作者：李政浩、周小琪 争议解决部 金杜律师事务所

Retention of title is an important mechanism in China’s civil legal system and also a common business arrangement.  In a sales contract where goods are sold on installment payments or deferred payment, a retention-of-title clause will allow the seller to retain ownership over the goods until the buyer pays the full purchase price.  If the buyer fails to pay as agreed, the seller could recover and sell off the goods to realize the unpaid price.  This helps the seller to control the risk that payment still remains outstanding after delivery.

Under the PRC law, retention-of-title clauses have traditionally been treated as purely contractual arrangements.  However, business should be aware that China’s new Civil Code has introduced important changes to this approach by treating retention-of-title clauses as a form of de facto security interest.  We will discuss this new change and its implications for business practice in this article.

Introduction: New developments to retention-of-title clauses in China’s Civil Code

As early as in 1999, China’s Contact Law already recognized retention-of-title clauses in Article 134 as a matter of principle.  On this basis, the Supreme People’s Court in China issued an Interpretation on Issues Concerning the Application of Law for the Trial of Disputes over Sales Contracts (“Judicial Interpretation over Sales Contracts”) in 2012 to further clarify the rules applicable to retention-of-title clauses.

On May 28, 2020, China’s National People’s Congress (“NPC”) enacted the Civil Code, which will enter into effect on January 1, 2021.  Apart from systematically integrating existing civil legal norms in different fields, the new Civil Code also introduces important changes to China’s civil legal system.  The rules on retention of title are set forth in Articles 641 to 643 of the Chapter on Contracts.  Specifically:

  • Article 641 sets out the basic principles governing retention of title;
  • Article 642 stipulates when and how the seller may reclaim the goods secured by a retention-of-title agreement;
  • Article 643 stipulates when and how the buyer may redeem the goods from the seller and the seller may sell off the goods.

Articles 641 to 643 are based on the existing rules from the Contract Law and the Judicial Interpretation over Sales Contracts, but they also alter the conceptual framework and the implementing rules for retention of title in significant ways.  Importantly, in the Civil Code, the rules governing retention of title are now linked to and integrated with the rules governing security rights.  This recognizes the fact that while the seller retains ownership over the goods under a retention-of-title agreement, its retained ownership will serve functions similar to a security interest.

Retention-of-title clauses as “contracts serving a security function”

Article 388 of the Civil Code stipulates: “security contracts include mortgage contracts, pledge contracts and any other contract serving a security function.”

According to explanations and interpretations[1] by legislative bodies and judicial authorities in China, “contracts serving a security function” in Article 388 refers to arrangements such as security by transfer of ownership, retention of title, financial leasing, and factoring.  This provision extends the range of security rights recognized by China’s civil legal system from standard security rights (such as mortgages and pledges) to non-standard contracts that nonetheless serve a “security function”.  In fact, this reconstruction of the conceptual framework for security rights follows the same line of reasoning as the Minutes of the National Court Conference on Civil and Commercial Trial Work, a guidance document issued by the Supreme People’s Court to guide lower courts at the end of 2019, which also calls for courts in China to “affirm the security function of non-standard security agreements”.[2]

Under a retention-of-title agreement, as a matter of form, the seller retains title over its own goods instead of a standard security interest over the assets of others.  In effect, however, since the purpose of retaining the ownership is to secure the payment of the purchase price, the retention-of-title clause also serves functions equivalent to a security interest.

In view of this two-fold nature, the Civil Code adopts a hybrid approach to retention-of-title clauses: on the one hand, Articles 641 to 643 governing retention of title are still set out in the Chapter on Contracts, rather than along with the rules for standard security rights in the Chapter on Property Rights; on the other hand, through the concept of “contracts serving a security function” in Article 388, the Civil Code also effectively integrates retention-of-title arrangements into the legal regime governing security rights.

Furthermore, in the Chapter on Contracts of the Civil Code, a number of provisions on the method to realize the retained ownership and registering notice against third parties also reflects the security function served by retention-of-title clauses, as explained in greater detail below.

