The gatekeepers to China’s capital markets are under the microscope via a comprehensive registration system that takes no prisoners. Yu Xiao reports
In China, the pace of comprehensive implementation of the stock offering registration system is accelerating. Under the comprehensive registration system, the duties of “gatekeepers” are becoming increasingly crucial, as their reviews of, and judgments on, the truthfulness, accuracy and completeness of corporate information disclosures have a direct impact on the quality of listed companies, and in turn investors’ interests.
Regulators perform a formal, but not substantive review on listing documents, while intermediary agents, the “gatekeepers” of the capital market, must shoulder the chief responsibility. Intermediaries include: securities companies, serving as the sponsor, underwriter, or placing agent; law firms, legal counsel to the issuer and fellow intermediaries; reporting accountants, auditors of financial records; and asset appraisers, financial printers and depositaries.
With recent stricter regulation steadily driving the rule of law in China’s capital markets, intermediaries must step up to fulfill their weightier roles.
‘FEIGNING SLEEP’ NOT AN OPTION
With intensifying capital market regulation, the legal responsibilities of intermediary agents, as gatekeepers in securities offerings, have increased.
Liang Qifeng, a part-time Master’s degree tutor at the Law School of Central University of Finance and Economics in Beijing, observes that the increasing burden on intermediaries in capital markets can be divided into two aspects: (1) solving historical problems by intensifying law enforcement and stringently cracking down on illegal and criminal acts that already exist in the market; and (2) regulating ongoing development by improving the development of legal systems and law enforcement capabilities, and implementing the rule of law in, and normalisation of, the responsibilities of intermediary firms.
“In the civil and administrative securities false statement cases during the past year or so, intermediary firms have inevitably been unable, in basically every case, to evade becoming the targets of punishment, and defendants in administrative penalties or civil damages,” says Liang.
In terms of specific cases, the Wuyang Bond case, being the first bond false statement dispute in which intermediary firms were sued for joint and several liability, sent tremors through the capital markets. In August 2017 Zhejiang private enterprise Wuyang Construction materially defaulted on its two-tranche offering of “small public bonds” totalling RMB1.36 billion (USD201.6 million), resulting in more than 100 institutional investors – such as securities houses, asset management institutions, banks, private funds – and more than 700 individual investors incurring losses.
In August of the following year, the China Securities Regulatory Commission (CSRC) found that Wuyang Construction had committed a fraudulent bond issue and imposed administrative penalties. The auditor for the bond issue, Wuyige Certified Public Accountants, and the lead underwriter, Topsperity Securities were also penalised. Subsequently, investors sued the intermediary firms in question for joint and several liability, with the court ultimately rendering a judgment that the intermediary firms, including AllBright Law Offices, were jointly and severally liable for damages. According to a Securities Daily report, AllBright paid out about RMB37 million.
“The judgment in the Wuyang bond case has had a strong deterrent effect on practitioners in securities houses and other intermediary firms, and the enhanced awareness of risk liability, in companies and among employees, is genuinely palpable,” says one individual who works in a leading domestic securities house.
Also ringing alarm bells in the markets was the Kangmei case, known as the largest financial fraud in China to date. Kangmei Pharmaceutical received administrative penalties from the CSRC for false statements and material omissions in its annual and interim reports. On 18 February 2021, the CSRC also imposed administrative penalties on Zhengzhong Zhujiang Accounting Firm, in charge for the financial audits of Kangmei Pharmaceuticals, as well as the personnel responsible.
On 8 April 2021, the China Securities Investor Services Centre was specially authorised by certain securities investors to institute a securities class action suit in the Guangzhou Intermediate Court. Kangmei Pharmaceutical was ordered, at first instance, to compensate 52,037 investors for investment losses of about RMB2.5 billion, with the auditor, Zhengzhong Zhujiang, ordered to bear 100% joint and several liability.
Additionally, in the pending ordinary representative action in the Le.com securities false statement liability dispute, a claim was made to have the various intermediary firms bear joint and several liability for investment losses of more than 2,000 plaintiffs, and King & Wood Mallesons, which provided legal services to Le.com, also had a case opened against it, and is being investigated by the CSRC.
