With the conclusion of the transition period for the “Guiding Opinions on Regulating the Asset Management Business of Financial Institutions” (hereinafter referred to as the “New Asset Management Regulations”), bank wealth management business has adhered to the principles of breaking rigid redemptions, removing channels, eliminating nesting, and deleveraging. On the basis of overall stable growth, it has transformed toward net-value-based, standardized, and normalized operations, returning to the fundamental nature of asset management business—“entrusted management of assets on behalf of clients.”

[1] Although in the post-New Asset Management Regulations era, bank wealth management investments in fixed-income assets are the absolute mainstream, bank wealth management funds can still invest through SPV vehicles such as trusts and asset management plans in varieties with smaller net value fluctuations and liquidity premiums, as well as non-standard assets with inactive trading, thereby providing financing services and capital support to market participants.

[2] To ensure capital security, banks often require relevant counterparties to provide credit enhancement measures, with deficiency compensation arrangements being a commonly used form of credit enhancement.

This article attempts to use the case of China Merchants Bank Co., Ltd. v. Everbright Capital Investment Co., Ltd. regarding other contract disputes ([2019] Hu 74 Min Chu No. 601, hereinafter referred to as the “China Merchants Bank v. Everbright Capital Case”) as a sample, combined with the existing legal framework and judicial practice, to conduct an in-depth discussion and analysis of the legal nature and validity of deficiency compensation as a credit enhancement arrangement for bank wealth management products.

I. Case Overview

(I) Case Information

Case Name: China Merchants Bank Co., Ltd. v. Everbright Capital Investment Co., Ltd. Other Contract Dispute [2019] Hu 74 Min Chu No. 601

Case Source: One of the 10 typical cases of 2021 published by Shanghai Financial Court on March 3, 2022

Keywords: Deficiency compensation; bank; non-standard products; credit enhancement

(II) Basic Facts

Everbright Capital’s wholly-owned subsidiary Everbright Jin Hui Company, together with Baofeng (Tianjin) Investment Management Co., Ltd. and Shanghai Qunchang Financial Services Co., Ltd. as general partners and other limited partners, entered into a Partnership Agreement to jointly establish a cross-border M&A fund—Shanghai Jinxin Fund—on February 25, 2016, for the purpose of acquiring 65% of the equity of overseas MPS Company. Everbright Jin Hui served as the executive partner. China Merchants Bank subscribed to RMB 280 billion in priority limited partnership shares through the Zhaocai No. 5 asset management plan established by China Merchants Wealth Company, while Everbright Capital subscribed to RMB 60 million in junior limited partnership shares.

In April 2016, Everbright Capital issued a “Deficiency Compensation Letter” to China Merchants Bank, stating: “WHEREAS… 4. China Merchants Bank, through the special asset management plan (the ‘Asset Management Plan’) established by China Merchants Wealth Company, subscribed to RMB 2.8 billion in priority limited partnership shares of the Fund; … on the basis of friendly cooperation, the Company hereby agrees: 1. Within 36 months from the establishment of the Fund, the Company agrees that Baofeng Technology or another third party designated by the Company shall acquire 100% of the equity of JINXIN HK LIMITED (Jinhui (Hong Kong) Investment Management Co., Ltd.) held by the Fund at a target price of no less than [RMB 2.8 billion * (1 + 8.2% * Asset Management Plan存续 days / 365)]. If the final equity transfer price is less than the target price, the Company agrees to unconditionally assume full deficiency compensation obligations for the difference between the target price and the actual equity transfer price. At the termination date of the Asset Management Plan, if the MPS equity has not been fully disposed of, the Company agrees to assume full deficiency compensation obligations.”

Everbright Securities Company, as the sole shareholder of Everbright Capital Company, issued a “Reply on the Cross-border M&A Fund of Everbright” to Everbright Capital Company, stating: “The Company acknowledges and approves Everbright Capital’s compensation arrangements with China Merchants Bank.”

On February 2, 2019, Everbright Securities Company issued an “Announcement on Important Matters of Wholly-owned Subsidiary,” stating that ”…MPS Company has fallen into operational difficulties, and the Shanghai Jinxin Fund has failed to exit as originally planned…”

(III) Reasons for Judgment

1. Everbright Capital was neither the manager nor the sales institution of the investment fund involved, nor was it a subject prohibited by law from promising principal and interest guarantees. The nature of the Deficiency Compensation Letter did not constitute rigid redemption.

