Civil Code revises and improves guarantee system

By Xu Yu and Li Yan, Hylands Law Firm
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The new code has boosted safeguards to ensure the realization of creditors’ claims and recognize guarantee contracts as a category of obligation contract

The guarantee system never found its appropriate place during the era of standalone civil laws. At the time that China’s security system was first established, the guarantee system was brought under the auspices of the Security Law, together with the mortgage, pledge, lien and deposit systems.

Xu Yu Hylands Law Firm Civil Code
Xu Yu
Hylands Law Firm
Partner

Subsequently, the security interest system only came into being after the theory of “separation of rights in rem and claims” was continuously put into practice in China, and the eventual promulgation of the Property Law, with the mortgage, pledge and lien systems all incorporated within.

However, the provision of a guarantee – as a security act that is in essence a claim, not rights in rem – should not be incorporated into the security interest system, but has also not been properly addressed in the Contract Law. After more than 10 years, it was seemingly “forgotten” by the Security Law.

The Civil Code, promulgated on 28 May this year, formally incorporates guarantee contracts in its contract chapter, and further revises and improves some of the issues that arose in the guarantee system in past practice. These revisions are mainly reflected in two aspects: (1) strengthening of the functionality of the guarantee system in ensuring the realization of creditors’ claims; and (2) fully manifesting the principle of autonomy of the parties on the basis of a recognition of guarantee contracts as a category of obligation contract.

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Li Yan
Hylands Law Firm
Associate

This article has selected two issues to explore. The first is the subordination of guarantee contracts. Pursuant to the Security Law, a security contract is a dependent contract to the master claim/debt contract, and its validity is identical to that of the master contract – if the master contract is invalid, the security contract is also invalid unless the security contract provides otherwise, in which case such provision applies. The principle expressed in this provision established the subordinate nature of security contracts, including guarantee contracts, but leaves some room for party autonomy.

With the establishment of the security interest system, the exception for the independence of party autonomy in security interests is denied by the Property Law. Article 172 of the Property Law specifies that: “A security contract shall be a dependent contract to the master claim/debt contract. If the master claim/debt contract is invalid, the security contract shall be invalid, unless otherwise provided in law.” That is to say that the discarding of the subordination of a security interest contract requires provision in law, and cannot be provided for by the parties themselves.

However, this provision of the Property Law does not make any revisions to guarantee contracts falling within the scope of obligations law, such that, for a considerable period of time, guarantee contracts can still secure the possibility of a separate entry into effect, pursuant to the Security Law.

On 7 November 2019, the Minutes of the National Work Conference on Civil and Commercial Adjudication by Courts, in its part on security law, repeatedly emphasized the subordinate nature of security contracts from numerous perspectives, including the creation, validity, scope, disposal and extinguishing of security, laying the groundwork for the provisions in article 682 of the Civil Code.

Ultimately, the Civil Code expressly provides in this article that: “A guarantee contract is a dependent contract to the master claim/debt contract. If the master claim/debt contract is invalid, the guarantee contract shall be invalid unless otherwise provided in law.” This article, in concert with the security interest system, confirms the statutory nature of a guarantee contract being a subordinate contract, and excludes the free will of the parties, thereby strengthening the guarantee system’s function of realizing guarantee claims, and weakening its function as an investment tool.

Although the Civil Code blocks the path to discarding the subordinate nature of a guarantee contract based on the will of the parties, it fully reflects the principle of autonomy of the parties to a guarantee contract as an obligation contract, which is the second issue this article explores.

Article 681 of the Civil Code specifies two circumstances under which a guarantor is required to perform the debt obligation or bear liability: (1) failure by the debtor to perform a debt obligation that has fallen due; or (2) the occurrence of a circumstance provided for by the parties.

The Security Law only provides for the first of the above-mentioned circumstances, with the due debt here referring to the master debt borne by the debtor under the master claim/debt contract, while excluding the debtor’s subordinated obligations and the various undertakings given by it in the representation and warranty clauses.

This gap can result in a situation where the debt has not yet fallen due, but the debtor commits another breach of contract that gives rise to some uncertainty as to whether the debt will be discharged, and if the master contract does not provide an acceleration clause the creditor will find itself in a position where it cannot obtain satisfaction by way of the guarantee contract, and thus incur a greater real or anticipated loss.

In contrast, since the promulgation of the Civil Code, a creditor facing such a circumstance can procure discharge of the debt by the guarantor in two ways: (1) providing express acceleration conditions in the master contract, such that, if the conditions are satisfied, the debt will be called by appropriate means, following which the guarantor will be called upon to assume liability for the debt that has fallen due; and (2) stipulating in the guarantee contract the instances of breach of contract by the debtor under which the guarantor is required to assume liability, such that, in the event of such a breach, the guarantor will, in accordance with the guarantee contract, be called upon to assume liability for the debt that has not yet fallen due.

On the other hand, in a bankruptcy-related procedure, the creditor and guarantor may also, in accordance with article 681 of the Civil Code, set out provisions that are conducive to the discharge of the claim, for example, “Where the debtor goes bankrupt but has yet to enter the bankruptcy procedure, the guarantor shall forthwith commence bearing its guarantee liability”. In this way, the creditor is not required to participate in a lengthy bankruptcy procedure, while the guarantor’s benefit of time under the current system is eliminated.

In addition to these two changes, the Civil Code also sets out express provisions on the subject that bears guarantee liability, the way in which guarantee liability is borne, beneficium ordinis, guarantee term, etc.

Xu Yu is a partner at Hylands Law Firm. He can be contacted on +86 10 6502 8912 or by email at xuyu@hylandslaw.com

Li Yan is an associate at Hylands Law Firm. She can be contacted on +86 10 6502 8888 or by email at yan.li@hylandslaw.com