The slow shift from governance of security contracts through a
requirement of government approval towards a greater freedom to
contract has taken another baby step. Security contracts are no
longer invalid just because they are not approved, but approval is
nevertheless still required. The most recent authority on this
issue is the Reply of the Supreme People's Court on the Validity of
Mortgage Contracts Entered by Creditors and State Owned Industrial
Enterprises in Relation to Machinery and Equipment (issued June 18,
2002, effective from July 22, 2002).
Where it started
The Security Law of the PRC, as well as the Rules
of the PRC on the Administration of Foreign Exchange (1997) (Forex
Rules), the Administrative Measures on Foreign Exchange Security
Given by Domestic Institutions (1996)(Measures), Detailed Measures
on Foreign Exchange Security Given by Domestic Institutions (1997)
(Detailed Measures) and the Interpretation of the Supreme People's
Court of the PRC on Various Issues in Relation to the Application
of the PRC Security Law (2000) (Interpretation) all require the
State Administration for Foreign Exchange (SAFE) to provide advance
approval for security or guarantee contracts securing debt
denominated in foreign exchange. The security contract is not
supposed to come into effect until such approval is obtained. In
practice this rule does not always mean what it appears to say.
Exclusions and exceptions to the rule
Some clear exceptions appear in the Forex Rules.
For example, security granted by a wholly foreign owned enterprise
to a foreign party, and some security granted by a Chinese entity
to secure debt it has borrowed itself, need not be registered.
The Measures and the Detailed Measures provide that
foreign exchange denominated security is void if SAFE approval is
not obtained. The conflicting position is introduced in the
Detailed Measures which recognize the validity of an unregistered
foreign exchange denominated security contract, but render it
ineligible for assistance to convert proceeds from Renminbi to
foreign exchange and ineligible for remission outside China of such
proceeds. This position implies that the security contract is
nevertheless valid except for foreign exchange provisions.
This inconsistency of treatment is further
highlighted in a Notice of the SAFE on the Approval Authority
Regarding the Performance of Foreign Security Contracts (June 2000)
and the Notice of SAFE on the Implementation of the Security Law
Interpretation (January 2001)(Approval Notice) wherein a procedure
is set out to rectify what is described as a "substantial breach"
of regulation, occurring where security is provided to support a
foreign exchange denominated loan and such security is not
registered. When this failure to register is encountered, the
security contract is to be submitted to the SAFE for ex post facto
approval. The procedure recognizes the possibility that such a
security agreement might not be invalid.
Thus while the Interpretation treats contracts
securing foreign exchange denominated debt as invalid,
administrative agencies treat such contracts as subject to approval
but not necessarily invalid. Thus the question arises as to whether
registration is mandatory or optional or only necessary for use in
getting foreign exchange repatriated. If the registration is
optional or merely for purposes of facilitating certain government
procedures (i.e., if it is only a "procedural breach" if
registration is not effected) then the contract is not void, could
be registered late, and fines are the appropriate remedy. This is
the position taken in the Approval Notice, which arguably
supersedes the earlier legislation which conflicts with it. The
Detailed Measures provide for fines in the range of RMB100,000 to
RMB500,000, plus administrative warnings, public criticisms,
suspension or the right to provide foreign exchange security, any
of which could be imposed on the provider of the security which is
not registered with SAFE.
Invalidity of the security does not mean that the
lender loses out. The Interpretation stipulates that compensation
would be due to the creditor for losses suffered by it due to the
invalidity of the security contract (assuming that the underlying
loan or other contract is valid) but the security provider would be
liable for no more than 50% of the debt unless the security
provider acted in bad faith.
Thus, while it might be difficult to determine that
a security contract supporting a foreign exchange denominated debt
will necessarily be invalid if not registered, it is clear that
such security contracts should be registered, and that registration
would provide some assurance of their viability should enforcement
This conclusion is nudged somewhat aside by the
Reply of the Supreme People's Court on the Validity of Mortgage
Contracts Entered by Creditors and State Owned Industrial
Enterprises in Relation to Machinery Equipment Assets (issued on
June 18, 2002 for effect as of July 22, 2002 which stipulates that
mortgage contracts are not invalid due to absence of approval.
For further information on this please contact
Luke Filei on email@example.com or +86 10 6590 0389 in
Beijing or +86 21 6289 6363 in Shanghai.