Walter Hutchens’ Blog

The Standing Committee of the PRC National People’s Congress amended a batch of laws on Saturday, including the PRC Company Law and PRC Securities Law. A Chinese news report of the changes is here.

The changes to the Company and Securities Law appear minor. All concern the approval requirements related to public offerings of securities. Both the Company Law and Securities Law were amended to eliminate an approval requirement concerning the price at which securities are offered, and the Securities Law was also amended to allow China’s exchanges rather than the CSRC to approve the listings of bonds on those exchanges.

The critical and I think generally harmful requirement that the PRC government approve all public securities offerings has not been removed.

Article 131(2) of the Company Law required that any issuance price in excess of the face value of a share must be approved by the securities regulatory authority of the State Council, meaning the CSRC. This article was completely deleted. In the same vein, Article 28 of the Securities Law provided that the issuance price of shares be negotiated between an issuer and underwriter but then confirmed (hezhun) by the securities regulatory authority of the State Council. The language requiring CSRC approval of the price was deleted.

Perhaps not coincidentally, the CSRC today posted on its website draft regulations concerning IPO pricing, and PRC media indicate IPOs will be halted while these regulations are considered. The CSRC requests comment by September 5. That is an extremely brief comment period, but the CSRC is not legally required to offer any notice of proposed rules or seek comments concerning them, so a small window is better than none. The proposed regulations are available here. The proposed rules contemplate a road show (路演推介) in which prospective issuers promote the offering to institutional investors. A Chinese commentary on the draft rules is here.

Concerning the listing of bonds, before this amendment Article 50 of the Securities Law required that the securities regulatory authority of the State Council approve (hezhun) applications to list corporate bonds. It provided that such approval authority could be delegated by the CSRC to a securities exchange. In the amended version, the securities exchanges are given direct approval authority for listing corporate bonds, with such approval to be given “in accordance with legal requirements and procedures.” However, Article 10 of the Securities Law still requires CSRC approval of all public issuance of securities. Thus, exchanges can now give a listing approval after the CSRC has given an approval for a public issuance.

I don’t want to say these legal amendments are of no consequence. I nearly always favor the removal of government approval requirements rather than their creation. But the core requirement of government approval of public offerings of securities remains. I think that approval requirement is itself far from ideal, and it probably gives the CSRC a way to approve issuance prices indirectly even if pricing approval is no longer an explicit requirement. Even if pricing is liberalized, who gets to have a road show and discuss pricing with institutional investors remains in the hands of government. It should be I think a matter between issuers, underwriters and those instutional investors. If they can set the price, why can’t they have more freedom to decide what they will buy?

Also, even if bond issuance approval is pushed down to the exchange level, 1) the exchanges are I think only nominally independent of the CSRC, 2) the PRC government still sets the objective requirements for bond issuers and 3) as I noted this is approval of listing, not approval of issuing bonds per se. This means for example that no junk bond market will emerge without government approval, even if issuers, investors and some people in the exchanges were so inclined.

Thus the erasure of these approval requirements may not be of earth-shattering significance. But it is not bad news either. At least symbolically it is another micro step in deregulation.

Also, it is good that the Co. Law and Securities Law were tweaked in tandem. This approach will be required for most substantive modifications since the 1994 Company Law includes a lot about securities; amendment of the 1998 Securities Law alone will usually not solve a problem.

Xinhua reports here that the Harbin Intermediate People’s Court has rendered judgment in favor of shareholders against Daqing Lianyi and its underwriter Shenyin Wan Guo. This appears to be the first court judgment rendered after full trial in a joint litigation action (gongtong susong) in PRC private securities litigation. Judgments in earlier individual actions (dandu susong) against Daqing Lianyi were rendered earlier this month.

Xinhua reports that in this joint action 109 plaintiffs sued for RMB 3.04 million, with 98 of them being awarded a total of 1.87 million.

Guo Feng (editor of the PRC Securities Law Review and People’s Univ. prof.) is named as lead plaintiffs’ counsel. Xuan Weihua, another PRC lawyer active in PSL, also seems to have worked in the Harbin litigation against Daqing Lianyi. Xuan has written a book about PSL and is in the same law firm as Guo Feng.

