7 August 2020
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The Civil Code (“Code”) has been passed at the Two Sessions of the National People’s Congress in 2020 after an extensive effort undertaken over a period of several years to re-compile the PRC laws it will replace.
The Code, which will come into effect from 1 January 2021, is largely a consolidation of the existing law. However, it is estimated that around 20% of the Code’s provisions will change the existing law in a substantive way.
This alert summarises some of the key changes, starting with a focus on the additional rights of termination and third party rights, which will affect to some degree all contracts governed by PRC law and then covers other issues which are more specific to financing contracts.
References to Article numbers below are to the corresponding provisions of the Code.
Additional termination stipulations
New termination right
Art. 563 gives a party to a contract containing obligations of an indefinite term a new right to terminate the contract upon reasonable notice to the other party. This is expected to spur parties to give more thought to defining the contractual period in situations typically thought as advantageous to one of the parties (such as warranty provisions with no end date).
Reflecting general principles of PRC law, the new termination right does not apply to contracts subject to specific regulations to the contrary (such as indefinite labour contracts, which can only be terminated in very limited circumstances).
Loss of the right to terminate
Under Art. 564, once a contractually stipulated termination right with no fixed period becomes exercisable, the right is automatically extinguished one year from the date on which the terminating party knew or ought to have known of the ability to terminate the contract.
This new principle underscores the importance of providing for a clear period and mechanics for the exercise of termination rights to avoid the risk of open-ended termination rights being brought to an end by the counterparty (or by operation of law).
It also emphasizes the policy preference of the law to preserve the continued performance of a contract, without giving either party the possibility of relying on an undated open-ended option to terminate the contract.
Release from obligations
Where performance of contractual non-monetary obligations is impossible or impracticable, Art. 580 now allows a party to be released from the contract, thus strengthening the protection which was available under the previous law in the form of a bar to specific performance being sought.
The right to obtain release is subject to important restrictions:
First, the party seeking to be released under Art. 580 must establish that
(i) performance is legally or factually impossible,
(ii) the obligation is inappropriate for specific performance or excessively expensive to perform, or
(iii) the promisee has not demanded performance within a reasonable period.
Second, it must be proved that the purpose of the contract is frustrated as a result; the new right applies only when the underlying rationale of the
contract is called into question as a result of obligations incapable of being performed or not performed in practice.
Third, Art. 580 only allows parties to cut their losses and avoid being saddled with future liabilities to perform onerous contracts. It does not remove liability for any breach of the contract that has already occurred (or would occur as a result of the termination).
Third party rights and obligations
Bringing mainland China in to line with most civil law countries and in step with common law jurisdictions such as the UK and Hong Kong SAR that have reformed the rules of privity of contract, the Code enables the exercise of rights by a third party under a contract to which it is not a party.
Rights
Art. 522 confers rights to require performance by an obligor if the claimant (i) is entitled to do so under the provisions of law or a contract (despite not being party to it), and (ii) had not expressly rejected this entitlement within a reasonable period of time. The right is subject to defences which the debtor may have against the original contractual counterparty.
Art. 522 is drafted in vague terms and needs to be further clarified, on points such as how the rejection is defined, and must the claimant be notified of its rights (in order to establish whether any rejection was made within a reasonable
period). Nor is it clear how the claimant’s rights would be affected by a subsequent variation to the contract.
Pending further legislative guidance on Art. 522, parties to a contract may consider expressly stating that (for the avoidance of doubt) no person who is not a party to the contract shall have any right to claim under it.
Obligations
As is seen in Japan, France and other civil law countries, Article 524 of the Code gives express permission for a non-party to a contract who has a “legitimate interest” in the performance of an obligation under it on behalf of the original contractual obligor and, to the extent that the obligee accepts the non-party’s performance, its contractual relationship with the obligor will be substituted by the non-party.
The Code’s new concept is vaguely worded and leaves further questions. For example, what happens to the original contractual relationship if the non-party partially performs the obligation? Is an obligee, who has obtained a benefit from the non-party, nonetheless entitled to refuse performance and retain its right against the original obligor?
Parties to contracts may wish to deal with the new provision’s lack of defined concepts by (i) excluding the operation of Article 524 entirely, (ii) specifically defining the circumstances in which substitute performance would be acceptable, or (iii) clarifying that the original obligor remains on the hook to the extent that the substitute performance by the non-party has not been expressly accepted by the obligee.
