China: Legal Risks And Impact On The Leased Property Under Financial Lease

Last Updated: 10 January 2017
Article by Rong Fan

Since the establishment of financial leasing companies within banking system in 2007, after around 10 years of development, financial lease has become one of the major sources of financing for domestic manufacturing equipment, infrastructures and public facilities. The financial lease business involves a variety of legal risks, among which the most important risk in respect of business practice and legal technique, is whether the agreed leased property is qualified. Disqualified leased subject matter would change the determination of the nature of legal basis for the transaction, and thus cause serious negative impacts on the assumption of risks, contractual liabilities, external supervision and other aspects of the lessor.

I. MAJOR SITUATIONS FOR DISQUALIFIED LEASED PROPERTY

Financial leasing is a financing behavior based on the leased property and the value thereof. In practice, there are mainly three common situations where the leased property is disqualified: 1) the description and definition of the leased property is ambiguous; 2) errors in the determination of the property right category of the leased property; 3) value of the leased property is comparatively lower than the financing amount.

(i) The description and definition of the leased property is ambiguous.

Due to the ambiguity of the description and definition of the leased property, the leased property cannot be legally indentified, and thus the property right thereof does not actually transfer and no subsequent lease will be established. In the first-instance judgment ((2013) Yi Zhong Min Chu Zi No. 5657) rendered by the No. 1 Intermediate People's Court of Beijing for the financial leasing contract dispute between China Foreign Trade Financial Leasing Co., Ltd. and Zhejiang Industrial Group Co., Ltd., the court pointed out that the descriptions of the leased property in the "Equipment List" attached to the lease contract signed by both parties were either only generic names or were unable to direct to specific tangibles, and that the relevant leased subject matter did not fit with the requirements on the transfer of property right under the Property Right Law. Hence the court ruled that the lessor did not obtain the ownership of the leased property.

(ii) Determination of the Property Right Category of the Leased Property

Another common type of legal dispute concerning the leased property is the equipment fixed to the land, especially infrastructures, public facilities (including structures thereof), e.g. whether the water pipe network constitutes as chattel or real estate. The prevailing view is that such leased property constitutes as real estate, and therefore shall be transferred in accordance with the requirements on real estate transfer under the Property Right Law, i.e., the possession and transfer of ownership of real estate is subject to registration, and the lessor must register the change of ownership of the leased property. However, the issue is that in addition to land and premises, there is no domestic registration system for other fixtures, which makes it practically impossible to legally complete the transfer of ownership of relevant leased property.

Facilities and equipment fixed to the land account for the largest financing amount of the current financial lease business. The aforementioned issue of real estate determination and registration has always been troubling the domestic financial leasing business. We believe that a reasonable solution to this issue is to define relevant property as chattel since real estate is a legal concept in the first place, and the distinction between chattel and real estate shall not be made based on the mobility thereof, but instead, shall be based on whether it is legally required to realize the rights of possession through registration.

(iii) The value of the leased property is comparatively lower than the financing amount.

Financial leasing is considered as the combination of financing and leased property. If the court finds and determines that the value of the leased property is obviously lower than the project financing amount, it might be ruled that the transaction does not have the property financing nature, and thus the leasehold relationship does not exist. Article 36 of the Administrative Measures on Financial Leasing Companies provides "In a sale and leaseback business, financial leasing companies shall set the purchase price of a leased property with reference to the pricing basis that is reasonable and not against the accounting standards, and shall not pay higher price for a leased property of lower value." In the ruling of enforcement rendered by Macheng People's Court, Hubei Province ((2015) E Ma Cheng Zhi Yi Zi No. 0002) ,with respect to the validity of involved "Financial Leasing Contract", the court held that this contract shall be held invalid because the leased property was paid with a higher price despite of its obvious lower value w, which was against the regulations of financial leasing industry.

Pursuant to Section 2, Article 1 of the Interpretations of the Supreme People's Court on Issues Concerning Laws Applicable to Hearing Cases Involving Disputes over Finance Lease Contracts (Fa Shi [2014] No.3), "With regard to a contract in the name of a financial leasing contract, if there is no actual financial leasing legal relationship, the people's court shall deal with the contract based on the actual underlying legal relationship thereof.", the court will determine the nature of relevant transaction based on the specific circumstances thereof. Due to the fact that the transaction purpose of financial leasing is financing, if a financial leasing transaction is not legally determined as a financial leasing, it is generally and practically considered as a loan.

