China Law and Governance Review
    A Publication of China Law and Development Consultants
December 2006 Issue No. 3   
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Main Feature

Secured Transactions Law Reform in China: Can a Commercial Law Serve the Needs of the Market?

Su Lin Han
Editor

For the past two years, the author has worked as legal consultant for the World Bank on an access to credit and secured transactions law reform project in China. The project coincided with efforts from within China to reform the existing secured financing system, including revising provisions of the 1995 Security Law (《担保法》, the “PRC Security Law”) to become part of the new Property Law. During this time, the World Bank team has worked closely in China with key stakeholders interested in and with the power to effect legal and institutional changes to improve access to credit by Chinese businesses. In this article, the author will share some personal observations about the reform process, including the background, the forces supporting the reform and the obstacles encountered.

(All views expressed in this Article are strictly personal and do not represent the views of those organizations for which the author has worked. Except as otherwise noted, this article is based primarily on information made public by the project report (see discussion below) as well as first-hand knowledge gained through the course of the project.)

The World Bank-PBOC Project

In 2004, the World Bank Group launched an access to credit and secured transactions law reform project with a team of researchers from China’s central bank, the People’s Bank of China (中国人民银行, PBOC, hereinafter referred to as the “WB-PBOC Project”). The project’s task was to investigate and analyze the extent to which movable assets such as equipment, inventory and receivables were being used as collateral to enable businesses, especially small and medium enterprises (SMEs), to obtain credit in China. Experts from the World Bank and the PBOC conducted extensive field interviews with Chinese banks, trade creditors, businesses (both state and privately-owned), as well as officials from movable collateral registries at the central and local levels. The project also included a survey of Chinese banks on current secured lending practices, the first of its kind for China. In January 2006, reports containing the project’s findings and recommendations by both the Chinese and World Bank teams were published in Chinese. (See “Secured Transactions Reform and Credit Market Development in China” 《中国动产担保物权与信贷市场的发展》 (2006), the “WB-PBOC Report”, published by the China CITIC Press.) The World Bank portion of the report is scheduled to be published in English later this year.

During the course of the WB-PBOC project, a series of high-level seminars on international best practice in secured financing were also held. The aim was to build awareness among China’s key stakeholders, including government agencies, banks, legal scholars and most importantly, officials from the National People’s Congress (NPC), on the need to reform the existing legal and institutional infrastructure in order to support a modern secured financing system capable of providing easy and inexpensive access to credit for businesses. NPC was already in the process of drafting the Property Law 《物权法》, China’s first comprehensive law on ownership and use of different types of property rights. The draft Property Law includes a chapter on security in real and personal property and NPC officials welcomed the opportunity to explore ways to make changes to the relevant provisions governed by the existing Security Law. In addition, the World Bank team submitted comments to the NPC when a draft of the Property Law was made public in July 2005.

Modern Secured Financing vs. Current Practice in China

The focus of the WB-PBOC Project is to encourage the use of movable property as collateral. In most developed economies, movable assets play a major role in securing financing for businesses. This is particularly important for small and medium firms that do not own significant real property but hold inventory and receivables as their primary assets instead. In the U.S., for example, 70% of small business financing is secured solely by movable property (WB-PBOC Report, p.195).

Such a high level of movable collateral financing is made possible by a legal infrastructure designed to facilitate rather than to regulate secured transactions. First, modern secured transactions laws give contracting parties maximum flexibility to structure their commercial transactions. The range of movable collateral is broad. Movable property of any kind, tangible or intangible, presently-owned or future-acquired, can be used as collateral. A borrower may also continue to use the collateral during the course of a loan. This so-called “non-possessory secured financing” allows the debtor to retain possession and control of the collateral after the loan is made so that it can be used to generate revenue and service the debt. With such flexibility, a manufacturer may pledge its equipment and/or products as collateral while retaining use of the equipment and selling its products to buyers. A car dealer may use its inventory, including cars it already owns and those that it plans to acquire in the future, as collateral while continuing to sell cars in the normal course of business. A service provider or supplier of goods may borrow against its income stream generated by payments due from its customers (receivables), regardless of whether the receivables have already been earned but not yet paid or will be earned in the future.

