introduction

Signing equity pledge agreements is a common form of guarantee in commercial transactions. Article 443 of the Civil Code of the People's Republic of China (hereinafter referred to as the "Civil Code") stipulates that "the pledge right shall be established when the pledge registration is handled." After the actual signing of the agreement, there are many attempts by the guarantor to block the establishment of the equity pledge by means of "not handling the pledge registration", and to achieve the purpose of evading the guarantee liability.

 

In judicial practice, although failure to register a pledge may result in the absence of a pledge, the terms of the equity pledge will not be directly invalidated. Relevant judicial precedents have also determined that such contracts are valid and support creditors in claiming liability for breach of contract on the grounds that the guarantor has not performed its contractual obligations. Of course, if the creditor has certain faults, it is also likely to face the risk of not being able to claim liability for damages.

 

The following mainly discusses equity pledge and its contractual effectiveness, the protection of creditors' interests, and the risk that creditors cannot obtain damages from these three aspects. Based on this, several practical suggestions are proposed when signing equity pledge agreements.

 

1、 The equity pledge has not been registered, how effective is the pledge? How effective is the pledge contract?

 

（1） Legal provisions

 

Article 443 of the Civil Code: Where fund units or equity are pledged, the pledge right shall be established upon registration of the pledge.

 

"After pledging fund units and equity interests, they may not be transferred, unless agreed upon through consultation between the pledgor and the pledgee.". "The money obtained from the transfer of fund units or equity by the pledgor shall be paid off to the pledgee in advance or placed in escrow.".

 

（2） Practical identification

 

"For equity pledge contracts that have not undergone pledge registration, the contract itself is valid, but the pledge right has not been established, and the creditor cannot require the guarantor to assume corresponding guarantee responsibilities.".

 

（3） References

 

Supreme People's Court (2017) No. 602

 

The court of first instance confirmed the fact that Sun Qiyin had borne a total of 250 million yuan of debt and interest expenses to Rongshi Hengda. Daji Group provided pledge guarantee for the above debt with 100% equity of Kangming Medical held by it ("Pledge Agreement 2"), but did not handle pledge registration.

 

Rongshi Hengda filed a lawsuit with the court, requesting Sun Qiyin to repay the repayment amount, and requesting Daji Group to assume joint and several liability for repayment within the scope of equity pledge with 100% of Kangming Medical's equity held by it. That is, requesting confirmation of the validity of the "Pledge Agreement 2". Rongshi Hengda has a pledge right to this, and the proceeds from the disposal of the pledged equity right enjoy a priority right of repayment within the scope of equity pledge guarantee.

 

The court of first instance held that the "Pledge Agreement 2" was valid, but due to the lack of pledge registration procedures, the pledge right was not established. The court of first instance did not support Rongshi Hengda's lawsuit that Rongshi Hengda had a pledge right to 100% of Kangming Medical's equity held by Daji Group, and that the proceeds from the disposal of the pledged equity had a priority right to compensation within the scope of equity pledge guarantee. (First instance judgment: IV. Reject other claims of Rongshi Hengda.)

 

Rongshi Hengda appealed and requested that the judgment be changed to confirm the validity of the Pledge Agreement 2.

 

The court of second instance held that the Pledge Agreement 2 was valid, but this case was not a separate action to confirm the validity of the contract. Although the "Pledge Agreement 2" involved in the case is valid, due to its non registration, the court of first instance determined that the "Pledge Agreement 2" was established and took effect, and that the pledge right was not established. It is correct for Rongshi Hengda to have a pledge right to 100% of Kangming Medical's equity held by Daji Group, and not to support the lawsuit request that the proceeds obtained from the disposition of the pledged equity right enjoy a priority right to compensation within the scope of the equity pledge guarantee.

 

2、 How to protect the interests of creditors without registering equity pledge?

 

（1） Legal provisions

 

Article 577 of the Civil Code states that if a party fails to perform its contractual obligations or fails to perform its contractual obligations in accordance with the agreement, it shall be liable for breach of contract such as continuing to perform, taking remedial measures, or compensating for losses.