It appears Yan Yiming from Jintian Cheng law firm represented a number of plaintiffs who obtained individual judgments earlier this month, based on comments on those judgments by Xuan made in an interview here.

Before any of this private enforcement, the CSRC already determined that Daqing Lianyi made false disclosure in its IPO materials and in its 1997 Annual Report. In both instances, the company reported vast profits that it had not actually made.

In this kind of litigation, PRC courts can award compensation to shareholders who 1) buy after bad disclosure is made and 2) sell after the falsity of such disclosure is revealed (the jie lu ri). In other words, if a shareholder sells shares before the jie lu ri, he or she is out of luck. Xuan indicates that the court denied recovery to many plaintiffs by its determination that the jie lu ri should be not the date that a major PRC newspaper reported that Daqing Lianyi was under CSRC investigation but when the CSRC a year later issued its final administrative penalty. In other words, if anybody sold shares after learning the company was under CSRC investigation (and many did, with the price tumbling), then those shareholders cannot sue because they sold their shares before the jie lu ri.

Many press stories have now reported on the deal involving Goldman Sachs and PRC banker Fang Fenglei to create a new investment banking venture in China. The Wall Street Journal chimed in on Friday, and Cajing magazine’s current cover story is available here (in Chinese). From these and other press accounts, the basic structure of the deal is discernible.

First, a PRC joint-venture investment bank (or, in official PRC parlance, a “foreign-invested securities company” or FISC) will be established. Goldman will own one-third of it, the maximum a foreign investor is allowed to own in an FISC under current PRC law.

The remainder of the FISC will be owned by a newly-established “Chinese” securities company to be called Gao Hua.

Besides paying for its own share in the FISC, Goldman will reportedly also bankroll the stake of the Chinese parties in Gao Hua. Goldman will reportedly loan about USD 100 million to PRC parties for the capitalization of Gao Hua.

In this respect, the name for Gao Hua is interesting. The are two Chinese characters in the name. The first one is also the first character used in the Chinese name of “Goldman Sachs.” The second character in the Gao Hua name is a common character meaning “China.” Thus the name Gao Hua suggests “Goldman Sachs China,” though it is ostensibly a PRC securities company which is invested in a FISC.

Gao Hua’s shareholders will be Fang Fenglei and some others, including perhaps some division of Legend computer company.

Presumably Goldman will get control rights of some kind over Gao Hua in exchange for the loans to PRC parties which fund Gao Hua’s establishment.

None of the press stories have revealed precise details of exactly how Goldman will control Gao Hua. They just indicate Goldman will indirectly fund Gao Hua’s capitalization. I am interested in these legal details. I presume Goldman will get rights to appoint the managers and maybe some directors of Gao Hua plus somehow direct the voting of Gao Hua shares whose capitalization was funded by Goldman loans. Repayment and profits on the loans may also be tied in with the profitability of Gao Hua.

This is clever stuff. Goldman has apparently come up with a structure that does not violate the PRC’s laws which restrict foreign investment in an FI-SC to one-third but yet manages to (1) avoid actual domination by the 67% PRC shareholders of the FISC and 2) create an entity that in its entirety (Gao Hua plus the FISC) can have a business scope broader than that allowed to an FISC alone.

Actually, solving issue 1 (control of the FISC) might not have required Goldman to fund and control Gao Hua (the Chinese partner to the FISC) because the relevant rules only cap foreign shareholding at one third. They do not actually prohibit contractual arrangements among the Chinese and foreign investors to an FISC concerning the FISC’s operations and management. Thus, if the CSRC were willing to allow a foreign party to control an FISC as its minority shareholder, they theoretically shouldn’t care if that control is arranged in the FISC’s own articles of association or through some other contract.

But the second issue (business scope) does seem to require this structure. The rules on establishing an FISC do limit business scopes for FISCs. They cannot broker A shares or trade for their own accounts. Gao Hua presumably can do those things, while the FISC can do underwriting and the other things permitted to FISCs under the regulations. Again, Goldman must have (as any FISC investor would) some way to be sure the Chinese investor in the FISC doesn’t compete with the FISC itself.

I admire the cleverness of Goldman’s structure. I imagine others will try to copy it. Contractual mechanisms of the sort I am imaging do not seem to break the letter of any PRC law.

