Judicial Interpretation on the PRC Security Law

This article considers certain issues that are dealt with by the Interpretation in the area of external security, guarantees, mortgages and pledges.

KEY POINTS:

• Certain issues arising out of the PRC, Security Law have been clarified by the Interpretation. Other issues,however, remain to be resolved.
• If external security has not been approved by or registered at the relevant authority, the security contract will be void.
• The term of an asset security and the term of a guarantee have been clarified.
• The Interpretation recognizes some innovative ways in which a pledge can be used.
• The Interpretation does not resolve all of the uncertainties and ambiguities surrounding security in the PRC.

GENERAL PROVISIONS

External Security

One issue that had previously caused some uncertainty was the effect of a failure to undertake registration at the State Administration of Foreign Exchange (SAFE) in respect of security provided by Chinese entities in favour of foreign parties (external security). It is clear from the relevant procedures and rules (the External Security Procedures and the External Security Implementing Rules respectively)1 that the failure to obtain approval in respect of a security that is subject to the requirement of approval will render the security contract void. However, the consequences of a failure to register the external security are not expressly stipulated. Article 42 of the External Security Implementing Rules suggests that the failure to register the security at SAFE will not render the security void, but will simply result in the inability to obtain approval to purchase and remit foreign exchange when the security obligations are performed.

The Interpretation provides in Article 6(1) that if external security has not been approved by or registered at the relevant authority, the security contract will be void. No exceptions to this rule are recognized.

Article 6 sets out other circumstances in which an external security contract will be void, including security provided by a financial institution that does not have authority to undertake foreign exchange security business, and security provided by a non-financial institution enterprise that does not have foreign exchange income. The latter is of some concern. Although the External Security Procedures establish the general principle that the outstanding balance of external security provided by an enterprise must not exceed its foreign exchange earnings for the previous year, it had not been clear whether this was simply a factor to be taken into account when obtaining approval, or whether it affected the validity of the security itself.

The Interpretation now provides that any security provided by a non-financial institution enterprise that does not have foreign exchange income will be void. There does not appear to be any legal reason for such an outcome, other than the need to enforce the foreign exchange controls.
Civil Liability for Invalid Security Contract

In Article 7, the Interpretation expands on the principle of civil liability for invalid security contracts, referring to the potential liability of a security provider and debtor to compensate the creditor for any economic loss where the principal contract is valid but the security contract is invalid. The effect is that if a security provider is at fault for the invalidity of the security, the security provider will be liable for a certain percentage of the unpaid debt owing by the debtor. The issue of civil liability for invalid security is a recurring theme throughout the Interpretation. The intention is clear enough: namely, to hold parties liable for their actions. It is unclear, however, how such provisions will operate in practice and the extent to which creditors that hold invalid security will be able to recover from the security provider on the alternative basis of fault.

Term of an Asset Security

Article 12 of the Interpretation provides that the agreement of the parties and the requirements of the registration authority in relation to the term of a security will not have binding legal force on the continuation of an asset security. Implicit in this provision is the principle that an asset security has an independent existence as a property right and can only be extinguished by a separate property act (for example cancellation of registration) or by operation of law.

Article 12 goes on to provide that a creditor may exercise its asset security within two years from the expiry of the limitation period for the debt secured by the asset security.

GUARANTEES

Guarantees by Branch Organisations of Legal Persons

Under Article 17 of the Interpretation, guarantees by branch organizations of enterprise legal persons will be invalid if provided without the written authorization of the relevant legal person. If the assets operated and controlled by the branch organization are insufficient to cover the guarantee liability, the enterprise legal person will bear civil liability. Banks are not expressly referred to in the Interpretation as enterprise legal persons. From the wording of Article 124, however, it would appear that commercial banks are considered to be legal persons for the purpose of the Interpretation. If this inference is correct, Article 17 also applies to branches of commercial banks.

Article 17 of the Interpretation restates the provision in Article 29 of the Security Law, except that it also draws a distinction between the assets of the branch organization and the other assets of the enterprise legal person, and provides that the enterprise legal person will ultimately be responsible for the guarantee liability.

Requirement for Guarantee to be in Writing

Article 13 of the PRC, Security Law, lays down the requirement for a guarantee contract to be in writing. Article 15 of the PRC, Security Law sets out the detailed content requirements for guarantee contracts. Significantly, Article 22 of the Interpretation provides that even if the principal contract does not contain a guarantee clause, a guarantee contract will be formed if the guarantor signs or affixes its seal to the principal contract in the capacity of guarantor.

The Term of a Guarantee
Article 15 of the PRC, Security Law provides that a guarantee contract must specify the term of a guarantee. Prior to the Interpretation, it had been unclear whether the term of a guarantee was subject to agreement between the parties and whether it was possible for the guarantee contract to provide (similar to the formulation in a guarantee governed by English law) that the guarantee would remain in full force and effect until all amounts owing by the debtor had been repaid in full.

