PRC Supreme People's Court Issues Draft of Interpretations Applicable to Security-related Parts of the Civil Code

China

On 9 November 2020, the PRC Supreme People's Court ("SPC") promulgated the Interpretations Applicable to Security-related Parts of the Civil Code of the People's Republic of China (Draft for Comment) (the "Draft") for public comments by 27 November 2020. This is the first interpretations issued by the SPC to the public for comments after the PRC Civil Code was officially promulgated. The Interpretations, once enacted, aims at a better implementation of the PRC Civil Code and is planned to come into effect simultaneously with the PRC Civil Code on 1 January 2021. It consists of five parts with 69 articles, i.e. general provisions, guarantee contracts, collateral rights, other types of security and supplementary provisions. In this article we list some key items of the Draft as below:

1. Provision of Security by an Unlisted Company

According to Article 16 of the PRC Company Law, if a company provides security for others, a resolution passed by the board of directors or the shareholders' meeting in accordance with the articles of association of the company is needed. This is a restriction stipulated by the PRC Company Law on the representative right of the legal representative of a company in order to prevent the legal representative from arbitrarily providing securities for others on behalf of the company which may cause losses to the company and damages to the interests of minority shareholders. Pursuant to this article, security is not a matter that the legal representative can decide independently but shall be based on resolutions of the company's shareholders' meeting or board of directors. However, according to Article 504 of the PRC Civil Code, where the legal representative provides security for others without authorization, i.e. acts ultra vires, the People's Courts shall differentiate whether a creditor has entered into the contract bone fide. If yes, the contract shall be valid towards the company.

The Draft emphasizes the definition of "bone fide" (good faith) principle, i.e. the creditor does not know or does not have ought to have known that the legal representative is exceeding the scope of his authority when signing the security agreement. Further, the Draft stipulates that if the company contests that the creditor has acted in good faith on the grounds that (i) the resolution made by the relevant company organ was forged or altered by the legal representative, (ii) the resolution procedure is illegal, (iii) the signature or seal is fake, or (iv) the amount of security exceeds the statutory limit, the People's Court shall not support such claim. However, exception shall be made where the company has evidence to prove that the creditors were clearly aware that the resolution was forged or altered when entering into the security contract.

There are also several circumstances under which relevant resolutions are not a mandatory requirement for validity of a security contract before the People's Court. Generally in line with the provisions in the Minutes of the National Court Work Conference for Civil and Commercial Trials (the "Minutes") issued by the SPC on 8 November 2019, the Draft reiterates the exception circumstances, under which even if the creditor knows or ought to have known that there is no resolution of the competent organ of the company on the relevant security contract, the contract shall still be deemed valid:

(1) Where the company is a guarantee company whose main business is to provide security to others, or a bank or non-bank financial institution which engages in letter of guarantee business; or

(2) Where the company provides a security to the counterparty of any company directly or indirectly controlled by the company in order to carry out business activities; or

(3) Where the security contract is signed and approved by the shareholders that individually or jointly hold more than two thirds of voting rights of the company.

From the above, we can see that compared to the regulations before, the Draft provides more protection to creditors in this regard.

2. Statutory Joint and Several Guarantee

According to Article 19 of the Judicial Interpretation of the SPC on Certain Issues Regarding the Application of the PRC Security Law (the "Old Interpretation"), which will be abolished on 1 January 2021, if two or more guarantors simultaneously or separately secure the same debt, but the guarantors and the creditor have not agreed on the extent of their respective guarantee obligations, the guarantee shall be deemed to be a joint and several guarantee. Thus, in the past, it sometimes happened that guarantors although they do not know each other but since there was no agreement on the extent of a guarantee obligation, they ended up being jointly and severally liable. After one of the guarantors assumed the guarantee obligation, the other guarantors are still obliged to internally make compensations to this guarantor accordingly.

This has been changed in the Draft. According to Article 13 of the Draft, if the security providers have not agreed on the extent of their respective security obligations, and the security does not constitute a joint and several security, if a security provider has assumed the security obligations and requests other security providers to share the loss that cannot be recovered from the debtor, the People’s Court shall not support such claim. From such provision we can conclude that lack of agreement on the extent of guarantee obligation does not lead to the result that the guarantee is a joint and several guarantee anymore.