In system terms, strict regulatory measures as well as legal norms and judicial interpretations are having an even greater impact on deterring gatekeepers may have looked the other way from continuing to do so.
At the level of civil liability, the Implementation Opinions on Setting up the Science and Technology Innovation Board and Launching the Pilot Programme of the Registration System on the Shanghai Stock Exchange, issued by the CSRC on 28 January 2019, set out the responsibilities of securities intermediary firms under the pilot registration system for the Science and Technology Innovation Board, requiring a sponsor to conduct a comprehensive examination and verification of an issuer’s application documents and information disclosure materials, securities service firms and their practitioners to exercise a special duty of care in respect of matters falling within their specialties, and increased penalties imposed on securities intermediary firms found liable.
In December of the same year, the new Securities Law was adopted, which: (1) added a chapter regulating information disclosure matters; (2) provided for the bearing by the sponsoring and underwriting securities companies and their directly responsible officers of presumption of fault, and joint and several liability to investors, in the event that they fail to perform their duties; and (3) established new civil procedure systems such as prior compensation by securities companies, representative actions by investor protection institutions, and a dispute mediation mechanism.
At the administrative law enforcement level, the new Securities Law increases the penalty range for failure by a securities service firm to perform its obligation of due diligence and care from the former maximum fine of five times the business income to 10 times. In serious circumstances, firms may be suspended or prohibited from engaging in securities services.
Data indicate that since 2019 the CSRC has investigated and dealt with 80 cases of violations of the law by securities intermediary firms involving 24 accounting firms, eight securities companies, seven asset appraisal institutions, three law firms and one credit rating agency over matters covering securities offerings, annual report auditing, asset acquisitions, and material asset restructurings.
Liang believes this indicates that, against the backdrop of the comprehensive registration system, regulators have extensively strengthened their oversight of securities intermediary firms, and that they will shift from pre-entry approval of securities service firms to enhanced interim and ex post oversight.
Luan Jianhai, a partner at Commerce & Finance Law Offices in Beijing, says that the regulatory measures aimed at intermediary firms involved in capital markets are gradually becoming more concordant with the duty of care that they bear and the scope of the duties that they perform.
Relevant regulations delineate the duties of different intermediary firms in the capital markets and specify the scope of intermediary firms that bear relevant legal liability, on the one hand avoiding a negative chain reaction caused by infinitely expanding the boundaries of liability for intermediary firms, and on the other hand scrutinising intermediary firms in the performance of their respective duties to jointly promote the healthy development of capital markets.
At the judicial level, the focus is on facilitating investor claims. The new Securities Law and judicial interpretations optimise the mechanism for claims made by securities investors of false statements, and innovate in the ways that securities investors can lodge claims. On 21 January 2022, the Supreme Court issued new judicial interpretations on false statements, setting out in detail how to determine the fault of securities intermediary firms such as sponsor and underwriting institutions, and accounting firms, and the grounds on which to argue for exemption from liability. These moves undoubtedly further facilitate the filing of civil claims by securities investors against intermediary firms.
Criminal liability of capital market intermediary firms is also being enhanced. Han Ke, the founding partner of Beijing Inno Law Firm and a former criminal division judge on the Supreme People’s Court, says that the further strengthening of criminal liability for intermediary firms by the revised Criminal Law conveys a determination to stringently crack down on securities law violations.
The Bill to Amend the Criminal Law (No. 11), implemented on 1 March 2021, expressly names sponsors as perpetrators of the crime of providing false supporting documents, and the crime of issuing materially inaccurate supporting documents, and provides for the application of such crimes in the pursuit of criminal liability. Additionally, it provides for the application of longer sentences to the personnel of intermediary firms, such as lawyers and accountants who, in the course of securities offering and material asset transaction activities, issue false supporting documents. Where circumstances are particularly serious, a maximum sentence of 10 years may be given.
Han reveals the case of an alleged fraudulent bond offering by a company in Shandong in which he was involved, where the two signatory accountants of the accounting firm that provided audit services to the company also had a case opened against them and were investigated by the public security authority as criminal suspects. The person-in-charge of the accounting firm that provided audit services was recognised as the signatory accountant instead.
