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The Interpretation on Issues of Application of Laws with respect to Disputes on Financial Leasing Contracts (Interpretation) published by the Supreme Court of China came into force on March 1, 2014.

The Interpretation consists of 26 provisions addressing the issues of the validity, performance, termination and liability for breach of financial leasing contracts as well as issues on litigation involving financial leasing contractual disputes.

Identifying financial leasing contracts

In practice, there has always been controversy surrounding the nature and validity of financial leasing contracts. For example, in some cases financial leasing contracts were identified as loan agreements and the business carried out by financial leasing companies was considered to be "shadow banking". This was particularly the case when the framework of a financial lease adopted the "leaseback model", as the nature of the contract could be mistaken for a mortgage contract in practice.

Article 1 of the Interpretation provides that, when identifying the financial leasing contractual relationship, the courts shall, in accordance with Article 237 of Contract Law of China, take into account:
• the characteristic and value of the subject matter;
• the composition of rent; and
• the specific rights and the obligations under the contract. 

It is the terms of the contract itself that are instrumental in defining the nature of the contract. Contracts which bear the name of "Financial Leasing Contract" but do not accurately reflect the nature of financial leasing will be interpreted as establishing such other legal relationship as the courts deem fit.  Such provision shows that, in identifying financial leasing contractual relationship, the Supreme Court of China strictly abides by the principle that a financial leasing shall be characterized by the combination of a "financing fund" and "financing assets".

It is also worth noting that the legitimacy of a financial leasing contract adopting a "leaseback model", which is typical in ship financial leasing schemes, is acknowledged in the Interpretation.
The reason, as explained by the Judge of the Supreme Court in a recent interview, is that the leaseback model is not contrary to the definition of financial leasing contracts made in Article 237 of Contract Law of China which provides:

"A financial leasing contract is a contract whereby the lessor, upon purchase of the lessee-selected lease item from a lessee-selected seller, provides the lease item to the lessee for its use, and the lessee pays the rent."

Such definition does not preclude the possibility that the lessee and the seller could be the same party. However, where borrowing and lending contracts assume the form of financial leasing of the courts have discretion to resort to the principle of "substance over form". It may be, for example, that in the absence of an actual object to the leased, the parties enter into a financial leasing contract  rent will none the less be payable.

Alternatively the parties may manipulate the price of the subject matter leased to a grossly inflated level such that part of the purchase price (i.e. the inflated part) paid by the lessor to the lessee is actually in the nature of a loan. In such circumstances the court would treat such transactions as a contractual relationship, for the borrowing and lending of money.

Impact of lessor's operating license/qualification on validity of financial leasing contracts

Prior to the enactment of the Interpretation, it was debatable whether a financial leasing contract would be valid if a financial lessor had not been granted the specific license/qualification required to manage or operate the subject matter leased (see, for example as the Water Transportation Business License in the case of financial leasing of ships flying state flags of China).

Article 3 of the Interpretation makes clear that the court will not rule the financial leasing contract to be invalid solely on the ground that the lessor lacks the specific license/qualification for management/operation of the subject matter.

The rationale behind this, as explained by the Judge of the Supreme Court of China, is that the purpose of the lessor to purchasing the subject matter leased is to provide it to the lessee for their operation and to alleviate the capital shortage of the lessee. The lessor will not possess and operate the subject matter themselves. As such, financial leasing, by its very nature, should not require the lessor to have the necessary license/qualification required to operate the leased subject matter.

Notwithstanding the above, the financial lessor must be licensed to engage in financial leasing activities themselves (such activities being regulated as a form of finance which can only be carried out by financing institutions under Chinese law). It should also be noted that the relevant business license/qualification of the lessee who will actually operate the leased subject matter is still required under Chinese law.

With respect to the financial leasing of ships in China, attention should be drawn to the Notice on Regulating the Administration of Domestic Ship Financial Lease published by the Ministry of Communications of China on 10 April 2008 (Notice). In that Notice, the Ministry of Communications requires that, for ships which are the subject of financial leasing to carry out domestic water transportation, where the lessor is a Chinese-foreign joint venture, the proportion of foreign investment must be less than 50% of total shares. That is to say, wholly foreign owned financial leasing companies will not be permitted to enter into the domestic market of ship financial leasing in China.

Relationships among contracts and parties in financial leasing transactions

A typical financial leasing transaction usually entails a sale/purchase contract and a lease contract, with reference to each other. Furthermore, usually more than two parties are involved in such transaction. Chinese law was previously unclear about the relationships between the contracts as well as the parties, as the financial leasing contract under Chapter 14 of Chinese Contract Law only refers to the lease contract in a financial leasing.

In this regard, the Interpretation makes significant explorations in three directions:

1. Article 11 of the Interpretation provides that either the lessor or the lessee is entitled to terminate the lease contract if the sale/purchase contract between lessor and seller is terminated, rescinded or invalidated as this would result in the frustration of the purpose of the lease contract;

2. Article 16 of the Interpretation provides that if pursuant to Article 11 (see above), the lessor may, in accordance with the provisions of the lease contract, or in the absence of such provisions, in accordance with the principle that the subject matter was selected/appointed by the lessee, claim losses against the lessee;

Article 24 of the Interpretation provides in the event that the lessee directly seeks compensation from the seller on grounds of termination of the sale/purchase contract and lease contract, the court must notify the lessor and add the lessor in the legal action as a third party. 

The Judge of the Supreme Court of China further explains that such provision to some extent breaks the privity of contract (i.e. the privity of the sale/purchase contract) by allowing the lessee to directly file an action against the seller.  The Judge also believes such an arrangement reflects the nature of financial leasing whereby the role of the lessor is to finance the subject matter and thus it is proper for the lessee who selects the subject matter to directly claim against the seller under the sale/purchase contract (especially quality warranty claims).

Remedies for lessor after termination

Under Chinese Contract law, the remedy available for the lessor in the event of breach by the lessee is to claim for the unpaid rent or repossess the subject matter leased. Prior to the enactment of the Interpretation, it was a debatable issue whether the lessor would be entitled to resort to the two remedies simultaneously. The Interpretation has clarified that the lessor has to make a decision on which remedy they are going to choose in a legal action. 

The reason for such provision is that, theoretically, a claim for unpaid rents is tantamount to a request for specific performance in that payment of rents presupposes continued use of the subject matter by the lessee, however, a claim for repossessing the subject matter is tantamount to requiring termination of the contract. As the two remedies are conflicting, the lessor is required to make a choice between them.

Andrew Rourke is a partner at Clyde & Co LLP