Second, modern movable secured financing laws recognize that in an efficient market secured lending should be low cost and low risk. Otherwise lenders would not be willing to lend against movable collateral. As a result, the law makes sure that it is easy to create a security interest by contract, requiring minimum formalities. No registration is required for the security interest to become valid and enforceable, nor is the secured transaction subject to review by government officials. Registration of minimum identifying information at a centralized electronic registry serves to disclose the existence of the security interest to third parties and to assure its priority status against the claims of other creditors. When a debtor defaults, a secured creditor is given the option, either contractually or by law, to enforce its rights by taking possession and selling the collateral without needing to obtain a court order.

Secured financing in China tells a different story. Movable assets offer little value as security. According to the survey conducted by the WB-PBOC Project, only 4% of commercial loans are secured solely by movable assets (WB-PBOC Report, pp. 195-196). This is the direct result of a secured financing legal system which gives the government too much control over what can be used as collateral and how secured transactions can be conducted. The problem is particularly acute in the area of non-possessory secured financing where the law is so restrictive and the requirements so cumbersome that the secured financing arrangement can generate little benefit for a lender. Under Article 34 of the PRC Security Law, a non-possessory security interest may only be created in two types of movable assets: equipment and motor vehicles. A pool of fluctuating assets such as inventory or receivables cannot be used as collateral because under Article 39 of the Security Law, the types, amount, nature and location of such assets must be specifically described at the time of contract, i.e., they must be fixed at the time of the contract. The result is “16 trillion RMB in dead capital—assets owned by private firms, SMEs and farmers that cannot be used to generate loans to fund business investment and growth” (WB-PBOC Report, p. 195).

To the extent movable assets are used as collateral, the government’s heavy-hand makes the process of creating, registering and enforcing the security interest unduly cumbersome, expensive and often uncertain. Under the Security Law, a security interest must be registered with a government-run registry to become valid and enforceable. However, because there is no centralized registry in China for all types of movable collateral, a lender must navigate through a registration system comprised of more than a dozen individual registries differentiated by the types of movable assets and the status of the debtor. The three general registries are operated by the Administration of Industry and Commerce (工商管理局), which registers charges over movable assets of enterprises; the Public Security Bureau (公安局) which registers charges over motor vehicles; and Public Notary Offices (公证处) which register security interests in non-enterprise assets(as well as any other types of charges where there is no other place to register). In addition, a number of specialized registries handle charges over specific types of assets, e.g., farm tractors by the Agricultural Management Bureau (农业管理局) and standing timber by the Bureau of Forestry (林业局). As a result, multiple registrations are required when more than one type of asset is involved. A foreign lender taking security over all of an enterprise borrower’s assets reportedly spent more than one year registering its interests with the appropriate registries. (WB-PBOC Report, p. 259)

In addition, the registration itself is subject to intensive scrutiny by registry officials. Lenders are required to submit excessive amounts of documentation, including loan and security agreements, all of which must be examined by registry officials to determine the legality of the transaction.

Registry officials also determine whether the secured loan amount exceeds the value of the collateral, regardless of whether lenders are satisfied with their own valuation. Under Article 35 of the Security Law, a secured loan may mot exceed the value of the mortgage property. Many registries interpreted this provision as requiring third-party appraisals even if parties have agreed to the value of the collateral. Valuation by registry-appointed appraisers are routinely required and their fees borne by lenders. In some locales, when the collateral consists of multiple assets, the registries even require separate contract documentation and appraisal for each asset component. Some lenders reported that registration-related costs could run as high as 1/3 of the loan amount. The process also gives registry officials wide discretion in accepting or rejecting registration applications. In the city of Shanghai, the local Administration for Industry and Commerce in charge of registering mortgages for movable property of enterprises accepts an average of only 1,000 registrations a year. The number is even lower in many other major cities (WB-PBOC Report, p. 263). In the U.S. and Canada, because registration does not create substantive property rights, a security interest filing requires only minimum information sufficient for third parties to identify the existence of the security interest. This allows for instant electronic registration which does not involve registry officials reviewing the underlying transaction. Such electronic filings often take a few minutes to complete and cost less than US$20.