2. The rights and obligations stipulated in the Deficiency Compensation Letter were clear. The condition for Everbright Capital to provide deficiency compensation was the failure to complete the equity transfer and repurchase of the investment target within a certain period, with the purpose of providing credit enhancement services for the exit of China Merchants Bank’s investment funds.

3. Everbright Securities, the sole shareholder of Everbright Capital, explicitly stated that it was aware of and approved the compensation arrangements. Even if Everbright Capital failed to obtain board or shareholder resolution approval when issuing the Deficiency Compensation Letter, it did not affect its validity.

4. Everbright Capital, based on its own interests, voluntarily utilized the structured arrangement and the form of the Deficiency Compensation Letter to allocate investment risks and returns with China Merchants Bank, which constituted a voluntary disposition of civil rights.

(IV) Judgment Result

On July 30, 2020, the Shanghai Financial Court rendered a first-instance judgment ordering Everbright Capital to pay China Merchants Bank over RMB 3.1 billion plus corresponding interest. Everbright Capital appealed, and the Shanghai Higher People’s Court dismissed the appeal and upheld the original judgment.

II. Case Implications

The China Merchants Bank v. Everbright Capital case selected in this article, where the Shanghai Financial Court made a positive judicial evaluation of the Deficiency Compensation Letter issued by Everbright Capital from the perspectives of the subject of the deficiency compensation obligation, the content of the deficiency compensation arrangement, the investment transaction structure, and the expression of intent, offers the following implications:

(A) Nature of Deficiency Compensation Agreements

The nature of a deficiency compensation agreement affects the validity of the arrangement, the method of liability, and the scope. Article 36 of the “Interpretation of the Supreme People’s Court on the Application of the Guarantee System of the Civil Code of the People’s Republic of China” (hereinafter referred to as the “Civil Code Guarantee Judicial Interpretation”) divides the legal nature of deficiency compensation arrangements into three categories based on their content: guaranty contracts, joinder of debt, or independent debt.

[3]

1. Recognized as a Guaranty Contract

Where the deficiency compensation transaction model contains an undertaking to assume guarantee or代为 repayment obligations, and the undertaking has a subsidiary nature, it may be recognized as a guaranty contract pursuant to Articles 681 and 682 of the Civil Code [4]. Generally, if the relevant agreement explicitly uses the terms “guarantee” or “suretyship,” it will first be considered as a guarantee. [5] If such terms are absent but the guarantee intent is clear and meets the elements of a guarantee, it may also be recognized as such. Additionally, if the deficiency compensation agreement provides that “the deficiency compensation obligor shall perform when the debtor fails to perform or is unable to perform the debt,” it will be recognized as a guarantee. For example, the Supreme People’s Court held this view in Judgment (2019) Zui Gao Fa Min Zhong No. 560.

2. Recognized as Joinder of Debt

Article 552 of the Civil Code [6] represents the first time Chinese law has provided for joinder of debt in statutory form. However, the constituent elements and legal consequences of joinder of debt still await further clarification and improvement through judicial practice. Both joinder of debt and guarantee share similarities in function, mode of occurrence, and legal effects, but they differ significantly in legal attributes and consequences. Compared with guarantee, which has clear subsidiary characteristics, joinder of debt results in identity with the debtor’s obligation. [7] In essence, joinder of debt adds a new debtor to secure the realization of the claim, and thus the debtor by joinder bears heavier liability than a guarantor. [8] Judicial decisions tend to characterize as joinder of debt those situations where the compensatory obligation overlaps with the repayment obligation of other debtors. For example, in Judgment (2020) Zui Gao Fa Min Zhong No. 295, the Supreme People’s Court held that “Jintao Company and Zhu XX promised to unconditionally fulfill the deficiency compensation obligations for the fixed income and principal that Kete Company might obtain under the Loan Contract, and assumed unlimited joint and several liability for such obligations… The Deficiency Compensation Agreement is关联 with the rights and obligations under the Loan Contract and has the nature of joinder of debt.”

3. Recognized as an Independent Contract

Article 2(1) of the Civil Code Guarantee Judicial Interpretation [9] thoroughly implements the subsidiary nature of guarantees. Going beyond the subsidiary nature implies invalidity. Therefore, credit enhancement measures that do not contain a clear guarantee intention, and deficiency compensation arrangements where no principal debt exists—such as commitments made by junior interest holders to priority interest holders in layered structured transactions—are mostly recognized as independent innominate contracts. Court reasoning often states that “the deficiency compensation commitment is independent from the principal claim, which is distinctly different from the subsidiary nature of guarantee liability,” or “the Deficiency Compensation Letter contains no clear expression of joint and several liability guarantee, nor does it specify a guarantee対象.”

