The Effect of Security Registration

China
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 become necessary.

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 luke.filei@cms-cmck.com or +86 10 6590 0389 in Beijing or +86 21 6289 6363 in Shanghai.