Halfway to Effective Shareholder Protection

Unfortunately, such optimism didn't last for long. As the Chinese Securities Regulatory Commission (the CSRC) strengthened its investigation of public companies over the past few years, investor confidence has largely eroded. In only a few months last year, the Shanghai Stock Exchange index dropped from its all-time high of over 2,200 to near 1,300 by January 2003; more than one third of market capitalization evaporated.

China has its share of Enron and WorldCom-type scandals. In this regard, PT Chengdu Hongguang (600083) and Yinguangxia (000557) are quite representative. According to the PRC Company Law, for a company to issue shares publicly, it must have been profitable for the three consecutive years prior to the issue, and its expected profit rate after going public shall be at least equal to the bank deposit rate for the same period. Hongguang made history in China's stock market by becoming the first public company that showed a loss within six months after listing in 1997. Further investigation by the CSRC showed that Hongguang had forged more than Rmb540 million in profits for prior years in order to qualify for listing. In fact, Hongguang had made huge losses in the most recent three years. After listing, it used more than 80% of its investors' money to pay off its debt rather than invest in a new product line as stated in its prospectus without any disclosure to the public.

Yinguangxia was widely regarded by the market as the biggest dark horse in the Chinese stock market in 2000 and a blue chip of great potential. A detailed report published by Caijing magazine in 2001 disclosed that revenue from its most profitable activity, export businesses worth millions of dollars, was totally faked. The CSRC's subsequent investigation discovered that Yinguangxia had made up sales revenue of nearly Rmb1.5 billion from 1998 to 2001.

Though administrative and criminal penalties were imposed on both of these public companies and their management, it was the investors that suffered the most from the frauds. In the Yinguangxia case as an example, its share price plunged from Rmb30.79 to 7.05 within 14 days after the scandal was disclosed. Rmb6.667 billion in Yinguangxia's market capitalization evaporated in less than half a month.

The CSRC's investigation and punishment of Hongguang and a few other public companies gave rise to the first wave of shareholder suits in 1998. However, these shareholders were quick to find that they were ill equipped under Chinese law to obtain any redress despite the fact that they directly bore the cost of market fraud.

The PRC Securities Law was enacted in 1998 shortly after the outbreak of the Asian financial crisis. The impact of the crisis on China's legislators can be traced clearly in the contents of the Security Law. As a result, the Securities Law gave considerable authority to the government to impose administrative and criminal liabilities on wrongdoers but paid little attention to civil remedies available to defrauded investors. There is only one clause in the Securities Law that is directly relevant to civil remedies for misrepresentation. Article 63 provides in the event that any issuer or underwriter makes a misrepresentation, a misleading statement or material omission in its prospectus, financial and accounting reports, or annual report, and which has caused losses to investors in securities transactions, such issuer and underwriter have an obligation to compensate the investors for the losses. The responsible director, supervisor and manager in the issuer or underwriter's company are also jointly liable for such compensation. The Company Law also contains a couple of clauses in connection with fiduciary duties of directors and managers, but these clauses lack practicality, as they are given in very general and abstract terms.

Despite these general principles set out in the Securities Law and Company Law, many fundamental issues remain unresolved. For example, which court has the jurisdiction to hear such cases of securities fraud; who can act as plaintiffs and defendants in a misrepresentation suit; and are there any preconditions for filing such suits? Most importantly, how can an investor prove the existence of any causal relation between the claimed misrepresentation and his losses, and how is his loss calculated? Due to these legal obstacles, most of the early shareholder suits were dismissed by the courts even before a hearing.

The PRC court was apparently unprepared for the sudden surge in shareholder suits. Its initial response was reflected in a notice issued by the SPC on September 21 2001. The notice stated that due to "the weakness of the current securities civil liability system and limits on the quality of judges", the court "would not accept and hear such cases for the time being". The SPC's policy on shareholders suits in connection with misrepresentation received immediate criticism from various sectors. In the face of mounting pressure in the market, the SPC quickly changed its mind.

