Walter Hutchens’ Blog

The Chinese Communist Party generally does not have a sense of humor about itself. Earlier this year, the newspaper Beijing Xinbao was shut down after publishing a satirical list of “seven disgusting things” about the PRC.

Moreover, media suppression lives on in China. This year, articles about Zhou Zhengyi, Sun Zhigang and the repercussions of the SARS cover-up have all been declared verboten at times. Plus, reports concerning the enormous Hong Kong protests over the security bill were smothered on the mainland this summer. Etc., etc.

But a new list of publications that will be shut down in China appears to be motivated by “clean government” aspirations rather than political oppression. According to official PRC sources, this list of terminated publications results from an effort to eliminate a form of rent seeking by government agencies.

Apparently it has been common practice for “departments in charge” to mandate that entities subject to their control provide their staff members with subscriptions to publications that are produced by such dept. in charge.

A recent anecdote suggests how common the practice is: the regulator of the securities markets has been the victim of “identity theft;” someone impostered the CSRC in an effort to sell books and seminars to entities regulated by the CSRC. The CSRC put a warning on its website disclaiming involvement, and I am not aware that the CSRC has ever engaged in such petty extortion. But such a con presumably works because regulated persons are accustomed to their regulators using such methods of extraction.

In the run-up to this list of extinguished pubs being compiled, I understand there was a nationwide, blanket moratorium on all publications taking new subscribers. I presume that has now been lifted.

Of course, some publications being eliminated may have been put on the list for reasons other than being foisted on subscribers. (Marxists, not us capitalists, are enamoured of mono-causal explanations). One can easily imagine that some political opportunism crept into deciding which pubs to eliminate. Maybe this was a chance for the central authorities to rein in some local authorities; center-periphery relations are a perennial theme of politics in China. But glancing at the list I see no reason to think this “publications purge” is fundamentally motivated by censorship rationales. I don’t think it is mainly motivated by a desire to slash expenses, either. The Party is clearly willing to keep some commercially inert pubs in business for propaganda reasons, and presumably the forced subscriptions made these eliminated pubs budget neutral, at least. So I am inclined to take the Party at its word–this is a purge primarily motivated by a desire to eliminate one form of petty extortion.

PRC insurance companies and the PRC national Social Security Fund may be allowed to invest in securities outside of mainland China–perhaps initially in Hong Kong–prior to launch of a broader qualified domestic institutional investor scheme, according to this PRC financial press report.

The article notes that PRC insurance companies earn some foreign exchange premiums now, and the Social Security Fund has FOREX from overseas listings by PRC companies. The CSRC requires that 10% of the shares sold in each overseas IPO be shares that were previously state-owned and that the proceeds from the sale of such shares be transferred to the Social Security Fund. This state-owned share reduction scheme initially applied to all issuances including those on PRC domestic markets, but now it only applies to overseas listings.

The article notes, however, there is no timetable for implementation of any precursors to a QDII system, not to mention a QDII scheme itself.

Of the 63 IPOs in Hong Kong so far this year, 28 are PRC companies, accounting for 77% of the capital raised there this year (HK 21.2 billion of HK 27.5 billion), according to comments by a Hong Kong stock exchange official quoted in this PRC press story.

Hong Kong exchange official Zhou Wenyao commented that the Hong Kong exchange has no quota system and welcomes private PRC companies to list, though he said many need greater transparency to qualify.

According to this article, upcoming changes to the Stock Issuance Examination Committee (which reviews IPO applications in the PRC) will include the following:
1. the number of members of the SIEC will be reduced from 80 to 25;
2. the composition of remaining members will change–there will be more professional members, including experienced lawyers and accountants;
3. the list of all members of the SIEC will be made public;
4. votes of the SIEC will be recorded by name;
5. proceedings of the SIEC will be recorded;
6. prior to meetings, participating members and meeting times will be announced publicly;
7. prior to meetings, participating members must obtain working drafts (gongzuo digao) and sign for the files;
8. the outcome of SIEC votes on IPO applications will be publicly announced.

