Disputes in supply chain finance

By Yang Guang and Sun Yangyang, Lantai Partners

The 2021 Government Work Report for the first time put the development of new models for supply chain financing onto the national agenda, signalling the central government’s intention to vigorously support the provision of such services in the economy.

杨光, Yang Guang, Partner, Lantai Partners
Yang Guang
Lantai Partners

Depending on the type of transaction structure, supply chain finance can be divided into accounts receivable, inventory and prepayment financing. Based on the latest laws, regulations and meeting minutes concerning the guarantee system, this article analyses three typical issues in business practices of supply chain finance.

The implications when pledges over accounts receivable arise at the same time as a mortgage on the underlying property of the receivables. When a financing party accepts pledged receivables in the form of rent from leased real estate, a mortgage may effectively be established on the property at the same time. That is, the mortgage and the pledge of the rent occur simultaneously, raising the issue of the order of payment between the two. Under the current laws, where both mortgage and pledge are created on the same property, the order of payment made with the proceeds from the auction or sale of such property shall be determined according to the time of registration and delivery.

The pledge of accounts receivable shall be established at the time of registration. If the pledge of rent is registered and takes effect prior to the mortgage, the pledgee shall have priority in terms of payment; if the mortgage is registered and established prior to the pledge, the pledgee will have the priority only if there is a surplus of rent after the mortgagee’s claims are fully paid off.

In the Supreme People’s Court (SPC) case of Min Shen (2020), a bank completed the mortgage registration procedures for the commercial real estate owned by company A. Company A then provided a pledge to company B of the rental proceeds from the real estate and completed the pledge registration. After company A defaulted on the loan, the bank sought to recoup the money owed. The court ordered that the real estate of company A be auctioned, which was challenged by company B.

The SPC held that if any property is mortgaged in favour of more than two creditors, the order of payment shall be determined according to whether the public notice is completed and the sequence of the notice. The court ruled that the pledge enjoyed by company B was not sufficient to challenge the mortgage of the bank, and its claim to suspend the execution of the real estate lacked legal basis.

孙洋洋, Sun Yangyang, Associate, Lantai Partners
Sun Yangyang
Lantai Partners

Whether the inventory under the custody of a third party constitutes an effective pledge in the inventory financing. Inventory pledge financing is the most basic product in supply chain finance and one of the most widely used. An inventory pledge is a pledge of movables, and relevant legal rules for the pledging of movables shall be applied. In the transaction structure of inventory pledge financing, the financing party and the financed party usually transfer the pledged property to a logistics enterprise that is legally qualified to safeguard the movables. This raised the question of whether the third-party custody constitutes an effective pledge.

For the validity of the pledge established under the custody of a third party, article 63 of the Minutes of the National Courts’ Civil and Commercial Trial Work Conference, and article 55 of the Interpretation of the SPC of the Application of the Relevant Guarantee System of the Civil Code of the People’s Republic of China, made it clear that the key is to prove whether the custodian is authorised by the creditor to supervise and actually control the pledged collateral.

Whether it is authorised by the creditor can be judged according to the custody agreement. The controversial focus is often on how to judge “actual control”. As can be seen from the SPC cases of Min Zhong (2019) and Min Shen (2019), the courts determine “actual control” depending on whether the creditor has conducted substantial custody over the pledged collateral. Judges determine this based on objective factors such as whether the consent of the custodian is required when the pledged collateral is released from the warehouse, whether the custodian arranges for personnel to enter the warehouse to carry out substantial custody of the pledged collateral and whether the custodian can freely access the warehouse.

In prepayment financing, the nature and effectiveness of the confirming warehouse transactions without a real trade background. Prepayment financing is where the financing party provides funds for the financed enterprise to complete an advance purchase based on the order provided by the financed enterprise. Afterwards, the financed enterprise repays the loan with the proceeds from sale of goods after the financing expires. Confirming warehouse transactions is the most common type of the prepayment financing. The basic legal relationship of confirming warehouse transactions is the sales contract between the buyer and the seller.

Article 69 of the minutes emphasises that the confirming warehouse transactions shall be carried out based on the premise that the buyer and the seller have a genuine trade background. The SPC also made the same determination in the case of Min Zhong (2019). Accordingly, if there is no real trade background, the confirming warehouse transactions will be invalid because it constitutes a false declaration of will. The transaction is ostensibly a confirming warehouse transaction but in fact constitutes a loan contract.

The real contractual legal relationship between the parties is the loan and guarantee, that is, the buyer applies for a financing loan from the financing party and the seller provides a guarantee for the loan. Simultaneously, if the loan and guarantee are the parties’ true declaration of will and do not violate any legal provisions, they shall be deemed valid.

Yang Guang is a partner and Sun Yangyang is an associate at Lantai Partners

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