THE CHALLENGE OF GLOBALIZATION AND CHINA’S SECURITIES EXPERIMENT (3)

II.  LEGAL FRAMEWORK UNDER NATIONAL LAWS

A.        A Legal Framework Under International Influences

On December 29, 1999, the long-awaited national securities law was finally passed by the top legislative authority of China.  Given overwhelming approval by the top legislators,[1] the law is supposed to serve as a milestone to mark China’s legal construction of its securities market.

Largely China’s securities has been greatly influence by western countries.  The initiation of international cooperation started in 1993, when CSRC, SHSE and SZSE concluded a cooperative memorandum regarding regulatory affairs with the Securities and Futures Commission of Hong Kong, and Stock Exchange of Hong Kong.  On April 28, 1994, SEC chairman Arthur Levitt signed a Memorandum of Understanding with his Chinese counterpart, CSRC then president Liu Hongru, advising Beijing securities regulators on developing Chinese financial markets.  Thereafter, the CSRC entered into a memorandum for regulatory cooperation with the Singapore Financial Administration in November 1995, and signed an agreement with the Ministry of Finance and Securities and Investment Committee of the United Kingdom in October 1996.  In total, the CSRC has established agreements for regulatory cooperation with 12 countries and regions. [2]  Recently China becomes active in international securities regulatory community.  On July 1995 CSRC was admitted by International Organization of Securities Commission (IOSC) as its formal member.  In 1998, the IOSC furthur selected CSRC as member of its executive committee. [3]

The United States plays a more influential role in the developing of China’s securities than any other country does.  Sino-U.S. cooperation regarding securities regulatory affairs began as early as 1986, when Chinese leaders invited Wall Street experts to explain to them the U.S. capital markets. [4] The 1994 Memorandum of Understanding between SEC and CSRC is quite comprehensive.   According to the Memo, the SEC will, provide China with assistance by SEC staff in drafting law and regulations, send experts to China to conduct intensive training or held training sessions in China or U.S., and provide internship programs for CSRC personnel at SEC and with U.S. financial service providers. [5] Another proof of U.S. influence is that one of the leading drafters of Chinese Securities Law is an U.S. trained lawyer who received his J.D. degree in Duke University. [6]  So it is not surprisingly that, in many respects, Chinese securities law will be similar to U.S. securities law and will be easy for U.S. lawyers or brokers to practice.  China’s legal system also borrowed some ideas from Hong Kong, inasmuch as China’s CSRC is modeled after Hong Kong’s Securities and Futures Commission, which was set up under a centralized system of “one agency, one market”. [7]

B.         The Scopes of Application of the National Securities Law

As previously noted, before the enactment of the Securities Law there had been released several hundreds of rules or regulations concerning securities.  Those rules and regulations were passed in such a haste and with such frequency by such a multiplicity of authorities that it is very difficult, if not impossible, to keep track of them.  Many commentators were critical of the chaos and expected that a national law would serve as a substitution.   However, they were not satisfied by the newly made national law.  Although in a few instance the new law amends or supersedes some of the previous rules or regulations, it does not as such unify or clarify existing rules or regulations.  Besides stating that the Corporation is to apply to the issuance the securities, [8]the Securities Law makes no any other applicable provisions.   Therefore to this extent, the relevant rules and regulations will continue to apply.  As a commentator pointed out, at the same time, it is understood that such rules and regulations will be reviewed, which would then form a basis for drawing up and implementing regulations under the Securities Law to take their place. [9]

In essence, the Securities Law applies to the issues and trading of shares, corporate bonds and other securities recognized by the State Council within China. [10] Shares of Chinese companies reserved for foreign investment (B shares) and overseas listing shares(H shares or N shares), as well as government bonds, are separately regulated by other regulations made by the State Council. [11]

C.        Stock Companies and Securities Issuance

a. Stock Companies

Chinese Corporation Law allows for two forms of corporations: the Limited Liability Company or Limited Company (You Xian Ze Ren Gong Si) and the Joint Stock Company (Gu Fen You Xian Gong Si).  According to the law, each shareholder of a limited company shall assume liability towards the company to the extent of the amount of capital contributed by him, and the company shall be liable for its debts to the extent of all its assets.  As to stock company, its total capital shall be divided into equal shares and each shareholder shall assume liability toward the company to the extent of the amount of the shares held by him, and the company shall be liable for its debts to the extent of all its assets. [12] Roughly, the two forms correspond to the British distinction between the Limited Company ( Ltd.) and the Public Limited Company (p.l.c.), or the American distinction between the closed corporation and the larger (including the listed) corporation. [13]

A limited company does not participate in the securities markets because it can just have a limited number of 2 to 50 shareholders, [14]and its shares can only be freely transferred among the existing shareholders. [15] If a shareholder wants to transfer his or her shares to an outsider, the consent of over half of the shareholders must be secured. [16] Such a share transfer may be executed through a commercial contract, but at no event can it be executed in the securities markets.  To participate in the stock markets, the company must be a joint stock company. 

