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China’s Securities Regulation: A Historical Perspective

     By Lehman Lee & Xu

The China stock market boom and its subsequent decline is certainly “old news.” In July 2007, the chairman of HSBC’s Asia-Pacific division described the domestic demand for its shares in China as “mind-boggling.” However, between October 2007 and April 2008, the country's stock market indices fell by nearly 50 percent.

The China stock market boom and its subsequent decline is certainly “old news.” In July 2007, the chairman of HSBC’s Asia-Pacific division described the domestic demand for its shares in China as “mind-boggling.” However, between October 2007 and April 2008, the country's stock market indices fell by nearly 50 percent. There are differing opinions as to the cause of this decline: some cite the US sub-prime market crisis, others credit the global economic slowdown, still others suggest that China’s shares were due for a downward correction.

On 23 April 2008, the Chinese government cut the rate of stamp tax on shares from 0.3% to 0.1% in an attempt to stimulate the market. The rate reduction was a reverse of its increase of the stamp tax in May 2007 from 0.1% to 0.3% in order cool down the market. Subsequently, on 24 April 2008 the Shanghai Composite Index rose by over 9% (China Daily).

There remain persistent criticisms of China’s securities market on the basis of perceived institutional flaws -- in particular, the protection afforded to minority shareholders. Those criticisms tend to forget the immature and developing nature of the Chinese market. It is important to take a step back and look at the history of China securities industry.

The Shanghai and Shenzhen stock exchanges were launched in 1990 and 1991 respectively. Initially, the governments of Shanghai and Shenzhen were principally responsible for the supervision of the exchanges. At this stage no national supervisory body existed. In 1992 the China Securities Regulatory Commission (CSRC) was created to address perceived failings of the previous supervision. However, it was not until 1998 that supervision was fully centralised in the CSRC as part of securities reform that led to the promulgation of China’s first Securities Law.

The Shanghai and Shenzhen exchanges initially competed quite heavily to attract listings. However, in 2000 Shenzhen agreed to forego larger enterprise listings in return for the right to host a new board of small and medium enterprises. The Shenzhen exchange suspended listings until May 2004, when the Shenzhen Stock Exchange’s Small and Medium Enterprise Board was established. Since then, larger enterprises tend to list on the Shanghai exchange, while small to medium enterprises generally list on the Shenzhen exchange.

China’s early experience with corporate governance and the regulation of securities was certainly not smooth. In the late 1990’s and early 2000’s, a succession of failed ventures strongly dampened investor confidence. In 1996 Lantian Co. Ltd. was listed on the Shanghai stock exchange and recorded soaring profits in the initial few years. However, it soon became apparent that the recorded profits were dubious, and it is estimated that profits were fabricated by up to US$60 million.[1] Another case is that of Sanjiu Pharmaceuticals Co. In 2001 the CSRC uncovered that the major shareholders of this company had siphoned approximately US$301 million from the company.[2]

China’s stock market has long been complicated by the existence of State owned non-tradable shares. This meant that majority ownership in many firms remained with the State. Many saw this as an impediment to the development of the market, primarily because it meant that holders of tradable shares were usually minority shareholders and could not influence management decisions. This was compounded due to the minimal protection that China’s securities and company law have offered for minority shareholders. From 2005 the government has gradually converted many non-tradable shares into tradable shares in recognition of the problems caused by the existence of these non-tradable shares (Hangzhou Municipality Website).

Originally, China’s stock market was segregated into A-share and B-share markets. Only domestic persons or corporations were allowed to deal in A-shares and only foreign persons or corporations were allowed to deal in B-shares. In 2001 the law was changed to allow domestic entities, under certain conditions, to acquire B-shares. The B share market is relatively small and traditionally has not attracted companies with shares that are in high demand.

In 2002 the CSRC announced the Qualified Foreign Institutional Investors (QFII) scheme. This scheme allowed foreign institutional investors to deal in A-shares. However, significant restrictions were placed on QFII’s. Over time, particularly in 2006, the rules in respect of QFII’s have been relaxed. Most recently, the CSRC has announced a further revision of these rules with the aim being to encourage “foreign institutions to make medium- and long-term investments in China's capital markets” (Yahoo! News Singapore). At this stage the detail of this revision has not been revealed.

By 2005 China’s stock markets were lagging, a point conceded by Wen Jiabao, who at the time stated “…we should admit, that regarding how to establish an all-around securities market, we are not knowledgeable or experienced enough.” Accordingly, China made significant reforms to its Company Law and Securities Law. These reforms were made in light of significant criticisms of the then existing laws, in particular:

1. The inability of private investors to enforce the Securities Law through private securities litigation;
2. The concept of securities was limited: in particular, it did not include financial derivatives;
3. The Law mandated the separate operation of securities, banking, trust and insurance business, leading to increased costs and inefficiency;
4. The Law only allowed spot transactions;
5. Ineffective civil liability provisions; and
6. No protection of minority shareholders.

On 27 October 2005 the Standing Committee of the Tenth’s People’s National Congress passed amendments to the Securities Law, which came in effect as of 1 January 2006. Some the significant changes were as follows:

1. Article 6 – allows the CSRC to permit securities business being run in conjunction with banking business, trust business and insurance business.
2. Article 39 – permits securities to be traded in stock exchanges or in any other places approved by the State Council
3. Article 42 – removes the restrictions on futures and options trading, albeit at the approval of the CSRC.
4. Articles 76, 77 and 79 – provide for civil liability compensation where officers breach the law;

The 2005 amendments made substantial changes to China’s securities law. Subsequent developments, such as the gradual sell down of non-tradable shares, have also contributed to an improved securities environment. Yet problems continue to persist. It is still difficult for minority shareholder to protect their interests. Hopefully, this will be less of problem with the reduction in non-tradable shares. Furthermore, the Western concept of corporate governance has not yet been fully embraced. Part of the reason for this is that speculators dominate the markets. A culture of long-term investment has not yet developed, as evidenced by the frenzied trading on the back of the reduction in stamp tax.

What this short outline of the history of China’s securities market should demonstrate is that it is presently unrealistic to expect Western standards of corporate governance. Substantial development has occurred since 1992, and undoubtedly there is a ways to go. China has implemented the requisite laws and regulations in order to modernise its securities market. The biggest problem now is cultural. The only truly effective way to manage this issue is with time and experience.

[1] Steven Shi and Drake Weisert, ‘Corporate Governance with Chinese Characteristics’, 2002 The China Business Law Review
[2] Ibid.
[3] People’s Daily Online, ‘Premier Wen addresses press conference on key issues”. 

Mathew McKee is a Foreign Legal Counselor at Lehman, Lee & Xu, the third largest corporate commercial law firm in China. He´s an expert in Australian Taxation Law, Corporate Law,
Commercial Litigation and Dispute Resolution, and Contract Law.

Copyright Lehman Lee & Xu

Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.

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