II. NEGATIVE IMPACT RESULTING FROM DISQUALIFICATION OF LEASED PROPERTY

In the transaction of financial leasing, in the event that the transaction is not deemed to constitute a lease due to disqualification of leased property, even though the transaction is deemed as a loan, with the principal provided by the lessor protected by law as creditor's right, the lessor will still bear a series of negative impacts.

(i) The lessor may lose the ownership of leased property

The most direct impact on denial of leasehold relationship of the transaction is that the court may determine no transfer of ownership of leased property has occured, and that the lessor does not possess the ownership of the leased property. Under such circumstance, the lessor will lose the right to dispose the leased property and the priority of compensation from the gains of the sale and disposal of leased property which will impair the lessor's interests and rights as a creditor under the lease agreement. Therefore, the financing arrangement of the whole project is equivalent to unsecured loan without real guarantee. The risk level of creditor's right thus increases.

(ii) The agreed rent cannot be completely realized

If financial leasing is regarded as a loan, the project will calculate interest based on the principal and interest rate on the basis of debtor-creditor relationship. Although the interest in most financial leasing arrangement is calculated based on the same method as the loan, yet since the leasehold relation itself is not subject to the mandatory components of principal, interest rate and interest, the lease project can have more flexible arrangement such as the special items of rent prepayment, deposit, capitalization of interest, and amount beyond interest to be paid as rent, and etc. Such flexible arrangement may be deemed as invalid due to incompliance with relevant legal requirements for loan (especially prohibitive regulations related to usury).

If deemed as a loan, with respect to the interest rate thereof, Article 26 of Provisions of the Supreme People's Court on Application of Laws to the Hearing of Private Lending Cases provides "if the interest rate agreed by the parties does not exceed the annual interest rate of 24%, the People's Court should support the lender's requests against the borrower to pay interest according to the agreed interest rate. If the interest rate agreed by the parties exceeds the annual interest rate of 36%, the part of interests that exceeds 36% is void. When the borrower requests the lender to return such amount above 36% that has been paid, the People's Court should support it."

(iii) Liability for default in sequent party's financing

Most of the lease projects of financial leasing companies have sequent financing in the form of commercial bank loan, sublease, rental factoring or transfer of beneficiary rights, etc. In these sequent financing, lease companies all make legal commitments to sequent financing parties (including assignee of the asset) on legality and compliance of lease property and authenticity of lease creditor's right. The lease company will bear corresponding liability for damage to sequent lease parties or the assignees for violation of its commitment and warranty or invalidity of mortgage and pledge of leased property, if provided that disqualification of leased property and denial of leasehold relation occurs. Furthermore, the sequent lease party may have the right to adopt remedy measures such as directly terminating the contract and announcing acceleration of the loan, etc.

(iv) Regulation risks

If the leasehold relation of lease project is denied, and then deemed as debtor-creditor relationship, it may attract attention from relevant financial regulatory authority. The company then will be regarded as engaged in credit business and may receive punishment accordingly. None of the various existing lease companies, whether financial leasing company or domestic or foreign invested lease company approved by the Ministry of Commerce, has the license for loan business. If a great many of the financial lease projects of a lease company are deemed as loans, such lease company may be subject to penalties by the financial regulatory authority for such non-compliance.

If a lease company goes public, and the leasehold relation of the transaction in its business is denied due to the risks in the leased property, it is inevitable that the company will violate its obligation for the authenticity of information disclosure, if it has disclosed such transaction. No matter listed in China or abroad, the violation the obligation for the authenticity of information disclosure will lead to penalties (including fines) imposed by the security regulatory authority and the relevant stock exchange against the listed company and the relevant directors and senior executives. In the worst case, the company may be de-listed and the relevant senior executives of the company may be prohibited from entering into the security business. In addition, the company and relevant senior executives may face claims and litigation from shareholders of the company accordingly, especially when the company is listed overseas.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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