Finance, Rule of Law and Development in Asia Perspectives from Singapore, Hong Kong and Mainland China [3] 9789004315815, 2016011200, 2016011506, 9789004315808

Table of contents :
Contents
Preface
Acknowledgements
List of Contributors
Part 1 Financial Centres in Asia: Law & Policy
Chapter 1 The Rise of Singapore as International Financial Centre
Chapter 2 Inside the Singapore Financial Centre
Chapter 3 Hong Kong: Evolution and Future as a Leading International Financial Centre
Chapter 4 Level Playing Field as an Institutional Challenge to China as a Socialist Market Economy
Chapter 5 Regulating Internationalization of Currency
Chapter 6 A Small Difference in Wording, but a Big Difference in Rule-Making
Chapter 7 Finance, Rule of Law and Human Rights in China
Part 2 Governing Financial Markets in Asia: Innovation and Financial Products
Chapter 8 Positioning Singapore as an International Centre for Fund-Raising
Chapter 9 A People’s Market of Hong Kong
Chapter 10 New Risk Management Requirements in Hong Kong’s Corporate Governance Code
Chapter 11 Regulating P2P Lending in China
Chapter 12 Regulating China’s Internet Money Market Funds
Chapter 13 Liberalizing Capital Market Entry in China
Part 3 Financial Crimes in Asia: Anti-Corruption Enforcement
Chapter 14 Anti-Corruption Enforcement in Singapore
Chapter 15 Cracking the Whip on Financial Crimes in Singapore
Chapter 16 Role of the Criminal Law in Maintaining Hong Kong as an International Financial Centre
Chapter 17 Anti-Corruption Law and Enforcement in Hong Kong
Index

Citation preview

Finance, Rule of Law and Development in Asia

Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

Silk Road Studies in International Economic Law Edited by Wenhua Shan (Xi’an Jiaotong University School of Law) Associate Editor Jinyuan Su

VOLUME 3

Silk Road Studies in International Economic Law offers incisive analysis of the latest developments in international and comparative law, with particular attention to interactions with China, the most populous country and the ­second largest economy of the world.

The titles published in this series are listed at brill.com/srsl

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Finance, Rule of Law and Development in Asia Perspectives from Singapore, Hong Kong and Mainland China

Edited by

Jiaxiang Hu Matthias Vanhullebusch Andrew Harding

LEIDEN | BOSTON

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Library of Congress Cataloging-in-Publication Data Names: Hu, Jiaxiang, editor. | Vanhullebusch, Matthias, editor.  | Harding, Andrew, 1950– editor. | Shanghai Jiao Tong University,  KoGuan Law School, sponsoring body. Title: Finance, rule of law and development in Asia : perspectives from Singapore,  Hong Kong and mainland China / edited by Jiaxiang Hu, Matthias  Vanhullebusch, Andrew Harding. Description: Leiden ; Boston : Brill Nijhoff, 2016. | Series: Silk road  studies in international economic law : volume 3 | Includes index. |  Includes papers presented at a symposium on Asian financial centres  organized by the Asian Law Centre of the KoGuan Law School, Shanghai Jiao  Tong University, the Centre for Asian Legal Studies and the Centre for  Banking and Finance Law of the National University of Singapore held on  21–22 November 2014 in Shanghai. Identifiers: LCCN 2016011200 (print) | LCCN 2016011506 (ebook) | ISBN  9789004315808 (hardback : alk. paper) | ISBN 9789004315815 (e-book) | ISBN  9789004315815 (E-book) Subjects: LCSH: Capital market—Law and legislation—China—Congresses. |  Capital market—Law and legislation—China—Hong Kong—Congresses. |  Capital market—Law and legislation—Singapore—Congresses. Classification: LCC KNC244.3.A6 F56 2016 (print) | LCC KNC244.3.A6 (ebook) |  DDC 346.5/08—dc23 LC record available at http://lccn.loc.gov/2016011200

issn 2352-5681 isbn 978-90-04-31580-8 (hardback) isbn 978-90-04-31581-5 (e-book) Copyright 2016 by Koninklijke Brill nv, Leiden, The Netherlands. Koninklijke Brill nv incorporates the imprints Brill, Brill Hes & De Graaf, Brill Nijhoff, Brill Rodopi and Hotei Publishing. All rights reserved. No part of this publication may be reproduced, translated, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission from the publisher. Authorization to photocopy items for internal or personal use is granted by Koninklijke Brill nv provided that the appropriate fees are paid directly to The Copyright Clearance Center, 222 Rosewood Drive, Suite 910, Danvers, ma 01923, usa. Fees are subject to change. This book is printed on acid-free paper and produced in a sustainable manner.

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Contents Preface ix Acknowledgements xii List of Contributors xiii

PART 1 Financial Centres in Asia: Law & Policy 1 The Rise of Singapore as International Financial Centre: Political Will, Industrial Policy, and Rule of Law 3 Jiangyu Wang 2 Inside the Singapore Financial Centre 18 Dora Neo 3 Hong Kong: Evolution and Future as a Leading International Financial Centre 49 Douglas W. Arner 4 Level Playing Field as an Institutional Challenge to China as a Socialist Market Economy  76 Xianchu Zhang 5 Regulating Internationalization of Currency: Comparative Experience in Asia 106 Weitseng Chen 6 A Small Difference in Wording, but a Big Difference in Rule-Making: A Retrospective and Prospective View on the Development of China’s Economic Zones 137 Jiaxiang Hu 7 Finance, Rule of Law and Human Rights in China 168 Matthias Vanhullebusch

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PART 2 Governing Financial Markets in Asia: Innovation and Financial Products 8

Positioning Singapore as an International Centre for Fund-Raising 197 Alexander F. H. Loke

9

A People’s Market of Hong Kong: Facilitating Crowdfunding of SMEs 220 David C. Donald, George Mok and Adrian Fong

10

New Risk Management Requirements in Hong Kong’s Corporate Governance Code: “More than Just a Box to Tick” 261 Angus Young and Coral Huo

11

Regulating P2P Lending in China: Industrial Landscape and Regulatory Approaches 286 Shen Wei

12

Regulating China’s Internet Money Market Funds: An Economic Perspective 324 Xiaoye Jin

13

Liberalizing Capital Market Entry in China: Building a Registration System 355 Jing Leng

PART 3 Financial Crimes in Asia: Anti-Corruption Enforcement 14

Anti-Corruption Enforcement in Singapore 411 Chee Kun Thong and Muslim Albakri

15

Cracking the Whip on Financial Crimes in Singapore 436 Hamidul Haq

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16

Role of the Criminal Law in Maintaining Hong Kong as an International Financial Centre 457 Simon N. M. Young

17

Anti-Corruption Law and Enforcement in Hong Kong: Keeping it Clean 479 Michael I. Jackson Index 517

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Preface A global financial centre (GFC) is, simply, “an intense concentration of a wide variety of international financial businesses and transactions in one place”.1 The causes of the success of such centres do not represent a closely guarded secret. Over the last 300 years since the City of London established itself as the first modern (but by no means the first in history) financial centre, one can see, in general terms, the same attributes repeated. A successful financial centre needs political and social stability; a strong and facilitative legal framework operating under the rule of law, with a credible dispute settlement regime; it needs good market access and attractive business conditions; it needs security of transactions and efficiency of dealings. It probably needs also those intangible and under-studies factors of, simply, place that create reputation, excitement, or “buzz”. Here we can adduce more nebulous aspects of success, such as the skills and education of the citizens, and issues of language and culture. The top 20 GFCs are also, in the main, great world cities, and this is no accident. Four cities are stably established at the top of this particular pole: New York, London, Hong Kong and Singapore. Altogether five Asian cities are in the top 20 (one can add here Shanghai, Seoul and Tokyo; Shanghai ranks at No. 20 but seems now destined to climb rapidly given the current efforts to push it in that direction under the Shanghai Free Trade Pilot Zone (SFTPZ). There is clearly potential for Asian cities such as Shanghai (a particular focus of this book) to become even greater financial centres. While the necessary conditions are well known, the precise means of achieving the desired conditions is a matter for some thought, and this is reflected in the narratives presented in this book. Although global financial centres share many characteristics, the journeys they took to achieve this status are rather different. The chapters in this book relating to Hong Kong and Singapore, for example, emphasise such factors as effective anti-corruption measures, availability of information and transparency of dealings, and the positive role of several traditional areas of the common law such as trusts, contracts, and criminal liability, as well as careful and comprehensive financial regulation in the administrative law sense. And yet the basis of Hong Kong’s success is more correctly characterised as reliance on laissez-faire principles as distinct from Singapore’s more instrumentalist, building-block approach. This should make us consider both the factors they have in common as well as 1  Michael Mainelli (2006) “Global Financial Centres: One, Two, Three . . . Infinity?” 7 Journal of Risk Finance 219–227.

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the areas where they differ, as well as the implications for Shanghai and other Asian cities. The present authors, perhaps naturally, emphasise the common law system as an important factor, and indeed 10 of the top 14 global financial centres are embedded in a common law system. On the other hand, 9 of the top 20 centres are embedded in a civil law system. What, again, might be the implications for Shanghai? One of the important factors contributing to the economic success of Singapore and Hong Kong is their sophisticated service markets, particularly the finance market. Developing from a small tip of the Malaysian Peninsula, Singapore has experienced a continuously successful history of economic development over 200 years. Much the same is true of Hong Kong, also developing from island transit-trade origins. Together with the international financial market, transit trade has played a key role in the development of Singapore and Hong Kong. Continuous innovations in financial products and comprehensive supervision of the financial markets have enabled Singapore and Hong Kong to develop into Asian financial centres that are increasingly respected and influential globally. In order to streamline administrative regulation and raise the level and sophistication of economic development in China, on 28 September 2013, the Chinese government decided to set up the SFTPZ as a testing ground for innovation. This concept develops the idea of the Special Economic Zone (SEZ) from the 1980s into a zone of experimentation. Specifically, the SFTPZ has the following objectives: during the course of two to three years of piloting reforms, it is mandated to further the opening up of financial services by exploring Renminbi (RMB) convertibility under capital account items; creating a framework to ensure the reliability and stability of financial transactions; and facilitate financial market access in accordance with China’s commitments under international agreements. Experience hence gained in this way should serve China by encouraging new ideas and approaches to sustain the national economy and deepen the reform process. For this reason, a comparison of Asia’s global financial centres offers much food for thought. As the various chapters explain, this development implies a conceptual or even ideological shift in China with regard to the role of government, governance and the market. In November 2014, the Asian Law Centre of the Shanghai Jiao Tong University (SJTU), the Centre for Asian Legal Studies and the Centre for Banking and Finance Law of the National University of Singapore jointly organized a symposium at SJTU to exchange views and ideas regarding the development of these three Asian financial centres: Singapore, Hong Kong and Shanghai.

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The symposium focused on law and policy implications which accompany the growth of international financial centres in Asia (Part I), on governance aspects regarding innovation and financial products in financial markets in Asia (Part II), and financial crimes and anti-corruption enforcement in Asian financial centres (Part III). These are issues which, although not exhaustive in scope, are essential to the establishment and development of a competitive finance market. The speakers delivered much insightful analysis on these important issues from their unique perspectives of Singapore, Hong Kong and mainland China, commenting also more generally on the experience and lessons learned in the cultivation of these financial centres. We can see the development of these financial centres as a result of deep planning and constant adjustment of regulatory impacts, incentives, and conditions. It is, ultimately, of prime importance to establish a framework of appropriate legislation. Beyond that we can see that success does not come easily just by mere flight of the imagination or ambition nor by political will, but rather by keeping a steady focus on the nostrums of “new institutional economics”. There is no substitute for real legal certainty, good regulation and governance, and fairness and consistency in settling disputes, and protection of the security of transactions. This is the real lesson of Singapore and Hong Kong. It is also the real challenge for China. Jiaxiang Hu Matthias Vanhullebusch Andrew Harding Spring 2016

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Acknowledgements This book project has been the published outcome of a symposium on Asian Financial Centres’ Development and Regulation: A Comparative Study from Singapore, Hong Kong and Mainland China—organized by the Asian Law Centre of the KoGuan Law School, Shanghai Jiao Tong University, the Centre for Asian Legal Studies and the Centre for Banking and Finance Law of the National University of Singapore on 21–22 November 2014 in Shanghai. We would like to warmly thank the participants from various institutions and countries for their timely submission of papers, active participation in the workshop and their careful revision after it. Without the support of the committed sponsors, in particular the KoGuan Law School, Shanghai Jiao Tong University, this event and the resulting publication would not have been possible. Special thanks to Dean Prof. Dr. Weidong Ji of the KoGuan Law School, the student volunteers in the organization of the workshop and our assistant editor, Ms. Chenzhu Wang, as well as to our colleagues at Brill Academic Publishers, Ms. Marie Sheldon, Mr. John Bennett and Mr. Michael Mozina for overseeing the production of this Volume and our colleagues of the Silk Road Studies in International Economic Law, Prof. Dr. Wenhua Shan and Dr. Jinyuan Su. Jiaxiang Hu Matthias Vanhullebusch Andrew Harding Spring 2016

