Trade Alert: China

CHINA

On 31 December 2021, President Xi delivered a televised speech to China centered on 2022 and the Chinese Communist Party’s vision of China becoming a global power. Xi addressed the 1.4bn nation stating: “We must always keep a long-term perspective, remain mindful of potential risks, maintain strategic focus and determination, and attain the broad and great while addressing the delicate and minute”. President Xi’s tenure has been consolidated in recent months with the CCP passing a resolution on 11 November 2021 leading Xi to likely be in power for another leadership term. The last two times a resolution of this magnitude had been passed was in 1945 with Mao Zedong and Deng Xiaoping in 1981.

On 17 January 2022, the People’s Bank of China (‘PBOC’) lowered interest rates on one-year loans to banks by 0.01 per cent, the first reduction since April 2020 as the Omicron variant continued to slow down the economy. Subsequently, on 20 January 2022 the PBOC cut the one-year prime rate by 0.01 per cent and the five-year rate was lowered by 0.005 per cent to 4.6 per cent which was a smaller cut than predicted. There are expectations that further cuts will be made in the first half of 2022 as the “PBOC will open the monetary policy toolbox wider, maintain stable overall money supply and avoid a collapse in credit”.

China’s economic target forecast for 2022 has been set at a benchmark of 5 per cent which is a drop from the pre-pandemic growth target of 7 per cent. This decrease is in light of real estate sector troubles, such as the Evergrande Group, and external demand with the latter expected to decrease from the record-breaking gains made in 2021.

INCREASED FOREIGN CAPITAL IN DISTRESSED DEBT MARKET

Following a trade deal between the US and China signed on 15 January 2020, American financial companies are now able to purchase Chinese NPLs directly. Once an asset management license is granted, US institutions can directly buy NPL portfolios from banks, bypassing Chinese intermediaries. Chinese intermediaries are financial asset management companies (“AMCs”), consisting of 5 state-owned AMCs,58 provincial AMCs, 5 banking system asset investment companies (“AICs”) and 1 foreign-invested AMC, with more members possible in the future.

Local regulations grant these AMCs the ability to buy NPLs from banks directly. Non-Chinese investors are subject to the following general rules when purchasing NPLs:

(i)    foreign (including US) enterprises are generally not allowed to purchase NPLs directly from banks;

(ii)   foreign (including US) enterprises must purchase NPLs through AMCs; and

(iii) foreign (including US) enterprises may apply to set up their own AMCs in China through which they may buy NPLs from banks but their establishment is subject to government approval at provincial/national level.

Historically, the majority of Chinese NPLs loans went to state-owned enterprises as well other companies with large capital expenditures but little revenue growth expected in the near term. The China Banking and Insurance Regulatory Commission (“CBIRC”) outlined that as of September 2021 there is an outstanding total of CNY3.6tn (USD563bn) NPLs in the banking sector with the bad-loan ratio rising to 1.87 per cent, from 1.86 per cent in June 2021.

Demand for liquidity in China this month is forecasted to increase exerting pressure on the PBOC to meet demand. Liquidity needs are expected to reach CNY4.5tn (USD708bn) which is an increase of 18 per cent from January 2021. Yishuan Li, an analyst at Cinda Securities Company Limited, stated: “there are a number of factors that may pose threats in January to the stable liquidity conditions the central bank has vowed to maintain. The bond market is currently vulnerable after an increase of leverage in December which means financial institutions will be more reliant on PBOC’s liquidity support”.

On 6 December 2021, the PBOC reduced the reserve requirement ratio (‘RRR’) for banks by 0.50 per cent effective from 15 December 2021. It is expected to release CNY1.2tn (USD188bn) into the economy in long-term liquidity. Wen Bin, a senior economist at Misheng Bank stated: “the RRR reduction will help alleviate the downward pressure on the economy and smooth the economic growth curve.” It is noted that this RRR cut will not apply to all financial institutions in China, with those already at 5 per cent, predominately rural banks, seeing no reduction. Overall, the weighted average ratio for financial institutions will be 8.4 per cent after the cut.

