Recent Legal Changes that Affect Secured Financing in the People’s Republic of China

December 2008 American Bankruptcy Institute Journal, Vol. XXVII, No. 10

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As some readers may be aware, on March 16, 2007, by order No. 62 of the president, the National People’s Congress of the People’s Republic of China (PRC) promulgated the Property Rights Law (property law). The property law went into effect on Oct. 1, 2007. The comprehensive law covers the creation of security interests on various types of property and recognizes and protects private property rights with respect to certain property types, such as immovable or real property. This article focuses on the property law in the commercial context and its effect on establishing security interests in movable assets, such as account receivables and inventory.

This article also pays special attention to the property law and its impact on security interests in account receivables because they are arguably one of the more important components of enterprise- or business - secured financing in modern financing jurisdictions. Furthermore, attention to this asset class is necessary because subsequent regulations that have been issued to implement the property law provide specific rules and guidance on security interests in account receivables, separate from regulations on other types of movable property. Before the property law, creation of security interests and secured financing in the PRC was governed by provisions contained in the Security Interests Law (security law), effective since 1995.

Security Law

Under the security law, nonpossessory security interests in a wide range of collateral could be created, including movable property, but that collateral was limited to equipment and motor vehicles.1 Thus, valuable movable assets such as inventory, accounts receivable or after-acquired property cannot be used as collateral under the security law. In order to create a security interest in the permissible movable property under the security law, the types, amount, nature and location of movable assets must be specifically described at the time of the parties’ contract2—in other words, the parties have to fix the assets at the time of the financing.

Furthermore, under the security law, a security interest in the permitted movable property has to be registered with a government agency to become valid and enforceable. Unlike the United States, which utilizes Article 9 of the Uniform Commercial Code (UCC) and has centralized filing of security interests (by filing a simple Form UCC-1 financing statement with the state of debtor’s domicile), the PRC has had numerous registries for registration of security interests.3

Some of these registries only register security interests for certain types of collateral, such as equipment or woodlands, while others record broader ranges of security interests.4 According to a January 2006 report by the World Bank Group and the People’s Bank of China on access to credit and secured transactions law reform in the PRC (report), “a foreign lender taking security over all of an enterprise borrower’s assets reportedly spent more than one year registering its interests in the appropriate registries.”5 To make matters more difficult, the registries themselves had to make valuations of the collateral to determine if the amount of the secured loan exceeded the value of the collateral.6 Furthermore, these registries had ultimate discretion over whether to accept or reject registrations of security interests.7

Accordingly, there are two central problems with the security law: First, the limited types of movable property permitted to be used as security, and second, the cumbersome and prohibitive registration process for registering security interests. These issues most likely account in part for the fact that the report found that “only 4 percent of commercial loans [were] secured by movable assets” and the result was “16 trillion RMB of dead capital—assets owned by private firms, small and medium enterprises (SMEs) and farmers that [could not] be used to generate loans to fund business investment growth.”8 By comparison, “[i]n the U.S., 70 percent of small business financing is secured solely by movable property.”9

Property Law

The property law seeks to address the problems of the security law, without specifically abrogating it.10 First and foremost, the following types of property have been added to the list of property that can be used as security, including both movable and immovable property:

  1. account receivables;
  2. existing and future production equipment, raw materials, semifinished goods and finished goods (i.e., inventory);
  3. contracted management rights in land;
  4. buildings, vessels and aircraft under construction or production; and
  5. transferable share interests in funds.11

Thus, under the property law, security interests can now be created in existing movable property and movable property that not yet exists, such as account receivables, inventory and other afteracquired property. This means that the “floating charge” or “floating lien” concept with respect to property like account receivables or inventory not permitted under the security law is now permissible in the PRC under the property law.

