• Notice Concerning Issues Involving the Administration of Security to Foreign Entities by Domestic Entities
  • October 19, 2010 | Authors: John V. Grobowski; Yiqiang Li; Wendy Yan
  • Law Firm: Faegre & Benson LLP - Shanghai Office
  • As part of China's "go-abroad" strategy to promote outbound investment, the nation's foreign exchange regulator has released new rules designed to simplify the administrative process and otherwise make it easier for Chinese banks and other domestic companies, including many foreign-invested enterprises (FIEs), to make loans and provide security for the debts of foreign entities. The State Administration of Foreign Exchange (SAFE) issued the Notice Concerning Issues Involving the Administration of Security to Foreign Entities by Domestic Entities (Foreign Security Notice) on July 30, 2010. The Foreign Security Notice streamlines the rules governing the provision of security to foreign entities and clarifies certain technical issues.

    Under Chinese law, companies incorporated in China, including FIEs, are allowed to pledge, mortgage, or otherwise encumber assets (provide security) to or for the benefit of a foreign entity ("beneficiary" or "creditor") on behalf of a debtor. In accordance with the Foreign Security Notice, the debtor must be an enterprise that is duly incorporated either inside or outside of China, and there must be a direct or indirect shareholding relationship between the FIE (or other Chinese company) and the debtor. Allowable types of security include guarantees, pledges of assets, and mortgages, among others. In the event that the debtor fails to repay the secured debt, the creditor is entitled to sell the secured assets as a remedy. For that debt to be enforced against a mortgage or other type of security given by a company that is incorporated in China, however, the security must have been granted in compliance with Chinese law.

    The Foreign Security Notice to some extent streamlines the administrative process for FIEs to provide security abroad. In most cases, a foreign-invested enterprise must secure SAFE approval every time it provides security to a foreign beneficiary to secure a third party's debt. However, if the FIE provides "relatively many" security interests to foreign beneficiaries, and the FIE maintains certain standards and sound internal management, it can apply with SAFE for a quota of security, which must not exceed 50 percent of the FIE's net assets. With certain exceptions, an FIE that has been granted such a quota does not have to obtain prior approval from SAFE for each security it provides, so long as the total amount of security remains within the quota.

    This quota system was previously available only to banks in China. The Foreign Security Notice extends it to non-bank financial institutions and other types of domestic enterprises.

    However, while the Foreign Security Notice simplifies the approval process for domestic-funded enterprises and FIEs that are joint ventures, the rules tighten the administration over security for wholly foreign-owned enterprises (WFOEs). Previously, WFOEs were allowed to provide security for debts to foreign entities without first seeking SAFE approval (although they were obliged to register the security with SAFE). Under the Foreign Security Notice, a WFOE must obtain SAFE approval for each security agreement and register that agreement with SAFE, unless it has been granted a quota for security, as described above.

    The Foreign Security Notice also makes uniform the asset ratios required for domestic-funded enterprises to provide security for debts abroad. In the past, domestic-funded enterprises that engaged in the trading of goods were required to have a net asset to total asset ratio of at least 15 percent in order to provide security for debts abroad; domestic-funded enterprises that did not engage in such trading of goods were required to have a net asset to total asset ratio of at least 30 percent. The Foreign Security Notice uniformly requires that ratio to be 15 percent or higher, thus expanding the scope of domestic-funded enterprises that can provide security for debts abroad.

    The Foreign Security Notice reiterates existing rules saying that domestic entities (including FIEs) must not provide security for a debtor that is unprofitable. The debtor must have had at least one profitable year in the preceding three.

    The Foreign Security Notice clarifies that non-banking financial institutions and domestic enterprises (but no longer banks) should obtain approval from the local SAFE office each time they perform their obligations under a security agreement.

    Conclusion

    One of the most important aspects of the Foreign Security Notice is its liberalization of rules pertaining to the quota system, thereby enabling more and different types of China-based enterprises to sign security agreements abroad without specific SAFE approval. That change and others should reinforce and support China's efforts to encourage domestic companies to invest—and, of course, earn profits—abroad, thereby expanding and diversifying the base of China's domestic economy.