Assessing validity of new credit-enhancing documents

By Yang Guang and Li Yunshi, Lantai Partners

With the continual innovation and rapid iteration of various kinds of investment and financing businesses, in addition to the traditional way of guarantee, the counterparties of financial institutions have extensively taken different forms of credit-enhancing measures, such as making up the difference, forward repurchase, liquidity support, etc., to avoid being included into the credit reference system of the People’s Bank of China, or to avoid issuing internal resolution documents, or to improve financial statements.

Yang Guang
Managing Partner
Lantai Partners

Given that there are no clear regulations in the existing laws and regulations regarding the innovated credit-enhancing measures that have emerged in transactions, when disputes arise from transactions, the determination of the nature of such credit-enhancing measures becomes the key concern of all parties and also usually the focus of judges’ reviews.

Under the existing judicial adjudication standard, the nature of the new credit-enhancing arrangements, according to their specific expressions, may be determined as guarantee, accession to debt, independent obligation, etc., each of which corresponds to a different legal effect.

On 8 November 2019, the Supreme People’s Court issued the Minutes of the National Courts’ Civil and Commercial Trial Work Conference, which, for the first time, made uniformed stipulations on whether certain credit-enhancing measures are a guarantee. It was clarified that on condition that the content of the credit-enhancing measures conforms to articles 17 and 18 of the Guarantee Law, it should be determined that a contractual legal relation of guarantee is created between the parties.

Li Yunshi
Lantai Partners

Specifically, if the credit-enhancing document clearly provides that a party undertakes a guarantee obligation, or jointly assumes joint and several liability with a transaction entity that defaults on its debts or fails to perform its payment obligations, etc., then regardless of the form it appears in, the credit-enhancing documents shall be applied and determined by the standard of guarantee.

Such adjudication rules have been sufficiently applied in previous cases. In No. 135 Civil Case of First Instance, of Beijing No.3 Intermediate People’s Court, in 2016, a Fujian company involved in the case committed to make up the difference for a Jiangyin company’s entire principal under the “trust loan contract” when the asset management plan expires. The court held that the “difference making-up agreement” is associated with the “trust loan contract”, and is not a completely exclusive independent contract. The nature and purpose of the “difference making-up agreement” was to secure the safety of Jiangyin company’s loan funds. Therefore, the agreement is, in fact, another form of guarantee in disguise.

In addition to the above-mentioned situations that are clearly determined as guarantee, credit-enhancing measures can also present non-guarantee legal effects depending on their content. For instance, in the No. 867 Civil Case of Final Appeal of the Supreme Court, in 2019, the court held that the “commitment letter” in question should be accession to debt, not guarantee.

With respect to the judgment standards of these two cases, the court elaborated with examples. First, the legal relation of the two debts in question are mutually independent, therefore, it should be accession to debt; if there are principal and subordinated debt, then it tends to be a guarantee. Second, when the obligor has paid off, or has other exemption behaviour to the creditor after undertaking the obligation, does he/she have the right to be reimbursed by the original debtor, and what is the scope of the reimbursement? In comparison, accession to debt tends to be determined based on the internal legal relation between the obligor and the original debtor, while the guarantee is more clear-cut. The Guarantee Law clearly provides that after the guarantor fulfils the guarantee obligation, it shall be entitled to be reimbursed by the original debtor.

Finally, if the parties do not have a clear declaration of will, or if the description of their will is not clear, then it should be judged based on specific circumstances. If the undertaking of the act is mainly for the interest of the original debtor, then it can be determined as guarantee; if the obligor has direct and actual interest, then it can be determined as accession to debt.

It should be noted that, given the actual needs of transaction entities in the financial market for the credit-enhancing measures arrangement, attention should be paid to the structural design regarding whether the design violates financial regulatory regulations, or circumvents supervision and conducts regulatory arbitrage. Although under the existing adjudication standard, the violation of regulations does not necessarily mean a denial of the validity of legal documents, it should not be ignored that compliance reviews have gradually become an important dimension of the judges’ judgment of cases.

For instance, the Implementation Opinions on the Implementation of Financial Risk Prevention issued by the Shanghai High Court clearly requires that, “for financial innovated transaction modes that do not comply with financial regulatory regulations and the supervision spirit, or financial non-compliance conduct in the name of financial innovation in order to cover up financial risks, circumvent financial supervision or conduct institutional arbitrage, courts should deny their legal effects in a timely manner, and determine their validity, and the rights and obligations of all parties, in accordance with the actual legal relations that they constitute”. It is foreseeable that the compliance issue of the credit-enhancing measures will also be an important aspect that influences the direction of future judicial adjudication.

From the existing judicial adjudication mentality, it can be seen that judges are trying to interpret the terms of the contract between the parties in order to make a qualitative determination of the real transaction arrangement behind it. Admittedly, the minutes more clearly define the determination standard for guarantee, but such determination still needs to be combined with, and be based on, the relevant terms of the transaction documents, and the true declaration of will of all parties.

Given that it is inevitable that judges have different determinations and interpretations, there is still uncertainty about whether they can actually meet the above-mentioned judgment standards in practice and achieve accurate and fine-grained judgment of the real purposes behind the new types of credit-enhancing arrangements. Therefore, with respect to both parties in a specific transaction, the maximum protection of their interest still relies on the careful wording of the document itself, to ensure that the contract is able to achieve both parties’ transaction purposes and obtain appropriate judicial determination in the event of dispute.

Yang Guang is a partner and Li Yunshi is an associate at Lantai Partners

Lantai Partners

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