However, I think there will be some risk that a deal such as this is only as durable as (1) the indulgence of the regulators who have signed off on it and (2) the continued cooperation of the PRC parties. If either of those things changes, Goldman might have a big mess on its hands. Apparently Goldman thinks such risks are tolerable in comparison to the potential advantages of the structure. They may be right. Or not. Time will tell. For Goldman, they are probably risking their reputation more than a meaningful amount of capital (to them).

However, as a cautionary tale I hope someone told the Goldman executives about what happened to many big, sophisticated foreign investors who established telecom ventures in the PRC using what was called the Chinese-Chinese-Foreign (Zhong-Zhong-Wai) structure. Many such deals were approved. Foreign capital and expertise poured in using the CCF structure. It seemed investors had found an acceptable way around regulations that kept foreign money out of certain telecom services. But before anybody established a lucrative telecom dynasty, PRC regulators reversed course and ordered that the CCH deals all be unwound. Lots of foreign money got burned.

Maybe such a risk is just like the risk that there will be a repeat of the nationalization of foreign property that occurred after the Communist revolution–a high-consequence but low-porability risk. Maybe.

There is another interesting aspect to this deal. Besides the Chinese partner to the FI-SC (Gao Hua,) being a new securities company indirectly funded (and apparently controlled) by Goldman, a USD 60 million “donation” has been made by Goldman to account holders of defunct Hainan Securities.

Some press stories have indicated a license for the new venture will come from Hainan Securities. Other stories have indicated the donation to Hainan only helps win approval. I do not know which version is correct, but I suspect it is the latter. Approval of both the new FI-SC and Gao Hua will entail various CSRC approvals and eventually issuance of business licenses, so I don’t see any great advantage in “buying” the Hainan CSRC license as opposed to obtaining a fresh one. If the CSRC will approve the creation of Gao Hua and the FISC, what’s the advantage of a license transfer, except maybe to save a little face about a naked “donation?”

My view of this reported “donation” is that if China wants to sell off rights for foreign investment in certain sectors (or approval of the arrangements for such investments), it should not sell an investment banking approval to Goldman Sachs in a one-off deal but rather hire Goldman Sachs to run a global auction for PRC approvals. That way China can get as much money as possible for granting government monopolies or waivers on existing restrictions.

I wrote in an article published last year that the essence of Chinese “law” is government approval, that the axiom “wei jing pizhun bu ke” (cannot be done without approval) is the PRC equivalent of Justice Marshall’s axiom that it is the business of the courts to say what the law is. “Markets” in government approval disgust me in some ways. Securities companies should exist and become strong by fulfilling market needs, not by getting special government approvals. But if the PRC is going to sell market entry, they should at least be sure they get top dollar for it.

More information on the Goldman Sachs-Fang Fenglei venture to create an investment bank in China continues to dribble out from unnamed sources. Caijing magazine has apparently published something, though it is not yet available on their website.

Contrary to a South China Morning Post report, the Financial Times reports Goldman Sachs (高盛) is not using Hainan Securities as the vehicle for its venture to set up a PRC investment bank with Fang Fenglei (方风雷). Rather–and this is quite stunning–Goldman is reportedly making a “donation” to compensate depositors in Hainan Securities who lost their money when Hainan ran into problems. In other words, this donation is not to purchase equity in Hainan Securities but to induce CSRC approval for its deal with Fang, a deal that will be structured separately.

Wow. Of course, China’s whole theory of FDI has long been that foreigners get some market access in exchange for capital, technology, know-how and maybe employment support. But the idea that direct, enormous donations are a requisite part of getting one’s project approved is stunning.

FT indicates a new corporate entity will be created and that Goldman will hold 1/3 of it–the maximum allowed under PRC law, and that the remaining 2/3 will be held by another newly-created securities company that will be owned by Fang Fenglei and others.

This latest FT story echoes earlier reports in indicating that Goldman will loan Fang the capital for his shares of the venture (or, strictly speaking, loan Fang money for his shares in the PRC securities company that will in turn hold the equity in the Fang-Goldman venture). Reportedly, Goldman will have an option to buy those shares when PRC law so allows (currently PRC law caps foreign ownership in foreign-invested securities companies at 1/3). The story makes that seem like some kind of a breakthrough, but I think option clauses are quite common in FDI projects in China.