(B) Validity of Deficiency Compensation Agreements

In general financial activities, parties adopt deficiency compensation as a credit enhancement measure mainly to avoid various institutional restrictions, including the inclusion of guarantees in corporate financial reports, information disclosure by listed companies, and various restrictive rules for guaranty contracts, thereby enabling efficient execution and realization of claims. [10] In judicial practice, the main factors affecting the validity of deficiency compensation agreements are as follows:

1. Whether Internal Decision-making Procedures Have Been Followed

Where the deficiency compensation arrangement constitutes a guarantee or joinder of debt, it undoubtedly requires compliance with internal corporate resolution procedures. However, when it constitutes an “independent contractual relationship,” is it still necessary to follow internal corporate resolution procedures? Some existing precedents hold that where the deficiency compensation agreement constitutes an independent contract, Article 16 of the Company Law regarding external guarantees by companies does not apply. For example, in Case (2019) Hu 74 Min Chu No. 2871, the Shanghai Financial Court held that the plaintiff’s commitment as a junior beneficiary to guarantee the deficiency in investment returns to the priority beneficiary was a promise by the debtor to the creditor to fully perform the contractual obligations, rather than a guarantee commitment made by a guarantor to the creditor for the performance of the principal contract by another person. Therefore, it did not constitute a guarantee and was not subject to Article 16 of the Company Law. In this regard, the author believes that Article 16 of the Company Law, which provides that “where a company invests in another enterprise or provides a guarantee for another person, the matter shall be resolved by the board of directors, the shareholders’ meeting, or the股东大会 in accordance with the company’s articles of association,” is a mandatory provision. Since providing deficiency compensation imposes additional debt burdens on the company, economically affecting the interests of the company and its shareholders, a purposive expansive interpretation of Article 16 of the Company Law should be applied to deficiency compensation agreements. [11]

2. Whether It Violates “Rigid Redemption”

Asset management business is an off-balance-sheet business of financial institutions. Financial institutions may not provide any direct or indirect, explicit or implicit guarantees for the underlying assets invested in by asset management products. Deficiency compensation commitments provided by financial institutions such as issuers, managers, or trustees to investors deviate from the entrusted asset management essence of “the seller fulfills its duties and the buyer bears its own risks” and would constitute “rigid redemption.” Based on the risk management needs of financial institutions, Articles 2, 13, and 19 of the New Asset Management Regulations and Article 92 of the “Minutes of the National Conference on Civil and Commercial Trial Work” explicitly prohibit “issuers, managers, or trustees of asset management products” from providing rigid redemption commitments to investors and from engaging in channel behaviors that constitute regulatory arbitrage. Therefore, deficiency compensation arrangements where the obligor is a financial institution such as the issuer, manager, or trustee are generally deemed invalid.

Deficiency compensation commitments made by affiliates of the manager, independent third parties, or junior investors in structured asset management products to priority investors have not been subject to categorical negative judicial evaluation of their validity under mandatory laws or regulations. Article 90 of the “Nine Civil Minutes” confirms the validity of junior investors bearing compensatory liability to priority beneficiaries under deficiency compensation agreements, holding that it does not constitute rigid redemption. Article 91 confirms the validity of deficiency compensation provided by third parties outside the trust and related contracts. Article 92 limits the scope of invalidity for rigid redemption to “trust companies, commercial banks, and other financial institutions acting as trustees of asset management products.” In trial practice, courts also tend to start from the principle of private law autonomy, respecting the parties’ autonomy of will. Unless there is a clear transaction structure aimed at evading regulation, courts generally exercise caution in applying look-through regulation. For example, in Case (2020) Zhe 01 Min Zhong No. 3445, where the parent company of the manager, Xin Dingming Investment Company, provided a deficiency compensation guarantee to priority investor Xu, the Hangzhou Intermediate People’s Court did not look through to identify Xin Dingming Investment Company as a subject prohibited from rigid redemption and held that the deficiency compensation commitment was valid and enforceable.