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List of Contributors Muslim Albakri is an Associate in the White Collar Crime Practices team headed by Mr Hamidul Haq and Mr Thong Chee Kun of Rajah & Tann Singapore’s Commercial Litigation Department. Muslim has been with Rajah & Tann Singapore LLP since he was called to the bar in 2014. He graduated with honours from the University of Liverpool in 2012. Since joining Rajah & Tann Singapore, he has been involved in several cases concerning white collar crime, including the cases of Public Prosecutor v Hergobind s/o Arjandas Goklani (case of dishonest receipt and money-laundering offences occurring over the internet), Ding Si Yang v Public Prosecutor (case of match fixing involving Lebanese match officials in Singapore) and Syed Mostofa Romel v Public Prosecutor (case of corruption offences in the marine surveying industry). Douglas W. Arner is a Professor in the Faculty of Law of the University of Hong Kong and Project Coordinator of a major five-year project funded by the Hong Kong Research Grants Council Theme-based Research Scheme on “Enhancing Hong Kong’s Future as a Leading International Financial Centre”. In addition, he is Co-Director of the Duke University-HKU Asia-America Institute in Transnational Law, and a Senior Visiting Fellow of Melbourne Law School, University of Melbourne. Douglas served as Head of the HKU Department of Law from 2011 to 2014 and from 2006 to 2011 he was the Director of HKU’s Asian Institute of International Financial Law, which he co-founded in 1999 along with the LLM in Corporate and Financial Law (of which he serves as Director). He has published thirteen books, including Finance in Asia: Institutions, Regulation and Policy (Routledge 2013), From Crisis to Crisis: The Global Financial Crisis and Regulatory Failure (Kluwer 2011), and Financial Stability, Economic Growth and the Role of Law (Cambridge University Press 2007), and more than 100 articles, chapters and reports on international financial law and regulation. Douglas is a member of the Hong Kong Financial Services Development Council and of the International Advisory Board of the Australian Centre for International Finance and Regulation. He has served as a consultant with, among others, the World Bank, Asian Development Bank, APEC, and European Bank for Reconstruction and Development, and has lectured, co-organised conferences and seminars and been involved with financial sector reform projects in over 20 economies in Africa, Asia and Europe. He has been a

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visiting professor or fellow at the Universities of London, McGill, Melbourne, New South Wales, Singapore and Zurich, as well as the Shanghai University of Finance and Economics and Hong Kong Institute for Monetary Research. Weitseng Chen is Assistant Professor and Deputy Director of the Center for Asian Legal Studies (CALS) at the National University of Singapore (NUS) Faculty of Law. Before he joined NUS in 2011, Dr. Chen has been the Hewlett Fellow at The Center on Democracy, Development, and the Rule of Law, Stanford University. He has also practiced law at Davis Polk & Wardwell LLP, specializing in international capital markets and financial institutions. David C. Donald is a Professor in the Law Faculty of The Chinese University of Hong Kong. David previously taught at the Institute for Law and Finance of the University of Frankfurt, Germany and worked as a commercial lawyer in the US and Europe. His publications include A Financial Centre for Two Empires: Hong Kong’s Corporate, Securities and Tax Laws in its Transition from Britain to China (Cambridge University Press, 2014), The Hong Kong Stock and Futures Exchanges—Law and Microstructure (Thomson, Sweet & Maxwell 2012), and Comparative Company Law: Text and Cases on the Laws Governing Germany the UK and the USA (with Andreas Cahn) (Cambridge University Press, 2010). He is participating with scholars from other universities on a Hong Kong Research Grants Council funded project, “Enhancing the Future of Hong Kong as a Leading International Financial Centre”. Professor Donald is currently a member of Hong Kong’s Standing Committee for Company Law Reform and its Financial Policy Research Committee. Adrian Fong is a Candidate for the Bachelor of Laws (LL.B) at The Chinese University of Hong Kong (CUHK), graduating in 2015. His areas of interest are banking and securities regulation, company law, and public policy. He is also interested in comparative Asian law and founded the Asian Journal of Legal Studies under the sponsorship of the Asian Law Students’ Association. He has published in a number of international peer-reviewed law journals including the Company Lawyer, Journal of International Banking Law and Regulation, and International Company and Commercial Law Review on topics such as shareholder rights, securities and banking regulation, and corporate liability respectively. He will be studying for the Postgraduate Certificate in Laws (PCLL) in 2015–2016. He is currently pursuing a law practice in Hong Kong after his PCLL degree with the aim of specializing in banking and securities regulation. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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Andrew Harding is a leading scholar in the fields of Asian legal studies and comparative constitutional law. He commenced his academic career at NUS before moving to SOAS, University of London, where he became Head of the Law School and Director of the Centre for South East Asian Studies. He joined NUS, as Director of the Centre for Asian Legal Studies and Director of the Asian Law Institute, from the University of Victoria, BC Canada, where he was Professor of ­Asia-Pacific Legal Relations and Director of the Centre for Asia-Pacific Initiatives. Professor Harding has worked extensively on constitutional law in Malaysia and Thailand, and has made extensive contributions to scholarship in comparative law, and law and development, having published nine books as author or editor. He is co-founding-editor of Hart Publishing’s book series ‘Constitutional Systems of the World’, a major resource for constitutional law in context, and has authored the books on Malaysia and Thailand in that series (2011, 2012). Hamidul Haq joined Rajah & Tann LLP as a Partner in 2006 after his extensive experience with the Commercial Affairs Department and the Attorney-General’s Chambers. His involvement bolstered the Commercial Litigation Practice in its strength and dominance in the legal circle, particularly in the area of securities law, business crimes, fraud and commercial litigation practice. He now gives advice to corporate and individual clients in these areas, as well as advice on anti-money laundering matters. Prior to joining Rajah & Tann LLP, Haq was a Deputy Senior State Counsel/Deputy Public Prosecutor of the Criminal Justice Division, Attorney-General’s Chambers dealing mostly with white collar crime in the corporate and securities space. His work included dealing with civil penalty actions for market misconduct under the Securities and Futures Act. Jiaxiang Hu is Professor of Public International Law, Director of Asian Law Center, KuGuan Law School of Shanghai Jiao Tong University, China. He earned a BA degree and a MA degree from Hangzhou University, the MPhil degree in law from Zhejiang University and the PhD degree in law from the University of Edinburg. He was also a visiting scholar at the International Economic Law Institute of Georgetown University, the East Asian Studies Center of Harvard University and the Asian Law Institute of National University of Singapore. Professor Hu has been awarded honors for his excellent teachings from the Ministry of Education, Shanghai Municipality and Shanghai Jiao Tong University. He is the author of five books and nearly a hundred articles. Professor Hu currently is teaching International Economic Law to the undergraduates and WTO Law Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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to the postgraduates. His research interests include Public International Law, International Economic Law and WTO Law. Coral Huo graduated with a Bachelor of Laws from Zhongnan University of Economic and Laws before she migrated to Australia in 2009. She then obtained her Juris Doctor degree and Postgraduate Diploma in Legal Practice at Bond University in Australia. Upon her graduation, Coral had been actively involved in local law associations and community legal centres and was later admitted as a solicitor to the Supreme Court of New South Wales in 2013. Currently she is a tutor in business law with the USW Law School at the University of Western Sydney. Michael I. Jackson is Associate Professor in the Faculty of Law, the University of Hong Kong, where his teaching includes Criminal Law and Privacy & Data Protection. He writes mainly in the field of criminal law and is the author of Criminal Law in Hong Kong and a contributing author to Archbold Hong Kong. He was a member of the Criminal Law and Procedure Committee of the Law Society of HK from 1996–2003, and has practised criminal litigation both in New Zealand and in Hong Kong. Xiaoye Jin trained as an economist at the Shanghai Maritime University. He then joined the International Centre for Shipping, Trade and Finance at the Cass Business School, City University, London, as a student on its MSc programme. He received his PhD from City University and is currently Lecturer of Finance at International School of Finance Law, East China University of Political Science and Law. He lectures in Monetary Finance, Financial Markets, Financial Engineering, and Mathematical Economics. His research interests lie in the areas of credit risk modelling, energy derivatives and financial regulations. He has published in several academic journals in the area of finance and economics. Jing Leng Professor of law, East China University of Political Science and Law; Chair Professor of Shanghai Universities (Oriental Scholar); LLB and MPhil, Peking University; LLM, Kyushu University (Japan); SJD, University of Toronto. Prior to joining ECUPL, Professor Leng had been an assistant professor at the Faculty of Law, University of Hong Kong from 2007 to 2013. Her specialties are corporate, banking and securities law in mainland China and Hong Kong, as well as comparative corporate governance and law and development. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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Professor Leng’s work has been published by leading law journals and academic publishing houses in both Chinese and English languages, including Virginia Law Review, Peking University Law Journal, Peking University Law Review, Routledge, Hong Kong University Press, Peking University Press, and China Legal Publishing House. She has held a variety of academic and professional affiliations, including council member of China Securities Law Association, Academic Secretary of the Asian Law and Economics Association, fellow of the Asian Institute of International Financial Law, fellow and founding member of the Institute of Chinese Law at the University of Hong Kong, research advisor on cross-border listing for the Hong Kong Institute of Chartered Secretaries, and editor of Hong Kong Law Journal. Alexander F. H. Loke is Professor of Law at City University of Hong Kong with research interests in contract law, international corporate finance and securities regulation. He was a member of the Principles of Asian Contract Law project (December 2010– March 2012), and is co-editor (with Mindy Chen-Wishart and Burton Ong) of the book series Studies in the Contract Laws of Asia (Oxford University Press), which vol. 1 on comparative remedies for breach of contract is expected to be published in early 2015. Loke contributed the chapters on “Remedies” and “Discharge by Breach and Repudiation” in Halsbury’s Laws of Singapore vol. 7: Contracts (2009, 2005 and 2000), as well as the chapters on “Directors’ Duties and Liabilities” and “Directors and Other Corporate Officers” in Walter Woon on Company Law, Rev 3rd Ed (2009) and 3rd Ed (2005). Representative publications include: “Tainting Illegality” Legal Studies (forthcoming), ­ “Rethinking the transplantation of TSC Industries v Northway in Singapore,” 28 Aus J Corp Law 253 (2013), “Rights, Duties and the Validation of Irregularities,” 23 Sing Ac LJ 838 (2011), “The Protected Interests in the Private Right of Action for Insider Trading: A Comparative Perspective,” 7 J Corp L Stud 307 (2007), and “From the Fiduciary Theory to Information Abuse: The Changing Fabric of Insider Trading Law in the U.K., Australia and Singapore,” 54 Am J Comp L 123 (2006). George Mok is a Candidate for the Juris Doctor (J.D.) at The Chinese University of Hong Kong (CUHK), graduating in 2016. He graduated with a Bachelor of Arts (B.A.) from Bowdoin College in the USA in 2014, majoring in International Relations and minoring in Asian Studies. This will be his first publication in a law journal, but hopefully not his last. His areas of interest are contract law, international law, and corporate law. He aims to be studying for the Postgraduate Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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Certificate in Laws (PCLL) in 2016–2017. He plans to practice law in Hong Kong after the PCLL. Dora Neo is Director of the Centre for Banking & Finance Law at the Faculty of Law, National University of Singapore. She specialises in banking and finance law, the law of credit & security, and contract law. She is co-author of Ellinger & Neo, The Law and Practice of Documentary Letters of Credit (Hart Publishing, Oxford, 2010). Her research interests include international economic law, particularly trade in services and free trade agreements. She completed her law degree with first class honours from Oxford University before pursuing postgraduate studies at Harvard Law School. She has been called to the English Bar (Gray’s Inn) and is an Advocate and Solicitor in Singapore. She holds a Certificate in Private Banking from the Wealth Management Institute, Singapore, and a Certificate in Real Estate Finance from the Department of Real Estate, NUS. She is a member of the Injunction Proposals Review Panel under the Consumer Protection (Fair Trading) Act, and of the Accreditation Committee of the Singapore Institute of Legal Education (SILE). Shen Wei KoGuan Chair Professor of Law and Special Oriental Scholar Professor of Law, Shanghai Jiao Tong University Law School, PhD Supervisor and Examiner; PhD (London School of Economics and Political Science), LLM (University of Cambridge), LLM (University of Michigan), LLM & LLB (East China University of Political Science and Law); Attorney-at-Law, New York. He is the Chair of the law school’s International Exchange Committee. Professor Shen is an arbitrator with Shanghai Arbitration Commission, Hong Kong International Arbitration Centre, and China International Economic and Trade Commission. He is a Global Law Faculty Professor at NYU Law. He is an Honorary Fellow of Asian Institute of International Financial Law, University of Hong Kong. He has been a Guest Professor at Copenhagen Business School (Fall 2012), a Senior Research Fellow at Max-Planck Institute of International and Comparative Law (Hamburg) (Summer 2013) and a Senior Research Scholar at Yale Law School (2013–2014). Professor Shen is now teaching international investment law, company law, international economic law and contract law in the law school. His current research interests include international investment law, corporate governance, financial regulations, and international commercial arbitration. Professor Shen is the author of the books: Rethinking the New York Convention—A Law and Economics Approach (Cambridge: Intersentia 2013) and The Anatomy of

