Real estate securitisation needs improving

The market must be improved to overcome legal uncertainties which are hindering its full development

The trust is the most important legal concept behind asset-backed securitisation (ABS) in China. Under the PRC Trust Law, a trust is a legal relationship where a settlor entrusts its asset to a trustee who possesses, utilises, profits from and disposes of the trust asset in the name of the trustee and for the benefit of a beneficiary. While a trust, being a legal relationship instead of a legal entity, is not restricted from attaining special purpose vehicle status, using a trust structure for ABS transactions still faces persistent challenges and uncertainties. Many of those problems are clearly present in ABS offerings by the real estate industry in China.

When the initial trust asset is capital paid by investors, the trust is called a capital trust. The investors are both the settlors and the beneficiaries. When the initial trust asset is a property right, the trust is called an asset trust. In an asset trust, the originator in need of financing is the settlor and the investors are the beneficiaries. The property right in an asset trust can be ownership of property, a contract right, an equity right or a right of return. Asset trusts and capital trusts are the two main methods of securitisation in China – credit asset securitisation and corporate asset securitisation.

In credit asset securitisation, a special purpose asset trust is used to issue ABS notes on the China interbank bond market (CIBM). These notes are regulated by the People's Bank of China and the China Banking Regulatory Commission (CBRC). In the credit asset securitisation market, the dominant assets are loans made by financial institutions, such as commercial banks, policy banks, financial leasing companies and auto finance companies.

In corporate asset securitisation, a special purpose capital trust, which is called a special asset management plan (SAMP) of qualified securities companies or securities fund subsidiaries, is used to issue ABS products on the block trade sections of the Shanghai and Shenzhen Stock Exchanges. The SAMPs are regulated by the China Securities Regulatory Commission (CSRC). Compared with credit asset securitisations, corporate asset securitisations feature more diverse asset types. The underlying assets mainly include receivable claims made by small loan companies, financial leasing companies, toll road companies, real estate developers and owners, and utility companies, such as water, electricity, heat and gas supply companies.

The Reit structure cannot achieve its potential without adequate tax incentives, which do not exist in China

Using an asset trust is a viable option for true sale analysis for securitisation. In an asset trust relationship adapted to a credit asset securitisation, the entrusted assets will be separated from the assets of the originator and trustee. If, for example, the originator of a trust dissolves in bankruptcy, the trust will continue to exist and the trust property will not be deemed part of the originator's property. Under the Trust Law, if the originator is not the only beneficiary or investor, the trust will continue to exist and its property will not be deemed part of the bankruptcy estate. As such, it is much easier to achieve a true sale under an asset trust structure.

As only trust companies are permitted to use the asset trust structure, securities companies and fund managers are forced to use a capital trust for their SAMPs. The entrusted assets (being investors' funds) can be separated from the investors' assets but the relationship between originator and trustee requires a sale and purchase of the underlying assets. However, there are uncertainties under the Contract Law and Enterprise Bankruptcy Law as to the conditions under which a true sale has occurred.

PRC law actually does not mention or define a true sale. Instead, courts review whether a sale can be completed under the law. The Supreme People's Court has recharacterised a sale agreement as a loan made by an unlicenced lender. This recharacterisation usually requires evidence of fixed payments to a lender who bears absolutely no risks in the assets. As part of the so-called transfer of risk test, article 133 of the Contract Law also places great weight on the delivery of the subject of a sale agreement. The delivery of the subject is generally regarded as the point when risk transfers.

Inside China

Inside China, written by FenXun Partners' Xusheng Yang and Sue Liu, is an insight into aspects of the China market that often elude the naked eye. Yang is a specialist in China's financial markets and institutions, having started his career at the China Securities Regulatory Commission and then co-founding FenXun in 2009. Liu's practice focuses primarily on the asset management industry, and has previously worked as an associate at Skadden Arps Slate Meagher & Flom in New York.

Despite the advantage of using the asset trust structure, commercial mortgage-backed securitisation (CMBS) has not been introduced in CIBM because the CBRC discourages it. By allowing financial institutions to securitise commercial mortgaged loans, the CBRC is concerned about sending a messages that it is facilitating financing for the real estate industry when the industry is facing an increasingly high asset bubble risk.

In contrast to the credit ABS market where all originators are regulated financial institutions such as commercial banks, in the corporate ABS market most originators are unregulated entities. As unregulated entities, these originators have more freedom to securitise assets on their balance sheets. This freedom results in corporate ABS originators being more market-oriented than their credit ABS market counterparts, which are policy-oriented.

From December 2014 to August 2016, China's real estate industry conducted over 30 corporate ABS offerings with the SAMP structure, which is in nature a private capital trust. About 20 of these were securitisations of residential property management fees and of rights of return on commercial rental properties. In terms of risk isolation mechanisms, the future flow assets underlying these securitisations posed challenges for true sale analysis. The remaining 10 offerings were CMBS and private real-estate investment trust (Reit) transactions. In terms of risk isolation mechanisms, the accrued receivable assets or combination loan and equity assets underlying these securitisations posed fewer challenges for true sale analysis.

