WFOEs and Foreign Security: The Waters are Muddied

February 29, 2000 | BY

clpstaff

The People¡¯s Bank of China promulgated the Administration of the Provision of Security to Foreign Entities by Domestic Institutions Inside China Procedures…

The People¡¯s Bank of China promulgated the Administration of the Provision of Security to Foreign Entities by Domestic Institutions Inside China Procedures (the Foreign Security Procedures), effective as of October 1 1996. Further, the State Administration of Foreign Exchange (SAFE) promulgated the Administration of the Provision of Security to Foreign Entities by Domestic Institutions Inside China Procedures Implementing Rules (the Implementing Rules), which took effect from January 1 1998.

Since these two laws (together referred to as the Foreign Security Laws) were issued, many commentators appear to have concluded that wholly foreign-owned enterprises (WFOEs) were exempt from the requirements to obtain SAFE approval for the granting of foreign security.

However, a circular issued by SAFE on August 29 1999 that prefaces the Interpretation of Relevant Provisions Concerning the Provision of Foreign Security by Domestic Institutions Letter [Huihan (1999) No 24] (the Circular) seems to suggest that SAFE, at least, has other ideas.

Are WFOEs Exempt from Approval Requirements?

Article 8 of the Implementing Rules expressly states that WFOEs are free to provide security to foreign entities and are not required to obtain case-by-case approval from SAFE. However, the Foreign Security Laws are silent as to whether WFOEs are required to meet the same financial and other prudential criteria imposed on non-financial institutions other than WFOEs in order to provide security thereunder (the Security Criteria).

The mechanism established under the Foreign Security Laws is that when approving an application to grant foreign security, SAFE will examine whether the Security Criteria have been satisfied by the applicant. However, WFOEs are not subject to such approval procedures and neither the Foreign Security Procedures nor the Implementing Rules require that the local SAFE office conduct such an examination while registering provision of foreign security by a WFOE. One can see the reasoning behind those who have taken the view that WFOEs are not subject to the Security Criteria when providing foreign security.

WFOEs are Subject to Certain Security Criteria

Given the absence of any clear guidance under the Foreign Security Laws, the Circular expressly provides that, although procedurally not subject to SAFE approvals in provision of foreign security (whether in relation to their own debts or the debts of third parties), WFOEs are required to satisfy certain Security Criteria.

The Security Criteria that they need to satisfy are those set out in paragraph 2 of Article 5 of the Foreign Security Procedures, such that the maximum liability that a WFOE can assume under all its subsisting foreign security cannot exceed:

a) 50% of its net assets; and

b) the total amount of its foreign exchange earnings for the immediately preceding year.

In addition, WFOEs are also subject to certain provisions of Articles 7 and 8 of the Foreign Security Provisions, such that:

a) WFOEs are prohibited from providing foreign security to secure the debts of an enterprise which is suffering from losses; and

b) WFOEs are not permitted to provide security in any form to secure the registered capital of a foreign investment enterprise.

The text of the Circular refers to, but appears to misquote, the relevant part of Article 8 by referring to securing the registered capital of WFOEs.1 Article 8 actually refers to foreign investment enterprises. It is particularly confusing because the first paragraph of Article 8 expressly carves-out WFOEs from its scope.

Are WFOEs Subject to Other Security Criteria?

The Circular actually raises more questions than it answers. Neither the Foreign Security Procedures nor the Implementing Rules draw a distinction between the Security Criteria cited in the Circular and others.

Under the Foreign Security Laws, other non-financial security providers are required to comply with additional restrictions other than those stated in the Circular. For instance, in principle they are not permitted to grant foreign security for the debts of an offshore-trading entity whose net assets account for less than 10% of its total assets. This raises the issue of whether WFOEs will, in practice, be subject to all the Security Criteria or just those parts of the Articles cited in the Circular.

The impression is that SAFE has cherry-picked those parts of the Foreign Security Laws that it thinks should apply to WFOEs, but without giving any clear legal basis for its choice.

Approval or Registration?

Under the Foreign Security Laws, WFOEs are required to conduct foreign security registration procedures with the relevant local SAFE and obtain a Foreign Security Registration Certificate within 15 days of signing its security agreement. In effecting such registration, WFOEs are only required to fill in a Foreign Security Registration Form.

In practice, some documentation, including the security contract, might need to be provided for such registration but overall the impression is that registration is a procedural, not a substantive review process.

In contrast, the Circular requires local SAFE bureaus to examine relevant documents to ensure that the Security Criteria are satisfied. This implies that WFOEs wishing to register foreign debts will be required to provide substantive documents such as the balance sheets and financial statements of both itself and the entity whose debts are secured by the WFOE. Furthermore, the Circular implicitly authorizes local SAFE bureaus to refuse a WFOE¡¯s¡¯ application to register foreign security when the Security Criteria are not met.

Thus the registration process becomes a de facto approval and seems to demolish the advantages of WFOEs as compared to joint ventures in this regard (with mortgages, WFOEs will now have to get approval from both SAFE and MOFTEC).

Implications for Foreign Investors

Foreign investors are likely to experience more difficulty in raising funds by way of using their WFOEs to provide foreign security. Not many WFOEs will be able to satisfy the Security Criteria, particularly, the requirement relating to foreign exchange earnings.

Perhaps the most worrying implication of the Circular is how it will impact on wholly foreign-owned holding companies in China (Holding Companies) which, on the face of it, appear to be caught by the Circular. One of the main functions of Holding Companies is to provide security for its subsidiaries in China to raise funds both inside and outside China. However, most Holding Companies are unlikely to generate foreign exchange earnings.

Many foreign investors may be left wondering why China should seek to impose further controls after the event, particularly on entities involving no state-owned or even Chinese assets.

Fang Jian and Andrew McGinty
Linklaters, Shanghai

ENDNOTES:

1. A SAFE officer confirmed that this is a mis-print in the regulations.

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