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China’s Banking Sector and Regulation (Wolters Kluwer 2014). Professor Shen has already contributed to 23 books (21 in English and 2 in Chinese) and authored (or co-authored) over 90 articles in English and Chinese law journals. Chee Kun Thong has a comprehensive commercial litigation and criminal law practice. His area of expertise is commercial and regulatory crimes and offences. Beyond representing clients in court and other enforcement proceedings, he has also advised several companies and banks on disclosure, regulatory, anti-money laundering, anti-corruption and compliance matters. He has also acted for and advised clients in corporate litigation matters such as disputes among shareholders or directors. He is also a contributor to the Halsbury’s Laws of Singapore, Criminal Law and has launched a book on Financial Crimes in Singapore. Between 1999 and 2005, Mr. Chee Kun Thong was a Deputy Public Prosecutor and State Counsel with the Attorney-General’s Chambers. He was attached to the Commercial Affairs Department (CAD) in 2003 and 2004 to advise CAD investigators on investigative, money-laundering and other prosecutorial matters. He led the prosecution of several complex, high-profile cases of commercial crime and securities fraud. Since joining private practice in 2006, Mr. Chee Kun Thong has advised and defended clients in several significant cases including PP v Ho Leng Woon (case of disclosure-based offence committed by officers of AP Oil International Ltd), PP v Masatsugu Takahashi (case of falsification of accounts committed by an officer of Mitsui Oil (Asia) Pte Ltd, PP v Ong Seow Yong (case of disclosurebased offence committed by directors of Airocean Group Ltd), PP v Eric Tan Boon Yang (case of falsification of accounts in Jel Corporation (Holdings) Ltd) and PP v Ong Thiam Hock (case of corruption involving a decorated police officer). Matthias Vanhullebusch is Associate Professor, Executive Director of the Asian Law Center, and KoGuan Youth Legal Scholar at the KoGuan Law School of the Shanghai Jiao Tong University since 2012. He has an expertise in Humanitarian Law and Policy, the Middle East, East Asia and Peacekeeping. He is the Managing Editor of the Asian Journal of Law and Society (CUP) and the Series Editor of Brill’s Asian Law Series (Brill Academic Publishers) and Routledge Studies on Asia in the World (Taylor & Francis). He has contributed to research projects at the Centre for Law and Conflict (SOAS), the Centre for International Studies and Diplomacy (SOAS), the Committee on Islamic Law and International Law of

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the International Law Association, EIUC, the Afghanistan Analysts Network, and the International Society for Military Law and the Law of War. He guestlectured International Human Rights Law at SOAS, Public International Law at the University of Pretoria, and International Humanitarian Law for the ICRC at the Handong Global University, University of the Philippines and Korea University. Jiangyu Wang is the Deputy Director of the Centre for Asian Legal Studies (CALS) and a tenured Associate Professor at the Faculty of Law of the National University of Singapore; Visiting Chair Professor of International Law, Xian Jiao Tong University Law School. He is also the co-Chief-Editor (with Andrew Harding) of the Asian Journal of Comparative Law and Deputy Chief Editor of the Chinese Journal of Comparative Law. He was on secondment as an Associate Professor and Director for the MPhil/PhD Programme at the Faculty of Law of The Chinese University of Hong Kong from August 2006 to July 2009. His teaching and research interests include international economic law, Chinese corporate and securities law, law and development, and Chinese legal system. He practiced law in the Legal Department of Bank of China and Chinese and American law firms. He served as a member of the Chinese delegation at the annual conference of the United Nations Commission on International Trade Law Conference in 1999. He is a member of the Chinese Bar Association and the New York Bar Association. He is also a director on the Executive Board of the WTO Institute of the China Law Society, a Senior Fellow at the Law and Development Institute (LDI), and a fellow of the Asian Institute of International Financial Law (Hong Kong). He has also been invited expert/ speaker for the WTO, International Trade Centre (UNCTAD/WTO) and United Nations Economic and Social Commission for Asia and the Pacific (UNESCAP). He recently received the 2007 Young Researcher Award of The Chinese University of Hong Kong in recognition of his accomplishment in research from 2007–2008. Dr. Wang has published extensively in Chinese and international journals and newspapers on a variety of law and politics related topics. He is a regular contributor to leading newspapers and magazines in Singapore, Hong Kong, and Mainland China. He served as an external reviewer for dozens of international journals and publishers and research funds. Angus Young has degrees in law, economics, and political science, including a PhD in law. He is also a Certified Compliance Professional and Certified Risk Professional accredited with the GRC Institute. Currently Senior Lecturer at the Department

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of Accountancy & Law, Hong Kong Baptist University, and has previously taught at several universities in Australia, New Zealand and Hong Kong. Angus is also Academic Advisor to the GRC Institute, where he was previously their Hong Kong Representative. He has also won several awards including the Honorary Fellow Award, joint recipient of the Brian Sharpe Memorial Essay Award in 2014 by the GRC Institute, and received an Honorary Mention for ACI’s Honorary Fellow Award in 2009. In addition, he is Distinguished Research Fellow at the German-Sino Institute of Legal Studies at Nanjing University, China and was previously an Adjunct Professor at the School of International Law, Southwest University of Political Science & Law in China from 2010–13. Angus’s core research interests are market and corporate governance. Simon N. M. Young is Associate Dean (Research) in the Faculty of Law, The University of Hong Kong, a practicing Hong Kong barrister and co-editor-in-chief of Asia-Pacific Journal on Human Rights and the Law. He was Director of the Faculty’s Centre for Comparative and Public Law from 2007 to 2013 and before moving to Hong Kong was counsel in the Crown Law Office-Criminal, Ministry of the Attorney General for Ontario, Canada. His books include Hong Kong’s Court of Final Appeal (Cambridge University Press 2014) (co-edited with Y. Ghai) and Civil Forfeiture of Criminal Property (Edward Elgar 2009). In 2014, he appeared as junior counsel to the Director of Public Prosecutions in two criminal appeals concerning money laundering before the Court of Final Appeal. He has been a member of Disciplinary Panel A of the Hong Kong Institute of Certified Public Accountants since 2011. Xianchu Zhang is a professor of Law from the University of Hong Kong. He earned his LLB, and MCL and JD degrees from Chine University of Political Science & Law in Beijing (CUPL) and Indiana University at Bloomington respectively. He taught various courses at CUPL, City University of Hong Kong, Fudan University in Shanghai, the Transnational Law Program of Duke University and WTO Asia Trade Policy Training Program in Hong Kong. Currently he serves as a member of Foreign Trial Expert Committee of China Law Society, and an arbitrator of CITAC, Shanghai Arbitration Commission and East China Arbitration Commission as well as a member of Hong Kong Legal Education Trust. His research interests include Chinese business and investment law, comparative commercial law, and conflict of laws.

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Part 1 Financial Centres in Asia: Law & Policy

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Chapter 1

The Rise of Singapore as International Financial Centre Political Will, Industrial Policy, and Rule of Law Jiangyu Wang Abstract Singapore is now one of the leading financial centres in the world, although the citystate started as a Third World country when independence was imposed on it in 1965. Although some natural conditions such as geographic location which possessed by other international financial centres are also vivid in Singapore’s case, some factors that contributed to Singapore’s financial rise are probably unique. This chapter argues that three key factors underpin Singapore’s success as a financial centre, which are the political will of the Singapore government, the government’s skilful use of industry policy, and the uncompromised practice of the rule of law in Singapore. These factors, taken together, made a state-led development model in the formation and maintenance of an international financial centre, Singapore style. From the perspective of law and development, Singapore’s path to the status of an international financial centre raises the question about the relationship between state and finance.

Keywords Singapore – international financial centre – financial industrial policy – rule of law – state and finance

*  Associate Professor of Law, Faculty of Law, National University of Singapore; Visiting Chair Professor of International Law, Xian Jiao Tong University Law School. Contact: jywang@nus .edu.sg. This paper was first presented at the International Conference on Asian Financial Centres’ Development and Regulation: A Comparative Study from Singapore, Hong Kong and Mainland China, co-organized by the Centre for Asian Legal Studies (CALS) of the Faculty of Law of National University of Singapore and the Asian Law Centre of the Shanghai Jiao Tong University Law School, on 21–22 November 2014. The author would like to acknowledge the CALS’ financial support and thank all the participants of the conference for their comments and feedback. The usual disclaimer applies.

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1 Introduction Financial centres rise and fall, and this is a constant phenomenon in world history. What explains this? As Youssef Cassis, a financial historian and author of a ground-keeping book on the history of international financial centres, remarked a few conditions are necessary for their development: The most important and most frequently debated of these [conditions] include: stability and political institutions; strength of the currency; sufficient savings that can readily be invested abroad; powerful financial institutions, firm, but intrusive, state supervision; a light tax burden; and highly skilled workforce; efficient means of communication; and plentiful, reliable and widely accessible information. This is may not be exhaustive, yet it is hard to refute it.1 The Global Financial Centres Index, a leading publication that evaluates the competitiveness of financial centres in the world, identifies six areas of competitiveness for cities which have successfully become financial centres, based on worldwide surveys of financial professionals.2 The first is business Environment, which is determined by the rule of law and anti-corruption in the jurisdiction. The second factor concerns human capital, which is about the availability of skilled staff for the financial sector. The third one relates to taxation, which requires a balanced approach between tax load and sustainability. The fourth factor is infrastructure, including the facilities for easy long distance transport routes and reliable and speedy information and communications technologies (ICT). The fifth factor concerns the reputation of the place, often evidenced by its position in various international rankings. Finally, the sixth factor is the city’s financial sector development, which is seen as less important by some but taken for granted by others.3 Singapore has been ranked as one of the top international financial centres. Compared with other leading cities on the rankings, such as London, New York and Hong Kong, Singapore’s path to and its model as an international financial centre are distinctive in many respects. Most notably, Singapore’s story of becoming and staying as an international financial centre is driven by

1  Cassis (2006), p. 279. (emphasis added) 2  The Global Financial Centres Index 16, September 2014, Z/Yen Group and Qatar Financial Centre authority (“GFCI 16), p. 8. 3  Ibid.

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the Singapore government’s political will, which is coupled by the state’s skilful use of industrial policy and its almost undisputable rule of law. 2

Singapore as an International Financial Centre

Credit Suisse, an international bank, outlines Singapore’s major comparative advantages as a premier financial hub for Asia as the following: The country’s high living standards, quality of life and environment, are frequently ranked among the most attractive in Asia for foreignskilled professionals. In addition, the government has taken a strong vision to establish Singapore as a global financial center. Over the years, the government has provided critical support and a wide range of opportunities and incentives for financial institutions to expand and grow their businesses in Singapore. [. . .] Singapore has a strong, efficient and transparent legal and judicial framework, presenting a favorable regulatory and business environment with a high degree of banking confidentiality. It also has a favorable tax regime, with no tax on interest and capital gains for non-residents.4 Singapore’s superb business environment, infrastructure, low tax, occupation of the top places in major world rankings on doing business, competitiveness, rule of law, anti-corruption, etc., together with it strategic geographic location, make the island an ideal place in Asia for financial transactions and provision of financial services. Singapore’s position as an international financial centre is based on its own robust financial sectors, of which the most notable is its asset management industry. There are currently close to 600 players in Singapore’s asset management market, managing assets of around Singapore dollar 2.4 trillion (about US$1.7 trillion) by the end of 2014.5 Significantly, total assets managed by Singapore-based asset managers grew by 30 per cent from 2013 to 2014, and 14 per cent on average in the five years from 2011 to 2014. As noted by the Monetary Authority of Singapore, the “robust growth was derived largely from positive asset inflows arising from Asia’s growth dynamism and Singapore’s position as a Pan-Asian asset management hub”.6 In 2013, the Global Private Banking 4  credit-suisse.com (2015). 5  Monetary Authority Singapore (2014), p. 2 (hereinafter, MAS, “Asset Management Report”). 6  Ibid.