Proposals to change the SIEC have already been submitted to the State Council by the CSRC.

A Beijing court has upheld an administrative punishment decision (行政处罚决定, xingzheng chufa jueding) imposed by the China Securities Regulatory Commission (CSRC) against an accounting firm for negligence in auditing a listed company, according to PRC press reports (for example, here (in English), here and here).

Under the rules on private securities litigation released by the Supreme People’s Court at the beginning of this year, such an administrative penalty (or, alternatively, criminal sanction) is a prerequisite for shareholder litigation. Thus, unless the court’s decision to uphold the CSRC penalty is overturned on appeal, this accounting firm–Hua Wei accounting firm of Henan province–can be sued by shareholders of Zhengzhou Yutong Bus Co.

Hua Wei audited Yuzhou’s financial statements in 1999. Yuzhou’s assets were inflated by RMB 135 million.

Interestingly, in the challenged decision the CSRC had only issued a warning to the accounting firm and confiscated RMB 300,000 in fees Hua Wei had received for its “negligent” work. The amount does not seem very substantial standing alone. Thus, the firm may have fought the penalty precisely because of the prospect of shareholder litigation.

This particular accounting firm appears to be a purely native PRC firm. However, unlike law firms, PRC accounting firms are allowed to form joint ventures with international firms, and so the “final four” all have PRC branches that may perform audits of listed companies and could thus be exposed to the same risks of CSRC censure leading to private securities litigation. In fact, China arms of KPMG were named as defendants in earlier shareholder litigation in connection with audits of Jinzhou Port, another PRC listed company. So this is more than a theoretical risk.

The CSRC was pleased enough with the result to put it on its own website.

Although shareholders will be allowed to sue Hua Wei, that does not mean they will succeed. Note that this decision in favor of the CSRC was handed down by a Beijing court because Hua Wei, as plaintiff, had to sue the CSRC in its own backyard. The same principle will apply to shareholders of Yuzhou who wish to sue Hua Wei; they will have to travel to Henan and face courts that may be inclined to protect local interests.

Deciding who can publicly issue securities has long been a contested process in China.

Previously, China had a quota system, whereby the central planners came up with a fixed amount of money to be raised through IPOs in a given year, then doled portions of that amount out to provincial authorities who then picked local winners.

Getting such a listing opportunity was a windfall for the selected company. It could raise millions in funds that, unlike bank loans, do not even theoretically have to be repaid.

A few years ago this overt quota system was replaced with a system ostensibly designed to get better companies to market by having a quasi-independent body, the Stock Issuance Examination Committee, review IPO applications.

Ironically, while the rules for the SIEC state that they are promulgated in order to increase transparency (tigao toumingdu), the regulations then go on to require that the membership of the SIEC and its work procedures be kept secret! I discussed this in a paper I wrote in law school that was presented at a graduate student conference at Harvard.

Now, there is again talk of changing the SIEC and the process for choosing firms to conduct IPOs in China. See for example this article from the China Daily, “IPO approval procedure reform.” Interestingly, among the reforms is to eliminate the paradox of “secret transparency” by making public the membership of the SIEC and requiring its members to provide written justification for their votes. Keeping the membership secret has apparently not thwarted attempts to improperly influence SIEC decisions, and the China Daily suggests the low quality of listed companies and the depressed market are somehow functions of the SIEC.

I think revealing the membership of the SIEC and making the process more transparent is a good idea, but the real issue is not the SIEC. Such limited reforms may help the SIEC pick relatively better IPO candidates from among the types of candidates they consider, but the real problem is that the list of candidates is too constrained in the first place. Under the Company Law, IPOs can only be conducted by firms meeting certain criteria (three years of continuous profitability, a certain amount of registered capital). But even these dubious “merit” requirements are not the most limiting constraints. In practice, firms conducting IPOs in China are nearly always repackaged state-owned enterprises. So to being with the SIEC is often deliberating about a list of duds.

