Over the past few years, revolving trade crises have frequently occurred in China, such as the steel trade crisis in 2011 in Southern China and the financing fraud case in Qing Dao last year. In these cases, many large stated owned enterprises were caught in crises of revolving trade. In particular, the Qingdao Port Case attracted wide world attention.
With our previous legal practice experience in these cases, we discuss the relevant issues regarding revolving trade and treatment methods for enterprises.
What is revolving trade?
Under PRC laws, only certain financial institutions may operate loaning business. This means that other enterprises in China are not allowed to lend money among each other. This is the case despite the fact that many private enterprises have great difficulties in raising funds from banks. As a result, merchants developed revolving trade as an unconventional financing method.
Revolving trade (“Revolving Trade”) is a type of trade finance in which at least three companies enter into multiple, related contracts. The contracts form a circular relationship between three parties (see the diagram below). There are upstream and downstream companies, which are affiliated to each other and controlled by the same person. Another company (generally a state owned enterprise (“SOE”) with good credit) sits between the upstream and downstream companies. The SOE lends the upstream company money and then is repaid by the downstream company.
As part of the Revolving Trade, the upstream company agrees to transfer goods to the downstream company. The purpose of the transfer of goods is to try to ensure that the transaction is not considered a loan (which is not permitted by non-financial institutions), but rather relates to the trade of goods. Generally, goods are recycled many times under the Revolving Trade. In extreme cases, the financing parties may collude with the warehouse/logistics operators to issue inauthentic warehouse receipts, bills of lading or other documents of title. In such a case, the parties would not actually take charge of goods, but would only deliver the title documents to the downstream companies.
In relation to the payment, the upstream company will provide a letter of credit to the upstream company. The upstream company will generally discount the letter of credit and use those funds for investment in other projects. Before the maturity date of the letter of credit, the downstream company will return the money to the SOE as the payment for the goods.
Discounting a letter of credit is a strategy of generating cash for a letter of credit before it is due to be honored at some point in the future. The beneficiary of the letter of credit (here, the upstream company) can obtain a reduced amount secured by the letter of credit (the discount amount) prior to the date that the letter of credit is due to be performed. Commonly, an honored l/c could be discounted to any bank (discounter), since the issuing bank had honored the l/c, which means the issuing bank guaranteed the payment in the future.
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The crises under the revolving trade
Due to the size of the investment project, each contract amount under Revolving Trade is generally quite large. If the downstream company is unable to make payment to the SOE in the middle of the chain, the SOE may be unable to pay the upstream company on the maturity date.
- In practice, usance drafts or letters of credit are frequently used in upstream contracts. Upstream companies may discount the drafts or letters of credit immediately after honored by SOEs or their banks. On the maturity date, SOEs or their banks will be responsible to make payment to the discounter bank or other drafts bearers (commonly not the upstream companies) as agreed.
- If SOEs fail to make payment on the maturity date, the discounted bank or other bearers are highly likely to lodge a lawsuit against SOEs to claim for payment in accordance with the honored drafts or letters of credit. To the best of our knowledge, in most of these cases, the banks have always been successful and the SOEs have been required to exercise their rights of recourse against the upstream companies at a later stage.
- Moreover, in practice, the upstream and downstream companies are generally shell companies which are specifically set up for the Revolving Trade. If the upstream or downstream company defaults in making any payments, these companies do not have any property that the SOE can seek to be preserved or against which it can enforced an award or judgment. Therefore, the SOEs which participate in Revolving Trade may suffer the risks of losing goods (no genuine goods under title documents) and money at the same time, and in fact, many SOEs had already suffered through hardships.
Under PRC laws, the legal risks of Revolving Trade are various. The operating of Revolving Trade on the basis of genuine goods may only result in civil consequences, e.g. contracts might be found invalid. But if there are no goods exchanged under the Revolving Trade, the relevant companies, enterprises and people may face criminal charges, such as, the crime of fraud, falsely issued VAT invoices, etc.
The validity of contracts of revolving trade under the PRC laws
For a long time, PRC laws have not permitted lending and borrowing activities between enterprises. Chinese courts have generally held that sales contracts under Revolving Trade are in fact financing contracts and therefore invalid under Article 52 of PRC Contract Law and other regulations. 
However, in recent years, the validity of sales contracts under Revolving Trade is uncertain under Chinese law. The opinions of the Supreme People’s Court (the “SPC”) and local courts differ.
There are three representative judgments in which the SPC found that sales contracts under Revolving Trade were invalid, because there were no true goods delivered and the contracts are actually loan contracts. If the contracts are invalid, Article 58 of PRC Contract law provides that the property acquired as a result of a contract shall be returned after the contract is confirmed to be null and void, and the party at fault shall compensate the other party for losses incurred as a result therefrom. If both parties are fault, each party shall respectively be liable. Due to the particular features of Revolving Trade outlined above, SOEs face many difficulties when seeking to recover funds or when initiating legal proceedings and claiming for damages.
However, with China’s market economy developing, the Chinese judicial departments have tended to deregulate borrowing and lending activities among enterprises. In September 2013, Mr. Xi Xiaoming, the Vice Director of the SPC, delivered his opinions regarding this issue. In relation to loans between enterprises, he said that courts should distinguish between the nature and validity of different activities. Where an enterprise is not qualified to operate as a financial institution, yet derives its primary income from lending money, the loan contracts it enters into should be invalid. However, where an enterprise borrows money from another enterprise (which is not qualified to operate as a financial institution, but does not derive its primary income from lending money) and the borrowed funds are used for the borrower’s production or business, the loan contract should be valid.