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and Wealth Management Survey compiled by PricewaterhouseCoopers suggested that Singapore would dethrone Switzerland in the next two years as the world’s top centre for managing international funds.7 Whether Singapore has become the top centre in 2015 is less significant. More important is that the signs of trends demonstrated in the survey show Singapore is steadfastly marching toward such a position. In addition, Singapore has a strong banking sector and is home to over 200 banks, most of which are from outside Singapore. The banks’ major businesses are to facilitate trade, corporate finance and infrastructural building in the region. Singapore is however not known for having a stock market which is as big as that in Hong Kong and even Shanghai, let alone New York or London. It is however a well-established market with sound institutional and regulatory frameworks, and the most attractive place to list their companies for Southeast Asian nations. In addition, it is a rather internationalized one, with 40% of the listings on the Singapore Exchange (SGX) being foreign companies. It is also the largest REIT market in Asia ex-Japan.8 What underlines Singapore’s leading position as an international financial centre is its foreign exchange and OTC derivatives market. The 2013 Triennial survey by the Bank of International Settlement (BIS) suggests Singapore is the third largest foreign exchange centre globally but the largest one in Asia Pacific. Singapore was also ranked as the largest OTC interest derivatives centre in Asia Pacific (excluding Japan) by turnover.9 3

Making Singapore an International Financial Centre: The Political Will of the Singapore Government

When independence was imposed on Singapore by Malaysia in 1965, the country immediately faced a major problem: how to survive as a new sovereign nation? On economic side, it is about “[h]ow was an independent Singapore to survive when it was no longer the centre of the wider area that the British once governed as one unit?”,10 as Lee Kuan Yew, Singapore’s founding father, once remarked, and continued that “[w]e had to create a new kind

7  8  9  10 

Reuters News (2014). Monetary Authority of Singapore (2015a). Ibid. Lee (2015), p. 23.

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of economy, try new methods and schemes never tried before anywhere else in the world, because there was no other country like Singapore”.11 Even in this context, namely knowing Singapore was determined to be different and innovative, it is still surprising that Singapore decided to grow itself as an international financial centre. Lee Kuan Yew himself admitted that “[a]ny one who predicted in 1965 when we separated from Malaysia that Singapore would become a financial centre would have been thought mad”.12 Indeed, it could not have happened without the political will of the Singapore state. The idea of turning Singapore into a financial centre began to develop with a telephone call from Dr. Wisemius, the then economic advisor of the Singapore government, to a senior bank executive in London. It was identified by them that Singapore sat in a geographic location that ideally filled in the gap in a day when all other financial centres were closed.13 On this basis, the leadership in Singapore decided to adopt unprecedented liberalizationoriented institutional and regulatory measures which were politically risky but believed to be necessary to create “stable social conditions, a good working and living environment, efficient infrastructure and a pool of skilled and adaptable professionals” to assure foreign bankers.14 The first political risk was being punished by the United Kingdom, which then imposed foreign exchange controls in the Commonwealth countries on transactions between Commonwealth members and outsiders. Singapore was thus warned by a Bank of England official that Singapore might have to leave the sterling area if it made this move. Lee Kuan Yew decided “the risk worth taking and told [the Singapore official in charge] to go ahead [lifting the controls]”.15 Fortunately for Singapore, the “Bank of England did not fore the issue and Singapore did not have to leave the sterling bloc”.16 It is however beyond doubt that this was a politically risky and sensitive move, because Singapore was indeed not sure of the intention of the Bank of England. If Singapore would have to be forced out of the sterling area then it also had to sever the institutional linkage of financial relations between Singapore and the United Kingdom, Singapore’s de facto protector at that time.

11  12  13  14  15  16 

Ibid. Ibid., p. 89. Ibid. Ibid., p. 90. Ibid. Ibid.

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The Singapore government was also determinative enough to set up an unconventional regulatory structure with which it did not have much experience to operate. Lee Kuan Yew and his government decided in 1965 not to have a central bank to issue currency and create money. Instead, the decision was to link Singapore’s currency to the international markets on the consideration of not allowing Singapore currency “to lose its value against the strong currencies of the big nations, especially the United States”.17 Accordingly, Singapore adopted a currency board system in which the issuance of Singapore dollars is always backed by its equivalent value in foreign exchange. In so doing, Singapore loses its sovereign autonomy on issuing currency. In exchange, it won the confidence of international investors and bankers in Singapore’s determination to main a strong and stable currency and to allow the free movement of capital into and out of Singapore. 4

The Use of Industrial Policy to Build Comparative Advantage

Government-Led Development of the Financial Sector and Financial Centre If liberalization only means that the host state shall surrender the control of its financial industry submissively to foreigners, it wouldn’t have been followed by Singapore in the first place. It is understandable that some governments wish to establish a “domestic industry” that has strong presence of domestic financial services suppliers, through certain government protection. Governments have also the concern that foreign financial firms will end up dominating the domestic market after liberalization and eventually damaging the social and public interests of the host country. The most commonly used form of protection by the host country is treating the domestic financial sector as an infant industry which is granted subsidies or better market access policies. Does this practice violate the principle of free trade and as such prevent the country from harvesting the benefits of financial services liberalization? It is submitted that the theory should be pragmatically modified to adopt the comparative advantages gradually acquired in a particular industry under certain period of government protection. Theoretically, free trade is premised on the economic insight of comparative advantage, which teaches that maximum gains can be achieved by all trading nations if each of the nations specializes in the production and export of goods and services that it can produces relatively 4.1

17  Ibid.

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more efficient than other countries.18 But where did a country’s comparative advantage come from? The orthodoxy belief of comparative advantage however does not offer an answer to this. The development experiences of many countries demonstrate that governments can help establish a domestic industry by according protection to it at the initial stage. After all, no country was born to have a strong financial services sector. Once liberalization is started, governments have also provided various form of protection to domestic firms to help them adjust to foreign competition, e.g. making liberalization only phased in overtime. However, the most important thing from the policy perspective is that government protection, as it always incurs significant distortions and long-term costs, should be used appropriately and wisely terminated after a limited period of time, whenever it is discovered that the industry has achieved a certain degree of competitive edge or that it is hopeless to establish such an industry in this country at all. In this regard, Singapore’s development to an international financial centre is an excellent example. Within about two decades, Singapore was developed into one of world’s leading financial centres. As the country’s Prime Minister Lee Hsien Loong remarked, Singapore’s comparative advantage lies in its “political and economic stability, the rule of law, efficient infrastructure and a highly-skilled professional workforce”.19 Obviously, all the aforesaid attributes were acquired through delicately designed, government-sponsored programmes, and under certain form of government protection.20 As noted by Tan, Lim and Chen, Singapore was in stark contrast with Hong Kong in this regard: Singapore adopted a two-pronged strategy with regards to its financial sector. First, it wanted the financial sector to play a key supporting role to the growing industries located in Singapore. Second, the financial sector itself was to become a key industry in line with the government’s effort to promote manufacturing and shipping industries. Since 1968, the Singapore government has provided incentives and preferential tax treatments for the development of the Asian Currency Unit (ACU) in order to cultivate an Asian Dollar Market (ADM). That helped Singapore to develop as a financial centre and a lead over Hong Kong. The Hong Kong 18  See e.g., McCulloch (2000), pp. 75–6. 19  bis.org (2002). 20  The Monetary Authority of Singapore had adopted policies to protect Singapore banks, especially retail banking, with the objective to help them “grow and assume a larger share of the domestic market”. See Kheng (2001), p. 103.

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government at that time was unwilling to waive the 15% withholding tax on interest income from foreign currency deposits. Further a moratorium was imposed on bank licensing after the bank crisis in 1965 which further impeded the development of an ADM. The year 1978 was a turning point for Hong Kong when China decided to embark on an ambitious open door policy that would enhance Hong Kong’s status as the financial gateway to the east.21 The Economist took notice of the Singapore government’s “handy habit of taking advantage of financial upheaval”.22 It observed that “[o]ne clear thread in Singapore’s rise has been its ability to take consistent advantage of global upheavals, beginning in 1971 when America de-linked he dollar from gold”.23 Singapore grasped the opportunity to create a regional centre for foreign exchange, which laid a solid foundation for its financial status on the world stage today.24 Further, in anticipation of the effects of the 1997 handover of Hong Kong to Chinese sovereignty, Singapore took measures to attract assetmanagement firms from Hong Kong and other parts of the world. As the handover approached, numerous clients move their assets to Singapore.25 As the Economist lucidly summarized: Singapore’s approach [to establishing a financial centre] is the antithesis of laissez-faire. Broadly speaking, it has kept a tight rein on domestic finance and done what it could do to induce international firms to come. Licenses can be obtained efficiently and quickly, a blessing in the bureaucratic world. So can work visas for key employees. There are tax breaks for firms considered important, as well as reimbursements for relocation expenses.26 The Asian Dollar Market: An Example of Government-Led Development The use of industrial policy for growing a financial centre is most vividly seen in the development of the Asian Dollar Market (ADM). The ADM was established in 1968 for loans or bank deposits that are dominated in foreign currencies 4.2

21  22  23  24  25  26 

Huat, Lim & Chen (2004). “Singapore’s Financial Rise: Going Swimmingly,” The Economist, 20 April 2011. Ibid. Ibid. Ibid. Ibid.

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(mainly US Dollar). As noted by Ngiam, “[m]uch of Singapore’s growth as an international financial centre in the early years resulted from the rapid growth of its [ADM], which is the Asian counterpart of the Eurodollar market”.27 To balance the protection of domestic financial sector and financial stability and the need for making Singapore a financial service provider for the region, the Singapore government designed its banking system to separate domestic banking operations from offshore operations. Banks or financial institutions can operate under the system of Domestic Banking Units (DBUs) or the Asian Currency Units (ACUs). Financial institutions were required to register their DBUs and ACUs as separate accounting entities. The DBU deals with transactions dominated in Singapore dollar, while the ACU holds its offshore transactions dominated in foreign currencies. The divide was intended to, on one hand, promote Singapore as a regional base for international financial activities, and, on the other hand, safeguard Singapore’s domestic financial markets by sheltering domestic banks from foreign competition. The separation between DBU and ACU was for the purpose of introducing the ADM. In 1968, Bank of America was the first foreign bank to be allowed to set up ACU in Singapore, kicking off the ADM. ACUs were licensed in the Asian Dollar Market to take non-resident foreign currency deposits and lend those funds to non-residents as well. The ADM became the first successful offshore market in Asia, which defined the foreign exchange markets in Asia. The size of the ADM went from USD 86 million in 1982 to more than USD 350 million in 1990. Meanwhile, Singapore’s foreign exchange market grew from a daily average of some USD 12 billion in 1985 to USD 139 billion in 1998, making it the fourth largest foreign exchange market after London, New York and Tokyo.28 Newest Ambition: To Build the Regional Gateway for Chinese Renminbi With the rise of China as an economic superpower, Singapore’s new ambition, which it has achieved with great success, is to become a leading offshore centre for trading in Renminbi (RMB), the Chinese currency which gradually starts to internationalize. It concluded a Free Trade Agreement with China, under which the People’s Bank of China appointed the Singapore branch of Industrial and Commercial Bank of China (ICBC) as the RMB clearing bank in Singapore on 8 February 2013, which has brought important new RMB capabilities to Singapore. As a result, financial institutions in Singapore are playing 4.3

27  Kee Jin (1996), p. 362. 28  Cassis, supra note 1, p. 276.

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an increasingly important role in intermediating the growing trade and investment flows between China and the rest of the world. Singapore also secured an agreement, through the Joint Council for Bilateral Cooperation between the Singapore government and the Chinese government, to apply the RMB Qualified Foreign Institutional Investor (RQFII) Programme in Singapore. Through this arrangement, Singapore-based financial institutions are allowed to channel offshore RMB from Singapore into China’s securities market.29 This alleviates, at least in part, an important concern of the overseas holders of RMB on where to re-invest their Chinese currency assets. RQFIIs may also issue RMB financial and investment products to investors in Singapore. In addition, the two governments have agreed to introduce direct trading between RMB and Singapore dollar.30 An increasingly wider range of RMB products and services are being offered in Singapore or by Singapore-based financial institutions. Some of the world’s top banks, including HSBC, Standard Chartered, ICBC and Bank of China have offered RMB bond issuance in Singapore. As of March 2014, “Singapore accounted for about 60 per cent of Renminbi trade finance outside China and Hong Kong”.31 Needless to say, the rapid growth of RMB business in Singapore should be attributed, to a very large part, to Singapore government’s pro-active measures in promoting Singapore as the regional hub for RMB commerce. Know When and Where to Stop Protection and March Toward More Liberalization However, the Singapore story has presented another experience: appropriate liberalization measures should be timely launched by a government which is sensitive to the cost/benefit analysis regarding the protection. Singapore’s domestic banking sector was protected for about 30 years before the government decided to make a change in the 1990s. The country’s leadership felt that the force of globalization was irresistible so that the protection afforded to domestic firms should be gradually phased out. Lee Kuan Yew noted: “I cautioned [domestic bankers] that, sooner or later, because of bilateral agreements with the United States or possible [WTO] agreements, Singapore would have to open up its banking industry and remove protection for local banks.”32 He wrote, “[f]or over three decades, I had supported [the Monetary Authority of Singapore (‘MAS’)] on restricting the access of foreign banks to the local 4.4

29  30  31  32 

Monetary Authority of Singapore (2015b). Ibid. Grant (2014). Lee, supra note 10, p. 99.

