The state of the pledge in China

• Security law in China has steadily evolved, with the most recent milestone being the implementation of the PRC Property Law in 2007.
• A regulatory regime governing the taking of security in China has evolved, administered by a range of government bodies, including the Ministry of Commerce and the State Administration for Industry and Commerce.
• There are inherent problems in the system of enforcement of security in China, but structures may be devised to overcome these problems.
• The current foreign exchange control regime in China permits a Chinese entity to provide security in favour of a foreign creditor subject to certain restrictions.

Borrowers have been offering collateral to lenders for as long as people have been trading. The practice of granting security over one’s assets in order to secure the cooperation and participation of another party is common throughout the world. What has always been key, and remains relevant as we move away from a decade of cheap borrowing, is the ease and confidence with which any collateral can be readily accessed by a lender in the event of a breach of the borrower’s underlying obligations.

A relatively comprehensive legal framework for the regulation of taking security in China was established with the introduction of the People’s Republic of China (PRC) Security Law in 1995. Since then, security law in China has steadily evolved, with the most recent milestone being the implementation of the PRC Property Law in 2007. A regulatory regime has grown up administered by a range of government bodies, including the Ministry of Commerce (MOFCOM), the State Administration for Industry and Commerce (AIC), and housing and land administration authorities; the types of asset that can be secured have increased; and the processes for perfection and enforcement of security have increasingly become well-regulated and harmonised with international practices and norms.

The purpose of this article is to review the state of the pledge in China, enforcement, and the extent to which the pledge will be a useful tool in structuring deals once the shock of the credit crunch has receded and economic confidence has returned.

Since the PRC Property Law came into effect on 1 October 2007, the Credit Reference Centre (CRC) of the People’s Bank of China has been operating an online registration system for pledges made over receivables. Examples of receivables include those arising from:

• The sale of goods;
• The supply of water, power, gas and heat;
• The leasing of movable and immovable property;
• The provision of services; and
• The fees charged for the use of transportation routes such as highways and bridges.

The CRC’s statistics indicate that there is appetite for this new type of pledge in the market, with more than 74,453 separate pledge registrations having been made as at 30 June 2009¹.

Interestingly, by the end of its first full calendar year in operation, around 80% of pledges had been registered in favour of domestic national financial institutions. In contrast, only 7% had been registered in favour of foreign-invested financial institutions. Foreign-invested financial institutions have been far more cautious in buying into this type of security. On the face of it, the reason for such a stark difference of approach is not clear. After all, most pledges over receivables registered at the CRC relate to toll road charges, export tax rebates and power grid tariffs – business streams that generate steady and constant flows of receivables. There is however substance to the more conservative response by foreign-invested financial institutions, and not all of it is due to the effects of the global downturn.

1 According to the CRC website

Risk of pledge losing its effectiveness

The key problem appears to be the risk of a pledge over receivables losing its effectiveness even after it has first been duly registered. There is a strict requirement for the information recorded on the CRC register in respect of the pledgor to be accurate, and kept accurate on an ongoing basis. The reason for this is that the CRC registration system is accessible online by the public and is intended to be relied upon by bona fide third parties. As such, great store is placed on the integrity of the CRC’s records, and it is therefore critical that the official name of any pledgor is correct at all times.

What concerns foreign-invested financial institutions is that, under the current CRC registration rules, it is the pledgee that is responsible for the accuracy of any such information, and therefore for updating any changes that have been made – for example, to a pledgor’s name – within four months of any such change. Failure to do so means that the existing pledge registration is no longer effective. There is a clear danger of a pledgor recklessly or intentionally failing to notify a pledgee of its change of name, leading to the pledge falling away.

In such circumstances, although the pledgee may still have recourse against the pledgor under the pledge contract, the pledgee would lose its priority in respect of the pledge and may fail to recover the principal debt. In comparison, under Hong Kong law, a charge over receivables should be registered with the registrar of companies in Hong Kong and details of the charge will be entered into a database (maintained by the Hong Kong Companies Registry) containing all up-to-date registration information of Hong Kong-incorporated companies and companies that are registered as an overseas company in Hong Kong. In the case where the charger changes its particulars (including its company name) after a charge over receivables is created, the charger should register such changes with the registrar. As the details regarding any registration of a charge in Hong Kong or change of company name can be found in one single registry database in Hong Kong, a simple company search on such database against the charger by a third party should reveal any change in registration information of the chargor and any charge over receivables that has been granted by the charger. Under Hong Kong law (unlike under PRC law), the chargee bears no obligation to update the registration information of a charge over receivables after it has been duly registered.