SPECIAL THANKS

We appreciate the assistance of Kevin Xu of MHP Law Firm with the following discussion of Chinese law, regulation and practice.

CHINESE LEGAL SYSTEM

The legal system of the People's Republic of China ("PRC") is officially defined as a "socialist system of law". However, in practice, the system is based primarily on the civil law model, unlike Hong Kong which retains the common law system. The Constitution of the PRC is the highest law within China with the current version having been adopted in 1982 with revisions in 1988, 1993, 1999, and 2004. There are four levels of the court system in China: the grassroots, intermediate, higher and supreme people's courts, in addition to specialised courts. Statutory law is comprised of Laws (fa lü), Administrative Regulations (xing zheng fa güi), Local Regulations (di fang fa güi), Administrative Rules (xingzheng güizhang) and Military Regulations. Although, judicial precedents are not enforceable in China, the Supreme People’s Court (SPC), bears the authority to issue nationally enforceable Judicial Interpretations (sifa jieshi). Treaties (tiao yue) China has entered into are also legally effective documents.

KEY POINTS FOR TRADERS

• Banking licence required from China Banking and Insurance Regulatory Commission.
• Assignment most common form of transfer with Participation also being used.
• Lenders are subject to corporate income tax at 25 per cent, VAT at 6 per cent and stamp duty at 0.005 per cent.
• Interest payments to foreign lenders are subject to a withholding tax of 10 per cent.

BANKING LICENCE REQUIREMENTS

Banking and lending activity is highly regulated in China. Institutions and individuals are not permitted to engage in commercial banking activity without the approval of the China Banking and Insurance Regulatory Commission ("CBIRC"). Certain non-bank financial institutions such as financial asset management companies, financial leasing companies, currency brokerage companies and consumer finance companies may be able provide lending services following the approval of CBIRC. Approval is subject to a high-entry standard with subsidiaries required to be established and the subsidiaries must be granted approval subject to the following prerequisites: (i) controlling shareholder must be a foreign bank and pure hedge funds, except for co-investing with another bank, can only establish a non-bank credit company; (ii) registered capital of the foreign-invested bank should be at least RMB1bn and fully paid up; and (iii) extensive disclosure of information of the applicant must be available to the CBIRC for review with the review period lasting from six to nine months.

Small credit companies are subject to government approval at provincial level with province-specific standards; for example, registered capital requirement in Shanghai is RMB200m and fully paid up. Additionally, major financial performance indicators of shareholders must meet various targets.

Foreign investor banks and non-bank financial institutions require approval from CBIRC for their establishment and operation of subsidiaries in China and the purchasing of loans through established Chinese AMCs.

METHOD OF TRANSFER

Assignment is the most commonly used mechanism for the transfer of a lender's rights under a loan. Pursuant to Chinese contract law, in order for a lender to assign a loan, including a revolving facility, to a third party, it must notify the borrower. This requirement should be included in the assignment agreement as an undertaking from the assignor to the assignee. Upon assignment, any guarantee will continue to be in full force and effect unless the guarantee contract provides otherwise. For a borrower to assign the loan to a third party, it must obtain consent from the lender and any guarantee will not continue to be valid, unless the guarantor agrees to the assignment in writing.

Transferring security under the current Chinese Civil Code is subject to detailed rules. However, in general, security including mortgage, pledge and liens transfer automatically with the lender’s loan. Registration is required for mortgages over immovables and are effective upon registration at dedicated registration centers. Liens, pledges and mortgages over movables are not subject to registration. Liens are effective on assertion of the collateral; pledges are effective on the delivery of the collateral; and mortgages over movables become effective with their respective contract. Liens, pledges and mortgages over movables can be registered at the registration system of the Central Bank with the Central Bank not conducting a substantial review. If a mortgage over a movable is registered, it can secure the right against bona fide third parties.

