This article was written by Richard Mazzochi, Minny Siu, Stanley Zhou, Stella Wang, David Mu and Jia Zhihang.
The China Interbank Bond Market (“CIBM”) is booming at a compound annual growth rate of 15% in the past three years.
The question now for foreign investors is not whether, but by what means, they should access the large and liquid Chinese bond market.
There are now well-established channels for foreign investors to access the market, as shown below.
Can investors create security over CIBM bonds?
There have been two hurdles for foreign investors to create security over their holdings of CIBM bonds:
- registration: security by way of pledge over CIBM bonds takes effect upon registration. However, the registration institutions, China Central Depository & Clearing Co., Ltd. (“CCDC”) and Interbank Market Clearing House Corporation (“Shanghai Clearing House” or “SHCH”), do not have detailed operational rules for the registration of a pledge in favour of the foreign investors, in particular when a foreign creditor (as the pledgee) does not have an onshore bond account, the parties are unable to register the pledge directly.
- The CCDC and the SHCH are also not familiar with the variety of overseas security documents governed by foreign law.
- KWM often assists clients on their negotiations with CCDC and SCH on an ad hoc basis for the registration of pledges.
- enforcement: article 219 of the PRC Property Law provides that a pledgee may enforce the pledge either by taking title to the pledged property with the consent of the pledger or otherwise by selling the pledged property by auction or private sale.
- But there has been an absence of rules as to how to enforce a pledge, in particular in the context of CIBM bonds. Pledgees (especially foreign pledgees) did not have a clarity as to how to enforce pledged bonds or otherwise seek recovery of amounts owed. As a result, the pledgee would normally pursue a court order, which is time-consuming and expensive.
- The second hurdle is now effectively addressed with the recent introduction of the Default Rules described below.
The Default Rules
The following default rules (“Default Rules”) were published in June to address the concern about enforcement rights:
- Operational Guidance on Enforcement of Collateral (Trial) (the “CCDC Enforcement Rules”) and Operational Procedures of Enforcement of Collateral by Auction (the “CCDC Auction Rules”), and the press release of Questions and Answers published by the CCDC;
- Implementing Rules on Enforcement of Bonds underlying Repurchase Agreements (Trial) (the “SHCH Enforcement Rules”) and Implementing Rules on Auction of Bonds underlying Repurchase Agreements (Trial) (the “SHCH Auction Rules”), published by the SHCH; and
- Implementing Rules on Enforcement of Bonds underlying Repurchase Agreements (Trial) (the “CFETS Auction Rules”), published by the China Foreign Exchange Trading System & National Interbank Funding Center (“CFETS”),
- (the CCDC, the SHCH and the CFETS are collectively called “Enforcement Organisations”).
The Default Rules clarify the rights of a pledgee under article 219 of the PRC Property Law to enforce its collateral in a timely manner following the pledgor’s default. The CCDC Enforcement Rules are illustrated in the following chart:
Comparison of different Default Rules
The table below provides a comparison of the Default Rules published by the three Enforcement Organisations:
|Self-remedy enforcement organised by
|Security agreement to be enforced
||All security agreements in respect of CIBM Bonds registered with the CCDC as collateral, provided that the parties have entered into the Collateral Management Service Agreement (CMSA) with the CCDC in advance (except for repos where a CMSA is not required)
||Repurchase agreements in respect of CIBM Bonds registered with the SHCH as repurchased securities
||Repurchase agreements in the CIBM including pledges and outright transfers
||Conversion into value
||To be agreed by the pledgor and the pledgee, and to submit a joint application to the CCDC
||To be agreed by the pledgor and the pledgee, and to submit a joint application to the SHCH
- to be applied for by the pledgee alone
- bid floor price to be determined by the CCDC by reference to the average trading price for the latest 30 consecutive trading days and the dirty price published by ChinaBond Pricing Center Co., Limited (“ChinaBond Valuation”) on the trading day immediately preceding the auction date
- to be conducted by way of tender-inviting by price, bidding in full-price (or dirty-price) and accepting in multiple prices
- proceeds realised from auction to be transferred from the successful bidders’ cash account to the CCDC’s enforcement special cash account, and then to the pledgee’s cash account
- to be applied for by the pledgee alone
- bid floor price at 80% of the average trading price for the latest 30 consecutive trading days, or 80% of the valuation price on the trading day immediately preceding the enforcement date
- to be conducted by way of tender – by price, bidding in full-price (or dirty-price) and accepting in multiple prices
- the SHCH to register the title transfer after the auction, and remit the proceeds from the successful bidders’ cash account to the pledgee’s cash account
- to be applied for by the pledgee alone
- bid floor price at 80% of the average trading price for the latest 30 consecutive trading days, or 80% of the valuation price on the trading day immediately preceding the auction date
- one single auction price to be determined based on the principle of price priority and time priority
- upon the completion of the auction, the relevant registration institution to effect the transfer of the proceeds and the title of the bonds
- (i) to be applied by the pledgee (alone) as the buyer; (ii) to be applied by the pledgee and third party buyer jointly
- sale price not below the dirty price of ChinaBond Valuation on the trading day immediately preceding the auction date (or to be otherwise agreed by the pledgor)
- proceeds realised from a private sale to a third party buyer to be transferred from the CCDC’s enforcement special cash account to the pledgee’s cash account directly
- to be applied by the pledgee and third party buyer jointly
- sale price not to fall below the fair market value (being the average trading price for the 30 consecutive trading days or the valuation price on the trading day immediately preceding the enforcement date (or to be otherwise agreed by the pledgor)
- the SHCH to register the title transfer after the private sale, and remit the proceeds from the third party buyer’s cash account to the pledgee’s cash account
The following chart indicates which Default Rules apply:
A party enters into a loan agreement or derivative instrument (“Underlying Agreement”) with a bank and creates a pledge over government bonds it holds in the CIBM to secure its obligations under the Underlying Agreement. An event of default occurs later under the Underlying Agreement.