In China, future flow assets are generally considered to be either a right of return or a future contractual right. However, PRC law does not recognise either of these concepts, which creates obstacles for the transfer of future flow assets. In particular, the transfer of a right of return faces two obstacles. First, a right of return generally cannot be separated from the right to possess and utilise a property (although a beneficial interest, which is similar to a right of return, can be separated from a property through a trust structure). As an exception, the Supreme Court has allowed the right of return on a franchise right granted by the government to be a pledgeable right, which therefore implicitly recognises it as a transferable legal right. Second, even if the right of return could be separated from the right to possess and utilise a property, China does not have a registration system in which to register the transfer of a right of return. Therefore, an outright transfer of this right is not a valid ground on which to base a claim against a bona fide third party. As a result, the transfer of a right of return is always treated as a loan from the buyer to the seller. To solve this transfer problem, the Property Law would need to be amended to include a new property right and registration system. This amendment, however, seems far from appearing on the People's Congress' agenda.

Due to this legal issue, stock exchanges prefer transactions involving future flow assets to be constructed to provide investors with a clear and ready means to enforce their rights in the assets. For instance, a securitisation of the right of return on rents can be reconstructed as a CMBS to the real estate company. In addition, stock exchanges require these transactions to be subject to risk mitigation measures. For instance, underlying assets related to the right of return may not be otherwise mortgaged or pledged; the cash flow and related accounts must be supervised by the bank; and the originator must provide adequate access and disclosures to prove the sustainability of its operations.

When an originator or its guarantor possess a high credit rating, and the originator does not intend a true sale, the stock exchanges will usually not review the originator's risk isolation structure at great length. If the originator does not have a good credit rating, the stock exchanges will either impose a strict true sale structure or require enough internal or external credit enhancements to support a AAA rating for the senior notes.

Today, China does not have specific laws or regulations to govern Reits. In 2015 and 2016, a few securities companies took a step into the unknown by launching several private Reits through the corporate ABS vehicle. However, a SAMP, a securities company's asset management vehicle, cannot serve as a public offering channel under Chinese law. In light of this restriction, a public mutual fund, which is also a trust relationship under the Securities Investment Fund Law, seems to be the only viable option for a Chinese Reit to achieve public status and realise the potential of Reits in mature overseas markets. Therefore, on June 8 2015, with approval from the CSRC, Penghua Fund Management launched China's first public Reit, worth RMB3 billion ($468 million) on the Shenzhen Stock Exchange.

Penghua's public Reit is governed by the Fund Law provisions on securities investment activities conducted by way of portfolio investments in publicly-traded securities and funded through fund shares (akin to mutual funds). According to article 72 of the Law, fund capital should be used for listed stocks and bonds and for other securities or their derivatives prescribed by the CSRC. However, in creating its fund, Penghua bought unlisted privately placed shares that were not intended to become publicly-traded securities. By afterwards approving the Penghua Reit as a public Reit, the CSRC has effectively allowed a public mutual fund to invest directly in private companies seemingly in contravention of article 72.

The legislature could have prevented or cured this inconsistency with its last amendment to the Fund Law. However, the legislature did not amend the Law to include non-listed securities funds and therefore missed its chance to transform it into a unified framework to govern the whole asset management industry. Legislators did consider the amendment, but they decided that the framework of the Fund Law, even with a non-listed securities funds amendment, would still not have been able to provide adequate protections for investors of non-listed securities funds such as Reits. Instead, legislators thought a complete overhaul of the law would be required to provide these protections. This overhaul will need further study and consultation before the legislators attempt it. One major hurdle to overcome is that, in contrast to publicly traded securities, the market value of private shares cannot be easily and constantly ascertained. Therefore, it will be a difficult task to formulate a harmonised set of rules within the Law's framework to regulate non-listed securities funds and provide adequate protections for their investors.

As the Fund Law now stands, the fund manager of Penghua Reit or any public Reit would have to adopt an asset portfolio approach when investing in securities because it recognises and adheres to the diversification principle for mutual fund investments. Also, according to article 32 of the Regulations on the Operation of Public Securities Fund, the investment in a single security may not exceed ten percent of the total fund assets. These provisions are meant to further ensure investments in securities follow the diversification principle.

However, the CSRC granted special approval to the Penghua Reit to invest more than ten percent of its total fund assets in a single security. According to the Penghua Reit's prospectus: 'its investment in a specific and single target company's equity does not exceed 50% of the fund assets; and fixed income and right of return assets shall be no less than 50% of the fund assets'.

While investing 50% of its fund assets in one security is not ideal for any Reit project, receiving permission to exceed the ten percent cap remains a breakthrough under the Fund Law. However, given that the diversification principle remains a pillar of the Law, any further increase of this new cap will not be possible without first overhauling the regime.

China also does not have adequate tax laws and regulations for Reits. As demonstrated in mature markets, the Reit structure cannot achieve its potential without adequate tax incentives, which do not exist in China. In China, commercial real estate rental income is subject to 5.5% business tax, 25% income tax, and additional property taxes. Dividends paid to individuals are also subject to individual income tax. And, for property acquisitions and transfers, sellers are also required to pay a high income tax. These taxes can make Reits' costs prohibitive for many investors.

By Xusheng Yang, partner at FenXun Partners (Beijing)