Project Finance in China: Taking Security in Future Assets and Earnings

Among other difficulties to security in future assets, the Security Law specifically prohibits the mortgage of future or after-acquired property in buildings. This creates real problems for lenders seeking to finance construction projects because at the time of advancing funds the lender only has a mortgage over the land and not against the building, thus potentially leaving the lender under secured. Registration, filing and documentation requirements for mortgages over movable property have similar effect for lenders seeking to finance machinery and equipment to be delivered in the future. Mechanisms such as the "building under construction mortgage" or contractual clauses providing for security over "all existing and future assets" have been developed in an attempt to deal with the need for security in such future assets. However, such mechanisms do not create an enforceable security interest in after-acquired property. Moreover, in order to be effective such mechanisms require the continued cooperation and assistance of the mortgagor.

In the building context, it is now routine practice for lenders to impose an obligation on borrowers to register a mortgage on a building after it has been constructed. Predictably, this practice introduces monitoring and implementation problems as it involves the need for amendment of the mortgage contract and its registration after issuance of the building ownership certificate.

The provision in the Security Law for "maximum amount mortgages" is a hopeful sign that China will move in the direction of more flexible security. However, the converse concept of providing changing collateral for a specific debt, such as through a floating charge or other general security interest, is still not possible. Accordingly, there is no clear legal basis in the Security Law for taking security over accounts receivable, raw materials, inventory, after-acquired property or fluctuating credit balances.

We understand that these deficiencies may be addressed in part in the draft Property Law, which contemplates the ability to mortgage future property subject to subsequent registration once the property comes into existence.

Pledges and the SPC Interpretation

The Security Law rather enigmatically provides for the pledge of "other rights that may be pledged by law" (Article 75(4)). Though potentially enabling, this provision is not generally viewed expansively but rather as a basis for limited interpretation and further legislation. The first significant expansion of pledgable items is contained in Article 97 of the SPC Interpretation, which expands the list by providing for pledge "of the right to the earnings from such immovables as highway bridges, highway tunnels or highway ferry crossings, etc."

Article 97 is helpful to project finance in that it potentially provides a basis for taking security in future earnings and assets. However, the nature of a pledge relying on such rights is not specified in detail. Questions remain as to how such a pledge may be implemented and whether registration will be necessary. Accordingly, the legal basis for pledges of such rights and by extension assignments by way of security, for example of contractual rights and bank accounts (especially with fluctuating balances), remains uncertain. Moreover, the reference only to highway-related projects, "etc." (potentially an expansive term) seems unnecessarily limited when guidance as to which projects may qualify for a pledge of revenues, other than the three named, is required.

The failure (or decision not) to elucidate such matters seems strange, especially when "overseas project financing of domestic projects" regulations suggest that no other security will be permitted in principle beyond that provided by a project's own future assets and revenues. The existence of Article 97 also indicates that the need for security in future assets and earnings is understood. The lack of needed detail is perhaps explained by the fact that the drafters preferred to avoid the appearance of "legislating from the bench" in favour of appearing merely to be interpreting the already-legislated content of the Security Law.

The SPC Interpretation's expansion of pledgable rights is encouraging to lenders who require such security. Therefore, the interpretation is consistent with current policies to encourage infrastructure development. However, the interpretation does not go far enough to establish a sufficient legal basis for security in future assets and revenues and is therefore disappointing. Further, although the SPC Interpretation should result in more uniform interpretation by the courts, it may be viewed by registration officials who report to various ministries rather than to the Supreme People's Court as not applicable to their actions. Accordingly, comprehensive and specific guidance is needed in the form of implementing regulations to the Security Law or the anticipated Property Law.

Conclusion

Neither the Security Law nor the SPC Interpretation adequately addresses the issue of security in future assets and income streams. As these issues must be adequately addressed before offshore lenders will make significant commitments for PRC infrastructure projects, additional regulations or legislation are needed to clearly establish a broad range of future assets and revenues as types of assets over which security may be taken and the methods of taking such security. In particular, it is to be hoped that any implementing regulations of the Security Law or the Property Law itself will adopt a specific and comprehensive approach to such security nationwide.

By Todd R. Benson,

Freshfields Bruckhaus Deringer, Hong Kong