Keepwell deed structure faces enforceability test

The use of keepwell deed has gained popularity over the past 10 years as credit enhancement for bonds and loans involving the People’s Republic of China (PRC). One of the reasons for their adoption is the belief that they could seek to avoid the regulatory restrictions in relation to the granting of PRC guarantees. Yet, there are considerable legal uncertainties regarding the enforceability of this structure, at least as far as PRC law is concerned. In this article, we will examine the recent restructuring case of Peking University Founder Group which highlights some of these concerns.

What is a typical keepwell deed?

Keepwell deeds are commonly used as credit enhancement for bonds and loans where a PRC parent entity provides support for its offshore subsidiary’s issuance of bond or borrowing. A typical keepwell deed comprises of undertakings provided by the PRC parent ensuring that it will retain ownership and control over the offshore debtor subsidiary, and that such subsidiary will remain solvent, comply with certain financial ratios and have sufficient liquidity to service the principal and interest of the bond or loan.

The recourse offered by the keepwell deed is relatively limited, compared to a corporate guarantee. Financiers would typically obtain corporate guarantees if offshore parents are involved which would allow for a direct claim against the guarantor for the due but unpaid obligations under the bond or loan. Whereas under a keepwell deed, the financier can sue the provider of the keepwell deed for breach of contract, but does not have a direct debt claim against it.

Why preferred?

One of the key reasons why the keepwell structure has become widely used where onshore parent companies are involved is due to the perception that it could avoid application of PRC registration, which is otherwise applicable to guarantees.

Pursuant to the Regulations on Foreign Exchange Administration of Cross-Border Guarantees and Security and the related Operational Guidelines on Foreign Exchange Administration of Cross-Border Guarantees and Security issued in 2014, a PRC parent granting a guarantee in support of financial obligations of its offshore subsidiary would be classified as an offshore loan guaranteed by an onshore entity (Nei Bao Wai Dai or 内保外贷) which must be registered with the PRC State Administration of Foreign Exchange (SAFE) within 15 working days from the date of execution. Given that the registration requirement is designed in part to control capital outflow, successful registration is not always guaranteed. The practical consequence of non-registration of a guarantee is that the PRC parent will be prohibited from remitting funds outside of the PRC to comply with its guarantee obligations.

Doubts as to enforceability

The keepwell structure was therefore developed to overcome such registration requirement. The structure is frequently used in offshore finance transactions and, especially in high yield bonds with PRC exposure.

Keepwell deeds for offshore deals are commonly governed by the relevant offshore law (such as Hong Kong or English law), and they will be interpreted and given effect in accordance with their terms. However, there are enforceability concerns over the keepwell structure under PRC law, as highlighted in the recent PRC court case concerning the restructuring of the Peking University Founder Group. PRC law will be relevant if, for example, there is a bankruptcy or restructuring of the company group in the PRC.

In the case of Peking University Founder Group, following the creditors’ meeting in late April 2020, the state-appointed restructuring administrator of the Peking University Founder Group refused to recognize about US$1.7 billion worth of keepwell deed claims as valid claims that were purportedly credit support for debts reportedly worth US$96 billion. In contrast, the administrator confirmed the validity of claims under the guarantee issued by the Group in respect of certain bonds.

The PRC court would take weeks or even months to hand down its decision on this issue; until then, whether the credit enhancement provided by the keepwell deed is worth anything at all remains a live question. No doubt many financiers will be anxiously awaiting the PRC court’s decision with bated breath.

Any alternatives?

Financiers may consider the following alternative credit support options.

Guarantee

The validity of guarantees is not challenged by the PRC courts so long as they are properly registered if they relate to an offshore loan guaranteed by an onshore entity. SAFE will issue a registration certificate in respect of each registered guarantee. Upon default of the underlying bond or loan, the beneficiary would typically present the registration certificate to the PRC bank of the guarantor to remit US dollars or other currency to repay the offshore outstanding debt.

Letter of comfort

Some financiers opt for a letter of comfort if they wish to avoid potential complications with obtaining registration of a guarantee. The nature of a letter of comfort, however, is similar to a keepwell deed, i.e. typically, it contains an undertaking from the provider of the letter of comfort that its policy is to ensure that the debtor subsidiary will at all times meet its repayment obligations.

There could also be issues with enforcing a letter of comfort, depending on its wordings. Some of the loosely drafted letter of comfort would only constitute a statement of present fact regarding the parent company's intentions and not a contractual promise as to the parent company's future conduct. Even if the wording amounts to undertakings, the financier can only sue the provider for breach of contract, but would not have a direct debt claim.

If the financier would like to incorporate guarantee equivalent language to add some weight, the instrument will likely require SAFE registration.

Bank guarantee (or on demand bond)

This involves an offshore financier obtaining a bank guarantee issued by a PRC bank which imposes a primary obligation on the PRC bank to pay an agreed amount upon presentation by the offshore financier of a compliant written demand stating that a specified triggering event (for example, an event of default under the loan or bond) has occurred.

The benefit of this instrument is that based on our experience, the PRC bank would generally make payment promptly upon receipt of the requisite documents, and very often there is no requirement for the offshore financier to prove its loss, but only that a triggering event had occurred. The PRC bank is willing to make prompt payment to the financier because it usually has a set-off right against the relevant PRC group company’s account, so it would recover the amount it paid to the financier.

The use of bank guarantee shifts the risk profile from the PRC parent to the PRC bank and is accordingly a relatively reliable credit enhancement alternative.

There is no SAFE registration requirement on the financier’s or the PRC parent’s part in respect of the PRC bank’s issuance of bank guarantee.

Security over collaterals

The best form of credit enhancement is creating security over collaterals. The common forms of security include legal and equitable mortgages, and fixed and floating charges over a variety of asset classes such as cash, securities accounts, overseas receivables, insurance proceeds and assets.

However, financiers should note that securities granted by PRC entities are also subject to the same SAFE registration requirement mentioned above.

Conclusion

The enforceability of keepwell structure has always been a known risk to financiers. If the PRC court rules that this structure is unenforceable as a matter of PRC law, financiers may have to restructure their existing bonds or loans by obtaining additional or alternative credit support, particularly if there is a risk that any bankruptcy or restructuring will take place in the PRC.