First trial

A recent decision by the Shanghai No.2 Intermediate People’s Court has caused panic in China’s trust industry.

The dispute revolved around a 215 million yuan project financing that real estate developer Kunshan Chungao Investment and Development Co Ltd sought from Anxin Trust & Investment Co in 2009, which the latter processed as a “trust of right of lucre” product for public fundraising. With this “trust contract,” the financing was able to circumvent some high qualifications required for real estate trust loans.

However, the two parties later signed another contract which stipulated that the 215 million yuan was provided to Kunshan Chungao as a “trust loan” at a higher interest rate. This was done because only with a loan contract could the assets be accepted as a mortgage by the property registration administration.

Once the stipulated deadline for the contract expired, Anxin sued Kunshan Chungao for failing to clear the payment for default and demanding a seizure and auction of the mortgaged assets in accordance with the loan contract. However, Kunshan Chungao claimed the loan relationship did not stand because of the “trust contract.”

The key question was which one of the two contracts signed by them would the court consider as valid, and also prove to be a guiding principle for the future.

The Chinese media reported that in its judgement, the court appeared to have annulled the loan contract (the second contract that was signed) for being “against the principle of good faith.”

“The trust loan contract is dependent on the trust contract, and the issuance of a loan is against the trust contract … Our court holds that the nature of the disputes in this case is disputes on business trust,” reads the judgement as quoted by Chinese newspaper.

By annulling the loan contract, the verdict has technically invalidated Anxin’s mortgage, and sounded an alarm to numerous trust companies that have entered into similar black and white contracts.

“It was a big shock to the trust industry,” says Dr. Shi Rui (石睿), a lawyer at Tiantong & Partners. “The amount of assets involved in such trust of right of lucre deals has been rising quickly.”

In fact, this ruling is being seen by legal practitioners as a heavyweight precedent of how the judiciary decides on “black and white contracts” which exist widely in real estate trust and are estimated to be worth billions.

As control and regulation on real estate financing tightens, more and more trust companies are using the vehicle of trust of right of lucre to avoid supervision by relevant regulatory, whilst still registering mortgage and gaining higher rates through loan agreements. The products in the form of “trust of right of lucre” made up 26 percent of all trust products issued in 2011 and 31.5 percent in 2012, according to a report by research organisation Use-Trust Studio.

“Sometimes, it could be even more complicated when the two contracts are intertwined,” says Shi.

“The two contracts each give the same behaviour a different legal definition. Lawsuit happens because the real nature of the behaviour is debatable. The two parties each choose to adhere to the contract in their favour. ”

Also, since loan contracts usually set higher rates of interest and/or lay more responsibility on the borrower, trust companies are worried that a greater number of developers who were reluctant to enter into such contracts will now be able to claim the court’s support to escape some of the stipulations.

“In the near future, similar cases might see an outbreak,” adds Shi.

Private lending

Over the past couple of years, the slowdown in the world’s second-largest economy has left many businesses facing hard times. Debts have kept rising and this has contributed to a build-up of risks and financial imbalances, something which productivity and economic growth have not been able to offset.

“When the economy goes down, the first to be affected are the small and medium enterprises (SMEs) who are in high danger of insolvency,” says Xie Gang, partner at Grandway Law Offices. “For the banks that have a number of such SME borrowers, there is risk.”

But once the insolvencies end up in court, they are not that complicated as the process of bank lending is standardised, says Xie. “Generally speaking, litigations are simple. The key point is how to effectively enforce the court judgement after the problem turns into a lawsuit.”

Companies which couldn’t acquire enough credit from banks for their business had to turn to other financing vehicles, such as company bonds. And some among them had to borrow from other sources - non-financial companies and individuals. But the glitch is that these private lending deals are sometimes legally flawed, and are more likely to end up in defaults or disputes.

Official statistics show that in 2011, there were more than 600,000 private lending cases accepted by the courts, with some 110 billion yuan involved. And the number of cases in the first half of 2012 went up nearly 25 percent on a year-on-year basis. In fact, the figures are expected to rise even higher, given the recent liquidity squeeze in the money market indicating that private lending too can expect to see many lawsuits crop up shortly.

“Litigation is an indicator of the economic environment, only with a little lag. My prediction is that an outbreak would not be too far away,” says Shi.

Currently, only lendings between individuals and those between individuals and organisations are recognised by the law. The lending between two non-financial companies is not protected. And with China's economic reformers trying for years to diversify the country’s credit markets to give companies new ways to raise funds, the Supreme People’s Court (SPC) is also now considering making a change to this.

“The SPC is working on a new judicial interpretation, and we [have] participated in the consultation for its draft. The overall direction is to admit the validity of the contracts to protect the deals and facilitate the economic development,” says Xie.

Once the new judicial interpretation comes into force, interest rates will have legal protection, and the attitude of both the borrower and the lender will be different from when inter-company lending and interest rates were not protected [owing to fear of avoidance of the contract], according to Xie.

Other types of private lending that are already recognised, such as individual fundraising from others, might also see changes in the new judicial interpretation. The current law sets the legal interest rate cap at no more than four times the benchmark bank rate. In July, the central bank removed control on the bank lending rate while keeping the ceiling on deposit rates intact. However, this was regarded as a long-awaited reform, and such reforming momentum is expected to be extended to relevant provisions on private lending.

“From earlier this year, signals have been observed that the SPC and the legislative have paid more attention to the freedom of act and the true intention of the parties. It has been clearly demonstrated by the attitude of the court and their decisions,” says Shi.

“The court would not easily declare void a civil act. It is a trend, and is linked to the level of development of China’s market economy.”

Non-financial companies, suggests Shi, should fully evaluate their risk tolerance before making decisions, and seek professional legal advice from the beginning.

“Of course, everybody would act carefully. But no matter how carefully a common person acts, it is far from what a legal professional would do,” he says.

Private equity

Only a couple of years ago, private equity firms served as generous capital providers to China’s cash-starved SME businesses. With topical subjects, high premiums and cutthroat biddings taking up their attention, venture investors had no time to hesitate before taking over a start-up to prevent a perfect target from getting snatched away.

“Some PE firms didn’t even do due diligence investigation, as so many funds were competing for the same target … big bubbles,” says Xie.

And now the bubble’s burst. Market depression continues; new IPOs have been suspended for the time being, not to mention that the bumpy business environment makes many once-qualified companies ineligible for listing now.

“Disputes and lawsuits occur a lot between unhappy private equity investors and their underperforming targets,” he says. “So many target companies could not meet their performance goals on the contract.”

Some companies have managed to sustain their operations despite financial losses, and PE investors too have not done any better owing to a lack of abilities to run a company on their own. “The purpose of a lawsuit is to reclaim the money. But in many cases, there is no money at all. It’s even worse for a PE firm to be forced to run the company themselves,” says Xie. “So the PE firms are still very cautious about suing their failing targets. But once the Chinese economy turns downward, such litigation would certainly boom.”

Lawyers’ preventive warnings have been unpopular among institutions given that investment is profit oriented and constantly pushing for innovation, and the incorporation of such innovation in the law almost always lags behind. Although lawyers’ opinions always sound conservative, according to Shi, a tough lesson on the economic cycle could be beneficial for lawyers, apart from bringing in more court cases.

“Our risk alerts are accepted much better now, after they have witnessed so many failures,” says Xie.

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