Legal effect of provisions on independent validity of security contracts

With the gradual development and improvement of the investment and financing markets in China, trusts have become an important financing instrument in the infrastructure and real estate sectors. In trust financing projects, of greatest concern to the funding party, other than the provisions on returns and withdrawal, are the credit enhancement measures, usually realised in the form of a security contract, and the funding party will usually demand the clear stipulation in the contract of a provision on the independent validity of the security contract.

However, in judicial practice, does such a provision really function as a “protective talisman”? This remains the subject of debate. This column will provide a brief analysis by looking at a certain trust financing project.

Particulars of the project

Recently, the first author provided legal services in the RMB4 billion (US$655 million) property trust financing project of a certain group company. In the trust investment project, the financier entrusted property to a trust company to establish a trust plan, and a financial institution purchased the trust product, thus becoming the actual investor. The credit enhancement measure for the trust was an irrevocable joint and several guarantee provided by a shareholder of the group (a triple-A rated entity).

In the course of the negotiations on the trust contract documents, the purchaser insisted that it be expressly provided in the security contract that the security contract was independently valid and would not become invalid due to the invalidity of the trust contract documents. The guarantor, however, holding that such a provision posed a problem of lawfulness, refused to add such a provision and the negotiations came to a standstill.

Relevant legal provisions

The earliest provision on the independent validity of a security contract can be found in article 5 of the Security Law (1995): “A security contract is a dependent contract to the master contract, and is invalid if the master contract is invalid. If the security contract provides otherwise, such other provisions shall apply.” It is generally believed that, pursuant to this provision, if the parties expressly provide in the security contract that the security contract is independently valid, the security contract will not become invalid if the master contract is invalidated.

However, article 172 of the Property Law (2007) specifies: “When a security interest is to be created, a security contract shall be entered into in accordance with this Law and other laws. 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.”

Pursuant to this provision, when a security interest is created – mortgage, pledge, lien – if the master claim contract is invalid the security contract is also invalid, unless otherwise provided in law. That is to say, with respect to a security contract for a security interest, only relying on the parties stipulation of a provision on independent validity in the security contract cannot function to give the security contract independent validity.

In a talk given at the National Civil and Commercial Adjudication Work Conference in 2007, Xi Xiaoming, vice president of the Supreme People’s Court, stated the following regarding the issue of the independent validity of security contracts: “Considering the exceptional severity of independent security liability, and the serious disadvantages such as fraud and abuse of rights that use of such a system can engender, independent security may only be used in international commercial transactions at present, particularly in order to avoid seriously affecting or rocking the foundation of China’s security law system regime.”

Proposed solution

The first author is of the opinion that the security in our example was to be provided in the form of a guarantee, not a security interest, therefore the provision in the Property Law reading “unless otherwise provided in law” did not apply; rather, the provision in the Security Law reading “if the security contract provides otherwise, such other provisions shall apply” was applicable. Accordingly, from this perspective, the provision on the independent validity of the security contract insisted on by the purchaser was in compliance with the law.

However, the dispute resolution method determined in the trust contract documents for the project was “shall be referred to the competent court for a judgment” and, although the talk of the senior officer of the Supreme People’s Court mentioned above certainly cannot be considered to constitute a legal provision, it does have significant guiding significance in court adjudication practice. If the parties in the case raised in this column were to have taken a dispute arising over the security contract to court, it is possible that the court would not have recognised their provision on the independent validity of the security contract. From this perspective, the guarantor’s opinion is not without foundation.

Therefore, the key to the resolution of this problem lay in finding the common ground in the diametrically opposed views of the parties. The first author strived to harmonise the opinions of the parties, worked on the provision on the independent validity of the security contract and, based on the contract/master contract invalidity situation, further refined the scope of the security liability of the guarantee. Ultimately the parties reached a consensus and executed the relevant agreements without a hitch.

The authors are of the opinion that, with regard to the issue of the legal validity of provisions on the independent validity of security contracts, because the Security Law and Property Law are not necessarily in agreement, article 172 of the Property Law should be complied with when it comes to security interests (mortgages, pledges, liens). Accordingly, unless otherwise provided in law, the “independent validity of the security contract” provided for at the parties’ discretion is invalid.

If the method of security is a guarantee, then the Security Law should be complied with, i.e. the parties to the agreement may, by way of a contract provision, determine that “in the event the master claim contract is invalid, the security contract shall be independently valid”. However, considering that the Supreme Court’s view that “independent security may only be used in international commercial transactions” has not expressly changed, the authors would not recommend that, unless an international commercial transaction is involved, adjudication by a court be selected as the dispute resolution method, but would instead recommend that arbitration be selected for the resolution of disputes.