By  Wei Qin

 

On March 15, 2013, the China Securities Regulatory Commission (the “CSRC”) promulgated the Administrative Provisions on the Securities Companies’ Asset-backed Securitization Business, which signaled that the securities companies’ asset-backed securitization business (the “ABS Business”) under the supervision of the CSRC has shifted from the previous pilot stage to the regular supervision stage.  During the pilot stage, the legal basis for the securities companies to conduct the ABS Business is the Guidance on Pilot Securities Companies Asset-backed Securitization of (For Trial) issued by the CSRC (No. [2009]224).

    
The author has participated in the first batch of the pilot ABS Business, rendered legal opinions on the relevant ABS Business to the CSRC and the exchanges, and as a retained legal counsel, he also assisted multiple securities companies to succeed in setting up special assets management scheme (the “Special Scheme”), and issuing and listing the asset-backed security on the Shanghai Stock Exchange or the Shenzhen Stock Exchange.  Currently, a number of the ABS projects for which the author is responsible are being examined by the CSRC or in preparation for approval.  

By this article, the author intended to brief the readers about the ABS Business from a lawyer’s angle and expected that the readers could benefit and get some enlightenment from this article.

I. Overview of the ABS Business in China

The asset-backed securitization or ABS, as one kind of structured finances, means a technique or process enabling an array of assets (the “Assets” or “Underlying Assets”), which are capable of generating predictable and stable cash flows income in the future, to be converted into certain securitization products via particular structural arrangement and coupling with corresponding credit enhancement, and which products can be traded on the financial market and possess certain credit rating.
      
The ABS is an emerging product in the financial sector during the recent 30 years, and it evolved in the USA and developed rapidly in Europe, Japan, etc., and currently it spreads over worldwide in a quick speed.  As to the ABS in China, since initially launched in 2004, it mainly consists of two systems: (i) one is the securitization of credit assets, which is originated by the banks and other financial institutions, and traded on the national inter-bank bond market upon the approval of the China Banking Regulatory Commission (the “CBRC”), and (ii) the other is the securitization of enterprises’ assets (including the state-run institutions’ assets), (the products of ) which are issued by the securities companies through a Special Scheme and in the form of ABS, and traded and listed on the Shanghai Stock Exchange or the Shenzhen Stock Exchange upon the approval of the CSRC.  In addition, the insurance companies, fund management companies, trust companies and other institutions are also allowed to conduct the ABS Business in accordance with the relevant rules regulating such business in their respective sectors.   
 

Please see below a comparison between such two systems of ABS:

 

 

Items	CBRC System	CSRC System
Applicable Rules	Measures on Administration of Pilot Credit Asset-backed Securitization ([2005] No. 7)	Administrative Provisions on the Securities Companies’ Asset-backed Securitization Business (No. [2013]16)
Originator	Financial institutions	Enterprise and/or state-run institutions
Issuer (SPV）	Special purpose trust	Special Scheme originated by the securities companies
Listing and Trading	National inter-bank bond market	Stock exchanges
Underlying Assets	Limited to the credit assets of financial institutions	Assets capable of generating stable cash flows, such as the rights to claim repayment of debts and the rights to claim proceeds generated by certain assets, etc.
Principal Investors	Commercial banks, insurance companies, etc.	Institutional investors like securities investment funds, social security fund, securities companies, finance companies, enterprises group, etc.

 

 

The Underlying Assets for the ABS Business include the rights to claim proceeds generated by the leases, the rights to claim highway tolls, the rights to claim receivables generated by the acquisition of assets, the rights to claim proceeds generated by the sale of electricity, the rights to claim receivables generated by the BT project of infrastructure construction, the rights to claim the proceeds generated by the disposal of urban construction sewage.  The ABS can be sorted as two different types in accordance with the status of the Underlying Assets—securitization of existing assets and securitization of future assets.  The securitization of existing assets lived in the form of contracts or agreements, such as various receivables, mortgage loans, etc., which reflect a debt-credit relationship; thus, the securitization of existing assets, as a matter of fact, can be deemed to be “securitization of rights to claim repayment of debts” (or “securitization of creditor’s rights”).  In contrast to the securitization of existing assets, the securitization of future assets is conditioned on certain legal rights, which could be a title or other rights to a particular property, such as the rights to claim highway tolls, thus in nature, it could be deemed to be one kind of “securitization of the rights to claim proceeds generated by a particular assets (or “securitization of rights of remuneration”).

