Genuineness of assets in securitisation remains key concern

By Fang Yan, DeHeng Law Offices
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China has seen a constant stream of innovation in asset securitisation products ever since the 2014 publication of the Regulations for the Administration of the Asset Securitisation Business of Subsidiaries of Securities Companies and Fund Management Companies. Whichever structure is used, however, the primary focus must remain the genuineness of the underlying assets.

Fang Yan
Partner
DeHeng Law Offices

Regulators have penalised intermediaries for failing to prudently perform obligatory checks and verifications in respect of the genuineness of the underlying assets in securitisation deals. This issue is a complex and key point for the asset securitisation industry.

Underlying assets (including their corresponding underlying assets) are the foundation of asset securitisation. According to the regulations, due diligence on the lawfulness of underlying assets is required to include the genuineness and lawfulness of the formation and existence of such assets.
In general, the types of underlying assets include rights in rem, claims (accounts receivable, etc.), rights to income (rent, infrastructure charges, etc.), intellectual property, private fund units, and rights to benefit from a trust. Checking the genuineness of assets is assessing whether they objectively and genuinely exist. Particular attention should be placed on the following:

The existence of a genuine transaction background or possibility. The parties to the transaction have a genuine demand for the transaction involving the underlying assets to occur, such as: The main business being upstream or downstream, or the existence of a supply and demand relationship; the transaction provider or recipient possessing the qualifications or permit necessary to engage in the relevant business; the transaction provider or recipient possessing the place of business, assets or equipment required to engage in the relevant business; and audit reports (financial statements) reflecting the relevant assets.

There is information supporting the formation process of the underlying assets. The formation of the underlying assets is the process of acquiring the rights in the underlying assets, and requires verification of the entity owning the rights, registration status, scope of the rights, the execution of the corresponding contract and the completeness of the procedures involved, whether the valid consideration has been paid in full, and whether the period of validity has been exceeded.

Evidence showing actual performance of the transaction. Actual performance of the transaction is mainly reflected in the genuineness of the flow of goods (including transaction forms such as project construction and services) and cash.

This requires the transaction provider to provide records of: Its provision of the goods (including but not limited to the release orders, logistics documents, notes of confirmation of construction progress, and documents evidencing service results at various stages); records of the receipt of goods by the transaction receiver (including but not limited to receiving orders, acceptance notes, documents from third-party institutions confirming inspection and quarantining of the goods, and use of documents evidencing service results at various stages); emails, WeChat and other such records from the transaction parties confirming the subject matter of the transaction; documents of the transaction parties confirming performance of the transactions (including but not limited to statements of account, evidence of delivery of the goods at various stages, and evidence confirming final settlement of prices); history of similar transactions, issuance of invoices and verification of their authenticity; and paying attention to the intimate relationship between business and amounts in different performance materials.

Intermediaries mainly conduct due diligence by such means as the review of written materials, onsite visits to the places of business relating to the underlying assets, interviews with relevant persons, random onsite examinations of original documents, and consulting publicly available information (if any) to achieve comprehensive verification.

In practice, the risk of non-genuine underlying assets increases if the proportion of connected transactions is relatively high, the concentration of suppliers or customers is high, certain participants (such as factoring companies, trust companies and asset operating companies) involved in the erection of the transaction structure lack independence or other such reasons. Accordingly, in the course of setting up an asset securitisation product using underlying assets with the above-mentioned features, attention is usually focused on the following three means of due diligence, in addition to setting out conditions and restrictions in the transaction structure by setting fixed amounts.

Onsite visits and interviews. It is necessary to make onsite visits to the entities connected to the underlying assets, and to the assets and the transaction counterparties, as well as to interview middle managers familiar with the details of the business. The main focus of such interviews is the details of the transaction, such as the procurement procedure, delivery times, billing period, delivery method and storage location.

Verification of the implementation of internal company systems. This mainly involves sifting through the internal management systems, management procedures, operating specifications and operation management of the enterprises that have a connection with the formation of the underlying assets, more specifically including: The system of selection before a transaction occurs, e.g. the systems relating to supplier management and the invitation and submission of bids; the contract execution system, e.g. the company’s procedural and approval system for the execution of contracts; the performance/acceptance management system, e.g. the system relating to the authority and procedural requirements for performance and acceptance; and the payment approval system, e.g. the systems for invoice management, approval authority and approval of material requirements.

Internet search. A comprehensive online search of relevant reporting on, and publicity about, the parties to the transaction may be conducted with search engines and on such websites as China Judgments Online and www.creditchina.gov.cn. The transaction involving the underlying assets should also be analysed to confirm whether the transaction is in line with commercial logic and whether the relevant entities pose a major risk of breach of trust, litigation, etc.

Although offerings of asset securitisation products still rely on trust in the relevant entities to a certain extent, the underlying assets remain the precondition for the securitisation, and it is only by focusing on the genuineness of the assets that securitisation can be sustainable.

Fang Yan is a partner at DeHeng Law Offices. She can be contacted on +86 755 8828 6447 or by email at fangyan@dehenglaw.com