Securitization in China: secured or not?

Author: | Published: 1 Jul 2005
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In April this year, the People's Bank of China and the China Banking Regulatory Commission jointly promulgated the Regulation on Securitization of Credit Assets (the Securitization Regulation). Before this regulation, the Chinese government had allowed the State Development Bank and China Construction Bank to make pilot reforms in the securitization of credit assets and mortgage-backed assets respectively. All of this has indicated the PRC government's resolve to carry out the first group of securitization products, among which mortgage-backed securitization (MBS) is foremost.

Compared with the legal structure of the project financing of real estate projects, the structure of mortgage-backed securitization tends to be more complicated. Under the PRC's legal framework, is securitization, including MBS, ready for kick off?

Legal groundwork for MBS in PRC

A typical MBS can be illustrated as follows: assets that bring stable income, that is, a creditor's rights over a real estate mortgage, will be sold to an independent entity, the special purpose vehicle (SPV). The SPV will issue securities with the support of these assets and pay for the consideration of acquiring the assets with the funds collected. The SPV, as the agency between the bank originators and investors, is crucial to the securitization operation. The purpose of the SPV is to insulate risks and issue securities. However, the Company Law of the PRC and Trust Law of the PRC will affect the risk insulation of SPVs. For example, particularities of the SPV's purpose will make it difficult to satisfy the Chinese Company Law's provision concerning the average annual distributive profit in the previous three years, and the stipulation in the Management Rules of Trust Investment Companies (that is, that the "trust investment company is forbidden to issue securities and engage in foreign borrowings") is apparently in conflict with the SPV for its purpose of securitization.

The Security Law of PRC and the Commercial Banking Law of PRC further challenge the legality of MBS. The Chinese Security Law provides that security, banking, trusts, and insurance must be operated and managed separately, making it difficult for banks to participate in securitization. The Chinese Banking Law strictly confines the business scope of financial institutions, which does not include securitization, and specifically provides that commercial banks are not allowed to engage in trust investment and stock business in China, invest in real estate that is not for their own use, or make investments in non-bank financial institutions and enterprises. These laws make it difficult to launch securitization. But the central government will adjust the work division between People's Bank of China, China Banking Regulatory Commission and other related government authorities to provide MBS with a green light.

Meanwhile, the Contract Law of the PRC also presents challenges to MBS. During the MBS process, loan packages are transferred to the SPV by true sale, which according to the Chinese Contract Law is a transfer of credit. However, to be valid the transfer must give notice to all debtors. The number of debtors in loan packages has become an obstacle to such notices. Asset evaluation, agency services, accounting rules, registry polices, tax administration and foreign exchange polices will also affect the implementation of MBS.

Real estate securitization, especially MBS, in China is faced with an immature legal environment that could directly restrict its progress. However, it is possible to set up specific provisions as to how real estate securitization could work by enacting specific regulation to get past the legal barriers.

Two core legal issues remain

So can the material obstacles or core issues of MBS in China be solved by issuing specific rules such as the Securitization Regulations? The legal structure of MBS promotes the self-repayment process, which minimizes legal risk and forms a fundamental part of securitization.

Choose the proper legal structure for SPVs

According to the practice and legislation of other jurisdictions worldwide, an SPV usually takes one of three forms, that is, a company, trust or partnership. The company is the most commonly used form. On one hand, the SPV can issue various kinds of securities and increase flexibility; on the other hand, restrictions on commercial business that a company is subject to can be added into the business licence and articles of association, and the participants in a security financing deal are usually familiar with bankruptcy and operation and management affairs. The company form will assist them in easily evaluating the legal risks of the securitization. Of course, an SPV taking the form of a company will also come across problems, such as double taxation, long-winded setup procedures and high administrative costs.

The trust is another form of SPV. One reason the trust is used in MBS is its inherent basic characteristic - the independence of a trust asset. The securitized asset for the trust is separated from the assets and risk of the originators and trustee and turns into the special asset pool for asset-guaranteed security. The trust has also been a system free of any tax in the US and some other countries. However, trusts are still a new thing in China and the country lacks the tradition of a trust legal system and well-developed trust regulations. There is no legal system for trusts to support the development of SPVs. As for partnerships, there is some sustaining theoretical legal research, but few countries have adopted this form in practice.