Chinese courts also play a central role in the enforcement of security interest. Upon default, unless the debtor is willing to cooperate, the secured creditor must seek a judgment and an execution order from the court in order to take possession of the collateral. The seizure and sale of the collateral must also be carried out by court officials. Approximately 75% of the enforcement actions take more than a year, some even longer (WB-PBOC Report, p. 284.). Since movable assets depreciate much faster than real property, the value of the movable collateral is likely to be greatly reduced during the long enforcement process. The prolonged enforcement also gives debtor the opportunity to hide or fraudulently transfer the collateral. When asked about how much a lender can recover from equipment collateral, one Chinese banker curtly replied, “Scrap metal”. The cost to a secured creditor is not limited to low recovery rate. Court fees, execution fees, taxes, appraisals and judicial auctions can consume more than 20% of the outstanding claims (WB-PBOC Report, p. 284). As a result, many Chinese banks do not pursue default cases and simply write them off as bad debt. In comparison, enforcement time in developed economies can take as little as 7 days and cost less than 1% of the secured debt (WB-PBOC Report, p. 284).

It is clear that the secured financing system in China is not working. The legal and institutional infrastructure must be changed to allow inventory and receivables to help generate financing for business growth so that secured transactions can be undertaken with flexibility and efficiency. In order for changes to take place, however, a number of obstacles have to be overcome. The question remains whether a demonstrated need of the market is sufficient to generate a political mandate for reform and whether it can be a driving force in shaping a commercial law aimed at promoting secured lending in China.

Recognizing the Need for Reform: A Crucial First Step

Although key decision-making within the Chinese government is often a collective matter, the success of a legal reform of this magnitude often hinges on whether the “right” individuals can be convinced of the need for change. The presence of an interested government agency spearheading the reform efforts and willing to use its political capital to lobby for reform appears to be critical. In the case of secured financing law reform, the central bank’s focus on the financing woes of SMEs has led to its recognition that reforming the country’s movable secured financing legal system will not only improve access to credit for SMEs, but it will also likely improve the profitability of domestic Chinese banks.

In a study released in 2004, the PBOC found widespread financing difficulties among SMEs, which account for 80% of all enterprises in China. (See PBOC, “Survey of the Financing Mechanisms for China’s Small and Medium Enterprises”, China CITIC Press (2005), hereinafter referred to as the “PBOC SME Report”.) Unlike state-owned enterprises which can rely on state-subsidized credit and large private companies with proven creditworthiness, SMEs have little access to bank loans. One of the biggest hurdles for SME financing is the requirement to provide real property as security. Under China’s land system, only use rights of state-owned urban land and buildings can be taken as collateral. Rural land use rights cannot be mortgaged (see Security Law, articles 34 and 37). Because 90% of China’s SMEs are rural township and village enterprises (PBOC SME Report), most SMEs have little to offer in terms of real property collateral. Even when factory buildings have value, lenders are unwilling to accept buildings on rural land because they are not transferable. Meanwhile, inventory and receivables, which account for approximately 50% of SME assets in China (WB-PBOC Report, p. 196), cannot be used as security due to restrictions under the Security Law. The PBOC concluded that reform of the secured financing system, particularly allowing greater use of movable collateral such as inventory and receivables, would be critical for improving SME access to bank loans.

The feedback from Chinese banks is equally compelling. In the survey conducted by the WB-PBOC Project, 98% of the banks supported reforming the system. Many Chinese banks, especially those in the more developed coastal regions, are already pushing the limits of the law in their lending practices. Some of these banks’ best customers have been able to borrow against their future income streams generated from highway toll collection, cable TV services, real estate management contracts, etc. However, Chinese bankers understand their risks. In the words of one banker, “These deals are done by gentlemen’s handshakes. The banks have no legal protection if something goes wrong.” Moreover, the scope of such lending is still limited. For example, in receivables financing, transactions typically involve the bank purchasing a single receivable due from a single customer. The transaction generally requires a three-party agreement under which the customer consents to the sale of the receivable. Such arrangement is necessary because lenders in China are required by Article 80 of the PRC Contract Law 《合同法》 to notify the customer of the sale. In most advanced economies, bulk receivables financing against both earned and future receivables due from a large number of known and unknown customers (e.g., mobile phone accounts) can easily be executed because lenders are not required to notify the customers.

