Is provision of debt security a ‘gratuitous transfer of property’?

By Gao Meili, Dentons
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According to article 31 of the Enterprise Bankruptcy Law, the administrator has the right to request the court to rescind certain acts involving the debtor’s property that occurred within one year before the court accepts the bankruptcy application, including the “gratuitous transfer of property”.

So, does providing security for others’ debts fall into this situation? The author often encounters this problem in the bankruptcy business, and summarises here the standards and mainstream views recognised by the Chinese courts to provide references for creditors, administrators and debtors.

高美丽__Gao_Meili__Dentons-s
Gao Meili
Senior partner
Dentons

One view is that the debtor’s provision of security for other’s debts is for consideration, as the debtor can exercise the recourse right against the third party in the future. Another view is that the debtor does not receive any economic benefits in providing security for others, and the debtor’s recourse right is unlikely to be realised as the third party often becomes insolvent when the security contract is formed. Therefore, the provision of security should be a gratuitous act.

There is also a third view that if the third party has no financial resources at the creation of the security, the recourse right is essentially of no value, but if the third party still has the financial resources, the debtor obtains the recourse right while assuming the obligation of security, and the recourse right can be seen as the consideration for assuming the obligation of security.

In judicial practice, the key to judging whether the provision of security is a “gratuitous transfer of property” lies in determining whether it is a “gratuitous” act. According to the judicial cases summarised by the author, the following two situations need to be discussed:

(1) The security provider (bankrupt enterprise) provides security for the loan of any third party while it knows that the third party is unable to repay the loan. The insolvency of the borrower means that the bankrupt enterprise transfers its property to the borrower without consideration, which is harmful to the overall interests of the creditors. Although the bankrupt enterprise enjoys the recourse right against a third party, it would constitute a gratuitous transfer of property because the recourse right cannot be realised.

(2) The security provider (bankrupt enterprise) has no obligation of security and receives no consideration from a third party. This kind of security damages the debtor’s property and cannot constitute an exception to specific repayment, i.e. the repayment that can benefit the debtor’s property. If the secured party is an affiliate of the security provider, there is a suspicion of malicious transfer of property, and the possibility of being rescinded is greater.

There are controversies in theory and practice as to whether the provision of property security or guarantee for third parties constitutes a “gratuitous transfer of property” specified in Article 31. Most courts tend to believe that the bankrupt enterprise’s provision of guarantee for third party debts constitutes a “gratuitous transfer of property” in the broad sense.

However, the provision of property security for others’ debts is more controversial. Some courts hold that the debts in the “provision of property security for unsecured debts” listed in Article 31(3) only refer to self-owned debts, and therefore providing property security for other’s debts constitutes a “gratuitous transfer of property”. However, other courts hold that the debts should include both self-owned debts and the debts of others, and there may be competition in the application of the law.

In practice, the provision of property security for others’ debts tends to be considered voidable, if it is gratuitous. But there is controversy as to whether articles 31(1) or 31(3) of the Enterprise Bankruptcy Law should be applied. In the second instance of a bankruptcy dispute over a rescission decision made by the administrator, The Administrator of Jiangsu Zhongyuan Special Container Manufacturing v Jiangyin Huaxi Rural Small Loan (2016), the provisions of article 31(1) were applied in the judgment.

The court held that this act of security would reduce the amount of repayment that ordinary creditors could obtain through bankruptcy procedures, which violated the goal of fair repayment, and was a gratuitous transfer of property.

Some courts, however, hold opposing views. In the second instance of a bankruptcy dispute over a rescission decision made by the administrator in The Administrator of Fujian Nanping Jiangong Real Estate Comprehensive Development v Zheng Jiansheng (2016), the court held that Jiangong’s provision of security for the borrower, Li Yuchun, was an act of increasing the debts of Jiangong rather than a gratuitous transfer of property, and Jiangong had the right of recourse against Li Yuchun after it assumed the liability of guarantee. Therefore, it could not be decided that the provision of security was gratuitous only because the right of recourse was difficult to realise.

In summary, it is recommended that relevant parties pay attention to the stability of transactions during the sensitive period, and avoid them being rescinded because they are deemed to be gratuitous.

For example, the security provider can require the debtor to provide a valid credit certificate to avoid triggering the above-mentioned situation, where it provides security when knowing the third party is incapable of repaying, causing the provision of security to be a gratuitous act.

If the security provider and the debtor are related companies, attention should be paid to whether there is such circumstance that the actual controller uses his dominant position to transfer property in disguised form when he knows that he/she is unable to pay his/her debts.

The rules and application of bankruptcy laws are of great significance to the administrator and the parties to a transaction. It is recommended that all parties pay attention to the bankruptcy rules and the practical viewpoints of bankruptcy dispute resolution in order to better handle projects that involve, or may involve, bankruptcy.

Gao Meili is a senior partner at Dentons. She can be contacted on +86 186 1163 9690 or by email at meili.gao@dentons.cn