Another peculiarity of pledges over receivables in China is that such pledges automatically terminate at the end of an agreed registration period up to a statutory limit of five years. The pledgee has the right to extend a pledge over receivables by another five years. However, given that a pledgor may naturally be unwilling to extend a pledge after the initial five years have elapsed, there is an inherent weakness in any pledge over receivables that is intended to attach to any medium- to long-term obligation of the creditor.

In our experience, while pledges over receivables are included within security packages, the creditor’s confidence remains low as regards the viability of their enforcement and effectiveness.

Pledges over shares, fund units or equity interests are widely used in China, and there is every reason to expect that the system of enforcement will continue to be improved and strengthened. Shares or (as the case may be) equity interests in most types of PRC company can now be pledged: domestic companies, foreign-invested enterprises (FIEs) and listed companies.

Domestic companies - pledges over equity interest

Under the regime of the PRC Security Law, if a pledge is created over an equity interest in a PRC domestic company, this fact only needs to be recorded on the relevant share certificate and no registration of the pledge at any governmental authority is required. However, after the PRC Property Law came into effect on 1 October 2007, a pledge over an equity interest in a PRC domestic company will only become effective upon registration of the pledge at the competent local branch of the AIC. For equity pledges created before 1 October 2007, registration enhances and better protects the pledgee’s rights and its ability to enforce them.

FIEs - pledges over equity interest

Noticeably though, no attempt has yet been made to address a serious weakness that has long been apparent to the market, namely the prominent and sometimes decisive role of the pledgor in the enforcement of an FIE pledge. To take effect, a pledge over equity interest in an FIE needs first to be approved by MOFCOM (or the competent local branch of MOFCOM), then registered with the AIC (or the competent local branch of the AIC). This can be a very time-consuming process, taking several months or up to half a year to complete if MOFCOM and/or AIC challenge or require amendments to be made to the transaction documents. At an early stage in a transaction, the relationship between pledgor and pledgee may be cordial and arrangements handled amicably, especially where underlying rights and obligations are made conditional upon perfection of the pledge. But problems often arise because enforcement of the pledge necessarily involves another round of applications to MOFCOM and AIC. At that point, even where an equity transfer agreement for the transfer of the pledged equity interest has been pre-signed, MOFCOM may well require evidence that the equity transfer price is not lower than the net asset value of the relevant FIE. This requirement triggers a valuation process, which can only be completed with the assistance of the relevant FIE and possibly also the participation of the pledgor. A speedy resolution by enforcement is therefore dependent in large part upon the goodwill of the relevant FIE and the pledgor – a prospect which many pledgees find unattractive. Where a pledgor refuses to cooperate, and an arbitration award or court judgment is necessary, there will be time and cost implications that dilute the effectiveness of a pledge as security over equity interests in an FIE.

A second, albeit less common, problem relating to FIE pledges is the risk of MOFCOM or AIC rejecting the transfer of equity at the time of enforcement of the pledge. Whereas in other jurisdictions enforcement may be a private matter between parties involving, at most, notifications and registrations, in China the regulators retain the role of final arbiter as to whether a transfer of assets from the borrower to the lender may take place, and this leads to further uncertainty regarding the lender’s security structure.

Listed companies - pledges over shares

Under the PRC Property Law, a pledge over shares in a listed company will only become effective upon registration with the China Securities Depository and Clearing Corporation (CSDCC). Upon enforcement of the pledge, the pledgee is entitled to dispose of the shares pledged and recover the principal debt from the proceeds of the disposal. Under the Administration Measures for Share-Pledged Loans of Securities Companies promulgated by the People’s Bank of China, China Banking Regulatory Commission and China Securities Regulatory Commission in November 2004 (the Share Pledge Measures), the only types of pledges which may be registered at the CSDCC comprise pledges made by securities companies (证券公司) over their A shares in listed companies, notes of securities investment fund certificates or convertible bonds issued by listed companies, for the purpose of securing loans granted by PRC commercial banks (including domestic banks and foreign-invested locally incorporated banks) to such securities companies. Other types of pledge not specifically mentioned in the Share Pledge Measures are not registrable with the CSDCC or with any other authority in China. Although the PRC Property Law provides for the registration of share pledges in China, it appears, upon closer examination, that only limited categories of share pledge are in practice registrable in China.

