Secured Transactions Reform: Opening US$570 Billion in Credit for Businesses

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1 Secured Transactions Reform: Opening US$570 Billion in Credit for Businesses China June 2009 Investment Climate Advisory Services World Bank Group With funding from FIAS, the multi-donor investment climate advisory service

2 About the Investment Climate Advisory Services of the World Bank Group The Investment Climate Advisory Services of the World Bank Group helps governments of developing and transition countries improve and simplify business regulations, attract and retain investments, helping clients foster growth and create jobs. It is funded by three World Bank Group members the International Finance Corporation (IFC), the Multilateral Investment Guarantee Agency (MIGA), and the World Bank and by several donor partners who collaborate with us through the multi-donor FIAS platform. The findings, interpretations and conclusions included in this note are those of the author and do not necessarily reflect the view of the Executive Directors of the World Bank Group or the governments they represent. About the Authors Sevi Simavi, is currently a Global Product Leader at IFC. She led the Secured Transactions Program of IFC at the time of this case study and during China s Property Law reform process. Carlotta Saporito, is currently a Financial Sector Specialist at the African Development Bank. Previously, she was the Program Analyst for the Secured Transactions Program at IFC. Alejandro Alvarez de la Campa, is currently the Global Product Leader for the Secured Transactions Program at the International Finance Corporation.

3 China's secured financing system is undergoing fundamental changes to keep pace with the country's dynamic economy. Since 2004, the International Finance Corporation has worked closely with the People s Bank of China (PBOC) and the National People s Congress (NPC) to support the latest development and reforms of China s secured financing laws and registry system. The goal is to encourage financing against valuable business assets such as inventory and receivables and to improve access to business credit for China s large number of small and medium enterprises (SMEs). The Case for Reform In most developed economies, businesses can use movable assets such as inventory and receivables as security to generate capital. In the United States, for example, movable collateral accounts for 70% of small business financing. In China, access to credit by SMEs has been severely limited by antiquated laws which restrict valuable assets such as inventory, receivables and rural land from being used as collateral. The result is more than 16 trillion RMB in dead capital assets owned by private firms, SMEs and farmers that cannot be used to generate loans to fund business investment and growth. 1 According to a joint PBOC-IFC survey of Chinese financial institutions, 80% of firms reported access to credit as a significant obstacle more than any other business constraint. 2 Access to credit by small firms is particularly difficult. Unlike large stateowned enterprises which can rely on state-subsidized credit and large private companies with strong balance sheets, small firms in China must provide collateral in the form of real estate to secure bank loans. 3 Since half of SMEs assets are held in inventory and receivables 4 and rural land is not permitted to be mortgaged, small firms in China (90% of which are rural enterprises) have little to offer in terms of collateral. As a result, SME loans in China is less than half that reported by firms in India, Thailand and Korea. 5 Many SMEs resort to paying exorbitant interests to pawn shops and sometimes to illegal loan sharks to meet their financing needs. Legal Obstacles to Secured Financing in China One key factor contributing to the SME financing difficulties in China is the severe restriction on the use of movable collateral under China s secured financing laws. Until 2007, secured financing in China was governed by the 1985 Security Law (the Security 1 See Foreign Investment Advisory Services of the World Bank Group and the Private Enterprise Partnership for China of the International Finance Corporation, Reforming Collateral Laws and Registries: International Best Practices and the Case of China (hereinafter referred to as the WB Report ) (March, 2006). This calculation is a lower bound as it does not include the dead capital caused by legal restrictions on taking security over other types of assets, such as crops and intellectual property. 2 See WB Report, id., pp. [ ]. 3 PBOC, Survey of the Financing Mechanisms for China s Small and Medium Enterprises, China CITIC Press (2005) (hereinafter referred to as the PBOC SME Report ). 4 See WB Report, id., pp. [ ]. 5 World Bank Investment Climate Assessments.