Transferred mortgages over immovables must be registered and transferred mortgages over movables require possession. However, failure to register or possess assets does not affect a creditor’s entitlement to the transferred security. In relation to NPLs, if a buyer does not register or take possession after the purchasing of the NPL, the security is still transferred. The majority of Chinese courts, including the Supreme People’s Court, are of the view that an NPL buyer may liquidate security assets under NPLs even if registration is not completed.

Novation and hardening periods for security are not recognised as concepts under Chinese Law. Participation agreements are also used as a method of transfer in China. Regarding look-through or other restrictions in using participation or fronting structures, there are not any restrictions as of yet. For participation agreements, the CBIRC has published regulatory requirements applying to domestic banks under the Guidelines on Syndicated Loan Business.

SECURITY AND TRUSTS / AGENCY

Trusts and agency structures are recognised under PRC laws. Although China has specialised Trust Law, trust and agency relationships in, inter alia, the capital, securities, financing sectors are governed by applicable implementation regulations and rules.

Lenders are generally able to appoint a security agent or security trustee to act on behalf of a syndicate, including to enforce security and apply proceeds in accordance with participation under the loan.

Security may be held by security agents/trustees or lenders. If security is registered in the name of an agent or trustee, a creditor may alone apply to a court to liquidate an asset if:

(i)    the security is registered under the name of a bond trustee;

(ii)   the security is registered under a trustee; or

(iii)  there is another commissioning relationship which the security provider is aware of.

Foreign agents and trustees are typically recognised by Chinese courts, provided that the same is permissible under the governing law of the agreement.

Upon the insolvency of a security agent, security will not fall into the insolvency estate of the security agent. According to China Securities Law, where a securities company is in bankruptcy or liquidation, client trading settlement funds and securities must not be classified under bankruptcy or liquidation assets.

A security interest in a marketable debt security may be created by way of a pledge. The pledger and pledgee must enter into a written pledge agreement and such security interest will be created upon the delivery of a certificate of marketable debt securities to the pledgee, where it is in the form of a definitive note. The certificate must be endorsed with the word "pledge" to be enforceable against a bona fide third party. In the absence of a tangible certificate, the pledge rights will be created upon registration of the pledge at the relevant authority. Security over receivables can also be created be way of a pledge. The pledger and pledgee must enter into a written pledge agreement which must be registered at the Credit Reference Centre for the pledge to be perfected.

It is not customary for buyers to take "back-up" security interest over the seller's ownership in receivables and related security, in the event that a court deems a sale to not have occurred or been perfected.

A common form of security in China is a mortgage over real property which takes effect once registered at the relevant land or building authority. However, mortgages can only be granted over land use rights as opposed to land itself, as all land is deemed to be owned by the state. The transfer or amendment of security such as a mortgage or lien is subject to a change of their registrations.

Where a guarantee is granted in favour of a foreign lender, governmental consents or filings may be required. Security in China should be considered on a case-by-case basis.

TAX AND STAMP DUTY CONSIDERATIONS

Foreign lenders are subject to a 10 per cent withholding tax on interest on loans or other proceeds, reduced to 5 per cent if there is an applicable tax treaty. The PRC has a network of over 100 tax treaties with foreign countries, including the UK and USA.

Stamp duty is payable on the transfer of a loan, irrespective of whether there is any security or whether the security is real estate. The stamp duty rate is presently 0.005% of the loan amount. However, under the Stamp Duty Law, which will come into force on 1 July 2022, the transfer of loans will no longer be subject to stamp duty.

Lenders trading in China are not subject to a transfer tax when acquiring the debt of a Chinese borrower from a Chinese lender. Corporate income tax at 25 per cent and VAT at 6 per cent is payable by domestic lenders on interest on loans or other proceeds. Save for corporate income tax, VAT, stamp duty and other taxes required by laws, there are no registration or license taxes relating to the transfer of real estate applicable to foreign entities. However, there may be a handling fee charged by real property registration centers.

