Developments and Prospects in China's Security Law

Regarding external security, two issues in the Foreign Debt Administration Tentative Procedures (effective from March 1 2003) should be noted. One is the special qualifications for creditors and debtors in external security contracts. The Security Law and the SPC Interpretation only provide for qualifications of security providers. Pursuant to Articles 20 and 21 of the Foreign Debt Administration Tentative Procedures, the creditor in the external security shall be a foreign institution of a business nature and, without the approval of the State Council, the debtor in the external security cannot be a government organ, a social organization, or an institution. Violation of such qualification provisions results in null and void external security contracts. Another issue is that it is now clear that the external security provider shall take the extra formality of examination and approval by the foreign exchange administrative department before performing his security obligations as per the external security contract.

Security for Company Shareholders

Article 4 of the SPC Interpretation provides that in the event that a director or a manager violates Article 60 of the PRC Company Law (中华人民共和国公司法) (the Company Law) by providing the company's assets as security for the obligation of a company shareholder or other individual(s), the security contract is void. Article 60, Item 3 of the Company Law states that a director or a manager can not use the company's assets to provide a security for debts of a shareholder of the company or other individual(s).

There have been heated debates in legal circles as to proper application of Article 4 of the SPC Interpretation. The debates have focused on three points. First, whether this article of the SPC Interpretation applies to the security provided by director(s) or manager(s), or to that provided by the company to which the related director(s) or manager(s) belong. Second, whether endorsement or confirmation by the company's board of directors would make the security valid. Lastly, whether there is exception to the invalidity of the company's security for its shareholders.

It is significant to note that on November 17 2001, the SPC rendered final judgment for a security dispute case among Fujian Zhongfu Industrial Shares Co. Ltd (the debtor), Industrial and Commercial Bank of China (the creditor), and China Fujian International Economic and Technology Cooperation Co. (the guarantor). This judgment has guided the security activities of companies in the PRC in order to maintain companies' assets and protect the interests of minority shareholders, and especially those of listed companies.

The wording of both the Company Law and the SPC Interpretation clearly refers to the case in which directors or managers provide security with the company's assets or credit, and not directors or managers providing the security with their own individual assets or credit. The prohibition contained in Article 60 of the Company Law relates to either the individual director or the board of directors as a whole. It is reasoned in the judgment of the Zhongfu Case that: "If there is neither a legal provision nor articles of association nor shareholders' meeting authorizing the board of directors to provide the security, the board of directors composed of directors shall not have the power to provide the security for the shareholder(s) with the company's assets due to the fact that the law has prohibited each individual director from providing such security." It is inferred from the judgment that the company's security for its shareholder(s) may be valid if it has been effectively approved by the shareholders of the company. Of course any shareholders having a conflict of interest shall not cast their votes regarding this resolution in the shareholders' meeting.

Foreign-invested Venture Capital Investment Enterprises

Foreign-invested venture capital investment enterprises in the PRC shall not provide security, pursuant to Article 32, Item (6) of the Administration of Foreign-invested Venture Capital Investment Enterprises Provisions (外商投资创业投资企业管理规定), effective from March 1 2003. Such provision is an exception to Article 7 of the Security Law, i.e., that a legal person or other organization with full discharge capacity can be a guarantor, but it may be justified for maintenance of assets of foreign-invested venture capital enterprises and their invested enterprises.

Validity of Independent Security

Article 5 of the Security Law provides that if the principal contract is null and void, the security contract shall be null and void accordingly; where it is otherwise agreed in the security contract, such agreement shall prevail. Nevertheless, in several judgments the SPC set the guideline to merely recognize the independence of the foreign-related guarantees (usually means at least one party to the guarantee contract is a foreign entity) but denied the independence of the security among all domestic parties. Meanwhile it is important to note that the SPC does not repudiate the entire guarantee contract but only the "independent clause" therein. Such a clause shall not prevent the guarantor from bearing his liabilities from other valid clauses of the guarantee contract. The judicial attitude obtains support from the formal legislative explanation of the Security Law: "It is the custom in international trade that security contracts, especially those in foreign-related economic and trade issues, such as payment guarantees on demand, are independent from the principal contracts and irrevocable according to parties' agreements." It appears that the true reason for the foregoing judgments may be concerns about security fraud and abuse of rights by creditors. Because such concerns also exist as regards foreign-related guarantees, it is anticipated that PRC courts will respect parties' agreement and uphold the validity of independent guarantees among domestic parties in line with Article 5 of the Security Law.