4 Law ) which allows few types of movable assets as security. Valuable business assets such as equipment, inventory and receivables are all excluded. Under such legal framework, the China secured transactions law lacked all the essential elements required to support the efficient and effective utilization of the secured lending market. Broad Scope of Permissible Collateral: A secured transactions law is of maximum use when it permits a broad range of movable assets, tangible and intangible, present and future-acquired assets, to be used as collateral. Under the Security Law, however, neither inventory nor receivables are permissible collateral. The law also requires the collateral and the secured debt to be described specifically in a security agreement. In practical terms this precludes borrowers from pledging future-acquired assets, a changing pool of assets, an entire business, or using security for a loan that fluctuates in value. Centralized Publicity System. A key feature of modern secured transactions laws is an efficient centralized registration system to notify third parties of the existence of a security interest and to establish the priority status of the security interest based on the time of registration. The collateral registry system in China is fragmented across more than a dozen government agencies and is fraught with problems that make it difficult and in many cases, impossible to register or search for a security interest. As a result, costs of registration are high and in practice some assets cannot be used as security because no registry will register an interest. Clear and Comprehensive Priority Rules. Modern secured transactions laws provide clear and comprehensive priority rules to establish the order of priority among competing claims to the same collateral upon a debtor s default. In China, a creditor s security interest in the collateral is not protected due to a lack of clear priority rules. Claimants other than the secured creditor, in particular those with government claims or judgment liens, may take priority over the secured creditor, introducing enormous uncertainty of debt recovery and raising the cost of credit accordingly. Effective Enforcement. Speedy, effective and inexpensive enforcement mechanisms are essential to realizing security interests. In China, the judicial system is the primary venue for enforcing security interests. The Security Law does not allow non-judicial enforcement or enforcement by agreement between parties, thereby increasing the delays and costs to recover security upon default by the debtor.

5 At the beginning of the project, China scored 0 out of an 8-point index on the degree to which secured transactions laws facilitate lending (Table 1). 6 By contrast, many of the 8 features in the collateral index are standard in most wealthy economies. The United States provides 7 of the 8 elements. Germany, with its fiduciary title system, scores a 5 (Table 1). Ireland, Singapore, Slovakia and the United Kingdom provide all 8 features. Table 1: Building Measures of Secured Transactions Law Feature of Secured Transactions Laws China USA Germany Ireland Slovakia 1. General description of assets No Yes No Yes Yes permitted 2. General description of debt No Yes Yes Yes Yes permitted 3. Any legal or natural person may take No Yes Yes Yes Yes security without restriction 4. Unified registry including charges No No No Yes Yes over movable property is in operation 5. Collateral registry can be accessed No Yes No Yes Yes online 6. Secured creditor has priority No Yes Yes Yes Yes 7. Parties may agree on enforcement No Yes Yes Yes Yes procedures by contract 8. Secured creditor may seize and sell No Yes Yes Yes Yes collateral out of court Collateral Index Score (sum of yes responses) Economic analysis suggests that reforms to increase China s collateral law score will considerably improve its lending markets. Countries that score higher on the collateral index have greater access to credit, better ratings of financial system stability, lower rates of non-performing loans, and a lower cost of credit. 7 Development of a modern secured transactions legal system to allow greater use of movable assets is critical for improving access to business financing in China. Effective secured transactions laws help borrowers obtain capital and help lenders ensure they will be repaid. They provide for a broad scope of assets that may be used as security, clear rules on priority for the secured creditor, cheap and simple registration of security rights, and effective enforcement of security upon default. Without effective secured 6 See WB Report, id., pp. [ ]. Variables in the index are broadly consistent with principles of good practice in secured transactions laws that are promoted by international agencies ranging from the EBRD, OAS, UNCITRAL and the ADB. 7 See WB Report, id., pp. [ ]..

6 transactions laws, lending is more risky. Banks respond by increasing the cost of credit to cover their risk and by lending less, especially to more risky borrowers such as small firms and low-income households. The Reform Process and the Key Stakeholders The success of a legal reform of this magnitude in a country like China depends on whether key stakeholders representing different interests within the government can be convinced of the need for change and can work together to come up with a solution. In the case of secured financing law reform, the active role of PBOC as an interested government agency proves to be essential, both in terms of spearheading the reform efforts and its willingness to use its political capital to build the support required for the reform. PBOC and the Joint Project with IFC As early as 2004, PBOC recognized wide spread financing difficulties among SMEs, which accounted for 80% of all enterprises in China. 8 It soon sought technical support from the IFC through a joint research project (the PBOC-WB Project ) to explore ways to improve SMEs access to credit through secured transactions law reform. Experts from the PBOC Research Bureau and the IFC Team conducted extensive field interviews with Chinese banks, trade creditors, businesses (both state and privately-owned), as well as officials from movable collateral registries at the central and local levels. The PBOC-WB Project also included a survey of Chinese financial institutions on current secured lending practices, the first of its kind for China. In addition, the IFC Team provided analysis and advice to PBOC on international best practice in secured transactions laws and on reform experience from other countries. In 2005, PBOC, in collaboration with the IFC Team developed detailed recommendations for reforming the legal system, including adopting principles of modern secured financing law in the Property Law, China s first comprehensive law on ownership and use of different types of property rights. 9 Backed by these studies and reports, PBOC actively shared its findings with other key government agencies such as the State Council, the China Banking Regulatory Commission and various movable collateral registries, as well as NPC which was already in the process of drafting the security rights chapter of the Property Law. A series of high-level seminars sponsored by PBOC and the IFC Team on secured financing law reform provided an effective platform for government officials, lawmakers, bankers, 8 PBOC, Survey of the Financing Mechanisms for China s Small and Medium Enterprises, China CITIC Press (2005) (hereinafter referred to as the PBOC SME Report ). 9 The Research Bureau of the People s Bank of China, the Foreign Investment Advisory Services of the World Bank Group and the China Project Development Facility of the International Finance Corporation, Secured Transactions Reform and Credit Market Development in China, published by the China CITIC Press (2006).

