A Q&A guide to finance in China. The Q&A gives a high level overview of the lending market, forms of security over assets, special purpose vehicles in secured lending, quasi-security, negative pledge clauses, guarantees, and loan agreements. It covers creation and registration requirements for security interests; problem assets over which security is difficult to grant; risk areas for lenders; structuring the priority of debt; debt trading and transfer mechanisms; agent and trust concepts; enforcement of security interests and borrower insolvency; cross-border issues on loans; taxes; and proposals for reform.
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The domestic lending market of the People's Republic of China (PRC) has been less active during the last 12 months, compared with 2008 and 2009. Data also suggests a slow-down from the year of 2010, due to the tight control of the liquidity market by the Chinese central bank.
Inward cross-border lending (mainly by international banks) is slowly increasing but may also slow down in the context of the European debt crisis from mid-2010, and PRC banks have greatly increased their offshore lending activities to facilitate the export of PRC-manufactured products and overseas investments by PRC companies.
Real estate comprises:
Land.
Buildings.
Land use rights.
Fixtures.
In the PRC, all land is owned by the state. Individuals or entities can hold land use rights (usually for a limited term). They can also hold ownership of the building on the land.
Construction-in-progress is considered quasi-real estate for the purpose of security interests. A construction-in-progress has no title document but can still be subject to a mortgage similar to a real estate.
A mortgage is the most common form of security over real estate in the PRC.
To create and perfect a mortgage, the mortgagee (lender) and the mortgagor (borrower or a third party) must enter into a mortgage agreement which is:
In writing.
Registered at the relevant land and real estate registrar, depending on the location of the real estate.
Mortgages can only be granted over land use rights, not over the ownership of the land itself (see above, Real estate).
Tangible movable property comprises:
Machinery.
Raw materials.
Semi-finished goods.
Finished goods.
Aircraft, including aircraft under construction.
Ships, including ships under construction.
Vehicles.
Any other property that is movable (that is, not affixed to land or other property).
The most common forms of security granted over tangible movable property are:
A mortgage.
A pledge.
Mortgage. A mortgage over tangible movable property is validly created on the mortgagee and mortgagor signing the mortgage agreement. A mortgage is perfected at the time that the agreement is registered with the relevant property register. It is advisable to consult a PRC lawyer regarding the exact perfection requirements.
For example, the State Administration for Industry & Commerce (SAIC), or its local branches, is in charge of the registration of mortgages over:
Machinery.
Raw materials.
Semi-finished goods.
Finished goods.
Under PRC law and accounting principles, raw materials, semi-finished goods and finished goods are collectively referred to as “inventory”.
The ship and aircraft registers are responsible for the registration of mortgages over ships and aircraft respectively.
Pledge. The pledgor (borrower or a third party) and the pledgee (lender) enter into a written pledge agreement. The pledge is perfected on delivery of the relevant property by the pledgor to the pledgee.
Financial instruments in the PRC include:
Shares.
Debt securities (both in certificated and dematerialised form, the vast majority of which are now in the dematerialised form).
Fund units.
Negotiable instruments.
A pledge is the only available form of security over financial instruments.
The pledgor and pledgee must enter into a written agreement. Depending on the type of the financial instrument, the perfection requirements are as follows:
For equity interests in a limited liability company: a pledge is perfected on registration at the SAIC.
For shares in a company limited by shares: a pledge is perfected on registration at China Securities Depository and Clearing Company Limited (CSDCC).
For fund units traded on stock exchanges: a pledge is perfected on registration at CSDCC.
For bonds traded on stock exchanges: a pledge is perfected on registration at CSDCC.
For bonds traded on the inter-bank bond market (OTC market): a pledge is perfected on registration at China Government Securities Depository Trust & Clearing Co Ltd.
For negotiable instruments, a pledge is perfected by:
a pledge endorsement on the instrument; and
delivery of the endorsed instrument to the pledgee.
Claims and receivables in the PRC are generally debts or rights under contracts, including without limitation:
Receivables arising from the sale of goods, supply of utilities, provision of services or licensing of IP rights.
Receivables arising from rentals of movable or immovable properties.
Rights to charge tolling fees (such as in relation to roads, highways, bridges, tunnels or ferries).
Debts arising from provision of loans or other credits.