Backed by these studies and reports, the PBOC has been active in sharing its findings with other key government departments as well as the NPC, the national legislative body currently in the process of formulating the secured transactions section under the draft Property Law. A series of high-level seminars on secured financing law reform provided a platform for government officials, lawmakers, bankers, judges, lawyers and academics to discuss and debate the merits of reform and to compare the existing system against international best practice benchmarks. In collaboration with the World Bank, the PBOC also developed detailed recommendations for reforming the legal system, including adopting principles of modern secured financing law in the draft Property Law. This effort to expand the scope of permissible movable collateral will improve both the movable security registry and the enforcement systems necessary to make secured transactions cost effective. In fact, a version of the Property Law released last July by the NPC drafting committee expanded the scope of permissible collateral to include presently-owned and future-acquired inventory. However, broader and more systematic changes are needed in order to remove the major legal and institutional obstacles to secured transactions in China. A reform mandate from the top leadership must also coincide with a different mind-set for those involved in implementing the changes.

Instituting Changes: The Role of the Market

In designing a legal structure for secured transactions in China, participants in the reform process must decide whether to adopt the market-oriented approach which forms the basis of modern secured transactions systems. Inherent in that approach is the belief that the market, i.e., contracting parties, are capable of assessing and managing their own business risks and that the role of the law is to set parameters within which secured transactions can be structured to the benefit of parties based on their particular needs. Adopting such an approach would be a significant departure from the Security Law’s control-oriented framework. It would require a re-evaluation of the relationship between government regulation and market activities and a better understanding of the practical effect of legal rules on financing transactions. Based on discussions with people involved in the legislative process, including many legal scholars who wield much influence as government advisors, resistance to adopting a market-oriented model is still quite strong, underscoring the challenges ahead. (Even those who are not formally invited to participate in the legislative process can exert influence by voicing their doubts and opposition. A case in point: The decision by the NPC to postpone the passing of the Property Law in March 2006 was reported to be at least partially the result of oppositions led by a Beijing University professor on issues unrelated to the secured transactions chapters of the draft law.)

First, the idea of allowing parties to control how secured transactions are structured and conducted troubles many people, who often cite “transaction safety” as their chief concern. To many, the law (and government officials implementing the law) should be responsible for ensuring that commercial transactions are safe, fair and legal to all parties concerned. There is fear that if parties are allowed to create a security interest without going through the government-mandated registration and review process, banks could face excessive risk exposure. There is also fear that by empowering creditors more so than the courts with control over the enforcement of security interests in commercial loan default cases, powerful lenders would have an unfair advantage over small Mom-and-Pop borrowers. Although protecting the interests of third parties is part and parcel of a market-based secured transactions legal system and has been successfully undertaken in other countries without much of the feared problems, many remain unconvinced that such a market-driven model could and should be adopted by China.

Another source of concern is fraud. In today’s China, fraud of all sorts is extremely common and often goes unpunished despite the numerous government rules specifically promulgated against fraud. Many fear that expanding the scope of permissible collateral to include inventory and receivables would invite fraud because lenders might be incapable of determining the value of fluctuating and intangible assets and of monitoring the collateral after a loan is made. Arguments have also been made that simplifying the registration process as well as making it inexpensive and accessible to the public would open the door to more fraud. Indeed, the following question is commonly asked: “What would stop anyone from registering a fictitious security interest against someone they do not like?” Still others blame China’s bad credit culture and entertain the notion that Chinese debtors would be more likely to cheat. One legal scholar even proclaimed that the modern secured transactions enforcement mechanism would not work in China because it simply would not be compatible with the Chinese culture.