NOTARY REQUIREMENTS AND ENFORCEABILITY

Depending on the financial institutions’ requirements and practices, security documents may need to be notarised. Lenders and borrowers must register a mortgage of real estate or movable property as well as other types of security if applicable laws so require.

Mortgages over immovables must be registered at local real property registration centres before they become effective and handling fees may apply. Mortgages over movables may be registered online at Movables Financing Unified Registration and Publication System. Mortgages over movables which have not been registered cannot stand against a bona fide third party who has already taken possession of the security.

The new Immovables Registration Operation Rules effective from June 2021 require foreign legal corporate applicants to submit registration or approval documents of their Chinese domestic branches or representative offices as supporting materials. Therefore, foreign entities without establishing presence in China will not be able to register mortgages over immovables. For registration of mortgages of movables, no fee is charged and notarisation is not required.

As debt trading is wide ranging, it could fall into different sectors under Chinese law, each with different regulatory compliance requirements. Accordingly, it is advisable for the foreign investor to consider market access in China before engaging in trading activities.

BROWN RUDNICK ADVISES ON USD 7.48BN TRADE TRANSACTIONS IN 2021

 2021 TRADE TRANSACTION SUMMARY

NOTABLE TRANSACTIONS

CHINA EVERGRANDE GROUP (“EVERGRANDE”)

On 9 December 2021, Fitch Ratings became the first rating agency to declare that China Evergrande Group’s overseas bonds are in default. Evergrande’s ratings at Fitch were downgraded to Restricted Default (‘RD’) from C. This was in response to the non-payment of coupons due on 6 November 2021 for Evergrande’s subsidiary Tianji Holding Limited’s USD645m 13 per cent bonds and USD590m 13.75 per cent bonds after the lapsing of the grace period on 6 December. On 17 December 2021, China Evergrande Group and Tianji Holding Limited were placed to ‘selective default’ by S&P Global Ratings.

Evergrande, which has more than USD300bn of liabilities, announced that its property sales for 2021 decreased 39 per cent from 2020 to CNY443bn (USD69.5bn), the first time it has experienced a decline in revenue for at least a decade. The property group’s sales remained flat from 20 October 2021 where it had contracted sales of RMB442m illustrating its liquidity troubles. More strikingly, according to Citi analysts, Evergrande’s sales for December 2021 fell by 99 per cent year-on-year. On 24 January 2022, Evergrande pleaded to its bondholders to withhold from taking legal actions against the property developer as it is formulating a “comprehensive, detailed and effective debt restructuring plan to protect the legal rights of all parties”. This statement was in response to reports that the ad hoc creditor group of Evergrande’s offshore bonds has been considering enforcement actions against the property developer. The bondholders have found a lack of substantive dialogue and “received little more than vague assurances of intent, lacking in both detail and substance”.

On 13 January 2022, Evergrande agreed to delay the early repayment of a 6.98 per cent USD707m onshore bond after more than half of the bondholders agreed to the extension. Earlier in January, Evergrande announced it will seek the six-month delay with its subsidiary, Hengda Real Estate, holding a bondholder meeting on the 7 January to the 9 January 2022 to discuss whether there will be any triggering of default. As a consequence, the bonds were suspended from trading on 6 January 2022.

The property group’s economic troubles has reverberated to citizens, with protesters outside China Evergrande Group’s offices in Guangzhou demanding repayment on their money which they had invested into various Evergrande wealth management products. RMB40bn of wealth management products have been sold to more than 70,000 retail investors with missed payments featuring heavily. In response, Evergrande announced that it will pay each investor CNY8,000 (USD1,255) per month from December until February 2022, which is a reduction on the previous agreed pay-out whereby, investors could receive 10 per cent of their principal and interest every quarter with full repayment expected in March 2024.