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market. Now I believe the time had come for the tough international players to force our Big Four [banks] to upgrade their services or lose market share”.33 Despite the strong desire of local banks for continuing protection, the MAS initiated a five-year programme to liberalise commercial banking in Singapore, allowing qualifying foreign full banks to open more branches and ATMs. More licenses on restricted banks were also issued. The authority also lifted limits on foreign equity ownership of local banks.34 5

Rule of Law and Anti-Corruption

The business environment, which is largely about rule of law, corruption and regulation, is considered to be the most important competitiveness factor for international financial centres.35 Financial centres must be sustained by good laws and regulations, but “[t]oo onerous a regulatory environment can directly affect the competitiveness of a financial centre”.36 Singapore is known for its rule of law, if rule of law is defined as the strong adherence to formal procedures and requirements. But even according to the World Justice Project’s liberal standards,37 Singapore occupies the 9th position on the Rule of Law Index 2015, among 102 nations in the world.38 Especially, it is ranked No. 3 on Absence of Corruption (after Demark and Norway), No. 4 on Order and Security and No. 1 on Regulatory Enforcement.39 It falls a little behind some Western countries on factors such as Constraints on Government, Open Government, Fundamental Rights, Civil Justice and Criminal Justice.40 On the regulation of the financial industry and markets, Singapore government has established a sound and comprehensive regulatory framework under the auspice of the Monetary Authority of Singapore (MAS) and Ministry of Finance, featuring a set of laws including the Banking Act, the Companies Act, 33  34  35  36  37 

38  39  40 

Ibid., p. 100. Ibid., p. See also Kheng, supra note 20, p. 103. See GFCI 16, supra note 2, p. 8. The Global Financial Centres Index 1, March 2007, City of London (hereinafter “GFCI 1”), p. 8. The factors considered in the World Justice Project (WJP)’s Rule of Law Index include: (1) constraints on government powers, (2) absence of corruption, (3) open government, (4) fundamental rights, (5) order and security, (6) regulatory enforcement, (7) civil justice and (8) criminal justice. See worldjusticproject.org (2015). Ibid. Ibid. Ibid.

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the Finance Companies Act, the Insurance Act, the Securities and Futures Act, the Securities Industry Act, the Futures Trading Act, the Development Loan Act, the Local Treasury Bill Act, among others. The MAS has maintained a stringent system of prudential regulation and supervision, which, though viewed as over-regulated by some, has however kept Singapore away from financial crises as it so did during the 1997 Asian Financial Crisis. As a matter of fact, financial regulators in Singapore can be very flexible when it is necessary to grasp opportunities—e.g. taking advantage of global financial upheavals—to enlarge Singapore’s chance to become a financial hub. As mentioned previously, Singapore attracted assets from Hong Kong by exploiting the opportunities arising out of the latter’s return to China in around 1997 to grow its own asset-management business. As observed by the Economist: To retain those assets, Singapore produced a legal framework enabling trust accounts, once the preserve of Jersey and Bermuda. This was despite the fact Singapore itself does not tax estates and Singaporeans have no need of the service. Good trust laws combined with strong asset-management and foreign-exchange capabilities make Singapore appealing for wealth-management types everywhere.41 Singapore’s development as a pre-eminent financial centre has also been underpinned by its strict enforcement of the rule of law, which applies equally to everyone and makes no exception for anyone. Two cases are worth mentioning here. The first one concerns a famous British financier, Jim Slater, who was introduced to Lee Kuan Yew in 1971 by British Prime Minister Ted Heath, who entrusted his own assets in the hands of Slater. Lee welcomed Slater’s participation in Singapore’s stock market. It was revealed in 1975 that Slater Walker Securities owned by Jim Slater engaged in manipulating the shares of Haw Par Brothers International, a listed company in the Singapore stock exchange. Although there were concerns about “[i]nvestigation into a big name in the London Stock Exchange, if not justified would give us a bad reputation”, Lee nevertheless ordered the investigation which led to 17 charges against Slater and his conspirators.42 Another case concerns the infamous Bank of Credit and Commerce International (BCCI). BCCI, later known as an icon for international financial frauds, was initially able to drag eminent members such as the royal families of 41  See supra note 22. 42  Lee, supra note 10, p. 92.

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Saudi Arabia, Bahrain, Abu Dhabi and Dubai into its scheme and established about 400 branches in 73 countries in major continents of the world. BCCI applied to set up a branch in Singapore, once through Van Oenen and once through Harald Wilson, the then British Prime Minister, who helped Singapore establish the Asian Dollar Market. Though Van Oenen saw Lee Kuan Yew in person and Harold Wilson wrote to Lee Kuan Yew directly, BCCI was never given permission to operate in Singapore. It eventually turned out that the illegal and dishonest operation of BCCI caused enormous losses to its creditors, reaching about USD 11 billion. However, “Singapore escaped unscathed because we refused to compromise standards”, as Lee Kuan Yew remarked later.43 6

Concluding Remarks

There might be of course many reasons behind Singapore’s success as an international financial centre. Like Hong Kong, Singapore was not starting from scratch, although some myths hold that Singapore was merely a place for small villages which depended entirely on fishing. It has solid banking institutions dating back to the 19th century.44 It is placed in an almost ideal geographic location in so far as global movement of capital transactions is concerned. It has also been governed by stable political regimes since being colonized by the British in 1819. However, all these favourable conditions do not necessarily make an international financial centre. As Youssef Cassis has observed, “there was nothing spontaneous about Singapore’s development, which preceded that of Hong Kong. On the contrary, it was the result of a systematic effort made on the part of the authorities, immediately upon the country’s independence in 1965, to turn it into an international financial centre.”45 This chapter argues that three key factors underpin Singapore’s success as a financial centre, which are the Singapore leadership’s political will, the government’s skilful use of industrial policy, and the uncompromised application of the rule of law in Singapore. These factors, taken together, made a state-led development model in the formation and maintenance of an international financial centre. Many signs suggest Singapore’s financial centre has a bright future ahead of it, especially when compared with other leading Asian cities such as Hong Kong. This is evidenced by its rapid rise as Asia’s largest centre for both 43  Ibid., p. 94. 44  Cassis, supra note 1, p. 275. 45  Ibid., p. 276.

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commodity and foreign exchange trading, as well as its occupation of the top place in Asia’s asset-management business. All these have contributed to the creation of new a new competitive dynamic in Asia. And the Singapore government never intends to take back its “helping hand” even though Singapore now is already a vivid international financial centre. On 28 July 2015, the Monetary Authority of Singapore announced the establishment of a Financial Centre Advisory Panel (FCAP), which comprises 26 leaders from the banking, insurance and asset-management industries. The FCAP has discussed strategies to grow Singapore’s financial centre, including attracting more institutional investors to strengthen the buy-side ecosystem for Singapore’s capital markets, promoting digital distribution and other innovations in the insurance industry, provision of more seamless capitalraising across the spectrum from star-ups to global companies, and building up foreign exchange electronic trading capabilities and enhance liquidity in Asian bond market, in addition to harnessing technology for all financial sectors.46 From the perspective of law and development, Singapore’s path to the status of an international financial centre raises the question about the relationship between state and finance. True enough, mainstream literature on finance has, quite rightly, explained why state interference harms financial market’s competitiveness, among other flaws. But Singapore’s experience suggests that the state can actually offer a helping hand to play a significantly instrumental role in the establishment of a financial centre. This chapter has pointed out that one of the secrets for Singapore’s success in this regard is the Singapore government’s wisdom of knowing when to stop protection and to march toward more liberalization. More research should be done to theorize this phenomenon. References bis.org (2002) “Lee Hsien Loong: Remaking Singapore’s Financial Sector,” Speech by Mr Lee Hsien Loong, Deputy Prime Minister of Singapore and Chairman of the Monetary Authority of Singapore, at a MAS Staff Seminar, Singapore, 29 October 2002 (BIS Review 62/2002), http://www.bis.org/review/r021101c.pdf (accessed 10 October 2015). Cassis, Youssef (2006) Capitals of Capital: A History of International Financial Centres, 1780–2005, Cambridge: Cambridge University Press.

46  Monetary Authority of Singapore (2015c).

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credit-suisse.com (2015) “Singapore as a Financial Hub,” https://www.credit-suisse .com/sg/en/private-banking/bank/financialhub.html (accessed 10 October 2015). Grant, Jeremy (2014) “Singapore Emerges as Regional Hub for Intra-Asia Renminbi Commerce,” Financial Times, 30 September. Huat, Tan Chwee, Joseph Lim & Wilson Chen (2004) “Competing International Financial Centres: A Comparative Study between Hong Kong and Singapore” Presented at Singapore as a Financial Centre: Development and Prospects, Saw Centre Studies and ISEAS Conference, November 2004 (on file with the author). Kee Jin, Ngiam (1996) “Singapore as a Financial Center: New Developments, Challenges, and Prospect,” in T. Ito & A. O. Krueger (eds.), Financial Deregulation and Integration in East Asia, Chicago: University of Chicago Press, 359–383. Kheng, Kenneth Tan Wee (2001) Development in Singapore Law between 1996 and 2000, Singapore: Sweet & Maxwell Asia. Lee, Kuan Yew (2015) From Third World to First. The Singapore Story: 1965–2000, Singapore: Marshall Cavendish Editions and the Straits Times Press. Monetary Authority Singapore (2014), “2014 Singapore Asset Management Survey,” available at http://www.mas.gov.sg/~/media/MAS/News%20and%20Publications/ Surveys/Asset%20Management/2014%20AM%20Survey%20Report.pdf (accessed 10 October 2015). ——— (2015a) “Capital Markets,” http://www.mas.gov.sg/Singapore-Financial-Centre/ Overview/Capital-Markets.aspx (accessed 10 October 2015). ——— (2015b) “Regional Gateway for RMB,” http://www.mas.gov.sg/SingaporeFinancial-Centre/Overview/Regional-Gateway-for-RMB.aspx (accessed 10 October 2015). ——— (2015c), “Industry Panel Discusses Strategies to Grow Financial Centre,” 27 August 2015, http://www.mas.gov.sg/News-and-Publications/Media-Releases/ 2015/Industry-Panel-Discusses-Strategies-to-Grow-Financial-Centre.aspx (accessed 10 Octo­ber 2015). McCulloch, John R. (2000) The Works of David Reicardo, New Jersey: Lawbook Exchange. Reuters News (2014) “Singapore to Emerge as Top Financial Hub by 2015: Study,” 4 July 2014, http://in.reuters.com/article/2013/07/04/singapore-swiss-funds-idINDEE 9630AX20130704 (accessed 10 October 2015). “Singapore’s Financial Rise: Going Swimmingly,” The Economist, 20 April 2011. worldjusticproject.org (2015) “Rule of Law Index 2015,” http://www.worldjustice project.org (accessed 10 October 2015).

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Chapter 2

Inside the Singapore Financial Centre Dora Neo Abstract Singapore has been ranked by the Global Financial Centres Index as a leading global financial centre engaged in broad and deep financial services activities, and assessed to be well-connected with many other financial centres. This is largely the result of careful planning by the Singapore Government in the 50 years since Singapore became an independent nation in 1965. The Government has implemented policies that are specifically directed at the financial sector, as well as broader policies that have led to rapid economic development generally, which in turn have created favourable conditions for the continued growth of the financial industry. This chapter explores the motivations and conditions for such single-minded policy-making, and examines selected aspects of the Singapore financial centre from the historical, legal/regulatory, attitudinal and policy response perspectives.

Keywords Singapore – financial centre development – government policy – law – regulation

1 Introduction In the 17th edition of the Global Financial Centres Index (GFCI 17), published in March 2015,1 Singapore maintained its previous position of fourth place, ranking behind New York, London and Hong Kong.2 The index assessed Singapore as * Associate Professor and Director, Centre for Banking & Finance Law, National University of Singapore. 1  This is published by Z/Yen Group, a think tank in the City of London. The report is available online, see longfinance.net (2015). GFCI 17 provides rankings for 82 financial centres using two separate sources of data, i.e., instrumental factors (external indices) and responses to an online survey. 2  G FCI 17, appendix, p. 42.