3. Whether It Falls under Legally Prohibited Circumstances Such as “Using Lawful Forms to Conceal Illegal Purposes”

For deficiency compensation agreements between investors, unless there are other grounds for invalidity, they are not per se invalid for violating the law or public order and good customs. [12] When a deficiency compensation arrangement hollows out the asset management investment legal relationship, reducing it to a “channel” for circumventing restrictions on investment scope, leverage constraints, etc., such deficiency compensation agreements are highly likely to be deemed invalid as “using lawful forms to conceal illegal purposes.” For example, in Case (2020) Zui Gao Fa Min Zhong No. 682, the Supreme People’s Court held that the transaction structure in question was designed to facilitate the target company’s financing from Jiangxi Bank. Huajin Securities’ true intention in entering into the Partnership Agreement and Supplemental Agreement was not to become a partner, but to achieve the purpose of lending with principal and interest repayment in disguise, through the form of establishing a partnership while simultaneously transferring the partnership property shares and collecting a fixed premium. The agreements involved were all虚假 expressions of intent by the parties and could not be protected by the court. The Supreme Court did not expressly rule on the validity of the “Partnership Shares Transfer Contract” regarding the repurchase and deficiency compensation arrangements, but once the Partnership Agreement was invalidated, the Partnership Shares Transfer Contract naturally became invalid as well.

In the China Merchants Bank v. Everbright Capital case, Everbright Capital was both the sole shareholder of the manager and a junior investor. The court did not simply deny the validity of the deficiency compensation arrangement on the grounds that a junior investor provided a deficiency compensation commitment to a priority investor. Instead, it focused on examining whether there was a collusive虚假 expression of intent among the parties at the time of signing, i.e., whether the parties had the purpose of achieving “illegal” goals through the contract. As long as the parties had a genuine expression of intent to achieve the expected effect of the investment contract, without violating mandatory provisions of laws and administrative regulations, it would not constitute collusive虚假 expression and be invalid.

4. The Impact of Timing on Court Adjudication Rules

Existing case samples are all legacy business cases. When adjudicating, courts apply the adjudication rules in effect at the time of the transaction. Therefore, the impact of timing on court adjudication rules should also be considered. For example, in Case (2019) Jing 02 Min Chu No. 110, the Beijing Second Intermediate People’s Court held that “trust companies should ensure that the trust purpose is legal and compliant and should not provide channel services for client banks to circumvent regulatory provisions… However, the trust product involved was established in 2017, which is a legacy bank-trust channel business prior to the implementation of the aforementioned financial regulatory policies… Therefore, Huarong Tianze Company’s purchase of the trust product did not constitute using a lawful form to conceal an illegal purpose.” However, with the end of the transition period and the arrival of the post-New Asset Management Regulations era, whether the existing adjudication rules will still apply remains unknown. Although from the perspective of legal hierarchy, financial regulatory rules such as the New Asset Management Regulations and the “Administrative Measures for Commercial Bank Wealth Management Subsidiaries” are departmental regulations and courts cannot directly invoke them to invalidate deficiency compensation agreements, under the background of strong regulation, based on Article 31 of the “Nine Civil Minutes” [13], when the regulatory object, purpose, and protected legal interests of financial regulatory rules involve public order and good customs such as financial security, market order, and national macro policy, judicial practice often adopts the “violation of public order and good customs” line of reasoning and declares the contract invalid.

In summary, the disputes in judicial precedents regarding deficiency compensation agreements mainly focus on the determination of legal nature and validity. Although courts tend to recognize deficiency compensation arrangements as valid, there are also instances where agreements are deemed invalid on grounds such as violating departmental regulations and harming public order and good customs. Banks and other financial institutions, in the practice of wealth management investment operations, should pay close attention to the above factors, reasonably construct transaction structures, and avoid defects in the validity of deficiency compensation agreements as much as possible.

Notes:

[1] Wei Peng. Transformation of Bank Asset Management Business and Coordinated Development of Wealth Management Subsidiaries [N]. China Insurance Asset Management, Issue 2, 2022.

[2] Dai Danmiao, Wang Jian, Shao Xiaofu. Bank Wealth Management Enters a New Development Stage [J]. China Foreign Exchange, 2022, (06): 70-72.

[3] Article 36 of the Interpretation of the Supreme People’s Court on the Application of the Guarantee System of the Civil Code of the People’s Republic of China: “Where a third party provides a commitment document such as deficiency compensation or liquidity support to a creditor as a credit enhancement measure, and such document contains an expression of intent to provide a guarantee, and the creditor requests the third party to assume guarantee liability, the people’s court shall handle the matter in accordance with the relevant provisions on guarantees.