First, the Default Rules published by the CCDC apply because the CCDC is the registration institution for government bonds in the CIBM.
What happens next?
If the defaulting party is cooperative and agrees with the bank on the value of the pledged bond (“Agreed Value”), then:
- (application) the defaulting party and the bank jointly file an application to transfer the title of the pledged bonds with the CCDC, which will examine the application and other supporting documents (such as the Underlying Agreement, the original pledge agreement and the written agreement between parties on the Agreed Value); and
- (transfer of bonds) the CCDC will facilitate the transfer of the bonds to the bank’s bond account;
If the defaulting party is not cooperative, then:
- the bank may enforce the pledge by auction:
- (application) the bank files an auction application with the CCDC;
- (organisation of auction) the CCDC organises the auction pursuant to the CCDC Auction Rules;
- (cashflow to CCDC) once the auction is completed, the CCDC arranges for the auction proceeds to be transferred from the successful bidders’ cash accounts to the CCDC enforcement special cash account;
- (transfer of bond) the CCDC transfers the enforced bonds into the successful bidders’ bond accounts; and
- (cashflow to pledgee) the CCDC transfers the auction proceeds to the pledgee’s cash account (and transfer the balance (if any) to the pledgor’s cash account); or
- the bank may enforce the pledge by private sale to itself:
- (application) the bank files a private sale application with the CCDC to buy the pledged bond, provided that the selling price is equal to or higher than the ChinaBond Valuation price; and
- (transfer of bond) the CCDC transfers the sold bonds into the bond account of the bank as the pledgee (and transfers the balance (if any) of the bonds to the pledgor’s bond account);
- the bank may enforce the pledge by private sale to a third party buyer:
- (application) the bank and the third party buyer file a private sale application with the CCDC to sell the pledged bond to the buyer provided that the selling price is equal to or higher than the ChinaBond Valuation price;
- (transfer of bond) the CCDC transfers the sold bonds into the bond account of the third party (and transfers the balance of the bond to the pledgor’s bond account); and
- (cashflow) the CCDC transfers the sale proceeds to the pledgee’s cash account via CCDC enforcement special cash account (and transfer the balance (if any) to the pledgor’s cash account).
|Question 1: Can foreign investors participate in the enforcement of collateral?
The Default Rules do not address how a PRC law pledge over CIBM bonds is created and perfected by or in favour of foreign investors.
The Default Rules apply in principle to self-remedy enforcements applied by a foreign pledgee or by an onshore pledge against a defaulting foreign pledgor. The procedures may vary as between the Enforcement Organisations and be subject to regulation of the cross-border channel used, for example (R)QFII or CIBM Direct.
Foreign investors holding an onshore account through (R)QFII or CIBM Direct may participate as third party buyers in the private sale procedures or as bidders in the auction procedures. Foreign investors acting through Bond Connect may only participate when the trading platforms (for example Tradeweb or Bloomberg) enable participations in onshore enforcement.
|Question 2: What if a bankruptcy proceeding commences in respect of the pledgor?
When the pledgor becomes bankrupt, the pledged collateral becomes the property of the bankrupt debtor and in principle subject to the administrator’s management. The PRC Bankruptcy Law does not expressly address whether the pledgee may exercise any self-remedy enforcement right. The better view is that the collateral should not become subject the bankrupt proceedings because the collateral is in the possession of the pledgee.
