Perspective | A Study on the Practical Issues of Whether "Renting to Offset Debt" Applies to the "Mortgage Does Not Break Lease" Rule

"Mortgage does not break lease" is one of the principles established and maintained by our civil law for a long time, with its core concept stemming from "subrogation" and "contractual relativity" as well as the protection of the legitimate interests of third parties (tenants). This principle can be traced back to our "Guarantee Law" and its judicial interpretation phase, and is also connected with a series of provisions in the "Property Law" (now the property section of the Civil Code) and the "Contract Law" (now the contract section of the Civil Code). The main reasons are as follows:
 

(1) The value balance of property rights prioritizing creditor rights. The mortgage right is a security right enjoyed over specific real estate, which functionally has the characteristic of priority in repayment; although the lease right is of a creditor nature, the landlord and tenant establish a lease contract through legal means and actually occupy and use the property, which also needs legal protection. If the mortgagee is allowed to dispose of the mortgaged property without regard to the existing lease relationship, it may severely harm the legitimate rights and interests of the tenant.

(2) Protecting transaction security and maintaining social order. From the perspective of transaction security, if the establishment of a mortgage can overturn the lease contract at any time, the tenant would be in a state of confusion, leading to significant instability in the rental market, which in turn affects social and economic order.

(3) Preventing malicious collusion by debtors and infringement of third-party interests. In practice, some landlords and mortgagees may collude maliciously, completing the disposal of the mortgaged property by arbitrarily terminating the lease contract and excluding the tenant's rights, which easily infringes on the legitimate rights of the tenant. The law stipulates that "leases are not terminated due to the disposal of mortgaged property" to counter potential damages.

Therefore, the purpose of establishing the "mortgage does not break lease" rule is that when the mortgage is established and the mortgage right is realized or executed, the tenant who has legally occupied and used the mortgaged property should not be arbitrarily deprived of their existing interests, otherwise it would contradict the law's intention to maintain transaction stability. However, this rule is not absolute and must be comprehensively examined in conjunction with the time of the lease contract's establishment and whether the rent is significantly below market price, to substantively determine whether a genuine and valid lease contract relationship exists.

The current provisions related to mortgages in the Civil Code mainly focus on the property and contract sections. Among them, Article 405 pertains to the effectiveness of mortgage rights and the disposal of mortgaged property: "If the mortgaged property has been leased and possession transferred before the establishment of the mortgage right, the original lease relationship is not affected by the mortgage right." According to this provision, it can be seen that mortgaged property can be transferred, leased, and disposed of during the mortgage period; if such disposal occurs after the mortgage registration, the tenant (transferee) cannot oppose the registered mortgage right; if a lease contract was established and actually performed before the mortgage was established, it should generally remain valid, reflecting the distinction between "first lease then mortgage" and "first mortgage then lease."
 

In addition to the relevant provisions of the Civil Code, the Supreme Court has also clarified the application of "mortgage does not break lease" in different scenarios through judicial interpretations. For example, in the Supreme Court's judicial interpretation regarding the guarantee system, it acknowledges that lease relationships established before the mortgage right is created can oppose the realization of the mortgage right; if the lease relationship is established after the mortgage right is created, it is difficult for the lease relationship to oppose the realization of the mortgage right. Related content has also been reflected in the previous "Nine Civil Summaries."

It can be seen that "mortgage does not break lease" is an important system that balances the statutory nature of property rights and transaction security, but in specific applications, it requires a comprehensive judgment based on the time of the lease contract's establishment, whether there is malicious collusion or significant unfairness, and whether there is damage to public interests.

"Renting to offset debt" refers to the arrangement between the debtor and creditor through the "lease" or possession and use of specific real estate to offset existing debts. In practice, the common scenarios mainly include the following two types:
 

(1) The debtor purely offsets the debt with rent

The creditor and debtor sign a lease contract, agreeing that the debtor will lease the real estate (such as houses, factories, land use rights, etc.) that they own to the creditor, during which the creditor does not need to pay rent, or the rent offsets the original debt within a certain period. In practice, in this model, the creditor is equivalent to the "tenant," but after the lease period expires or the debt is fully repaid, the property is returned to the debtor.

