratio and other risks in the financial market, banking regulator issued a series of regulations and launched a comprehensive inspection called ‘three-three-four-ten’. It refers to the chaos in the market including ‘three types of violations’, ‘three types of arbitrage’, ‘four types of improper behaviours’ and ‘ten types of chaos’.
Along with the inspection, the CBRC issued over 2,700 sanction orders in 2017. Some significant sanctions are the following: (1) 27.50 million yuan fine on the Beijing branch of China Minsheng Bank for selling fake wealth management products and violating the principle of prudent operation; (2) 19.5 million yuan fine on the Beijing branch of Agricultural Bank of China for violating the principle of prudent operation when carrying out financial instrument-related business; and (3) 722 million yuan fine on China Guangfa Bank for violating regulations when providing guarantees.
iii Regulations on shadow banking
Since the global financial crisis, China’s shadow banking grew dramatically to provide loans to borrowers who cannot get credit from banks. Shadow banking can be broadly defined as off-balance sheet credit intermediation outside of regulatory framework. Typical examples are entrusted loans, trust company loans, P2P lending and other off-balance sheet business. Many shadow banking funds venture into risky sectors, such as real estate and stock market and many are provided to local government investment platforms.
In 2017, the CBRC issued a series of regulations to restrict shadow banking, such as Measures for the Administration of Entrusted Loans by Commercial Banks to regulate entrusted loans. Circular for Regulating Bank-Trust Business to restrict trust companies loans, Plans for Regulating Risks of Internet-based Finance to regulate P2P loans. All these regulations aimed at reducing the leverage ratio and avoiding systemic financial risks.
iv Basel III – capital adequacy requirements
China implemented Basel III on 1 January 2013 pursuant to the Pilot Rules on Capital Management of Commercial Bank issued by CBRC. Capital requirements in China are 11.5 per cent for systemic important financial institutions (SIFIs) and 10.5 per cent for non-SIFIs.
III TAX CONSIDERATIONS
i Stamp duties
The parties to a loan agreement executed within the territory of China shall pay stamp tax at a rate of 0.005 per cent of the loan amount. If a loan agreement is executed outside China but will be used in China (for example, for governmental registration or court enforcement), stamp duties will also be applicable.
ii Income taxes
Interests received by a lender will be subject to income taxes. The tax rate for resident lenders (which is incorporated in China or considered as a permanent entity in China) is 25 per cent.
A non-resident lender will be subject to a tax rate of 10 per cent, which shall be withheld by the borrower when making payment of the interest. This income tax rate may be reduced pursuant to a tax treaty between China and the country or region of tax residence of a foreign lender. For instance, pursuant to the Arrangement between the Mainland of China and the Hong Kong Special Administrative Region for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income promulgated in 2006, the income tax rate for a Hong Kong lender is reduced to 7 per cent.
iii Value added tax
Interest under a loan agreement is subject to value added tax (VAT) after the VAT reform in 2016. The VAT reform is aimed to replace business tax by VAT in all industries, including financial services sector. Pursuant to the Notice of the Ministry of Finance and the State Administration of Taxation on Overall Implementation of the Pilot Programme of Replacing Business Tax with Value-added Tax, which took effect on 1 May 2016, financial services including providing a loan facility within China shall be subject to VAT at a rate of 6 per cent.
China implemented the Foreign Account Tax Compliance Act (FATCA) model 2 intergovernmental agreement. China has reached agreement in substance with the United States,4 although the formal intergovernmental agreement has not been released and come into effect to date.
In most cross-border loan transactions involving China, FATCA provisions are inserted into the facility agreement. Such provisions require that, when the borrower is obliged to make a FATCA deduction, the amount of the payment due from the borrower to the lender shall be increased to an amount that (after making any FATCA deduction) leaves an amount equal to the payment that would have been due if no FATCA deduction had been made.
