Investors As Stakeholders
Recent Developments of Securities Investor Protection in China
China’s securities market has achieved fast growth in the past decades although it remains being dominated by retail investors. Chinese legislators and regulators have developed various mechanisms to enhance protection of securities investors in recent years including the establishment of a specialised investor protection entity, CSISC. This article briefly reviews the major recent initiatives adopted in China for securities investor protection with a focus on the actions taken by CSISC. It also shows that the strategies used by Chinese courts and regulators to protection investors often can find their origins in the US. However, in contrast to the shift toward stakeholder capitalism lately in the US, it seems that Chinese policymakers still prioritise the interest of investors in securities market, especially shareholders of public companies.
China’s stellar economic performance in the past two decades has given birth to one of the fastest growing securities markets in the world. Since 2001, the year in which China officially joined WTO, its total market capitalization has expanded by more than 16 times, from US$524 billion to US$8.52 trillion. In 2001, China’s market capitalization was less than 4 per cent of that of the US while in 2019, the proportion has grown to above 20 per cent.1https://finance.sina.com.cn/worldmac/indicator_CM.MKT.LCAP.CD.shtml. Apart from the equity market, China now also has the second largest bond market in the world with an overall size of over US$17 trillion.2Yao, International Investors Enthusiastically Allocating Capital to China【国际投资者踊跃配置中国资产】, International Business Daily【国际商报】, 13 Oct., 2020, available at: http://finance.people.com.cn/n1/2020/1013/c1004-31889750.html. In 2019, Shanghai Stock Exchange (SSE) launched its new STAR Market targeting at high-tech and innovative companies, and in this September, the third stock exchange in mainland China, the Beijing Stock Exchange (BSE), was formally established.
In addition to its breathtaking expansion, China’s securities market has stood out also because of the predominance of retail investors. Despite the solid growth of institutional investors, individuals still own 99.7 per cent of the 175 million stock brokage accounts in China as of Oct. 2020. More importantly, retail investors account for 80 per cent to 85 per cent of the trading volume in Chinese stock market. 3Zhang, Retail Investors Losing Power, A-Share Market Heading for an “Institution Market”【散户力量趋弱 A股走向“机构市”】, Economic Information Daily【经济参考报】, 16 Dec. 2020, available at: http://www.cs.com.cn/xwzx/hg/202012/t20201216_6121159.html. Against this backdrop, it is anything but surprising to see China’s policymakers make a significant effort to protect securities investors in general and retail investors in particular.
Various legal and regulatory initiatives have been launched to strengthen the protection of securities investors in China. The most noteworthy one probably was the creation of the China Securities Investor Services Center (CSISC) in December 2014. Although incorporated as a limited liability company, CSISC is, in essence, a non-profit organisation as part of the Chinese securities regulatory authority. Holding approximate 100 shares in every public company listed in China, it is entitled to exercise almost all the rights belonging to ordinary shareholders of listed companies. Moreover, to advocate investor rights, the PRC Securities Law has empowered CSISC to take actions not permitted for ordinary shareholders. To a large extent, the activities of CSISC illustrate many of the newly adopted regulatory measures for investor protection in China. Therefore, my discussion below will be focused mainly on some noticeable steps taken by CSISC.
In the realm of corporate governance, one pronounced in China change is seen in the regulatory attitude toward hostile bids for control of public companies. CSISC has been an active proponent for shareholder decisions and restrictions on takeover defenses. Back in the years of 2015 and 2016, the role of hostile bidders in corporate governance was considered quite negatively by the Chinese regulators. Maybe the remarks of the former Chairman of the Chinese Securities Regulatory Commission (CSRC), Liu Shiyu, provide a good account of that old attitude. On 3 December 2016, Liu declared that private acquisition funds making hostile bids were “barbarians”, “industry robbers”, and “challenging the bottom line of financial laws and regulations of the state”.
However, the opinions held by the Chinese regulators regarding hostile bidders pivoted quickly in the opposite direction thereafter. This is perhaps largely due to the introduction of American corporate governance theories to China by scholarly efforts, including some of the author’s own works, but CSISC is certainly a catalyst for this change. On 7 December 2017, soon after the first successful hostile tender offer for the control of a Chinese listed company had closed,4This was Zuig’s bid for control in Zhenxing Biotech Corp. CSISC issued a public announcement, hailing it as a “milestone of public tender offers in Chinese capital market”. And CSRC quickly reposted CSISC’s announcement on its own official website.
Apart from endorsing hostile bids launched by the private players, CSISC, too, has led campaigns against anti-takeover mechanisms embedded in articles of listed companies, or the so-called “shark-repellents”. On April 28, 2018, CSISC won its first lawsuit against a listed company, Haili Biotech, on its article amendments restricting shareholders’ nomination and proposal rights at general shareholder meetings. The Court sided with CSISC to hold that, essentially, any extra condition on exercising these rights beyond the statutory requirements for continuous holding of at least 3 per cent of shares for a minimum of 90 days would be invalid.5CSISC v. Haili Biotech Corp.,（2017）沪0120民初13112号.