A pledge is the only available form of security over claims and receivables.
The pledgor and the pledgee must enter into a written pledge agreement. The pledge is perfected by registration of the pledge agreement at the Credit Reference Centre of the PRC.
The only available forms of security over cash are:
Pledges over a deposit.
Pledges over a deposit certificate.
Intellectual property could include, for example:
Patents.
Trade marks.
Copyright.
Designs.
Intellectual property rights can only be secured by a pledge.
A pledge is created by a written pledge agreement. Depending on the intellectual property type, the perfection requirements are as follows:
For patents: a pledge is perfected on registration at the State Intellectual Property Office.
For trade marks: a pledge is perfected on registration at the SAIC's Trade Mark Office.
For copyrights: a pledge is perfected on registration at the National Copyright Administration of the PRC.
Generally a security cannot be granted over future assets under PRC law.
The parties can execute a security document that sets out a mechanism for the creation and perfection of a security interest over future assets. These contractual clauses are binding between the parties. However, security interests can only be created and perfected when future assets come into existence.
The law does not expressly prohibit granting security over fungible assets. However, it may not be feasible in practice as the relevant registration authority will require a clear description of the mortgaged or pledged property.
A mortgage or pledge cannot be granted over the following categories of assets or real estate:
Ownership of land. In the PRC, all land is owned by the state. Only land use rights can be mortgaged in the PRC (see Question 2).
Use rights of collectively owned land (for example, land for farming or farmers' residential use), unless otherwise provided by the applicable laws.
Facilities used for education, hygiene, medical and other social benefits (for example, schools, hospitals or kindergartens).
Properties with unidentified or disputable ownership or use right.
Assets owned by a governmental authority (for example, the authority's office building, facilities and equipment).
Illegal constructions.
Assets subject to legal retainer, or freezing or attachment order.
Assets that cannot be mortgaged or pledged under a law or an administrative regulation.
The release of security will usually depend on whether the security interests are registered or unregistered.
For security interests that are registered at the relevant register, release is subject to a system of de-registration. Normally the register requires the parties to submit either a:
Short form release agreement.
Termination agreement.
Letter of confirmation for the purpose of processing the de-registration.
For security interests which do not need to be registered, the parties can enter into either a:
Short form release agreement.
Termination agreement.
Letter of confirmation to evidence the release of such security interest.
The PRC Company Law does not recognise the concept of an SPV set up to hold the debtor's assets.
Quasi-security is not generally common in the PRC, although factoring and retention of title have been used more frequently in practice (see below, Factoring and Retention of title). Sales and leaseback is not common in practice although the risk of recharacterisation is low.
Banks use factoring to facilitate financing certain assets or commodity-based transactions. The risk of recharacterisation is low.
Hire purchase is not common. Banks use hire purchase to finance leasing transactions over equipment or ships. The risk of recharacterisation is low.
Banks use retention of title to facilitate financing of certain assets or commodity-based transactions. The risk of recharacterisation is low.
No other quasi-security structures are used.
Negative pledges (that is, undertakings by the borrower not to create a subsequent security interest on the pledged property) are used in loan agreements and considered contractually binding, but not as security or quasi-security.
Guarantees are commonly used under PRC law. A guarantee is created by the guarantor signing it in writing, in one of the two following forms:
A guarantee letter under which the guarantor is the signing party.
A guarantee contract under which the guarantor and the beneficiary are the signing parties.
There is no general prohibition on financial assistance. However, certain stringent rules apply to financial assistance for purchasing either:
A listed company's shares.
Interests in a state-owned enterprise (SOE), such as:
equity interests in a limited liability company; or
interests in an SOE which has still not been converted to a limited liability company.
Therefore, banks must be extremely careful when financing the acquisition of a listed company's or SOE's shares in the PRC.
There are no express provisions on corporate benefit rules under PRC law. However, when a company provides a guarantee or security for the debts of third parties it must comply with rules set out in the articles of association for the grant of guarantees (PRC Company Law). These can include:
Guarantee limits.
Requirements to obtain board or shareholder approval.
If a company provides a guarantee or security for the debts of a shareholder or the actual controlling party of the company, that guarantee or security must be approved by a shareholders' resolution of more than 50%. This vote does not include the relevant shareholder or the shareholder controlled by the actual controlling party.