To fulfil the obligations under the Convention on Mutual Administrative Assistance in Tax Matters and the Multilateral Competent Authority Agreement on Automatic Exchange of Financial Account Information, the Chinese government issued Administrative Measures for the Due Diligence Investigation of the Tax-related Information of Non-resident Financial Accounts, effective from 1 July 2017. A financial institution incorporated in China has the obligation to distinguish accounts of different types to understand the tax resident status of their respective account holders or relevant controllers, identify non-resident financial accounts, and collect and submit account-related information to tax authority and financial regulators. Banks have revised their accounts documents to comply with these due diligence and reporting requirements, but so far loan agreements have not been affected.
iv CREDIT SUPPORT AND SUBORDINATION
The legal framework for taking security in China was first established in 1995 by the PRC Security Law, supplemented by the Judicial Interpretations of the Supreme People’s Court (SPC) on Certain Issues Concerning the Application of the Security Law. In 2007, the PRC Property Law came into effect, which improves the security law regime by allowing more types of asset for security and simplifying the process for perfection and enforcement of security. There are three types of security in China:
- Mortgage: A mortgage can be created on either immovable or movable properties, including land, buildings, aircraft, ships, cars, raw materials and finished products. A mortgage must be evidenced in writing. The mortgaged property remains in the mortgagor’s possession. The mortgagee enjoys priority over the mortgaged property in the event of the mortgagor’s insolvency, but ownership of the mortgaged property will not be transferred to the mortgagee.
- Pledge: A pledge can be created in respect of movable properties or rights. Rights that can be pledged are limited to proprietary rights, including bills, certificates of bonds, certificates of deposit, warehouse receipts, bills of lading, fund units, shares, proprietary rights under intellectual properties or receivables. To create a pledge, a written contract must be signed and the pledgor needs to transfer to the pledgee possession of pledged movables or title documents representing the rights. If the rights are not evidenced by title documents but by registration at a relevant authority such as fund units, shares, intellectual property, the pledge must be registered at the same registration authority.
- Lien: a lien is created by law under limited situations. The beneficiary of the lien must take possession of the property in a lawful manner, otherwise it will not be entitled to the security rights over the property.
Security over real estate is created by way of mortgage. Real estate that can be mortgaged refers to buildings and other fixed objects on the land; land use right; and buildings under construction.
PRC law distinguishes between the ownership of land and the right to use land. All land in China is either state-owned or collectively owned. The land ownership cannot be mortgaged. Land use right is granted by the state to a person to entitle him or her to the exclusive use of a piece of land for a specified purpose within a specified term. The maximum term that can be granted for the right to use a piece of land varies from 40 to 70 years.
Security interests created over the real estate shall become effective upon completion of mortgage registration. Registration of the mortgaged real property shall be made with the real estate registration authority at or above county level.
Tangible movable properties
Security over tangible movable properties can be created by way of either mortgage or pledge.
Pursuant to Article 180 of the Property Law, movable property that can be mortgaged includes machinery, equipment, raw materials, semi-products and products that the mortgagor is legally entitled to dispose of. Article 181 of the Property Law further provides that by entering into a written contract an enterprise as mortgagor may create a mortgage over its existing and future acquired machinery, equipment, raw materials, semi-products and products. To perfect the mortgage, it shall be registered with the company registration authority. In the absence of the mortgage registration, the security interest so created cannot defend against competing claims of a bona fide third party.
Machinery, equipment, raw materials, semi-products and products as movable properties can also be pledged. To create an effective pledge, the movable properties shall be transferred to the pledgee’s possession. Possession can be either physical or constructive. As banks will not take physical possession of movable properties, pledge is usually created by a collateral management agreement to be entered into with a warehouse keeper.
Security over shares is created by way of pledge. Perfection procedure will be different between shares of listed companies and non-listed companies. Listed companies are registered and cleared at the securities register – the China Securities Deposit and Clearing Corporation Limited (CD&S). The pledge of listed shares shall therefore be registered with CD&S. Pledge of a non-listed company shares shall be registered at the company registration authority.
Security can be created over the bill of exchange and the promissory note by way of pledge. The PRC Negotiable Instruments Law defines bill of exchange as an instrument signed by the issuer to order the payer to unconditionally pay a fixed sum to the payee or the bearer of the instrument at sight or at the specified date. A promissory note is defined as an instrument signed by the bank, undertaking to unconditionally pay a fixed sum to the payee or the bearer of the instrument at sight.
