Making an effective pledge of a bank’s financial products

The pledge of a bank’s financial products can maximise their value, but China’s current laws and regulations have not made clear provisions on them, and companies face resulting legal risks. This article analyses how to effectively make the pledge of banks’ financial products, based on judicial practice.

CURRENT APPLICATIONS

The pledge of a bank’s financial products refers to a form of security where the borrower creates a pledge over its bank’s financial products to secure repayment of the loan from the bank. If the borrower fails to repay in a timely manner, the bank has the right to recover the loan from the corresponding value of the financial products.

In practice, major banks have launched the business of financial products pledge. However, a notable feature is that most banks only recognise the security of their own pledge.

The main reason is that there is no unified information sharing mechanism for the pledge of a bank’s financial products. This makes it impossible for a bank to monitor the value change of other banks’ financial products creating potential obstacles for a bank to dispose of other banks’ financial products when realising their pledge.

REALISATION OF PLEDGE

Generally, a bank’s financial products pledge is realised in such a way that the pledgee can receive priority payment from the value of the financial products when its claim becomes due but is not satisfied, or when any circumstance of realising the pledge under the pledge agreement occurs.

However, in the pledge of a bank’s financial products, the pledge relationship is intertwined with the financial relationship, causing banks and customers to have mutual claims and debts and providing a further basis for both parties to exercise the right of set-off.

EXERCISING PLEDGE RIGHT

In judicial practice, realisation of a bank’s financial products pledge mainly includes the following:

(1) Courts only confirm pledgee has right to receive priority payment from financial products. In China Everbright Bank Guangzhou Branch v Liu Jian (2015), the court held that the plaintiff (creditor and pledgee) was entitled to priority payment from the financial products provided by the defendant (debtor) as collateral when the defendant failed to perform its debt.

(2) Courts confirm pledgee has right to receive priority payment from proceeds of auctioning or selling financial products. In China Construction Bank Corporation Suqian Branch v Suqian Hua Yi Technology (2016), the court ruled that where the financial product pledged by the debtor to the creditor was auctioned or sold, proceeds should first repay the debt owed to the creditor.

(3) Pledgee makes deduction according to contract, realising pledge by exercising right of set-off. When the borrower fails to repay the due loan, or other agreed circumstances occur, the bank in whose favour the pledge is created may offset the principal and interest of the loan by directly deducting funds from the customer’s financial product account. In judicial practice, some courts have also supported this way of exercising rights.

In Zhang Suping v China Industrial and Commercial Bank Xushui Sub-branch (2016), the court ruled: An entrustment contract on wealth management was formed between the plaintiff and defendant. Accordingly, when the financial product matured, the defendant should return the principal and earnings of the financial product to the plaintiff. The plaintiff created a pledge over the financial product in favour of the defendant, and a loan and pledge relationship was formed between them. When the loan matured, the defendant deducted the loan principal and interest from the principal and earnings of the financial product pledged by the plaintiff to realise defendant’s claim, and then transferred the balance to the plaintiff’s bank account. Thus, claims and debts between the plaintiff and defendant were extinguished.

SUGGESTIONS ON BANK PLEDGES

Banks are recommended to improve the design of pledge realisation clauses to protect their security interests in the following ways.

1. 1. Delivery and registration clause. The pledgor should deliver the original contract of the financial products, or corresponding right certificates, to the bank and co-operate to complete the corresponding pledge registration, minimising legal risk of failure to pledge the financial products effectively.
   2. Margin clause. The financial product account is set up as a margin account, and the bank is authorised to freeze and stop payment before the loan is settled, and directly deduct the principal and earnings of the financial product to offset the secured loan to better protect the bank’s priority of repayment from the financial product.
   3. Collateral value replenishment clause. When depreciation of the financial products causes the pledge rate requirement not to be met, the bank has the right to require additional security, or early repayment, to ensure the function of securing realisation of claims is not weakened.
   4. Escrow clause. There are two terms in the pledge of banks’ financial products. One is the duration of a bank’s financial products, and the other is the term of the debt secured by the pledge. If the maturity of the financial products precedes the maturity of the secured debt, the bank may first freeze or place in escrow the financial funds that should pay the debtor, and receive priority payment from such funds when the secured debt becomes mature.
   5. Early redemption clause. Where the maturity of the financial products is later than the maturity of the debt, in addition to first discharging the debt with the value of the financial products upon their maturity, the bank has the right to redeem the financial products on behalf of the pledgor if the bank’s claim becomes due but is not satisfied, or any circumstance of realising the pledge under the agreement occurs.

In this case, the pledgor voluntarily bears the loss of principal and earnings (if any) to enhance the operability of exercising the pledge right.

Yao Xiaomin is a partner and Sun Yangyang is an associate at Lantai Partners