On January 15 2002, the Circular was issued, and it basically solved such procedural issues as acceptance of cases and which courts were competent to hear them. Encouraged by the Circular, an explosion of shareholders suits arose, with more than 900 suits filed in 2002. The enthusiasm for suits quickly cooled down, however. Despite the issuance of the Circular, shareholders are still ill equipped to pursue an effective remedy. The Circular has only seven clauses, which are too sketchy on details to be operational. The Circular failed to address many key issues that must be determined in any misrepresentation cases, such as burden of proof between plaintiff and defendant and permitted methods of loss calculation. It is not surprising that only two cases out of 900 have been closed to date, all by way of settlement. The market is still waiting to see the first case in which a monetary remedy is awarded by the court. It is against this general background that the Provisions were introduced.

New Developments

The Provisions have 37 articles divided into eight sections, including general provisions, acceptance of cases and jurisdictions, methods of bringing lawsuits, determination of misrepresentation, liabilities determination and exemption, joint tort liability, calculation of loss and miscellaneous. Compared with the Circular, the Provisions have made some significant progress.

Clarification and Expansion of "Misrepresentation"

The definition of misrepresentation in the Circular covered only "fraudulent records". The Provisions expand the definition to include fraudulent records, misleading statements, material omissions and improper disclosure. The Provisions also provide clear definitions for each of the four types of fraud. The expansion and clarification of the key concept of misrepresentation will make the pursuit of civil remedies by investors easier.

Clarification of "Plaintiffs" and "Defendants"

Article 6 provides that the plaintiff must submit its identification card or certificate. It is quite a common, though unlawful, practice in the secondary market for speculators to buy and sell securities using the names of other persons in order to cover their real identity and intention. The Provisions intend to provide legal protection only to those genuine investors, and not speculators, trading in the names of other persons.

The Provisions substantially increase the scope of potential defendants who can be held liable for misrepresentation. Apart from the issuer and its directors, managers and underwriters as provided in Article 63 of the Securities Law, the Provisions make it clear that sponsors, promoters and controlling shareholders of the issuer, the intermediary agencies (such as accounting firms, law firms and asset appraisal firms) involved, and persons directly responsible for misrepresentation in the intermediary agencies can all be held jointly liable for misrepresentation. In some cases, even journalists and market commentators can be found liable.

More Details on How to File a Suit

To considerable disappointment, the Provisions follow the same method of the Circular by excluding class action as a permitted channel for investors to bring a lawsuit. Investors can file a suit either individually or jointly with other investors. The Provisions also give more details on how to bring an action. For example, the number of plaintiffs must be decided before a hearing. The plaintiffs may select two to five litigation representatives and each litigation representative can authorize one or two attorneys.

Burden of Proof on the Plaintiff

Under the PRC Civil Law General Principles, a plaintiff must establish that there is a direct causal relation between a tort action and the loss. In a misrepresentation case, it is extremely difficult for investors to prove that there is indeed such direct casual relation between the misrepresentation and their claimed losses because many factors can affect the movement of stock prices. It is impossible to isolate one factor from the others. The Provisions make it clear that the burden of proof lies on the defendant. Article 21 of the Provisions provides that promoters, issuers or listing companies shall bear strict liability for misrepresentation. Other persons are also assumed to be liable for misrepresentation unless they can prove that they commit no fault in the misrepresentation activities. According to Article 18, the plaintiff only needs to prove that: (1) the securities it has invested are directly related to the misrepresentation; (2) it has purchased such securities on or after the misrepresentation date but before such misrepresentation is disclosed or corrected; and (3) it has suffered losses when reselling the securities or while holding such securities after the disclosure or correction date. All these requirements are easy for investors to satisfy. As such, the Provisions make shareholder suits for misrepresentation feasible for the first time.

