New rules on mortgage rights in the Civil Code

Based on the Property Law[1] and the Security Law[2] of the People's Republic of China, the Property section of the Civil Code[3] has made important modifications and added some new principles to the rules of mortgage of property. In this article, we will focus primarily on the interpretation of the new system of mortgage rights in the Civil Code in the following three aspects: pactum commissorium provision, transfer of mortgaged property, and the priority order of security interests.

Modification to the absolute prohibition of the pactum commissorium provision

Property Law

Civil Code

Article 186  

A mortgagee shall not, before the expiration of the time limit for performing debt obligations, agree with the mortgagor on the transfer of ownership of the mortgaged property to the creditor in the event that the debtor defaults on its obligations when due.

Article 401

Where, before the expiration of the time limit for performing debt obligations, the mortgagee and the mortgagor agreed that the ownership of the mortgaged property shall be transferred to the creditor when the debtor fails to pay the overdue debt, the mortgagee shall only enjoy priority in repayment from the realisation of the mortgaged property according to law.

 

Pactum commissorium provision, also known as contract for pactum commissorium, mortgage property appropriation provision or fluidity contract, refers to the agreement between the mortgagee and the mortgagor that the mortgagee has the right to directly obtain the ownership of the mortgaged property when the debtor fails to perform the debt obligations by the due date[4]. The Property Law adopts an “absolute prohibition” attitude towards the pactum commissorium provision, for the reason of protecting the benefits of the debtor, preventing the debtor from being forced under financial difficulty to enter into a security arrangement out of desperation, whereby providing security over a property that is several times over the value of the debt. If the pactum commissorium provision is allowed under such circumstances, it will result in the exploitation of the debtor.

However, with the development and popularisation of private lending, pactum commissorium provisions have become widely adopted in civil and commercial activities. Some held the view that in today's market environment where creditors and debtors are getting equal standing, choosing a security arrangement in the mode of a pactum commissorium provision between two rational parties through consultation and agreement should be regarded as a reflection of the parties' freedom to dispose of their own properties. By allowing the parties to choose the mode of security freely, Article 401 of the Civil Code appears to have changed the attitude on the absolute prohibition against a pactum commissorium provision by not explicitly forbidding it, and providing that in such a case the mortgagee may still have priority in repayment from the realisation of the mortgaged property according to law. Accordingly, it is perceivable that a pactum commissorium provision will not directly lead to the loss of the mortgagee’s right to enjoy priority in repayment from the enforcement of a mortgage. Yet, the provision states that "the mortgagee … shall only enjoy priority in repayment from the realisation of the mortgaged property according to law”. Therefore, it does not mean that the pactum commissorium provision will be regarded as valid. As there is still much uncertainty concerning the interpretation of that Article, understanding them would therefore have to await illustration through judicial practice, after the Civil Code takes effect.

Stipulating the tracing effect of the mortgage right - mortgaged property can be transferred freely

Property Law

Civil Code

Article 191  

Where the mortgaged property is transferred by the mortgagor with the consent of the mortgagee during the mortgage period, the mortgagor shall repay the debt due on the mortgage in advance with the proceeds obtained from the transfer or otherwise have it held in escrow. Any amount exceeding the mortgagee’s rights shall belong to the mortgagor, while any shortfall shall be settled by the debtor.

The mortgagor shall not transfer the mortgaged property during the mortgage period without the consent of the mortgagee, except where the transferee settles the debt on behalf of the mortgagor thereby extinguishing the mortgage right.

Article 406

The mortgagor may transfer the mortgaged property during the mortgage period. Where the parties have agreed otherwise, their agreement shall prevail. The mortgage right shall not be affected if the mortgaged property is transferred.   

A mortgagor who transfers the mortgaged property shall notify the mortgagee in a timely manner. If the mortgagee is able to prove that his interest is jeopardised by the transfer of the mortgaged property, he may require the mortgagor to repay the debt in advance with the proceeds obtained from such transfer or have it held in escrow. Any amount exceeding the mortgagee’s right from the transfer proceeds shall belong to the mortgagor, while any shortfall shall be settled by the debtor.

 

Article 191 of the Property Law stipulates strict restrictions against the transfer of the mortgaged property by the mortgagor during the existence of the mortgage. Namely, the mortgagor can only transfer the mortgaged property with the consent of the mortgagee; and the transfer proceeds must be applied to prepay the debt or have it held in escrow. Otherwise, the mortgaged property cannot be transferred without the consent of the mortgagee. In fact, during the mortgage period, the mortgage right will not be affected when the mortgaged property is transferred by the mortgagor, since the mortgaged property is a property subject to the mortgage, when transferred, the mortgage right is transferred along with the property, and the transferee who obtains the mortgaged property becomes the mortgagor from the moment he acquires ownership, bearing the obligations of the mortgagor and bound by the mortgage right[1]. Article 406 of the Civil Code sets up new rules for the transfer of a mortgaged property, which confirms the tracing effect of mortgage right on the transferred mortgaged property. The priority of the mortgage right still applies to the mortgaged property after the transfer, and the transfer of mortgaged property will not have a substantive impact on the mortgagee. Article 406 of the Civil Code also has some flexibility. In terms of the provisions on the transfer of mortgaged property, where the parties agree otherwise, their agreement shall prevail. Article 406 of the Civil Code complies well with the transfer principle in respect of property rights and clarifies the basic rule that mortgage rights follow the transfer of a mortgaged property.

