By  May Liu

 

I. Types of Asset Securitization Businesses in China

 

In China, there are currently existing two types of asset securitization businesses: (i) one is the securities companies’ asset-backed securitization business, which uses the special assets management scheme as the special purpose vehicle and is supervised by the China Securities Regulatory Commission (the “CSRC”) and mainly traded on the fixed income platform of Shanghai Stock Exchange and the comprehensive protocol platform of Shenzhen Stock Exchange and (ii) the other is the credit asset securitization business, which is supervised by the China Banking Regulatory Commission (the “CBRC”) and the People’s Bank of China (the “PBOC”) and mainly traded on the asset-backed commercial paper platform (which platform is under the charge of National Association of Financial Market Institutional Investors), and the trust companies play a role of trustee institutions in the course of the securitization of credit assets.

 

II. Participating Parties to Securitization of Credit Assets

 

The securitization of credit assets refers to an activity of structured finance, under which the banking financial institutions (the originator) will entrust the credit assets to the trustee institutions, and then such trustee institutions will issue and sell the beneficiary securities to the investment institutions in the form of asset-backed security (the “ABS”) and will use the cash derived from such credit assets to pay the returns on the ABS.

 

A. Originator (acting as the trustor): It shall be the banking financial institutions;

 

B. Trustee Institutions (acting as the trustee)/Issuer: Generally, it shall be the trust companies;

 

C. Loan Service Providers: Generally, it shall be the originator;

 

D. Fund Depository Institutions: Generally, it shall be the banks, but it shall not be either the originator or the loan service providers at a same deal; 

 

E. Securities Registration and Custodian Agencies: it shall be the Inter-bank Market Clearing Company Limited by Shares (namely, Shanghai Clearing House);

 

F. Underwriters: It must be an underwriting group and each of which must be a financial institution;

 

G. Investment Institutions (namely, the holders of ABS): the following approved and qualified non-banking institutional investors are encouraged to invest in the ABS: insurance companies, securities investment funds, enterprise annuity funds, national social security fund, etc.  For each single ABS product, a banking financial institution shall not, in principle, purchase or hold a percentage of ABS greater than 40% of the total ABS issued therefor.

 

III. Types of the Underlying Assets for Securitization of Credit Assets

 

Financial institutions are encouraged to use the following credit assets as the underlying assets for securitization of credit assets so as to enrich the types of underlying assets for credit asset securitization: loans to major national infrastructure projects, agriculture-related loans, loans to small and medium-sized enterprises, loans to local government financing vehicles that are in compliance with the law after clean-up, loans for energy conservation and emission reduction, auto loans and other diversified credit assets that meet relevant requirements.  A product of credit asset securitization shall be simple and clear in structure.  Pilot programs on re-securitization and synthetic securitization are not allowed during the current round of expansion.

 

IV. Process of Securitization of Credit Assets

 

A. Restructure the cash flows and assemble the securitized assets

 

The originator will (i) set the goal of asset securitization per its financing needs; (ii) clean up, estimate and assess its credit assets capable of generating future cash flows; (iii) conclude its primary judgment on the average degree of the whole portfolios’ cash flows; (iv) assess the borrower’s credit and the market value of the collateral for the extended loan, etc.; (v) assemble the assets of receivables and predictable cash flows; (vi) restructure the cash flows in accordance with the structure of maturities, and the rearrangement of the principal and interest or reallocation of the related risks; and (vii) identify the targeted assets per the goal of asset securitization and pool these assets.

       

B. Set up a special purpose trust (the “SPT”) to fulfill true sale of credit assets and achieve the bankruptcy remote

 

The originator will set up a SPT and transfer the securitized assets (as the trust assets) to a trustee institution through the SPT.  Then, the trustee institution will issue the ABS.

  

C. Improve the deal structure and enhance the credit rating

 

[The trustee institutions will] take a series of the following steps to improve the deal structure of asset securitization: (i) conclude the loan service contract with the loan service institution for assets pool, (ii) sign the custody contract with the custodian bank, (iii) reach the revolving credit agreement with the banks for liquidity support in necessary time, (iv) enter into the underwriting agreement with the underwriter, etc.  At the same time, after conducting certain risk analysis to the securitized assets, the SPT must conduct the risk restructuring for particular portfolio assets, and make up for the predictable losses by using additional source of cash flows to reduce the predictable credit risk and enhance the credit rating of the ABS.

 

D. Credit rating of asset securitization

 

The credit rating of the ABS serves as an investment basis for the institutional investors and thus constitutes a vital part of the asset securitization.  Two duly qualified credit rating institutions shall be engaged to make the initial credit rating and the follow-up credit ratings for the issuance and trading of the ABS on the national inter-bank bond market, and pursuant to relevant rules and policies, the credit rating report shall be submitted to the financial regulatory agencies when applying for issuance of the ABS.

 

E. Arrange for sale of securities and payment to the originator

 

After the enhancement of the credit and the announcement of the rating result, the underwriter shall be responsible for the sale of ABS to the institutional investors.  The sale of the securities could be either by a firm commitment or by proxy.  After the SPT receives from the underwriters the revenues generated by the sale and issuance of the securities, the SPT will pay and deliver a large part of the revenues to the originator.  Thus, the originator’s financing purpose will have been achieved.   

 

For each single credit securitization scheme, the originator shall hold a certain percentage of the most junior class (or the equity class) ABS for a period not less than the term of the equity class securities, and which percentage shall be, in principle, not lower than 5% of total ABS issued for such securitization scheme.

 

F.Listing and trading

 

Within two months following the consummation of issuance of ABS on the national inter-bank bond market, trustee institutions may apply for listing and trading of the ABS on the national inter-bank bond market to fulfill the liquidity of the ABS.

