Safety first

With regulation beefing up investor protection and expanding the disclosure requirements for listed companies, what review responsibilities do financial institutions bear as creditors of companies providing security for third parties? Li Xinyang, general manager, and Ye Qing, senior legal manager of the Legal Compliance and Supervision Departments at Dajia Asset Management, explore how to control the legal risks

The China Securities Regulatory Commission (CSRC) recently announced that for the 603 cases it handled in 2022, there was an increase of 203 information disclosure violation cases, while another 64 were fund misappropriation and unlawful provision of security cases. Unlawful information disclosures and unlawful provision of security cases still accounted for a large proportion, seriously affecting the development of the securities market.

A series of regulatory measures on the provision of security by listed companies has been issued across the industry, and judicial practice has also shifted towards placing greater emphasis on protecting the interests of listed companies and their small and medium retail investors, elevating the importance of the verification of publicly available information by financial institutions to a greater height.

This article sifts through the latest regulatory provisions on, and certain judicial cases involving, the disclosure by listed companies of security provided to third parties, analyses the legal risks and offers practical control measures to financial institutions, which are often the creditors in these provisions of security.

ENHANCED REGULATION

On 5 October 2020, the State Council issued the Opinions on Further Improving the Quality of Listed Companies, proposing to “stringently deal with the issues of fund misappropriation and illegal provision of security … [and] determine in accordance with laws and regulations that listed companies do not bear security liability under illegal security contracts”. The opinions state that such entities as the CSRC, the Supreme People’s Court (SPC) and provincial-level people’s governments are responsible for implementation.

The unlawful provision of security by listed companies had become an issue urgently requiring resolution by judicial adjudication as the “last line of defence”.

On 28 January 2022, the CSRC together with the Ministry of Public Security, the State-Owned Assets Supervision and Administration Commission of the State Council, and the China Banking and Insurance Regulatory Commission issued the Regulatory Guidelines for Listed Companies, No. 8: Regulatory Requirements for the Fund Transactions of, and the Security Provided for Third Parties by, Listed Companies.

These guidelines, together with the latest Stock Listing Rules and Self-Regulation Guidelines of the Beijing, Shanghai and Shenzhen stock exchanges, strengthen the disclosure by listed companies of security provided for third parties. More specifically, they include the following directives.

Making the requirements for the disclosure by listed companies of security provided for third parties more detailed.

Where a listed company submits the annual limit on the security to be provided for its subsidiaries to its shareholders’ general meeting for consideration and centralised approval and authorisation, regulations set out further requirements in respect of continuous disclosure when security liability has actually arisen or revision of the limit occurs, including disclosure of the basic particulars of the specific security, the balance of the security and other key information.

Continuous disclosure has resolved the issue of the difficulty creditors face in comprehensively securing information on the actual security liability that a listed company and its majority-owned subsidiaries are required to bear, but they remain unable to determine whether a certain item of security remains within the total security limit.

Expressly specifying the requirements for the disclosure by the majority-owned subsidiaries of a listed company of security provided for third parties.

Pursuant to article 9 of the Interpretations on the Application of the Security System in the Civil Code, there are three types of entities that are required to announce and disclose security provided for third parties: listed companies; majority-owned subsidiaries disclosed by a listed company; and companies with stock traded on other national securities exchanges approved by the State Council.

The scope of majority-owned subsidiaries is not limited solely to first-tier subsidiaries, but also includes second and third-tier subsidiaries, the specific scope of which can be determined by consulting the documents publicly disclosed by a listed company, such as its annual reports.

Companies with stock traded on the Beijing Stock Exchange or National Equities Exchange and Quotations are also required to disclose information on the provision of security for third parties in accordance with the rules of the corresponding trading venue.

The expansion of the scope of disclosure at the judicial level is an active response to concealed acts of providing security in a listed company’s system, which can only be genuinely scrutinised by the public if “a light is shone thereon”.

Emphasising financial institutions’ responsibility for prudential verification.

The above-mentioned No. 8 guidelines emphasise that financial institutions in the banking industry have a responsibility to prudently verify the performance of listed companies of their obligation to disclose information on security provided for third parties. Similarly, article 9 of the above-mentioned interpretations specifies that, on the basis of requiring creditors to review security announcements, “where a counterparty concludes a security contract with a listed company without basing the same on information on items of security publicly disclosed by the listed company and adopted by the board of directors or shareholders’ general meeting in the form of a resolution, and the listed company asserts that the security contract has not become effective as for it, and that it does not bear security liability or is not liable for damages, the People’s Court shall uphold such assertion”.

The objective of the regulator is to compel public companies to trade compliantly, promote the enhancement of the quality of listed companies, and ultimately spur the creation of a good, law-abiding and compliant securities market order.

Although the No. 8 guidelines specifically mention banking financial institutions, non-banking financial institutions such as insurance asset management companies and securities companies must also attach significant importance to reviewing the resolutions and security announcements of listed companies in order to avoid their status as “bona fide counterparties” being questioned.

NECESSITY OF DISCLOSURE

Theoretically, the new trends at the regulatory and judicial level described above can effectively resolve the current concerns regarding the acts of provision by listed companies of security for third parties.

However, at the present stage, listed companies generally adopt the method of annual anticipated security for the provision of security for their subsidiaries, but a common issue encountered in practice is whether a financial institution can rely on a listed company’s annual anticipated security announcement to recognise that it has fully performed its information disclosure, and co-operate with it with regard to the provision of security.

It is the opinion of the authors that financial institutions still need to look at the specific security disclosures before they can rely on the validity of such security, and the reasons for this are set out below.