An endorsement with remarks of pledge must be made on the bill of exchange or promissory note in order to perfect the security interest. In the absence of such endorsement, the pledge created over the bill of exchange or promissory note cannot defend against the competing claim from a bona fide third party.
Security over receivables is created by way of pledge. Receivables is defined as the rights to request a payment arising out of provision of goods, services or facilities, including the rights to claim present or future monetary payment and interests thereof. Typical forms of receivables that can be pledged are: claims arising from sales, including sales of goods, supply of water, electricity, gas, heating, licence to use intellectual property; claims arising from lease, including leasing of movable assets or real properties; claims arising from provision of services; toll rights arising from real properties, including highways, bridges and tunnels; and claims arising out of loans or other credit facilities.
The Property Law authorises the PBOC to register a receivables pledge. The PBOC launched an online registration system to enable the pledgee to conduct the registration.
No security can be created over any contractual rights except for the pledge of receivables.
Intellectual property rights
Security can be created over intellectual property rights by way of pledge. Intellectual property rights include patents, trademarks and copy right. Pledge over intellectual property rights shall be registered at the State Intellectual Property Office.
Cash is in general characterised as a special type of movable asset under PRC law. According to the judicial interpretation issued by the SPC, cash may be delivered to the creditor as security and the creditor shall have priority in applying this cash towards the satisfaction of an obligation owing to the creditor, provided that cash is ‘fixed’ in the form of special accounts, sealed deposits or security deposits.
An alternative practice is to create a pledge over a certificate of deposit, which is issued by the deposit taking bank. The certificate of deposit shall be transferred to the pledgee’s possession to perfect the pledge.
Other than pledge over cash deposit or certificate of deposit, no security can be created on a bank account.
Security can be created over a vessel by way of mortgage, even if the vessel is still under construction. Mortgage over a vessel that is in excess of 20 tons shall be registered with the vessel registration authority at the vessel’s nationality port.
Security can be created over a civil aircraft by way of mortgage. The mortgage shall be registered with the Civil Aviation Administration of the PRC. In the absence of the registration of the mortgage, the security interest so created cannot prevail against competing claims to which a bona fide third party is entitled.
ii Guarantees and other forms of credit support
A guarantee refers to an agreement between the guarantor and the creditor that when the debtor fails to perform its obligation under the loan agreement, the guarantor will take the responsibility of repayment. There are two types of guarantee: general guarantee and guarantee with joint and several liability.
A general guarantee will require the beneficiary first to exhaust available remedies against the debtor, to the extent of obtaining a judgment or arbitral award.
A guarantee with joint and several liability is not conditional on obtaining a judgment or an arbitral award against the obligor. When the obligor fails to perform his or her obligations, the beneficiary may require the guarantor to perform the obligations.
Both forms permit the guarantor to enjoy the obligor’s rights of dispute under the underlying contract. That means that they are not independent guarantees.
The SPC issued Provisions on Certain Issues involving Trials of Independent Guarantee Disputes, effective from 1 December 2016, to acknowledge the increasing use of independent guarantees by Chinese banks and other financial institutions in China-related transactions.
This is the first set of rules governing the issue, operation and enforcement of independent guarantees under Chinese law. It defines an independent guarantee as a written commitment of a bank or a non-bank financial institution to pay a specified or capped amount to a beneficiary upon a demand for payment and the presentation of certain documents that satisfies the requirements specified in the guarantee. This follows the general principles in the Uniform Rules for Demand Guarantee (ICC publication No. 758).
Quasi-security is not common in China, although the following alternative structures have been used frequently in practice:
- a factoring: banks use factoring to facilitate financing certain assets or commodity-based transactions;
- b hire purchase: banks use hire purchase to finance leasing transactions over equipment or ships;
- c in certain assets or commodity-based transactions, banks may also use retention of title as a credit support; and
- d a separate negative undertaking letter is not common in China; however, in some bilateral loans, some banks may require a negative pledge provision in the loan agreement.
