China Opens the Door to Securitization

STRUCTURE OF SECURITIZATION

The structure of securitization provided by the Procedures includes a number of differences compared with the common structures of securitization adopted in the West. Instead of special purpose vehicles (SPVs), banking financial institutions acting as originators (the originators) set up special purpose trusts (SPTs) to pool assets to be securitized. The credit assets of the originators are transferred into a SPT; the trustee of which is a trust and investment company, or other entities approved by the CBRC (the trustee). Backed by future income streams from a debtors' payment under the entrusted credit assets, the trustee issues asset backed securities (ABS) in the form of trust beneficiary certificates rated by qualified rating agencies in the China inter-bank bond market.

SUBSTANTIAL IMPEDIMENTS REMOVED

Special Purpose Trust

Under the common securitization structure utilized in the West, SPVs are established to exclusively acquire certain assets of the originators, issue ABS and enter into various transaction contracts. The latter can be done, for the purpose of securitization, without limitation to service contract, custody contract, insurance contract, or hedging contract. Further, in order to minimize their insolvency risks, SPVs are generally restricted to engage businesses other than those related to the securitization.

However, in general, companies set up in China do not facilitate the establishment of shell companies. They are always empowered and mandatorily required by the regulatory authorities to conduct substantive business, without which they cannot pass the annual inspection by such authorities, nor maintain their valid existences. Obviously, the companies incorporated in China are not able to meet the requirements of SPVs utilized in securitization.

According to the PRC Trust Law (中华人民共和国信托法, trust and investment companies are capable of holding credit assets in trust. These entrusted assets are generally isolated from the insolvency risk of the trustee, settler and beneficiaries. Therefore, basically, the SPV concern under PRC Company Law(中华人民共和国公司法) (1993) has been successfully addressed by the SPT concept introduced by the Procedures.

Transfer Issues

The provisions regulating the transfer of credit assets under the Procedures are expected to give comfort to the market. Although market participants are able to achieve transfers by assignment under the provisions of the PRC Contract Law(中华人民共和国合同法) (1999), an assignment of contract rights cannot be bound on the counter party until a notice is served on such party. The Procedures eliminate the related onerous administrative requirements of such notices. Indeed, a public announcement of the transfer of credit assets in nationwide media, does constitute a deemed notice under the Procedures.

Considering that in practice debtors are more likely to continue to pay into an originator's account, the Procedures provide that the originator may be the loan administration servicer (the servicer), provided that a servicing agreement is entered into in writing between the agent and the trustee. As a result, collections from debtors continue to be credited to the same account. In other jurisdictions, commingling the collection's monies in such an account has traditionally given rise to concerns about the insolvency of the servicer. The law deals adequately with this issue by requiring the servicer to transfer the collections into a segregated account with the fund custodian engaged by the trustee (the custodian). To eliminate all doubts about the servicer's credit risk, the Procedures provide that the entrusted credit assets are independent and separate from the assets of the servicer and do not form any part of the insolvency estate thereof.

The ABS

A big challenge that most securitizers in the China market face, in adopting Western securitization techniques, is the absence of appropriate forms of securities available for the securitization purpose. Securities issuances are highly regulated in the local market and only a few types of securities, including stocks, corporate bonds, and convertible bonds, are currently available in the market. Further, issuances of such securities are subject to substantial approval and verification processes of the China Securities Regulatory Commission (CSRC), or other government authorities empowered by the State Council.

The size of China's capital market is another import concern. Compared with other developed markets in the world, China's capital market is extremely small in size. Insufficient investor protection and other structural flaws are recognized as the main underlying reasons behind this small size. The market has already encountered difficulties in satisfying the finance needs of existing listed companies, and new IPO applications are currently being postponed by the CSRC with the ongoing merging of tradable and non-tradable shares (see p.17 and p.35).

Given the restraints on China's capital market, legislators have turned to seek facilities from the inter-bank bond market, where financial institutions are the main investors. The ABS to be issued under the Procedures, are in nature a share of the beneficiary rights of the SPT, which are backed by revenues generated by the entrusted credit assets. After approval from the PBOC, the trustee may issue ABS in the inter-bank bond market. Members of the inter-bank bond market can subscribe to such an ABS if it has been given investment grade status by a qualified rating agency. If the ABS is offered by private placement, its rating is not essential.

According to the Procedures, within two months of completion of the ABS issuance, the trustee may apply for the ABS being traded in the inter-bank bond market. However, if the ABS is placed with selected investors, it is only permitted for transfer among subscribers; meaning the initial subscribers are forbidden to resell the ABS to other investors.

