2021.04.01 ZHU, Jiayin (Jay)
Along with the implementation of the new rules concerning Qualified Foreign Investors (the "QFI or QFII/RQFII New Rules"), leading securities brokers have started opening securities borrowing and lending (SBL) credit accounts for their QFII/RQFII clients trading in the A-share market. While the SBL market welcomes onboarding of QFII/RQFII clients, it is inevitable that clients will be concerned with the legal issues on ownership and segregation of property concerning a SBL account. To respond these questions, the legal relationship between client and broker in SBL transactions needs to be determined. In particular, with the implementation of the Civil Code of People’s Republic of China (the “Civil Code”) and relevant guarantee provisions that have resulted in multiple changes, it is necessary to refresh and revisit our understanding of relevant issues.
There is no doubt that the client and broker establish a securities brokerage and loan relationship in SBL transactions. The question is whether the counterparties establish a trust relationship in relevant SBL transactions. Article 14 of the Administrative Measures for the Securities Borrowing and Lending Business of Securities Companies (the “SBL Business Administrative Measures”) issued by the China Securities Regulatory Commission (CSRC) stipulate “SBL contracts shall provide that, the securities held in a client credit transaction guarantee securities account and the cash deposited in a credit transaction guarantee cash account, both opened under the names of securities companies, are trust properties used to guarantee the securities companies’ claims against clients arising out of SBL transactions”. Similar provisions can be seen in the Administrative Regulations for Supervision of Securities Companies. Moreover, Article 6 of the Necessary Terms for Securities Borrowing and Lending Contracts released by the Securities Association of China (SAC) provides detailed rules on the specified trust relationship in terms of the purpose of a trust, scope of trust property, establishment and effectiveness of trust, management of trust property, disposition of trust property and termination of trust. Currently in the market, these terms are widely adopted in SBL contract templates (including the contract templates used for QFII/RQFIIs) provided by securities companies.
In judicial practice, some courts have determined that the legal relationship between clients and brokers in SBL transactions shall constitute a trust relationship based on these explicit agreements in the SBL contracts. For example, see Shanghai Pudong New Area People’s Court (2017) Shanghai 0115 Minchu No. 33817.
However, this determination of the client-broker legal relationship in SBL transactions to be a trust relationship was highly doubted in academic circles, where the issue was raised that it conflicts with the basic purpose and principle of the Trust Law, namely: (i) the securities company is not qualified to conduct trust business; (ii) it violates the basic principle of a trust, that is “a trustee shall deal with trust affairs in the best interests of the beneficiaries”, and (iii) in SBL transactions, the securities company, which is supposed to be the trustee, only passively holds the trust property rather than actively manages the trust property. In this regard, some courts denied the trust relationship between clients and brokers in SBL transactions, for example, in the case of Li Mou v. Company A, a dispute arising from securities misrepresentation (one of the ten significant financial and commercial trial cases in the Shanghai Courts in 2017 as released by Shanghai High People’s Court), the court concluded that:
…this case clarified that investors, as the de facto holders of securities, have substantive property rights over the assets in the credit accounts. The SBL Business Administrative Measures define such assets as 'trust property' with the aim of providing guarantee for the securities companies’ claims against clients, while such ‘trust property’ is not equivalent to the ‘trust’ under the Trust Law and does not directly apply the basic rules of the Trust Law.
Based on our observations of the above judicial practice, despite the CSRC determination, the possibility cannot be ruled out that the client-broker legal relationship in SBL transactions may not be determined to be a trust relationship and therefore relevant principles and rules under the Trust Law are inapplicable.
According to the SBL Business Administrative Measures and the Necessary Terms for Securities Borrowing and Lending Contracts,securities and cash in the SBL credit accounts are collateral for securing securities companies’ claims against clients arising from SBL transactions. When the SBL pilot was first introduced to the market, both the publicity of security interests and the procedures for disposing security interests established under the then Guarantee Law and the Property Law were inefficient and fell short of the “timeliness” demand of SBL transactions, hence, subject to the old legal framework of security interest, the CSRC had no better choice but to define the credit guarantee arrangement under SBL transactions as a trust, after taking into account the interests of each party as well as other considerations, i.e., on one hand, securities companies are prohibited from embezzling or misappropriating any securities or cash in the credit accounts; on the other hand, while aiming to secure the securities company’s priority on the compensation value of the securities and cash, the conflict between the timeliness of securities transactions and the inconvenience for creating security interests needs to be addressed.