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a leading global financial centre engaged in broad and deep financial services activities, and one that is well-connected with many other financial centres.3 This chapter will introduce some factors which contribute to the competitiveness of financial centres, and explore selected aspects of the Singapore financial centre from the historical, legal/regulatory, attitudinal and policy response perspectives.4 2

What Makes a Global Financial Centre?

Singapore’s competitiveness as a financial centre can be attributed to factors such as its political and economic stability, strong rule of law, robust supervisory and regulatory regime, skilled financial sector workforce, world-class communications and payment network, competitive business environment, well-developed infrastructure, rapid economic growth domestically and in the surrounding region, and a strategic location within a favourable time zone. Most of these factors, except the last, are to a greater or lesser degree the result of careful government planning. Just to take two examples, specific policies to enhance Singapore’s tax and cost competitiveness have contributed to its positive business environment; and special efforts have been made to develop Singapore’s human capital by providing opportunities for education and personal development, both generally, and specifically in relation to banking and finance. The producers of GFCI 17 have methodically identified a long list of factors that combine to contribute towards the competitiveness of a financial centre. These factors were used to assess the competitiveness of Singapore and other financial centres for the purposes of the index. According to GFCI 17, the top 20 financial centres are, in order of rank: New York, London, Hong Kong, Singapore, Tokyo, Zurich, Seoul, San Francisco, Chicago, Boston, Toronto, Washington DC, Geneva, Riyadh, Vancouver, Shanghai, Luxembourg, Montreal, Frankfurt, and Doha.5 The factors identified by GFCI 17 are grouped into five areas of competitiveness: business development; financial sector development; infrastructure; human capital; and reputational and general factors. Each of

3  G FCI 17, pp. 12–13. 4  For an introduction to the financial services industry in Singapore, see Tan (2005); Tan (2011); Lee (1990). 5  G FCI 17, table 1, p. 4.

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these areas, with its component factors, is summarised below, and Singapore’s GFCI 17 rank is indicated in brackets.6 a.

b.

c.

d.

e.

Business environment (Singapore’s rank: 3) (i) political stability and rule of law; (ii) institutional and regulatory environment; (iii) macroeconomic environment; and (iv) tax and cost competitiveness. Financial sector development (Singapore’s rank: 4) (i) volume and velocity of trading; (ii) availability of capital; (iii) depth and breadth of industry clusters; and (iv) employment and economic output. Infrastructure (Singapore’s rank: 5) (i) building and office infrastructure; (ii) transport infrastructure; (iii) information communication technology infrastructure; and (iv) environmental care and sustainability. Human capital (Singapore’s rank: 4) (i) availability of skilled personnel; (ii) education and development; (iii) flexible labour and market practices; and (iv) quality of life. Reputational and general factors (Singapore’s rank: 4) (i) city brand and appeal; (ii) level of innovation; (iii) attractiveness and cultural diversity; and (iv) comparative positioning with other centres.

Singapore scored well in all five areas in GFCI 17 (although it is surprising that it did not rank higher in terms of the business environment) indicating that it must generally have been assessed favourably on many of the component 20 factors.7 This corresponds with other assessments of Singapore. For example, the World Economic Forum has ranked Singapore the second most competitive

6  G FCI 17, table 4, p. 9. 7  Some of these factors have themselves been the subject of separate rankings, ranging in diversity from the World Bank’s Ease of Doing Business Index to the World Economic Forum’s Quality of Roads Index. See CGFI 17, tables 21–25, pp. 48–52.

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economy worldwide, and more specifically, also the second most competitive country worldwide for financial sector development.8 The precise factors to be considered in any ranking exercise are, of course, subject to debate. Nevertheless, the above list of five areas comprising a total of 20 factors is generally helpful for an understanding of the diverse range of considerations that are relevant to building a successful global financial centre. A factor such as the attractiveness of a city and its cultural diversity might appear to be removed from the financial industry and not obviously related to the city’s ranking as a financial centre, yet this attribute could be the decisive factor, other things being equal, in attracting top financial talent to one city rather than another. GFCI 17 has identified certain issues9 which need special consideration in each of the five areas. For instance, corruption and the rule of law are key issues when it comes to providing a favourable business environment. The existence of a simple, fair and transparent taxation regime is also important. In order to boost financial sector development, professional service clusters are vital, and despite the ease of non-face-to-face communication, physical proximity remains very important. Efficient transport infrastructure is also important as people are becoming impatient about waiting for transport, and a good information communication technology infrastructure has become a prerequisite. From the human capital point of view, the race to attract skilled personnel has become more competitive and diversity of nationalities more prevalent. Finally, safety and security are becoming more important in building financial centre reputation, and marketing has become required to compete effectively with other financial centres. Singapore’s success as a financial centre is closely connected to its high level of economic competitiveness, and these mutually reinforce each other. Both are the result of purposeful and persistent government policy over the past 50 years, which created and shaped the component factors that formed the building blocks for such success. One unifying explanation for the strength of the government’s resolve to ensure the economic success of Singapore can be traced back to Singapore’s history. Singapore was founded in 1819, when its deep natural harbour and strategic geographical location along the trade routes between east and west caught the attention of Great Britain and it became a British colony. Singapore was under British rule for 140 years before it obtained partial self-government in 1959 when the People’s Action Party (PAP), led by Singapore’s first Prime Minister, Lee Kuan Yew, came into power. Singapore 8  See World Economic Forum (2015). 9  G FCI 17, table 5, p. 10.

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subsequently became part of the Federation of Malaysia in 1963. However, this merger was short-lived and Singapore left Malaysia in 1965, abruptly becoming an independent and sovereign nation. Lee Kuan Yew and the PAP leadership had believed that Singapore’s future lay with Malaya. Thus, separation was painful. For a small country10 without any natural resources, the future was uncertain. The government believed that it had to do everything within its power to ensure that Singapore remained economically viable, as this was a matter of survival. This resolute approach has prevailed for the past 50 years of PAP rule in Singapore, seeing the country through its transformation from Third World to First.11 It is well-ingrained in the Singaporean psyche that Singapore must consistently strive hard to attain and maintain success. Even today, after Singapore has achieved one of the highest per capita GDPs in the world of USD 56,286 in 2014,12 the question is still being asked, whether Singapore can survive.13 If any policy in the sphere of financial services, as in other aspects of Singaporean life, is pursued despite seeming to be too different or too difficult, the boldness of the government and the support (or at least tolerance) of the citizenry is likely to be linked to the constant reminder that Singapore has to be exceptional to survive.14

10  Singapore’s land area has been expanding incrementally because of land reclamation. 2014 data estimates its total land area to be 718.3 square kilometres. See singstat.gov.sg (2015). 11  Lee (2010), pp. 23–24, Lee Kuan Yew wrote:  “How was an independent Singapore to survive when it was no longer the centre of the wider area that the British once governed as one unit? [. . .] We had to create a new kind of economy, try new methods and schemes never tried before anywhere else in the world, because there was no other country like Singapore. [. . .] We had to make extraordinary efforts to become a tightly knit, rugged and adaptable people who could do things better and cheaper than our neighbours, because they wanted to bypass us and render obsolete our role as the entrepôt and middleman for the trade of the region. We had to be different.” 12  See data from the World Bank (2015). 13  Kishore Mahbubani, Dean of the Lee Kuan Yew School of Public Policy at the National University of Singapore, postulates this question in his book. See Mahbubani (2015). 14  For example, this was the theme of Prime Minister Lee Hsien Loong’s May Day Rally speech to trade unions and workers on 1 May 2015, in which he paid tribute to founding Prime Minister Lee Kuan Yew, who passed away in March 2015. See pmo.gov.sg (2015).

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Planning the Singapore Financial Centre15

At the time of Singapore’s independence in 1965, its banking sector was largely domestically-oriented. In the post-independence self-examination that took place to strategize for Singapore’s future, economic diversification was found to be vital for economic success. The financial services industry was identified as a new area of growth, and massive efforts began to be targeted towards developing this sector. The first major step in the carefully calibrated journey towards being a regional, and then global, financial centre took place when Singapore established the Asian Dollar Market (ADM). The ADM pooled together the foreign currency holdings from various Asian countries to be traded and utilised. It enabled Singapore to take on a regional role without being limited by its domestic resources. In 1968, banks were allowed to set up separate Asian Currency Units (ACUs) into which these deposits from non-residents were placed, and from which they lent in United States (US) dollars and other currencies to finance activities outside Singapore. This has since become a very successful activity and the assets in the ADM have grown from USD 33.16 million in 1968 to over USD 1 trillion in 2011.16 The flow of funds into the ADM facilitated the growth of Singapore as a funding base for US dollars and also a global foreign exchange trading centre. Basic forex products have evolved into sophisticated ones, including derivative products. According to the 2013 Triennial survey by the Bank for International Settlements (BIS), Singapore’s foreign exchange market ranked 3rd in the world after London and New York, and daily turnover was USD 383 billion in April 2013.17 The 2013 Triennial BIS survey also found the OTC interest rate derivatives market turnover to be USD 37 billion in Singapore, making it the largest OTC interest rate centre in the Asia Pacific, excluding Japan.18 Equities started to be listed on Singapore’s own Stock Exchange in 1973, when it broke away from its Malaysian counterpart. The new Stock Exchange of Singapore (SES) established itself as an attractive listing destination by a combination of rules as well as infrastructure and product innovations. 15  A useful account is found in Ignatius Low et al. (2012), chapter 7, which forms the basis of the discussion in this section. 16  Ibid., p. 150. 17  See Bank for International Settlements, “Triennial Central Bank Survey, Foreign Exchange Turnover in April 2013,” pp. 8, 14. See bis.org (2015a). 18  See Bank for International Settlements, “Triennial Central Bank Survey, OTC Interest Rate Derivatives Turnover in April 2013,” p. 11. See bis.org (2015b).

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For instance, it allowed trading on a settlement basis, was the first in Asia to introduce options trading, and replaced traditional white boards with electronic trading boards as early as 1982. Continual improvements have been implemented through the years. In a significant development towards the internationalisation of the Singapore capital markets, the Singapore International Monetary Exchange (SIMEX), a futures exchange, was founded in 1984. The motivation for this new exchange was so that it could partner the Chicago Mercantile Exchange (CME) to establish a joint Eurodollar futures market. This partnership created the first global round-the-clock trading platform. Because of the 13-hour time difference between Singapore and Chicago, a trader who bought a Eurodollar contract in Singapore could offset it by selling on the CME or vice versa, and so, eliminate overnight risks. SIMEX and SES merged in 1998 and became the Singapore Exchange (SGX). The establishment of SGX improved Singapore’s competitiveness in terms of size and product range. SGX was demutualised and its shares listed on the main board of SGX in 2000, resulting in a different ownership structure from the old SIMEX and SES, which were previously owned by their members. This structural change came with other changes such as the freeing up of commissions and the admission of foreign brokerages, for example, those using the Internet and other forms of electronic trading. New services were also introduced and there were initiatives making it easier for foreign companies to list in Singapore. SGX now has a listing of nearly 800 companies in diverse sectors, of which 40% are based outside Singapore,19 in the Asia Pacific, particularly South East Asia, and also Europe and USA. SGX is Asia’s leading market for real estate investment trusts (REITs) and business trusts, having a total listing of more than 40 REITs and business trusts, the most in Asia, excluding Japan.20 The bond market in Singapore came alive only after the 1997 Asian financial crisis. There was no need for ways to raise funds other than bank loans or the equity markets, as the Singapore Government was sitting on budget surpluses and Singapore companies were generally cash-rich. The 1997 crisis showed that it would be useful for private borrowers to have an alternative source of funding in the form of bonds,21 leading the Singapore authorities to make a concerted effort to develop Singapore into an international debt hub. Typical of the Singapore Government, it led the way by stepping up its issuance of government bonds although it had no need for additional funds. Prior to that, 19  See Singapore Exchange Annual Report 2014, p. 5. See sgx.com (2015). 20  Ibid., p. 7. 21  See Lee (2006), pp. 146–51.