 

（2） Practical identification

 

If the equity pledge registration has not been completed and the pledge has not been effectively established, the court may not support the creditor's claim to require the guarantor to assume joint and several liability for payment of the debt, but the creditor may require the guarantor to assume the liability for breach of contract to compensate for losses on the grounds that the guarantor fails to perform its contractual obligations.

 

（3） References

 

Supreme People's Court (2015) Min Er Zhong Zi No. 70

 

Jinhui Company borrowed 120 million yuan from Jinqiao Company, and Great Wall Ningxia Company pledged its legally held 80% equity and legal fruits (including dividends and other income due from pledged equity) of Jinhui Company to Jinqiao Company as security.

 

Jinqiao Company sued and requested Jinhui Company to return the remaining loan and interest. Great Wall Ningxia Company shall bear joint and several liability for the above payment.

 

The court of first instance held that the terms of equity pledge were legal and valid. However, due to the failure to complete the pledge registration procedures, the pledge right has not been effectively established. As Jinqiao Company requested Great Wall Ningxia Company to handle the pledge registration procedures, but Great Wall Ningxia Company failed to do so, Great Wall Ningxia Company was at fault and violated the principle of good faith, and it should bear corresponding liability for compensation within the scope of the value of the pledged equity. The claim of Jinqiao Company that Great Wall Ningxia Company should bear joint and several liability for the debts involved has no legal basis and is not supported. Finally, in the first instance, it was decided that Great Wall Ningxia Company would be liable for compensation for the above amounts within the scope of the value of the pledged equity involved.

 

Great Wall Ningxia Company appealed and requested to dismiss the lawsuit filed by Jinqiao Company against Great Wall Ningxia Company.

 

The court of second instance held that the responsibilities evaded by Great Wall Ningxia Company due to breach of contract and the rights and interests lost by Jinqiao Company should be considered as losses of Jinqiao Company. According to law, Great Wall Ningxia Company shall bear the liability for compensation within the scope of 80% of the equity value and legal fruits held by it in Jinhui Company, including the dividends due from the pledged equity. The judgment of the court of first instance conforms to the legal provisions, and the court of second instance upheld it.

 

3、 How to identify the creditor's fault for the fact that the pledge right has not been registered? How are the responsibilities for breach of contract/compensation allocated?

 

（1） Legal provisions

 

Article 592 of the Civil Code: If both parties violate the contract, they shall bear corresponding responsibilities. "If one party breaches the contract and causes losses to the other party, and the other party is at fault for the occurrence of the losses, the corresponding amount of compensation for the losses may be reduced.".

 

（2） Practical identification

 

If the agreement does not specify who will handle the registration of equity pledge, the court generally believes that the guarantor has the obligation to handle the registration of pledge. However, if the creditor cannot prove that it has taken positive measures to urge the guarantor to handle the registration of pledge, the creditor also has a certain degree of fault, and accordingly orders the creditor and the guarantor to assume certain responsibilities. For example, the judgment issued by the Supreme People's Court [(2019) Supreme Law and People's Republic of China No. 202].

 

There is also a difference between the Supreme People's Court's judgment No. 579 (2020) issued by the Supreme People's Court. According to the judgment, due to the fact that the pledge involved in the case was pledged by others and registered first, and after the parties signed the pledge contract, the creditor failed to perform reasonable review obligations, and there was no valid evidence to prove that the failure to effectively establish the pledge involved was due to the reasons of the guarantor, it was ultimately determined that the guarantor did not need to bear the liability for breach of contract, that is, it did not need to bear joint and several liability for repayment of the loan involved.

 

（3） References

 

Supreme People's Court (2019) No. 202

 

Zhongdingxiang Company owes 9196980.50 yuan to Commercial Reserve Company. In 2016, Liu Changning issued a "Letter of Guarantee" to the Commercial Reserve Company, stating that Liu Changning voluntarily assumed the guarantee liability for the debts owed by Zhongdingxiang Company to the Commercial Reserve Company, and the guarantee assets were 10% of the shares of Guiyang Jinyang Tianhe Building Materials Co., Ltd. (valued at 10 million yuan) legally held by him.

