Keepwell Deeds: A workable solution to PRC's foreign exchange control? | Hong Kong

Keepwell deeds have emerged as a popular tool for credit enhancement in recent years, particularly in financing arrangements where an offshore debtor is tied to a PRC parent company.

This keepwell structure often serves as a workaround for the stringent regulations in PRC governing onshore guarantees for offshore debts (内保外贷). Despite their growing usage, questions regarding the validity and enforceability of these agreements have lingered. In this article, we will explore the nature of keepwell deeds, the reasons for their rising preference, their legal standing, and the uncertainties that continue to surround them.

What is a Keepwell Deed?

A keepwell deed is a financial tool that is often used by a company to enhance the creditworthiness of its subsidiary when seeking loans or issuing bonds. This mechanism is particularly favoured by PRC companies to provide credit support to their offshore subsidiaries, providing creditors with the assurance that the parent companies will uphold the subsidiaries' financial health. 

At its core, keepwell deeds include commitments from the PRC parent company to its offshore subsidiary (being the debtor) and the creditors of this offshore subsidiary that it will retain ownership and control over the debtor offshore subsidiary. The parent company further undertakes to ensure that the subsidiary remains financially robust, meets specific financial benchmarks and has sufficient cash flow to cover loan repayments and interest.

While the terms of keepwell deeds vary, they typically fall into three main categories of obligations:

• Solvency Obligation: The parent company will ensure the offshore subsidiary remains solvent.
• Liquidity Obligation: The parent company will ensure the offshore subsidiary has adequate liquidity to fulfill its payment obligations.
• Net Worth Obligation: The parent company will ensure that the offshore subsidiary maintains a positive net worth.

It is important to note that most keepwell deeds explicitly state they are not guarantees of payment obligations. The undertakings of the PRC onshore parent company are often contingent on obtaining necessary regulatory approvals. Furthermore, these deeds typically require the parent company to exert its best efforts to secure approvals within the specified timeframe set by the relevant authorities.

Why Opt for a Keepwell Deed?

One might wonder: why would one prefer a keepwell deed over a straightforward guarantee? The answer is tied to the PRC foreign exchange control regulations, which create significant barriers for PRC domestic companies looking to transfer money offshore, and also when it comes to guaranteeing loans for their offshore subsidiaries.  

Under the Regulation of the People's Republic of China on Foreign Exchange Administration (《中华人民共和国外汇管理条例》)¹ , Provisions on the Foreign Exchange Administration of Cross-border Guarantees (《跨境担保外汇管理规定》)²  and related laws, any guarantee from a domestic entity for offshore debts must be registered with the State Administration of Foreign Exchange (“SAFE”) within 15 days. This registration process can be unpredictable, and there is no certainty that SAFE will approve the request. 

If the parent company’s guarantee obligation is triggered and it is called upon to fulfill the offshore subsidiary’s debt, it must undergo an additional registration procedure³ . Similarly, when the parent company’s liability under the guarantee is discharged, it is required to notify the relevant authorities⁴.

Furthermore, the onshore guarantor is legally obligated to conduct due diligence on the offshore debtor and ensure that the funds provided under the guarantee are utilized in accordance with their intended purpose⁵.

Choosing not to register the guarantee is not an option. While an unregistered guarantee remains legally valid under PRC law, the remittance of funds offshore by the parent company (for the purpose of fulfilling its guarantee obligation) would not be approved by the handling bank without the relevant registration in place.

There are also stringent regulations regarding the use of funds guaranteed by the PRC companies. These funds may only be used for the relevant expenditures within the usual scope of business of the offshore debtors⁶.

In this light, keepwell deeds, which present themselves as non-guarantees emerge as a savvy alternative to get around the SAFE registration requirements. They allow the PRC companies to support the financing of their offshore subsidiaries without the regulatory hurdles associated with traditional guarantees.

Enforceability of Keepwell Deed

Despite their popularity, the legal standing of keepwell deeds was once clouded by uncertainty. The widespread perception that keepwell deeds serve to circumvent SAFE registration requirements, along with the absence of established case law on their operation, had in the past led to concerns about their validity and enforceability. An example illustrating this uncertainty is found in the case of Peking University Founder Group Company Limited (PUFG), in which the Beijing First Intermediate People's Court granted a creditor's petition to reorganize PUFG and appointed a bankruptcy administrator. The restructuring administrator refused to recognize claims related to a keepwell deed entered into by PUFG and its offshore subsidiaries, citing the lack of established validity and enforceability of these arrangements within the PRC legal framework.  