Under the property law, priority of security interests for these types of property is for the most part determined by time of registration of the security interest.12 Specifically, for registered security interests, priority is determined by the date of registration as it is in the United States.13 This means that registered security interests have priority over unregistered security interests. Interestingly, the property law provides that unregistered security interests in these types of property have priority over unsecured creditors in the same assets.14

In furtherance of the property law and to initiate its application, two implementation procedures have been issued under authorizing a law effective with the property law. First, on Sept. 30, 2007, the People’s Bank of China (PBC) issued the Procedures on Registration of Pledge Over Receivables (receivables procedures). Second, on Oct. 17, 2007, the PRC State Administration of Industry and Commerce (SAIC) issued the procedures for the Registration of Charges of Personal Properties (personal property procedures) and with the receivables procedures (procedures). Both procedures went into effect with the property law in October 2007. These procedures provide guidance and supplement the property law by more specifically defining the permissible collateral and providing registration schemes for security interests. For example, the property law provides that account receivables are now permissible security; however, the receivables procedures define what constitutes account receivables and how one perfects a security interest in this type of collateral.

The personal property procedures revise and bring forward procedures that were already in effect with respect to registration of permissible security interests in personal property under the security law. Personal property procedures differ from prior procedures in that they institute a notice filing concept, akin to the UCC, and provide a more simplified process for registration security interests. In order to perfect a security interest in personal property (other than account receivables), such as inventory, the secured party must file a form for registration.15 The form is a significant change and implements the notice filing concept. It appears to be similar to a form UCC-1 Financing Statement and requires only basic information about the parties, the debt and security, with no further documentation being necessary for effectiveness. The form is to be filed with the local subset of the SAIC for the county in which the debtor is domiciled. The location for filing is a major improvement over the prior procedures, which provided that filing was in the location of the property. The personal property procedures do not provide for any centralized booking system, however the filings of record for each SAIC office are to be available to the public so now lenders can search potential borrowers needing only the name and domicile.

Account Receivables

As stated earlier, the ability to include account receivables in secured financing is important in most jurisdictions, whether it stands alone as an account receivable facility or as part of a larger enterprise or business financing. Perhaps in recognition of this, the receivables procedures were initiated to provide rules on account-receivable financing that are separate from the general personal property procedures. The receivables procedures define account receivables as the right to require payment from debtors arising out of sales of goods, services or facilities, including existing and future monetary claims and proceeds, but not including those arising from negotiable instruments or other negotiable securities. 16 The receivables procedures further provide that account receivables include the following:

  1. claims arising from sales, such as sales of goods, sale/provision of water, electricity, gas and licenses to use intellectual property;
  2. claims arising from leases, whether movable assets or real property;
  3. claims arising from provision of services;
  4. fee or toll collecting rights arising from highways, bridges tunnels and ferries; and
  5. claims out of loans or other credit facilities.17

Essentially, the receivables procedures provide that account receivables are rights to payments, which now are permissible security under the property law. As discussed above, one of the largest problems under the security law was security interests registration. The receivables procedures, similar to the personal property procedures, addresses this issue by introducing a centralized registration system for security interests created in account receivables.

Perfection of a security interest in account receivables is completed by registering the security interest with the Credit Reference Center (center) at the PBC. The receivables procedures provide that the center is to set up a public filing and search system for the registration of security interests in account receivables and the ability to search registrations already filed.18

This is important because now lenders or other parties will be able to access a single centralized system in order to obtain information about a borrower or other registered security interests. In order to access the public system, one must be registered as a user.19 Then, a creditor or its agent must complete the registration by submitting basic information to the center about who/what the creditor is and the debtor, a description of the account receivables that have been pledged in the transaction, as well as a copy of the underlying agreement that is the subject of the registration.20

Once the initial registration is complete, the creditor will be given a certificate number assigned by the center and a certificate evidencing the registration.21 Similar to the filing under the personal property procedures, initial registration completion perfects the security interest in the account receivables.22 The security interest remains effective as provided in the terms of the transaction, but the receivables procedures provide that the duration of the security interest cannot exceed five years,23 then the security interest registration in account receivables becomes invalid.24

However, the creditor may extend its registration by filing for an extension within 90 days before the expiration date, which such extension cannot exceed five years.25 There is no limitation of extensions that may be filed by the creditor.26 Furthermore, where the amount of account receivables pledged by the debtor increases, the amount of the increase is regarded as a new registration of the security interest.27

