‘Security by assignment’ and its regulatory framework

By Wu Jiejiang, Jingtian & Gongcheng
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On 6 August 2019, the Second Adjudication Division of the Supreme People’s Court posted the Minutes of the National Work Conference on Civil and Commercial Adjudication (draft for comment) on www.chinacourt.org, proposing the full leveraging of the positive role of security in mitigating the issues of difficulty and expense of financing, and not lightly denying the validity of contracts involving new and non-traditional types of security.

Based on the “trial of the execution of sale and purchase contracts serving as security for private loan contracts” mentioned in article 24 of the Judicial Interpretations on Private Loans, and “recognizing the legal validity of new types of security in accordance with the law” mentioned in the 2017 Several Opinions on Further Strengthening Financial Adjudication Work, the draft minutes further set out the concept of “security by assignment” and its regulatory framework in an official manner.

Security
Wu Jiejiang
Partner
Jingtian & Gongcheng

Security by assignment is a form of security provided by the debtor or a third party for the debt under the master contract, where the debtor or third party transfers property, such as movable assets, immovable property or equity, to the name of the creditor. It can be understood from the following two dimensions:

(1) From the perspective of the creation of the security by assignment, it is an assignment or transfer of rights, but such assignment or transfer is not final, as the rights will subsequently be returned or disposed of, depending on whether the specific debt that they secure is repaid or not; and

(2) From the perspective of the creditor, the objective in obtaining the rights is not a final acquisition of such rights, but rather securing the performance of the specific debt obligation. Once the specific debt is repaid, the corresponding guarantee measures, or executed transfer contract, should be terminated or returned. It is only when the term of the debt expires without its being repaid that the thing provided as security can be disposed of.

Security by assignment has the following features: First, it is a type of non-traditional security which, as compared to such traditional means of security as mortgage, pledge and lien provided for in China’s Security Law and Property Law, is a form of security that is defined in practice in judicial interpretations and precedents, and falls into the category of non-traditional security.

Second, it is a type of security that is provided for by the parties, that is to say that its creation is based on provisions agreed upon by the parties. Statutory security has the effect of maintaining an equality of claims, and has a marked subordinated nature. In contrast, security by assignment has a more pronounced financing function with a weaker subordinated character.

As compared to numerus clausus security, security by assignment has the following major advantages and significance:

(1) The subject matter of security by assignment can be much wider. While property security stresses numerus clausus, certain special subject matters lack a clear numerus clausus security registrar, e.g., calligraphic works, paintings, works of art, etc.;

(2) It is conducive to clarifying legal relationships and providing accurate characterization and application of judicial law, for example securities transfers and repo transactions. Some time back, securities and financial regulators approached the legislative authorities recommending that they formulate legislation addressing security by assignment, but because it is difficult to set it apart in the current dichotomy of rights in rem and claims, there hasn’t been any progress;

(3) The creator of security by assignment over subject matter can maintain possession of the subject matter, still enjoying usufruct; and

(4) It cuts down on transaction costs or system costs. In terms of the procedure for revising the price of the subject matter of the security by assignment, the creator of the security enjoys a certain degree of liberty.

The draft minutes erect the corresponding regulatory framework for security by assignment:

(1) In the absence of a circumstance that would invalidate the contract, the relevant contract creating the security by assignment should be found to be valid. The Supreme People’s Court states in the draft minutes that, although the rights/obligations relationship with security function created by the parties through the contract does not fall within the typical types of security provided for in the Security Law and Property Law, in the absence of a circumstance set out in article 52 of the Contract Law that would make the contract invalid, the contract should be found to be valid;

(2) Bestowing the effect of priority repayment from the liquidation proceeds. Since the movable assets serving as the property provided as security have actually been delivered to the creditor, or amendment of registration has been carried out for the immovable property, equity, etc., the rights/obligations relationship between the parties may be determined with reference to regulations on the pledge of movable assets, the mortgage of immovable property, or the pledge of equity;

(3) Exclusion of “retention” clause. If the debtor fails to perform its matured debt obligation or a specified event arises and the creditor claims that it directly has ownership of the movable assets or immovable property or rights in the equity, the People’s Court will reject such a claim, unless the creditor and debtor or guarantor subsequently agree, through consultations, upon a separate transfer transaction in respect of the movable assets, immovable property or equity; and

(4) Provision of a relief channel for the debtor. If the debtor requests that the People’s Court refer to relevant provisions on “cases involving the realization of rights in rem provided as security”, of the Civil Procedure Law, and auction or sell off the movable assets, immovable property or equity, the People’s Court should uphold such a request.

The above-mentioned regulatory framework clearly confirms the validity of liquidation-type security by assignment and gives the rights holder priority for repayment from the proceeds derived from liquidation of the subject matter. However, there are perhaps some issues that require further clarification, e.g., how should the means of liquidation of the subject matter of security by assignment be defined? Is the rights holder limited to carrying out liquidation through a judicial procedure, such as litigation or enforcement, or does he/she have the right to carry out liquidation? If the creditor disposes of the subject matter of the security by assignment to a third party, or if the creditor’s property is placed under seal or seized, can the creator of the security by assignment put forward an effective defence? These questions may require waiting for future specific judicial precedents for clarification.

Wu Jiejiang is a partner at Jingtian & Gongcheng

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