Credit insurance has been frequently used nowadays, in particular in the project finance under the Belt and Road Initiative. China Export and Credit Insurance Corporation is the key provider of credit insurance in China and it has been very active in cross-border finance transactions.
iii Priorities and subordination
Contractual subordination of debt is possible in China. However, its validity is questionable because, according to a basic statutory principle, all unsecured creditors are treated equally (pari passu) on the debtor’s insolvency. It is therefore probable that, during the bankruptcy proceedings, PRC courts will not uphold a contractual subordination.
In a syndicated loan, the lenders may enter into an inter-creditors agreement to govern relationship among lenders, such as mechanisms for the provision of loans and the voting procedures for deciding key issues. However, in practice an inter-creditor agreement is not common in China. It is more common for the provisions governing the relationship between the lenders to be directly set out in the syndicated loan agreement.
V LEGAL RESERVATIONS AND OPINIONS PRACTICE
i Legal reservations
A legal opinion is usually qualified by various reservations. Under PRC law, corporate benefit and financial assistance are not issues. The most common reservations in China are the following.
An enforceability opinion is subject to all applicable bankruptcy, insolvency, reorganisation or similar laws affecting creditors’ rights generally.
Registration or perfect of security
Certain finance document shall be filed with relevant government authority. For example, loan by a Chinese borrower from a foreign lender shall be registered with State Administration of Foreign Exchange (SAFE), share pledge shall be registered with the company registration authority.
Choice of foreign law
Pursuant to the PRC Law on Application of Laws to Foreign-Related Civil Relations, a party in a cross-border transaction may choose foreign law as governing law.
Enforcement of foreign courts’ judgment
Except that a bilateral treaty has been signed between China and the relevant jurisdiction, a foreign court judgment will not be recognised and enforced in China unless (1) there is a reciprocity mechanism established between China and the relevant jurisdiction for mutual recognition and enforcement of court judgments; and (2) the PRC court confirms it does not contradict the primary principles of PRC law nor violates sovereignty, security and social and public interest of PRC.
Limit on certain provisions
A legal opinion will include a provision setting out which clauses of the finance documents have limits on their efficacy. For example, effectiveness of terms that seek to exclude or limit a liability or duty owed may be limited by law.
Issues not covered by legal opinions
A legal opinion will not cover those areas that lawyers are not familiar with, for example, financial and accounting matters or the taxation consequences.
ii Legal opinion practice
In a purely domestic transaction or a finance deal arranged by non-bank institutions, delivering a legal opinion is not common. Depending on the lenders’ internal risk control, some banks may require a law firm to issue a legal opinion. For regulatory compliance purpose, a legal opinion may also be required in some transactions, such as a trust company loan using funds raised from individual clients.
In most cases, there is only one law firm engaged by the lender so the legal opinion will be issued by the lender’s counsel. For bond issue deals, the issuer will engage a law firm and a legal opinion will be issued to the issuer, while banks as underwriter do not engage law firms.
Legal opinions for domestic transactions are different from international practice. In addition to due incorporation of the borrower and legal validity of the transaction documents, a legal opinion may also be required to cover compliance with law by the borrower in all its business, satisfaction of legal and regulatory requirements applicable for the transaction, etc.
In cross-border finance transactions, legal opinion letters are very common. A legal opinion will include sections of background, documents reviewed, assumptions, opinions, qualifications and reliance. Legal opinions are usually given by the lender’s legal counsel.
Choice of foreign law is valid and binding and would be given effect by Chinese courts except to the extent that it would be manifestly incompatible with public policy in China or that the choice of law was made with the intention of evading Chinese law and which, in the absence of the stated choice of law, would have invalidated such obligations.
A foreign court judgment may be enforced in China if there is a treaty or establishes a reciprocity mechanism between China and the jurisdiction of the foreign court. China is a member of the New York Convention so arbitration award will be enforceable in China.
VI LOAN TRADING
Trading of bilateral loans used to be active among banks, in particularly before 2015 when there was a loan-to-deposit ratio that shall not exceed 75 per cent. This ratio was repealed by an amendment to the Commercial Banking Law in 2015. Therefore, trading of bilateral loans is less common now. When trading bilateral loans, banks are required to comply with the principle of authenticity and complete transfer. The parties should not circumvent regulation by way of signing repurchase agreements, spot buyout plus forward repurchase, etc. Regulators specifically focus on the transfer of credit assets between banks and trust companies to avoid regulatory restrictions.
