Paving the Yellow Brick Road: China's New Rules for Pension Funds'Overseas Investments

Under the Provisions, the NSSF is allowed to invest up to 20% of its total assets (calculated at cost) overseas.⁵ Based upon the 2005 reported assets, it is estimated that the NSSF would initially have approximately Rmb40 billion available for overseas investments. Moreover, the Provisions permit up to 50% of the total value of assets to be invested overseas to be entrusted with a single manager.⁶

National Council for the NSSF

The Provisions are very user-friendly and delegate substantial discretion to the National Council for the National Social Security Fund (National Council) for the overall management of the NSSF's overseas investments. Although the National Council is required to report to numerous regulatory authorities,⁷ prior approval of its decisions in respect of engaging managers and custodians is not necessary, as long as it follows the broad requirements outlined in the Provisions.

The main body of the Provisions provides for the eligibility criteria for international fund managers and custodians, the nature of the agreements to be entered into with such persons and the types of investments permitted to be made by the NSSF.

International fund managers

Eligibility criteria

Under the Provisions, to be eligible to manage the NSSF's overseas investment, an international fund manager ('manager') must satisfy the following criteria:

i. have six or more years of experience in the asset management business with assets of not less than US$5 billion under management in the most recent fiscal year ('US$5 billion assets requirement');

ii. have stable finances, good creditworthiness and risk control norms that comply with the laws of the country or region where the manager is located and the requirements of the regulatory authorities;

iii. have a sound governance structure and internal controls, and legally-compliant operations;

iv. have professional staff that meet the requirements in respect of their professional qualifications of the country or region where the manager is located;

v. during the most recent three years, the manager must not have been subjected to a heavy penalty by the regulatory authorities of the country or region where the manager is located, and

vi. is established and incorporated outside the PRC; the country or region where the manager is located must have sound laws and a sound financial regulatory system, and the regulatory authorities of such jurisdiction must have signed a memorandum of understanding on cooperation,⁸ and maintain an effective regulatory cooperation relationship with the CSRC.

Clearly, the most restrictive eligibility criterion for managers when seeking to apply for the management of the NSSF's overseas investments is the US$5 billion assets requirement. As similar requirements in other areas of PRC regulation are interpreted, it is likely that the National Council will require that such assets are either directly managed by the entity making the application, or that such entity is the holding company for various asset management entities that are consolidated into the holding company, collectively having at least US$5 billion under management. In this regard, it is likely that the National Council will not permit a subsidiary entity to qualify as a fund manager if it does not satisfy the US$5 billion assets requirement itself, even though the subsidiary is part of a larger group that does satisfy the requirement.

Interpreting ambiguous provisions

The six eligibility requirements for managers contain certain ambiguous terms that have appeared in other PRC regulations governing the involvement of non-PRC entities in the PRC financial markets.⁹ For example, no explanation is provided as to how the US$5 billion assets requirement is to be assessed and what constitutes "stable finances, good creditworthiness and risk control norms" and a 'heavy' penalty.

Based on practical experience in assisting foreign investors with the establishment of fund management joint ventures in the PRC (subject to the scrutiny and approval of the CSRC) and the making of strategic investments in large-scale PRC commercial banks (subject to the scrutiny and approval of the CBRC), it is likely that respective candidates may be requested by the National Council to prepare written submissions setting out relevant data to demonstrate that the criteria has been satisfied, even if the method for determining satisfaction is rather unclear. The relevant regulatory bodies are generally reasonable and practical when accepting submissions regarding ambiguous terminology that demonstrate compliance.

Occasionally, the National Council may issue clarifications or updates on the interpretation of the eligibility requirements. It is important for interested asset managers and their counsel to be familiar with these interpretations. For example, on April 29 2006, the National Council issued an announcement (Manager Announcement) that the six-year requirement and the asset management requirement should be met by current applicants as of March 31 2006.¹⁰ Presumably, the date (March 31 2006) will be updated from time to time because this particular date appears to indicate that the assets under management level is to be measured as of a specific date, rather than over a year as may be interpreted from the Provisions. Such a date would also indicate that the six-year experience requirement is more accurately a period of 72 months rather than six full calendar years.

Permitted investments

Under the Provisions, a manager is only permitted to invest the NSSF's assets into the following investment products or instruments:

i. deposits made in wholly PRC-owned banks overseas or foreign banks with a long-term credit rating of 'A' or higher, or the equivalent of 'A' or higher, during the most recent three years, as rated by an internationally recognized rating agency;

ii. bonds issued by foreign entities with a rating of 'BBB' or higher, or the equivalent of 'BBB' or higher, as rated by an internationally recognized rating agency, or bonds issued overseas by the PRC government or PRC enterprises;

iii. money market products, such as banker's drafts and large negotiable certificates of deposits, with a rating above 'AAA' or the equivalent of 'AAA' as rated by an internationally recognized rating agency;

iv. stocks listed on an overseas stock exchange;

v. mutual funds publicly issued on an overseas stock market with their scope of investment in compliance with the restrictions on allowed investment products under the Provisions, and

vi. derivative financial instruments freely tradable on a financial market, such as swaps and forwards.