(2) The debtor uses rental income to repay the debt

Unlike the aforementioned situation, if the debtor has not rented the relevant real estate to the creditor, but continues to operate the property for rental purposes, the rent collected monthly or quarterly will be paid to the creditor to directly offset the debt. For example, if the debtor is the owner of the property and is unable to repay the loan in a timely manner due to difficulties in business operations in another location, they may rent the property to a third party, using the rent received each month to repay the principal and interest of the loan to the creditor. In this case, the creditor and the actual user of the property may not be the same person. In this situation, the relationship between the debtor and the third party is a general leasing contract, without any other legal relationship; the debtor merely uses the rental income to repay the creditor's debt. Therefore, this situation can apply the rule of "mortgage does not break lease," and there is no need for further discussion in the following text.

From the perspective of legal relationships, to determine whether the contract of "renting to offset debt" is a true lease, it is necessary to consider multiple factors such as the essence of the contract content between both parties, the background of the creditor-debtor relationship, whether there is a rental consideration, and whether there is actual delivery for use. The core characteristics of a lease contract are: (1) the lessor delivers the subject matter to the lessee for possession and use; (2) the lessee pays rent to the lessor; (3) the lessee's use of the leased property is for the purpose of the contract; (4) upon expiration of the lease term, the lessee must return the leased property.
 

In the lease contract of "renting to offset debt," there often appear expressions such as "rent-free" or "rent offsetting debt," and the expiration of the lease term is highly correlated with the progress of debt repayment; sometimes, whether the lessee enjoys independent and autonomous rights to the income from use is also uncertain. This leads courts to first determine whether the agreement is a lease contract or another type of contract (such as a loan, mortgage, or a contract that is nominally a lease but is actually a loan or investment cooperation, etc.) when adjudicating such disputes. However, through the aforementioned analysis, it can be seen that "renting to offset debt" is significantly different from general leasing, and the following text will further analyze the differences between the two.

Compared to general leasing, "renting to offset debt" mainly has the following differences:
 

(1) Different contract purposes and economic objectives

The purpose of general leasing is to obtain rent (lessor) or to gain income from use (lessee); although "renting to offset debt" superficially also has the nature of "income from use," its fundamental purpose is to repay debts or obtain creditor protection. Both parties are more concerned about whether the debt can be recovered on time, rather than general rental income.

(2) Methods of rent payment or offsetting

In general leasing, the lessee pays rent directly to the lessor; whereas in the case of "renting to offset debt," the lessee may be rent-free or offset existing debts with rent. The generation and payment of rent are not market behaviors but rather a reduction of the debt amount, possessing strong subordination.

(3) True intention and guarantee function

Some debtors may use "leasing" as a guise, with the real purpose being to conduct a disguised mortgage or pledge to ensure that the debt can be realized by controlling the property use rights or income rights upon maturity. This scenario does not completely overlap with the essence of "long-term operational use" in general leasing.

Therefore, in practice, accurately determining the nature of "renting to offset debt" requires a substantive review of the lease contract.

Based on the above analysis, when the real estate involved in "renting to offset debt" has been mortgaged, if the creditor claims "mortgage does not break lease" in their capacity as a "lessee," while the mortgagee claims "the contract is a false lease and is not protected by 'mortgage does not break lease'," a dispute between the leasing rights and mortgage rights will inevitably arise. Through the analysis of practical cases, it can be summarized that there are mainly two viewpoints in judicial practice:

Proponents of this viewpoint believe that as long as both the creditor and debtor have a genuine and valid leasing agreement, even if the contract contains special provisions regarding rent payment forms such as "offsetting debt" or "rent-free," it does not affect the legal nature of the lease contract. As long as it can be proven that the contract was established prior to the establishment of the mortgage right (or meets the requirements for opposition), and there is no significant unfairness or malicious collusion, the rule of "mortgage does not break lease" should apply. The legal basis for this is: (1) it meets the constitutive requirements of a lease contract. If the court determines that the agreement between the parties is a legal and genuine leasing behavior, and there are no false or hidden actions, it should be handled according to the nature of the lease contract; (2) it protects transaction security. Since there has been actual performance regarding the possession and use of the property between the creditor and debtor, it is inappropriate to easily deny its validity; (3) it encourages autonomy of will. As long as both parties genuinely decide to use rent to offset debt, it can be regarded as adding a debt repayment clause to the lease contract, which is essentially still a lease contract and should not be denied.
 