Where a commitment document provided by a third party to a creditor contains an expression of intent to join the debt or to assume debt jointly with the debtor, the people’s court shall recognize it as joinder of debt under Article 552 of the Civil Code.

Where the commitment document provided by the third party in the preceding two paragraphs is difficult to determine whether it is a guarantee or joinder of debt, the people’s court shall recognize it as a guarantee.

Where the commitment document provided by a third party to a creditor does not meet the conditions set forth in the preceding three paragraphs, and the creditor requests the third party to assume guarantee liability or joint and several liability, the people’s court shall not support the request; however, this does not affect the creditor’s right to request the third party to perform the agreed obligations or assume corresponding civil liability based on the commitment document.”

[4] Article 681 of the Civil Code of the People’s Republic of China: “A guaranty contract is a contract under which a guarantor and a creditor agree that the guarantor shall perform the debt or assume liability when the debtor fails to perform its due debt or when the circumstances agreed upon by the parties occur.”

Article 682 of the Civil Code of the People’s Republic of China: “A guaranty contract is an accessory contract to the principal creditor-debtor contract. If the principal creditor-debtor contract is invalid, the guaranty contract is invalid, unless otherwise provided by law.

After a guaranty contract is confirmed to be invalid, the debtor, guarantor, and creditor who are at fault shall bear corresponding civil liability according to their respective fault.”

[5] Huang Mingfei. On the Definition of Deficiency Compensation and Implicit Guarantee [J]. China Business & Trade, 2021, (13): 64-66.

[6] Article 552 of the Civil Code of the People’s Republic of China: “Article 552 Where a third party agrees with the debtor to join the debt and notifies the creditor, or the third party expresses to the creditor its willingness to join the debt, and the creditor does not explicitly refuse within a reasonable period, the creditor may request the third party to assume joint and several liability with the debtor within the scope of the debt that the third party is willing to assume.”

[7] Wu Siping. Identification of Joinder of Debt and Guarantee [D]. East China University of Political Science and Law, 2021. DOI: 10.27150/d.cnki.ghdzc.2021.000247.

[8] Research Group of Hunan Branch of China Orient Asset Management Co., Ltd., Su Ning. Legal Risk Analysis of Non-performing Asset Business of Financial Asset Management Companies from the Perspective of New Civil Code Guarantee Rules—Taking Mortgage Property Transfer and Deficiency Compensation as Examples [J]. Financial Economy, 2021, (07): 57-65.

[9] Article 2 of the Interpretation of the Supreme People’s Court on the Application of the Guarantee System of the Civil Code of the People’s Republic of China: “Where the parties agree in a guaranty contract that the validity of the guaranty contract is independent of the principal contract, or agree that the guarantor shall assume guarantee liability for the legal consequences of the invalidity of the principal contract, such agreement on the independence of the guarantee is invalid. If the principal contract is valid, the invalidity of the agreement on the independence of the guarantee does not affect the validity of the guaranty contract; if the principal contract is invalid, the people’s court shall determine that the guaranty contract is invalid, unless otherwise provided by law.”

[10] Zhu Xiaozhe. Reflection and Reconstruction of the Guaranteeization of Credit Enhancement Measures—An Empirical Study Based on Chinese Judicial Decisions [J]. Modern Law Science, 2022, 44(02): 133-151.

[11] Li Zhigang, Deng Jiangyuan, Wang He, Xie Shu, Jiang Qiang, Zhuang Jiayuan, Ji Hailong, Yao Mingbin, Zhu Xiaozhe, Zhu Hu, Xu Tongyuan, Ge Yunsong, Si Wei. Nature, Validity, and Subordination of Guarantee of Deficiency Compensation [J]. People’s Judicature, 2021, (25): 104-109.

[12] Li Hao. On the Validity Determination of Deficiency Compensation Agreements in Asset Management Products—An Analysis Based on 108 Relevant Judicial Decisions [J]. Financial Law Forum, 2020(04): 220-244.

[13] Article 31 of the Minutes of the National Conference on Civil and Commercial Trial Work: “Violation of regulations generally does not affect the validity of a contract. However, if the content of the regulation involves public order and good customs such as financial security, market order, and national macro policy, the contract shall be deemed invalid. When determining whether a regulation involves public order and good customs, the people’s court shall, on the basis of examining the regulatory object, carefully consider the intensity of regulation, protection of transaction security, and social impact, and provide full reasoning in the judgment document.”

This article was first published in issue 97 of Shenzhen Lawyers and is reproduced with the author’s consent.