Policy Considerations Reflected in Security Cases

Website: www.freshfields.com

The current basic framework for security law in the PRC is largely made up of the PRC Security Law (Security Law, effective on October 1 1995), the Judicial Interpretation of the Supreme People's Court on Some Issues Regarding the Application of Security Law (Judicial Interpretation, effective on December 13 2000) and the decisions of the Supreme People's Court (SPC) concerning security cases. Recent SPC decisions in security cases, which reflect the court's policy considerations, will be examined in the following discussion.

Fairness to the parties

Due to the potentially extended time line for litigation (including the appeal process), it is possible for the SPC to be judging cases today for security contracts entered into more than a dozen years ago.

In Shijiazhuang Branch of China Xinda Asset Management Co. v. China-Arab Fertilizer Co. (2005), the loan contract was signed before the Security Law came into force. To solve this problem, the SPC held that any issue not regulated by any other law (in existence at the time) in China may be resolved by referring to the Security Law. However, if the Security Law conflicts with any law in effect at the time of signing the contract, the latter will prevail. The court decision strikes a balance between showing deference to matters governed by the Security Law and being fair to the parties who acted in accordance with the laws in effect during that time.

Protecting creditors' interests

In Yingmao Co. v. Tianyuan Co. (2002), one of the companies providing a joint guarantee had disappeared. There is no law or interpretation dealing with this problem. The SPC held that companies providing a joint guarantee should share the risks, including the risk of the disappearance of the co-guarantee provider. Applying Article 20 of the Judicial Interpretation, which provides that joint guarantee providers must bear liability equally (in the absence of any other agreement to the contrary), the SPC held that the remaining joint guarantee providers share equal liability. The SPC's decision provides creditors with further protection against disappearing guarantee providers and this may influence companies to choose their co-guarantors more carefully.

Compliance with law encouraged

Pursuant to Article 6 of the Judicial Interpretation, contracts providing security to offshore entities are invalid without the approval or registration of the relevant governmental authorities.

In Bank of China (Macao) v. Zhuhai Huadian Hongwan Diesel Engine Fadian Factory (2005), the SPC held that the share mortgages provided as security to offshore entities are 'foreign debts' and without registration of the foreign debts, the share mortgage contract itself should be deemed invalid. However, the decision of this case was not arrived at by the strict application of Article 6, since the share mortgages were provided before the Judicial Interpretation became effective. Instead, the SPC discussed various foreign debt registration requirements in effect at the time and concluded that the non-registration of the share mortgages violated the mandatory foreign debt management regulations and so therefore, the contracts should be held invalid. In this case, the SPC's decision punishes the non-registration of foreign debt and this is likely to encourage compliance with the relevant laws.

Consistent statutory interpretation

Article 60(3) of the old PRC Company Law (Company Law) provides that, "Directors or a manager of a company shall not provide assets of the company as security for the debts owed by shareholders of the company...". In contrast, Article 16 of the new Company Law states that a company may provide security for the company's shareholders, subject to the approval of the shareholders' meeting.

However, in China Bank of Import and Export v. Guangcai Shiye Investment (Group) Co. and Sitong (Group) Co. (2006), the security was provided before the promulgation of the new Company Law. The SPC held that Article 60(3) did not intend to prohibit a company from providing shareholders with security if approval is received from a shareholders' meeting, as well as the board. The court reasoned that the original intention of Article 60(3) was to protect minority shareholders' interest from the abuse of majority shareholders and did not strictly prohibit such provision of security
per se.

Decisions arising from policy considerations

The SPC's policy considerations in deciding security cases, such as fairness to the parties, protecting creditors' interests and also the likelihood that the court will decide a case by interpreting the previous existing laws (for example, at the time when a security contract took effect) to maintain consistency with newly promulgated laws adopted at the time of judgement have been demonstrated in the aforementioned cases. It is advisable for practitioners to keep such policy considerations in mind when engaging in security cases.