Legal Avenues for Foreign Investors to China’s NPL Market （I）

Following continuous decline of China’s economy, the ratio of non-performing loans (“NPL”) in commercial banks continues to grow. In February 2016, eight ministries and commissions including the People’s Bank of China released ‘Several Opinions on Financial Support to Maintain Steady Industrial Growth, Adjust Industrial Structure and Improve Industrial Efficiency’ calling for increasing the efficiency and strengthening the process for disposing of NPL, offering new market opportunities to the business of NPL disposal. Furthermore, for foreign investors actively involved in disposal of Chinese NPL since 2001, it is undoubtedly another round of hot investment opportunities for them to share with the Chinese NPL market!
Foreign investors were first permitted to participate in disposal of Chinese NPL as early as October 2001 with the announcement of the Tentative Regulations on the Attraction of Foreign Capital by Financial Asset Management Corporations to the Restructuring and Disposal of Assets by the Ministry of Finance, the People’s Bank of China and the former Ministry of Foreign Trade and Economic Cooperation, which established the foundation for the system by which foreign investors were able to engage in the disposal of Chinese NPL. In November 2001, a bidding group consisting of Salomon Smith Barney, KTH Fund and Zhong Jin Feng De under Morgan Stanley, Lehman Brothers and Citigroup purchased four NPL portfolios from China Huarong Asset Management Corporation (“Huarong”) with a total book value of RMB 10.8 billion, which started a new chapter in foreign investors massively engaging in the disposal of Chinese NPL. Subsequently, following the introduction of relevant national policies, foreign investors fully participated in the disposal of Chinese NPL in various ways up until the NPL previously allocated to the Financial Asset Management Corporations (hereinafter collectively referred to as the “AMCs”) as per the state economic policy were all disposed of, and then the investors gradually faded out in around 2005. At present, the banks’ NPL has maintained a rapid growth since 2015, and the huge market has attracted the attention and interest of more and more international investment banks. By virtue of the emergence of a new round of hot opportunities for investing in NPL, we hereby summarize the major methods foreign investors have previously used to participate in the disposal of Chinese NPL, and put forward some innovative methods for foreign investors to invest in NPL disposal in the current economy environment. We offer these insights for both international investment banks that are preparing for or that are already actively participating in the disposal of NPL, as well as for domestic institutions intending to partner with foreign investors in the disposal of NPL.
1 Outbound Investment by AMCs with NPL Portfolio
According to the Tentative Regulations on the Attraction of Foreign Capital by Financial Asset Management Corporations to the Restructuring and Disposal of Assets, AMCs are the organizations to enlist foreign investors in the disposal of NPL. In the past, as commercial banks were not authorized by relevant laws and regulations to enlist foreign investors in the disposal of NPL, all foreign investors entered into the Chinese NPL market through participating in the restructuring and disposal of the NPL previously owned by AMCs.
At the beginning of the first round of introducing foreign investment in the restructuring and disposal of NPL in 2001, AMCs were still exploring specific operating methods to utilize foreign investment, given that the only guiding principles were provided in the Tentative Regulations on the Attraction of Foreign Capital by Financial Asset Management Corporations to the Restructuring and Disposal of Assets, and no supporting regulations were released by relevant authorities including the State Development and Reform Commission, foreign trade and economic cooperation departments and foreign exchange administration departments. The “Yanjiang Portfolio” project, where we provided legal services to China Orient Asset Management Corporation (“Orient”) in 2001, was the pilot project officially approved by relevant authorities under the State Council to dispose of an NPL portfolio in the model of outbound investment. The fundamental transaction structure of the project was as follows: (i) A fund management LLC was established in the US, in which the Guangzhou office of Orient invested with the appraising value of an NPL portfolio with the book value equivalent to RMB 1.8 billion to subscribe corresponding equity interests in the fund management LLC, and the US investor invested with cash; (ii) Orient transferred its equity interests to overseas investors and received the transfer price; (iii) the aforementioned fund management LLC entrusted Lowe Bingham & Matthews - Pricewaterhouse Coopers to take charge of debt collection as its servicer; (iv) given that debt collection was not Lowe Bingham & Matthews - Pricewaterhouse Coopers’ expertise, they cooperated with the Guangzhou office of Orient so that the Guangzhou office of Orient was responsible for debt collection in exchange for service fees. The “Yanjiang Portfolio” project was the first NPL disposal project which utilized foreign investment in China. It facilitated the establishment and optimization of China’s foreign exchange administration system in the area of NPL, including registration methods for turning domestic debts to foreign debts, settlement procedures of income in foreign exchange, and filing registration procedures of foreign securities, etc. These procedures gradually took shape during the actual process of the project, and were reflected in the Notice on Foreign Exchange Administration with regard to Financial Asset Management Corporations Utilizing Foreign Investment in Disposal of Non-performing Asset (Hui Fa [2014] No. 119, which was annulled) issued by the State Administration of Foreign Exchange on December 17, 2004.