The creditor must cancel the registration if several situations occur, including that the debt has been satisfied by the debtor, enforcement of the security interest by the creditor or the creditor relinquishes the security interest in the account receivables.28 The receivables procedures also provide a mechanism for objecting to registration of security interests in account receivables. The debtor or any other “interested parties” (not defined in the receivables procedures) may request that the creditor amend or cancel a registration when it believes there is an error therein or otherwise contest the registration.29 If the creditor does not amend or cancel the registration, the debtor may file an objection registration, after first registering as a user.30 After the filing of an objection registration and notice thereof to the creditor, the creditor must then initiate litigation against the debtor within 15 days or the center will cancel the registration of the security interest in the account receivables.31 In the event that a suit is filed, the center will only cancel the registration on the basis of a valid verdict or judgment of the court.32

As in most cases where a significant legal and transactional scheme is revised, the property law and receivables procedures are not entirely perfect because there are certain issues left unaddressed. There is no guidance on the requirement that the registration include a “description of the receivables” and what constitutes a satisfactory description. Also, there is no mechanism to prevent someone in bad faith from using different user names and passwords to register false security interests, amendments or registration objections.

Furthermore, after the securityinterest registration expires, such registration becomes “invalid,” but does that mean that the security interest is invalid or simply the registration is ineffective and will lose in the event of a priority fight? It appears that under the property law and procedures the security interest would still be valid, but more clarification on this issue would be helpful. However, many problems and issues with the registration system will likely be worked out as it is implemented and used or will be further determined at the administrative or judicial level. Regardless of pending issues, the point remains that the property law and receivables procedures will greatly benefit borrowers and lenders in the PRC by expanding the scope of permissible collateral to include account receivables and to provide a centralized scheme and system for registration of such security interests.

Conclusion

Clearly, the property law and the procedures attempt to address the primary issues under the security law. The property law greatly expanded the range of permissible movable collateral available to borrowers and lenders in secured finance transactions. The procedures and the creation of the publicregistration systems will provide greater levels of certainty for secured lenders because they can search the system for security interests registered for any potential borrower, rather than relying on representations (or misrepresentations) of borrowers. This means that the property law and procedures are likely to lead to more secured financing options for borrowers and secured lenders, such as more comprehensive and advanced secured lending facilities encompassing a wider range of collateral. In particular, this will be attractive to SMEs and other enterprises engaged in manufacturing with high levels of account receivables and inventory. Furthermore, regardless of the industry, the property law and procedures will certainly free up substantial amounts of previously unavailable capital in the PRC. More clarification and further refinement of the procedures and the registration systems, and perhaps further regulations, will be necessary, but the foundation laid by the property law and the procedures have greatly enhanced the secured lending options and opportunities in the PRC and promote business development growth, which should benefit the PRC and beyond as the financial integration of the global economy continues.

Notes:
1 Article 34 of Security Law.
2 Article 39 of Security Law.
3 Article 42 of Security Law.
4 Id.
5 See Su Lin Han, “Secured Transactions Law Reform in China: Can a Commercial Law Serve the Needs of the Market?, China Law and Governance Review,” Iss. No. 3 at 3, December 2006; The Research Bureau of the People’s Bank of China, the Foreign Investment Advisory Services of the World Bank Group and China Development Project Facility of the International Finance Corporation, “Secured Transactions Reform and Credit Market Development in China,” at 259, China CITIC Press (2006).
6 Id.
7 Id.
8 Su Lin Han, at 3; Report at 195.
9 Su Lin Han, at 2; Report at 195.
10 Article 178 of Property Law (providing that “[w]here any provision in the Security Law conflicts with that of this Law, the provisions of this Law shall prevail.”)
11 Articles 180 and 223 of Property Law.
12 Article 199 of Property Law.
13 Id.
14 Id.
15 Article 189 of Property Law.
16 Article 4 of Receivables Procedures.
17 Id.
18 Article 2 of Receivables Procedures.
19 Article 9 of Receivables Procedures.
20 Article 10 of Receivables Procedures.
21 Article 11 of Receivables Procedures.
22 Article 228 of Property Law.
23 Article 12 of Receivables Procedures.
24 Id.
25 Article 13 of Receivables Procedures.
26 Id.
27 Article 14 of Receivables Procedures.
28 Article 17 of Receivables Procedures.
29 Article 19 of Receivables Procedures.
30 Articles 19 and 21 of Receivables Procedures.
31 Article 21 of Receivables Procedures.
32 Article 22 of Receivables Procedures.