There is no express prohibition on a limited liability company granting loans or security interests to its directors. However, a company limited by shares (that is, a joint stock company) is expressly limited from granting loans to its directors directly or through its subsidiary (PRC Company Law).
There is no express restriction on the amount of interest to be charged for a loan by a financial institution. However, PRC civil laws have some general principles which a PRC court can use as grounds to refuse to enforce a loan agreement with too high an interest rate, including:
Acting in good faith.
Reasonableness.
Avoidance of obvious unfairness.
There is no uniform market practice in this regard, but if the interest rate is higher than four times the PBOC-published lending interest rate for the same tenor (which is normally between 20% and 30% per annum) it may be open to challenge.
There are no other laws that affect the validity of a loan, security, or guarantee.
If a lender becomes the owner of the land use right on enforcement of the mortgage, it becomes responsible for pollution of the land even if it is not the actual polluter. However, the lender can claim compensation from the previous owner of the land use right (the actual polluter).
Contractual subordination of debt is possible but still not commonly used in practice. However, its significance is questionable because, according to a basic statutory principle, all unsecured creditors are treated equally (pari passu) on the debtor's insolvency (see Question 27). It is therefore probable that, during the bankruptcy proceedings, PRC courts will not uphold a contractual subordination clause.
The effect of structural subordination is also questionable under PRC law.
Intercreditor agreements are not common in a PRC onshore financing. If it is a syndicated loan, the lenders can enter into a syndicate agreement between themselves, as a way of governing:
The mechanisms for the provision of loans.
Exchange of information.
Voting procedures for deciding key issues in relation to the facility.
However, it is more common for the provisions governing the relationship between the lenders to be directly set out in the syndicated loan agreement. In this case, a separate syndicate agreement (or other form of intercreditor arrangement) is not required.
Trading of secured debt is uncommon, although the Chinese banking regulator is encouraging the development of a loan secondary trading market. During the past year, there were substantial developments in this market:
The China Banking Association published templates for the secondary sale of syndicated loans in March 2010.
The National Financial Market Institutional Investors Association published a Master Agreement for Transfer of Loans (which mainly applies to bilateral loans) in September 2010.
A couple of exchanges (for example, in Beijing and Tianjin) have also launched an exchange-based trading platform for loan assets.
Assignment and novation are the two major transfer mechanisms but a number of sub-participation transactions (where a lender sub-contracts all or part of its risk to another financial institution) also occur in practice.
The law is silent on the appointment of a security trustee or security agent. In practice, a security agent is often used in syndicated loans to hold security interests on behalf of the lenders from time to time. As the concept of a security agent is not expressly set out under law and the agent is not one of the creditors, the registrars (for example, a registrar for mortgages over land and real estate (see Question 2, Formalities)) in some cities do not accept an application for a mortgage registration from a security agent. However, the registrars in other cities are more flexible and willing to accommodate security agents. The inconsistency of approach between the registrars creates a great degree of legal uncertainty.
The advantage of registering the security interests under a security agent's name is that the buyers of secured debt need not register themselves as security holders. If the security interests must be registered under the name of each creditor, the buyers must go through an amendment procedure to update the information with the registrar to reflect their addition to the secured creditors.
PRC recognises the agent concept. However, a security agent is not commonly used due to the absence of legal rules on this matter (see Question 17).
The courts will normally recognise a foreign facility agent holding the security interest, provided that this is permissible under the governing law of the agreement. A facility agent holding the security interest can initiate litigation before a PRC court to enforce its rights under the relevant finance documents.
PRC recognises the trust concept. However, a security trustee is not commonly used, due to the absence of legal rules on this matter (see Question 17).
The courts will normally recognise a foreign trust, provided that the trust is enforceable under the governing law of the agreement. A security trustee under a foreign trust can initiate litigation before a PRC court to enforce its rights under the relevant finance documents.
Different types of security are generally documented separately. The relevant registrars normally expect a separate security document for each type of security (sometimes each type of asset). Therefore, a single security document, although possible in theory, is impractical and makes registration with most registrars more difficult, if not impossible.
A loan agreement becomes binding on the parties when it is signed. There is no additional documentation required for the effectiveness or enforceability of this agreement.
A secured creditor can enforce its security when either (PRC Property Law):
The debtor fails to make a payment of the debts that become due.
