Financial regulation for entrusted loan contracts and businesses

The January 2023 National Conference on Court Financial Trials reflected on signals that entrusted loans are regulated financial activities, not private lending contracts. Financial regulations may serve as an important basis for judging whether a contract violates ‘public order and good morals’

The National Conference on Court Financial Trials on 10 January 2023 received correction signals about entrusted loan regulations. Liu Guixiang, a member of the Supreme People’s Court judicial committee and a grand justice of second rank, delivered a speech on financial civil and commercial trials that covered their concepts, mechanisms and specific legal application.

Current judicial practice is guided by the precedence of Beijing Changfu Investment Fund v Zhongsenhua Century Real Estate Development of Wuhan City et al, a model case picked by the Gazette of the Supreme People’s Court for that year. This practice tends to perceive entrusted loan contracts as private lending contracts, or those with the attributes of private lending. Accordingly, the validity of entrusted loan contracts, as well as rights and obligations on interest, late interest and default, are governed by laws, regulations and judicial interpretations relating to private lending.

However, in his speech, Liu pointed out that the “look through” determination of entrusted loans as private lending is a misinterpretation of relevant regulatory policies. Instead, as an entrusted loan is a regulated financial activity, it should be approached similarly to a financial loan.

The authors believe that, apart from “correcting” the perceived nature of entrusted loans, Liu’s speech further signalled an enhancement in the financial regulation of entrusted loan contracts and businesses.

Compatibility of current provisions. Articles 4 and 19 of the Measures for the Administration of Entrusted Loans of Commercial Banks, issued by the China Banking Regulatory Commission, provide that banks should act only as the “middleman” in entrusted loans; they may charge handling fees but assume no credit risks.

Other provisions focus on reviewing consent between parties, the qualification of the subjects, the source of funding and how they are used, with emphasis on the banks’ role to assist the lender if other arrangements were agreed on under the contract. Rarely, if ever, do they concern post-loan management or supervision.

If entrusted loan contracts are determined as financial loan contracts, with their financial attributes and elements accentuated, financial regulation in this area may need to be further strengthened. This would maintain security and stability of the financial order lest the financial risks negatively affect the market environment.

However, apart from macro regulation from the likes of the China Banking and Insurance Regulatory Commission, the entrusted loan business has in practice been largely left to rely on banks’ moderate involvement. In other words, redefining entrusted loan contracts as financial loan contracts without increasing banks’ responsibilities in post-loan management and supervision would fall short of the goal of enhancing regulation. Entrusted loans would remain private lending in all but name.

The authors are of the opinion that existing provisions on banks’ roles and responsibilities may no longer be compatible with the direction of strengthened financial regulation. Enhancing banks’ post-loan supervisory duties with follow-up regulations may be the most feasible approach.

This does not mean that banks are no longer “middlemen”. As they do not take credit risks, banks should still consider assisting the lenders as their primary duty, even with the ramped-up regulatory pressure. They should refrain from acting in any way that may be construed as exceeding their jurisdictions under article 19 of the measures.

Mounting likelihood of contract invalidity. Liu also pointed out that financial regulations may serve as an important basis for judging whether a contract violates “public order and good morals”. If entrusted loan contracts are to be inducted into the financial regulation system, further tying their legal relationship with the financial order, it would also to some extent affirm their status in, and impact on, the financial system.

According to the Minutes of the National Courts’ Civil and Commercial Trial Work Conference, courts were already tending to invalidate contracts that threatened financial security. However, this was far from a certainty. Some courts believe entrusted loan contracts should not be invalidated as the measures are but ministerial rules.

The authors believe that they draw such a conclusion because:

• • The minutes are not formal judicial interpretations and cannot be used as a basis for judgments; and
  • The entrusted loan contracts are of a private lending nature and thus do not affect financial security and market order.

However, as Liu pointed out, if entrusted loans are to be regulated as financial loans, and considering the above-mentioned minutes, the likelihood of contract invalidity will surge. The requirements for compliance are much higher during the transaction and execution of entrusted loan contracts.

What it means for lenders and borrowers. As banks’ duties in entrusted loans and their role as middlemen remain largely unchanged, the burden of obligations arising from the strengthened regulation may first need to be borne by lenders and borrowers.

When entering into entrusted loan contracts, lenders should further confirm the source of funding to avoid risks of contract invalidation due to violation of the measures. They should step up supervision of the use of loans to prevent any breach of regulatory requirements.

As the interests, penalty interests and default fees in entrusted loan contracts are no longer subject to cap restrictions under the Provisions of the Supreme People’s Court on Several Issues Concerning the Application of Law in the Trial of Private Lending Cases, borrowers should place more emphasis on communication and negotiation with lenders on matters concerning borrower obligations, such as payment of interests, so as to ensure that such payments are affordable.

Borrowers should also strengthen legal compliance in the use of loan funds to avoid more severe default liabilities for illegal use of loans.

Chen Zhuo is a partner at Tian Yuan Law Firm. He can be contacted at +86 138 1041 7260 or by e-mail at chenzhuo@tylaw.com.cn

Qin Zhuan is an associate at Tian Yuan Law Firm. He can be contacted at +86 137 5311 9630 or by e-mail at qinzhuan@tylaw.com.cn