Companies, Exchanges and Transactions: Regulating the Re-emergence of China's Financial Futures Industry

The Futures Companies Measures operate within a complex and comprehensive range of laws, regulations and rules in the area of futures trading. These laws, regulations and rules can be usefully grouped into four levels:

• The Company Law was promulgated by the National People's Congress (the NPC) in 1993 and amended in 2005, and the Securities Law was promulgated by the NPC in 1998 and amended in 2005. These together lay the legal foundation for the securities market and the futures market, and set forth the corporate and regulatory framework for market participants, including futures companies.

• The was promulgated by the State Council on March 6 2007. It replaced the promulgated in 1999 and sets forth the overall legal framework for the operations of futures exchanges, futures companies and futures industry associations as well as the authority of the CSRC in regulating the futures market.

• In addition to the Futures Companies Measures, the were promulgated by the CSRC on April 9 2007. These set forth more detailed rules, as compared with the Level Two regulation, for the operations of futures companies and futures exchanges in China.

• The CSRC has promulgated a series of rules that provide further details for different aspects of futures companies' operations, including qualifications for directors, senior management members and other employees, financial futures trading settlement procedures and risk control management.² In addition, futures exchanges, including the CFFEX, have issued rules governing membership, settlement and clearance, risk control and other aspects of futures trading with which a futures company must comply.

Within the context of this multi-layered regulatory regime, we discuss below the key provisions of the Futures Companies Measures, which appear sharply focused on delineating a set of appropriate conditions for market entry and participation as well as regulating ongoing operations.

WHO CAN INVEST IN FUTURES COMPANIES

Bar on foreign capital

The Futures Companies Measures do not allow foreign investment in futures companies in China, except for those from Hong Kong and Macau. Before the Futures Companies Measures were promulgated, practitioners speculated that China might lift its bar on foreign capital in the futures sector. However, the Futures Companies Measures explicitly require shareholders of a futures company to be China-incorporated legal entities,³ except for investors from Hong Kong and Macau, who are allowed to have up to a 49% interest in a futures company in China, pursuant to economic partnership arrangements between mainland China and each of Hong Kong and Macau.

The restriction on foreign capital suggests that a foreign investor could only invest in mainland futures companies through Hong Kong or Macau branches, an approach taken by ABN Amro through China Galaxy Futures, or through its subsidiaries or affiliates incorporated in China. The latter route has yet to be tested.

Enhanced shareholder qualification

Regardless of whether investment is foreign or domestic, the CSRC clearly contemplates investment only from sizable investors. The Futures Companies Measures require that any entity that holds 5% or more equity interest in a futures company must either (i) have both paid-in capital and net assets of at least Rmb30 million, have been in operation for two consecutive years and have achieved profitability in at least one of the recent two years, or (ii) have both paid-in capital and net assets of at least Rmb200 million if it does not satisfy the operation or profitability requirements.⁴ An entity that holds 100% of the equity interest in a futures company must have net capital of at least Rmb1 billion or net assets of at least Rmb1.5 billion.⁵ These enhanced shareholder qualification requirements serve a screening function, as they are likely to result in futures companies having investors that are better positioned to bear higher levels of risk.

Securities companies in China have shown significant interest in acquiring futures companies. About 30 of the approximately 100 securities companies currently in business in China have registered capital of Rmb1 billion or above and thus would be permitted to enter into the futures business. As a sign of possible transactions to come, Guotai Junan Securities, one of the biggest securities companies in China with registered capital of Rmb3.7 billion as of December 31 2006, received approval from the CSRC in July for its acquisition of a futures company and an increase in the registered capital of the futures company from Rmb1 billion to Rmb1.6 billion.

START A NEW COMPANY, OR BUY AN EXISTING ONE

For investors that are qualified under the Futures Companies Measures, one immediate question is whether to apply for establishing a new futures company or to acquire an existing one. The Futures Companies Measures allow an investor to start a futures company of its own or partner with other investors if it does not wish to be a sole shareholder. The Futures Companies Measures appear, however, to favor acquisition of an existing futures company over the establishment of a new one, as they impose practical difficulties on new futures companies in obtaining financial futures licenses.

Establishment approach and the challenge of obtaining a financial futures license

The Futures Companies Measures provide that once an application for establishing a new futures company is approved, the futures company is automatically licensed to be a commodity futures broker.⁶ If a futures company would also like to be a financial futures broker or a clearing member of the CFFEX, it must apply for a separate license and satisfy additional qualifications. For example, a futures company must submit, among other materials, its audited financial statements for the latest year if the application is made in the first half of a year, and for both the latest year and for the interim period if the application is made in the second half of a year, to support its application for a financial futures brokerage license.⁷ Subject to clarification from the CSRC, this requirement appears to assume that the applicant has been in operation for at least a year. An applicant must also submit a report on the implementation of its policies in respect of corporate governance, risk control and internal control, which also appears to implicitly require the applicant to have maintained operations for a certain period of time before the submission of its application.⁸

For a futures company that applies for a license to be a clearing member of the CFFEX, it is further required to have, among other things, registered capital of at least Rmb50 million and having achieved profitability for at least one year in the most recent three years in the case of a ¡°trading clearance license¡±, or registered capital of at least Rmb100 million and having achieved profitability for the most recent three years in the case of a ¡°full clearance license¡±.⁹ A futures company that has a ¡°trading clearance license¡± is allowed to conduct clearance only for its customers at the CFFEX, while a futures company that has a ¡°full clearance license¡± is allowed to conduct clearance for its customers and non-clearing members of the CFFEX.

