New Provisions for Corporate Governance of Fund Management Companies

ii. Measures for the Administration of Securities Investment Fund Operations (June 1 2004);

iii. Measures for the Administration of Securities Investment Fund Management Companies (October 1 2004), and

iv. Measures for the Administration of Appointment of Senior Management Personnel of the Securities Investment Fund Management Industry (October 1 2004).

With the rapid development of the securities investment funds industry, one of the China Securities Regulatory Commission's (CSRC) longstanding concerns has been trying to improve the corporate governance standards of FMCs. The CSRC issued numerous drafts of the Corporate Governance Guidelines of Securities Investment Fund Management Companies (Trial Implementation) (Guidelines) for discussion and comment from within the funds industry before their final release. However, to ensure that the Guidelines reflect and are consistent with corporate governance provisions of the PRC Company Law (Company Law), the CSRC did not formally issue the Guidelines until June 15 2006 (after the promulgation of the revised Company Law on January 1 2006).

The Guidelines apply to all FMCs established in accordance with the Funds Law, including those FMCs incorporated before the Funds Law took effect. They also provide a framework for the corporate governance of FMCs including provisions for general principles, shareholders and shareholders' meeting, directors and board of directors, supervisors and board of supervisors, the chief compliance officer (CCO), executive management, related party transactions, and an incentive and restrictive mechanism.

Corporate governance benchmark

The CSRC requires an FMC to use the Guidelines as a major benchmark to assess whether it has sound corporate governance standards based on its current circumstances. An FMC whose corporate governance standards fail to meet the Guidelines' requirements must report to the CSRC in writing. Although, it is presently unclear who in the FMC is directly responsible for undertaking such an assessment, it is nevertheless an obligation on the FMC to internally review its corporate governance.

The CSRC may consider that the FMC's corporate governance is unsound and adopt corresponding supervisory measures pursuant to relevant laws, administrative laws and regulations, and CSRC rules to ensure that compliance with the Guidelines is met. The CSRC further requires all FMCs to revise and amend their articles of association in accordance with the Guidelines' requirements by the end of 2006.

Corporate governance principles

The following are 10 basic corporate governance principles of FMCs, which may be extracted from the Guidelines:

i. prioritizing interests of fund unit holders;

ii. independent operations;

iii. power-balance mechanism;

iv. maintaining the integrity of the company;

v. assuming social responsibility of the shareholders;

vi. treating all shareholders, different fund assets and client's assets fairly;

vii. information separation systems and avoiding undue connected party transaction and transfer of interests;

viii. public and transparent operations;

ix. long term incentive and restrictive mechanism, and

x. directors, supervisors and senior managers being dutiful and diligent.

The CSRC expects most of these basic corporate governance principles to be honoured and reflected in FMCs' constitutional documents. Some of the key principles can be discerned in the following discussion.

Prioritizing interests of fund unit holders

Maintaining financial order and placing a high importance on protecting fund unit holders is vital for stability in the funds industry. The Guidelines provide that the formulation of an FMC's articles of association, policies and manuals, working procedures, meeting procedures, exercising of authorities by organizations at all levels, and professional behaviour of an FMC's employees must be oriented to protect the interests of fund unit holders. Where there are any conflicts of interests between the FMC, its shareholders, employees or fund unit holders, priority must always be given to the fund unit holders.

Undoubtedly, an FMC managing a securities investment fund must carry out its fiduciary duties, between itself and the fund unit holders, in accordance with the laws and as stipulated in the fund contract. However, extending the application of such duties to the FMC's shareholders and its employees may not be practical. Shareholders and employees are treated as separate entities and individuals of the FMC respectively; and they have no direct relationship with fund unit holders.

The relationship between the FMC and its shareholders, as well as the relationship between the FMC and its employees are internal relationships within an FMC. On the other hand, the relationship between the FMC and fund unit holders is an external relationship, constituting a trust relationship, which is regulated and governed by the relevant laws and the fund contract. In most cases, FMC employees act on behalf of the FMC when performing their duties and thus, the FMC will be responsible for its employees' actions. From a legal perspective, only the FMC is answerable to the fund unit holders rather than its employees or shareholders.

Regulating shareholders' activities

The Guidelines set out certain detailed provisions on the FMC's obligations to regulate the activities of its shareholders.

Prohibiting provision of finance or guarantees

Pursuant to Article 15 of the Guidelines, shareholders are prohibited from requesting the provision of finance or guarantees from the FMC. This provision is stricter than Article 16 of the Company Law, which provides that the provision of guarantees for shareholders is permitted, but is subject to shareholders' approval with a resolution passed by a simple majority of the other shareholders present at the shareholders meeting.