Creating meaningful shareholder rights through private enforcement actions (a robust right to sue) and letting foreign companies and private companies list will do more I think to improve the quality of PRC securities markets than tinkering with the SIEC. Those kinds of changes, however, would be fundamentally challenging to the status quo. Here “development” is in tension with “stability” and the interest of many powerful parties (SOEs that would like to list; shareholders who own existing dud shares; politicians who don’t want the market to acquire more power than they have). So baby-step reforms such as tinkering with the SIEC are more feasible than embracing the apparently needed revolution. But I fear the real impact of such easy measures is likely to be minimal.

The headline to this New York Times story AIDS Care in Rural China Now Better Than Nothing struck me as apt not just for its specific subject matter but for many things in China.

One could use the formula “FILL IN THE BLANK in China Now Better than Nothing” in many contexts: Human Rights in China Now Better Than Nothing. Freedom of Expression and of the Press in China Now Better than Nothing. Democracy and Rule of Law in China now better than nothing.

This may sound overly harsh. Of course, China is now dramatically different and usually better than it was before the Reform Era began. And many trends are promising. At least on many days, I am a China optimist.

But while it is important to acknowledge positive, dramatic changes in many areas, it is important to acknowledge the absence of dramatic, positive change in many other areas.

It is easy to show, for example, dramatic economic growth in China, but that’s starting from a very low base. For hundreds of millions of people, poverty remains their reality. Per capita, productivity and incomes in China remain quite low.

It is also possible to show some evidence of positive developments in terms of press freedom in China. Now there are more media outlets, and they publish increasingly interesting stuff. However, such claims of progress also use a very low point as the basis for comparison. Plus, press freedoms have expanded far less dramatically than the economy.

If the baseline is the Cultural Revolution (as it often implicitly is in these comparisons), then one can show improvement in almost everything. But that hardly means there’s been sufficient improvement.

Though the media is indeed more robust and free now, it still remains subject to the whims of Party policy. For example, earlier this year when 500,000 marched in Hong Kong to protest the security bill and other matters, not a word about it was reported in the mainland press! This year the Party has also suppressed coverage of the Sun Zhigang case, the Zhou Zhengyi case, the SARS cover-up and a number of other “sensitive” matters.

So, “PRC media freedom now better than nothing,” but still it has a long, long way to go.

Making all shares of listed companies tradeable through a “supplemental compensation method” (补偿式) may not be feasible, according to a speech given by Zhang Wenkui, a deputy director of the “Enterprise Department” of the State Council’s Research Center on Development.

Zhang made the remarks at a forum on mergers and reorganizations in Beijing, according to this story from the China Securities Journal.

The CSRC has announced approval of Credit Suisse First Boston as yet another QFII, according to this announcement.

The State Administration of Foreign Exchange must approve an investment quota for each QFII the CSRC approves.

JPMorgan got SAFE approval for a US$50 million quota this week. SAFE also granted UBS permission to double its quota to US$600 million. SAFE has announced a number of these increases lately.

Is there a reason behind the recent spate of quota ante-upping? Perhaps these increases are related to the pressure regarding the RMB’s exchange rate. For investors, they may have asked to increase their quotas thinking they will get an immediate windfall if the RMB is revalued (because they invest at current exchange rates, putting in US dollars or other hard currency and getting RMB-denominated assets; then when the RMB is revalued to a higher level, they capture instant appreciation, assuming the RMB-denominated assets did not substantially decline in value). Also, these QFIIs may simply want bigger quotas because they think the PRC bear market is near bottom and prices will soon improve.

For the PRC, perhaps the recent spate of quota increases is designed to be a market stimulant. The markets reached four-year lows this week. News of fresh capital inflows might help stem the downward drift.

Whatever the motivations, the approved QFII quotas now stand as follows:

UBS———————–600
Morgan Stanley———-300
Citigroup—————-200
Deutsche Bank———-200
HSBC———————100
ING———————–100
Goldman Sachs———–50
Nomura ——————-50
JPMorgan Chase ———-50
Total US$1.65 billion

This various individual quota announcements are available on the SAFE website. In English ChinaOnline does a good job following the QFII roster.