Article 32 of the Interpretation now recognizes two possibilities:

(a) if the guarantee term stipulated by the guarantee contract is shorter than or equal to the term for the performance of the principal debt obligation, the term will be treated as not having been agreed and will be six months from the expiry date for the performance of the principal debt obligation (this is consistent with Article 26 of the PRC, Security Law); and

(b) if the guarantee contract stipulates that the guarantor shall bear guarantee liability until the principal and interest on the debt has been repaid in full, the term will be treated as not having been stipulated clearly and the guarantee term shall be two years from the expiry date for the performance of the principal debt obligation.

MORTGAGES

Effect of Registration

The final version of the Interpretation contains significantly fewer provisions on mortgages than the earlier drafts. As a result, a number of issues arising out of the provisions of the PRC Security Law(中华人民共和国担保法)remain unresolved. One issue that has been the subject of lengthy debate is Article 41 of the PRC Security Law(中华人民共和国担保法) , which provides that if a mortgage is created over an asset that is required to be registered, the mortgage contract will take effect from the date of registration.

At issue is not whether the creation of the mortgage should be conditional on registration, but whether the effectiveness of the mortgage contract itself should be conditional upon registration. The dilemma that this creates is that prior to registration, the mortgagee has no contractual basis for its relationship with the mortgagor. Some commentators have suggested that the wording of the provision is defective and that the original intention was that the mortgage rights should only take effect upon registration. Other commentators have suggested that the wording does in fact reflect the original intention and have pointed out that it was borrowed from the Soviet model.

The Interpretation provides some clarity on this issue by providing in Article 56 that if the mortgagor refuses in bad faith to register the mortgage agreement, the mortgagor will be liable to compensate the creditor for any losses incurred as a result.

Of interest is Article 59, which provides that if the mortgaged asset is not able to be registered as a result of reasons to do with the registration authority, but the mortgagor has delivered the relevant rights certificate to the creditor, the creditor has the right to receive payment from the asset in priority to other creditors. If registration of the mortgaged asset is not undertaken, however, the mortgage will not prevail over third parties.

This provision constitutes something of an exception to the rule in Article 41 of the PRC Security Law(中华人民共和国担保法), since in the circumstances the mortgage right will still be effective as against the mortgagor, even though registration has not been completed.

The requirement for the relevant rights certificate to be delivered to the creditor may prove difficult in the case of a mortgage over real estate, since some regional regulations (such as the Shanghai Mortgage Procedures) require the real estate rights certificate to remain in the custody of the mortgagor and provide that the mortgagee may only take custody of the mortgage rights certificate issued by the real estate registration authority.
Effect of a Lease on Pre-existing Mortgage

Another issue that has been resolved by the Interpretation is the effect of a lease on a property that is subject to a pre-existing mortgage. The converse (that is, the effect of a mortgage on a pre-existing lease) was already clear under Article 48 of the PRC Security Law(中华人民共和国担保法)- the lease contract remains effective - and this has been reiterated in Article 65 of the Interpretation. This Article actually goes further than the corresponding provision in the PRC, Security Law and provides expressly that after the mortgage rights are exercised, the lease contract shall continue to have effect as against an assignee of the mortgaged property for the effective term of the lease.

In terms of the effect of a lease over a pre-existing mortgage, Article 66 of the Interpretation provides that after the mortgage rights are exercised, the lease contract will not have any binding effect on the assignee of the mortgaged property. It further provides that the mortgagor shall be liable to compensate the lessor for any loss that the lessor incurs if the mortgagor did not inform the lessor that the property was subject to a mortgage.

Assignment of Mortgage Property

One issue that is still uncertain is the impact of the assignment of the mortgaged property on the mortgage. The uncertainty began with Article 49 of the PRC, Security Law, the wording of which suggests that if the mortgagor notifies the mortgagee of the assignment and discloses the fact that the property is mortgaged to the assignee, the mortgage will be discharged and the mortgagor will be under an obligation to provide alternative security, to use the assignment proceeds to repay the debt or to post the proceeds as some form of security deposit.

Article 49 of the PRC Security Law(中华人民共和国担保法) has been the subject of considerable debate, with most commentators arguing that if a mortgage right is in the nature of a true property right, an assignment of the mortgaged property should not affect the mortgage unless the mortgagee expressly agrees to discharge the mortgage.

Article 67 of the Interpretation attempts to resolve the uncertainty by providing that after the assignment of mortgaged property that has been registered, the mortgagee may still exercise its mortgage rights. However, the exercise of rights by the mortgagee still appears to be limited to the circumstances in which "the mortgagor has not informed the mortgagee or notified the assignee". Although this reflects the wording in Article 49 of the PRC, Security Law, it does not explain what should happen to the mortgage in the event that the mortgagee is informed of the assignment, but does not consent to the assignment or agree to discharge the mortgage.

