Uncertainty continues over derivatives transactions with counterparties in the People's Republic of China following rejection of swap claims in October 1999 by the liquidation committee of Guangdong International Trust & Investment Corp., despite recent clarification by the State Administration of Foreign Exchange.
The key administration regulation in this matter is the Notice Regarding The Prohibition of Derivative Transactions Conducted By Financial Institutions Outside China At their Own Discretion, promulgated by the People's Bank of China on March 29, 1995, which governs foreign exchange transactions, including derivatives, with Chinese financial institutions such as GITIC. This notice states the approval of SAFE should be obtained for these types of transaction by the contracting PRC institution.
Prior to the liquidation of GITIC many market participants, including Deutsche Bank, believed that the requirements of the 1995 notice were satisfied if the following conditions were met:
* The transaction came within the scope of the business license that the Chinese institution is operating under, being either a "foreign exchange business license," a "financial institution legal person licence" or a "financial institution business license" as issued by the People's Bank of China or SAFE; and
* The transaction was for a demonstrable hedging purpose.
In effect, the market participants took the view that satisfaction of the above two points constituted general, or standing, SAFE approval. This view was reinforced by the fact that SAFE does not have any procedures in place to provide transaction-by-transaction, or specific, approval.
GITIC Liquidation
In October 1999 the liquidation committee of GITIC indicated its intention to reject all swap claims because GITIC failed to obtain a transaction-specific approval from SAFE prior to its entering into swaps with foreign institutions. From early June 2000 swap claimants began to receive letters from the liquidation committee formally rejecting their claims. The liquidation committee also claimed that, in the event of failure to obtain a transaction-specific approval, the derivatives transaction would be invalid and unenforceable.
Swap claimants were left facing the possibility of being able to claim on a restitution basis, that is, the return of payments made by them to GITIC and the repayment of amounts received from GITIC. Naturally this was considered to have far-reaching implications both legally and for the fledgling onshore derivatives market in the People's Republic of China. It has cast serious doubt on the validity and enforceability of every existing derivative transaction between People's Republic of China institutions and foreign institutions and, it has also created uncertainty as to how derivatives transactions can be conducted. Since this issue first surfaced, the onshore derivatives market has remained illiquid, and there seems little prospect of significant development of this market for the foreseeable future.
The Positions
The formal rejection letters that began to appear in June 2000 expanded on the initial position of the committee in October 1999. In addition to claiming that swap claims could only be considered if the swap in question had been specifically approved by SAFE, it also claimed that the swaps were for speculative purposes and therefore void.
The following is a summary of the main arguments put forward by claimants:
* Because the question of whether a transaction in question has been entered for hedging or speculative purposes is one of fact, it seems reasonable to assume that the committee had some factual basis for asserting that all the transactions they rejected were speculative. However, there has to date been no indication of such factual basis.
* There is considerable uncertainty as to what is "hedging" and "speculation" under Chinese law, and therefore it is unclear what legal due diligence would put a party in a position of confidence that a transaction is permissible. It is moreover not clear from the committee's position whether the requirements of SAFE approval and hedging are independent of each other. If they are, then even with SAFE approval one can never be certain that a given trade is permitted.
* There has been no indication from SAFE itself or the PBOC that the wording of the 1995 PBOC Notice was intended to mean that specific approval is necessary. The most compelling circumstantial evidence to this effect is that SAFE has itself indicated that it has no procedure for granting such transaction-by-transaction approval and that no criteria have ever been established for verifying any application for approval of SAFE on this basis.
* Even if the committee's points on hedging and/or speculation are correct and substantiated, appropriate remedies for failure to comply with the 1995 PBOC Notice should be "regulatory-style" sanctions such as a fines or other disciplinary action. It should not invalidate the swaps claims themselves, as this is a matter of substantive law, not of regulation.
* In support of the above point, it was pointed out that the 1995 PBOC Notice is an "administrative rule" and not a law promulgated by the National People's Congress or other body empowered to enact laws that could have the effect of rendering transactions invalid.
* The fact is that GITIC itself was the party culpable for the failure to obtain the approval, and therefore it would seem reasonable to assume that it should not be the other party that suffers as a result of such failure (or, to put it another way, that GITIC should benefit from its own negligence). Moreover, GITIC must have made material misrepresentations as to its own capacity, authority and status of regulatory approvals at the time it entered these trades. It should be liable therefore for these misrepresentations.
The liquidation committee's responses to claimants included the following:
* The rejection letters clearly stated that the transactions were for speculative purposes, but do not give an indication of the source of the requisite facts.
* The point as to the uncertainties of hedging and speculation has to my knowledge not been addressed by the committee.
* The committee responded to the point that there is no procedure established for specific approval by baldly asserting that there is such a procedure.
* The committee has responded to claimants by simply rejecting the argument and repeating that the transactions are invalid.
* As mentioned above, the committee has asserted that the swap claimants were equally culpable for the failure to obtain SAFE approval, and should therefore share the consequences. Many swaps participants in the People's Republic of China (including Deutsche Bank) had carried out extensive investigations into the necessity for SAFE approval, and despite these investigations at no time was it clear that specific SAFE approval was necessary.
Clarification by SAFE
As a result of this impasse, in August last year the International Swaps and Derivatives Association wrote to SAFE seeking clarification of this issue in general and of the necessity of specific approval in particular. ISDA's letter stated that:
The lack of clarity on the requirement for transaction-specific SAFE approval would fundamentally affect the availability of such derivative transactions and severely limit the ability of PRC institutions to engage in derivative transactions for the purposes of hedging and risk management.
ISDA went on to request:
SAFE's guidance on whether a specific case-by-case approval from SAFE is indeed required under the 1995 PBOC Notice.
On November 27, SAFE issued a response in which it reiterated the need for the transactions to come within the scope of the institution's relevant license, and that compliance with such licenses would mean that it is not necessary to obtain transaction-specific approval from SAFE.
While this would appear to be an encouraging development, most market participants have reacted cautiously. This is for the following main reasons:
* It is not clear what the liquidation committee's reaction to SAFE's statements is yet.
* Even if the liquidation committee accepts SAFE's position, it no longer has the power to reverse its previous findings, since these have in effect been ratified by the Higher People's Court of Guangdong Province, when it approved the resolution of the third creditor's meeting. Accordingly, true resolution can only be obtained at the same level; that is, a finding by the Higher People's Court that the previous assertions as to specific approval have been withdrawn.
* The debate over "hedging" versus "speculation" has not been resolved by SAFE's clarification, so the uncertainties over the meaning of these terms and there impact on derivative transactions remain.
* The products affected by these uncertainties remains. Certainly currency swaps are caught, but what about other types of derivatives; hybrid transactions, embedded derivatives, structured products, and so forth.
Accordingly, while SAFE's intervention is to be welcomed, the liquidation committee's stance continues to have reverberations for the fledgling derivatives market in the People's Republic of China. Numerous fatal uncertainties remain as to the legal status of all derivative transactions, and it is difficult to see how the market can develop to any significant extent until there has been significant clarification.
This week's Learning Curve was written by Stephen Trevis, a lawyer in the legal department at Deutsche Bank in Hong Kong.