I try to follow the development of law in China as it relates to financial markets. As a lawyer, I tend to focus on the texts of promulgated laws and regulations and, when reported, the text of court decisions concerning application of these laws and regulations. While relevant laws and regulations deserve attention, surely a full description of the regulatory structure of China’s stock markets has to acknowledge the continuing importance of one-party rule.

The fact that China is governed by the Chinese Communist Party means CCP policy affects–or more accurately directs–legal developments in China, including of course legal developments relevant to securities markets.

At the top level, CCP policy is what regulates the markets; the laws and regulations promulgated by “the state” (the National People’s Congress and its Standing Committee for laws, the State Council and its subordinate ministries such as the China Securities Regulatory Commission for administrative regulations) articulate and implement CCP policies.

One might say that CCP policy does not just aim to affect the law–it is the law. You could qualify this by showing occasional instances where legal developments have shaped CCP policy–one hopes this is happening more and more–but I think the general paradigm and common practice is still the other way around. Legal developments and party policy have to be in tandem, at least.

For example, in October the Central Committee of the CCP issued a document on economic policy. The prose of the document is turgid and platitude-filled, but that doesn’t make it unimportant (only difficult to trudge through). I have subsequently read where CSRC chairman Shang Fulin (who is–surprise–also Party secretary for the agency) stresses–without a touch of irony–the need for the CSRC to thoroughly study and implement this CCP policy pronouncement. PRC financial media also genuflect to the language of the policy document when writing about developments in the markets.

One section of the document is particularly relevant to securities markets. The Chinese text is here, but I would translate the most relevant passage as follows:

Decision of the Central Committee of the Chinese Communist Party Concerning Several Issues Related to Perfecting the Socialist Market Economic System (中共中央关于完善社会主义市场经济体制若干问题的决定)

Part 5, Section 15–Strongly Develop Markets for Capital and Other Key Factors [of Production]

Vigorously promote the reform and opening and stable development of capital markets, expand direct financing. Establish a multi-tiered capital market system, perfect capital market structure, enrich the types of capital market products. Regularize and develop the main board, promote the establishment of venture capital and a board for start-up enterprises. Vigorously expand the market for debt securities, and perfect and regularize the procedure for issuing [debt securities]. Enlarge the scale of issuing corporate bonds. Strongly promote the development of institutional investors. Relax the channels for qualified capital to enter the markets. Establish unified, interrelated capital markets, perfect systems for the trading, registration and clearing [of securities]. Quicken the development of markets for land, technology, labor and other important factors [of production]. Regularize and develop property rights transactions. Energetically promote markets for property insurance, personal insurance and reinsurance. Gradually develop futures markets.

First, we ought not to just glide by the fact that this is an allegedly communist party stating that its official policy is to develop capital markets, the epitome of capitalism. I mean, at its first congress in 1921, Mao and the other CCP founders passed a resolution stating they wished to eliminate the institution of private property, and upon coming to power they did shut down China’s stock markets. Now their party–as a matter of official policy–wants to develop institutional investors!

But the passage is important for reasons other than its value as an example of stunning ideological change. I think it is “the law” with respect to securities market reform in China. I can think of no recent CSRC or NPC initiative that doesn’t fit under one of these exhortations. For example, the recent PRC Investment Funds Law (Zhengquan touzi jijin fa, 证券投资基金法)–which is the only law directly addressed to the securities market passed for several years–fits under the exhortation to “Strongly promote the development of institutional investors.”

China has changed a lot in recent years. These changes affect the way millions of people live (so that the Party is gradually being replaced by the party, as someone has so delightfully quipped). But the Leninist political system is still there. Its resilience means not only that some human rights have a precarious existence in China, but also that even with regard to something as ostensibly antithetical to the founding principles of the CCP as stock markets, you still have to pay attention to Communist Party utterances.

Recently, a number of articles in the PRC financial press have been stressing that transfers of some non-circulating shares in PRC listed companies do not foretell an onrush of new circulating shares into the already depressed markets, nor do they foretell the elimination of state holdings in listed companies.

The title of this article for example is literally “Full Circulation (of shares) doesn’t equal reduction in state-owned shares and doesn’t equal a complete sell-off of all state-owned shares.”

