OPINION – Building a National Unified Market: 10 Rules needed for Supply Chain Finance

In April, the State Council started to build a national unified market. In July the Supreme People’s Court affirmed to accelerate it with effectuate judicial services. Those are both great and long expected developments.

Qi Lyu, expert in financial law, founder of Beijing Finlegal Corp.
[email protected] 

For SCF ( supply chain finance), a definite and clarified rule system is a requisite facility which at the present stage is mainly implanted from the U.S UCC-9 (Uniform Commercial Code Article 9) and incorporated the civil law system jurisprudence as well. Here are the most pressing 10  issues affecting the options of business models.

1-Drawing a line between true factoring and disguised lending

 Factoring and lending are both types of financing as well as bill acceptance, bill discount, and financing guarantee. They are usually covered by one credit line, which is intended to share a maximum amount security for all specific credits. They are not of the same nature, but are instead parallel notations subordinate to the terms of finance.

However, there is a new trend to pierce existing financing including factoring to be lending when all under the umbrella of one credit line. That is partially due to the recent popular substantial determining approach in trial practice, as well as the limitation of individual judge’s personal acknowledgment. But it is horrible for factoring, since the security interests may turn invalid accordingly when the nominal prime legal relation is judged void, where the recourse factoring, a typical transfer by way of security, may lose its cushion. The test line for the terms needs to be clarified.

2-Who owns the surplus value in case a non-recourse factor collects more 

A non-recourse factor may advance partial commercial AR but recover the whole, if all goes well. Then who is entitled to keep the gap, the seller or the factor? China civil code gives his answer for the latter despite it against the international factoring custom and domestic banking practice

That is not a simple formula as of recoup amount minus advance amount, instead, it is a explanation of basic legal relationship. What is full protection for bad debt,a basic factoring function? Is it a whole AR outright sale ,or a guarantee to the customer against payer’s credit risk which authorizes the factor to collect the whole but to keep the indemnity he suffered only.

3-What elements work in determining the certainty of future AR

Future Accounts Receivable (AR) value uncertainty is separate from the unidentifiable. The former is within the sphere of the creditor’s autonomy, while the latter denies it to be qualified collateral.

Here is a question: when an agreement on a subject, matter, and quantity is achieved,  is it sufficient for binding? Is the monetary debt under it qualified AR collateral as well? It seems a logical consequence. Then is the advertising fee under a one-year term agreement between Guangdong TV and Gree A.C. identifiable? Further, would allA.D. (advertising) fees that GD TV is going to receive in 2023 be considered? Is it a qualified collateral like a highway fee? The answer to thisquestion may determine the scope of the AR collateral.

4-How to enforce an AR collateral

When bringing an action in court for outstanding debt, what is allowed to attach? To notify the payer and wait for his active fulfillment, or to attach those desired assets with the AR amount at the creditor’s discretion, since the debtor is due to pay with all his assets for the AR eventually.

The extent andthe proceeding to enforce makes a huge difference when the creditor seeks a cure for default. The AR collateral itself is intangible and unattachable, whereas the payer’s whole assets may effectuate the credit substantially.

The effectiveness of AR enforcement affects the willingness to accept it as collateral.

5-Would Bona fide rule apply to the case of title transfer with possession retained

Sale-and-leaseback is a widely used subtype of financial lease, where the possession of property is unchanged with only the title transferred. The leasee capitalizes his assets this way effectively, while also getting space to commit fraud by selling the asset multiple times due to his possession status. The tough question is left to the court: who to protect? The former buyer or the latter one? What doctrine could the court rely on, and will the bona fide rule apply?

 Actually, most Chinese jurists are against protecting the prior transaction, since the former buyer chooses the business model knowing the possession status may misleadingly indicate the ownership, so it is his turn to burden risk when a third party is involved in bona fide. However, the conflicting two transactions are of the same structure, and the only difference lies in the latter’s luck, with no actual risk having occurred. How to make a reasonable risk allocation? This could be a general issue, not limited to financial leasing but all sales retaining possession transactions, such as sales + consigning.

6-How to rank securities over warehouse receipt and over inventory related.

China has no separate warehouse receipt law, where the related issues are mainly governed by a specific chapter on warehousing contractin the Civil Code. Meanwhile, China is accelerating atransferable warehouse receipt system.

Then, what if the owner grants the receipt to bank A as security interest while granting regard to inventory to bank B? The related judicial interpretation by SPC provides the priority by timing date, which differs from UCC-9’s style as of locking up inventory into receipt at its issuance.

A derivative issue is: What if the fixed inventory charge was converted into a floating charge? In China, inventory is expressly listed as qualified collateral for floating charge, but warehouse receipt is not, although the underlying asset is identical. Would the prior floating charge cover the later attached receipt pledge?

7-What is the perfection manner for digital warehouse receipt, registration or possession?

China has built a centralizedmovable registration database, which may facilitate a perfected system for warehouse receipt. The rule regarding digital receipts, on the other hand, is dependent on whether the receipt is defined as having a certificate or not. The one with a certificate is perfected by possession, while the other is by registration. Who can define the issue of with or without a certificate? The receipt issuer.

 That may cause confusion when the issuer offers variant explanations to various bailors, which has occurred inQindao Port event and the recent Foshan aluminium commodity event, and obviously, could occur again. The key point may not be economic efficiency, but economic interests over separate but sparse digital systems.

8-Any Necessity to further divide goods into inventory and equipment

It is closely related to PMSI (purchase money security interest) device. China requires a perfection deadline of within 10 days after delivery. It is uniformed without further discerning inventory from equipment, in contrast to UCC’s requirement of 20 days for equipment and before the delivery date for inventory.

The Chinese PMSI version suits the equipment better. Potential risks may emerge in the case of a highly fluid inventory. In the event that a bank spots another PMSI held by the seller retaining PMSI at his registration but after his advance, the seller may enjoy the priority based on the timing sequence, which is hard for a bank to expect before his advance.

9-How to determine the priority among consecutively attached while conflicting existed PMSIs

A supply chain usually includes many links, and each link unpaid fully may set a PMSI, which means several PMSIs could co-exist over the same batch of movables. Take a car, for instance. If the engine supplier, the manufacturer, and the dealer all retain their titles and perfect it, the car is subject to several valid PMSIs provided the creditor has not paid off. Who might enjoy the PMSI first?

  In another circumstance, if all prior PMSIs die in the ordinary course of business rule when titles are transferred, only the final PMSI survives. But if so, how could the former parties be protected for their unsatisfied credits.

10-The relation between fixed charge over the movables and account receivables from the sales of the movables 

A regular question raised in supply chain finance is which style is better, over goods or over AR. Given China’s security over goods does not cover the proceeds from its sales, both could co-exist separately. Take Gree AC as an example again. A dealer grants Bank A security over AC inventory while granting Bank B security over AR.  Who ranks as superior when the dealer defaults? By timing first rule or by ordinary course of business rule, the result may be absolutely contrary.

 In the case of a floating charge, could the security agreement provide to cover the after-acquired sales proceeds? If so, does this mean that a security over changing ARs can be perfected only once, even if the AR does not fall under a qualified category of floating charge?

 These 10 questions are among the hottest ones in supply chain practice. Clear and unified answers play a crucial role in developing the business.