 

G. Payment on time

 

The trustee institutions will manage the assets pool and accordingly have the responsibilities to collect and record the cash revenues generated by the assets pool, and further distribute such revenues to the investors on time.

 

V. Principal Legal Documentation

 

A. Trust Contract

 

Contracting parties: (i) the originator acting as the trustor and (ii) the trustee institution acting as the trustee;

 

Main content: (i) the originator transfers the securitized assets (as the trust assets) to the trustee institution (the trust company) and receives transfer price generated by the sale and issuance of the ABS; and (ii) the trustee institution (acting as the trustee) shall have the right to manage, use and dispose of the trust assets, convene the meetings of the securities holders, and engage the underwriters to underwrite the securities.

 

B. Fund Depository Contract

 

Contracting parties: trustee institution (the trust companies) and fund depository institution (the banks);

 

Main content: (i) the trustee institution opens a trust account (with the depositor and) in the name of SPT and delivers instructions with respect to the trust account in accordance with the Trust Contract; and (ii) the fund depository institution monitors the trustee’s instructions.

 

C. Loan Service Contract

 

Contracting parties: trustee institution (trust company) and loan service provider;

 

Main content: the loan service provider (i) offers loan service and management per the trustee’s instructions, receives the principal and interest of the loan and transfers such to the trust account, and (ii) periodically provides the trustee institution with the assets management report, and puts forward solutions to the borrower’s breach of contract.

   

C. Managing Underwriter Agreement

 

Contracting parties: trustee institution (trust company), the originator, and the managing underwriter;

 

Main content: (i) the trustee institution engages the underwriters to underwrite the ABS; and (ii) the managing underwriter should assist in setting up an underwriting group.

   

D. Underwriting Group Agreement

 

Contracting parties: the managing underwriter and other underwriters.

 

VI. A Diagram Illustrating the Deal Structure of Credit Assets Securitization

 

 

 

VII. Approval Procedure

 

A. Approval for Qualification.  The trust investment company shall apply to the CBRC for SPT qualification.   

 

B. Approval for securitization of credit assets.  The originator and the trustee institution shall submit a joint application to the CBRC for approval of the securitization of specific credit assets.

 

C. Approval for issuance of ABS.  The trustee institution (the trust companies) shall submit an application to the PBOC for approval of the trading of ABS on national inter-bank bond market.

 

D. Approval for trading of ABS.  Within two months following the consummation of issuance of ABS on the national inter-bank bond market, the trustee institution may apply to the CBRC for listing and trading of the ABS on the national inter-bank bond market.

 

VIII. Registration and Custody

 

The issuer shall register the ABS with the Inter-bank Market Clearing Company Limited by Shares (namely, Shanghai Clearing House).

 

IX. Taxation

 

A. Stamp Tax: Exempted temporarily.

 

B. Business Tax

 

(a) 5% business tax shall be levied on the entire interest income received by the trustee institution and derived from the trust project of the credit assets managed by the trustee institution.

  

(b) In the course of securitization of credit assets, 5% business tax shall be levied on the following income: (i) the service fees received by the loan service institutions, (ii) the commissions received by the trustee institutions, (iii) the custody fees received by the fund depository institutions, (iv) the trustee fees received by the securities registration and custodian agencies, and (v) other service fees received by other institutions offering services for the trading of ABS.

  

C. Income Tax

 

(a) 25% income tax will be levied on such proceeds acquired by the originator and gained from the transfer of credit assets.

 

(b) As to such portion of proceeds generated from the trust project and distributed to the institutional investors, in the trust stage, the income tax is temporarily exempted thereon; 

 

As to such portion of proceeds generated from the trust project but not distributed to the institutional investors, in the trust stage, the income tax shall be paid by the trustee institutions in accordance with the PRC Law on Enterprise Income Tax (the “Enterprise Income Tax Law”);

 

As to such proceeds for which the income tax has been paid in the trust stage, when they are distributed to the institutional investors, the institutional investors shall deal with such proceeds in accordance with the provisions relating to after-tax income under the Enterprise Income Tax Law.

 

(c) In the course of securitization of credit assets, 25% income tax shall be levied on the following income: (i) the service fees received by the loan service institutions, (ii) the commissions received by the trustee institutions, (iii) the custody fees received by the fund depository institutions, (iv) the trustee fees received by the securities registration and custodian agencies, and (v) other service fees received by other institutions offering services for the trading of ABS.

 

(d) During the exemption period [for the distributed proceeds mentioned above in paragraph C(b)(i)], the institutional investors shall recognize such investment returns generated from the trust project as taxable income in accordance the accrue basis accounting principle, and calculate and pay the income tax in accordance with the Enterprise Income Tax Law. 

 

The institutional investors shall calculate and pay the income tax for earnings acquired by them form the trading of ABS in accordance with the Enterprise Income Tax Law; and the losses sustained or suffered by the institutional investors by reason of the ABS trading shall be deductible in accordance with the Enterprise Income Tax Law.

 

The institutional investors shall calculate and pay the income tax for proceeds acquired by them form the liquidation of the trust project in accordance with the Enterprise Income Tax Law; and the losses sustained or suffered by the institutional investors as a result of the liquidation of the trust project shall be deductible in accordance with the Enterprise Income Tax Law.

 

(This article was originally written in Chinese, and the English version was translated by Mr. Wu Wang, a Beijing-based senior associate with Global Law Office.)

 

Ms. May Liu is a Beijing-based partner with Global Law Office who specializes in mergers & acquisitions, foreign direct investment, general banking, international syndication, acquisition financing, project financing, trading financing, aircraft and shipping financing, real estate financing, private equity/venture capital investment and capital markets. (E-mail: mayliu@glo.com.cn)