These reassurances suggest that the markets have gotten jittery again about the prospect of “guo you gu jianchi” (国有股减持) or a reduction in state-owned shares. The CSRC tried earlier to implement a policy requiring that 10% of new issuances (IPOs or follow-on offerings) be comprised of state-owned shares, with the proceeds from sale of those shares to be put into the social security fund. This scheme caused the markets to nosedive. The policy was quickly reversed by the CSRC, and even the State Council (the PRC executive branch uber-organization, to which the CSRC reports) has itself said there will be no sell-down of state shares for now. Still, form time to time the markets dip down on rumors that such plans will be revived. Most people explain this reactrion by saying that an abundance of new shares coming into the market will create an over-supply of circulating shares, depressing current valuations of such liquid shares. Basically, the idea is that current share prices are based on the current scarcity of shares, and if more shares are available prices will go down.

Of course, the shares do exist now, but they are not “circulating;” they are not listed on the public markets. This underscores that to understand PRC stock markets, one simply has to understand the different categories of shares that comprise the capital structure of a typical PRC listed company. Generally, a listed company has only a third or so of its shares publicly floated (listed on the PRC stock markets). These “circulating” shares (liu tong gu) are generally trading at P/Es dramatically higher than the valuations given to non-circulating shares (fei liu tong gu) which are not listed but can sometimes change hands through negotiated agreements (xieyi zhuanrang) with government approvals.

These non-circulating shares which comprise 2/3 of the total shares of most listed companies have various sub designations. There are many permutations, but the key types of non-circulating shares are state-owned shares (guo you gu) and legal person shares (fa ren gu). The state-owned shares are generally held by government entities (say a local government or State Council ministry such as the old-line ministry that the “company” was carved out of). The legal person shares are held by corporate entities (legal persons) but are in fact often just owned by the state indirectly–rather than being held by govt. departments themselves, the government owns a company that owns the shares. In any case, the fear is that if the government starts to divest itself of non-circulating shares (by allowing state-owned shares and/or legal person shares to become circulating shares), the markets will tank.

Banking in China is dominated by four big state-owned banks: the Bank of Agriculture, China Construction Bank, Bank of China and Industrial and Commercial Bank of China.

There are also a number of smaller banks, including three that have listed some of their shares on China’s stock exchanges. These are Pudong Development Bank, China Minsheng and China Merchants Bank (Bank of China-Hong Kong has shares listed outside of China, but none of the domestic arms of the big four PRC banks have yet listed anywhere).

Asian Banker, according to this story from a PRC English-language publication, indicates that the three PRC listed banks have better performance than the big four state owned banks. The listed banks have better returns on equity and fewer non performing loans (or NPLs) than the big four. However, the big four account for more than 84% of PRC bank lending, and bank lending in the PRC dominates corporate finance. The stock markets still contribute very little to the financing needs of PRC companies.

The South China Morning Post has a story by Andrew Collier here concerning unofficial stock exchanges in China. Based on some information about such an exchange in Chengdu, it estimates the potential scale of such exchanges.

The story was posted on CLNET, and Knut Pissler in Germany asked, borrowing the title of an article by Don Clarke, “What’s law got to do with it?” He meant I think “how are we to understand the development of illegal PRC stock markets?” After all, securities exists only as a legal creation, so how can securities markets develop without the sanction of law?

China ’s essentially minor stock markets (official and unofficial) do invite one to theorize.

According to the SCMP story, the CSRC currently has a laissez faire attitude towards illegal exchanges. But this seems like a thin basis for turning money over to someone in exchange for intangible “legal rights.”

Since this is going on, one might conclude that you don’t need legally enforceable property rights to develop stock markets. Don Clarke has in fact challenged in a recent article the “rights hypothesis” of new institutional economics, at least with respect to third party enforcement of contract rights being essential to economic development, using China as the example.