The above transaction also created a transaction model where an NPL Portfolio is used as capital contribution for outbound investment in order for the foreign capital to be utilized in NPL disposal. The basic transaction models are summarized as follows: on one hand, an AMC may invest in an overseas LLC at the appraised value of the NPL Portfolio, through which it subscribes equity interests in overseas LLC and thereafter sell such equity interests in exchange for the transfer price; on the other hand, the AMC may act as a service provider for the NPL portfolio, providing debt collection services and obtaining relevant service fees.
2 Transfer of NPL Portfolios from AMCs to Foreign Investors
The difference between the second model and the previous one mentioned above, where AMCs carry out outbound investment with NPL portfolios, is that the AMCs directly sell the NPL Portfolios to foreign investors in exchange for cash instead of equity interests in overseas LLC. This is the most direct and widely-used way for foreign investors to participate in China’s NPL disposal. Four major AMCs in China, namely Huangrong, Orient, China Cinda Asset Management Corporation, and China Great Wall Asset Management Corporation, conducted many transactions of this type with foreign investors. We previously represented AMCs as sellers, as well as international investment banks as buyers, in a number of direct sale transactions of large NPL Portfolios.
When selling NPL Portfolios to foreign investors, AMCs are required to obtain approval and implement disposal of NPL in accordance with the Regulations on AMCs, including the Administration Measures on Asset Disposal by Financial Asset Management Corporations (Revised) (Cai Jin [2008] No. 85) and other relevant regulations. AMCs also need to follow relevant Chinese laws and regulations on foreign debts.
Unlike selling NPL Portfolios to domestic investors, AMCs selling NPL Portfolios to foreign investors will lead to a change in creditors (i.e., from domestic creditors to foreign creditors) to whom the debts are owed by domestic institutions, and are therefore become regulated by the foreign exchange administration departments as well as the development and reform departments. In our many years of experiences in providing legal services to AMCs and foreign investors respectively in such areas, we have observed a trend of gradual relaxation in legislation and government regulatory measures. Specifically:
(1) State Administration of Foreign Exchange
The first regulation issued by the State Administration of Foreign Exchange relating to the utilization of foreign investment in NPL disposal is the abovementioned Notice on Foreign Exchange Administration with regard to Financial Asset Management Corporations Utilizing Foreign Investment in Disposal of Non-performing Asset (Hui Fa [2014] No. 119, which was annulled). According to this Notice, AMCs were required to obtain approval in terms of income and payment in foreign exchange and its settlement issue from the State Administration of Foreign Exchange when transferring NPL portfolios to foreign investors; the foreign investors who purchased or received NPL portfolios were required to complete the filing registration procedures with foreign exchange administration departments for transfer of NPL portfolios upon completion of the transaction. Foreign investors were also required to complete verification and approval procedures with the State Administration of Foreign Exchange where it converted its income gained from the disposal of NPL portfolios from RMB into foreign exchange and remitted it outside of China.
However the Notice of Relevant Issues on Foreign Exchange Administration of Disposal of Non-performing Asset by Financial Asset Management Corporations (Hui Fa [2015] No. 3) stipulates that the transaction price obtained by AMCs from the disposal of NPL may be directly deposited and settled in banks; as for income obtained by foreign investors from the disposal of NPL, foreign investors may directly purchase and remit foreign exchange in banks without going through procedures for verification, approval or registering with State Administration of Foreign Exchange.
(2) National Development and Reform Commission
On April 1, 2007, the National Development and Reform Commission and the State Administration of Foreign Exchange issued the Circular regarding the Administration of the Filing Procedures for Transfer of Bad Debts from Domestic Financial Institutions to Foreign Investors (Fa Gai Wai Zi [2007] No. 254), in which domestic financial institutions transferring distressed debts were required to report such transfers to the National Development and Reform Commission after the transfer agreements for distressed debts were signed, and the National Development and Reform Commission would then issue a confirmation notice of filing within 20 working days of receiving all of the required materials for registration.
However, the above Circular was annulled on January 1, 2016, and replaced by the Circular of the National Development and Reform Commission on Promoting the Administrative Reform of the Record-filing and Registration System for the Issuance of Foreign Debts by Enterprises (Fa Gai Wai Zi [2015] No. 2044), in which the registration procedures for transferring distressed debts to foreign investors should be completed with the National Development and Reform Commission, and the National Development and Reform Commission will issue a confirmation notice of registration within 7 working days of receiving a complete application. Compared to previous procedures, current procedures are more streamlined and more efficient.