In 2014, in the case of MinErZhongZiNo.56, the SPC found that the legal relationship of buyer-seller should not be denied despite the fact that the parties to the contracts did not deliver or transfer any goods. Accordingly, SPC did not find that the contracts were invalid.
On December 9th, 2014, the SPC issued the Opinions about Equally Protecting Non-public Sectors of the Economy and Promoting Sound Development of Non-public Sectors of the Economy (the “Opinions”). Subject to Section 9 of the Opinions, the innovative activities conducted by non-public sectors of the economy must be legally handled and considered with great care. Activities shall be not punished if not against the law or judicial interpretations. Further, on December 29th, the SPC held a news conference to explain its permissive attitude to innovative financing mechanisms practiced by non-public enterprises. When responding to a report’s question, Mr. Zhang Yongjian, the presiding judge of No.2 Civil Court of SPC, said that parties may conduct innovative practices in the aspect of guarantee and financing, “we shall take a permissive attitude to these guarantee or innovative practices, by hearing these cases, the financing difficulties of entities of non-public sectors of the economy might be improved or solved”.
In general, on one hand, from the view of abovementioned cases and the SPC’s interpretation, there is a trend that loan contracts among enterprises will be deregulated and contracts under Revolving Trade might not all be invalid, but on the other hand, most local courts in China now are still hold these contracts are invalid and the legal risk of these contracts are still exist.
All in all, once a Revolving Trade crisis has happened, the key issue for the SOEs is not to obtain a conclusion regarding the validity of contracts, but to recover damages under the contract.
How to prevent and control risk ?
From our observations of recent cases, a majority of the participants of Revolving Trade exposed to loss are state-owned enterprises or its overseas subsidiaries. In order to avoid damages, SOEs could take many different measures at different stages to prevent and control the risk of Revolving Trade.
1. The stage of contract conclusion
In order to be in a position to consider the financial purpose and contractual risk, before the conclusion of the contract, it is necessary to examine the background information and relationship between upstream and downstream companies as well as their affiliated companies. Particularly in relation to domestic bulk commodity transactions, if associations between the upstream and downstream companies are discovered, and thus a Revolving Trade found to be possible, the party concerned should immediately end the negotiations or require the other party to provide valid guarantees and mortgages.
Secondly, before the transaction, the asset and credit state of the opposite party should be collected, with a list of assets under its name provided. In this way, even if the capital chain is broken, the damaged enterprises may recover the losses to the greatest extent by filing a lawsuit seeking property preservation.
Further, when entering into a contract, SOEs should as far as possible avoid using usance drafts or letter of credit to make payment to an upstream company (except that the downstream company is willing to accept the settlement by usance drafts or letter of credit as well). However, of course, without the use of usance drafts or letter of credit, the purpose of creating Revolving Trade might not be realized.
2. The stage of contract performance
At this stage, it is essential for SOEs is to ensure that the commodities the subject of the Revolving Trade in fact exist. It is important that, if the downstream company fails to make payment in time, the SOE’s title to the commodities may still provide assurance for them. The SOE could then sell the commodities to recover the payment and, at the same time, avoid being involved in criminal allegations due to the Revolving Trade being seen as a shame transaction.
In addition, where payment is made by way of a letter of credit, acceptance may only be made upon strict careful examination of documents attached to the letter of credit, with the emphasis on whether the documents of title are duly signed, endorsed, transferred, etc. as provided by law. Meanwhile, SOEs should carefully retain the documents delivered, including the original bills of lading, warehouse receipts, drafts, honored SWIFT.
3. The stage of dispute resolution
Due to there being multiple parties involved and the complexity of the trade structure, the enterprises involved may be in urgent need of experienced lawyers to preserve the assets of the opposite party, and to deal with possible criminal investigations, relevant international and domestic litigations and arbitrations.
We note that, in previous Revolving Trade cases, the dispute resolution clause stipulated in the contracts differed significantly. For example, they included domestic litigation, overseas litigation, domestic arbitration and international arbitration and other methods. In many circumstances, when disputes occur, one enterprise may have to simultaneously file a claim or respond to a claim under different dispute resolution mechanisms, for the reason that it may participate several Revolving Trade transactions (even in the same transaction chain, the articles of disputes resolution between upstream and downstream varies). Further, when the enterprises or persons involved in the Revolving Trade faced a criminal investigation, according to the principle of Criminal Case Prior to Civil Case, the civil litigations and arbitrations taken inside China might be terminated due to the criminal investigation. Therefore, after a dispute arises, SOEs should analyze risks from all the aspects and decide the overall plans to control risk, pursue civil recourse and and potentially responding to criminal investigations.
Meanwhile, when a dispute arises in relation to a Revolving Trade, the top priority for a SOE is to recover the money it has lent or to claim damages. The SOEs should take immediate legal action to preserve the property of the upstream and downstream companies. This will put them in the best bargaining position in relation to the upstream and downstream companies as well as other creditors. In many cases, a company may win a case but fail to execute the property, which have been transferred by the other party early on.
Lastly, if the financing gap of the trade is too large to repay, the SOEs may consider, at an appropriate time, initiating bankruptcy or reorganization proceedings to preserve the legal personality and the licenses or certificates under its name. This may also assist in clearing the external debts arising out of its normal trade, which is particularly important to the SOEs in China.