One might also explore how social norms regulate markets in a way unsynchronized with legal texts. If the CSRC, local governments and investors are acting in ways that legitimize these markets (or at least creates a sense that the risks are tolerable given the alternatives), then this joint action creates “imagined markets” through social norms rather than NPC-adopted texts. One might compare how this relates to the historical development of securities markets elsewhere and what it says generally about the evolving status of the rule of law in China. The phenomenon of illegal stock markets may suggest, as Don argues generally, that market development can get pretty far simply with an expectation that government will not confiscate, even if you don’t have more developed enforcement of rights.

But to pronounce NIE ideas kaput (or refine them), one must take account of special PRC factors. Investors in China do not decide between investing in unofficial exchanges or buying shares of Microsoft. The could put their money in the bank at low interest rates, buy national bonds at low interest rates, lend to a cousin, go into business directly or buy securities on the official exchanges which have not seen a major bull market for years. Choices are few and each has risks. Putting money into unofficial shares has to be contextualized into this environment of severely limited choice.

Also, the role of the state in PRC securities markets is important. The state in China does more than just to officially sanction and enforce property rights shaped by private ordering. The state is the main issuer and regulator. Thus, an expectation that the state will not confiscate (including on a local, “unofficial” level) may count for more than it would in other contexts.

Moreover, in practice shareholders in the nationally sanctioned markets have pretty anemic rights against a miscreant issuer or trader. There may be less danger of a crack down closing the whole exchange, but where are the robust rights of PRC shareholders in the official exchanges? Usually they are just minority shareholders in corporatized SOEs, and even nearly a year after the SPC’s rules on private securities litigation (and four years after the Securities Law), I don’t know of any case in which a judge has awarded relief to defrauded investors after a trial.

And even taking all that into account, there is a scalability limitation to unofficial markets, as the article notes. I don’t think one will see China ’s insurance companies, investment funds or the national social security funds Gao Xiqing now shepherds moving substantially into these unofficial markets. That limits domestic capital accumulation and allocation, not to mention the possibility of attracting international capital on an institutional scale. Plus, unofficial markets are marginal in comparison to the official markets, which are themselves marginal contributors to PRC corporate finance.

Thus, rather than showing you don’t need strong property rights for stock markets, China’s minor stock markets (official and unofficial) may indicate how essential property rights are for certain kinds of economic development.

This strange notice appeared on the CSRC website recently, warning about a scam in which someone has tried to con the PRC securities industry by impostering the CSRC.

The culprit(s) apparently obtained a counterfeit seal or “chop” of the CSRC legal department, then asked listed companies, securities companies (meaning investment banks and brokerages) and fund management companies to buy various books and pay for various seminars concerning the securities industry.

One might note several interesting things here. First, the CSRC publicly disclosed this. This may or may not suggest the problem was severe (possibly there were other things going on?), but in any case I think the CSRC deserves a thumbs up for disclosing something that, even though not their fault, might be perceived as embarrassing. Hiding bad news is probably common throughout the world, but sometimes seems particularly acute in China–for example with the outbreak of SARS last year.

Also, it is interesting that the con depended on people believing the CSRC would lean on enterprises to buy books and pay for seminars. I have never heard of the CSRC engaging in such coercive extra-budgetary fund raising activities, but such tactics may be common forms of soft extortion in China. Earlier this year, a moratorium was declared on new subscriptions to periodicals and it was announced a review of government publications was underway. Apparently, many govt. entities publish newspapers (and require regulated parties to subscribe) as a fund-raising mechanism, and there was an effort to crack down on this.

In the notice, the CSRC legal department disclaims connection to these practices, announces that information concerning the scam has been turned over to prosecutors and provides a number for parties to call if they encounter any suspicious activity.

The annoucement appeared on the CSRC home page on Nov. 10, but the text of the notice is dated Nov. 6.

According to this PRC news report, CSRC Chairman Shang Fulin acknowledges that discussions are underway regarding reform of the Stock Issuance Examination Committee.

The SIEC reviews applications for IPOs in China. It is composed of 80 members–including appointed industry experts and some CSRC staff. They are supposed to make sure IPO candidates meet the requirements of the Co. Law (three years of profitability, sufficient registered capital) and other standards set up by the CSRC.