The story suggests Goldman will have “effective control” of the venture, but does not clearly explain how that will happen. In fact, the PRC’s rules on foreign-invested securities companies (FISCs) only discuss the 33% cap on foreign shares; they do not discuss limits on what type of day-to-day management arrangements the parties can work out contractually. However, the rules do require that the articles of association and contract to establish an FISC venture be submitted to the CSRC for approval. Thus, if Goldman tries to gain “effective control” through contractual mechanisms that the CSRC doesn’t like, the CSRC doesn’t have to approve them.

Alternatively, Goldman could try to set up a voting trust or some other contract with Fang that doesn’t go through the approval ringer. Maybe they will condition the loan to Fang for the money to create Gao Hua (the PRC securities company that is to hold 2/3 of the Fang-Goldman FISC) on letting Goldman votes his shares in Gao Hua. Again, that would be clever, but I wonder if such an arrangement might encounter problems if Fang one day decides to vote his shares however he wants. The PRC Trust Law, for example, explicitly makes illegal any trust intended to flout PRC law. If a “voting trust” were deemed to violate the cap on foreign ownership of a FISC, then it might not be enforceable. But maybe it would hold up as a condition of a loan contract.

The article indicates the structure of the venture will allow it to underwrite securities, trade securities, broker securities and provide advisory services. The article quotes someone (unnamed, as are all the sources) suggesting that this business scope is broader than that possessed by CICC (中国国际金融有限公司) and broader than the business scope any other FISC will get. Maybe. But that sounds to me like a Goldman (or Fang) PR person spinning the FT reporter.

Article 5 of the rules on establishing an FISC allows these firms to underwrite (A shares, B shares and government and corporate bonds), so there’s not much Goldman could enlarge on in the underwriting department.

Article 5 allows FISCs to broker only bonds and B shares, not A shares.

Article 5 prevents FISCs from dealing in A shares or B shares for their own account (though trading bonds is ok).

Inevitably, there is a “qita” (other) clause at the end of Article 5 that allows the CSRC to approve “other” businesses for an FISC. Such qita clauses are ubiquitous in PRC laws and regulations. But I’d be surprised if the CSRC were so brazen as to allow Goldman’s donation to Hainan to “buy” a business scope not explicitly contemplated by the rules. Whatever Goldman is allowed to do, others will clamor for equal treatment. (I wonder if they, too, will have to make “donations?”)

But the article suggests it is not the business scope of the FISC itslef that will be broader than CICC’s. Rather, the idea is that the Gao Hua securities firm created to hold the non-Goldman part of the new venture will itself provide the services that the Fang-Goldman venture cannot directly provide (A share brokerage business and trading A and B shares for its own account). That is an interesting “group company” (jituan) approach, but I wonder if the Gao Hua “parent” entity will not have some conflict of interests with the Goldman-Fang “sub?” Will it only provide those services that the FISC cannot provide? And if it does, how will the profits mean anything to Goldman? (Again through the terms of the loans?)

A PRC company is generally not allowed under the PRC Company Law to have more than 50% of its assets invested passively in other companies. That is why Goldman would have to invest USD 100 million in the Gao Hua “parent” in order to then capitalized the Goldman-Fang FISC “sub” with another USD 50 million.

Whatever machinations Goldman is involved in to work out this deal, it strikes me that once they get into China’s securities market they will continue to face challenges. Today’s’ South China Morning Post reports that PRC macro economic performance is remarkably disassociated from PRC securities markets. This is not an insignificant point. In the same way that Goldman has doubtlessly spent a lot of time and money figuring out how to structure this deal and get it approved, once they actually get in they may find that government approval continues to be a key to success in these “markets.” In such an environment, will the competencies that Goldman has developed in global stock markets mean much?

The Financial Times reports that PRC officials have approved the establishment of a PRC-based investment bank between Goldman Sachs and Fang Fenglei, a prominent PRC banker. The FT report has been repeated by others, here for example by Reuters. The South China Morning Post reports here that this will be accomplished by converting Hainan Securities into the Fang-Goldman JV.

I have previously expressed an opinion that this cannot happen under PRC law because the PRC rules on foreign investment in the PRC’s investment banking sector do not contemplate that an individual can be the dominant Chinese party to such a venture.