Stipulating the priority order of repayment for security interests and introducing the concept of “purchase price security interest”

Property Law

Interpretation of the Security Law[6]

Civil Code

Article 199  

When the same property is mortgaged to two or more creditors, the proceeds obtained from an auction or sale of the mortgaged property shall be applied to repayment in the following priority:

  1. if the mortgage rights have been registered, the proceeds shall be applied in order of their repayment priority according to the date of their registration; where registration is in the same priority, the proceeds shall be applied proportionately;

  2. registered mortgage interests shall have repayment priority over unregistered ones; and

  3. if no mortgage is registered, the proceeds shall be applied to repay creditors proportionately.

Article 79  

Where both a mortgage and a pledge have been created over the same property and legally registered, the mortgagee shall have priority over the pledgee in the order of repayment.

Where both a mortgage and a lien have been created on the same property, the lien holder shall have priority over the mortgagee in the order of repayment.

Article 414

Where the same property is mortgaged to two or more creditors, the proceeds obtained from the auction or sale of the mortgaged property shall be applied to repayment in the following priority:  

  1. if the mortgage has been registered, the proceeds shall be applied in the order of their repayment priority according to the date of their registration; and
  2. registered mortgage interests shall have repayment priority over the unregistered ones; and
  3. if no mortgage is registered, the proceeds shall be applied to repay creditors proportionately.

The provisions of the preceding paragraph shall apply, mutatis mutandis, to the order of repayment with respect to any other secured interest that are registrable.

Article 415

Where both a mortgage and a pledge have been created over the same property, the priority of repayment out of the proceeds obtained from the auction or sale of such property shall be determined according to the time of registration and delivery of possession.

 

 With reference to Article 199 of the Property Law, Article 414 of the Civil Code sets forth the priority of repayment when there are several mortgages on the same property, and abolishes a rule under Article 199 of the Property Law that the repayment shall be made according to the respective proportion of creditors' rights in respect of securities registered with the same priority. At the same time, Article 415 of the Civil Code stipulates that, where both a mortgage and a pledge are created over the same property, the order of repayment shall be determined according to the time of registration of the mortgage and the delivery of possession of the subject matter of the pledge. It therefore amends the rule in Article 79 of the Interpretation of the Security Law which provides that mortgage right has priority over pledge right. It has clarified the principle that publication of security interest assures the priority of repayment.

In addition, Article 416 of the Civil Code introduces a new concept of “purchase price security interest”: Where the principal claim secured by a mortgage on movable property is the purchase price of the mortgaged property and the mortgage registration is fulfilled within 10 days after delivery[7], the mortgagee shall have priority of repayment over other security interest holders of the mortgaged property, except for a lien holder. The typical application scenario of this rule is a floating charge of movable property, where the goods are mortgaged as a security for the purchase price before they are transferred to and become part of the properties subject to a floating charge. After the transfer, it is also subject to the floating charge. The security right of the creditor of the purchase price has higher priority over that of the general floating chargee. Since a lien is a statutory security right, and not a contractual security right, thus the priority of purchase price security interest cannot defeat a lien.[8]The establishment of this rule stems from the increasingly popular trading and financing demand of the market. The priority of purchase price security interest is not only beneficial to protecting the right of the creditor, but can also facilitate the purchaser in obtaining financing to expand its production.

 

 

 

 
 

[1] Property Law of the People's Republic of China, issued on 16 March 2007, came into force on 1 October 2007, and is currently effective.

[2] Security Law of the People's Republic of China, issued on 30 June 1995, came into force on 1 October 1995, and is currently effective.

[3] Civil Code of the People's Republic of China, issued on 28 May 2020 but is not yet effective. It will come into force on 1 January 2021.

[4] Yang Lixin, Li Yiwen The Amendments and Specific Application of the property rights rules in the Civil Code Property Section, published in the 11th issue of Law Journal, 2020.

[5] Yang Lixin Interpretation of the New Rules of Mortgage Rights Stipulated by the Property Law Chapter in Civil Code, published in Legal Forum, July 2020, Issue 4 (Vol. 35, No. 190).

[6] Judicial Interpretation of the Supreme People's Court on Some Issues Regarding the Application of Guarantee Law of the People's Republic of China, issued on 8 December 2000, came into force on 13 December 2000, and is currently effective.

[7] “Delivery” refers to the delivery pursuant to the sale and purchase of the mortgaged property.

[8] Yang Lixin Interpretation of the New Rules of Mortgage Rights Stipulated by the Property Law Chapter in Civil Code, published in Legal Forum, July 2020, Issue 4 (Vol. 35, No. 190).