Repossession through simplified court procedure for security rights

In a sales contract with a retention-of-title clause, if the buyer (i) fails to pay the purchase price according to agreement, (ii) fails to perform other terms as agreed upon by the parties, or (iii) sells, pledges or otherwise disposes of the goods sold, the seller will be entitled to repossess the goods.  Under the Civil Code, for the first time ever, the seller could resort to the simplified procedure under China’s Civil Procedure Law for realizing security interests to repossess the goods.[3]  This is also an important manifestation that retention of title is recognized as a de facto security right by the Civil Code.

Article 642 of the Civil Code recognizes two ways for a seller to exercise its right of repossession: by negotiation or by statutory means.  For the latter, Article 642 directly references the special procedures for realizing security rights under Articles 196 and 197 of China’s Civil Procedure Law.[4]  If the seller opts for this procedure, it may file an application for repossession with the local people’s court at the place where the goods are located or ownership of the goods is registered.  After the court accepts the application, if the seller files a motion for interim measures of protection over the goods, the court could apply relevant provisions in China’s Civil Procedure Law on interim measures of protection to resolve the issue.[5]

Upon examination of the seller’s application for repossession, if the court finds that the parties are not in any substantive dispute over the right to repossess, and conditions for the seller to repossess the goods have been satisfied, it will issue a ruling to permit repossession.  However, if there is any substantive dispute over the seller’s right to repossess, the court must dismiss the application and ask the seller to raise its claim through standard civil procedures.[6]

Before the Civil Code comes into effect, the seller could only repossess the goods under a retention-of-title agreement by filing a civil lawsuit through standard civil procedures.  As an example, in a dispute arising from the seller’s request to repossess the equipment under a machinery purchase agreement,[7] the seller initiated a civil lawsuit after the buyer failed to pay the full purchase price, requesting the court to confirm its ownership over the goods and order the defendant to either return the goods within a specific time limit or pay damages.  Its claims were ultimately upheld by the court.

Compared with this standard procedure, Article 642 of the Civil Code creates a simpler process for exercising the right of repossession by allowing the seller to opt for the special procedures for realizing security rights.  However, this simplified procedure does not apply in all cases: if the parties are in any substantive dispute over whether conditions for repossession have been satisfied, or the scope of the assets to be repossessed, they still need to file a lawsuit through standard civil procedures.

Retention-of-title clauses effective against third parties by registration

Generally speaking, it is difficult for third parties to be aware that the goods are encumbered by a retention of title arrangement, since the contractual arrangements have no external appearance.  To protect third parties who unknowingly enter into future transactions over the same goods, Article 36 of the Judicial Interpretation over Sales Contracts provides that the seller cannot repossess goods under a retention-of-title clause if a third party has acquired ownership or other proprietary interests over the goods in good faith.

Article 36 has made it difficult for sellers to enforce retention-of-title agreements where a third party has created proprietary rights over the goods.  For example, in a dispute where the seller objects to court enforcement of third-party mortgage rights over the goods under a prior retention-of-title arrangement, the court observed that the seller’s retained ownership is not manifest to the general public, and therefore should not be effective against third parties in good faith.  Ultimately, the seller’s objections to the third-party mortgage right was rejected.[8]

Now the Civil Code has introduced a notice-by-registration mechanism for sellers to provide notice on retention of title.  Article 641 of the Civil Code stipulates: “Ownership over the subject matter [of the sales contract] retained by the seller will not be effective against third parties without registration.”  Article 641 is similar to the notice-by-registration rules applicable to mortgage rights over movable assets in the Chapter on Property Rights.  Again, this reflects the fact that retention of title is recognized as functionally equivalent to a security interest under the Civil Code.[9]

In practice, the notice-by-registration rule in Article 641 could have two major implications.

First, the notice-by-registration rule better protects the seller by making the retained ownership effective against bona fide third parties upon registration.  Pursuant to Article 641, the seller could register the retention of title in a unified registry, and once registered, the retention of title will be effective against third parties even if they have acquired ownership or other property interests over the goods in good faith.

At present, the People’s Bank of China operates a “CCRC Movables Financing Registry System” which already allows retention-of-title agreements to be registered.[10]  Once the Civil Code comes into effect, the retention of title clauses registered in officially recognized registries will be effective against third parties in good faith as a matter of law.  This will provide better legal certainty for the seller in retaining title over goods.  At the same time, the notice-by-registration rule will also incentivize the seller to register the retention of title and avoid the risk that the buyer may sell the goods before full payment or encumber the goods with additional security interests.