A joint stock company is required to issue shares to the public.  Chinese joint stock companies resemble the common law model of a company at the most, but its incorporation is under a more strict scrutiny, namely, the establishment of a joint stock company is subject to the approval of a State Council-authorized department or the government at provincial level. [17] A joint stock company may have any number of shareholders but must have a minimum registered capital of RMB ten million yuan(US$1.15 million) [18]  A joint stock company is governed by the shareholders’ meeting, a board of directors, a supervisory board,[19] and the executive management.  According the Corporation Law in text,[20] shareholders have extensive powers.  The Law provides that the shareholders’ meeting, which is required to be held once a year, is the most powerful authority of the company, making decisions on the selection and dismissal of directors of any corporate board, setting their salaries and considering their reports. [21] The foregoing rights are universal rights of shareholders in light of traditional corporation law of western countries.  However, Chinese shareholders enjoy some rights that are unavailable to their American counterparts.  In addition to the rights to vote on the resolutions of fundamental changes as merger, division, dissolution and liquidation of the company, the Chinese shareholders are entitled by the Law to “decide the policy of business operation and investment plans of the company,” approve the budget, consider and approve the plan of distribution of profits and recovery of losses, and vote on whether to issue corporate bonds. [22]  American corporate law, in contract, places those decisions exclusively within the scope of the directors’ authority. [23] However, whether the Chinese shareholders can exercise their rights according to the Law is in fact doubtful, given the facts that most Chinese joint stock companies are transformed from large state-owned enterprises with corporate officials accustomed to the old ways of administrating their companies, and the Corporation Law itself does not specify procedures for shareholders to exercise their rights.

b. Securities Issuance

1.       General Rules governing Securities Issuance

The Securities Law refers to the Corporation Law as the applicable law to the issuance of corporate securities. [24] The two laws established a mandatory “approval system” according which, the issue of stocks to the public must be subject to the ratification of the securities regulatory authorities under the State Council (Currently the “CSRC”) in accordance with relevant requirement defined by the Corporation Law; the issue of corporate bonds must be subject to the examination and approval competent authorities authorized by the State Council in accordance with relevant requirements defined by the Corporation Law. [25] The Securities Law requires that the relevant authorities in charge of examination and approval shall make a decision on any application for the issue of securities within three month counted from the date of accepting it for its review.   Where an application is not ratified or is approved, the authority shall explain the reason. [26] However, the law gives no hint as to what shall happen if the authority fails to do so within the period stipulated.

To meet the abundant demands from companies, China set up a quota system which represents its inveterate tradition of centralized government control and central planning.  Initially, a fixed amount of stock to be issued to the public is set by several State departments (including SCSC, CSRC, Ministry of Finance, State Commission of Economic and Trade, etc.).  CSRC, under the authorization of SCSC, allocates the issuance quota to provincial governments and some ministries, and the latter then distributed the quota among enterprises under their direct control. [27] Since 1999, because the central government required that governments of every level break off relations(Tuo Gou) with enterprises, the CSRC is, in theory, able to allocate quotas directly to enterprises, but it still has to consult with other ministries and local governments.

The Securities Law mandates that shares must be issued the public through underwriters which are registered as securities firms with the CSRC. [28]

2.       Two ways to issue stock to the public

  The Corporation Law provides two ways for a joint stock company to issue shares to the public.  The first one is the method of establishing a joint stock company through issuing to the public.  Under this approach, the promoter of the company purchase only a portion (at least 35 percent) of the total shares to the public while the remaining are offered to the general public for subscription. [29] The law, in order to prevent the promoter from selling highly risky securities to public investors while avoid personal assumption of risk, requires that promoter must retain their stock for three years.[30]  In this way the Corporation Law for the first time allows individuals and private enterprise to act as promoters.