An event of default, as agreed between the parties in the security agreement, occurs.
However, a security document cannot contain a clause providing that the ownership of the mortgaged/pledged property will be transferred to the mortgagee/pledgee when the debtor fails to repay the due debt. This means that a foreclosure provision (without a court procedure) is not valid.
The mortgagee and the mortgagor can agree on the sale or foreclosure of the mortgaged property on the mortgagor's default. If their agreement prejudices other creditors' interests, the other creditors can, within one year from the day that they discovered, or should have discovered, the agreement, apply to the court for revocation.
When the mortgagee and the mortgagor fail to agree on the realisation method of the mortgage, the mortgagee can apply to the court to sell or auction the mortgaged property (a fast-track approach).
When the mortgagor challenges the existence of a mortgage or the mortgagee's right to enforce it (for example, on the ground that the mortgagor has not defaulted under the relevant documents), the mortgagee must start litigation or arbitration proceedings against the mortgagor to obtain the judgment or arbitral award. The mortgagee must then apply to the court to enforce the judgment or award.
The pledgee and the pledgor can reach an agreement on the foreclosure of the pledged property, or the pledgee can sell, either by auction or private sale, the pledged property to repay the secured debt in priority.
The PRC Enterprise Bankruptcy Law provides for restructuring and reconciliation procedures, in addition to bankruptcy.
On restructuring, secured creditors are categorised as one group for the purpose of voting on the restructuring plan. If more than 50% of secured creditors present at the meeting approve a restructuring plan, which covers over two-thirds of the secured debts, the restructuring plan is considered approved by secured creditors. However, even if secured creditors refuse approval, the bankrupt debtor (or the liquidator) can apply to the court for an approval of the restructuring plan provided that:
Secured debts will be fully repaid (together with a fair compensation for loss resulting from delay in repayment).
Security interests are not substantially prejudiced.
The reconciliation plan must be approved by more than 50% of creditors that hold more than two-thirds of the unsecured debts who are present at the meeting. Secured creditors do not attend the meeting, as their claims are satisfied in priority to unsecured creditors' claims.
On the acceptance by a court of a bankruptcy application, any litigation or arbitration proceedings brought by a creditor against the bankrupt debtor must be stayed until the liquidator takes over the bankrupt debtor's assets. If a creditor has applied to the court for an attachment order and the enforcement of a judgment or arbitral award, the attachment order will be lifted and the enforcement stayed on the court's acceptance of a bankruptcy application. The secured creditor's claim will be satisfied at the end of the bankruptcy proceedings from the proceeds of the realised security assets or the repayment by the guarantor. An unsecured creditor's claim will be satisfied at the end of the bankruptcy proceedings from the remaining assets of the bankrupt debtor in a pari passu ranking with other unsecured creditors.
There is a one-year hardening period under the PRC Enterprise Bankruptcy Law. Therefore, the liquidator can apply to the court to revoke a security that a bankrupt debtor has granted over otherwise unsecured debt or an undue loan repaid by that bankrupt debtor within one year before the acceptance by the court of a bankruptcy application.
On the borrower's insolvency, creditors are paid in the following order:
Secured creditors' claims are satisfied from the realised proceeds of the sale of security assets. PRC law has no provision on the order of priority between security interests on insolvency. If the secured creditor's claim cannot be fully satisfied from the realised proceeds, he becomes an unsecured creditor for the outstanding amount and ranks pari passu with other secured creditors whose claims could not be fully satisfied.
Statutory claims.
Unsecured creditors (probably including subordinated creditors, unless they have security (see Question 16)).
The following principles apply to determine the priority between creditors holding a mortgage over the same asset:
The order of mortgage registration determines priority. For example, a mortgage registered first ranks over a mortgage registered second. If the order is the same, the creditors' claims are satisfied on a pro rata basis.
Registered mortgages prevail over unregistered.
If none of the mortgages have been registered, the creditors' claims are satisfied on a pro rata basis.
A pledge over the same tangible property cannot be created in favour of more than one creditor, as a valid pledge requires physical delivery of the pledged asset to the pledgee (see Question 3, Formalities: Pledge).
If more than one creditor holds the same pledge over the same intangible assets (for example, shares, bonds or receivables), the pledgees' priority is determined by the same rules applicable to mortgages (see above, Mortgage).
