Application of law to commercial factoring operations in China

The precondition for commercial factoring is the assignment by a creditor of its accounts receivable, and the nature is the assignment of the creditor’s rights. Given the absence of specific legislation on commercial factoring in China, how to apply the current rules is of practical significance in regulating the operation of the commercial factoring business.

Q: What is the legal basis for commercial factoring in China?

A: Article 79 of the Contract Law primarily serves as the legal basis. It says a creditor may assign all or part of the rights under a contract to a third person, except for the following circumstances: (1) the rights are not assignable according to the nature of the contract; (2) the rights are not assignable as agreed between the parties; and (3) the rights are not assignable in accordance with the law. In the commercial factoring business, as long as a supplier and a buyer (debtor) have not agreed in a contract that the rights under the contract are not transferable, the creditor’s rights arising from the contract are not rights that are not transferable according to the nature of the contract or legislation.

The first paragraph of article 80 of the Contract Law provides that a creditor must notify a debtor of the assignment of its rights. Otherwise such assignment is not legally effective to the debtor. Accordingly, if a supplier notifies a debtor, then the assignment has a legal effect between the assignee and the debtor, otherwise the assignment has no legal effect.

Q: Are contractual terms on the prohibition of the assignment of creditor’s rights effective against a bona fide third party?

A: The assignment of creditor’s rights by a creditor in breach of contract terms prohibiting such assignment should be regarded as a breach of contract. However, according to the principle of relativity for a contract, such prohibitive contract terms should not be binding upon a bona fide third party (an assignee) who is not aware of such terms.

In practice, since it is not possible to expand the interpretation of item 2 of article 79 of the Contract Law, when a dispute arises due to the prohibition of the transfer of creditor’s rights under an underlying contract, the interests of the bona fide assignee are protected. Therefore, attention must be paid to the stipulations of an underlying contract prohibiting the assignment of creditor’s rights.

Q: In the factoring business, what should a debtor do after it pays off its debts directly to an assignor?

A: Pursuant to article 84 of the Contract Law, a debtor must obtain consent from a creditor if it assigns the obligations under a contract, in whole or in part, to a third person. After the assignment of creditor’s rights in connection with accounts receivable under a factoring contract, the performance by the debtor to the original creditor does not have any effect against debt settlement. Therefore, if a debtor in the factoring business pays off its debts directly to an assignor, the debtor should still be required to repay the creditor’s rights to an assignee, but the debtor may request the refund of payment for the debts from the original creditor on grounds of unjust enrichment.

Q: How do you register the assignment of accounts receivable? What is the effect of this registration?

A: China currently has no specialised registration procedures or corresponding stipulations on the assignment of accounts receivable in the factoring business. The Credit Reference Centre of the People’s Bank of China as a registration platform has provided registration and inquiry services for the assignment of accounts receivable.

But the Contract Law clearly stipulates that the assignment of creditor’s rights takes effect on a precondition that the debtor is notified of such assignment. Assignments of creditor’s rights are registered in a central registration system with the effect of public notification, but without the legal effect of notification to the debtor.

Q: How do you resolve conflicts of rights triggered by the repeated assignments of accounts receivable? How do you resolve conflicts due to both assignment and pledge of accounts receivable?

A: Chinese law does not explicitly establish any rule for resolving conflicts of rights triggered by the repeated assignments of the same creditor’s rights. In the factoring business, if a supplier carries out a number of assignments of the same creditor’s rights in connection with accounts receivable, this may cause a third party to claim its rights to the same accounts receivable, resulting in conflicts of rights between the third party and the factoring company, so that the factoring company will encounter legal obstacles during the exercise of creditor’s rights.

Under the precondition that the scope of, and assignment time for, accounts receivable may be determined under a factoring contract, the ownership of a subject matter shall be assigned at the time of the delivery of the subject matter according to article 133 of the Contract Law.

For accounts receivable as creditor’s rights, it is the evidence on the creditor’s rights that should be delivered, primarily the commercial invoice. The factoring company that is designated to obtain the commercial invoice has priority. Moreover, according to the requirements for the assignment of creditor’s rights, the party with the right of priority is to be the assignee that notifies the debtor (the time of notification is to be determined as the time of the receipt of the notification). The right of priority is a statutory right. To resolve the conflicts of rights, the best way is to simultaneously handle the pledge and registration of accounts receivable during the assignment of creditor’s rights in connection with such accounts receivable.

According to article 228 of the Real Rights Law, after the pledge of accounts receivable, the reassignment of the accounts receivable is prohibited by law, and the factoring contract will be a void contract unless the pledgor and the pledgee agree through negotiations. The pledge and registration of accounts receivable have the legal effect of public notification. In practice, if the same creditor’s rights in connection with accounts receivable are both pledged and assigned, the pledgee is entitled to priority of claim.

Q: Is the assignment of future creditor’s rights in the factoring business valid?

A: Chinese legislation does not contain any specific provisions for the effectiveness of the assignment of future creditor’s rights. However, according to article 3 of the Supreme People’s Court’s Interpretation on the Application of Law to the Trial of Disputes over Sale and Purchase Contracts, in judicial practice China has recognised the validity of the assignment of future creditor’s rights when basic legal relationships exist as the foundation to support this assignment. Under the current circumstances, Chinese companies should only embark on the factoring business for future creditor’s rights with basic legal relationships, and should fully assess whether future creditor’s rights are legitimate, assignable or defective.