  The other way to issue stock to the public is the secondary offering, so called IPO, after incorporation of the company.  To be entitled to issue public shares, the following conditions must be satisfied: (1) the previous issue of shares has been fully subscribed and at least one year have elapsed since that issue; (2)the company has been continuously profitable for the last three years and is able to make dividend payments to its shareholders; (3)there has been no false reporting in the company's financial and accounting documents during the last three years; and (4) the projected profit rate of the company equals or exceeds the rate of interest on bank deposits for the same term. [31]

3.       Listing in the Stock Exchange

In Chinese Corporation Law to issue stock to the public does not necessarily means that the company is “going to public”.   “Going to public” means the company is listed on a stock exchange and its shares can be traded therein. [32] According to the Corporation Law, in order to be listed on one of the two stock exchanges, a joint stock company, in addition to having issuing shares to the general public,[33] must have at least fifty million RMN yuan in capital and at least one thousand shareholders holding shares at a face value of more than RMB 1,000 yuan. [34] Futhermore, it must have been profitably for at least three years and it have no records of involvement in serious illegal activities or  commitment of falsification of financial accounting during the three years. [35] In addition, the law also requires that shares of the company issued to the general public must account for 25 percent of the total shares. [36] One commentators views these requirements as obstacles for the small and medium companies to raise capital and suggest that they reflect the government’s cautious approach to the securities markets. [37]

4.       Corporate Bonds Issuance

The Corporation Law provides ways for companies to raise capital through issuing bonds.  In this regard, not every company incorporated under the Corporation Law has the equal rights.  Only a joint stock company, a wholly State-owned company or a limited liability established by two or more State-owned enterprises or by two or more State investment entities may issue corporate bonds. [38]  To issue bonds, a joint stock company or an eligible limited liability company must have net assets of at least 30 million RMB yuan and 60 million RMB yuan, respectively. [39] The accumulated value of the bonds issued must not exceed 40 percent of the net assets of the company. [40]  To protect investors, the law provides that the company must have a average distributable profit during past three years that is sufficient to pay the interest on the bonds for one year. [41] The law prohibits bonds with interest rates that are more than forty percent above the banking deposit rate. Moreover, failure to make payments on previous bonds or default on other debts disqualifies a company from issuing bonds. [42] The Law also allows the joint stock companies to issue convertible bonds that may be converted into stock at the investors’ will. [43]

D.        “Chinese Classification” of Stock;

Even though both the Corporation Law and Securities Law is curiously silent on the classification of corporate stock, it remains the most distinctive feature of Chinese securities markets: the stock, in addition to its universal classification as common stock, preferred stock, etc, also is defined by the status and nationality of the shareholders.  Roughly, there is four types of shares: State shares, Legal person shares, individual shares, and foreign capital shares.  The basic rational under the classification is to control the transferability of different types of shares: State shares and legal person shares are theoretically nontransferable, foreign shares may only be traded in a special, closed market, and individual shares may be transferred only between Chinese citizens.

State Shares (Guo Jia Gu)

State shares refers to shares held by governmental agencies or authorized institutions on behalf of the State.   According to relevant regulations, it shall include: (1) The shares converted from the net assets of SOEs which have been transformed into joint stack companies. (2) Shares initially issued by companies and purchased by the governmental departments investing on behalf of the State. (3) Shares initially issued by companies and purchased by the investment companies, assets management companies, and economic entity companies authorized to make investment on behalf of the State. [44] State shares are not allowed to be traded on an open market.

Legal Person Shares (Fa Ren Gu)

Legal person shares refer to shares of a joint stock company owned by another company or institution with a legal person status.  The legal person shares can be indirectly hold by the State if the shareholders are State-owned companies. [45] Basically, there are four types of owners for legal personal shares, namely, state-owned legal person shares, collective enterprise legal person shares, private enterprise legal person shares, foreign invested enterprise legal person shares, and institutional legal person shares. [46] The transfer and trading of legal person shares are also restricted.

Individual Shares or A Shares(Ge Ren Gu)

Individual shares, with an official recognized nick name of “A shares”, refer to shares that may only be owned by Chinese citizens.  A shares has the full function born by classic stock, and it can be freely traded and transferred in domestic markets. [47] 

Foreign Capital Shares

Foreign capital shares include B shares and overseas listing shares.

B shares are shares which are offered exclusively to foreign investors.  Like other shares, they are denominated in RMB, but Chinese citizens are not permitted to own or trade in B Shares.  Issuing B shares is another channel for Chinese companies to raise foreign capitals.  [48]

Overseas listing shares are shares issued by Chinese companies listed on securities markets outside mainland China.  Among which are H shares, N shares and L shares:

H shares are offered by Chinese companies listed on Hong Kong Stock Exchange.  They are subscribed for and traded in Hong Kong Dollars, and denominated in RMB.  They can only be purchased and traded by Hong Kong local investors or overseas investors. [49]