If a security interest has not been validly perfected, the security holder will, on the borrower's insolvency:
Rank as an unsecured creditor if it is the borrower's fault.
Not be able to enforce its security at all, if it is his own fault.
The making of loans by foreign lenders to an onshore entity constitutes a foreign debt. Different rules apply depending on the length of the term of the debt:
Over one year: a domestic company must obtain the approval from the National Development and Reform Commission (NDRC) for borrowing mediumto long-term foreign debt.
Within one year: a domestic company must obtain the approval of the State Administration of Foreign Exchange of the PRC (SAFE) for borrowing short term foreign debt.
In both cases, it is necessary to register the debt at SAFE.
However, foreign-investment enterprises (FIEs) can borrow foreign debts, in an amount not exceeding the difference between the total investment amount and the enterprise's registered approval, without the NDRC or SAFE's approval (SAFE registration is still necessary). FIEs include:
Chinese-foreign equity joint ventures.
Chinese-foreign contractual joint ventures.
Wholly Foreign Owned Enterprises (WFOEs) (that is, enterprises with limited liability and wholly owned by foreign investors).
SAFE imposes relatively stringent restrictions on the grant by an onshore entity of security interests (including guarantees) in favour of an offshore lender. (This type of security is commonly referred to as external security in the PRC.) Generally, granting an external security requires both:
SAFE's prior approval (subject to two exceptions below).
Registration of the security at SAFE or its local branch.
SAFE can exercise discretion when considering whether to grant approval. It uses a number of financial ratio requirements, which makes the approval process a bit unpredictable. Therefore, legal practitioners try to rely on one of the two exceptions to the general rule:
An onshore financial institution or an onshore company can apply to SAFE to be granted a quota for its provision of external security. If it falls within that quota, there is no need to apply for a case-by-case approval procedure and the financial institution or company only needs to go through SAFE registration. SAFE will use a number of financial ratios to assess and decide whether and how big a quota can be issued to an applicant.
An onshore debtor can use its own assets to secure its foreign debts. For example, FIEs can use their own assets to secure their own foreign debts from offshore lenders, provided that the security interest is registered at SAFE (see above, Foreign debt). Currently, this is the main method to secure cross-border loans in the PRC.
A number of foreign exchange controls exist. However, this can be easily resolved in practice, provided the loan agreement or another security document has been duly registered at SAFE.
From a contractual perspective, PRC courts will recognise and apply a foreign choice of law clause in a security or loan document, provided there is a foreign element in the relevant security or loan document (for example, one party is a non-PRC entity or individual). However, the lex situs (that is, the law of the place where the assets are located under the PRC private international law rules) will regulate creation, perfection and priority of security interests over assets located in the PRC.
A loan agreement is subject to stamp duty of 0.005% of the amount of the loan, which is payable by the lender (or the lenders as a whole if there is more than one lender) and borrower to the transaction. If the loan is made by a foreign lender, PRC withholding tax and PRC business tax must be deducted from the interest and fees payable by the borrower.
Security documents are not subject to stamp duty or other documentary taxes in the PRC.
Depending on the type of a security interest, some registrars may charge a registration fee, either:
Based on the value of the collateral.
In a lump sum.
Generally, the registration fee is not substantial.
Security documents do not require notarisation, subject to very limited exceptions or local cities' practice (for example, certain cities require a mortgage over residential property sold to a non-PRC citizen to be notarised before it can be registered at the local land and real estate registrar).
The applicable fees, if any, are likely to not be substantial (see Question 29). However, if the fees are substantial, there are no established strategies to minimise costs. The only available option is for a security provider or borrower to negotiate with the relevant local tax authority or registrar for any reduction in fee, as a special case. Whether reduction is granted depends solely on each registrar's policy and discretion.
The China Banking Regulatory Commission (CBRC) has issued Interim Provisions of Working Capital Loans, which have put in place more stringent regulation on working capital loans.
SAFE has issued a circular on the reform of external security regime by reducing the requirements on the qualifications of external security providers for cross-border transactions.
T +86 10 6584 6676
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E zhangxin@globallawoffice.com.cn
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Qualified. People's Republic of China, 1996; England and Wales, 2004
Areas of practice. Banking; derivatives; project financing; restructuring.
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