Collateral Arrangements in Trade Financing

Trust Receipts

Generally, a bank under a documentary credit arrangement may hold shipping documents as security, which protects it against the bankruptcy of or non-payment by the purchaser. But if the purchaser needs to re-sell the goods in order to pay the bank, it would have to obtain the bill of lading. In the meantime, the bank is usually unwilling to be involved with the physical handling of goods itself. It is common that the bank will release the bill of lading to the purchaser in exchange for a trust receipt. However, this arrangement is quite controversial in the PRC as there are no express provisions regarding the nature of trust receipts in Chinese law. Under the 2001 PRC Trust Law(中华人民共和国信托法), a trust must be set up by a written agreement that specifies the purpose of the trust, the scope, type and status of the trust property, and the ways in which the trust benefits are available to the beneficiaries, among other things. In addition, trust property shall be transferable. If the bank holds the bill of lading as the pledgee, the trust property under a trust receipt would then be the security interest. However, under PRC law, the security interest shall be transferred together with the secured obligations and cannot be transferred alone. Thus, for a bank considering creating an effective trust under PRC law, the above regulatory requirements as provided by the Trust Law should be noted.

Dual Pledges

After the purchaser takes delivery of the goods as agent and trustee of the bank, it can re-sell the goods and make payment to the bank. In a case of non-payment by the purchaser, the bank acting as the beneficiary of the goods is entitled to the proceeds of the sale so long as the proceeds remain traceable.

If the purchaser still needs time to seek a subsequent buyer, a further security arrangement must be made during the storage of the goods. Normally, in such a situation, the goods will be put into a warehouse (bonded or non-bonded) and a pledge of goods created. It should be noted that a mere pledge of a warehouse receipt may not be sufficient to fully protect the bank against an unauthorized disposal of the goods. A pledge of warehouse receipts is an encumbrance on the rights to take delivery of the goods rather than on the title of the goods under PRC law, and the bank accordingly is not entitled to enforce its claims directly on the goods. It is highly recommended that a dual security arrangement be created - pledge of the goods plus pledge of warehouse receipt.

For pledge of goods, according to the 1995 PRC Security Law(中华人民共和国担保法), a pledge of movables should become effective upon the delivery of possession by the pledgor to the pledgee. In the event that the goods have been stored in the warehouse, the storer has physical possession of the goods while the purchaser holds constructive possession by the custody agreement. Thus, for the perfection of such a kind of pledge, a notice of the pledge is required to reach the storer pursuant to Article 88 of the Supreme People's Court's Interpretation on Issues regarding Application of the PRC Security Law dealing with the pledge of movables constructively possessed by the pledgor.

With respect to pledge of a warehouse receipt, it shall become effective upon the delivery of the warehouse receipt to the bank. Alternatively, the bank can also require a warehouse receipt solely in favour of the bank itself. Under such an arrangement, the storer shall hold the goods on account of and to the sole order of the bank and shall not release the goods without the bank's instruction. This arrangement can to a large extent serve a similar function as pledge of a warehouse receipt.

Assignment

As the release of the goods will defeat the pledge, the bank then needs another type of security to bridge the period from the release to the payment by the purchaser. Generally, an assignment of the sale proceeds will be taken into account. The assignment may take two forms: assignment by way of security (usually plus a charge over the account receiving the proceeds); and outright assignment. The former cannot be created under PRC law, since it does not fall within any of the PRC-recognized security forms.

The outright assignment of the interests and benefits under the sub-sale agreement will give the bank direct claims against the PRC buyer in case of its failure of payment and the bank shall then enforce its claims in accordance with the sub-sale agreement. In the event of PRC law governing the sub-sale agreement, a notice conforming to the 1999 PRC Contract Law needs to be severed to the PRC buyer to perfect the assignment. This is because the bank's claims against the PRC buyer derive from the sub-sale agreement and obtaining as well as enforcing such claims shall be subject to the same governing law of the sub-sale agreement.

Conclusion

Unlike in common law jurisdictions, there is no concept of legal title or equitable title in PRC law, and taking security in international trade financing faces some specific requirements in the PRC. To be safe, it is advisable for financiers to be cautious and seek legal advice before making security arrangements.