 

Set out below are some ABS products of securities companies issued and listed successfully up to date:

 

Asset-backed Security	Issuer (Originator)	Date of Issuance	Total Issue Amount  (RMB/100 Million)	Maturity (Year)
Securities Backed by Network Rental Fees Charged by China Unicom CDMA	China Unicom New Space Co., Ltd.	Aug., 2005	95.00	2.7
Special Assets Management Scheme of Dongguan-Shenzhen Highway Rolls	Dongguan Development Holdings Co., Ltd.	Dec., 2005	5.80	1.5
Securities Backed by  China Netcom’s Receivables	China Netcom (Group) Co., Ltd.	Mar., 2006	103.10	4.68
Special Assets Management Scheme of Far Eastern’s First Tranche Securities Backed by Leases	Far Eastern International Leasing Co., Ltd.	May, 2006	4.77	2.4
Special Assets Management Scheme of Charges for Electricity of Huaneng Nancang River	Huaneng Nancang River Hydropower co., Ltd.	May, 2006	20.00	5
Securities Backed by BT  Construction Project of Pudong	Shanghai Pudong Construction Company Limited by Shares	Jun., 2006	4.10	4
Securities Backed by Charges for Disposal of Nanjing Urban Construction Sewage	Nanjing Urban Construction Holding (Group) Co., Ltd.	Jul., 2006	7.21	4
Special Assets Management Scheme of Securities Backed by Nan-tong-tian Sale of Electricity	Nantong Tiansheng Harbour Power Co., Ltd.	Aug., 2006	8.00	3
Special Assets Management Scheme of Repurchase Price Paid on Jinagsu Wuzhong BT Project	Jiangsu Wuzhong International Trade Group Co., Ltd.	Aug., 2006	15.88	5.31
Far Eastern Second Tranche Special Assets Management Scheme	Far Eastern International Leasing Co., Ltd.	Aug., 2011	12.79	1.90
Special Assets Management Scheme of Securities Backed by Charges for Disposal of Sewage	Nanjing Public Holding (Group) Co., Ltd.	Mar., 2012	13.30	5
Special Assets Management Scheme of Securities Backed by  Overseas Chinese Town’s Theme Park Ticket	Overseas Chinese Town Co., Ltd.	Dec., 2012	18.5	3＋2
Special Assets Management Scheme of ICBC Leasing	ICBC Financial Leasing Co., Ltd.	Dec., 2012	16.3	2.25
Special Assets Management Scheme of Minsheng Financial Leasing	Minsheng Financial Leasing Co., Ltd.	Pending	19.02	1.75

 

II. Main Features of ABS Business

A. The ABS Business is one kind of direct financings but different from stock or bond, and its main features are as follows:

(a) The enterprise segregates certain profitable assets capable of generating stable cash flows (from its total assets) and issues asset-backed security on the basis of such assets (namely, the Underlying Assets); and the investor will profit from the cash flows income generated by such Underlying Assets;
 
(b) The Special Scheme will purchase or use other lawful means to acquire the Underlying Assets; when the enterprise comes to bankruptcy, the Underlying Assets shall not be deemed to be the bankruptcy estate so as to achieve the “bankruptcy remote”;

(c) Different from the stock or bond, it will not directly form a “financing relationship” between the financing enterprise and the investors.  Instead, it is a pattern of structure finance, the financing enterprise will use its profitable assets to constitute the Underlying Assets and then acquire the funds by issuing and selling the asset-backed security to investors via the Special Scheme established by the securities companies and reimburse the principal and interest to investors from the proceeds in cash generated by the Underlying Assets;

(d) The asset-backed security has finite term and stable rate of return and bears the nature of fixed-return products;
(e) The asset-backed security can be classified into priority classes and subprime classes so as to explicitly deliver the investors different risks v. returns.  The priority class asset-backed security has the priority to participate in the distribution of the Underlying Assets.
 