The Chinese Property sector has suffered immensely in the last couple years and as such, the PBOC and the Housing Ministry introduced the “three red lines” in late 2020 to contain the ever-growing debt crisis. The redlines are as follows: (i) a 70 per cent ceiling on liabilities to assets, excluding advance proceeds from projects sold on contract; (ii) a 100 per cent cap on net debt to equity; and (iii) a cash to short-term borrowing ratio of at least one. If a developer is successful in adhering to the thresholds, it can increase its debt by a maximum of 15 per cent the following year. Recently, the Chinese authorities have instructed banks to increase lending to property developers and if borrowing by major property firms is to facilitate M&A, the funds borrowed will not be counted towards the three red lines restrictions.

In January 2022, USD197bn of maturing bonds, coupons, trust products and deferred wages to migrant works are due. The latter takes the greatest share with deferred wages totaling USD173bn and they are expected to have been paid by 31 January 2021, according to Nomura International (Hong Kong) Ltd. The CCP and regulators are demanding Evergrande and other stressed property developers to prioritise workers’ wages in an effort to ensure social stability. Premier Li Keqiang stated on 2 December 2021: “making sure migrant workers receive salary in time and in full is a big matter for their livelihood. The end of the year as well as the beginning of the next year are settlement seasons for all kinds of projects. China will severely punish those who delayed the salary payment.”

KAISA GROUP HOLDINGS (“Kaisa”)

On 9 December 2021, Kaisa Group Holdings had its Long-Term Foreign-Currency Issuer Default Rating downgraded to RD from C by Fitch. The real estate group failed to repay its USD400m offshore bond repayment due 7 December 2021. There were efforts from Kaisa to avoid the default, with talks held to extend the maturity date to 6 June 2023 at the same interest rate, however, the property developer failed to gain the 95 per cent approval need from the bondholders.

On 20 December 2021, the company announced that it had appointed Houlihan Lokey (China) Ltd as its financial adviser to evaluate its capital structure and explore all feasible solutions with regards to its USD11.78bn outstanding debt. However, like Evergrande, Kaisa has sold wealth management products to Chinese citizens and the Shenzhen government has demanded Kaisa to submit a proposal to repay these investors by the end of January 2022. According to Reuters, if Kaisa fails to provide an adequate solution, the Shenzhen government will look to seize Kaisa assets with the possibility of taking over control of the company in the future. Kaisa has earmarked 18 retail and commercial properties to sell in 2022 which have a combined total of USD12.8bn. 

SHIMAO GROUP HOLDINGS LTD (“Shimao”)

Shimao, China’s 13^th largest property developer by contracted sales, on 6 January 2022, defaulted after missing a CNY645m (USD101m) loan interest payment. Shimao builds and develops residential, hotel, office and commercial properties and has previously been regarded as a stronger borrower and unscathed amidst the defaulting of other property developers. According to China Credit Trust Co, Shimao failed to meet the CNY645m interest payment which was demanded early due to it missing previous installment requirements. Shimao had passed all three thresholds during the first half of 2021, however, credit assessors have cut back on Shimao. In December 2021, Shimao sold property management assets to a sister company Shimao Service Holdings which has raised corporate governance red flags. According to Karl Chan, an analyst from JP Morgan Chase, the transaction “not only implies tight liquidity conditions for Shimao but is also a corporate governance red flag as it is essentially transferring the cash from property manager to developer level”.

Subsequently, on 10 January 2022, Shimao announced that it has put all of its projects on sale and has agreed a preliminary deal with a Chinese state-owned company to sell its Shimao International Plaza for more than CNY10bn (USD1.5bn). Shares in Shimao closed 19 per cent higher on the Hong Kong exchange in response to reports that China Vanke Co is in discussions with Shimao to acquire assets. However, Fitch downgraded Shimao’s issuer default rating to B-from BB. Fitch outlines that Shimao’s liquidity is weakening and it is relying strongly on debt extension to maintain liquidity when its access to capital markets remains limited. On debt maturities in 2022, Fitch estimates that Shimao has CNY20bn, comprising of onshore corporate bonds and offshore notes. The group’s sales have decreased by 50 per cent year-on-year in November 2021 and Fitch expects its contracted sales will decline by 10 – 15 per cent in 2022. Similarly, S&P downgraded Shimao’s long-term rating to B- from B+ as it sees the property developer’s liquidity deteriorating further and in order for Shimao to manage its debt maturities, it will need to “expedite sales and asset disposals”.