“Regulation of the securities market in China has always emphasised administrative supervision, de-emphasised judicial adjudication and, as securities crimes involve a higher level of specialisation and complexity, they have to a certain extent weakened the fight against securities violations and crimes carried out through criminal justice,” says Han.
“However, in recent years, reliance on criminal justice to strengthen regulation and the ‘zero tolerance’ attitude in combating securities and futures crimes have become more and more pronounced in practice,” he says. “In 2021, the CSRC referred or communicated criminal leads in two securities intermediary firm violations in which it had opened cases and conducted investigations in accordance with the law to the public security authority, which was rare.”
MATURE MARKET EXPERIENCE
At the heart of the registration system is true, accurate and complete information disclosure. Increasing the liability of intermediary firms can ensure the truthfulness, accuracy and completeness of information disclosures, and is conducive to protecting the interests of investors, who are at a disadvantage in terms of information available. So, how does one oversee intermediary firms? Mature capital markets have experience in this regard.
Harrison Jia, a Beijing-based partner at DeHeng Law Offices, believes that the regulatory approaches of the US and Hong Kong capital markets are valuable references for China.
Whereas the US adopts a registration system for company listings, a hybrid system, half way between approval and registration systems, is implemented for issuance in Hong Kong, emphasising the principle of information disclosure and market-based pricing, while retaining the power of substantive review.
Jia recommends that Chinese regulators, on the one hand, learn from the practice of the Hong Kong Securities and Futures Commission (SFC) of publicising sponsors that fail to exercise due diligence and care, and establish an objective and impartial intermediary firm integrity public disclosure system, and on the other hand, strengthen oversight over the self-regulation of the securities intermediary firm industry, such as referring the professional opinions, work reports and working drafts of intermediary firms to industry associations for review, imposing self-regulatory sanctions in cases of violations of laws or regulations, and transferring the same to the regulators for administrative penalties.
Jia additionally recommends that intermediary firms specify their respective responsibilities and tasks by means of an agreement, and disclose them in relevant documents so as to avoid any mutual shifting of blame once an issue arises. Furthermore, he says that an expert report argumentation system should be put in place to enhance the effectiveness of expert reports and enhance each firm’s independence and professionalism.
In terms of intermediary firm accountability, he calls for increased amounts of penalties for liable entities, and if the acts of an intermediary firm have serious consequences and adverse effects, it should be penalised in ways including suspension of business or revocation of business licence. In egregious circumstances, the case should be referred to the procuratorial authority for criminal prosecution of the relevant persons.
In terms of remedies, securities class action suit accountability under the registration system is one of the key measures for ensuring truthful information disclosures and safeguarding of investors’ rights.
“The registration system provides fertile soil for securities class action suits,” reminds Luan Jianhai. “A mature securities class action suit accountability system gives rise to a strong restraint and deterrent effect on listed company directors and intermediary firms, and if an intermediary firm fails to duly perform its duties, it could be liable for massive damages, as well as incur consequent significant time and economic costs.”
FUTURE OF RISK CONTROL
Stricter regulation increases intermediary firms’ costs of illegality, compelling them to improve their internal risk management. In order to protect projects from being affected, the erection of a “firewall” becomes the most crucial task for intermediary firms, particularly law firms.
The firewall mechanism, also known as a “Chinese wall” or ethical screening, originated in the US after the stock market crash in 1929, with the revision of relevant legislation compelling information segregation between investment banks and securities houses. Such information segregation mechanism was analogised to the Great Wall of China. This is also the origin of the name “firewall” for the information segregation mechanism established within securities companies and other such firms. Subsequently, learning from the experience of financial institutions, many industries began to establish similar firewall mechanisms based on their own business needs.
In practice, securities companies have established sound risk control mechanisms. For example, auditing firms’ three-step review system, in which the project leader first reviews all working papers, followed by the department manager conducting the second-step review, and finally the certified public accountant or partner directly responsible for the audit in question conducting the third-step review.