Proponents of this viewpoint argue that most "renting to offset debt" cases in practice are often not purely leasing; they are more likely a form of guarantee transaction for repaying other debts. Since the fundamental purpose is to repay debts or evade legal restrictions, once entering the procedure for realizing mortgage rights, it should be based on substantive review. If it is determined that it is not a genuine lease, in principle, it cannot rely on "mortgage does not break lease" to oppose the mortgagee. Specific reasons include: (1) "renting to offset debt" often lacks genuine rental consideration. For example, the parties did not negotiate based on market fair prices, nor did it reflect the independent income value of the leased property; (2) the essence of renting to offset debt is a contractual obligation, which is different from the lease contract signed between the lessor and lessee, where the purpose of debt repayment exceeds the scope of leasing. In this relationship, the so-called lease is more like "possessing the mortgaged property" or "using property to secure debt," lacking the independence of leasing itself, and does not meet the characteristics of leasing legal relationships; (3) it can easily lead to confusion in the order of rights opposition. If "renting to offset debt" is recognized as meeting the characteristics of "leasing," then mortgage rights or other property rights holders will face the risk of excessive dilution of rights.
 

Currently, this viewpoint is the mainstream viewpoint in judicial practice, and the following text will further elaborate on typical cases in judicial practice.

To gain a more intuitive understanding of the court's attitude towards whether "renting to offset debt" is applicable to the rule of "mortgage does not break lease" in judicial practice, this article summarizes and refines the viewpoints in practice through empirical analysis and selects typical cases for analysis.

Case Summary:
 

Yinjiang Company signed a financial loan contract with Ruihua Company and used its real estate as collateral. Later, Yinjiang Company was unable to repay the loan. Ruihua Company (later transferred the involved debt to a certain asset management company) sued Yinjiang Company in court. After the court hearing, a civil mediation was made. During the hearing, the court issued civil ruling (2017) Lu 0321 Minchu No. 1763 and assistance execution notice, and placed a provisional seizure on the real estate and other immovable properties under the name of the defendant Yinjiang Company. Later, a certain asset management company applied for execution, and after evaluation, the total estimated value of the real estate was 20,058,291 yuan. In May 2021, the court posted announcement (2019) Lu 0321 Zhi No. 973: This court has legally assessed, auctioned, and sold the land use rights and attached properties located on A Street under the name of the defendant Yinjiang Company. This court requires all tenants who are using the property to vacate the occupied houses and land by June 15, 2021, otherwise, this court will legally enforce the eviction of the occupied houses.
 

On June 1, 2021, the court notified tenant Miao that the court has legally assessed and auctioned the land use rights and attached properties located on A Street under the name of the defendant Yinjiang Company, and the ownership rights of the land use rights and attached properties have now changed to the buyer. Therefore, you are required to vacate the house by June 15, 2021, otherwise, the court will enforce the eviction. Later, the outsider Miao was dissatisfied and filed an execution objection lawsuit, claiming that the involved immovable property was leased by Yinjiang Company to offset the debts between both parties, and Miao is a tenant of the involved immovable property, thus the rule of 'mortgage does not break lease' should apply to exclude the enforcement.

Court's Viewpoint:

The court believes that there are two focal points of dispute in this case: one is whether the 'mortgage does not break lease' applies to the offsetting of debts with rent; the other is the relationship between the rights of offsetting debts with rent and property rights.