Form of a Security Contract

Articles 13, 38, 64 and 90 of the Security Law lay down the requirement that guarantee contracts, mortgage contracts, pledge contracts, or deposit contracts shall be in written form. If there is no written contract, none of these security contracts is valid. Notwithstanding such provisions, according to Article 36 of the PRC Contract Law, there may be exceptions to such a requirement. If it is shown that one party to the security contract has performed the principal obligations and the other party has received them, the security contract shall be established between both of them even if they never sign a written security contract.

Mortgages

State-owned Assets

Article 34 of the Security Law provides that "the following property may be mortgaged: "......(4) state-owned machinery, means of communication and transportation and other property of which the mortgagor has the right to dispose of according to law". There is no provision regarding Article 34 in the SPC Interpretation. Using the State-owned Industrial Enterprises Transformation of Operating System Regulations (the State Council Regulations, issued on July 23 1992), some judges have insisted that mortgages over essential assets of state-owned enterprises shall be null and void unless the mortgages have been approved by the competent government department. Article 15 (1) of the State Council Regulations provides that "in accordance with the requirements of its manufacture and operation, the state-owned enterprise may decide on its own to let, mortgage or transfer its usual fixed assets for payment; subject to the approvals of the government's departments in charge, the state-owned enterprise may mortgage or transfer its key equipment, full sets of equipment or important buildings for payment". Other judges have staunchly held the opinion that government approvals shall not be the precondition for the valid creation of mortgages over any state-owned assets.

The differing interpretations of the above Article in judicial practice have prompted the SPC to clarify this issue. The SPC rendered a written Reply on June 18 2002, instructing PRC courts at all levels to support the above opinion.¹ The Reply points out that the mortgage agreement executed between a state-owned enterprise in the manufacturing industry (the mortgagor) and the mortgagee for mortgage over machinery, equipment, buildings and other assets of the state-owned enterprise shall not be null and void solely owing to lack of approvals of the mortgage agreement by the government's departments in charge. The possible reasons that the SPC made this determination are: (1) the Security Law has higher legal force than the State Council Regulations; (2) the Security Law came into force after the State Council Regulations; (3) there are no criteria of "key equipment" and "important buildings" mentioned in State Council Regulations; and (4) the state-owned enterprise as an independent legal person should have full power to efficiently dispose of any of its own assets so as to compete with private enterprises on an equal basis in China's market economy.

Registration of Mortgages for Vessels or Aircraft

Pursuant to Article 41 and Article 42(4) of the Security Law, the mortgage contract for vessels or aircraft shall not be valid until such mortgage is registered with the proper authorities. But per Article 13 of the PRC Maritime Law and Article 16 of the PRC Civil Aviation Law, a mortgage between the mortgagor and mortgagee shall be established even though the registration of a mortgage for a vessel or aircraft is not made, and the effect of non-registration is limited to the consequence in which such mortgage shall not be against any bona fide third party. According to a generally held PRC interpretative rule that specific laws will prevail over general law if there is a conflict, the special provisions of the Maritime and Aviation Laws on this point will prevail. It would appear that Article 42(4) of the Security Law might be amended or replaced by provisions in the new civil code.

Priority of Construction Project Payment

As per Article 286 of the Contract Law, if the contract letting party to a construction project fails to pay the contractor the costs and remuneration in accordance with the terms of the construction contract, the costs and remuneration shall be compensated and compensation will be derived from the conversion or auction of the project into its monetary value. Prior to the SPC Reply in June 2002, if the project was mortgaged to the lender, it was uncertain whether the contractor's or the mortgagee's right to receive payment was the priority. The Reply balances both parties' interests to a certain extent; that is, the contractor's right shall be prior to the mortgage right only if the contractor exercises his priority right within six months starting from the actual completion date of the construction project or the agreed completion date provided for in the construction contract. Therefore a lender who has been secured by the mortgage over the building or other structure currently being constructed should find out whether and when the contractor's costs and remuneration under the construction contract have been overdue.