B. Impacts of ABS on corporate accounting

 

 

 

Underlying Assets	Creditor’s  Rights		Rights of Remuneration
Transfer of Risks and Premium	The risks and premium can be transferred to a full extent; for instance, the originator or its mother company dose not need to provide collateral or counter guarantee.		The risks and premium can be transferred to some extent, and the originator or its mother company is still subject to recourse against it.	The risks and premium cannot be transferred.
Accounting Treatment	Can be recognized as “true sale”		Cannot be recognized as “true sale”
Off Balance Sheet (Y/N)	Y		N
Accounting record of receipt of raised funds (not taking into account such portion of subprime class securities subscribed by the originator)	Credit: Cash in bank Debt: The item corresponding to the sale of specific assets ( such as holding  maturity investments or long-term bond investment, accounts receivable)		Credit: Cash in bank Debt: Long-term account payable
Main impacts on the financial ratios:
Debt/Asset Ratio		The debt/asset ratio will remain the same upon the receipt of raised funds; The amount of total debts and assets will be simultaneously decreased upon the repayment of the debts by using the raised funds, as a result thereof, the debt/asset ratio will be decreased as well.	The amount of debts and assets will simultaneously be increased upon the receipt of raised funds, as a result thereof, the debt/asset ratio will be increased as well; The amount of total debts and assets will be simultaneously decreased upon the repayment of the debts by using the raised funds, as a result thereof, the debt/asset ratio will be decreased as well.
Liquidity Ratio/Quick Assets Ratio		The liquidity ratio will be increased upon the receipt of raised funds; The liquidity ratio will be subject to little change upon the repayment of current debts by using the raised funds; The liquidity ratio will be decreased to the original level upon the repayment of non-current debts (on the assumption that the current assets and current debts remain unchanged).
All Capital Earnings Ratio/Total Assets Turnover Ratio		It will be decreased upon the receipt of raised funds; It will be increased upon the repayment of debts by using the raised funds.

(Note: The above dose not constitute our legal advice and professional opinions.  Please refer to qualified accountants for specific advice and opinions.)

III. Deal Structure of ABS Business of Securities Companies

The deal structure of the ABS is composed of two parts: (i) transfer of assets and (ii) issuance of securities.  As to the transfer of assets, the essential difference between the ABS and mortgage financing or other ways of financing is whether or not the “bankruptcy remote” can be achieved.  Moreover, the true sale of the Underlying Assets and the establishment of the SPV (Special Purpose Vehicle) constitute the key point to fulfill the “bankruptcy remote”.
    

 

 

 

The common steps of the ABS Business financing are as follows:

 

 

(a) The securities companies set up the Special Scheme and promote and sell the asset-backed security to domestic institutional investors;

(b) The securities companies use the funds raised from the promotion of the asset-backed security to purchase the Underlying Assets which can generate predictable and stable cash flow (i.e., creditor’s rights or rights of remuneration) from the originator;

(c) Distribute the proceeds generated by the Underlying Assets to the asset-backed security holders.
Please see below the deal structure diagrams of (i) using the creditor’s rights as the Underlying Assets (Graphic 1)  and (ii) using the rights of remuneration as the Underlying Assets (Graphic 2).

Graphic 1: Deal Structure of Using the Creditor’s Rights as the Underlying Assets

 

 

 

Graphic 2: Deal Structure of Using the Rights of Remuneration as the Underlying Assets

IV.    Comparisons Between Securities Company’s ABS Business and Other Ways of Financing

The essence of the ABS is to raise funds by selling such kind of assets which are lack of liquidity but capable of generating predictable and stable cash flows, and its greatest utility is to improve profitability of the total assets, and acquire in one lump sum such returns (i.e., cash flows) which would have been generated by the Underlying Assets in the next few years or future ten years; moreover, (under the ABS Business) the use of the raised funds is subject to less restrictions and the cost of financing is relatively low.
 
