By Qi Zhang, Dacheng Law Offices
The Provisions on Foreign Exchange Administrative of Cross-Border Security (“New SAFE Rule”) (跨境担保外汇管理规定Hui Fa  No.29) released by the State Administration of Foreign Exchange (“SAFE”) of China became effective on June 1st, 2014. The New SAFE Rule allows onshore Chinese corporations to use onshore assets as guarantee to access offshore financing (内保外贷) with no preapproval requirement. Prior to the New SAFE Rule, only state-owned enterprises, such as China Petroleum, could provide domestic assets as guarantees against offshore debt without prior approval from SAFE. Thus, the New SAFE rule is viewed as a positive regulatory development to Chinese non state-owned corporations to raise offshore capital.
For us to understand why this new provision is so important, we need to understand how offshore financing worked before. Due to the prior restrictions on cross-border transfer, if a Chinese company defaults, an offshore investor is likely to end up with nothing; thus, offshore investors ran a high risk. According to previous SAFE regulations and Chinese law, offshore investors were inferior to domestic creditors in terms of accessing a company’s assets in China. To address the concerns of foreign investors, Chinese companies came up with different measures. For example, BaoSteel Group, the second largest steel producer in the world, granted an investment and keepwell deed (written promise that BaoStell would repay overseas creditor), and a liquidity support covenant to assure foreign investors that BaoSteel had enough assets to meet its obligations for the note. However, overseas investors remained wary because their status as creditors were not recognized by Chinese regulators and similar issued had never been raised in a Chinese court.
Chinese companies’ need for offshore financing has been in the spotlight for a few years. The investment community has long called for renminbi liberalization and easy cross-border capital flow, but Chinese government has been cautious and slow about currency reform. For example, the investment community had high hopes for Shanghai Free Trade Zone to spearhead currency reforms, but little has been done. Thus, the New SAFE Rule is also viewed as a positive step toward currency reform.
However, it seems the benefit of the New SAFE Rule is limited for offshore bond issuance due to two other provisions. First, the New SAFE Rule disallows onshore operating subsidiaries to provide upstream guarantees because the onshore security holder must, directly or indirectly, hold shares in the offshore bond issuer. This provision is important because most Chinese companies that try to access offshore capital have done so through an offshore holding company registered in another jurisdiction such as Hong Kong and Cayman Island. Thus, a change of corporate structure may be needed to enjoy the benefit of the New SAFE Rule. Second, the New SAFE Rule imposes additional restrictions on use of proceeds. Of which the most important one is that debt proceeds cannot be used for equity investment or shareholder loans into PRC entities without SAFE approval. It means that debt proceeds must not be reentered into China.
Despite the limitations, the New SAFE Rule marks an important step toward liberalization of cross border capital flow. It will help Chinese companies to secure offshore financing and expand their business overseas.