The type of overseas investments permitted is quite broad, but appears intended to limit investments in riskier debt, equity and derivative investments by requiring certain minimum ratings for debt instruments and that equity and derivatives be publicly listed. As a result, investment managers managing the NSSF's overseas investments will not be permitted to invest in over-the-counter or individually-tailored derivatives, or equity of unlisted companies. In addition, any investment in derivative financial instruments is required to be for risk control and risk hedging purposes only and not for speculation or leveraged trading. The Provisions also have diversification requirements that generally prohibit any investment in a security or fund, issued by any organization that exceeds 10% of the outstanding shares of such security or fund, or calculated at cost, 20% of the total NSSF assets under management by the relevant manager.¹¹

Application

The NSSF recently announced that international fund managers applying for the first batch of approvals should collect application forms and other documents from the National Council during the period from May 10 2006 to May 23 2006 and submit application packages by 5pm on June 30 2006.¹²

Custodians

Eligibility criteria

Under the Provisions, the National Council is required to appoint custodians for the NSSF's assets available for overseas investment. To be eligible to hold NSSF's assets, each custodian must meet the following criteria:

i. have a paid in capital of not less than US$5 billion (or the equivalent in another currency) during the most recent fiscal year, or assets in custody of not less than US$500 billion;

ii. have a long-term credit rating of 'A' or above, or the equivalent of 'A' or above, for the most recent three years as rated by an internationally recognized rating agency;

iii. have a sufficient number of full-time staff familiar with the custody business;

iv. have secure and effective clearing and settlement capabilities;

v. have business premises, security facilities and other facilities for NSSF custody business that comply with requirements;

vi. have a sound internal auditing and monitoring system and risk control system;

vii. have not been subjected to a heavy penalty during the most recent three years by the regulatory authorities of the country or region where the custodian is located, and

viii. is established and incorporated outside the PRC; the country or region where the custodian is located must have sound laws and a sound financial regulatory system and the regulatory authorities must have signed a memorandum of understanding on cooperation¹³ and maintain an effective regulatory cooperation relationship with the CBRC.

In an announcement (Custodian Announcement) issued on April 29 2006, the National Council also indicated that eligible custodians must have an established presence in the PRC in one of the specified forms, such as a representative office or a subsidiary, and must have customer service personnel who are proficient in Mandarin Chinese.¹⁴ Thus, it would be important for any interested custodian to monitor the public announcements of the National Council for further information or clarification on the relevant criteria.

Ambiguous provisions

The criteria for custodians in the Provisions contain many of the same ambiguities as those for managers and will likely result in a similar process whereby custodians must demonstrate and certify compliance with ambiguous requirements. Again, the most limiting criteria is likely to be having the US$5 billion paid-in capital or the US$500 billion in assets in custody, which is likely to be similarly interpreted as the assets under management for the investment management entity.

Application

Unlike the selection process for managers which is open for application to any interested investment manager who qualifies under the Provisions, the selection of custodians is conducted by invitation only. In the Custodian Announcement, the National Council stated that a list of all qualified custodians worldwide has been prepared, but this list is not publicly available. The National Council will contact selected candidates on the list individually.

Contract requirements for managers and custodians

The Provisions provide 10 broad requirements that must be satisfied in each asset management contract with a manager.¹⁵ However, these requirements do not generally mandate the content of specific provisions in the asset management contract, but rather merely require that certain important matters be appropriately covered in the contract. For example, the Provisions indicate that the contract must specify various investment limits, the method for calculating investment returns and contain requirements relating to conflict of interest. However, the Provisions do not attempt to regulate the exact investment limits, calculation methodologies or what other conditions should be included.

Five broad requirements under the Provisions must be satisfied in each asset custody contract with a custodian.¹⁶ Similar to those required for asset management contracts, the requirements do not generally mandate specific provisions, but rather specify the custodian's responsibilities and the custodian's obligation of faithfulness. However, there is a separate requirement for the custodian to provide an undertaking to the National Council that it will monitor the investment operations of the manager, to determine if the manager is complying with its obligations on the scope of income and expenditures permitted in the foreign exchange account opened with the custodian.¹⁷ Such a requirement for the custodian to police the activities of the manager is not generally consistent with customary contracts entered into between managers and custodians regarding the management of assets. For custodians to effectively comply with this policing requirement, additional investments in personnel, systems and training may be required. Custodians may also request the relevant asset managers to indemnify them for any breach of the relevant requirements.