Proxy contests were nearly unheard of in China until this year, but CSISC does not shy away from this intense corporate governance tactic, either. On 17 Jun 2021, it launched probably the first ever proxy fight in Chinese capital market against the management of China Baoan Group, one of the oldest listed companies in China. CSISC successfully mobilized more than 3,000 retail investors to give their proxies to it, which represented about one-third of the total outstanding votes. Acting in concert with a major shareholder, CSICS managed to force an amendment to the articles of China Baoan Group, scraping off two clauses with apparent anti-takeover effects. One of the two was a “golden parachute” arrangement allowing directors and officers to pocket 10 times of their annual compensations in case of dismissal before expiration of their terms. And the other was essentially an extreme form of staggered board that could take as long as four years to reshuffle the majority of the board.
Besides being an enthusiastic champion for pro-shareholder corporate governance practices, CSISC is also active in fighting against securities frauds. In December 2019, PRC Securities Law was amended to introduce a new type of securities litigation, the special representative litigation. This is modelled on the US securities class actions which include, by default, as plaintiffs all investors in the securities involving the fraud unless the investors explicitly opt out. To address the issue of frivolous litigations that prevail in the US, however, the Chinese legislators delegate the power of initiating this new type of litigation only to CSISC. CSISC can decide whether to file a special representative litigation on behalf all relevant securities holders when it receives at least 50 requests from these securities holders.
On 31 July 2020, CSISC released its business guidelines on filing special representative litigations. The guidelines elaborated the standards that CSISC would use to select specific securities frauds to bring special representative litigations including the preceding regulatory sanctions against such frauds, the material negative social impact of the frauds, and the defendants’ abilities to pay damages. In March 2021, CSISC further organised an expert committee to advise it on filing such litigations, and the author was invited to be a member of this committee.
In April this year, CSISC officially filed the first securities special representative litigation against Kangmei Pharmaceutical Co. (hereinafter as Kangmei) that listed on the Shanghai Stock Exchange. Kangmei allegedly committed accounting fraud in three consecutive years from 2016 to 2018, reaching a total amount of over US$4.5 billion, one of the largest securities fraud incidents in the history of Chinese securities market. Later, in July of the same year, after Kangmei declared bankruptcy, CSISC continued to represent Kangmei’s shareholders in its bankruptcy proceeding.
Another special treatment furnished to CSISC by the PRC Securities Law as amended in 2019 is its unique standing to bring derivative actions without being subject to the prerequisites set in the PRC Company Law for ordinary shareholders to file such lawsuits. In other words, CSISC can sue derivatively regardless of its percentage or length of shareholding in the relevant listed company. It does not need to make demand to the board, either, before bringing derivative actions. CSISC swiftly grasped this opportunity to advance investors’ interests, too. In this year’s CSISC annual forum, it invited multiple law scholars, including the author, to provide advice on exercising this new right of action. Just one month after the forum, in October 2021, CSISC filed its first derivative action against the controlling shareholder and officers of Shanghai DZH Ltd., requesting the defendants to reimburse the damages paid by the company to its shareholders in a previous securities fraud case.
Certainly, Chinese regulators’ endeavors to protect securities investors go beyond the actions taken by the CSISC. For instance, CSRC launched a new slogan of “Zero Tolerance” toward securities frauds. Eradication of securities fraud is perhaps infeasible in most jurisdictions because the enforcement of securities law itself is costly. After certain level of enforcement intensity, therefore, additional resource spent on fighting against fraud will not be worth the benefit of eliminating that extra extent of fraud. However, this catchy slogan is highly expressive of Chinese regulators’ determination to combat fraudulent activities committed by insiders of listed companies at the expense of public investors.
One step taken by the CSRC and Chinese courts under this slogan is to tighten the liability of intermediaries assisting in securities offering, underwriters, accountants, lawyers, and, in case of debt issuance, credit-rating agencies. In fact, this is also inspired by the legal theories and practices in the US urging “gatekeepers” to play active parts in scrutinizing securities offering documents.6The most well-known academic work in this regard is Coffee, Gatekeepers: The Professions and Corporate Governance, Oxford University Press, 2006. Earlier this year, Chinese courts rendered influential decisions that ordered various offering intermediaries to pay damages of nearly US$800 million, jointly and severally, to investors in a civil action against fraudulent issuance of debt instruments.7Wang et al. v. Wuyang Construction Group Ltd. et al.,（2020）浙01民初1691号, affirmed in（2021）浙民终389号. The credit-rating agency and the law firm involved in this issuance were ordered to be liable for 10% and 5%, respectively, of the damages.
