On 22 March 2018, the Shanghai Stock Exchange, Shenzhen Stock Exchange and the Inter-agency Quotation and Service System for Privately Offered Products issued the Guidelines for the Management of Credit Risks During the Existence of Asset–Backed Securities (for Trial Implementation) (Draft for Comment) – hereafter, the Risk Guidelines – and the Guidelines for the Substance and Content of Regular Asset–Backed Security Reports (Draft for Comment), indicating that the regulators have now formally placed regulation of the risks during the existence of the financial product that is asset–backed securities on their agenda.
As a legal service practitioner in this sector, the author pays close attention to the direction of regulation of the period of existence of asset-backed securities, and wishes to share her relevant understanding with readers.
Risk of deterioration of the quality of the underlying assets and the isolation of the risks of the underlying assets from those of the original rights holder are focal points of the management of the risks during the existence of asset-backed securities.
Asset-backed securitization is a form of financing where a specific asset pool provides the underlying assets to offer tradable securities that are backed by the specific cash flow arising from the underlying assets. Deterioration of the quality of the underlying assets and less than complete isolation of the risks of the underlying assets from those of the original rights holder are two major risks that exist during the life of asset backed securities. Looked at from the substantive risk level, the risk management measures described in the previously mentioned Risk Guidelines can be summarized essentially as revolving around the prevention and control of the risks associated with the underlying assets themselves and the mechanism for isolating the risks of the underlying assets from those of the original rights holder.
With respect to the quality of the underlying assets, the Risk Guidelines expressly list the underlying asset type, features, title, security, rights limitations, involvement in a legal action, cash flow generation capacity, and the external environment in which the cash flow is generated (including changes in the environment of the industry in which the underlying assets are found, and the policy environment) as risk information elements. As for the isolation of the risks of the underlying assets from those of the original rights holder, the Risk Guidelines list the original rights holder’s equity structure, internal governance structure, change in production, operations and financial position, unfavourable media reports, whether the risk isolation measures are practicable, and whether they have been
thoroughly implemented as risk information elements.
These two types of risk information elements, plus the effectiveness and practicability of the credit enhancement measures, jointly constitute the key indicators for the Risk Guidelines’ division of asset-backed plans into four categories: “normal”, “attention”, “risky” and “default”.
Prominence of the risk management responsibilities of plan managers. Notwithstanding the fact that the Risk Guidelines lists all such participants in the business as the asset-backed plan manager, custodian, original rights holder, asset service firm, credit enhancement institution, credit rating agency, accounting firm, law firm, asset appraisal firm, etc. as entities with responsibility for managing risks during the existence of asset backed securities, clearly, the securities company or fund subsidiary, as the manager, bears the prime management responsibilities, is the entity responsible for organizing the entirety of the work associated with the management of risks during the existence of the asset backed securities and is the primary entity directly accountable to the regulators, including the stock exchange, the Asset Management Association of China, the China Securities Regulatory Commission, etc.
Compliance with the principles of market orientation and rule of law. A thorough reading of the Risk Guidelines shows that the establishment and description of the relevant risk management measures fall within the category of the conventional, with the main highlights being the “management of the credit risks of asset-backed securities must comply with the principles of market orientation and rule of law”, and “managers … and other participating entities must duly perform their duties and act with due diligence and care, and investors must themselves bear the investment risks” mentioned in article 3.
This provision directly points out that asset-backed securities are not a financial product that guarantees principal and returns, such that, provided that the manager and other participating entities fully and prudently perform their due diligence, structure design, information disclosure, risk warning, risk prevention and control measure implementations and other such obligations in accordance with laws, regulations and the rules set out in the contracts, investors are required to themselves bear the risks. This can shatter investors’ rigid repayment expectations.
In the past two years, the author, as legal counsel, has been involved in a substantial number of asset-backed security duration risk management cases. Her take-away from handling these cases is that deferred payment of the service remuneration of such participants in the business as the manager, custodian, asset service firm, etc., (avoiding payment of the remuneration in one lump sum at the time of offering of the product) and requiring the manager to establish a direct engagement relationship with external intermediary firms (e.g., an accounting firm, law firm and credit rating agency) during the life of the product (avoiding the party seeking the financing independently executing engagement contracts with the intermediary firms) are also effective measures for controlling risks during the existence of the product. These are things that need the attention of the regulators.
In short, the author anticipates that the issuance of the Risk Guidelines will have a corrective effect on such issues as the low price competition between asset-backed securities market practitioners, similitude in the content of transaction documents, “emphasis on offering, little regard for management”, and rigid repayment that are now common in mainland China. If the guidelines are duly implemented, they will necessarily have a profound positive impact in promoting compliance in, and the sustainable development of, the asset-backed securities market in mainland China.
Li Wenmin is a partner at JunZeJun Law Offices. She can be contacted on +86 20 2801 6766 or by email at email@example.com