Acquisition approach

The Futures Company Measures appear to reflect a desire on the part of the CSRC to promote acquisitions of existing futures companies over the establishment of new ones. In addition to the acquisition by Guotai Junan Securities, CITIC Securities announced in August 2007 that it had received approval from the CSRC for its proposed acquisition of Jin Niu Futures Company and the increase of Jin Niu's registered capital to Rmb100 million in order to further apply for a ¡°full clearance license¡±. Certain CSRC officials were also reported to have said that the acquisition approach ¡°would reduce the total number of futures companies to an appropriate level and improve the aggregate quality of futures companies in China¡±. There are currently about 180 futures companies in China, while the average registered capital for futures companies is only about Rmb30 million.

The ¡°acquisition approach¡±, however, is not without its hurdles. The Futures Companies Measures set forth a series of approval requirements regarding capital increases, shareholder changes, domicile changes and changes of legal representatives of a futures company.¹⁰ Under the Futures Companies Measures, an investor may acquire a futures company in one province, inject additional capital into the company and relocate it to another location, but only after receiving the CSRC's approval. The investor would also require CRSC approval to replace the incumbent directors and senior management members of the investee company and appoint individuals to fill in the vacancies.¹¹ All these changes to the investee company, together with any other changes that an acquiror or investor may wish to make, including those relating to employment matters or internal controls, must be carefully planned and structured in order to minimize difficulties in the CSRC approval process. Failure to plan adequately in advance and seek all necessary approvals will limit the ability of the investee company to operate as intended after the acquisition, including potentially preventing it from engaging in the financial futures business.

CORPORATE GOVERNANCE, RISK CONTROL AND EMPLOYEE QUALIFICATION

All owners of futures companies must ensure that the futures company complies with requirements set forth in the Futures Companies Measures in respect of corporate governance, risk controls and employee qualifications. These requirements are intended to strengthen the risk management capabilities of futures companies in China. They will also substantially increase the cost of acquiring and operating a futures company.

Qualified personnel

The Futures Companies Measures require a futures company to have at least 15 employees who are ¡°qualified futures practitioners¡± and three senior management members who have qualifications as required by the CSRC.¹² Two other CSRC regulations set forth detailed requirements for qualifications for directors, supervisors, legal representatives, senior management members (e.g., general manager and managers in charge of finance matters) and other key employees of a futures company.¹³

Chief risk officer

The Futures Companies Measures, for the first time, require a futures company to appoint a chief risk officer who is responsible for compliance and risk management of the futures company and who has an obligation to report any illegal conduct to the board of directors of the futures company and the relevant local offices of the CSRC.¹⁴

Independent director

The Futures Companies Measures also require a futures company that is owned by one shareholder, or that has a financial futures trading clearance license, to appoint at least one independent director¹⁵ to safeguard interests of all shareholders, the futures company and its customers.¹⁶

Other requirements

Compliance with other requirements may drive the investment cost even higher. For example, the Futures Companies Measures require separation of personnel between a futures company and its controlling shareholder. It is not clear whether this requirement applies to directors and senior management members. If it does, investors will not be able to appoint its existing directors or senior management members to a futures company in which they invest.

In addition, recruiting and retaining qualified individuals to serve as directors or senior management members in a futures company in which they invest are likely to be a time-consuming and challenging endeavor. Appointment of these individuals is subject to CSRC approval. Even before an application is submitted to the CSRC, candidates for these positions must pass a futures practitioner qualification examination, which is administered by the China Futures Association only several times a year, along with other qualification examinations administered by entities approved by the CSRC (e.g., the China Futures Association). The examination and approval process require time and effort, and must be carefully considered by investors who plan to replace the existing directors and management members of a futures company that they acquire.

ONGOING OPERATIONS

To realize the policy goals of safeguarding the integrity of the futures market in China,¹⁷ the Futures Companies Measures have tightened the requirements regarding customer protection and imposed significant ongoing reporting obligations upon futures companies and shareholders of futures companies. For investors who have international backgrounds and long-term experience in managing risks in futures trading, these requirements may not in themselves appear overly onerous. There could be major challenges to these investors, however, in harmonizing their practices in their home country and elsewhere outside of China with those required to be adopted by futures companies in China.