N shares are issued to foreign investors on US stock exchanges.  They are denominated in RMB and subscribed for in US dollar.  Dividends are declared in RMB but paid in US dollars.  In fact, N shares are not traded directly on stock exchanges but are issued by way of ADRs (American Depository Receipts). [50]

L shares are issued on London Stock Exchange according a memorandum of understanding signed between U.K and China’s relevant authorities on October 7, 1996. [51]

E.          Market Regulations

        a.   Disclosure of Information

A large portion of the Securities Law stipulates the initial disclosure and continued disclosure of corporate information.  In the process of applying to go to public, five days before its trading on the stock exchange, the company shall place its documentation at a designated site for public review. [52] Those documents shall contains information including, among other things, the prospectus of the present issuance and last issuance, the charter and business license of the company, financial statement of the company, the date of approved to be listed on stock exchanges, the top ten shareholders and the quantities of shares hold by them, and the names of the directors, supervisors, managers and relevant senior officer and their holding of stock of bonds of the company. [53] For corporate bonds, the way of placing the bonds and the actual amount of bonds issued is essential information. [54]

For companies listing stocks or corporate bonds on the securities exchanges, the Securities Law requires continued disclosure of information be submitted two times a year:

Half-Yearly Reports As a minimum requirement, a half-yearly report shall carry the following information of the company: the financial statements, the performance of the company’s operation, major lawsuits concerned, changes in stocks or bonds already issued, major matters submitted to the shareholders’ meeting, and other matters required by the CSRC. [55]

Annual Reports An annual report shall contain the following information: the general situation of the company, the financial statement and operation situation of the company, a brief introduction of the directors, supervisors, managers and seniors officers of the company, and information on their holding of shares. [56]

In addition to the above specified reports, the listed company shall also submit interim report whenever there occurs any major issue which may be significantly impact the price of the securities issued.  Those major issues concerning the company include major change in operation policy, major investment acts, the conclusion of an important contract, the incurring of major liability and the company’s default in paying major debts, great changes of holding of shares by shareholders holding over 5% of the shares of the company, major legal actions involving the company, as well as important personnel change of the company. [57]

b. Prohibition of Short-Swing Trading; Conflict of Interests

The Corporation Law prohibits directors, supervisors and managers of the company from transferring shares they hold during their terms of office. [58] A 5% shareholder is also discouraged to purchase stocks within six month of any sale, or sell stocks within six month of any purchase, otherwise any gain from the purchasing or selling shall go to the issuing company other than the shareholder himself. [59]

As to conflict of interests, the Securities Law sets out mandatory code of conducts for all market participants, as well as regulators: officers and employees of stock exchanges, securities firms, securities registration and clearing companies, and securities regulatory authorities may not hold or trade in shares, and may not accept gifts of shares; [60] auditors, assets valuers and lawyers involved in a new issue of shares may not trade in those shares until six month after the end of the underwriting period, and in other transactions or cases must not do so until five days after the reports or opinions furnished by them have been made public; [61] officers of a stock exchange must withdraw from any official business involving interest of themselves or their relatives. [62] The law also requires that all authorities having the power to examine and approve securities issues must act fairly and lawful and make such processes more transparent, and their officers must avoid conflict of interest and not making improper gains using their positions. [63]

c. Inside Trading

The national securities law, as long-anticipated, incorporated a substantial number of measures against inside trading.  This is of particular importance in China, a country where very often personal relationships or connections (Guan Xi) embrace more popularity than business loyalty does.  The Securities Law expressly prohibits insiders who know inside information on the trading of securities of a company or other personnel who has illegal access to the inside information from buying or selling securities, divulging the inside information or advising others to trade in the securities. [64]

The Law defines “insider” broadly, including: directors, supervisors, managers, senior executives of the company; 5% shareholders; seniors officers of the parent company of the issuing company; any person who has access to the inside information due to his business position; officer or staff of relevant regulatory authorities; other persons specified by the CSRC. [65] Inside information is defined as undisclosed information which concerns the operation or financial affairs of a company or which will have material impacts on the marketing price of the securities of the company. [66] It includes, but not limited to, the following: the plan of the company to distribute dividends or increase capital; major changes in the structure of stock ownership of a company; major changes in the guarantee of liabilities of a company; mortgage, sale or scrapping for one time of over 30% of the assets of the company; acts of directors, supervisors, managers or other senior officers which may incur material damage to the company; plan of the company to acquire a listed company.  The CSRC may specify other matters as inside information. [67] 

