Defect warranty obligations in financial leasing ABS

By Sun Shiqi and Chen Shu, Jingtian & Gongcheng

Asset securitization refers to the process of merging the cash flow generated by underlying assets in the future into asset packages as repayment support, enhancing credit through structural design and restructuring of securities, and transforming them into securities that can be sold and circulated in the financial market, and then issuing asset-backed securities (ABS).

Sun Shiqi Jingtian & Gongcheng ABS
Sun Shiqi
Jingtian & Gongcheng

Specific to financial leasing ABS, its basic mode is: the original owner (originator and lessor) leases the physical assets to the original debtor (lessee) by means of financial leasing (including leaseback) so as to obtain leasehold claims, and then combines the leasehold claims and related rights (such as security rights) into asset packages and sells them to special purpose vehicles (SPVs). SPVs integrate the asset packages, and after credit enhancement and securities rating, entrust the manager to issue ABS based on the asset package of the leasehold claims, which will be subscribed by individual investors and institutional investors after being put into the market.

The SPV pays all the considerations for purchasing the asset package with the funds raised from securities issuance, and pays the principal and interest of the securities in instalments with the continual income of the asset package Thus, investors get regular income. If the repayment of underlying assets is overdue, a default event will occur, which may trigger the performance of difference payment and credit enhancement measures.

Chen Shu Jingtian & Gongcheng ABS
Chen Shu
Jingtian & Gongcheng

The subjects of legal relationship in the above-mentioned mode mainly include original owners, original debtors, SPVs, securities investors, securities traders, custodian banks, credit enhancement institutions, law firms and accounting firms. Among them, the legal relationship between SPV and the original debtor, and SPV and the original owner, are the basic legal relationships of financial leasing ABS, and the causes of disputes are common in financial leasing contract disputes.

Basic legal relationship

The legal relationship between SPV and the original debtor. The SPV has acquired ownership of the asset package through the transfer contract. Since the asset package right is actually an unrealized leasehold claim, the SPV has become a new creditor (including security right) of the original debtor,and has the right, according to the underlying contract of financial leasing, to request the original debtor to pay rent, and to reduce or exempt the original debtor from performing its obligations under the underlying contract. Accordingly, the original debtor has the right of defence and set-off against the SPV.

The legal relationship between SPV and the original owner. The SPV and the original owner have established the transfer relationship of the asset package of leasehold claims by signing the transfer contract. After the transfer, the SPV obtains the relevant rights to require the original debtor to directly pay the rent due and liquidated damages. In the design process of financial leasing ABS, in order to ensure the legal effect of the transfer, all parties should ensure the true performance of the contract, and all the rights and interests and risks related to the asset package of leasehold claims should be transferred at a fair price to realize bankruptcy remoteness.

Defect warranty and liability

Since the transfer of rights is essentially a buyer-seller relationship, in the transaction of financial leasing ABS, the defect warranty of the SPV by the original owner is mainly the security for defects of right, i.e., a civil responsibility that the asset package of leasehold claims should be true and effective and no right would be claimed by any third party. The defects of right generally show as follows: (1) the original owner’s rights to the asset package are incomplete, such as missing leased property, wrong specifications, unfair transaction prices, undisclosed related relationships, and incomplete notification procedures; and (2) the right itself does not exist, such as concealing the original debtor’s right of set-off, fabricating receivables, stamping false seals, forging invoices, using false warehouse receipts, etc.

In practice, the SPV usually requires the original owner to make representations and warranties on the authenticity and accuracy of the underlying assets. However, in fact, when some original owners participate in the business of financial leasing ABS in the role of channel, they largely rely on the credit and rating qualifications of the original debtors and securities traders, and do not actively and independently examine the ownership, real value and liquidation feasibility of the leased property, neglecting the importance of face-to-face interviews and signing, and due diligence.

Therefore, the stipulation in an agreement that: “If either party breaches any representation or warranty and causes losses to the other party, it shall constitute a breach of contract. The breaching party shall compensate the non-breaching party for all losses, costs and expenses incurred to the non-breaching party” might put the original owner in a disadvantageous position of breach of contract.

When the SPV fails to realize its contractual rights, it will hold the original owner accountable according to the representations and warranties on the authenticity of the underlying assets. If there are cases of no face-to-face interview and signing, false signatures and seals, fictitious collateral, etc., the original owner will not only face serious regulatory measures – as shown in the Decision on Taking Measures of Warning Letter against Zouping Electric Power Group Co. Ltd. (2018) No.19 by Shandong Securities Regulatory Bureau – but also be sued by the SPV for compensation for rent, overdue interest and other reasonable expenses. For example, a Securities Co., Ltd. sued a Chemical Co., Ltd. for a financial leasing contract dispute.

Some suggestions

The authors suggest that when the original owner operates ABS business in the channel role, in order to avoid being trapped in a litigation of defect warranty, compliance management should be carried out from the following aspects: (1) thoroughly examine the authenticity of underlying asset packages (such as leased property and security right); (2) if there are defects in underlying assets, they should be disclosed in advance, and are not recommended to be included in the asset package for sale; (3) adhere to the principle of taking written documents as evidence and complete the procedures such as face-to-face interviews and signings; (4) fulfil the duty of due diligence, conduct on-site inspections, and check the procedures of right registration; and (5) weaken the dependence on the subject’s credit and rating qualification, and actively supervise the performance of ABS.

Sun Shiqi is a partner and Chen Shu is an associate at Jingtian & Gongcheng

Sun Shiqi Chen Shu Jingtian & Gongcheng ABS

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