Article 67 of the Interpretation provides some additional clarification by providing that an assignee may pay the debt to the mortgagee on behalf of the debtor and thereby cause the mortgage to be extinguished. Thereafter, the assignee will have recourse against the debtor.

Significantly, the provision is inconsistent with Article 49 of the PRC Security Law(中华人民共和国担保法) to the extent that it implies that an assignment will be effective irrespective of whether the mortgagor has informed the mortgagee of the assignment, or notified the assignee of the fact that the property is subject to a mortgage. Article 49 of the PRC, Security Law provides expressly that an assignment will be void in such circumstances.

Article 35 of the Security Law

A further issue that has been resolved by the Interpretation is the effect of Article 35 of the PRC Security Law(中华人民共和国担保法). Article 35 provides that the debt secured by a mortgage may not exceed the value of the mortgaged property. The dilemma caused by this provision was whether it prohibited a mortgage in such circumstances, or whether it just reiterated the obvious principle that the mortgaged property could only act as security to the extent of its value. The dilemma has occurred in practice as well as in theory, since there have been instances (previously experienced by these writers) in which the real estate bureau in certain localities has refused to register a mortgage on the basis that the value of the mortgaged property was insufficient to cover the total amount of the debt. Thankfully, this dilemma has now been resolved in favour of the latter interpretation. Article 51 of the Interpretation provides that where the debt secured by the mortgagor exceeds the value of the mortgaged property, the excess amount will not be repaid in priority.

PLEDGES

Types of Pledges

The provisions of the Interpretation in respect of pledges are set out under two categories: (1) a pledge of movables; and (2) a pledge of rights.

In terms of a pledge of movables, certain provisions merit attention. Article 85 of the Interpretation provides that a pledge can arise where a debtor or a third party creates security in favour of a creditor by transferring possession of money that has been designated in the form of a special account or what can be generally described as cash cover. The requirement for the money to be designated is not clear. Does the amount of the money need to be fixed, or can a pledge arise in respect of a fluctuating balance of a designated account? If a pledge can arise in respect of a special account and the physical characteristic of the cash is not preserved, why does such security fall under the category of a pledge of movables rather than a pledge of rights? (Once the cash is deposited in a special account, one would expect that the relevant property is the right that the debtor or pledgor has against the bank in respect of the relevant credit amount and not a movable in the form of a tangible item of property.) The extent to which Article 85 may allow security arrangements in respect of bank accounts is uncertain.

Another provision that is of some interest is Article 88. This provides that a pledgor can create a pledge where it has indirect possession of the pledged asset.

The provision recognizes that the person with actual possession will be bound by the terms of the pledge upon receiving notice of the pledge.

In terms of a pledge of rights, a noteworthy provision is Article 97. This provides that the right to receive income in respect of immovable property such as public bridges and tunnels can be secured as a pledge of "other rights that may be pledged in accordance with the law" under Article 75(4) of the PRC, Security Law. Although the nature of such a pledge is not specified in detail, the effect appears similar to assignment security over contractual rights under English law. If this is the case, the provision will assist security arrangements that involve contractual rights over income from immovable property.

THE IMPACT OF THE INTERPRETATION

The Interpretation is likely to have a significant impact on the application of the PRC, Security Law by PRC courts and the treatment of security by PRC authorities generally. As noted above, certain issues arising out of the PRC, Security Law have been clarified by the Interpretation. In this respect, the Interpretation should provide a greater degree of certainty to creditors and other parties who are involved in security arrangements in the PRC.

It should be noted, however, that the Interpretation is limited in its scope to the forms of security recognized by the PRC, Security Law and that it does not resolve all of the uncertainties and ambiguities surrounding security in the PRC. In particular, it is important to bear in mind that although the Interpretation clarifies the ways in which certain forms of security may be used (for example, Articles 85 and 97 in respect of pledges), it does not recognize any new forms of security. As a result, creditors will continue to be frustrated by the limited forms of security available in the PRC and the absence of a legal basis for certain types of security (such as security over bank accounts, floating security and security over receivables and contractual rights).

ENDNOTES:
1. Administration of the Provision of Security to Foreign Entities by Domestic Institutions Inside China Procedures, promulgated by the People's Bank of China with effect as of October 1 1996, and their Implementing Rules, issued by SAFE with effect as of January 1 1998

CORRECTION:

"Top Chinese Enterprise IPOs of the Year,"
China Law and Practice, December 2000/January 2001,P25-28. Throughout the article, the author makes reference to "Freshfields".This should, in fact, be read as "Freshfields Bruckhaus Deringer".