Unpacking the pitfalls of bulk commodity pledges

By Yao Xiaomin and Wang Yumo, Lantai Partners
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Because of their high value, bulk commodities, mainly raw materials and inventory goods, have become one of the go-to types of collateral for many enterprises seeking finance. As movable property, bulk commodities can be used to create a chattel pledge, and the warehouse receipt of bulk commodities can be used to further create a pledge of rights. In practice, a pledgor often creates a pledge over the warehouse receipt, while at the same time a pledge or floating charge over the goods under the warehouse receipt is also created.

WAREHOUSE, CHATTEL PLEDGES

If the pledgor creates a warehouse receipt pledge, and also sets up a chattel pledge with the goods listed on the receipt, two pledges are created. The warehouse receipt pledge is created from the date of delivery (registration) of the warehouse receipt, and the chattel pledge is created from the date on which the pledgee or the third-party custodian actually controls the goods.

Yao Xiaomin, Lantai Partners
Yao Xiaomin
Partner
Lantai Partners

Article 59.2 of the Interpretation by the Supreme People’s Court on the Application of the Security System in the Civil Code of the People’s Republic of China provides that: “Where a pledgor creates a warehouse receipt pledge and a security over the warehoused goods, the order of payment shall be determined according to the order of public notice; if it is difficult to determine the order of public notice, payment shall be made in proportion to creditors’ rights.”

“Public notice” can mean either “registration” or “delivery”. Thus, the order of payment should be determined according to the order of creation of a pledge. It should be noted that when bulk commodities are pledged, they are usually not under the custody of the pledgee, but under the supervision of the custodian.

Article 55 of the interpretation provides that, “Where the creditor, pledgor and custodian enter into a tripartite agreement, and the pledgor provides security for the performance of the debt with goods whose scope can be determined by description of quantity and variety, and the parties have evidence to prove that the custodian is entrusted by the creditor to supervise and actually control the goods, the people’s court shall determine that the pledge is created from the date on which the custodian actually controls the goods.” Therefore, when bulk commodities are pledged, the pledge is created from the date of the custodian controlling the goods.

Where a warehouse receipt pledge and chattel pledge exist concurrently, the order of payment to the pledgee should be determined by comparing the time of delivery or registration of the warehouse receipt and the time of the custodian actually controlling the goods.

MOVABLE FLOATING CHARGE

If the pledgor creates a warehouse receipt pledge, and also sets up a movable floating charge with the goods listed on the receipt, the pledge and charge exist concurrently, and the order of payment should still be judged by the order of “public notice”.

Wang Yumo, Lantai Partners
Wang Yumo
Associate
Lantai Partners

Article 403 of the Civil Code provides that: “A charge on movable property shall be created at the time when the charge contract enters into effect; without registration, such a charge may not be asserted against a bona fide third person.” A charge on movable property needs to be “registered” to make a public notice. Therefore, where a warehouse receipt pledge and movable floating charge exist concurrently, the order of payment to creditors should be judged by comparing the time of delivery or registration of the warehouse receipt and the time of registration of the charge contract.

The Shanghai High People’s Court held, in Bank of China Yantai Branch v KBC Bank Shanghai Branch (2017), that: For the same collateral involved in this case, both floating charge and pledge have been created, and the order of payment with the price of the collateral should be judged according to the order of the creation and effectiveness of the security interest. BOC Yantai Branch and Yantai Penghui Copper Industry created a floating charge on 15 December 2011, and 7 July 2014, respectively, and completed registration of the charge on 19 December 2011 and 10 July 2014.

According to the judgment, this charge had become effective against third parties as early as 19 December 2011, when the first registration of the charge was completed. However, delivery of the pledge collateral of KBC Group Shanghai Branch was completed on 23 December 2014, and its pledge was thus created at the time.

The judgment of the case was as follows: The appellant BOC Yantai Branch has priority over the appellee KBC Group Shanghai Branch to obtain payment out of the value or proceeds of the collateral under the name of Yantai Penghui, which was sealed up by Shanghai No. 1 Intermediate People’s Court.

RECOMMENDATIONS

Whether a chattel pledge or a warehouse receipt pledge of bulk commodities, the validity of the pledge may be in doubt due to irregular operations.

When a pledgee accepts a pledge over bulk commodities, proper delivery procedures should be ensured. If the commodities are stored with a third party, the pledgee should confirm the delivery and the scope of the commodities by signing a premises lease agreement and a storage agreement with the pledgor and the custodian. If the commodities are stored at the pledgor’s own premises, they should be distinguished from other goods of the pledgor. In addition to specifying the storage location in the agreement, other distinguishing measures, such as fencing at the storage site, should be taken into consideration.

When accepting a warehouse receipt pledge, the pledgee should first examine the authenticity of the underlying assets of the warehouse receipt and ensure the existence of the goods through on-the-spot verification, confirm the legality of goods by reviewing the sales documents, and confirm the ownership of goods through investigation.

Furthermore, the pledgee should ensure the specificity of assets under the warehouse receipt by determining the storage address, supplier and serial number of the goods. Finally, the pledgee should guard against custody risks, and investigate the custodian’s operating conditions and management conditions to ensure it has sound management facilities and policies in place.

Yao Xiaomin is a partner and Wang Yumo is an associate at Lantai Partners

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yaoxiaomin@lantai.cn

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