Like many other policies adopted in China’s reform era, current practices of investor protection spearheaded by CSISC, with CSRC having its back, naturally have various limits. For one thing, CSISC has not been authorised to make shareholder proposals or nominate board candidates under the PRC Company Law. Thus, in the above case of China Baoan Group, it had to count on the largest shareholder of the listed company to propose a removal of anti-takeover clauses in the articles. Yet, as the amendment to the PRC Company Law is around the corner, such legal hurdles can be cleared with relative ease. A more chronic weakness in CSISC, though, lies in its detachment from the market as a public entity, which renders it impossible to adequately align incentives with market participants in high-powered competition. In particular, CSISC is lack of teams conducting professional market analyses. Hence, its decisions on launching activist attacks have so far been largely based on mainstream corporate governance theories developed in the US, instead of projected impacts on firm value. Even though many of these theories do find robust empirical supports, corporate governance strategies are not “one-size-fit-all”, but specific to each company.
Similarly, while anti-fraud rules are supposed to be embraced by securities regulators everywhere, the current practice in China seems to have tipped the balance excessively toward compensation of existing victims rather than deterrence of future wrongdoings. As a result, courts are willing to find deep pockets from offering intermediaries when the issuers become insolvent themselves. As those intermediaries are forced to bear liabilities disproportionate to their culpabilities, they will have to pass along costs to investors, or, if that is infeasible, refrain from providing services in securities offerings. Either way, it will not be a boon to Chinese securities investors. To make matters worse, if the actual perpetrators of securities fraud, usually the insiders of the issuer, are off the hook since intermediaries have shouldered the legal liabilities, then insufficient deterrence will leave the very source of fraudulent activities unchecked.
Finally, as I have alluded to in various places above, it is worth noting that many securities investor protecting rules and practices seen in China are borrowed from the playbooks in the US. The special representative litigation mechanism is unquestionably inspired by the US securities class action, and the rules used to hold offering intermediaries accountable in securities fraud are modeled on section 11 of the US Securities Act of 1933. Perhaps most prominently, the anti-takeover devices that CSISC has targeted at are blamed by well-known scholarly works in the US8A most eminent research is Bebchuk, Cohen & Ferrell, What Matters in Corporate Governance?, 22 Review of Financial Studies 783 (2009), which condemns staggered boards, golden parachutes, among other anti-takeover devices, as bad corporate governance practices. and were under similar attacks by the American shareholder activists earlier in this century.9One good case in this point is the de-staggering of corporate boards in the US.
This becomes an especially interesting phenomenon at a time when the China-US tension accelerates and when the stakeholder, instead of shareholder, capitalism has been increasingly gaining popularity in the US. On the one hand, it gives outsiders one window to look into the China-US relationship and its potential trajectory. On the other, it probably also manifests the belief held by the Chinese policymakers in terms of whose stakes should be prioritised in a nation that strives to propel a robust economic growth while maintaining a stable societal environment. Protecting securities investors appears to be that one stone that can kill the two birds. After all, economic growth relies on return on investments, and, in a securities market composed of hundreds of millions of retail investors, ensuring honest returns to them is, of course, an essential contributor to the social stability. Thus, indeed, securities investors themselves are vital stakeholders in China’s economy and society alike.
|↑2||Yao, International Investors Enthusiastically Allocating Capital to China【国际投资者踊跃配置中国资产】, International Business Daily【国际商报】, 13 Oct., 2020, available at: http://finance.people.com.cn/n1/2020/1013/c1004-31889750.html.|
|↑3||Zhang, Retail Investors Losing Power, A-Share Market Heading for an “Institution Market”【散户力量趋弱 A股走向“机构市”】, Economic Information Daily【经济参考报】, 16 Dec. 2020, available at: http://www.cs.com.cn/xwzx/hg/202012/t20201216_6121159.html.|
|↑4||This was Zuig’s bid for control in Zhenxing Biotech Corp.|
|↑5||CSISC v. Haili Biotech Corp.,（2017）沪0120民初13112号.|
|↑6||The most well-known academic work in this regard is Coffee, Gatekeepers: The Professions and Corporate Governance, Oxford University Press, 2006.|
|↑7||Wang et al. v. Wuyang Construction Group Ltd. et al.,（2020）浙01民初1691号, affirmed in（2021）浙民终389号. The credit-rating agency and the law firm involved in this issuance were ordered to be liable for 10% and 5%, respectively, of the damages.|
|↑8||A most eminent research is Bebchuk, Cohen & Ferrell, What Matters in Corporate Governance?, 22 Review of Financial Studies 783 (2009), which condemns staggered boards, golden parachutes, among other anti-takeover devices, as bad corporate governance practices.|
|↑9||One good case in this point is the de-staggering of corporate boards in the US.|