Private Banking in China – When the Honeymoon Is Over

The honeymoon did not last long though. By the end of 2007, it was already evident that the credit crunch might eventually precipitate a global financial market downturn. New QDII products dried up, with a rumour circulating that the regulator had called a "soft" stop to QDII products. In truth, objective market conditions would likely have resulted in the same outcome even without any regulatory interference. Investors have now turned their anxious gaze to the sliding NAV figures of the outstanding QDII products, which are coming under increasing scrutiny from the regulator, the QDII bank and investors alike. Hitherto theoretical legal issues have now become real.

Typical legal issues arising from a market downturn

Legal relationship, commercial risks and regulatory requirements

The collapse of Lehman Brothers demonstrated that an offshore product provider may go bust despite a decades-long history and a strong reputation on Wall Street. When this occurs, the question arises as to who is responsible to the individual investors and to what extent?

These issues cannot be answered without first looking into the legal relationship between the parties. Though far from universal and subject to specific contractual language, the prevailing view is that dealings between individual investors and a QDII bank on the one hand and between a QDII bank and an offshore product provider on the other hand are conducted on a "principal to principal" basis. The QDII bank "repackages" the offshore product into one of its own QDII products and offers the product to their individual clients. This means that the QDII bank is contractually liable to its own clients, whilst the offshore product provider, in the absence of conduct or contractual provisions to the contrary, is only contractually liable to the QDII bank. An individual investor will not have any recourse against the offshore product provider unless it can find a non-contractual ground for its legal claim.

This legal relationship, however, does not prevent the parties from distributing the commercial risks underlying their dealings through contractual provisions. For example, if a QDII bank's payment obligation to the individual investor is contingent upon receipt of payment from the offshore product provider, the QDII bank will be protected in the event that the offshore product provider enters into liquidation. This does not alter the legal relationship between the parties, but shifts any credit risks surrounding the offshore product provider to the individual investors, though this would raise issues of risk disclosure.

Having said that, the contractual distribution of commercial risks is also subject to regulatory restrictions. For example, under the regulations the QDII bank is under an obligation to apprise itself of information relating to its prospective clients. Any attempt to shift this obligation wholly or partially to the offshore product provider is likely to be ineffective from a regulatory perspective and generally frowned upon by the regulator.

Misselling claims

In any market downturn claims of misselling are likely to abound, but it is still surprising how quickly Chinese investors have caught up with the concept. The entire array of banks in China, from foreign banks to large state-owned banks to privately owned banks to regional banks, are currently handling or preparing for misselling claims by their clients to varying degrees.

The first question is, again, which of the QDII bank and the offshore product provider should be primarily liable to the end investor in the event of default by the latter. The QDII issued the onshore product directly to the client, whilst the offshore product provider in many cases devised the structure of the offshore product on which the onshore product is based. Given the above legal analysis, the answer is likely to be the QDII bank.

The bank holds the regulatory duty to carry out know-your-client procedures and risk assessment concerning its prospective client, and ensure suitability and adequate disclosure when carrying out its own marketing and sales activities. It remains to be seen to what extent the PRC courts are prepared to transcend a QDII bank's regulatory burden to a legal liability to compensate investors.

However, in some cases the offshore product provider has agreed to review the marketing materials for the onshore products or even offered to explain the products to the onshore investors. In other cases, the offshore product provider has provided training to the sales people of the QDII bank. This provides an angle for disgruntled investors to start blaming the offshore product provider. PRC law unfortunately provides little guidance on how to address this potential liability.

The second question is how to prevent misselling claims. The truth is that, no matter how well one prepares in respect of risk disclosures, liability disclaimers, sales training and policies, there will be misselling claims when an investment fails to perform up to expectation. It is particularly difficult to ascertain what measures are sufficient in an emerging market like China where no consistent market practice has emerged. It has also been argued that lengthy risk disclosures and disclaimers may increase the volume of the product materials, inhibiting sales by making it difficult for investors to fully digest the product information.