Customer protection

The Futures Companies Measures include a series of requirements that aim to protect customers from any illegal activities conducted by futures companies, such as embezzlement of customers' margin deposits, which were widely reported by the Chinese media in the 1990s. Futures companies are required to place customers' margin deposits into designated accounts with third-party custodian banks. Third-party custodian banks must be approved by relevant authorities before they can engage in margin custody businesses.¹⁸ Futures companies are also required to report to their customers and the local offices of the CSRC details of, and any changes to, the margin accounts with third-party custodian banks.¹⁹ Except for margin accounts with third-party custodian banks and settlement accounts with futures exchanges (e.g., CFFEX), futures companies are prohibited from depositing customers' margins with any other party and may face severe penalties and the loss of licenses if they fail to comply with this requirement.²⁰

Other rules that aim at protecting customers include, for example, the use of form futures contracts and futures trading risk disclosures documents approved by the China Futures Association. The Futures Companies Measures also require that customers use their real names to open their futures trading and margin accounts with futures companies. All these requirements are not entirely new to practitioners in China - they have been seen in recent CSRC rules in other areas such as securities trading or futures regulations that were promulgated in late 1990s. The adoption or refinement of these requirements in the Futures Companies Measures clearly reflects the regulator's intention to safeguard the integrity of the futures market as it expands once again from commodity futures trading to the riskier financial futures trading.

Ongoing reporting obligations

The Futures Companies Measures require futures companies to submit monthly reports, annual reports and reports for certain changes.²¹ One notable requirement is that directors, senior management members and the person in charge of finance matters of a futures company must personally sign annual reports, and the legal representative and persons in charge of operations and finance matters of a futures company must personally sign monthly reports. However, the Futures Companies Measures are silent with respect to the legal consequence if these persons fail to sign the reports.

In addition to futures companies' reporting obligations, the Futures Companies Measures also authorize the CSRC and its local offices to request certain individuals or entities to submit additional documents relating to a futures company's operations and financial matters. These individuals or entities include directors, supervisors, senior management members and other employees of the futures company, shareholder(s), controlling person(s) or other affiliates of a futures company, and professional advisors of a futures company such as accountants and lawyers. The Futures Companies Measures do not specify, however, the circumstances under which the CSRC may make such requests and the legal consequence if these parties, in particular shareholders and professional advisors, fail to cooperate with the CSRC.

MARCHING TO THE FUTURES

The Futures Companies Measures pave the way for futures companies to engage in financial futures trading on the CFFEX. In the near term, it appears that securities companies on China, in particular well-capitalized securities companies that have a profitable recent operating history, will benefit from the Futures Companies Measures and could contribute towards an orderly redevelopment of China's financial futures market through acquisition of existing futures companies and by application for required licenses.

About the authors

Michael G. DeSombre is a partner resident in the Hong Kong office of Sullivan & Cromwell LLP, and Robert Chu and Yingmao Tang are associates in the Beijing office of Sullivan & Cromwell LLP. 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 and Beijing offices

Endnotes

1 For an excellent review of the history of China's futures markets, see Wang Xueqin and Mike Gorham, ¡°The Short, Dramatic History of Future Markets¡±, (Spring 2002).

2 See the Trial Measures for the Financial Futures Clearance Business of Futures Companies promulgated by the CSRC on April 19 2007, the Trial Measures for the Provision of Intermediary Introduction Business to Futures Companies by Securities Companies promulgated by the CSRC on April 20 2007, the Interim Measures for the Administration of Futures Investor Safeguard Funds promulgated by the CSRC on April 19 2007, the Measures for the Administration of Futures Practitioners promulgated by the CSRC on July 4 2007 and the Measures for the Administration of Qualifications for Directors, Supervisors and Senior Management Members of Futures Companies promulgated by the CSRC on July 4 2007.

3 See Article 7 of the Futures Companies Measures.

4 See Article 7 of the Futures Companies Measures.

5 See Article 8 of the Futures Companies Measures.

6 See Article 11 of the Futures Companies Measures.

7 See Article 13 of the Futures Companies Measures.

8 See Article 13 of the Futures Companies Measures.

9 See Article 8 and Article 9 of the Trial Measures for the Financial Futures Clearance Business of Futures Companies promulgated by the CSRC on April 19 2007.

10 See Article 14 through Article 22 of the Futures Companies Measures.

11 See Article 3 of the Measures for the Administration of Qualifications for Directors, Supervisors and Senior Management Members of Futures Companies promulgated by the CSRC on July 4 2007 (the Director Qualification Measures).

12 See Article 6 of the Futures Companies Measures.

13 See the Measures for the Administration of Futures Practitioners and the Director Qualifications Measures, both promulgated by the CSRC on July 4 2007.

14 See Article 43 of the Futures Companies Measures.

15 The Futures Companies Measures do not provide a definition of independent director. The Director Qualifications Measures provide a list of persons who are not permitted to be independent directors of a futures company. These persons include individuals who or whose close relatives are employed by the futures company or by an entity that holds 5% or more of the equity interest of the futures company, individuals who or whose close relatives provide financial, legal or consulting services to the futures company, individuals who hold positions other than independent directors in other futures companies and individuals who are considered by the CSRC to be inappropriate to be an independent director of a futures company. See Article 9 of the Director Qualifications Measures.

16 See Article 40 of the Futures Companies Measures.

17 See Articles 1-5 of the Futures Companies Measures.

18 See Article 70 of the Futures Companies Measures.

19 See Article 70 of the Futures Companies Measures.

20 See Article 71 and Article 94 of the Futures Companies Measures.

21 See Article 77 and Article 80 of the Futures Companies Measures.