There is no concept of novation under PRC law. For assignment of outstanding loans without commitment of new loans, a notice to the obligor will be sufficient. For transfer of commitment, the transferee shall sign a new agreements with the borrower.
As the primary market of syndicated loan is yet to be promoted, it still takes time to develop the secondary market of syndicated loan. The regulatory authorities together with industry associations are actively promoting the development of syndicated loans market. China Banking Association has set up rules and issued standard documents to facilitate trading of syndicated loans.
The transfer of non-performing loans is now vigorously promoted by Chinese authorities, which is based on China’s supply-side reform and mainly aiming at reducing the leverage ratio. There are several different methods, among which debt-to-equity swap is highly recommended. Owing to the restrictions of the Commercial Banking Law, debt-to-equity swap of credit asset has to be carried out through implementing agencies, which is usually set up by a commercial bank or local government.
VIi OTHER ISSUES
i Limits on interest rate
Limits on lending interest rate is set up by the SPC through a judicial interpretation. The upper limit is 36 per cent per annum. Any interest exceeding the upper limit is not valid and the court will uphold borrower’s request to refund any interest exceeding the upper limit (if it has been paid). In addition, there is an alarm rate, which is 24 per cent per annum. For interest exceeding 24 per cent but below the upper rate of 36 per cent, the court will not uphold a lender’s claim of payment by the borrower if it has not been paid, nor a borrower’s claim of refund if it has been paid.
ii Entrusted loan
An entrusted loan refers to a loan provided by a corporate lender to a corporate borrower through a commercial bank that acts as a trustee of the lender. Entrusted loans reached 13.97 trillion yuan by the end of 2017, accounting for 8 per cent of the aggregate financing in China. In January 2018, the CBRC released the Measures for the Administration of Entrusted Loans by Commercial Banks to regulate entrusted loans and monitor risks thereof. A financial asset management company or a licensed lending institution, which had been commonly used entrusted loans to avoid regulatory restrictions, can no longer be an entrusted loan lender. The new regulation also restricts funds from asset management products of securities firms, fund managers or private equity firms to be lent through entrusted loans.
iii Fake equity investment
Fake equity investment is an innovative method of investment, which makes debt in the name of equity investment. It is typically structured by a repurchase agreement, which promises a guaranteed redemption. This makes equity investment essentially a fixed-income debt finance. Fake equity investment is commonly used by trust companies, private equity funds and insurance companies, etc., particularly in real estate and infrastructure sectors to evade regulatory restrictions. Considering the characteristics and risks of the fake equity investment, regulators have taken measures to restrict fake equity investment.
iv Foreign exchange control
The yuan is not fully convertible into foreign currency at present. Payments in foreign currency from China to offshore and receive of foreign currency from offshore to China fall under the supervision of SAFE.
Foreign debt means debt owed by a domestic institution to a non-resident in the form of foreign currency. Borrowing foreign debt by a PRC company is subject to administration by National Development and Reform Commission and SAFE.
Provision of security by a PRC entity in favour of a foreign lender (outbound security) is subject to SAFE’s administration. SAFE appealed quota for the outbound security in 2014, but non-financial entity shall register the outbound security at SAFE within 15 business days after the security document is executed. If there is any previous outbound security that has been enforced before the offshore obligor indemnified the Chinese security provider, the Chinese entity will not be allowed to provide any new outbound security unless otherwise approved by SAFE.
VIII OUTLOOK AND CONCLUSIONS
The overall enterprise debt ratio is still high in China and exceeds the warning threshold of the International Monetary Fund. Chinese regulators are undertaking financial reforms to mitigate financial risks. It is expected that more regulations will be promulgated to reduce leverage ratio and monitor risks in the debt market.
1 Gulong Ren is a partner at AnJie Law Firm.
2 This chapter does not cover Hong Kong, Macao and Taiwan.