As a general rule under the PRC Security Law, funds in the account for a pledge over a bank account must be ascertained and identified at the time of perfection of the pledge. A pledge may not therefore be granted over future funds – for example, future flows of dividends or debt service reserve into an account – because they cannot be identified at the time of execution of the pledge. Structures may be devised to overcome the more serious problems inherent in the system. It might be possible, for instance, to include an undertaking for a pledgor to sign up to a pledge over deposit each time funds enter the relevant account, or alternatively, upon the occurrence of an event of default, with the form of pledge document agreed at the outset. Alternatively, a pledge agreement may be signed at the outset of arrangement, thereby removing the need to garner new signatures from the pledgor. Either method would, however, require the continuing cooperation of the pledgor in order to perfect the pledge. A pledge over money deposited in a bank account will only become effective when the money order (存单) recording the deposit is physically in the possession of the pledgee. This final step requires the active cooperation of the pledgor, and consequently there is a constant risk of the pledgor resiling from its obligations, thereby jeopardising the lender’s security arrangements. The key to making this type of pledge workable in practice is to require the pledgor to open an account with the pledgee bank so that the pledgee has a degree of control over the pledgor’s account.
Although taking a pledge over a money order is relatively secure and well-regulated from a legal perspective, the problems noted above make it less attractive from a practical point of view. As a result, commercial banks take a pledge over a special account which is more flexible than a pledge over a money order. The Interpretation of the Supreme People’s Court regarding the PRC Security Law provides that if the money of a borrower or a third party is maintained in a designated bank account, namely a “special account” (as explained below), and the possession of the special account is transferred to the creditor as security for a debt owed by the borrower, the creditor shall have preference rights over the money in such special account if the borrower falls into default. The term “special account” is interpreted in practice to mean a type of account that is:

• Set up for a specific purpose;
• Under the possession of the creditor (usually, a bank);
• Only permitted to receive money (usually, on a regular basis), so there should not be any outflow of money from the special account; and
• Under the effective control of the creditor (for instance, the pledgor is not permitted to dispose of the money in the special account without the prior consent of the creditor).

By having actual possession and control over the special account together with an effective pledge agreement in place, a bank may better protect its position against other third party creditors.

As a pledge over a special account stems from only one provision of the Interpretation of the Supreme People’s Court regarding the PRC Security Law which is itself not entirely clear, the practice of different commercial banks in taking a pledge over a special account may vary and the validity and effectiveness of this type of pledge as a form of security has been questioned. However, a recent court case where a local PRC court recognised the validity and effectiveness of a pledge over a special account should serve as encouraging news for commercial banks.

Pledges over moveables are comparatively easy to perfect. Physical delivery of the moveables to the pledgee and a contract in writing are all that is required. Cooperation of the pledgor is not an issue - the pledgee has the right and ability to sell the pledged goods in the event of default, and the pledgor has no way of barring the way. In reality though, pledges over moveables remain rare for the simple and understandable reason that the parties - the pledgee in particular - may find it inconvenient for possession to transfer between them at the outset of the transaction.

Due to the foreign exchange control regime in China, a PRC entity may provide security in favour of a foreign creditor (foreign security), subject to certain restrictions. Under the applicable PRC regulations, the provision of all foreign security shall be subject to either the prior approval of, or registration with, the State Administration of Foreign Exchange (SAFE) or its competent local counterparts. Generally speaking, SAFE approval is difficult to obtain whereas SAFE registration is easier to achieve.

Generally, financial institutions (e.g. commercial banks) are subject to fewer restrictions in terms of providing foreign security compared to ordinary legal entities. In terms of non-financial institutions, a PRC domestic entity or a PRC equity joint-venture company is usually only permitted to provide foreign security for its own foreign debt (or the foreign debt of its subsidiaries) and the provision of such foreign security must be approved by SAFE. A wholly foreign-owned enterprise may provide foreign security with a greater degree of flexibility, but it must not provide foreign security for the obligations of its foreign parent company, its foreign affiliates or any foreign third party. Under the current PRC regulations, “secured parties” in relation to the provision of foreign security include PRC domestic enterprises, FIEs and foreign entities invested wholly or partially by the PRC entity that provides the foreign security.

The introduction of the PRC Property Law has been viewed as an important step in the development of the law governing the taking of security in China. However, it continues to have shortcomings, affording local governmental authorities wide discretionary powers of interpretation and implementation. As a result, the practice of implementation varies between different local governmental authorities.
In order for the regulatory regime governing the taking of security in China to progress to a more advanced level, further detailed regulations regarding implementation in practice will need to be promulgated. Only in this way will the existing serious deficiencies in the system be addressed.

Note: This article was first published in HSBC's Guide to Cash, Supply Chain and Treasury Management in Asia Pacific 2010, as requested for by the publisher of the HSBC Guide.