“If a project is investigated, other projects for which the signatory is responsible will also be affected, but the projects without involvement from the person under investigation will be left untouched,” says the above-mentioned individual serving in a leading securities house. “However, if the intermediary firm itself is investigated, all of its projects will be affected.”
Luan argues that it would be beneficial for law firms to learn from the firewall mechanisms of such financial institutions as investment banks. However, as compared to the versatility of securities companies, law firms have a relatively fixed role in the securities business, and the current firewall mechanisms of large law firms at the business management level mainly address such compliance issues as conflict of interest.
The Measures for the Administration of the Securities Law Practice of Law Firms, issued by the CSRC and the Ministry of Justice – which, at present, are the principal dedicated legal norms governing lawyers’ practice in the securities market – expressly encourage law firms engaged in securities law practice to satisfy such conditions as having compliant internal management, sound risk control systems, a high standard of practice, and good social reputation, reflecting regulators’ risk control requirements in respect of law firms engaged in securities activities.
Jia also points out that the firewall mechanisms of law firms seem at present quite thin. The reason is that the kernel work of law firms is done by lawyers on a part-time basis for relatively low pay, and they cannot fully exercise their duty of diligence and care, making it impossible for the kernel to fully fulfill its role. Accordingly, learning from the firewall mechanism of investment banks to improve that of law firms seems particularly necessary.
However, Han says that a firewall mechanism mainly resolves internal conflicts of interest within intermediary firms, but fails to protect projects from being affected by an administrative audit of the firm, so it is imperative to establish an insurance risk control mechanism.
In March 2001, the Beijing Lawyers Association executed a lawyer’s practice liability insurance contract with Ping An Property & Casualty Insurance Company of China, under which the association purchased practice liability insurance for its lawyers. Similar pilot centralised insurance schemes were also carried out in Shanghai and Guangzhou to reduce the practice risks in the legal profession.
The scope of coverage of such centralised practice liability insurance is “claims filed by clients against the insured”. However, with respect to claims in securities false statement disputes, as they are lodged by investors in listed companies, it is unlikely that such legal actions are covered by existing liability insurance policies.
Additionally, current centralised practice liability insurance inclines more toward general insurance, with limits on indemnities, making it difficult to cover the claim amounts in securities false statement disputes. In view of the difficulty for simple centralised practice liability insurance to fully satisfy law firms’ internal risk control requirements, establishing a “centralised practice liability insurance + personalised professional insurance” risk mechanism can be a preferrable option, allowing for the purchase of personalised professional insurance that addresses the types and loss level of risks in securities-related services.
Hong Kong professional indemnity insurance has also come to the attention of mainland law firms in recent years. Jia explains that it covers the damages that professional and technical personnel are required to bear in accordance with the law for personal injury or property loss incurred by contract counterparties or others due to professional negligence or fault by such personnel. Such insurance can cover physicians, accountants, architects, engineers, lawyers, insurance brokers, exchange brokers and other professional and technical personnel.
“At present, lawyers in China are required to enroll every year in compulsory lawyer’s liability insurance taken out by lawyers associations, but the premiums are relatively low and the coverage narrow, limiting the protection that it offers against practice risks,” says Jia. “With the gradual rollout of the registration system and the sharing of professional responsibilities still insufficiently clarified, there is strong demand from professionals in intermediary firms for insurance products that can offer genuine protection and realise effective risk isolation.”
Jia says that several insurance companies in the market have launched a variety of commercial practice liability insurance products that mitigate practice risks, but the number of intermediary firms that have taken out such insurance is limited, and the products have not been well promoted or taken up. Accordingly, he would advise insurance companies to increase their publicity for such products, and encourage intermediary firms to take out commercial practice liability insurance to protect their practice.
Firewall systems and insurance mechanisms are both effective risk isolation measures, but law firms that engage in the provision of capital market-related services cannot rely simply on a firewall mechanism to evade risks. The lawyers interviewed are generally of the opinion that, when law firms and lawyers engage in their business activities, they should keep a close eye on service quality, and remain diligent and prudent in performing their obligations of examination and verification.