Calculation of Loss

Another significant breakthrough in the Provisions is to provide a detailed and practical method for calculating losses attributable to misrepresentation. In the past, the courts have been very hesitant to grant compensation because they have had no clear legal basis to calculate the losses suffered by the plaintiff. Now the Provisions set forth clear guidance on how to calculate such loss: if an investor suffers a loss in the primary market, the investor is entitled to a refund of his share subscription money plus interest equal to the bank deposit rate for the same period; if an investor suffers a loss in the secondary market, he is entitled to the differential loss of the investment, plus any commission and stamp duty tax relating to the price difference and interest at the rate of bank deposit for the same period. The Provisions also include provisions on how to calculate the "investment differential loss" under various circumstances.

Unresolved Issues

Though the public generally believes that the Provisions have made significant progress on shareholder lawsuits arising from misrepresentation in the stock market, the Provisions have also led to some criticism. The criticism is mainly focused on three aspects.

Limitation on Cases that can be Heard by the Court

In practice, misrepresentation can be made by either a public or a private company. Though generally it occurs on a much smaller scale and is often done outside of the public eye, misrepresentation made by a private company in a private placement can be equally harmful to the investors involved. Unfortunately, the Provisions deal only with misrepresentation made by public companies. For those investors who have suffered from misrepresentation made by private companies, they still lack a clear legal basis on which to recover any losses. Even for public companies, the Provisions only cover misrepresentation and leave investors facing any other kind of market fraud, such as share price manipulation or insider trading, without an effective remedy.

Preconditions for Filing a Misrepresentation Lawsuit

The Provisions follow the example of the Circular by imposing a precondition for filing any misrepresentation lawsuit. Before the court accepts and hears a misrepresentation case, the government authority in charge must have already imposed administrative or criminal punishments on the persons responsible for making the misrepresentation. The Provisions make such a precondition easier to satisfy by expanding the number of government agencies that have the power to discipline public companies. Nevertheless, from a legal point of view, it makes little sense why a civil action must be based on an administrative or criminal ruling. It should be within the authority of the court to decide whether a given activity constitutes a misrepresentation or not. Some scholars have argued that such a precondition unnecessarily limits the fundamental right of a person to bring a lawsuit. Moreover, given the limited resources of the CSRC and other government authorities, and the many practical difficulties, only a small percentage of companies that ever commit a misrepresentation are eventually caught and punished by any government agencies. For those companies that have not received punishment from the government authority, an investor would be prohibited from bringing a lawsuit against it, though the investor may possess strong evidence to show that the company has indeed made a misrepresentation.

Unavailability of Class Action

Prior to the issuance of the Provisions, there were many discussions in the market about the possibility of introducing class action by the new regulations. To the disappointment of many investors and market observers, the Provisions repeat the stipulations made in the Circular, which in effect exclude class action as a permitted method for bringing a shareholder lawsuit. The SPC has both legal and technical reasons to exclude class action. First of all, there is no legal basis for class action under Chinese law. Arguably, class action is in conflict with the fundamental "no claim, no acceptance" principal in Chinese law: i.e., the court will not accept and hear the cases of those persons who have not filed a claim. The technical reason is that the court has no experience or resources with which to deal with a class action that can cover thousands of investors nationwide. Nevertheless, as pointed out by many scholars, class action has been proved in many countries as the most effective method of bringing shareholder lawsuits. China's stock market is characterized by large numbers of individual investors. With a couple of exceptions, all lawsuits on misrepresentation are required to be filed with the intermediate court in the locality of the public company's place of business. For many small investors, the tremendous costs of bringing a legal action against a public company are simply too high via s via their relatively small claimed amounts. Further if an investor intends to bring a joint action with other investors, the coordination and transaction costs are also very high. On the other hand, the court has to hear and adjudicate many independent cases of a very similar nature, which is also a significant waste of limited legal resources.

In summary, the Provisons make significant progress in removing many obstacles on shareholder suits for misrepresentation. They have also done a good job in clarifying many ambiguous issues left by the Circular. However, there is still a long way to go for investors to receive full and effective protection under Chinese law. There is an old saying in China: "If one intends to travel 100 miles, 90 is only half the way." The final distance is often the hardest to cover.

By Hongchuan Liu, Yiwen Law Firm & Zili Ren,
Law School of Peking University of Aeronautics and Astronautics, Beijing