Mortgage Re-registration

Several security rules at the ministerial level, such as the Administration of Urban Real Property Mortgage Procedures (promulgated in 1997 and amended in 2001 by the Ministry of Construction) require amendment registration after any variation to security contracts. In both the Security Law and the SPC Interpretation, however, there is no re-registration requirement arising from either amendment of security contracts or assignment of both principal contracts and the ancillary security contracts. It was implied that re-registration of mortgage over movables (transferred from commercial banks) by financial assets management companies shall be necessary according to the Reply (Gongshangshizi [2000]40) dated February 12 2001 of the State Administration of Industry and Commerce. But the SPC rendered new relevant stipulations in the Several Issues Concerning the Application of Law to Trials Concerning the Assets Formed by the Bad Loans of the State-owned Banks Acquired, Managed and Disposed by the Financial Asset Management Companies Provisions (the SPC Provisions), effective April 11 2001.

This was probably done for three reasons. First, re-registration would possibly alter the sequence of original mortgage registrations over the same property. Second, mortgage registrations of large quantities of assets in various forms would involve many different government departments (such as the land bureau, housing bureau, company registration office, and others). Third, the overall PRC mortgage registration system is in need of improvement to ensure uniformity throughout the country in regard to registration requirements, procedures, fee charge standards, and other particulars. Article 9 of the SPC Provisions recognizes that the financial asset management company has the power to obtain the ancillary mortgage rights per the law after assignment of the principal contract. Further, the original mortgage registration shall remain in force. The financial asset management companies therefore have been entirely relieved of the heavy burden of conducting re-registrations of mortgages created over the applicable assets under the SPC Provisions.

Mortgage up to a Maximum Amount

According to Article 61 of the Security Law, it is not permitted to transfer obligations secured by a mortgage up to a maximum amount. But it seems difficult to justify such a provision. It is anticipated that the future civil law will not include such a provision. As a matter of fact, both Article 83 of the SPC Interpretation and Article 8 of the SPC Provisions have already provided some flexibility regarding application of Article 61 of the Security Law. Because the mortgagee may exercise his mortgage rights if the term for the discharge of an indeterminate obligation secured by a mortgage up to a maximum amount has expired and obligation has become determinate, transfer of obligation secured by a mortgage up to a maximum amount may not be restricted after such determination.

Pledge

Account Pledge

Pursuant to Article 85 of the SPC Interpretation, the debtor or a third party can deliver possession of his money to the creditor as security for an obligation after specifically allocating it for such purpose by placing it in a special account, or providing it as a guarantee. Thus, generally speaking, an account including its fixed amount therein could be pledged. There can, however, be exceptions to this rule. For example, in Article 24 of the recently issued Administration of Securities Investments in China by Qualified Foreign Institutional Investors Tentative Procedures, a QFII's renminbi account opened in his custodian bank shall not be used to provide security.

Pledge of Rights

Article 75 of the Security Law stipulates that the following rights can be pledged: (i) bills of exchange, cheques, promissory notes, bonds, certificates of deposit, warehouse receipts, and bills of lading; (ii) legally transferable shares and share certificates; (iii) legally transferable trademarks, copyrights and patents as property rights; and (iv) other rights that can be legally pledged.

Pledge of Rights to Earnings from Immovables

Article 97 of the SPC Interpretation only stipulates that the rights to the earnings from such immovables as highway bridges, highway tunnels or highway ferry crossings can be pledged pursuant to Item (4) of Article 75 of the Security Law. The SPC is recognizing the pledge of such rights to the earnings from immovables. But it would appear that other rights that can be pledged from immovables of a similar nature might be recognized by the civil law or the SPC as valid security interests to secure financing for infrastructure projects. These include the earnings from subways, light rail trains and elevated roads, the importance of all of which has been growing steadily in China.

Pledge of Rights to Electricity Payments

The State Development Planning Commission (the SDPC, now restructured as the State Development and Reform Commission) and the People's Bank of China (the PBOC) jointly issued the Administrative Measures of Pledge of Rights to Earnings from Electricity Payments for Electricity Networks Construction and Improvement Projects in the Countryside (Jijichu [2000]198) on March 1 2001. According to these measures, electricity network operation enterprises are entitled to pledge their rights to earnings from future electricity payments to obtain loans from lenders in order to construct and improve rural electricity networks, and the relevant pledge contracts shall be effective upon registration in the relevant provincial offices of the SDPC. Although the SPC Interpretation does not recognize such pledge of rights, it should be noted that Li Guoguang, the Vice President of the SPC, confirmed such earnings as a valid security interest in a published speech during the working session on Nation-wide Civil and Commercial Trials on November 13 2001.