Interestingly, under the Provisions, both the asset management and asset custody contracts are required to be in Chinese. The Chinese version of the contract will prevail unless the contract, or market practice, requires otherwise.¹⁸ Consequently, it will be prudent for parties to clearly indicate in the relevant contract whether the English or Chinese version should prevail.

An enviable position for a lucky few

The Provisions pave the way for overseas investments by the NSSF. The National Council has already identified qualified custodians and is accepting applications from interested investment managers. In anticipation, the National Council has reportedly opened an account with the Hong Kong Stock Exchange's clearing system.¹⁹ In the very near term it would appear that a few investment managers and custodians will benefit from the Provisions and be in the enviable position of handling the increasingly growing overseas investments by the NSSF.

Endnotes

* Michael G. DeSombre is a partner resident in the Hong Kong office and Jie Wei is a former associate in the Hong Kong office. The views expressed herein are the views of the authors and do not represent the views of Sullivan & Cromwell LLP. Sullivan & Cromwell LLP practices only New York and U.S. Federal law in its Hong Kong office.

1 See the news release of the Second Meeting of the Second Session of the Directors' Meeting of the National Council for the National Social Security Fund published on March 29 2006, a copy of which is available on NSSF's official website (www.ssf.gov.cn).

2 According to the NSSF's 2004 annual report, the NSSF's total assets reached Rmb171 billion at the end of 2004. See Section 3, Major Financial Data of the National Social Security Fund, of the NSSF's 2004 Annual Report, a copy of which is available on the official website of the NSSF (www.ssf.gov.cn).

3 The Shanghai Stock Exchange Composite Index, an index indicating the overall performance of the share price of all stocks listed on the Shanghai Stock Exchange (including both A-shares and B-shares), has risen 37% from 1161 as of January 4 2006 (the first trading day in the year) to 1590 as of May 24 2006.

4 On April 29 2005, the CSRC promulgated the Issues Relevant to Pilot Reform Projects Regarding the Separation of Equity Ownership and Trading Rights of Limited Companies Circular. See DeSombre, M.G., and Chen, W., Unloading State-owned Shares: Another Trial Under New Rules, China Law and Practice, June 2005, pp. 17-19.

5 Article 14 of the Provisions.

6 Article 18 ibid.

7 The CSRC, Ministry of Finance (MOF), Ministry of Labour and Social Security (MLSS), State Administration of Foreign Exchange (SAFE) and, in respect of custodians, the China Banking Regulatory Commission (CBRC).

8 According to the CSRC's official website (www.csrc.gov.cn), as of July 2005, the CSRC had entered into memoranda of understanding with securities regulatory authorities in Hong Kong, United States, Singapore, Australia, United Kingdom, Japan, Malaysia, Brazil, Ukraine, France, Luxembourg, Germany, Italy, Egypt, Korea, Romania, South Africa, Netherlands, Belgium, Canada, Switzerland, Indonesia, New Zealand, Portugal, Nigeria and Vietnam.

9 See, for example, Article 7 of the Administrative Measures on Equity Investment by Overseas Financial Institutions in Domestic-funded Financial Institutions and Article 6 of the Rules on the Establishment of Asset Management Companies with Foreign Investment.

10 See, for example, Section 1 of the Announcement with respect to Selections of Overseas Asset Managers (Announcement) issued by the National Council on April 29 2006, a copy of which is available on NSSF's official website (www.ssf.gov.cn).

11 Article 16 ibid.

12 See Section 4 of the Announcement.

13 According to the CBRC's website (www.cbrc.gov.cn), as of November 2005, the CBRC had entered into memoranda of understanding with finance and monetary regulatory authorities in Canada, United States, United Kingdom, Germany, Korea, Singapore, Kirghizia, Pakistan, Hong Kong, Macau, Poland, France, Australia, Italy, the Philippines and Russia.

14 Section 11 of the Announcement with respect to Selections of Overseas Asset Custodians issued by the National Council issued by the National Council on April 29 2006, a copy of which is available on NSSF's official website (www.ssf.gov.cn).

15 Announcements issued by the National Council may again supplement or modify these requirements. See Section 3 of the Announcement which clarifies that the term for each asset management agreement shall be unlimited with termination rights for each party.

16 Article 12 ibid.

17 Article 13 ibid.

18 Article 8(1) ibid.

19 See the news release dated March 20 2006, 'National Council Social Security Fund becomes CCASS Investor Participant', a copy of which is available on the official website of the Hong Kong Exchanges and Clearing Limited (www.hkex.com.hk).