Article 14 of the PRC’s 1999 Securities Law directed the establishment of an SIEC-type organization, and CSRC regulations on it were adopted by the State Council in 1999. The Chinese text of those SIEC Regulations is here. A 1999 PRC newspaper account about them is here.

An irony of the 1999 SIEC Regulations is that Article One states a purpose of the regulations is to “promote transparency” (zengjia toumingdu); however, the regulations then go on to provide that the identity of the members of the SIEC and information concerning their work process must be kept confidential!

I presume this is to make it harder to find and bribe the people whose approval enables an enterprise to access millions of dollars in public financing.

The Xinhua article is cryptic about what kinds of problems the secrecy of the SIEC is causing.

The Supreme People’s Court is soliciting comments on a judicial interpretation concerning disputes under the PRC Company Law.

The Chinese text of the draft is here. A PRC news report concerning the draft is here.

I have long thought notice-and-comment rule making would be a good idea in China, and I have found it positive that the CSRC dabbles with it (for example, here), but the SPC doing it surprised me!

They have provided until Dec. 5 to comment. A month is not a very long time, but the CSRC often provides only weeks. (For example, here they put out a draft on Oct. 15 and asked for comments by Oct. 24!).

The People’s Daily has a helpful web site collecting background materials and articles about the new PRC Law for Funds for Securities Investments here. The PRC Securities Times has a similar site collecting articles written before the law was enacted here.

A report from PRC media in English about the new law is here, from the China Daily.

I’ve been reading through the new PRC Law on Funds for Securities Investments (Zhengquan Touzi Jijin Fa) which was enacted on. Oct. 28 and will come into effect on June 1, 2004.

There appears to be nothing revolutionary about this law.

PRC policy makers have for some time been eager to increase the role of institutional investors. They think institutional investors will help mature the PRC stock markets by investing for the longer term and doing research and analysis of fundamentals, not just speculatively trading for the short term.

A nascent funds industry has been developing for several years, composed initially of several listed closed-end funds and now some open-ended listed funds that are similar to US mutual funds. As part of its WTO accession, the PRC now allows some foreign investment in fund management companies.

Before now, the legal basis of this PRC funds industry has been regulations, most of them promulgated by the China Securities Regulatory Commission, China’s stock market regulator.

This enactment solidifies that regulatory structure, giving the industry a basis in national law passed by the Standing Committee of the PRC’s National Peoples Congress, China’s highest legislative body.

What seems notable about this law is not what’s in it but what is not. At times during the drafting process, which went on formally for more than three years, the drafters contemplated a comprehensive funds law regulating all kinds of funds, including venture capital and private equity funds. As passed, the law’s scope is more narrow. It addresses only funds that invest in securities markets in Shenzhen and Shanghai.

Currently, many PRC citizens are investing in real estate, not stocks, but no real estate investment fund can be directly created under this law. The funds enabled can invest only in stocks and bonds of firms listed on the PRC mainland. Such firms are almost always majority state-owned with only about a third of their shares publicly floated. So, the law didn’t enlarge the product offerings of China’s funds industry.

Interestingly, violators of the law are at risk of civil liability. It is a good thing that the law provides an explicit statutory basis for its enforcement by investors through private rights of action. The risk of civil liability in addition to administrative or criminal enforcement should encourage compliance. However, the 1999 Securities Law also had a similar provision on civil liability, but courts ducked cases. They claimed the law’s provision of a basis for civil liability for disclosure violations–in language very similar to what is used in this new funds law–was insufficiently detailed to allow them to resolve cases. In fact, the Supreme People’s Court came out with detailed rules for private shareholder litigation in January, but to date no PRC court has yet awarded any investor relief through such litigation. So, it is unclear whether the civil liability announced in the new law will be meaningful in operation, but at least there is a seed of possibility there.

The law keeps the CSRC in charge of the funds industry. The CSRC approves fund management companies and fund custodians, approves individual funds and licenses funds industry professionals. The law contemplates creation of a funds industry self-regulatory organization, but even its activities are to be under the guidance of the CSRC.