Pledge Endorsement on Negotiable Instruments

There are conflicting provisions between the SPC Interpretation and the Several Questions Concerning the Trial of Disputes over Negotiable Instruments Procedures effective November 14 2000, which is another important SPC decision regarding the effect of pledge endorsements on negotiable instruments that was issued at the same time as the SPC Interpretation. Article 98 of the SPC Interpretation stipulates that if the pledgor and the pledgee of a bill of exchange, cheque or promissory note who have failed to endorse such a negotiable instrument with the word "pledge" subsequently set up the pledge against a bona fide third party, the people's court shall not support such a setting up of the pledge. Article 55 of the November 14 2000 Procedures, however, provides that if there is a pledge contract or clause instead of the word "pledge" endorsed by the pledgor on a bill of exchange, the pledge to the bill of exchange shall not be set up. Therefore, without endorsement of "pledge" on a bill of exchange, no pledge shall be established under the November 14 2000 Procedures; according to the SPC Interpretation, the pledge of the bill of exchange is regarded as having been validly established between the pledgor and the pledgee, but such pledge shall not be against any bona fide third party. On June 6 2001 the No. 2 Civil Department of the SPC, which is in charge of all trials of security and negotiable instrument dispute cases, held a meeting to study these differences in interpretation. A preliminary opinion was reached that closely follows the provision in the SPC Interpretation. To further clarify any confusion on this topic, a new or amended law as regards pledge of negotiable instruments is expected to be issued soon.

General Contractual Rights

Except for the above Article 97, the SPC Interpretation does not make explicit what exactly is entailed in the provision "other rights that can be legally pledged" mentioned in Article 75, Item (4) of the Security Law. It remains undecided what kinds of transferable general contractual rights can be pledged under Article 75 Item (4). The validity of the pledge of general contractual rights has not been expressly recognized in laws promulgated by the National People's Congress or its Standing Committee, by administrative regulations issued by the State, or by the judgments of the SPC.

Nevertheless, with reference to some noteworthy rules and notices issued by the relevant ministries in charge, we can preliminarily conclude that part of the general contractual rights, such as accounts receivable might be pledged under certain circumstances. First, the PBOC, the Ministry of Foreign Trade and Economic Cooperation (MOFTEC, now the Ministry of Commerce) and the State Administration of Taxation jointly issued a Notice on August 24 2001, pursuant to which the accounts receivable in the exporter's tax rebate accounts can be pledged to the lender as security interest for repayment of the outstanding loan principal. Second, SPC Vice President Li Guoguang emphasized in the above-mentioned speech that in principle the validity of the pledge of a tax rebate shall not be rejected out of hand. Third, the Registration of Mortgages by Notaries Public Procedures, promulgated by the Ministry of Justice on February 20 2002, expressly provide that contractual rights and interests for the contracting operation, accounts receivable or future rights and interests as security interests may be registered by the public notary offices. Registration for the pledge of the account receivables upon relevant parties' application has been one business of notary offices. Fourth, the PBOC and MOFTEC jointly issued a second Notice on August 21 2002 in which they encouraged lenders and exporters to utilize the pledge of rights concerning the accounts receivable as the security for loan repayment.

Conclusion

The general purpose of the Security Law is to promote the free movement of capital and merchandise and secure the realization of contractual rights. In the PRC the reality of security arrangements differs markedly from the goal of legal concepts that govern them, and there are still a number of new security concepts or issues, like vadium and sicherungsubereignung (transfer of ownership as security on debt, rangyu danbao) to be addressed. With the rapid growth of China's economy and further legislative and judicial development, we are optimistic that the pending PRC Civil Law and additional SPC judicial interpretations and judgments will properly deal with security issues to meet the need for greater financial innovation and promote China's economic growth.

Endnotes

1 Supreme People's Court, Questions Concerning the Validity of a Mortgage Contract Signed by a State-owned Industrial Enterprise with the Creditor Using Such Property as Machines and Equipment as Mortgaged Property Official Reply, effective June 22 2002.