New standards for loans and finance

The Guidelines apply to project finance where:

(i) the proceeds are usually used for building or manufacturing large production equipment, infrastructure, real estate property or other projects (including project refinance);

(ii) the borrowers are usually enterprises or public institutions specifically established for project construction, operation or finance; and

(iii) repayment funds are usually generated from sales and subsidy revenues of the projects.

Considering this application scope, project finance will normally be categorised as fixed asset loans in practice, but should be distinct from general fixed asset loans in terms of its risk characteristics. The regulator therefore promulgated the Guidelines on the basis of the Measures to specifically guide the operation of project finance. Accordingly, in addition to complying with the Measures, financial institutions must also follow the Guidelines when carrying out project finance business.

Due diligence
The Measures firstly provide rules and requirements for the process of acceptance, investigation, risk evaluation and approval of fixed asset loan applications, in which due diligence shall be emphasised as a key step in evaluating a potential project.

A borrower is disqualified for applying for a fixed asset loan unless:

(i) it is legally registered under the approval of the relevant administration for industry and commerce or other authorities concerned;

(ii) it has a good credit reputation with no records of serious offence;

(iii) in case it is a legal person for a new project, its controlling shareholder shall have a good credit reputation with no records of serious offence;

(iv) as the investor of the proposed project, it must meet the qualifications and operation requirements stipulated by the State (if any);

(v) the use of the loan and the source of repayment shall be clear and lawful;

(vi) the operation of the project must conform with the relevant State policies on industry, land, environmental protection, etc., and it must have proceeded under the management procedures for fixed asset investment projects;

(vii) the operation of the project conforms with the project capital system; and

(viii) other conditions, as required by the lender, are met.

After completing due diligence, a due diligence report together with a risk valuation report must be produced for the lender's internal review. Pursuant to the Measures, the credit risks are to be evaluated from the following perspective: the borrower, the project promoter(s) (the shareholder(s) of the borrower in most cases), the compliance of the project, the feasibility of the project's technique and finance, the market of the project, the structure of project finance, the source of repayment, security, insurance, and so on.

The Guidelines further stipulate that the lender shall retain professionals with risk management capabilities when carrying out project finance business.

Use of proceeds
One of the key tasks of the new regulations is to stop misappropriation of loan proceeds. The Measures stress repayment and post-lending management.

Conclusion of the contract: In order to monitor the use of loan proceeds, the Measures urge the financial banking institutions to incorporate into the contracts:

(a) the purposes and payment methods of the loan proceeds;

(b) the conditions precedent to drawdown and the lender's administration or control over the proceeds payment;

(c) that the relevant proceeds account shall be monitored by the lender (including the drawdown account and the deposit account if necessary); and

(d) the borrower's undertaking and liabilities in case of event of default.

Post-lending monitoring: The Measures require the lender to set up an independent department or position to monitor the use of loan proceeds and repayment.

Drawdown methods: The drawdown methods under the Measures are divided into entrusted payment and self payment. Part 5 of the Measures provides that the lender shall be entrusted to transfer the loan proceeds if a single payment exceeds 5% of the total investment of the project, or Rmb5 million.

By means of entrusted payment, the lender must transfer the loan proceeds directly to the ultimate payee in line with the contractual purposes in accordance with the borrower's application and payment entrustment letter. Accordingly, the flow of credit funds will be strictly controlled pursuant to the loan contract. On the other side, by means of self payment, the borrower will transfer the loan proceeds to its counterparty under some transaction agreements after making the drawdown from the lender. However, even if under such method, the lender must verify whether the actual utilisation of loan proceeds complies with the stipulations under the loan contract through account analysis, certificate review and in-site investigation while the borrower must report the payment conditions to the lender on a regular basis.

Post-lending management: In order to strengthen risk management in providing financing for projects by financial institutions, the Measures provide that the lender must establish a perfect mechanism for post-lending management. The Measures not only set forth the regular requirements for post-lending management which have been ignored in credit practice for a long time, but also provide that the financial institutions may be subject to administrative punishment if they fail to follow such requirements (see Part 6 of the Measures).

Enforceability of the Measures
A three-month transitional period (from the issuing dates of the new regulations) is given by the regulatory body for the financial institutions to meet the requirements thereunder. The financial institutions are required to formulate and promulgate implementation procedures, update the finance documents and adjust internal arrangements in accordance with the Measures. Thereafter, any financial banking institution which violates the Measures shall be punished by the regulatory body pursuant to the PRC Banking Regulation Law (中华人民共和国银行业监督管理法), under which the most severe punishment may lead to criminal liabilities.

Special requirements under the Guidelines
As special rules to the Measures, the Guidelines provide some special provisions in respect of risk control in project finance:

Mortgage/pledge: Pursuant to the Guidelines, mortgage/pledge must be created over the assets, properties and/or potential revenues of the properties in favour of lenders. Lenders shall also obtain equity pledge over equity/shares in the project companies if necessary.

Charge over account: Pursuant to the Guidelines, a borrower must open a specific project account with the lender to ensure all the earnings and revenues under the project are deposited in the account. Any drawing from this account by the borrower is to be made pursuant to the requirements of the loan contract.

In most cases, the borrower is required to maintain a credit balance in the charged account and procure its counterparties or other obligors in respect of the property to make repayments (for example rental or purchase price) into the charged account. In addition, any withdrawal made from the charged account must only be used for the project construction or operation or other purposes agreed by the lender.

Syndicated loan: The Guidelines require that if several financial institutions engage in one project financing, the loan shall be made in the form of syndicated loan in principal.

Other methods: To reduce the risks in the process of project construction, the lender shall require the borrower, or require the borrower to procure the construction
party, to execute a project general contract, take out an insurance policy and provide a completion guarantee or performance bond. To reduce the risks in the process of project operation, the lender must require the borrower to execute a long-term sales contract, use financial derivatives instruments or require the project promoter(s) to provide over-cost undertakings.

As for the insurance in respect of the property, the lender is to be the first beneficiary or loss payee under the insurance policy. In addition, the lender can also provide finance consulting services by designing the finance structure and combining different finance tools to widen the resource of the project funds.

Charles Qin, Michael Mei and Robert Xia, Llinks Law Offices