The minutes: Security issues affecting financial institutions

By Yang Guang and Wang Qing, Lantai Partners

The Minutes of the National Working Conference on the Trial of Civil and Commercial Cases by Courts, which were issued by the Supreme People’s Court and became operative on 8 November 2019, clarify some security issues that arise from discrepancy in judgment criteria due to major disputes over application of laws, and deserve the attention of financial institutions.

The following key points are closely related to the financing services of financial institutions:

Yang Guang
Managing Partner
Lantai Partners

Dependency of security. For all types of security, other than the independent letters of guarantee that are issued by banks or non-banking financial institutions, and conform to applicable judicial interpretations, security agreements should be accessory to principal contracts, which should not be excluded by agreements between the parties.

The agreements on the liability to provide security in excess of the principal obligation should be invalid. Unless otherwise agreed, when the principal creditor’s right is transferred, the mortgage will be transferred with the creditor’s right. The assignee has the right to enforce its mortgage against the mortgager.

Lending new loans to repay the old ones. Unless the party concerned agrees to provide security for new loans by the security measures under the old loan contracts, the security under the old loan contracts will expire with the repayment of old loans.

Wang Qing
Lantai Partners

Extent of security and exercise of security interest. If the registration system does not include “extent of security”, then extent of security should be that as agreed in the contract. The mortgagee will enforce the mortgage subject to the same limitation of action for the principal obligation.

If the limitation of action for the principal obligation expires and the mortgagee does not enforce its mortgage, the mortgagor has the right to cancel the registration of mortgage.

This provision is also applicable to pledge over rights, which is demonstrated by registration.

Separate mortgage of housing and land. In principle, housing and land should be mortgaged as a whole. Under exceptional circumstances, they may be mortgaged separately, and the order of repayment should be determined based on the sequential order of registration. If land use right is mortgaged, subsequent additional projects in progress will not be deemed a part of the mortgaged property.

Floating pledge. Where the creditor, pledgor and escrow agent enter into an escrow agreement, the effect of pledge will be affected directly by the fact of who appoints the escrow agent. If the pledged property is released in violation of the agreement, or is damaged or lost because the escrow agent fails to properly take care, the escrow agent should assume the liability for breach to the creditor.

If the escrow agent is appointed by the pledgor, or if the pledged property is actually under the control of the pledgor even through it is agreed in the escrow agreement that the escrow agent should be appointed by the creditor to supervise the pledged property, the pledge will be created ineffectively, and the creditor may request the pledgor or the escrow agent to assume the liability for breach.

New types of security. Except for the circumstances of statutory invalidity, new types of security, in principle, may be recognized to have the effect of a security agreement. The security, similar to pledge and mortgage that are not registered, will not have the effect of property right.

Title assignment as security is effective in principle. The agreements involving lex commissoria, however, are ineffective. Both the creditor and the debtor may claim repayment of debt by disposal of the assigned property, but the creditor’s claim for title to the property will not be supported.

If the parties reach an agreement on debt repayment in kind before expiration of the debt repayment period, but the assets for debt repayment have not been delivered to the creditor, such security is not title assignment as security. If the credit enhancement measures – such as supplement of shortfall by third parties, vicarious performance of the obligation of buyback upon maturity, and liquidity support – have the elements of guarantee, it can be recognized as a guarantee.

Based on the above-mentioned requirements, financial institutions, including commercial banks and trust companies, should pay attention to the following points.

First, in borrowing new loans to repay old ones and borrowing new loans after repayment of old ones, continuation of the same security measure should be handled with discretion.

The authors advise that the new creditor’s right should be registered as the principal creditor’s right and the financial institution involved should be registered as the second-rank creditor, which will automatically become the principal creditor when the old loan is repaid with the new loan.

Meanwhile, it should be provided in the security agreement that the original security measures for the old loan will continue to provide security for the original debt until the security measures for the new loan are properly completed.

Second, the parties concerned should learn about whether a local registration authority will accurately register the scope of security before handling the mortgage registration formalities. No matter what requirements the registration authority has for specific registration information, the mortgage contract should contain a complete and accurate statement of the actual scope of security.

If a mortgage of housing and land is involved, the parties concerned should check whether the housing and land are mortgaged separately; if the housing and land are mortgaged separately, mortgage registration of such housing and land should be handled together. If only land is mortgaged, the parties concerned should follow up on the construction progress of related plots and timely register mortgage of the additional projects and housing
in progress.

Third, in the event of a creative security method that involves specific assets, if such security fails to be registered, the parties concerned should timely initiate the disposal procedure and sell off the security as soon as possible when risks occur.

Fourth, if a floating pledge and three-party escrow are adopted in the financing for supply chain, it should be stated in the escrow agreement that the escrow agent is appointed by the creditor to supervise the pledge, and the escrow agent will be required to fulfill its duties in actual performance of the contract.

Yang Guang and Wang Qing are partners at Lantai Partners

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