Comparing to other ways of financing:

Table one:

 

 

 

 

Items	Medium-term Notes	Corporate Bonds	Enterprise ABS	Bank Loans
Legal Basis	Administrative Measures for Debt Financing Instruments of Non-Financial Enterprises in the Inter-bank Bond Market	Trial Measures of Issuance of Corporate Bonds	Administrative Provisions on the Securities Companies’ Asset-backed Securitization Business	Measures on Administration of Pilot Securitization of Credit Assets
Regulatory Agency	National Association of Financial Market Institutional Investors	CSRC	CSRC	CBRC
Examining and Approving Agency	National Association of Financial Market Institutional Investors	CSRC	CSRC	Lending Bank
Time Period for Examination and Approval	2－3 months	2－3 months	2 months	1－2 months
Trading Market	Inter-bank market	Stock Exchanges	Stock Exchanges	/
Investors	Banks, insurance companies	Funds, insurance companies	Securities dealers, funds, insurance companies	/
Cost of Financing	Low	Low	A bit low	A bit high
Issuer	Financial institutions, enterprises	Listed companies (include companies listed abroad)	Various enterprises	Various enterprises
Scale of Issuance	Shall not exceed 40% of the net assets.	Shall not exceed 40% of the net assets.	Per the discounted future cash flows	Restricted by the enterprises’ loan-deposit ratio
Use of Proceeds	Few restrictions on use	Few restrictions on use	Few restrictions on use	The use of proceeds shall be subject to national policies and supervised by banks.
Advantages	Speedy approving process and low interest	The scale of issuance dose not take into account the amount of short-term and medium-term notes.	The scale of issuance and the rating are not subject to the entities’ credit and debt-paying ability; the transferred Underlying Assets can be “off balance sheet” under certain conditions, and thus the debt ratio will not be increased.	Speedy approving process
Disadvantages	The scale of issuance is restricted.	Policies inclined to the listed companies.	Shortfall in liquidity, and the cost of financing is high.	Focus on short term loans, the cost of financing is high, and the scale of issuance is restricted.

 

Table Two:
 

Items	Insurance Credit Plan	Trust Plan	Asset-backed Notes	Corporate Asset-backed Securitization
Legal Basis	Interim Provisions on the Management of Infrastructure Investment Plan	Administrative Measures for Collective Investment Trust Schemes of Trust Companies	Administrative Measures for Debt Financing Instruments of Non-Financial Enterprises in the Inter-bank Bond Market	Administrative Provisions on the Securities Companies’ Asset-backed Securitization Business
Regulatory Agencies	China Insurance Regulatory Commission (the “CIRC”)	CBRC	People’s Bank of China	CSRC
Examining and Approving Agencies	CIRC	CBRC’s local counterparts	National Association of Financial Market Institutional Investors	Stock Exchanges and CSRC
Approving System	Examining and approving system	Filing system	Registration system	Examining and approving system
Speed of Examining and Approving	Fast	Fast	Fast	Fast
Trading Market	Qualified financial assets exchanges	No public market	Inter-bank bond market	Bulk trading platform of exchanges.
Investors	Insurance companies	Trust companies	Banks, insurance companies, funds	Securities dealers, funds, insurance companies
Cost of Financing	Low	High	Low	Low
Subject of Financing	Assets of infrastructure project	The entities in real estate and city investment companies are restricted.	The entities in real estate and deputy provincial city investment platform are restricted.	The entities in real estate are restricted.
Trustee	Insurance assets management companies	Trust companies	/	Securities companies
Scale of Issuance	No restrictions to the ratio of net assets	No restrictions to the ratio of net assets	No restrictions to the ratio of net assets, and per the discounted future cash flows	No restrictions to the ratio of net assets, and per the discounted future cash flows
Advantages	The time period for approval is short, the cost of financing is low, and the various fees incurred by the issuance are borne by the trsutor or the trustee.	The funding cycle is short, and the  products portfolios  are flexible	The time period for approval is short, and the pledge, repurchase (including buyout repo) are permitted.	The transferred Underlying Assets can be “off balance sheet” under certain conditions, thus the debt ratio will not be increased; and the subjects of financing are less restricted.
Disadvantages	The issuers are limited—only a portion of qualified insurance assets management companies are allowed to conduct such business.	No liquidity, high cost of financing, the deduction of net capital are strictly controlled, and subject to regular policy regulations	The current deal structure is similar to collateral financing, and the Underlying Assets cannot be “off balance sheet”	Strict approval process, high requirement on the legality of the Underlying Assets and the ownership of the cash flows.