After comparison and analysis of these three forms, the company is definitely more suitable for MBS in China and is a well-developed and realistic solution to legal risk. But under the present legal environment, and especially considering the immaturity of the Chinese security market, the instability of the real estate market and the absence of a credit system, the trust is probably more realistic for MBS in China. The latest Securitization Regulation has been enacted precisely for this reason and seems to be a realistic choice.

Build the bankruptcy-isolation system for SPVs

Issues of bankruptcy are always focus issues in securitization. Almost all legal opinions provided for a securitization project will be required to analyze the bankruptcy risk, and a detailed analysis in particular is required for issues related to transferring receivables to an SPV, which may be questioned by the liquidators. Therefore, only by clearly defining the business scope of an SPV and enforcing the principle of prudence established in legislation can an SPV be made properly bankruptcy-remote. On the other hand, only by enforcing the bankruptcy isolation system can the SPV be isolated from operational risk and kept running smoothly.

The bankruptcy isolation system is, to some extent, applied to isolate risk of the originator's bankruptcy and to avoid a so-called material merge. Material merge refers to a situation where the SPV is deemed to share the account of the originator by satisfying certain conditions and the originator's transferred assets appear on its balance sheet again, making it impossible to deal with the assets off balance-sheet. Once a material merge happens, the asset isolation previously achieved by means of true sale becomes meaningless.

In the US, the court will usually rule on material merge of two entities according to the equity right in bankruptcy law, by taking into consideration the material legal relationship between two entities that are ruled to be merged and the impact of the material merge on all creditors. The application of material merge will not harm the SPV's bondholders' interests or benefits. In the UK, however, the principle of piercing the corporate veil is applied to deal with similar cases. So it is hard to find a comprehensive and generally accepted standard upon which to make the material merge decision because so many factors must be taken into consideration and so many parties are involved.

By taking into consideration legal practices and legislation of all other countries, China could apply standards of control as core standards. When the originator controls the SPV, that is, the SPV substantially or totally loses its autonomy, a material merge between the originator and SPV might happen. The standards of control might include, for instance, whether the SPV has an independent name or office of business; whether the SPV has adequate capital; whether the SPV has directors independent from the originator and whether such directors can decide on the SPV's relevant issues independently; and whether the business between SPV and originator satisfies the arm's length principle and whether there is any commingling of business. However, in the legal environment of China, laws and regulations regarding such standards of control are yet to be established or further improved.

Based on the above analysis, MBS in China is just taking its initial steps. Even with the new Securitization Regulation, many issues are still pending.

Author biography

Anthony WJ Qiao

Zhong Lun Law Firm

Anthony Qiao is a partner of Zhong Lun Law Offices, one of the most prominent law firms in China, and heads the firm's Shanghai office.

Qiao specializes in land and property, infrastructure, electric power, telecom- and media-related industries, including buying state-owned assets, foreign direct investment, mergers and acquisitions, corporate reorganization, corporate finance and securitization. He has actively represented a number of international and domestic clients. Qiao is also highly recommended in the field of banking and project finance. He advises various commercial banks as the PRC legal counsel to syndicated lenders and/or borrowers, and has been responsible for providing PRC legal advice and opinions, participating in negotiations, and preparing legal documents in connection with project finance projects in China.

Qiao received his LLB from East China University of Law and Politics and his LLM from Fudan University. He also studied at the LLM programme of New York University Law School in 1999/2000. He has been practising PRC law since 1992. He is the vice-chairman of the Banking and Insurance Committee of the Shanghai Bar Association. He was nominated by Asia Law & Practice as an "Asian Leading Lawyer" in the areas of mergers and acquisitions, and banking in 2004 and 2005, and was awarded in Shanghai as one of "The Top 10 Leading Lawyers" in 2003 and 2004.

Email: anthonyqiao@zhonglun.com