Second, the notice-by-registration rule also creates a clear priority rule for retention of title and other competing security rights.  Article 414 of the Civil Code establishes a priority rule for multiple creditors claiming mortgage rights over the same asset: (i) registered mortgage rights will have priority over unregistered mortgage rights; (ii) multiple registered mortgage rights will be ranked in the order of their timing of registration; and (iii) unregistered mortgage rights will be satisfied in proportion to the amount of each creditor’s claim.  Importantly, Article 414 also stipulates that the same priority rules may be applied to determine the priority of “any other security rights that could be registered”.

As discussed above, retention of title is treated as a non-standard security right under Article 388 of the Civil Code, and Article 641 recognizes that retention of title may be registered.  Therefore, the ownership retained by the seller could be regarded as a “security right that could be registered” within the meaning of Article 414.  This leaves open the possibility that the priority rules in Article 414 for competing security rights could be applied to retention of title as well.

Summary

The Civil Code recognizes the security function served by retention-of-title clauses and integrates this mechanism into the legal regime governing security rights.  This change in conceptual framework has a number of practical implications including the statutory procedure for repossession, the registration of retention-of-title clauses, and its priority order with other competing security rights.  Since retention of title is a common business practice and similar clauses are frequently used in the sales and distributor contracts of domestic and foreign companies, businesses should pay attention to the changes introduced by the Civil Code and evaluate their potential impact.

* With thanks to Wang Xinyi for her input to this article.

 

 

[1] Explanation of the Draft Civil Code to the 13th National People’s Congress, Wang Chen, Vice Chairman of the Standing Committee of the NPC: http://www.npc.gov.cn/npc/c30834/202005/50c0b507ad32464aba87c2ea65bea00d.shtml; Working Group on the Implementation of the Civil Code of the Supreme People’s Court, Understanding and Application of the Property Right Chapter under the Civil Code of People’s Republic of China (People’s Court Press, 2020), p. 995.

[2] The Minutes of the National Courts’ Civil and Commercial Trial Work Conference, pp. 66: “[Determination of security relationships] A contract with a security function entered into by the parties shall be determined as valid, unless it is under any statutory circumstance of nullity. Although the relationship of rights and obligations agreed in the contract is not a typical form of security right in the Property Law, its security function shall still be affirmed.”

[3] Article 642 of the Civil Code.

[4] Article 196 of the Civil Procedure Law: “To apply for realization of a security interest, the security interest holder or any other party entitled to request realization of the security interest shall, in accordance with the Property Law and other laws, file an application with the local people’s court at the place where the property posted as security is located or at the place of registration of the security interest.”

Article 197 of the Civil Procedure Law: “After accepting an application, if the people’s court finds that the application complies with legal provisions upon examination, it shall issue a ruling to auction or sell the property posted as security, and the parties may, based on the ruling, apply to the people’s court for enforcement; or, if the application does not comply with legal provisions, the people’s court shall issue a ruling to dismiss the application, and the party may institute an action in a people’s court.”

[5] Article 373 of the Interpretation of the Supreme People’s Court on the Application of the Civil Procedure Law of the People’s Republic of China.

[6] Article 372 of the Interpretation of the Supreme People’s Court on the Application of the Civil Procedure of the People’s Republic of China, Working Group on the Implementation of the Civil Code of the Supreme People’s Court, Understanding and Application of the Property Right Section under the Civil Code of People’s Republic of China (People’s Court Press, 2020), p. 1104.

[7] Sales contract dispute between Nanjing Daliang Numerical Control Technology Co., Ltd. and Tongjian (Huiyang) Electronics Co., Ltd., Judgement by the Court of First Instance, (2017) Su 0116 Min Chu No. 6895.

[8] Dispute from third party objection to court enforcement between Ningbo Hairun Yirun Plastic Equipment Co., Ltd. and Hu Xuxin, interested parties, et al. Judgement by the Court of Second Instance, (2019) Su 02 Min Zhong No. 1045.

[9] Article 403 of the Civil Code: “Where a movable asset is mortgaged, the mortgage right is created at the time when the mortgage contract takes effect; and if it is not registered, it shall not be effective against a bona fide third party.”

[10]See CCRC Movables Financing Registry System：https://www.zhongdengwang.org.cn/.