After years of ambiguity, the Hong Kong Court has finally brought clarity to the keepwell deeds through three key decisions handed down in the past few years.

(a)    CEFC

The first major breakthrough came with the case of Joint and Several Liquidators of CEFC Shanghai International Group Ltd [2020] HKCFI 167, where the Hong Kong Court of First Instance entered into default judgment in favour of a bondholder who claimed against CEFC Shanghai International Group Limited (“CEFC”) for breach of a keepwell deed. This case marked the first official recognition of keepwell agreements by the Hong Kong Court.

The bondholder then sought to have this Hong Kong default judgment recognized and enforced by the Shanghai Financial Court under the Arrangement on Reciprocal Recognition and Enforcement of Judgments between the PRC and Hong Kong (the “Arrangement”)⁷.

In trying to resist enforcement, CEFC contended that, the keepwell deed was effectively a guarantee and should be subject to relevant PRC regulations including the SAFE registration requirement.  The Shanghai Financial Court rejected this argument, holding that the keepwell deed in question was not governed by PRC law and that its validity under the PRC law was irrelevant⁸. The PRC court ultimately decided to recognise the Hong Kong default judgment under the Arrangement.

(b)    PUFG and Tsinghua

Building on this momentum, two more recent cases— Nuoxi Capital Ltd & ors v Peking University Founder Group Company Limited [2023] HKCFI 1350 (the “PUFG case”) and Citicorp International Limited v Tsinghua Unigroup Co., Ltd [2023] HKCFI 1572 — saw the Hong Kong Court of First Instance, and for the first time, the Hong Kong Court of Appeal in the PUFG case⁹, heard substantive arguments of and ruled on the effect of keepwell deeds, reaffirming the validity and enforceability of the keepwell arrangement.

As a result of these rulings, creditors can now approach keepwell arrangements with greater assurance. They now have the option to secure judgments for breaches of keepwell obligations in Hong Kong and leverage the Arrangement to enforce claims against the assets of PRC parent companies in Mainland China.

Uncertainty Persists: Quantification of Damages

While we now have a clearer picture of the enforceability of keepwell deeds, there remains another aspect of uncertainty: quantification of damages, in particular damages claimed by a debtor subsidiary. In a claim for breach of keepwell obligations, a plaintiff needs to establish not only the breach itself but also the damages incurred.  Determining how and when these losses occurred can be a tricky endeavour and often presents significant evidentiary challenges. 

It may not always be immediately apparent whether a debtor subsidiary has suffered actual losses resulting from the keepwell provider’s breach. For instance, consider a liquidator acting on behalf of an offshore subsidiary, suing the onshore parent company for not maintaining the subsidiary’s liquidity. To avoid a breach of the Liquidity Obligation, the parent company could have injected liquidity into the subsidiary by way of a loan. In such a scenario, one could argue that the parent company’s failure to lend did not result in any loss suffered by the subsidiary. This was the argument presented in the PUFG case, where the counsel for the onshore parent company contended that the net balance sheet position of the offshore subsidiaries would remain unchanged regardless of whether the loan was advanced¹⁰. Therefore, the offshore subsidiaries could claim no actionable loss from the onshore parent company.

However, the Hong Kong Court of Appeal disagreed. It ruled that the keepwell deeds required PUFG to ensure the offshore subsidiaries had consolidated net worth of at least US$1, and the loss suffered by the subsidiaries from the breach of the Liquidity Obligation should be assessed on the premise that PUFG would provide liquidity by way of a gift¹¹.

This decision of the Hong Kong Court of Appeal is not the final word on this matter, as PUFG has been granted leave to appeal on how the actionable loss incurred by the offshore subsidiaries should be measured — specifically, whether it should reflect the pre-existing debt that could have been settled with liquidity from PUFG as a gift¹². This issue will be reviewed and further explored by the Hong Kong Court of Final Appeal in its upcoming hearing in February 2025. It is hoped that Hong Kong's apex court will provide clearer guidance on determining the actionable loss.