The Securities Law imposes strict punishment upon those insiders unlawfully making use of inside information.  They may have their gains confiscated, and shall be imposed a fine which shall be up to five times of the gains.  Officers of the regulatory authorities shall face a heavier punishment.  Moreover, the insiders may also incur criminal liability. [68]

d.  Market Manipulation

Manipulation of the market by large investment institutions (Zhuang Jia) is a well-known “secrecy” in China.  The Securities prohibits any investor or investors jointly from manipulating trading price of securities by making use of capital superiority or taking advantage of shareholding position to buy or sell securities.  Investors are also not allowed to trade securities, in collusion with one another, on a beforehand agreed time, price and manner.  Trading securities with oneself is absolutely forbidden. [69]  People involved in manipulation of market may face confiscation of profits, a fine five times of illegal gains, and even criminal liability. [70]

e. Fiduciary Duties; Deceptive Practices

Securities firms and intermediaries must perform fiduciary duties, executing customers’ orders faithfully and to make timely confirmations.[71]  Securities firms, securities exchanges and securities registration and clearing institutions must keep secret the customer’s accounts therein. [72]  To maintain a fair climate in the market, the law enumerates a series of deceptive practices that are strictly prohibited.  Securities firms and their staff are prohibited from misappropriating securities entrusted by customers or trade for themselves on customers’ account, enticing customers into unnecessary trading in order to gain commission. [73] In addition, the securities firms are not allowed to finance or loan securities to their customers. [74] However, the term “unnecessary trading” was left undefined. 

F.          Regulations on Acquisitions

Chinese law at first was hostile to takeover or acquisitions made by large shareholders.  The State, in order to retain the so-called socialist public ownership, has been particularly conscious of the need to protect relatively smaller and weaker Chinese enterprises from being absorbed by larger, more wealth overseas corporations.  However, since the effectiveness of the Company Law, a substantial development in takeover and merger activity has led to a gradual reform.  Now, the national securities law is significantly less restrictive than its previous counterpart.[75]

The Securities Law provides two forms of acquisitions: acquisition by offer and acquisition by agreement. [76] In case of acquisition by offer, the following arrangements should be followed:  (1) Report of shareholdings: When an investor’s shares holding exceeds five percent of a listed company’s total shares, the investor must, within three days, report the fact in writing to the company, the stock exchange, and the CSRC. [77] Thereafter, the investor must report immediately whenever his or her holdings increase or reduce to another five percent of the listed company’s total outstanding shares. [78] Meanwhile, there is a “black out” period of two days following the disclosure of the holding during which the acquiring investor is not allowed to trade stocks of the listed company.[79]  (2) Mandatory Bid: Where an investor has held 30% shares of a listed company and plans to continue acquiring its shares, the investor shall extend an offer to all the shareholders of the company for the acquisition of their shares. [80] The period during which the offer remains open shall not be less than 30 days but no more than 60 days.[81]  (3). Report to CSRC: A report must be submitted to the CSRC prior to a mandatory bid offer being made, stating the parities, the purpose of acquisition, the price and amount of share, etc.[82]  (4) Delisting of the Acquired Company: Where the acquiring party holds more 75 percent of the total issued shares of the acquired company following the expiry of the offer, the company will be delisted.[83]  (5). Compulsory Acquisition: At the expiry of the offer, where the acquiring party holds more 90 percent of the shares of the listed company, the holders of the remaining shares have the right to sell their shares to the acquiring party under equal conditions as defined by the acquisition offer. [84] After the completion of acquisition, the corporate form of the acquired company shall be changed accordingly if necessary. [85]

In case of acquisition by agreement, the acquiring party and the acquired party can conclude an agreement on the transfer of ownership of shares, and thereafter the acquiring party must report to the CSRC its acquisition. [86]

G.        Regulations on Securities Industries

Another distinctive feature of China’s Securities Law is that a large part of its rules focus on the establishment and operation of securities firms, securities exchanges, and securities intermediaries.  This is a little bizarre because it is indeed a Chinese “characteristic” which can hardly be found in securities laws of western countries.  The Securities Law in this regard trespasses the authority of the Corporation Law.  The Securities Law regulates four types of securities institutions, [87] of which we hereby single out securities firms because they are of significantly importance in the running of securities markets.

The establishment of a securities firm, and thereafter, its business operation, are subject to the approval of the CSRC. [88] Securities firms are to be divided into two categories: “comprehensive securities firms”, which have a paid-up capital of at least RMB500 million and possess other prescribed qualifications;[89] and “broking securities firms’, which have a registered capital of at least RMB 50 million and posses other prescribed qualifications. [90] Broking securities firms may only engage in broking business, [91] while “comprehensive securities firms” may in addition engage in proprietary trading (which must, however, be kept completely separate from broking, employing separate personnel and keeping separate accounts), underwriting, and other securities business. [92]