If the Draft will be enacted, a guarantee will only be a joint and several guarantee, if one of the following circumstances is fulfilled: (i) if it is expressly stipulated in the guarantee agreement that it is a joint and several guarantee; or (ii), according to Article 13 of the Draft, if several guarantors sign, seal or press their fingerprints on the same contract.

3. Security Obligations under the Circumstance of Insolvency

When the People's Court accepts the insolvency application of a debtor during the validity term of a security, the creditor may either file his claim with the People's Court in order to participate in the insolvency proceedings to get compensations or make a claim directly against the security provider.

In case that the creditor fails to get fully compensated during the insolvency proceedings, the creditor is entitled to request the security provider to assume the obligation under the security for the portion of the creditor's claim that remains unpaid in the insolvency proceedings. Same as the provisions in the Old Interpretation, the Draft stipulates that the creditor shall make such request within six months of the date on which the Insolvency proceedings are terminated.

Compared to the Old Interpretations, the Draft further provides the circumstance that the creditor files a lawsuit in the People’s Court to request the security provider to assume the security obligation after it has filed the creditor’s claims in the insolvency proceedings. Under such circumstance, the People's Court can directly rule the security provider to assume the security obligation and it shall be clearly stated in the judgment that the security provider shall be entitled to replace the creditor in the insolvency proceedings in order to get compensation.

Further, there is a new provision in the Draft regarding calculation of interests on security obligations in case of insolvency. After the People’s Court accepts the debtor’s insolvency application, the creditor can request the security provider to assume the security obligation. If the security provider claims that the interest calculation on the security obligation shall be stopped from the day when the People’s Court accepted the insolvency application, the People's Court should support such claim. In other words, the calculation of the interests on security obligation can be stopped once the People's Court accepts the insolvency application of the debtor. The reasons for introducing such provision are as follows: (i) According to Article 46 of the PRC Insolvency Law, the debts of the company that are not due shall be deemed to be due upon acceptance of an insolvency application and debts with interest accruing shall cease to accrue interest upon acceptance of an insolvency application; and (ii) the security shall be dependent on the principal debt and the security obligation shall be limited to the scope of the liability of the debtor. Thus, if the calculation of interests on secured debts stops upon acceptance of the insolvency application, the interest calculation on the security obligation shall accordingly also stop.

4. Security in Form of Transferred Shares

The security in form of transferred shares has already been mentioned before in the Minutes and now the Draft provides more details. It is a new type of security stipulated in PRC law. Different from a share pledge, the security in form of transferred shares refers to formally transferring shares to the creditor as a security for the debts. It is also different from a mere share transfer. According to Article 67 of the Draft, when a People's Court determines whether a transaction is a mere share transfer or transfer of shares to the creditor to provide security for debts, the following factors need to be comprehensively examined:

(1) Whether there is a secured principal debtor-creditor relationship;

(2) Whether there is a share repurchase clause;

(3) Whether the creditors, who are the transferees of the shares, enjoy and exercise shareholders’ rights.

However, the above Article 67 only lists the factors to be examined but the exact criteria are missing. Taking item (3) above for example, whether the creditor as a nominal shareholder shall be entitled to enjoy and exercise shareholder's rights or not under the security in form of transferred shares is not clear. Theoretically speaking, the creditor shall only have the right of priority in seeking payments with the transferred shares. However, it is also reasonable to argue that the creditor enjoys the shareholder's right, because, if only the original shareholders can operate the company and make relevant decisions, it is possible that they may conduct some business with high risks so that the value of the shares of the company may be decreased. Accordingly, the benefits of the creditor would be harmed. Thus, it is suggested that the final version of the Draft shall set clear provision regarding the shareholder's right under a security in form of transferred shares.

Further, to protect the creditor who accepts the transferred shares as security for debts and accordingly serves as nominal shareholder of the company, the Draft further stipulates that if the company or the creditors of the company request the creditor as the nominal shareholder and the shareholders of the company to bear joint and several liability of not contributing or not fully contributing the registered capital of the company or withdrawal of capital of the company, the People's Court shall not support such claim.

5. Conclusion

The Draft provides considerable details for implementation of the security part of the PRC Civil Code and tries to find a balance between the debtor, the creditor and the security provider. However, some provisions are still vague and more details need to be stipulated. We expect that after collecting the public comments the final version of the Draft will provide further clarification.