V. Operating Process of Securities Companies’ ABS Business

Here, we take the creditor’s rights to accounts receivables generated by BT project as an example to introduce the relevant operating process of ABS Business.
 
“BT” is an abbreviation of “Build-Transfer”, to which currently there is no clear legal definition in China.  Under which, the construction entity (generally, the government agencies) will invite the investment entity to invest in the construction project via a BT cooperation agreement (the “BT Agreement”), then the investment entity injects the funds to construct by itself or by using the construction contracting enterprise, after completion of the construction project, the construction entity will buy back the construction project in accordance with the BT Agreement.  On Feb. 13, 2003, the Ministry of Construction of the PRC issued a document (No. [2003]30) to encourage the use of BT to operate the construction project.
 
The financing process of the ABS of BT project is as follows:
 
(a) Identify and determine the Underlying Assets.  The investor will have the rights to claim the payment against the government agencies in accordance with the BT Agreement, under which the government agencies must transfer and pay the repurchase price and the promised interest to the investor’s bank account on the date of maturity. Thus, the steady cash flows (i.e., the repurchase price paid by the government agencies) generated by the BT project will form the investor’s Underlying Assets.  In the event that there isn’t a BT Agreement signed in advance, it can be otherwise agreed that, after the completion of the government agencies’ construction project, the government agencies can repurchase the project on installments made by the city investment companies or urban construction companies owned by the government agencies so as to form the future stable cash flows.
 
(b) Set up special purpose vehicle (the “SPV”).  The originator shall transfer the Underlying Assets to the SPV.  And the SPV, at a position between the originator and the investors, plays a key role in the course of ABS by conducting a series of following businesses: purchasing the Underlying Assets, integrating the cash flows, dealing in the credit enhancement and rating, collateralizing and issuing the securities, etc.  According to the CSRC’s relevant rules, it is required that the Special Scheme set up by the securities company to act as the SPV under the current mode of ABS financing.

(c) Credit Enhancement.  The ABS pose certain inherent risks to the investors as the returns on the asset-backed security are dependent on whether or not the future cash flows yielded by the Underlying Assets can be smoothly achieved.  However, the credit enhancement can upgrade the credit rating, improve the issuance conditions and reduce the financing cost.
   
(d) Credit Rating.  The credit rating agencies will evaluate the cash flows yielded by the Underlying Assets so as to evaluate the securities proposed to be issued upon the credit enhancement.  The credit rating agencies shall need to do the follow-up monitoring and from time to time to make adjustment to the rating in accordance with any variation in the quality of assets credit.

(e) Sale and Issuance of Securities.  The SPV, acting as the issuer, will sell and issue the asset-backed security to the investor via various financial institutions like banks or securities underwriters, etc.

(f) Management of and service to the assets pool.  The SPV needs to manage the assets pool and accordingly have the responsibilities to collect and record the cash revenues generated by the assets pool, and transfer and deposit all such revenues into the trustee bank or special bank account designated in advance so as to pay the principal and interests to the investors on time.

(g) Liquidation.  As agreed upon at the time of issuing the securities, when the asset-backed security become mature, after the payment of the principal, interests, and various service fees from the revenues generated by the assets pool, if there are any remaining revenues, which revenues can be distributed between the originator and the SPV.
 