 

The Commercial Reserve Company filed a lawsuit with the court, requesting that Zhongdingxiang Company pay the principal of 9196980.50 yuan and interest and other expenses, and requesting that Liu Changning be jointly and severally liable for the above amounts payable by Zhongdingxiang Company.

 

In the first instance, Liu Changning was held jointly and severally liable for the above payment.

 

The court of second instance held that the "Letter of Guarantee" is a guarantee provided by way of equity pledge, rather than joint and several guarantee liability. The court of first instance ruled that Liu Changning was the guarantor and that there was no factual and legal basis for assuming joint and several liability. At the same time, it believed that the equity pledge had not been established due to non registration, and there was no need to assume joint and several liability for repayment. Therefore, the court of first instance revoked the judgment "II. Liu Changning shall bear joint and several liability for repayment of the funds determined in the first paragraph of the judgment", and rejected the lawsuit claim of Commercial Reserve Company against Liu Changning's joint and several liability for guarantee.

 

Later, due to the application for retrial by the Commercial Reserve Company, the retrial court determined that:

 

First, Liu Changning's "Letter of Guarantee" is a pledge guarantee of equity, not a guarantee guarantee.

 

Secondly, about whether Liu Changning should bear civil liability and the nature of the liability. Liu Changning's failure to register the pledge constitutes a breach of contract and shall bear corresponding liability for breach of contract.

 

Third, because the commercial reserve company did not provide evidence to prove that it had urged registration or other positive actions, it also had faults. Based on the breach of contract and the degree of fault of each party, the retrial court determined that Liu Changning should bear civil liability of 50% of the collateral value (10 million yuan) stated in the "Letter of Guarantee".

 

Supreme People's Court (2020) No. 579

 

China Construction Bank Changsha Huaxing Sub-branch (the plaintiff was later changed to "Oriental Asset Management Hunan Company" due to the transfer of rights and obligations) filed a lawsuit with the court, requesting Yahua Holding Company to repay the loan of 87749900 yuan and interest and other expenses, and requesting Yahua Dairy Co., Ltd. to assume joint and several liability for the aforementioned liabilities of Yahua Holding Company.

 

The court of first instance held that the equity interests involved in the "Rights Pledge Contract" had been pledged to others and the pledge registration had been handled first, and it was unable to handle the pledge registration again, leading to the fact that the pledge right involved in the case was not established. Considering that both parties have signed the "Rights Pledge Contract" based on the possibility of obtaining the establishment of future pledge rights, and China Construction Bank Changsha Huaxing Sub-branch has not provided effective evidence to prove that the failure to effectively establish the pledge rights involved is due to the reason of Yahua Dairy Company, Yahua Dairy Company is not required to bear the liability for breach of contract, that is, it is not required to bear joint and several liability for repayment of the loan involved. "And hereby rejects the application for joint and several liability for repayment from Yahua Dairy Company.".

 

Dongfang Asset Management Hunan Company appealed and requested that Yahua Dairy Company be adjudged to assume joint and several liability for the debts determined in the first paragraph of the (2017) Civil Judgment No. 30.

 

The court of second instance held that:

 

First of all, CCB Changsha Huaxing Sub-branch should exercise reasonable review obligations and know or should know that the equity involved has been previously pledged.

 

Secondly, the contract stipulates that the registration procedures are the obligations of both parties, not the unilateral obligations of Yahua Dairy Company. China Construction Bank Changsha Huaxing Sub-branch failed to fulfill the obligation of equity pledge registration within a reasonable period of time.

 

Finally, the applicable premise of Item 3, Paragraph 1, Article 9 of the "Rights Pledge Contract" is "due to the reasons of Yahua Dairy Company..." The court of first instance determined that the CCB Changsha Huaxing Sub-branch did not provide valid evidence to prove that the pledge was not established due to the reasons of Yahua Dairy Company, and there was no obvious misconduct in the failure to support the application of Dongfang Asset Management Hunan Company.