(1) Whether the offsetting of debts with rent applies to 'mortgage does not break lease'

Due to the loan not being repaid upon maturity, outsider Miao signed a wage arrears settlement agreement with Yinjiang Company, repaying the owed wages in the form of factory leasing, that is, offsetting debts with rent. The offsetting of debts with rent is different from a housing lease contract. In a housing lease contract, one party pays rent and uses the leased property; during the lease period, changes in property rights do not affect the validity of the lease contract. The offsetting of debts with rent reached due to the creditor-debtor relationship aims to eliminate the debt. Although it involves the use rights of the leased property to repay the debt, it does not change its nature; essentially, it is still a way to realize a general creditor's rights. The offsetting of debts with rent agreement is not a lease contract in the general sense and does not apply to 'mortgage does not break lease', thus does not produce the effect of preventing enforcement.

(2) The relationship between the rights of offsetting debts with rent and property rights

Property rights take precedence over creditor's rights. The rights of offsetting debts with rent based on creditor's rights (and without any other registered rights) cannot oppose the property rights obtained by the bidder Chenglian Yesheng Company through auction. The wage arrears settlement agreement between outsider Miao and Yinjiang Company, in terms of effectiveness, does not bind third parties (the buyer) Chenglian Yesheng Company.

Case Summary:

In the case of Wang and Meng, Chang's private lending dispute, the facts established: Wang lent money to Meng and Chang, and in November 2015 obtained the mortgage property under the names of Meng and Chang, specifically a property at No. 8, Nanbei Danfeng Street, Tianqiao District, Jinan. Later, Meng and Chang failed to repay the debt upon maturity, and Wang sued in court and won. Wang then applied for compulsory execution in the first instance court, and the involved property was transferred to Wang's name to offset Wang's debt. During the execution process, Yan claimed to be a tenant of the involved immovable property, stating that Meng rented the involved house to Yan to repay the debt owed by Meng to Yan, thus Yan filed an execution objection lawsuit.
 

Court's Viewpoint:

The focal point of the dispute in this case is whether Yan enjoys civil rights sufficient to exclude enforcement of the involved house. Yan claims that the reason for terminating the execution of the involved house is that he has leasing rights to the involved house, which were established before Wang's mortgage rights. In this regard, the court believes that, firstly, Yan submitted that the lease contract's performance period has expired; even if the leasing relationship is genuine, it no longer applies to the 'mortgage does not break lease' provision after renewal; secondly, according to Yan's statement, the debtor Meng repaid Yan's debt in a leasing manner, that is, offsetting debts with rent is actually a way for Yan to realize his ordinary monetary claim against Meng, and the contract between both parties is not a true housing lease contract, thus the contractual rights enjoyed by Yan cannot take precedence over Wang's mortgage rights. Therefore, the first-instance court's refusal to support Yan's lawsuit request is not inappropriate.
 

Case Summary:

Zhang and Dang lent Li 20.38 million yuan before February 8, 2012. Due to Li's inability to repay the loan, YHZ Company, which purchased Li's Carnival project, was responsible for repaying Zhang and Dang's loan. Later, due to YHZ Company's tight operating funds, it signed the involved 'Housing Lease Contract' with Zhang, and YHZ Company used the 20-year lease rights to offset Zhang's debt. Later, due to disputes between YHZ Company and a third party, the court prepared to enforce the involved house.
 

Court's Viewpoint:

The focal point of the dispute in this case is whether Zhang enjoys civil rights to exclude execution of the involved house. A lease contract is an agreement where the lessor delivers the leased property to the lessee for use and benefit, and the lessee pays rent. Changes in ownership of the leased property during the lease period do not affect the validity of the lease contract. In this case, YHZ Company's contract debt to offset Zhang's debt with the involved house is different from the lease contract signed between the lessor and lessee, thus the principle of 'mortgage does not break lease' stipulated in contract law does not apply.

From the above cases, it can be seen that at this stage, courts generally believe that 'offsetting debts with rent' is essentially a contractual debt, which is different from the lease contract signed between the lessor and lessee, where the purpose of debt repayment transcends the leasing scope. In this relationship, the so-called leasing is more like 'possessing collateral' or 'using property to secure debt', lacking the independence of leasing itself, not conforming to the characteristics of leasing legal relationships, and should not apply the rules of 'mortgage does not break lease' or 'sale does not break lease'.