This new FT report has prompted me to review the regulations in detail. On review, it looks to me like Fang could be a shareholder in such a venture. The main rules are the Establishment of Securities Companies with Foreign Capital Participation Regulations (外资参股证券公司设立规则 or Waizi can gu zhengquan gongsi guize) promulgated by the CSRC June 1, 2002 and effective July 1, 2002.

Under these rules there are two ways to create a foreign-invested securities company (FISC) in the PRC mainland. One is to take an existing securities company and convert it into an FISC. When you do this, at least one PRC shareholder must after the conversion hold at least 1/3 of the FISC, and the foreign shareholder(s) are capped at 1/3.

Thus, shareholders of Hainan Securities could sell up to 1/3 of the firm’s shares to Goldman and theoretically sell up to 2/3 of the firm to Fang Fenglei. In any case, some single Chinese shareholder would have to hold 1/3 of the shares of the converted entity.

Alternatively, an FISC could be established afresh. Under that approach, a PRC securities company must hold at least one third of the shares of the venture.

Since Fang is an individual and not a PRC securities company, if a Fang-Goldman FISC venture were created by establishment of a fresh FISC (rather than conversion of an existing securities company into an FISC as the SCMP article suggests), Fang could hold at most 1/3 of the venture because there would have to be a securities company shareholder in the mix. (Fang could hold more than 1/3 under this approach if Goldman was willing to take less than the 1/3 maximum it is permitted, but that seems unlikely since they eventually want control and are reportedly looking for a way to option Fang’s shares).

Before I wasn’t sure Fang as an individual could hold any shares in such a Chinese-foreign investment bank venture, but that doesn’t appear to be a problem. Article 8 of the Establishment Regs cited above requires only that PRC shareholders to a Chinese-foreign investment bank meet the general CSRC-established qualifications for Chinese investors in securities companies.

Those qualifications in turn are spelled out in the CSRC’s Procedures for Security Company Administration (证券公司管理办法, or Zhengquan gongsi guanli banfa) promulgated December 28, 2001 and effective March 1, 2002. Article 9 of that regulation simply requires that shareholders in PRC securities companies not have a record of serious violations of PRC laws and be solvent. The CSRC must confirm (rending) Chinese shareholders if they hold more than 5% of a securities company, but there is no explicit bar against an individual holding such shares.

The FT story that this long-rumored deal is moving forward makes no mention of creating this venture through conversion of an existing PRC securities company into an FISC. That made it seem to me like the JV would be established afresh and hence that Goldman and Fang were getting around the requirement that a PRC securities company hold 1/3 of the venture. Thinking that, I was ready to launch a rant about how despicable it is that Goldman sought a special dispensation that flouts promulgated PRC law. But it obviates my concern if the carcass of Hainan Securities is the vehicle for establsihing this venture as the SCMP reported.

Some PRC shareholder will have to hold 1/3, and Goldman will be capped at 1/3, but Fang Fenglei could hold up to 2/3.

The FT article suggests the CSRC must still approve the deal. Because the CSRC is part of–indeed under–the State Council that has reportedly granted this special approval, it is hard to imagine that approvals from the “financial regulator” will be a problem if the FT facts about a State Council approval are accurate.

The China Securities Regulatory Commission (CSRC) is advertising for foreign-trained staff members. The announcement is here.

Within China the CSRC has often been criticized–sometimes unfairly I think–for imposing policies on China’s stock market that are believed unsuited to the Chinese situation. Some blame this alleged propensity on the “faction of returnees (海归派 or hai gui pai).”

Personally, I don’t think the problems of information asymmetry and agency inherent in securities markets have special Chinese characteristics. Sure, these problems are embedded in a special historical context in China’s case, but the essential problems are not ones you need a nativist education to understand. I further think “hai gui pai” members such as Anthony Neoh (Liang Dingbang), Laura Cha (Shi Meilun), Gao Xiqing and many others less famous have been among the most impressive Chinese regulators (Neoh was I suppose a consultant, not a regulator per se). It just makes sense for the CSRC to recruit foreign-trained experts. Cadre schools, tending pigs (as many intellectuals did in the Cultural Revolution) and seminars on the san ge daibiao are not going to produce savvy capital market regulators.