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Singapore Government Securities (SGS) were issued merely to provide financial institutions with a risk-free asset in their liquid asset portfolios, and were not actively traded. In 1998, the Monetary Authority of Singapore (MAS) started to enhance the efficiency and liquidity of the SGS markets. In 2000, these efforts were refined by introducing a focused issuance programme to build large and liquid benchmarks bonds to carry out the mutually reinforcing strategies of: (i) creating a liquid SGS market to provide a robust government yield curve for pricing private debt securities; (ii) fostering the growth of an active secondary market that would enable efficient risk management; and (iii) encouraging local and overseas investors and issuers to participate in the Singapore bond market.22 Since then, the SGS market has grown tremendously to become one of the fastest-developing bond markets in Asia from SGD 43.2 billion outstanding in 2000 to SGD 124.8 billion outstanding in 2013.23 This encouraging growth in government securities has been surpassed by the growth in the corporate bond market, which went from a volume outstanding of SGD 49.5 billion in 2000 to a volume outstanding of SGD 272.4 billion in 2013.24 The growth of offshore banking, foreign exchange and capital markets provided the foundation for then Deputy Prime Minister Lee Hsien Loong in 1998 to announce a plan to promote the fund management industry in Singapore and its development as asset management hub.25 The plan was to have international fund managers establish themselves in Singapore and use it as a base to invest in Asia, and for Asian investors to use Singapore as a base to diversify out of Asia into other more developed markets in other parts of the world. Some of the strategies used by the Singapore Government to achieve this aim will be discussed later in this chapter. Total funds under management in Singapore have risen from SGD 150.6 billion in 1998 to SGD 2.4 trillion in 2014.26 Singapore’s wealth management industry is now well-developed, and it has established itself as a private banking centre globally. Singapore was ranked the world’s sixth largest international wealth management centre in the Deloitte Wealth Management Centre Ranking 2015.27 22  Information on SGS is available online, see sgs.gov.sg (2015a). 23  See MAS, “Outstanding SGS,” available online see sgs.gov.sg (2015b). 24  See MAS, “Annual Survey of the Singapore Corporate Debt Market” for the years 1999 and 2013, see mas.gov.sg (2015a). 25  MAS, “Fund Management in Singapore: New Directions,” Speech by Deputy Prime Minister Lee Hsien Loong at the Investment Management Association of Singapore Seminar, 26 February 1998, see mas.gov.sg (2015b). 26  See MAS asset management surveys for 1998 and 2014, see mas.gov.sg (2015c). 27  See deloitte.com (2015).

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Singapore is also a regional insurance and reinsurance hub for Asia. The insurance industry in Singapore started by focusing on serving domestic clients, largely in the area of life insurance, with the market being closed to direct insurers in the 1990s. In 2000, MAS lifted the closed-door policy and reversed the 49% foreign shareholding limit that had been imposed previously for direct insurers. Since then, the offshore insurance business has grown to reach USD 5.4 billion in 2012, with the share of offshore non-life business reaching 65% in 2012. Insurance groups from different segments of the industry, including 16 of the top 25 reinsurers in the world, have set up their regional hubs in Singapore. In addition to life policies and general policies covering traditional property and casualty risks, there is now significant expertise in specialised risks such as marine, energy, catastrophe risks. Indeed, Singapore is the second largest market for structured credit and political risk worldwide after London. In September 2015, there were 181 licensed insurance companies in Singapore, comprising 81 direct insurers, 32 reinsurers and 68 captive insurers, providing a wide range of insurance products.28 Insurance may also be provided by authorised reinsurers (overseas insurers authorised to solicit business and collect premiums from insurers in Singapore) and the Lloyd’s Asia Scheme. MAS’s vision is for Singapore to be a global centre for insurance, with the ability to accept global risks, and not just regional risks, by 2020.29 A recent development in Singapore has been its role in facilitating the offshore renminbi (RMB) business. The Industrial and Commercial Bank of China’s (ICBC) Singapore branch was designated Singapore’s RMB clearing bank in February 2013. MAS and the People’s Bank of China signed a Memorandum of Understanding on RMB Business Cooperation. The growth of RMB liquidity will enable financial institutions in Singapore to offer a wider range of RMB products and services. In October 2013, China and Singapore agreed to new initiatives to strengthen cooperation on financial sector development and regulation, under which, for instance, China would extend its RMB Qualified Foreign Investor (RQFII) Programme to Singapore with a total quota of RMB 50 billion, and China and Singapore would introduce direct currency trading between the Chinese yuan and the Singapore dollar. These initiatives will further promote the international use of the RMB through Singapore. The growth in the RMB business has been phenomenal. By January 2015, ICBC 28  See MAS Financial Institution Directory, see masnetsvc.mas.gov.sg (2015). 29  For matters discussed in this paragraph, see MAS, “Singapore as a Global Insurance Marketplace,” Keynote Address by Mr Ravi Menon, Managing Director, MAS, at 12th Singapore International Reinsurance Conference, 6 November 2013, see mas.gov.sg (2015d).

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had cleared 40 trillion yuan since its appointment as the sole yuan clearing bank in Singapore in 2013,30 and in June 2015, yuan deposits in Singapore had reached 322 billion yuan.31 In July 2015, ICBC Singapore executed the first RMB bond pledged repo among foreign institutions in the Chinese interbank bond market in the amount of RMB 200 million,32 thereby facilitating financing in RMB by Singapore banks and also allowing them to tap into the liquidity of the domestic Chinese capital market. The Singapore Government’s attitude towards foreign banks has changed through the years. In the early days, with the Asian Dollar Market and the growth of foreign exchange trading, it became attractive for international banks to establish in Singapore. These banks were welcomed by the Singapore authorities, but in order that they did not pose excessive competition to local banks, MAS created the category of “restricted licence” banks in 1971. Restricted banks could have the same domestic banking business as local banks, but they were restricted to only one main branch and could not operate Singapore dollar savings accounts or take Singapore dollar fixed deposits of less than SGD 250,000 from non-bank customers. Another category of banks, called “offshore banks” was created in 1973. Such banks were allowed to engage mainly in Asian Dollar Market and foreign exchange market activities, and to provide wholesale banking services to non-residents. No new licences for full banks had been granted since 1970, nor for restricted banks since 1983. Existing foreign banks that had full licences prior to Singapore’s independence were not allowed to expand their domestic retail activities freely. The thinking was that having too many foreign banks could be destabilising to the economy if a number of them were to pull out of Singapore, whereas local banks could be counted on to stay rooted to the country. Local banks were therefore protected from excessive competition in order to allow them to grow. In the 1990s, as banks and financial institutions started consolidating internationally, and markets become increasingly global, the government became of the view that it would be beneficial for Singapore to have strong foreign banks that had a stake in the country.33 In 1999, MAS announced measures to liberalise commercial banking and upgrade local banks.34 This 30  Yahya (2015). 31  See MAS, “RMB Statistics,” see mas.gov.sg (2015e). 32  Announcement by ICBC Singapore on 20 July 2015, “ICBC Singapore Completes First Onshore RMB Repo Transaction,” see singapore.icbc.com (2015). 33  Tan & Tan (2006). 34  Statement by MAS, “Liberalising Commercial Banks and Upgrading Local Banks,” 17 May 1999.

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would provide competition and help improve product knowledge, and spur local banks to greater innovation and efficiency. Singapore banks were encouraged to merge to become stronger to prepare for the market opening. The result of this is that there are now five locally-incorporated full banks belonging to three banking groups. At the same time, MAS mandated that local banks should strengthen their corporate governance and aim to attract top talent. Various steps were taken as part of a five-year liberalisation plan to give foreign banks access to Singapore’s domestic banking market. These included (i) the award of a new class of Qualifying Full Bank (QFB) licence whereby each QFB would be allowed additional branches, off-premise automated teller machines (ATMs) and ATM sharing with other QFBs; (ii) an increase in the number of restricted bank licences (these were later replaced by wholesale bank licences), and (iii) giving offshore banks greater flexibility in the Singapore dollar wholesale business. The successful result of the liberalisation has been that local banks have become stronger, and at the same time, international banks have a greater presence in Singapore. 4

Law and Regulation

An important factor in the development of banking and financial services in Singapore is the strong legal and regulatory framework within which the financial centre operates. Statutes and other legal instruments comprehensively set out the rules that financial institutions and finance professionals must abide by. The MAS, which was set up in 1971, is both Singapore’s central bank as well as its financial regulator.35 It plays a key role in all aspects of financial regulation in Singapore, overseeing the banking, securities, futures, and insurance industries. MAS is also responsible for the development and promotion of Singapore as an international financial centre. Aside from regulation, under Singapore law, legal relationships between various parties in financial transactions are facilitated and governed by established principles of private law that have their roots in the well-respected English common law. 4.1 Statutes The highest level of laws governing the financial industry are statutes which have been passed by the Singapore Parliament. Major statutes governing banking and financial services include the Monetary Authority of Singapore 35  Section 4, MAS Act (Cap. 186, 1999 rev. ed.).

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Act,36 the Banking Act,37 the Securities and Futures Act,38 the Financial Advisors Act,39 the Insurance Act,40 the Finance Companies Act,41 and the Trust Companies Act.42 A statute or any statutory amendment is usually introduced to Parliament in the form of a Bill by a Minister on behalf of the Government. By this time, the matters covered in the Bill would have been considered and evaluated thoroughly by the Ministry or government department sponsoring the Bill, in consultation, formally or informally, with others who may have a particular interest in, or knowledge of, its subject matter. After its introduction, each Bill will typically be debated and voted upon at a subsequent Parliamentary sitting. Statutory law-making in Singapore is smooth. Finance industry-related Bills, like others, are generally passed with no problems. The ruling People’s Action Party (PAP) has enjoyed an overwhelming majority in Parliament since Singapore’s independence.43 Debates and discussions in Parliament are typically followed by a disciplined voting process, where PAP Members of Parliament vote according to the party line unless the whip is exceptionally lifted. As finance industry-related Bills have not been particularly controversial and there is general confidence in the judgment and expertise of MAS in proposing the content of such Bills, there is no reason to think that Members of Parliament would have voted differently in any case. Laws are updated regularly to respond to the changing international financial landscape and policy aims of Singapore, sometimes leading to major legislative changes. An example is the completely new Securities and Futures Act that was passed in 2001. It sets out in one statute the legislative framework governing the securities and futures industry by consolidating the provisions in the Securities Industry Act and the Futures Trading Act as well as certain provisions in the Exchanges (Demutualisation and Merger) Act44 and the Companies Act.45 This reform was partially in response to the demutualisation 36  37  38  39  40  41  42  43 

Cap. 186, 1999 rev. ed. Cap. 19, 2008 rev. ed. Cap. 289, 2006 rev. ed. Cap. 110, 2007 rev. ed. Cap. 142, 2002 rev. ed. Cap. 108, 2011 rev. ed. Cap. 336, 2006 rev. ed. As of 1 January 2015, there were 80 PAP elected MPs and seven opposition elected MPs in the Singapore Parliament. As regards non-elected members, which is a special feature of the Singapore parliamentary system, there were three Non-Constituency MPs and nine Nominated MPs. 44  Cap. 99B, 2006 rev. ed. 45  Cap. 50, 2006 rev. ed.

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and merger of the securities and futures exchanges in Singapore, referred to earlier in this chapter. Capital markets had become increasingly sophisticated as a result of technological advances, giving rise to competition and globalisation. There was a rise of electronic business models, and a diversity of new products. Cross-selling had blurred sectoral boundaries and financial innovation had blurred product lines. MAS needed to create a legal framework which would balance prudential concerns with market development and be sufficiently flexible to allow and facilitate innovation. Changes to the existing legislation were also necessary to reflect the shift in MAS’ regulatory philosophy from the tight supervision of a “one-size-fits-all” regime to the risk-focused supervision of a disclosure-based regime.46 4.2 Subsidiary Legislation Singapore statutes generally allow for subsidiary legislation, known as regulations, to be passed under the authority of the relevant Act to flesh out its provisions in greater detail. Subsidiary legislation has the force of law, and contravention is an offence. The power to make subsidiary legislation is given to the Minister in charge of the particular subject matter covered by the statute, and Parliament plays no further part in the process. Statutes relating to banking and finance matters generally contain provisions that give the power to make subsidiary legislation to MAS.47 The managing director (MD) of MAS is the person who makes decisions and exercises all powers and does all acts which may be exercised or done by MAS under any written law.48 This puts him in charge of a wide range of activities, given MAS’s role as Singapore’s central bank and integrated financial regulator. The MD’s power is curtailed only in that he is answerable to the Board of Directors of MAS. At the time of writing in 2015,49 the MD of MAS is Ravi Menon, who had previously served as the Permanent Secretary of the Ministry of Finance. The Chairman of the Board of Directors of MAS is Deputy Prime Minister and Minister for Finance, Tharman Shanmugaratnam, who was himself once MD of MAS. Its Deputy Chairman is 46  MAS, “Making Singapore Asia’s Premier Banking Centre,” Speech by DPM Lee Hsien Loong at the 25th Anniversary of the Association of Banks in Singapore, 8 June 1998. See mas.gov.sg (2015f). 47  See, e.g., s. 78 of the Banking Act (Cap. 19, 2008 rev. ed.); s. 104 of the Financial Advisers Act (Cap. 110, 2007 rev. ed.); s. 341 of the Securities and Futures Act (Cap. 289, 2006 rev. ed.); s. 57 of the Finance Companies Act (Cap. 108, 2011 rev. ed.); s. 64 Insurance Act (Cap. 142, 2002 rev. ed.); and s. 82 Trust Companies Act (Cap. 336, 2006 rev. ed.). 48  S. 9(3) MAS Act (Cap. 186, 1999 rev. ed.). 49  The latest update was made in August 2015.