Article 388 of the Civil Code recognizes the validity of other atypical guarantee contracts that function as guarantees for the first time, which provides the groundwork for exploring the legal relationships for SBL credit guarantee arrangements based on the new legal framework of security interests. Article 68 of the Interpretation of the Supreme People's Court on the Application of the Guarantee Rules in the Civil Code of the People's Republic of China (the "Interpretation on Guarantee Rules") stipulates that:
…where the debtor or any third party reaches an agreement with the creditor to superficially transfer property ownership to the creditor, so that the creditor has the right to convert the property into money, or to satisfy its rights with the proceeds from auction or sale of the property when the debtor is in default, the People's Court shall confirm the validity of such an agreement; where the aforementioned parties have completed the statute publicity formalities with respect to the change in ownership of the property, the creditor then claims priority on the compensation value of the property with reference to and in accordance with relevant provisions in the Civil Code regarding security interests when the debtor is in default, the People's Court shall grant such a claim.
According to the Understanding and Application of Interpretation on the Application of Guarantee Rules in the Civil Code (the "Understanding and Application of Guarantee Rules") written by the Supreme People's Court, Article 68 of the Interpretation on Guarantee Rules specifies a typical form of Assignment Guarantee. An Assignment Guarantee (also known as the Trust Guarantee) have the following characteristics: (i) when setting up an Assignment Guarantee, the guarantor needs to temporarily transfer the ownership of property to the creditor so that the creditor becomes the nominal owner of the property; (ii) to enable the guarantor to continue to use the property, the creditor often enters into a separate rent or lease agreement with the guarantor so that the guarantor may use such property; (iii) the creditor shall return the ownership of the property to the guarantor after the debtor pays the debts; (iv) if the debtor fails to pay the debts, the ownership of property does not automatically goes to the creditor, rather, the value of the property must be liquidated.
According to the SBL Business Administrative Measures and the Necessary Terms for Securities Borrowing and Lending Contracts, the cash and securities used to secure the debts arising out of SBL transactions are deposited by clients in the client credit transaction guarantee cash accounts and the client credit transaction guarantee securities accounts opened under the names of the securities companies, and the securities companies are the nominal holders of such cash and securities, i.e., the collateral. Throughout the term of SBL transactions, clients have the right to instruct securities companies to trade securities, and after paying off the debts arising out of SBL transactions, are entitled to request the securities companies to deliver the remaining part of the collateral. If the clients fail to provide enough collateral in a timely manner or fail to repay the debts in other forms arising out of SBL transactions, the securities companies have the right to forcibly close the transaction and dispose of the collateral, and the proceeds of such a disposition shall first be used to repay the debts owed by the clients to the securities companies. In this regard, it can be inferred that the SBL credit guarantee arrangement conforms to the elements of an Assignment Guarantee under the Civil Code.
In judicial practice, early before the official implementation of the Civil Code, some courts held that the credit guarantee arrangement under SBL transactions shall constitute an Assignment Guarantee. For example, see (2018) Jiangxi 0103 Minchu No.2921.
Although the relevant regulations and rules of the CSRC and SAC provide that the SBL credit guarantee arrangement constitutes a trust relationship between the counterparties of SBL transactions, we have observed different opinions in judicial practice and we tend to believe that it may be improper to apply the law of trust for determination of ownership and segregation of property in the SBL credit accounts. Under the brand-new legal system of the Civil Code and relevant guarantee laws, the SBL credit guarantee arrangement should be determined as an Assignment Guarantee pursuant to the Civil Code, and we note that some courts have already made the same determination. We hope that the judicial practice in post-Civil Code era will further clarify and unify the views to mitigate the uncertainty arising from the relevant legal issues.
We will continue to monitor these issues and keep our client appraised of important developments.
This Client Briefing is excerpted from Legal Relationships of Collateral Concerning Securities Borrowing and Lending Business – Reviewed from a Civil Code Perspective, an article written by Jay Zhu, a partner at JunHe LLP.