7 judges, lawyers and scholars to discuss and debate the merits of reform and to compare the existing system against international best practice benchmarks. Through this process, PBOC was able build awareness among key stakeholders of the need to reform China s existing legal and institutional infrastructure in order to support a modern secured financing system capable of providing easy and inexpensive access to credit for businesses. The Engagement of NPC The new Property Law offers the PBOC-WB Project an opportunity to introduce modern secured transactions law principles and to reform the legal regime established under the Security Law. Members of the NPC Legislative Affairs Commission (NPCLAC), the group responsible for drafting the secured transactions section of the Property Law, were invited to participate in almost all of the high-level awareness-building seminars. The PBOC and the IFC Team also submitted formal comments to the NPC when the 4 th draft of the Property Law was made public in July 2005 and provided ongoing advice to NPCLAC on a wide range of issues important for bringing the law more in line with international best practice. In addition, the IFC sponsored a study tour for NPCLAC and PBOC officials to learn firsthand how secured financing operates under the modern secured transactions law systems in the US and Canada. The Chinese officials visited movable collateral registries and held extensive discussion with bankers and lawyers on the application and the practical impact of the law. They also participated in seminars offered by experts from North America and Europe for an in-depth understanding of the different legal systems and the reform experiences around the world. The impact of the study tour was enormous: Both NPCLAC and PBOC officials left with an unmistakable understanding of the strength of a modern secured transactions law system in fostering and supporting easy and inexpensive access to credit. The engagement of NPCLAC into the reform process has several advantages: (1) it made lawmakers well aware of the dire need to improve SME financing and the negative impact of the existing legal obstacles; (2) it allowed lawmakers to learn from experiences of advanced economies and other countries which have undergone similar reforms; and (2) it provided lawmakers with the legal expertise needed to navigate a technically complex and challenging area of commercial lawmaking. Input from China s Financial Community The involvement of China s financial community is equally important. In the survey conducted by the PBOC-WB Project, 98% of the banks supported reforming the system. 10 Many Chinese banks, in practice, had already been pushing the limits of the 10 WB-PBOC Report, p. 199.

8 law by lending against the future income streams generated from highway toll collection, cable TV services, real estate management contracts, etc. From the lenders perspective, the legal system created by the Security Law was out of touch with commercial reality. At the same time, however, lenders were keenly aware that both the legality and enforceability of such transactions were not assured under the existing legal framework. PBOC s close ties with the financial community made it possible for Chinese lenders to convey their views directly to lawmakers through the various awareness-building seminars offered through the PBOC-WB Project. In a country where commercial lawmaking is heavily dominated by government officials and scholars who have little understanding of the workings of market forces, the input of the financial community brought a fresh perspective to NPC on the practical need of secured financing and the economic incentives that drive parties to financing transactions. Progress and Impact of the Reform The collaborative reform efforts by key stakeholders have led to significant progress in reforming China s secured financing laws. The Property Law Until 2007, secured financing in China was governed by the Security Law of 1995, which had a number of deficiencies when compared to international best practices in secured transactions. The Security law was restrictive in the scope of permissible collateral (machinery and motor vehicles for tangible and certain rights on financial instruments for intangibles), imposed excessive formalities in creating security rights, and lacked clear priority rules, an effective publicity mechanism and an effective enforcement mechanism. In 2005, the People s Bank of China (PBOC), our counterpart/client for the project, in collaboration with the IFC team developed detailed recommendations for reforming the legal system, including the adoption of a modern secured financing system in the Property Law, China s first comprehensive law on ownership. The involvement, from an early stage, of the National People s Congress Legislative Affairs Commission (NPCLAC), which was in charge of approving the draft law, proved crucial in garnering support from this key stakeholder. After numerous consultations, workshops, drafting efforts and reaching consensus among the main stakeholders, in March 2007, the NPC passed the historic Property Law, which adopted a number of important principles of modern secured transactions systems. The chapter on secured transactions significantly improves the legal framework for asset based finance in the country. Major improvements under the Law include:

9 Expanding the scope of movable collateral by adopting a single unitary security interest which applies to movable property of all kind, tangible and intangible, present and future, eliminating the positive list of assets that can be used and allowing all types of movables as collateral. Simplifying the formalities required for creating security interests and improving the publicity of the system by: allowing notice registration, eliminating the need to register the security agreement; allowing any person, natural or legal, to give a security interest; creating an electronic registry of security interests allowing public on-line access to information on secuirty interests. A more transparent priority scheme for secured and unsecured creditors, by incorporating specific rules about priority by date of registration, rules on proceeds, buyers of collateral, special priority rules or super-priorities, etc. As a result, China s collateral law index score which measures the degree to which secured transactions laws facilitate lending (see Table 1 above) is raised from 0 to In addition to the enactment of the Property Law, the project team also contributed to the drafting of other important pieces of legislation that were required to proper implement the secured transactions aspects of the property law. These laws were: 1) PBOC's regulation on accounts receivable registration; and 2) PBOC's leasing regulations. Registry for pledges of receivables and leasing With IFC's support, in October 2007, the PBOC Credit Reference Center (CRC) created a national online registry for pledges of receivables, the first of this kind for China. The costs for the development of the registry (software and hardware) were financed by our client (PBOC) but IFC provided the know-how on the best practices needed to develop a moder on-line registry. The registry is located in Shanghai. The new receivables registry is easy to use and efficient, incorporating all the key features of a modern movable collateral registry (accesible on-line to the public, user accounts, information limited to the creditor, debtor and the description of assets, centralized information, reasonable fees, etc). In conjunction with the launch of the registry, the PBOC also issued receivables registry rules which are in line with modern collateral registry principles. As of June 2009, the CRC had impressive results that consists of: Over 75,000 registration (notices) of security interests representing loans with a value estimated at over US$570 billion. Of the US$570 billion in financing, approximately US$240 billion corresponds to SME financing. 48,000 SMEs are registered as secured debtors and are benefiting from increased access to credit (SMEs that are receiving loans secured by receivables). 11 Doing Business 2009

10 More than 100,000 searches on existing pledges movable assets have been recorded in the registry. The % of moveable based lending in China went from 12%, pre-reform and prior to the creation of the receivables registry, to 20 % after the creation of it. The use of receivables as collateral has led to the development of a factoring industry in the country. The value of domestic factoring has reached a volume of US$ 21 billion. Around 3,000 people have participated in workshops, trainings and awareness raising events. Among the registry s 5,000 users are banks, guarantee companies, law firms, finance companies and pawn shops. The user experience with the registration system has been overwhelmingly positive. The reform of the secured transactions system in China has helped put in circulation over US$ 2 trillion of movable assets that could not be used before as collateral. In June 2009, PBOC s CRC also started registering leasing transactions in the registry, after passing leasing regulations to harmonize the registration of all credit related transactions (including leases) into the same registry. Remaining challenges These efforts to expand the scope of permissible movable collateral under the Property Law and to improve the movable security registry have opened the door for the development of a modern secured financing system in China. However, a few challenges remain: The Property Law remains vague in a few areas, notably rules regarding registration, given the parallel system of registries that exist. The Property Law fails to consolidate more than 15 movable collateral registries into a single nationwide system. The IFC project only focus on creating an electronic registry for secuirty interests in receivables, but could not focus, due to lack of political support, on centralizing all types of secuirty interests on movable assets into one single electronic registry, by unifying the 15 registries for machinery, equipment and inventory. The result of this is that, at the moment, receivables are registered in PBOC's new electronic registry created with the support of IFC, but the rest of security interests on movable assets (machinery, equipment and inventory) are registered in 15 decentralized registries, including the Administration of Industry and Commerce (AIC). The issue with this is that not all the information on pledges of assets is contained in a single depository, where financial institutions can search for existing pledges. In addition to this, the 15 decentralized registries are not accesible on-line and, therefore, the search for existing pledges in real time is not possible, creating additional risks to financial institutions when lending accepting movable assets as collateral. In the second

11 phase of this project IFC will focus on working with the State Council (responsible for the 15 decentralized registries) in trying to merge all the registries into one and make the information available on-line to users. The enforcement process remains court-oriented, while private enforcement or out of court enforcement is not permitted. The critical issue of how to improve the judicial enforcement process is still left primarily to the judicial system to address. wb N:\FIAS\Alejandro\BEE PRODUCT DEVELOPMENT\COLLATERAL REGISTRIES\Operational support\eap\china\case study\case Study Secured Transactions in China.doc 9/4/2009 3:50:00 PM