Protecting rights of lessees when lease, mortgage rights conflict

By Efar Zhou, Martin Hu & Partners
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In the financing market, security provided in the form of a mortgage is one of the financing security methods most trusted by banks and capital contributors. If the debtor fails to discharge its debt on schedule, the mortgagee may secure repayment of its claim on a priority basis by realising its mortgage rights. If the mortgage property is additionally leased out, realisation of the mortgage rights will necessarily have a certain impact on the lease rights. Although Chinese laws contain specific provisions on the method for resolving a conflict between lease rights and mortgage rights, in practice each party wishes to go beyond the law to secure greater benefits.

周成成 Efar Zhou 胡光律师事务所 律师 Lawyer Martin Hu & Partners
Efar Zhou
Lawyer
Martin Hu & Partners

Application of the principle of sale/purchase not undermining lease. If the mortgaged property is leased out before the creation of the mortgage, the acquirer of the mortgaged property is obliged to continue performing the original lease contract after the mortgagee realises its mortgage rights. If the acquirer of the mortgaged property unilaterally amends or terminates the lease contract, the lessee may institute a legal action in a court demanding that the acquirer continue to perform the contract.

If the lessee asserts its lease rights at the time of realisation of the mortgage rights, the mortgagee may question the motivation for, and the genuineness of, such an assertion. In this respect, the mortgagee may be required to provide the lease contract and the evidence showing that the creation of the lease rights occurred earlier than the creation of the mortgage rights.

Accordingly, it is recommended that lessees retain vouchers related to the performance of their lease contracts. If the mortgaged property is real estate, the simplest method is to require the lessor to apply to the competent authority for registration/recordal of the premises lease contract.

If the lessee successfully provides such evidence, the principle of “sale/purchase not undermining lease” will apply to the lease rights, and the lessee will have the right based on the lease contract to continue possession of the leased property. If not, it is very possible for the lease rights to be deemed by the mortgagee and the court as an obstruction erected by the mortgagor and lessee to impede realisation by the mortgagee of its mortgage rights.

Exceptions to the principle of sale/purchase not undermining lease. The Property Law expressly provides that if a mortgage has been created over property prior to its lease, the lease rights cannot oppose the mortgage rights, that is to say that the lessee does not have the right to demand that the buyer of the mortgaged property continue to perform the original lease contract.

In the face of property encumbered by a mortgage, the way of proceeding most commonly seen in practice is securing the mortgagee’s consent for the lease, the lessee deeming that if the consent of the mortgagee is secured before the lease of the mortgaged property, its lease rights can oppose the mortgage rights.

However, such a method of proceeding clearly lacks a legal basis. Three options are available to a mortgagee in realising its mortgage rights: (1) holding consultations with the mortgagor for a conversion into money; (2) auctioning the mortgaged property; or (3) selling off the mortgaged property. The law expressly prohibits mortgagees and mortgagors from executing “fluidity clauses”, and accordingly there is a strong likelihood that the acquirer of the mortgaged property will not be the mortgagee. Pursuant to the doctrine of privity of contract, where a mortgagee has consented to a lease, its consent is not binding on the acquirer of the property. Accordingly, the lease rights cannot oppose the mortgage rights.

If the mortgagee and the acquirer of the mortgaged property are coincidentally one and the same entity, where the mortgagee consents to the leasing out of the mortgaged property, the preponderant opinion in current judicial practice holds that lease rights still cannot oppose the mortgage rights.

In a civil judgment rendered in 2013, the Guangdong Provincial Higher People’s Court held that article 66 of the Interpretations of the Supreme People’s Court of Several Issues Concerning the Application of the Security Law of the People’s Republic of China, specifying that “if the mortgagor leases property that has been mortgaged, the lease contract will not, after the realisation of the mortgage rights, be binding on the assignee”, and article 190 of the Property Law, specifying that “if, before conclusion of the mortgage contract, the mortgaged property had been leased out, the existing lease relationship shall not be affected by the mortgage rights.

“If the mortgaged property is leased out after the creation of the mortgage rights, the lease relationship may not oppose the registered mortgage rights”, do not contain any expressions indicating exceptions to the rule, nor do they contain any provisions along the lines of “unless the mortgagee consents to the lease”.

Accordingly, the Guangdong court held in its judgment that even if the mortgagee consents to the lease of the mortgaged property and is concurrently the acquirer of the mortgaged property, the lease rights still cannot oppose the mortgage rights.

Protection of the rights and interests of lessees in the realisation of mortgage rights. Although the lease rights cannot oppose the mortgage rights, the lessee can control the risks through design of the terms of the lease contract executed with the lessor (mortgagor) and should consider the following points:

  1. Before execution of the lease contract, the lessee should assess the losses that could be caused if the lease contract is terminated early due to realisation of the mortgage rights and, to the extent possible, detail the makeup of the losses and quantify their amount in the contract;
  2. In the lease contract, specify that a termination of the contract arising due to realisation of the mortgage rights is a breach of contract by the lessor and expressly specify the liability for such breach;
  3. The lease contract should confer on the lessee the right to refuse to pay rent, thereby making it possible for the lessee to set off the losses it incurs as a result of the realisation of the mortgage rights against the rent;
  4. Make it possible for the lessee to become the owner of the leased property by exercising its pre-emptive right of purchase. Except in specially mandated circumstances, a lessee has a pre-emptive right of purchasing the property it is leasing, and even in a circumstance where lease rights cannot oppose mortgage rights, it still enjoys such statutory right in the course of the realisation of the mortgage rights.
MHP

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胡光 Martin Hu

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周成成 Efar Zhou

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