Interestingly, the same fears are not shared by bankers and many other participants, particularly younger, mid-level bank representatives and officials from government agencies who have shown a remarkable openness towards a legal system that gives more freedom to parties. Nor do they think that either banks or commercial borrowers in China lack the business acumen to protect their interests in a secured loan transaction. These differing reactions on the part of scholars and others may stem from lack of practical experience with and knowledge of how secured transactions are conducted as well as the economics behind these transactions. In one instance, after learning how foreign lenders use contract mechanisms to monitor the collateral and the debtor’s financial health, a law professor declared, “That’s exactly how Western lenders practiced hegemony on the poor Latin borrowers!” A banker, however, showed us his loan and security agreement which contained the standard warranty and covenant provisions commonly seen in transactions in developed financial markets.

Chinese bankers will need not only the protection of contract mechanisms, but a law which allows parties to define a breach of a covenant or warranty as an event of default so that a secured creditor can take action against the collateral at the first sign of trouble, thereby reducing the risk of loss. Under the Security Law, a secured creditor can only sue a defaulting debtor in court for damage, a position no better than that of an unsecured creditor. Such disparities in the practical implications of the law, however, are often lost on lawmakers. Commercial lawmaking has a strong paternalistic bias due to the fundamental mistrust of the risk management capabilities of transacting parties. It is therefore not uncommon to encounter well-intentioned but ill-suited legislative provisions with potentially disastrous effects on secured financing transactions.

Another persistent view is that China, as a civil law country, should look to civil law jurisdictions for reform inspiration and must not deviate from certain civil law principles already in place under the Security Law. Germany is often cited as a possible model, including the use of title retention for non-possessory secured financing. However, such discussions tend to focus on the mechanics of certain legal concepts, rather than the history and context under which the German system evolved, its progress vis-à-vis other countries and the implications of importing specific elements of the German experience into the Chinese system.

In many countries, development of modern secured transactions laws has often resulted in a blurred distinction between civil law and common law. Changes to the law are driven by the practical need of improving access to credit not by legal traditions. Fifty years ago, the United States abandoned many traditional legal concepts inherited from English common law and developed a codified commercial law system (Article 9 of the Uniform Commercial Code) which makes it possible for secured transactions to be conducted with maximum flexibility and efficiency. The detailed and comprehensive legislation was intentionally designed to reduce both potential litigation and judicial interpretation. Such an approach has been followed in other common law jurisdictions such as Canada and New Zealand. In recent years, many Central and Eastern European countries with long civil law traditions also have embraced key principles of the Uniform Commercial Code in their effort to develop modern secured financing systems. Although the German Civil Code still does not recognize non-possessory security interests, German courts have liberally interpreted the statute to allow secured transactions to be structured by way of title retention, achieving the same effect of non-possessory security interests by transferring ownership of the collateral to the creditor. The downside of such judge-made law is that Germany does not have a publicity system for security interests.

To some extent, China’s Security Law has progressed beyond the traditional civil law limitations. The Security Law already recognizes non-possessory security interest in equipment and motor vehicles and provides for publicity of the security interest through registration. At the same time, however, the negative impact of traditional civil law principles is evident. For example, the Security Law relies on the principle of numerous clausus in defining the scope of permissible collateral, setting forth a narrow list of assets which may be used as security. Only assets specifically permitted by law may be used as collateral, thus prohibiting security interests in any other form of movable property. Similarly, the requirement to specifically describe the collateral in the contract prevents the use of future-acquired property as security. In reforming the laws, Chinese lawmakers must weigh the pragmatic needs of China’s modernizing economy against the constraints of these traditional legal principles. To this end, a better understanding by lawmakers of what motivates commercial transactions, i.e., how market participants assess risks and analyze the benefits of individual transactions, as well as input from those whose business is directly affected by the law would be crucial.

Conclusion

China’s secured financing law must keep pace with the demands of the country’s rapidly growing economy or otherwise will risk being obsolete, hindering economic growth. Experience elsewhere has demonstrated that the development of a market-oriented modern secured financing system is key to making secured lending more efficient and to improving the overall credit market. However, the extent to which market forces foster change to existing laws will likely be subject to the constraints of China’s overall political and economic environment. Additionally, the pace and scope of reform undoubtedly will be influenced by exogenous factors as well. In order to advance the reform process, key stakeholders face the difficult task of designing a legal system capable of addressing both market needs and political realities in China.


 

 


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