The difference making-up clause and compliance risks

By Paul Zhou and Harry Wu, Wintell & Co
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In recent years, financial institutions have tended to use the difference making-up clause as a new type of credit enhancement measure for a variety of reasons. The difference making-up clause involves various transaction design, structure and entity relationships, and its legal meaning may be confusing. Meanwhile, in the current environment of strong regulatory policy, institutions need to pay attention to the compliance risks that exist in the use of the difference making-up clause.

Definition of difference making-up obligation

compliance risks
Paul Zhou
Senior Partner
Wintell & Co

“Difference making-up obligation” means the obligation that when a debtor fails to perform the payment obligation, or when the specific settlement fund is insufficient to pay any debt and/or triggers certain conditions, a third person will make up the difference according to a relevant agreement to guarantee the obligatory relationship between the creditor and the debtor. By consulting the definitions and analysis in certain authoritative court decisions, the authors believe the difference making-up obligation in financial products may be classified as follows in respect of legal nature.

(1) Aleatory contract. The difference making-up obligation is set for contingent investment loss, which is aleatory. The difference making-up clause in asset management products generally requires that the person subject to the difference making-up obligation should guarantee the minimum return of the senior investors when any asset management plan is liquidated and suffers loss. Whether investment loss actually occurs is mainly dependent on risks of market (such as the stock market), rather than the subjective will of the manager or the person subject to the difference making-up obligation.

(2) Debt accession. Debt accession is a kind of cumulative debt assumption. When a new debt is incorporated, the liability, amount and scope of original debt have been defined. If it is unclear whether the original debtor needs to assume liability, the difference making-up obligations agreed between the parties would be an aleatory contract. Although in case of debt accession the original debtor and the new debtor are joint and severally liable to the creditor, the original debt and the new debt may be independent from each other and may be different in respect of liability assumption, triggering condition and elements of debt (such as term, condition and security).

(3) Guarantee. In judicial practice, it is possible that the difference making-up clause may be classified as guarantee if the clause expressly reflects such an indication of intention of the parties. The laws of China impose many restrictions on provision by an enterprise of security for others. In contrast, the difference making-up clause, as a new type of credit enhancement, can circumvent these legal restrictions, thus creating its living space.

Compliance risks of difference making-up clause

compliance risks
Harry Wu
Partner
Wintell & Co

The prohibitions of departmental regulations are the largest source of risk for the validity of difference making-up clause. The minutes of the fifth Judge’s Meeting of the Supreme People’s Court Second Civil Division point out that where departmental regulations or regulatory policies expressly prohibit a certain transaction mode, it would be a violation of laws or policies to circumvent such regulations by using such a transaction mode. Although the difference making-up clause is generally decided valid as the judicial authority cannot decide is a contract invalid according to any provisions other than laws and administrative regulations, financial institutions should pay close attention to the latest development of judicial trials. A court may decide that a clause in violation of regulations “damages public interest”, and thus invalidate the clause according to article 52 subparagraph (4) of the Contract Law.

Guaranteed payment and difference making-up obligation

The current laws of China expressly prohibit financial institutions (normally securities companies and managers of publicly offered funds) from guaranteeing payment to investors. However, a difference making-up clause requires a third person or junior investor to guarantee a minimum return of a senior investor or an asset management plan, and is thus not guaranteed payment. Therefore, there is not any legal risk that the difference making-up clause will become void due to violation of the provisions on guaranteed payment.

Difference making-up obligation and shadow banking

Shadow banking exists when a financing party obtains financing in a disguised way through an asset management channel, and a financial institution guarantees its fixed return through a difference making-up clause. In such a case, the financing party can avoid the circumstance where it will not be able to obtain loans from any formal channel due to loan qualification, purpose and other factors, while the financial institution can acquire a better fixed return disregarding the government requirements on guiding rate or loan term, etc., and avoid approval and supervision by the China Banking Regulatory Commission (CBRC) and other authorities on credit products.

Development trend

With the development of the financial industry, the financial products of banks, securities and insurance have been over-innovated and separated from the real economy, and the asset management products are nested at various levels, resulting in frequent financial chaos. In order to control the chaos in the financial industry, the central government’s control over the financial order has become increasingly strict. The authors believe that the return to basic functions of financial products under the premise of legal compliance is the trend of the times.

At present, China’s departmental regulations have a negative attitude towards the difference making-up clause, and the judicial authorities cannot directly apply departmental regulations to invalidate contracts. However, with the strong financial supervision rules and measures winning great popular support, the violation of departmental regulations will be regulated by more stringent interpretation standards and regulatory measures, and even the contract may be invalidated eventually. Therefore, financial institutions should be more cautious when they use the difference making-up clause in violation of departmental regulations, and pay more attention to compliance risks to ensure the smooth development of their own business and the stable development of the financial market.

Paul Zhou is a senior partner at Wintell & Co. He can be contacted on +86 21 6854 4599 or by email at [email protected]

Harry Wu is a partner at Wintell & Co. He can be contacted on +86 21 6854 4599 or by email at [email protected]