 

Practical recommendations

 

In order to protect the legitimate rights and interests of creditors, it is recommended to refer to the following suggestions when signing the equity pledge agreement to avoid disputes as far as possible from the source:

 

1. Confirm the method of proposed guarantee. In practice, a creditor originally wishes to sign a guarantee contract, but what the two parties ultimately actually sign is a similar clause that "the guarantor assumes the guarantee liability for the relevant debts with the equity of XX Company held by him, and the guarantor guarantees that, if not...", it is likely to be recognized that the "guarantee" herein is not a guarantee in the sense of the civil code ("PICC"), This clause is only a guarantee clause in the form of equity pledge ("material security").

 

2. Review in advance whether there are other pledge registrations for the equity. The creditor may request the guarantor to provide information such as industrial and commercial registration materials to confirm whether the equity has been pledged or has been pledged. This is mainly to ensure that creditors fulfill their reasonable review obligations, while effectively avoiding the adverse consequences of waiting for pledge not being able to handle pledge registration and not being able to realize the pledge right normally.

 

3. Timely supervise and urge the guarantor to handle equity pledge registration, and retain written evidence of communication. At present, judicial precedents tend to believe that the registration of equity pledge is a common obligation of both the creditor and the guarantor. In order to avoid the failure of pledge registration in the future, and the creditor being identified as "the creditor has a certain fault" by pursuing the guarantor's liability for breach of contract, it is recommended to fix the corresponding evidence in advance to prevent accidents from occurring.

 

4. In the event that the guarantor does not handle the registration of equity pledge, and the creditor does not realize the creditor's rights and interests, timely safeguard their rights through litigation and other means. At the same time, it is recommended to pay special attention to the expression and adjustment of litigation claims, such as requiring the guarantor to assume liability for compensation or breach of contract according to the contract.

 

5. If dormant shareholders (actual investors) are involved in external pledge of their equity holdings, and the registration of equity pledge requires the cooperation of the nominating shareholders, it is recommended that the nominating shareholders sign the pledge agreement for confirmation and agree on the relevant responsibilities when the nominating shareholders do not cooperate. It should be noted that, if there is no special agreement, the obligation assumed by the named shareholder is generally to assist the actual investor in handling the pledge registration, rather than the obligation assumed by the named shareholder itself. For reference, please refer to the jurisprudence made by the Supreme People's Court [(2018) Supreme Court Minshen No. 2723, Liu Jianhua, Yang Chun Civil Ruling on Civil Loan Dispute Retrial Review and Trial Supervision].

 

(This article is translated by software translator for reference only.)

 

The above referenced precedents are excerpts. If necessary, please refer to the following case sources to further understand the details of the case. (In the order in which they appear in this article)

1. (2017) Supreme People's Court No. 602 [Beijing Rongshi Hengda Investment Center, Sun Qiyin Equity Pledge Dispute Second Instance Civil Judgment]

2. (2015) MEZZ No. 70 [Civil Judgment of Second Instance on Enterprise Loan Dispute between Beijing Jinqiao Guosheng Investment Co., Ltd. and Great Wall (Ningxia) Asset Management Co., Ltd. and Beijing Jinhui United Investment Co., Ltd.]

3. (2019) Supreme People's Court No. 202 [Civil Judgment for Retrial of Sales Contract Dispute between Guizhou Shangchu Shengjicang Logistics Co., Ltd. and Liu Changning]

4. (2020) No. 579 [Civil Judgment of Second Instance on Financial Loan Contract Dispute between China Eastern Asset Management Co., Ltd. Hunan Branch and Hunan Yahua Dairy Co., Ltd.]

5. (2018) Supreme Court Law Minshen No. 2723 [Civil Ruling on Reexamination, Review and Trial Supervision of Civil Loan Disputes between Liu Jianhua and Yang Chun]