VI. Recent Trends of CSRC’s Examination and Approval

A. Supervising Principles adopted by the CSRC

(a) Strictly control the speed of examining and approving; the project options and the use of the raised funds shall be in line with the country’s economic policies and conforming to the characteristic and nature of ABS;

(b) The securities companies shall proceed the ABS Business on the basis that the related risks should be assessable, controllable and sustainable; the risk control shall penetrate each step of the ABS Business; and there should be back-up plans, emergency plans and progressing monitoring;
   
(c) The ownership of the Underlying Assets of the pilot project shall be clear of any doubt; the rights and obligations of each related parties shall be undisputable; the content of the relevant contracts shall be lawful and valid; and the deal structure shall be in compliance with the applicable laws, regulations and rules;

(d) The project of ABS shall be equipped with external credit enhancement measures to protect the investors’ interests to a feasible extent.

B. Application documents

(a) A written application;

(b) Draft statements on the Special Scheme;

(c) Drafts of principal transaction contracts;

(d) Written legal opinion;

(e) The originator’s audited financial and accounting report over the past three years (in the case that the originator has been in operation for less than three years, then the report of the past period commencing from the date of establishment will suffice); and

(f) Other materials requested by the CRSC

C. Content of legal opinion

(a) The qualifications and authority of the manager, sales institutions and the custodian;

(b) The legality of the statements on the Special Scheme, the asset transfer agreement, the custody agreement, the subscription agreement and other legal documents;

(c) The authenticity, legitimacy and validity of the Underlying Assets, their ownership and any encumbrance thereon;

(d) The legality of the transfer of the Underlying Assets;

(e) The legitimacy and effectiveness of the credit enhancement arrangements of the Special Scheme; and

(f) Opinions on other material matters that may affect the interests of the asset-backed security investors.

VII. Re-analysis of Other Legal Issues

As a creative product of structured finance, there are many legal issues as to the ABS worth discussing and analyzing.  Although a lot of such issues have been resolved in practice, there still plenty of issues are not fixed yet.  Since this article intended only to do a brief introduction, we will not take a long page to discuss those pending issues.
       
A. Trust relationship and entrusting relationship

The CSRC once defined the relationships between the parties involving the ABS Business as “trust relationship” in its prior drafts for public comments, and defined the Underlying Assets as the “trust assets”.  However, the above definitions are finally abandoned as they are in conflict with the existing Trust Law, Management Measure on Trust Companies, etc., also, due to the CSRC’s failure to coordinate with the CBRC.  Therefore, the prevalent view as of the date hereof is that the legal relationships between the parties involving the ABS Business are “entrusting relationship plus joint ownership”.  

B. Legal status of SPV

As the SPV in the financing structure of ABS Business is the Special Scheme established by the securities companies, its legal status is still subject to further clarification.

C. True sale and bankruptcy remote

 

 

The “true sale” is treated not as the same in each of legal, accounting and taxation respects.

 

 

 

The “true sale” in accounting area refers to that “the assets sold out shall cease to be recognized in the balance sheet after the completion of the transfer, and the funds received shall be recognized as the income generated by such transfer, and the relevant loss and profit shall also be recognized, that is to say, the assets sold out shall be “off balance sheet”.  To define the “true sale” in taxation area is to make judgment on whether the activities of transferring assets are taxable.  With respect to the legal perspective, the “true sale” refers to the true transfer of assets occurred between two legal entities (the seller and the buyer), moreover, such transfer should not be revoked or declared to be invalid, and it should not be subject to the creditors’ recourse so as to achieve the bankruptcy remote.
     
Up to date, there have been no breach occurred as to such structured finance, that is to say, there have been no dispute finally resolved by the courts.  We will keep an eye on whether there will be any lawsuit adjudicated by the courts in the future.
 

(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.)

 

Mr. Wei Qin is a Beijing-based partner with Global Law Office who specializes in M&A, restructuring, reorganization of companies (entities); equity financing (IPO, PE, etc.) and debt financing (convertible bonds, enterprise bonds, corporate bonds, short term financing bills, etc.); ABS; private equity financing, etc. (E-mail: qinwei@glo.com.cn)