Like much of the financial services industry in China, the investment funds sector is undergoing remarkable growth. At the end of 2003, there were 54 registered closed-end funds and 50 registered open-end funds in operation, and by March of this year there were 49 registered fund management companies. In addition, twelve foreign-invested fund management companies had either been established or were in the formal stages of registration.
Against this background, China has promulgated the Securities Investment Funds Law of the People’s Republic of China (the “Funds Law”) (effective June 1, 2004). The Funds Law is designed to promote rapid but stable development of the funds sector. China believes that a strong funds industry can more effectively distribute risk and help produce a more stable market by concentrating the scattered funds of numerous individual investors into portfolio investments managed by professionals. This article attempts to give a brief description of the new Funds Law, highlighting its main features as well as key issues that are yet to be addressed.
Relatively narrow scope
Despite its stated aim of promoting the funds industry, the new law has turned out to be narrower in scope than had originally been hoped. It is largely a consolidation of the 1997 Provisional Measures for the Administration of Securities Investment Funds (the “1997 Measures”) and various notices issued by the China Securities Regulatory Commission (“CSRC”). In terms of types of funds, it only applies to funds which invest in PRC listed stocks and bonds and other securities specified by the CSRC; it does not cover other types of funds such as venture capital investment funds or industry investment funds. In terms of types of organization, the Funds Law only deals with open-end and closed-end funds which are established by means of fund contracts between fund managers, fund custodians and fund shareholders, and not with funds established in the form of a company (the form of organization typically used for open-end mutual funds and closed-end funds in the U.S.).
Nature of the fund relationships
Although the Funds Law is not explicit on whether the contractual relationship between fund managers, fund custodians and fund shareholders should be considered to be in the nature of a trust, this can be reasonably inferred from its provisions imposing “fiduciary” obligations of good faith, prudence, diligence and strict observance of professional ethics on fund managers, fund custodians and their personnel and providing that matters not covered by it will be governed by the Trust Law of the People’s Republic of China among other laws and regulations.
Fund managers and fund custodians
The Funds Law requires fund managers to be fund management companies established under PRC law. It raises the minimum registered capital of a fund management company from RMB 10 million to RMB 100 million, though RMB 100 million was already the minimum capital requirement for foreign-invested fund management companies under the 2002 Rules for the Establishment of Fund Management Companies with Foreign Equity Participation. The fund management company’s principal shareholder must have a registered capital of not less than RMB 300 million. Fund managers are not permitted to promise earnings to, or bear losses for, fund shareholders.
Fund custodians must be commercial banks that have obtained fund custodian qualifications. The Funds Law gives fund custodians a greater supervisory role than they had previously. For example, fund custodians must refuse to follow investment instructions that violate either regulations or the fund contract and must report such incidents to the CSRC. (The 1997 Measures only applied to breaches of the regulations, not the fund contract.) Fund custodians must also issue opinions on financial and accounting reports as well as interim and annual reports prepared by or for the fund.
The Funds Law provides fund shareholders with certain powers and remedies to protect their interests. They can sue the fund managers and fund custodians for damages if they violate the Funds Law, breach the fund contract or commit any act that is prejudicial to their interests as fund shareholders.
They also can take certain actions to protect their interests at shareholders’ general meetings. Although fund managers are responsible for calling shareholders’ general meetings, the Fund Law does not specify in what circumstances or how often such meetings are required. If the fund manager fails or is unable to convene a meeting, the fund custodian is required to convene the meeting in its place. Fund shareholders representing 10% of the fund’s shares may also request that a meeting be convened if both the fund manager and fund custodian fail to call a meeting.
Subject to a 50% shareholding quorum and a two-thirds majority voting requirement, the shareholders’ general meeting can vote to replace the fund manager and/or the fund custodian, terminate the fund contract or change the way in which the fund is managed. It may however be noted that, as a practical matter, it may be very difficult for fund shareholders to take such action at shareholders’ general meetings, due to these high quorum and supermajority voting requirements.
The Funds Law also contains more extensive disclosure requirements than the 1997 Measures. Among the information to be disclosed are: the net value of fund assets and fund shares; financial and accounting reports; resolutions of the fund shareholders’ general meeting; and legal actions involving the fund manager, fund assets or fund custodianship. Both fund managers and fund custodians must warrant the truthfulness, accuracy and completeness of the information disclosed.
The Funds Law includes numerous prohibitions to ensure the independence of fund assets and to prevent conflicts of interest. Some of the prohibitions are:
• Fund assets may not be used for the sale or purchase of shares of other funds, unless otherwise provided for by the State Council.
• A fund manager may not be a fund custodian and vice versa. Neither may one contribute capital to the other or hold shares in the other.
• Fund assets may not be used for the underwriting of securities.
• Fund assets may not be used for the extension of loans or provision of security to others.
• Fund assets may not be used for the sale or purchase of securities issued by the controlling shareholder of the fund manager or fund custodian or by a company that is otherwise materially interested in the fund manager or fund custodian, nor may they be used for the sale or purchase during the underwriting period of securities underwritten by any of the aforementioned parties.
• Directors, supervisors, managers and other working personnel of fund managers may not serve in any capacity for a fund custodian or other fund manager and may not engage in any securities trading or other activities that are prejudicial to a fund’s assets or the interests of its shareholders.
Short-term bank financing not allowed
A draft of the Funds Law contained a provision permitting fund managers of open-end funds to seek short-term financing from commercial banks, primarily to enable them to deal with situations in which fund shareholders seek to redeem large numbers of shares and the cash that is readily available is not sufficient for the redemptions. This provision drew opposition on the basis that, indirectly, it might allow bank funds to be invested in the securities market, contrary to banking and securities regulations. Such lending, it was argued, might also lead to a bubble effect in the market as well as introducing an undesirable risk for banks. As a result, this provision is absent from the Funds Law as enacted.
The new Funds Law is relatively narrow in scope and leaves a number of important issues untouched. Nevertheless it provides a clear legal framework for the operation of investment funds and the activities of fund managers and fund custodians. It is hoped that the growth of investment funds will bring increased stability to China’s stock markets as professional investment firms are permitted to manage a greater share of securities investments. A clearer and more detailed legal framework is also a welcome development for foreign firms investing in fund management companies, especially as they will be permitted to increase their investments to a 49% ownership level after December 11, 2004, in accordance with China’s WTO commitments.
If you need further information or want to discuss any specific issue raised in the above article, please feel free to contact John Grobowski via email [email protected] or telephone +86 21 5047 8558.