Direct shareholding requirements

Since the fund industry is highly regulated and its investors must meet mandatory qualifications, the Guidelines emphasize that shareholders must hold the FMC's shares directly and must not hold shares on behalf of other institutions or individuals, or entrust other institutions or individuals to hold shares on their behalf. A similar requirement also applies to share transfers involving FMCs and it is used as a mechanism to restrict those investors, who want to avoid the stringent legal requirements associated with becoming an FMC shareholder, from attempting to enter into special undisclosed arrangements.

Share transfers involving FMCs

The Guidelines restate some requirements provided in the Circular on Issues Relevant to Regulation of the Establishment of Fund Management Companies and Disposal of the Equity Interests issued by the CSRC on May 8 2006, which sets out certain details of share transfers involving FMCs, including a limitation period for holding shares to avoid the volatility of the FMC's shareholding structure. A shareholder intending to transfer its shares is required to have knowledge of the potential transferee's qualifications to ensure that the latter and its actual controller can meet the requirements specified in relevant laws and regulations, administrative law and CSRC rules.

The Guidelines also require FMCs, their shareholders and the transferees of the shares to report information about the actual controllers and their related parties to the CSRC. Since the Guidelines do not provide for the definitions of what is meant by "actual controllers and related parties", the application of such a provision in practice could be problematic. Furthermore, the penalties for violating such a provision is also absent.

FMC independence

The main function of an FMC is to make investments at its own discretion, for example, in the securities market or monetary market using the large volume of capital that it holds. Therefore, the independent operation of an FMC is a necessity, in order to prevent investment activities, which may be seen as having undue influence from its shareholders and cooperative institutions (for example, custodian banks and distribution agents, and connected individuals).

Pursuant to Article 18 of the Guidelines, an FMC is prohibited from signing any agreement that will influence the FMC from operating independently. In addition, the FMC is required to submit the agreements signed with its shareholders concerning technical support, service or cooperation to the CSRC and its relevant local delegates. Since the criteria for assessing whether an agreement may influence the independence of an FMC are unclear, close attention should be given as to how the independence test will be applied in practice.

Information separation mechanism

To prevent illegal related party transactions and prohibit transfer of interests, shareholders must not directly or indirectly require the FMC's directors, executive management or other employees to provide non-public information or documents concerning fund investment or research. This provision is intended to protect the fund unit holders' interests and to avoid related party transactions by such means. However, shareholders have legal information rights provided by law, including information concerning the FMC's performance and its financial status.

In some cases, shareholders may be also required to provide, for example, technical support to the FMC which, to some extent, must be based on background information concerning the FMC's operations. Therefore, in practice, it would be difficult to distinguish the information that the FMC can disclose to its shareholders from that which cannot be disclosed due to its confidential nature.

Notification of shareholders' meetings

Article 32 of the Guidelines state that the issues to be voted at a shareholders' meeting must be notified to the shareholders in advance, otherwise the relevant motions will not be voted, except where all the shareholders have attended the meeting and have reached a consensus on discussing and voting for the motions.

In the Company Law, content of the notification is not specific and leaves scope for the articles of association to provide for otherwise. The Guidelines appear to provide more protection for shareholders' rights as the notification requirement for meetings to be made in advance - a requirement popularly adopted by most company's articles of association - is now treated with material significance due to the legislative support it now receives from the Guidelines.

Directors and the board

Protection for directors

To enhance a director's duties in order to protect the interests of fund unit holders, safeguard company assets and operate the FMC efficiently, the Guidelines stipulate that before a director's term of service expires, the board of shareholders must not dismiss a director without proper reason. In a situation where the board of shareholders dismisses a director before his or her term of service expires, the causes must be clarified in written form. A director who is dismissed from his or her post has the right to make statements at the shareholders' meeting and to the CSRC and its relevant local delegates.

Directors' power of attorney

Under the Guidelines, it is worth noting that directors who are unable to attend a board meeting can provide their authoritative opinions on the issues to be voted at the board meeting using a power of attorney. However, the Guidelines do not provide a solution in circumstances where the opinions of directors are not stated. Furthermore, it is unclear whether the resolution adopted is void or the authorized attorney is prohibited from voting or otherwise.

The provision of directors' authorization is different from that of the Company Law, which provides that directors acting as agents and authorized by other directors acting as principals may let the agents decide the final voting.

Independent directors

The Guidelines introduce some new approaches for independent directors performing their functions in the FMC corporate governance regime.