GUANGZHOU R&F PROPERTIES (“R&F”)

On 14 January 2022, Fitch downgraded Guangzhou R&F Properties long-term issuer default ratings to RD from C after it completed a tender offer and consent solicitation on its USD725m bond due on 13 January 2022. The property developer bought back 16 per cent of the note and delayed the maturity for six months, casting fears over the group’s overall liquidity.

Previously, on 5 January 2022 R&F announced that it does not have the funds to repay partially its USD725m bond maturing on 13 January 2022. Last month, the group, through its indirect wholly owned subsidiary Easy Tactic Limited, offered to repurchase for cash any and all of its USD265m 5.75 per cent Senior Notes due 13 January 2022 and its USD460m 5.75 per cent Senior Notes due 13 January 2022. The property developer had hoped to portion USD300m in order to repay bondholders, but it had not managed to do so.

The outlook is not good for the rest of 2022, as R&F has USD1.04bn of local notes maturing in April and May accompanied by a USD288m bond in July. In total, R&F needs to repay or refinance approximately USD3bn of bonds this year excluding the 5.75 per cent note which was extended in mid-January.

LMA UPDATE

NEW STANDARD TERMS AND CONDITIONS

In our last Trade Alert we covered the 1 November 2021 update of the LMA’s Standard Terms and Conditions for Par and Distressed Trade Transactions (Bank Debt/Claims) (the “LMA STCs Exposure Draft”). The finalisation of the LMA STCS Exposure Draft has now been completed (the “New Standard Terms”) and it has replaced the previous standard terms and will apply to all LMA trades carried out on or after 4 January 2022.

The New Standard Terms have sought to provide the following: a documentary reflection of the recommendations for the SONIA Loan Market Conventions (the “£RFR Working Group Conventions”) issued by the Working Group on Sterling Risk-Free Reference Rates (the “£RFR Working Group”) for secondary loan trading; provide standard terms and conditions for secondary trade transactions which relate to facility agreements entered into on the terms of the Compounded Rate/Term Rate Facilities Agreements (including where loans are switched from IBOR to RFR rate); and broadly maintain the existing framework for secondary trade transactions which relate to facilities agreement where interest is calculated on the basis of IBOR rates.

The changes made are centered on Condition 11 (Delayed Settlement Compensation) and the associated definitions. The New Standard Terms’ delayed settlement compensation provisions comply with the £RFR Working Group Conventions for purchased assets denominated in sterling and other risk-free rate currencies. There has been a change in how parties address the unavailability of the relevant rate for the IBOR rate currency of the traded loan. Previously, the seller (acting reasonably) specifies the rate for cost of carry in circumstances where the IBOR rate (previously 1-month IBOR) is unavailable. The New Standard Terms replaces this fall back rate with the daily simple risk-free rate for that currency and if the risk-free rate is unavailable, the central bank rate will apply.

Additionally, the New Standard Terms have revised the “Other Terms of Trade” section with the following tick boxes added or removed:

• Tick-box for disapplication of Credit Adjustment Spread from cost of carry rate added;
• Tick-box for application of zero-rate floor in cost of carry calculation added;
• Tick-box for disapplication of buy-in/sell-out provisions removed; and
• Tick-box for specification of fall back cost of carry rates for certain currencies removed.

CONTACT 

Please contact Louisa Watt or Iden Asl with any queries regarding this month's Trade Alert. 

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