Finance-related provisions
Other new provisions of the Code protect the maintenance of security interests and the rights of debt factors, which should increase the marketability of secured assets and accounts receivable and expand borrowers’ financing options. The scope of factoring business and other forms of security interest has also been expanded.
Transfer of assets subject to mortgage
The current position under PRC law that requires the mortgagee’s consent to the transfer of mortgaged assets (including land use rights, fixed assets, plant and machinery) has been changed by Art. 406, which provides that unless otherwise agreed between the mortgagor and the mortgagee, the mortgaged assets may be transferred by the mortgagor with prior notice to the mortgagee and the mortgage over such assets will not be affected by such transfer.
This should improve the marketability of mortgaged assets from 2021 onwards, though how to assess value (relative to unencumbered assets of the same type) remain to be seen. Mortgagees concerned about the impact of potential transfers should seek to disapply Art. 406 in the terms of the
mortgage agreements. If adverse impact to the mortgage can be proven, the mortgagee can also require sale proceeds to be appropriated or applied to discharge the mortgage.
Commercial factors
The Code makes several clarifications in the interests of commercial factors, as follows:
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once the debtor has been notified of a factoring, any amendment to or termination of the underlying debt obligation without proper justification (likely to include amendments adversely impacting the factoring transaction) will not bind the factor;
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if there are multiple transfers of the same account receivable, all purported transferees rank pari passu with respect to repayment. However, the transferee whose interest is first registered, or whose notice to the debtor is first received, has priority over the others;
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a bona fide factor is given a direct right of action against a debtor involved in a fraudulent/invalid commercial arrangement in relation to the factoring arrangement; and
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the permitted scope of activities of a commercial factor now includes financing, servicing of accounts receivable and guarantees of factored accounts receivable. Recourse and non-recourse factoring have been made two distinct categories.
These changes should encourage factors to tighten up their due diligence and debt administration practices, enabling a more mature commercial factoring market to take shape.
PMSI-like security over chattels
Art. 416 contains a concept similar to purchase money security interest (“PMSI”) under the US Uniform Commercial Code, giving the beneficiary of security over chattels equal to the value of the assets secured, priority to all other perfected security (such as floating mortgage) given by the purchaser over the same assets. The security must be registered within 10 days of delivery of the assets to the purchaser.
It is, however, unclear (and ought to be clarified in further rules/ interpretations) whether Art. 416 applies where the mortgagee is financing the acquisition of the relevant assets, in addition to the situation where the mortgagee acts as seller of the assets.
Expanded scope of financing activities
The Code includes the concept of “other agreements with the effect of security”, in addition to the existing three categories of legal security under PRC law (mortgage, pledge and lien).
This is a potentially significant development, which the market expects will pave the way for such contractual structures as financial leases, retention of title, factoring and conditional sale to be recognised as security. Clarification on how they will be brought within the PRC security law framework is awaited.
The Code should increase the marketability of secured assets and expand borrowers’ financing options.”
Changes to default rules of guarantee agreements
Secured creditors should take note of key changes made by the Code to the default terms of, and enforcement of, guarantee agreements.
Art. 686 provides that unless a contrary intention is expressed, a PRC law guarantee will be construed to be a general guarantee (under which, the guarantor only assumes liability if the principal debtor is unable to discharge the debt).
It is therefore key to ensure that any PRC law guarantee used to secure a debt is expressed to be a “joint and several” guarantee to enable the creditor to make a claim immediately following default by the primary debtor, without having to first seek recourse against it.
Also, if no guarantee term is specified, or if its duration is until full repayment of the debt or is otherwise unclear, the Code deems the term to end six months after the maturity date (reduced from two years under the PRC Guaranty Law).
Conclusion
With 1260 provisions (some 11.7% of which are new), compilation of the Code has been an exercise of unprecedented scale. More implementing rules and judicial interpretations are expected to be forthcoming, in order to clarify the broad principles of the Code, resolve any inconsistencies with previous legislation and provide for any necessary transitional periods. Meanwhile, all parties doing business in mainland China are advised to keep abreast of future legislative changes and structure the terms of their contracts to the extent they would be affected by the changes introduced by the Code.
Implementing rules and judicial interpretations are needed to clarify the broad principles of the Code.”
For further information, please contact:
John Xu, Partner, Linklaters
john.xu@linklaters.com