Firstly, an FMC is obligated to publicly disclose the appointed independent directors' basic background information. Secondly, an independent director can only accredit another independent director to attend relevant company meetings on his or her behalf. The Guidelines also set out some good practice rules, which are encouraged to be adopted in an FMC's articles of the association. For example, successive independent directors may be nominated by existing independent directors and the office of independent directors should be limited to two terms. These practices, if adopted, may safeguard the impartiality of independent directors.

role of the Chief compliance officer

A CCO is a special senior management post of an FMC who provides internal supervision with respect to fund operations compliance and the company itself. In the Measures for the Administration of Securities Investment Fund Management Companies (issued September 16 2004), an FMC is required to set up an office for the CCO. The Provisions for the Administration of Inspectors of the Securities Investment Fund Management Companies, effective as of May 8 2006, provide for the regulatory framework and detailed rules applicable to CCOs. The Guidelines reiterate some of the points contained in existing laws and regulations and allow the CCO, who is dismissed before the expiry of his or her term, to state his or her opinions at the shareholders' meeting and to the CSRC and its relevant local delegates.

In accordance with the relevant regulations, the CCO's independence must be maintained when performing his or her duties and protecting the fund unit holders' interests. As an internal supervisory post, the CCO, to some extent, inevitably serves for the benefit of the FMC. In practice, if there is any conflict between the interests of the fund unit holders and those of the FMC, it will be difficult to require the CCO to treat the former more preferable because the CCO is employed by the FMC and it would be difficult for the CCO to differentiate between the interests of fund unit holders and the FMC as they are inextricably linked.

Related party transactions

Related party transactions may be an unavoidable issue in the development of securities investment funds for the FMCs. One reason is that major domestic shareholders of FMCs are securities firms, trust and investment companies, and commercial banks are also active participants in the securities market. Another is that most of the custodian banks are listed or will be listed in the securities market. There is therefore a high possibility that shareholders and the custodian banks of an FMC may be in a position where there is a conflict of interest concerning fund investments and competition in the same market.

A sound legal framework for related party transactions is vital to protecting the interests of FMCs and fund unit holders. However, when compared with the regulatory system used for protecting fund unit holders' interests, the system used for protecting related party transactions is not well developed. In previous regulations, there is no explicit definition given to related parties and related party transactions, albeit some relevant provisions scattered in a variety of laws and regulations.

The Funds Law expressly provides that the fund property must not be used for:

i. capital contributions to the fund manager or fund custodian;

ii. buying or selling shares or bonds issued by the fund manager or fund custodian, or

iii. buying or selling securities issued by, or securities distributed during the distribution period by, a shareholder with a controlling shareholder relationship with, or a company that has other material interests in, the fund manager or fund custodian.

The Guidelines do not expressly state 'related party transactions' but simply provide that related party transactions may be connected to the fund's investments or a company's investments. As for related parties, the Guidelines only recognize the shareholder, actual controller, director, supervisor and executive management as those parties that have a 'related relationship' with an FMC. Without a specific definition of related party transactions, regulating such a transaction relies heavily on the FMC's self-discipline.

An improvement that has been made under the Guidelines is the system of avoidance voting on related party transactions, that is, the directors whose interests are involved must withdraw from voting on the related party transaction in question.

The external supervisory mechanisms on related party transactions are also limited. In connection with the restriction on shareholders' activities provided for in the Guidelines, the obligation of an FMC to submit the agreements signed with shareholders concerning technical support, service and cooperation with the CSRC and its relevant local delegates may be deemed to be under the CSRC's supervision and administration over such transactions. However, this is far from satisfactory since the Guidelines remain silent on relevant punishment measures in cases where the FMC fails to comply with the reporting obligations.

Incentive and restrictive mechanism

For the first time, the Guidelines provide that FMCs may implement a long-term incentive and restrictive mechanism for their employees according to the features of the fund industry. An incentive mechanism, for example, may be in the form of stock options. A restrictive mechanism could provide for punitive functions, such as when an employee is involved in a breach or is fraudulent during performance of his or her duties, the FMC may decide to withdraw the granted stock option .

The mechanism is viewed as a positive signal from the regulatory body, since it may be inferred that the CSRC is likely to further relax the qualifications for becoming an FMC shareholder by allowing FMC management to directly hold shares. However, the implementation of such a mechanism is not clear at this stage and needs to be further developed by the CSRC. The CSRC is expected to provide more detailed measures to resolve these outstanding issues such as the qualifications of a natural person to act as an FMC's shareholder.

Developing a sophisticated legal framework

Generally, the Guidelines set out a framework and some operational guidelines on the corporate governance of FMCs, requiring such companies to deal with their corporate governance issues in accordance with the Guidelines. Any non-compliance with the Guidelines without justification may lead to the CSRC taking disciplinary measures, and inadvertently jeopardize an FMC's application to offer new fund products.

Since parts of the Guidelines are still vague and provided in very general terms, detailed rules and regulations such as the provisions for related party transactions are expected to be further developed by the CSRC, during its regulatory practices. Protecting the interests of general investors is the CSRC's main goal. However, corporate governance is only one of the many important issues in the fund industry's regulatory framework. The fund industry is still a relatively new business for China's securities market and such an industry will require more time in order to become more sophisticated.