According to a press release published by the CCDC, the Enforcement Organisation may continue to apply self-remedy enforcements at the request of the pledgee, unless prohibited by law or the administrator objects.
|Question 3: Do the Default Rules apply in the event of a pledgee’s default?
No, the pledgor cannot rely on the Default Rules to enforce the collateral when the pledgee defaults. Instead, the non-defaulting pledgor may require the return of the collateral by operation of law, or pursuant to the agreement between the parties. For example, under the NAFMII Repo Master Agreement (2013 version) (pledge-style), upon the occurrence of a reverse-repurchaser’s default, the repurchaser may early terminate the outstanding transactions, repay the debts (or the early termination amount) and take back the collateral.
In general, the pledgor’s rights are not prejudiced or otherwise impacted by the Default Rules.
|Question 4: What if the issuer of the CIBM bonds defaults?
The Default Rules only deal with the scenario where the pledgor defaults, rather than where the issuer of the CIBM bonds defaults. When a credit event occurs in respect of the CIBM bonds used as collateral, resulting in a significant drop of the collateral value, then the pledgee may issue a margin call or substitution request as contemplated under the agreements between them (such as Pledge-style NAFMII Repos).
The Tripartite Repurchase Agreement launched by the PBOC in October 2018 provides for collateral to be priced on a mark-to-market basis with the assistance of a recognised third party (being the CCDC or the SHCH for now).
The People’s Bank of China (“PBOC”) released the draft Circular on Transfer of Defaulting Bonds and sought public comments on 28 June 2019. The PBOC in principle allows the defaulting bonds to be transferred to third party buyer(s) through the CFETS and settled by the CCDC and/or SHCH. The implementation rules to be promulgated by the Enforcement Organisations are expected to provide more clarity on how to enforce defaulted CIBM bonds.
|Question 5: Do the Default Rules apply to transfer-style NAFMII Repos?
The Default Rules apply to the enforcement of collateral provided by way of pledge, in particular the Pledge-style NAFMII Repos. There are also Transfer-style NAFMII Repos in the onshore market.
Only the CFETS Auction Rules specifically cover the default scenario under Transfer-style NAFMII Repos. According to the CFETS Auction Rules, reverse-repurchaser (i.e. the buyer) of a Transfer-style NAFMII Repo may enforce the collateral upon the occurrence of the repurchaser’s (i.e. the seller’s) default by reference to the auction procedures that apply to pledge-style NAFMII Repos under the CFETS Auction Rules.
Unlike the offshore structure where all repurchased securities and margin facilities (cash margin and margin securities) are provided by way of outright transfer (such as under the Global Master Repurchase Agreement (“GMRA”)), Transfer-style NAFMII Repos are a hybrid and complex instrument – the repurchase bonds are subject to title transfer but cash margin or margin securities are provided by way of pledge.
As a result, if the pledgee enforces the cash margin or margin securities, then:
- CFETS Auction Rules should apply, but
- if the pledgee wishes to enforce the repurchased bonds, it may be unnecessary for the pledgee to follow the CFETS Auction Rules because the title of the bonds already sits with the pledgee and the pledgee in theory could exercise its proprietary rights to dispose of the bonds.
The Default Rules provide a clear mechanism by which secured parties may enforce against, and procure the sale of, CIBM bonds following default by counterparties.
King & Wood Mallesons has advised on the formulation of the Default Rules. Please speak to us if you have any questions.
 PRC law prohibits a “fluidity” clause (禁止流质) under which the parties agree at the time of entry into the pledge agreement that the title to the collateral will transfer to the pledgee upon the pledgers default (in effect, a self-executing title transfer).
 In the context of a repurchase agreement, the pledgor is also known as “repurchaser” or “seller” and the pledgee is known as “reverse-repurchaser” or “buyer”.
 Inviting by price, bidding in full-price (or dirty-price) and accepting in multiple prices” means that:
- the Enforcement Organisation invites bids from eligible bidders. The bids will be sorted by price (from highest to lowest);
- the price on each bid is a dirty-price if it includes accrued interest; and
- the bidder with the highest bid price is successful for the amount of bonds it bid at its bid price; the bidder with the second highest bid price is also a successful bidder for the amount of bonds it bid at its bid price, and so on, until the aggregate amount of all successful bids reaches the amount auctioned.
 Unlike the mechanism used by CCDC and SHCH (“inviting by price, bidding in full-price (or dirty-price) and accepting in multiple prices”), the CFETS calculates a single auction price at which all successful bidders will buy the respective amounts of the auctioned bonds.