Documentation

If large volumes of existing loans are to be securitized, lenders will need to transfer their rights regarding such loans to a securitization vehicle. They need first ensure that all the loans are suitable for securitization. Generally, existing documents used for loans to be securitized are expected to be of a high standard. They are also expected to be relatively similar, drafted by a handful of law firms with plenty of experience in the sector, and on terms similar to loans of comparable corporates or individuals.

However, in general practice, loan documents of Chinese banks are not carefully drafted by experienced banking lawyers. Furthermore, different branches in different cities always use different loan documents due to the cultural and economic differences.

Typical issues with loan agreements that can make securitization difficult include the following.

· Prohibitions on the transfer of a lender's rights regarding loans to an entity that is not a bank or other financial institution.

· Restrictions on disclosure of information.

· No restrictions on the right of a borrower to set-off amounts owed by a lender with amounts owed by a borrower.

In light of the low quality of loan documentation in China, the Procedures provide that the originator and the trustee shall reach agreement on the coverage, type, standard and conditions of the credit assets to be securitized in the trust contract. It is further provided that if the trustee finds that the credit assets, at the time of the entrustment, do not conform to the coverage, type, standard and conditions as described in the trust contract, it may request the originator to redeem or repurchase such credit assets. This redemption arrangement should definitely provide a claw-back mechanism for unsuitable credit assets.

UNSOLVED ISSUES

Bankruptcy Remoteness

The introduction of SPTs has made substantial contribution to the establishment of "true sale" under PRC law. Article 7 of the Procedures provides that entrusted credit assets are independent and separate from the assets of the originator, trustee, servicer, custodian and other service agents involved in the securitization. Nor do they form part of the insolvency estate thereof. This standing had already been established by the PRC Trust Law (中华人民共和国信托法in 2001.

However, the effect of a "true sale" between an originator and a SPT is still doubtful under undeveloped PRC bankruptcy law. The PRC Enterprise Bankruptcy Law (中华人民共和国企业破产法)(Trial Implementation), enacted on 2 December 1986 and followed by a few judicial opinions issued by the People's Supreme Court, is recognized as failing to provide a workable framework for bankruptcy.

It is beyond dispute that credit assets of financial institutions may be assigned under PRC law. Notwithstanding this fairly unambiguous statutory background, some unclear provisions of the PRC Enterprise Bankruptcy Law (Trial Implementation) may cause questions as to the effectiveness of the assignment of credit assets into a SPT in the event of the insolvency of the originators.

For instance, Article 35 of this law provides that any sale of assets at an unusually low price by a bankruptcy enterprise, which is effected up to six months before the court's acceptance of the bankruptcy petition and ending on the date of bankruptcy declaration, shall be nullified and such assets shall be part of the bankruptcy estate. Though the concept appears reasonable, lack of implementing rules of this provision will definitely impose huge pressure on the pricing of credit assets to be securitized. As in light of the generation of future cashflows by the securitized assets, the pricing of the same is not expected to be simple nor straightforward. If the liquidation committee of an insolvency proceeding questions the pricing, the effectiveness of the asset assignment will accordingly be doubtful. This is particularly so if State-owned assets are involved, where pricing will be more sensitive.

Security Arrangements

Under PRC law, some security interests (mortgages) need perfection. If they are not registered with the authorities required, it renders the security unenforceable against third parties. These formalities can be both costly and an administrative burden if they are required in large amounts. A further problem with the existing registration system arises if parties need to amend existing registrations of security interests, because this can cause an undesirable workload. The legislator has not addressed these concerns and has left them to future legislation.

Other jurisdictions have seen the registration of transfer contracts over segregated collection accounts and receivables. This could simplify the re-registration of existing security interests in favour of both the issuer and holders of ABS.

Another related issue is creating security interests over securitized credit assets for the benefit of ABS holders and credit enhancement purposes, which is not rare in the international market. Contract rights under loan documents are not mortgageable under the PRC Security Law (1995). Therefore, as it now stands, this frequently used credit enhancement technique may not be used in China.

Eligible Assets

The Procedures only contemplate the securitization of credit assets of banking financial institutions. Entities other than banking financial institutions appear not able to securitize their receivables pursuant to the Procedures.

Further, the term "credit assets" has not been clearly defined. Loan facilities are generally recognized and included in the spectrum of "credit assets". However, it is not clear whether other types of cashflows, like credit card receivables and lease receivables, fall within the coverage.

Tax and Accounting

The Procedures leave the related tax and accounting issues to further legislation.

CONCLUSION

It is still too early to determine whether the legislative breakthrough of the new Procedures go far enough to develop an active securitization market in China. Indeed, the development needs further observation. Although the Procedures leave some issues to the market and future law development, this long awaited law gives market participants the requisite legal certainty on several fundamental issues. This undoubtedly deserves considerable approbation.