There may also be other factors, such as pressure from regulators or reputational considerations, which may influence the eventual outcome of the misselling claims. However, there is no doubt that a bank would be in a much stronger position both from a public relations perspective and in terms of defending itself against any misselling claims in a courtroom or in front of a regulator, if it has on record a risk disclosure signed by the investor, with relevant risks highlighted in bold.

The contents of risk disclosure are crucial. Often they are too generic. They need to be addressed going forward. Marketing, sales and legal should give careful consideration of the potential exposures and articulate them in plain language.

Documentation

Needless to say, all of the above issues should have been considered at the outset and documented accordingly. For example, the legal relationship should be reflected not only in the sale and purchase agreement between the QDII bank and the offshore product provider, but also in the onshore product agreement between the QDII bank and the individual investors. Where the onshore product agreement does not expressly state that the individual investor may not bring any claims against the offshore product provider, it is more likely that individual investors will be tempted to commence litigation proceedings against the offshore product provider.

In addition, the recent collapse of Lehman Brothers and other lenders offers a stark reminder of the importance of good documentation in times of financial distress. Robust documentation increases the chance of securing a favourable ruling or settlement and saving potential litigation costs. Using derivative transactions as an obvious example, most cross-border derivative transactions are documented under the ISDA standard documentation (such as the 1992 and the 2002 ISDA Master Agreement). ISDA documentation is complex and it takes not only time but also specialist know-how and experience to fully understand it.

When Lehman Brothers collapsed, many counterparties, including many Chinese banks, realised the benefits of its clear termination provisions, which gave certainty as to what exact steps need to be taken and when and enabled them to terminate their transactions swiftly and confidently. On the other hand, in other cases Chinese banks have struggled to grasp even the most basic concepts, such as title transfer or close-out netting, an inconvenience they can scarcely afford in such pressured financial circumstances.

It is equally important that the onshore documentation "matches" the offshore documentation. Often this may be practicable in the private banking context. For example, when a product is sold by the offshore product provider to the QDII bank, the relationship is between two financial institutions and the product documentation is therefore likely to be more technical and complex, sometimes referring to other industry standard documentation such as the ISDA product definitions.

However, it is extremely difficult if not impossible to use the same complex documentation for the product offered by the QDII bank to its individual investors. Industrial standard documentation is not available to most private individuals who in any case are unlikely to have either the patience or the knowledge to understand such complex provisions. Many QDII banks have opted instead to simplify the onshore product documentation. The onshore documentation would usually preserve a high degree of discretion in favour of the QDII bank and flexibility on certain issues to cover some of the technical complexity in the offshore product documentation. Such discretion must typically be exercised in good faith, and ideally after taking legal advice. Though this practice is not uncommon in retail products in more developed jurisdictions, it is important to bear in mind that China is an emerging market and such practice may therefore be unfamiliar to Chinese investors. There is a danger that the discretion afforded to the bank may be regarded as unfair or lacking in transparency if the associated risks are not appropriately disclosed and acknowledged.

A step forward

The liquidation of China Mingshen's QDII product in March this year, the subsequent drying up of the QDII product pipeline and the associated legal issues have cast doubt on the future of the private banking industry and of the QDII regime.

The honeymoon is clearly over but the marriage continues. Lessons, though costly for the parties involved, are useful in allowing the market to focus on areas of weakness, such as understanding the legal relationship, commercial risks and documentation. It is possible that temporary breaks may be put in place to allow time to address these issues and to insulate the onshore entities from the turbulence of the global financial market. However, it is highly unlikely that the private banking industry as a whole will be discredited. Given the massive wealth onshore, providing differentiating services to high net worth investors gives banks a competitive edge and is beneficial to the banking industry in the long run. It is also unlikely that QDII regime will be permanently junked. Chinese financial regulators continue to promote investment diversification. Access to offshore financial products will remain an important gateway for financial institutions and individual investors to acquire a more sophisticated understanding of financial products as well as associated risk management skills.