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Minister for Trade and Industry, Lim Hng Kiang. There are seven other members of the Board of Directors, a number of whom are political office-holders or senior civil servants;50 and a Senior Advisor, Goh Chok Tong, who is a former Prime Minister of Singapore. Current Prime Minister, Lee Hsien Loong, was once the Chairman of MAS. Subsidiary legislation under the different statutes pertaining to banking and finance vary in coverage and detail. Regulations may be drafted narrowly. One example would be regulations made for the specific purpose of giving effect to United Nations Security Council resolutions to freeze the assets of designated individuals or entities.51 Or they could be much broader and apply to regulate a particular area of activity in some depth. An example is the Banking (Credit and Charge Card) Regulations 2013.52 These regulations, made under the authority of the Banking Act,53 control credit and charge card operations generally, including the conditions under which unsecured credit and charge cards can be issued to individuals, such as income and asset requirements and satisfactory background checks. The regulations provide that any card issuer that contravenes them commits an offence and is liable to a fine.54 4.3 MAS Instructions and Communications There are rules governing the banking and financial services industry that emanate directly from MAS, and are in addition to the subsidiary legislation made by MAS under the authority of various statutes as discussed above. These rules are given different labels depending on their content, purpose and level of bindingness. MAS also issues communications which provide information to financial institutions and the financial industry. A valuable aspect of MAS’s policy and rule-making process is the importance that it places on understanding international best practices and on consultation regarding intended regulatory changes. In 2014, MAS issued 24 consultation papers, inviting views on a range of proposed legal and regulatory changes, and in the first six months 50  The seven other directors of MAS are Heng Swee Keat (Minister for Education, formerly the MD of MAS), Lawrence Wong (Minister for Culture, Community and Youth), Lim Chee Onn (Senior International Advisor, Singbridge Pte Ltd), Quek See Tiat (Chairman, Building and Construction Authority), Peter Ong (Permanent Secretary, Ministry of Finance), Tan Chor Chuan (President, National University of Singapore) and V. K. Rajah (Attorney General of Singapore). 51  E.g. MAS (Freezing of Assets of Persons—Yemen) Regulations 2015 (No. S. 109) made under the authority of s. 27A(1)(b) MAS Act (Cap. 186, 1999 rev. ed.). 52  No. S. 729/2013. 53  S. 78 Banking Act (Cap. 19, 2008 rev. ed.). 54  Reg. 8(5).

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of 2015, 10 consultation papers were issued.55 In many cases, MAS also issued response papers addressing the feedback received during the consultation process. This approach contributes towards identifying solutions and models that are most appropriate and effective for Singapore. 4.3.1 Directions in the Form of Directives or Notices MAS is empowered under the MAS Act to give “directions” to financial institutions or other specified persons in relation to various subject matters set out in the statute. For example, MAS can request information from, and make recommendations to, financial institutions if it thinks this to be in the public interest, and may issue directions for the purpose of ensuring that effect is given to such request or recommendation.56 It can also give directions for a range of other purposes, including to discharge the government’s international obligations;57 to prevent money laundering and terrorist financing;58 and to control the operations of financial institutions.59 Such directions are distinct from the regulations (subsidiary legislation) which MAS is empowered to make under the MAS Act and other financial statutes. One difference is that regulations, being subsidiary legislation, must be published in the Singapore Government Gazette, whereas directions under the MAS Act are not required to be published in the same way.60 Directions can therefore have a more immediate effect and can remain confidential if necessary. At the same time, directions are similar to regulations in that they also have the force of law. The consequences of non-compliance with directions made under different sections of the MAS Act could be a fine or a term of imprisonment or both, and are clearly specified in each case. In practice, directions can take the form of “directives” (which are addressed to a specific financial institution or person) or “notices” (which typically apply to a specific class of financial institutions or persons). The potential importance of a notice is demonstrated by “Notice 626 to Banks on the Prevention of Money Laundering and Countering the Financing of Terrorism”. It is this notice, rather than a statute or a regulation, which contains detailed provisions governing anti-money laundering and anti-terrorism 55  56  57  58  59  60 

See mas.gov.sg (2015g). S. 27(1) MAS Act. S. 27A(1) MAS Act. S. 27B(1) MAS Act. S. 28(3) MAS Act. Various provisions of the MAS Act have this effect. See, e.g., s. 27(5) MAS Act which provides that directions made under particular sections of the statute need not be published in the Gazette.

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financing in Singapore. A financial institution that fails to comply with this notice would be guilty of an offence and would be liable on conviction to a fine not exceeding SGD 1 million.61 There is also potential criminal liability under the anti-money laundering and anti-terrorist financing statutes if those provisions are contravened. 4.3.2 Guidelines and Codes The MAS Act gives MAS a general power to issue guidelines to, and impose conditions of operation on, financial institutions as it thinks fit. In practice, MAS gives instructions which it labels “guidelines” or “codes” depending on the nature of the rules concerned. Guidelines set out best practice standards that govern the conduct of specific institutions or persons, whilst codes set out rules governing the conduct of specified activities. Examples of guidelines are the “Technology Risk Management Guidelines for Financial Institutions”, and the “Guidelines on MAS Notice 626 on Prevention of Money Laundering and Countering the Financing of Terrorism”, which elaborates on the requirements of Notice 626, mentioned above. Examples of codes are the “Code on Collective Investment Schemes” and the “Code of Conduct for Credit Rating Agencies”. No explicit sanction is stated under the MAS Act for a breach of guidelines or conditions issued by MAS. Guidelines and codes are not laws and non-compliance is not a criminal offence. However in practice, breach of a guideline may affect MAS’s risk profile assessment of the person or institution, and breach of a code could lead to a private reprimand or public censure.62 4.3.3 Practice Notes, Circulars and Policy Statements There are three other types of communications issued by MAS which do not have the force of law: practice notes, circulars and policy statements. Practice notes give guidance to specified institutions or persons on administrative procedures relating to matters such as licensing, reporting etc. A breach of a practice note does not attract criminal sanctions unless the procedure is also required under a statute or a regulation. Circulars are informational communications which may be sent to specified persons for their information, or are published on the MAS website for public information. Policy statements outline the major policies of MAS.

61  S. 27B(2) MAS Act. 62  See mas.gov.sg (2015h).

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4.4 Voluntary Codes of Conduct Financial institutions in Singapore may also be bound by voluntary codes of conduct by virtue of their participation in various groupings. Good examples are the codes of conduct under the auspices of the Association of Banks of Singapore (ABS), which has more than 150 member banks.63 ABS members have adopted a self-regulatory approach and have their own codes of conduct for a range of activities. Examples are the “Private Banking Code of Conduct”, the “Code of Consumer Banking Practice”, the “ABS IPO Due Diligence Guidelines”, and the “Code of Banking Practice for Small Businesses”. Although these do not have the force of law, ABS members are bound by their membership agreement to abide by these codes. 4.5 Role of the Common Law The statutory provisions and regulations discussed above operate within the framework of the common law legal system which Singapore inherited from its history as a British colony. Most important in governing the relationships between the parties to a financial transaction are the common law principles of contract law and tort law, especially the tort of negligence. Equity, including the law relating to fiduciaries, is also relevant to determine the remedies available to the parties. Further, the law of trusts has become increasingly important to facilitate financial planning in wealth management, and the common law in this area has been supplemented by specialised statutory provisions. The principles of the common law in Singapore are well-established and wellsuited to be applied in complex commercial disputes. This is to be expected from the fact that the principles of private law in Singapore were derived from English law, and English case law remains persuasive in Singapore today. Judicial law-making has been enhanced by the efforts of the Singapore courts, particularly in the past 10 years, to develop their own local jurisprudence. This has been done in the area of contract law, for instance, where the Court of Appeal has re-stated principles pertaining to topics such as the interpretation and implication of terms,64 termination of contracts65 and remoteness of damage.66 Exclusion clauses are used extensively by banks to limit their contractual liability to their customers, and Singapore judges have been active in

63  64  65  66 

See ABS website, see abs.org (2015). Sembcorp Marine Ltd v PPL Holdings Pte Ltd [2013] SGCA 43. RDC Concrete Pte Ltd v Sato Kagyo (S) Pte Ltd [2007] SGCA 39. Out of the Box Pte Ltd v Wanin Industries Pte Ltd [2013] SGCA 15, and MFM Restaurants Pte Ltd v Fish & Co Restaurants Pte Ltd [2011] SGCA 36. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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considering the enforceability of such terms.67 If criticism were to be made of the role played by the common law, it would be that case law, being judgemade law and subject to the doctrine of precedent, develops incrementally. It would not be especially responsive to changes in the financial landscape unless the highest courts in the land have an opportunity to adjudicate in a timely manner on troublesome issues (which depends on these issues coming up for decision in the courts in the first place), and when doing so, are willing to develop existing legal principles and, where appropriate, depart from them. A quick way to change any common law rule is, of course, for Parliament to pass a statute to that effect. 4.6 Assessment The law-making process for the banking and financial industry in Singapore is smooth and effective. All aspects of policy and rule-making are in the hands of MAS, overseen by the Minister for Finance. Legal changes that require legislative steps are well-facilitated by the political composition of the Singapore Parliament and also the delegation of the power to make subsidiary legislation to MAS, allowing direct law-making. Many of the detailed rules affecting the financial industry are set out in MAS guidelines and communications rather than in the statute books. The ability of MAS to make legally-binding guidelines that do not require publication in the Singapore Government Gazette enable these to take effect immediately, so that swift action can be taken in response to changing circumstances. It is obvious from the many notices, circulars and other communications issued by MAS at regular intervals (and readily accessible from the MAS website for public information) that it keeps in close touch with financial institutions and financial industry professionals, and supervises and guides them closely. The regulatory framework in Singapore is supported by detailed common law rules that govern the relationship between various parties in a financial transaction. These rules are historically based on English legal principles that apply in the leading financial centre of London and are well-suited for the adjudication of complex commercial disputes. 5

A Matter of Attitude

A fundamental factor which underlies the functioning and development of the Singapore financial centre is that of attitude. This includes the attitude of MAS 67  A question which often arises is whether the clause in question falls within the control of the Unfair Contract Terms Act (Cap. 396, 1994 rev. ed.), and if so, whether clause satisfies the requirement of reasonableness under ss. 2(2), 3(2) and 11. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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as a consistent and flexible regulator. These two qualities are complementary. MAS’s actions are predictable and it enforces high standards in a variety of situations. At the same time, it is prepared to meet unexpected circumstances and changing global trends with appropriately tailored action and policies. Also significant is the attitude of the Singapore Government to do its utmost to ensure that the banking and finance sector, which plays an important part in Singapore’s economic well-being, succeeds. This has been done through single-minded and coordinated policy-making cutting across various spheres of government activity. 5.1 MAS: Holding Steadfast to High Standards—Two Financial Scandals The banking and finance industry in Singapore has been fortunate to have been affected by only a modest number of scandals since the 1960s. Apart from sheer luck of circumstances, the main credit for this must be given to MAS’s effectiveness as a financial regulator and supervisor. This can be seen in relation to two well-known international scandals which took place long before the excesses that led to the global financial crisis of 2007–2009: the shutting down of the Bank of Credit and Commerce International (BCCI) in 1991, and the collapse of Barings Bank in 1995.68 5.1.1 BCCI BCCI was founded in 1972 by a Pakistani financier Agha Hasan Abedi. It was registered in Luxembourg and had head offices in London and Karachi. The bank grew at a very rapid pace, and at its peak, operated in over 70 countries, with more than 400 branches and assets exceeding USD 20 billion. By 1991, the party was over, and BCCI was shut down by the regulators of several countries for being guilty of widespread fraud and manipulation.69 Time magazine denounced BCCI as the “sleaziest bank in the world”.70 A 1992 US report found that BCCI was “not an ordinary bank. It was set up deliberately to avoid centralised regulatory review, and operated extensively in bank secrecy jurisdictions.”71 This report found that the bank was involved in criminal activities including money laundering, terrorist financing, bribery, facilitation of tax evasion, illicit 68  69  70  71 

Both of these scandals are mentioned in Henley (2007). See, e.g., Lohr (1991). Beaty & Gwynne (1991), p. 42. John Kerry and Hank Brown (1992), “BCCI’s Criminality”, chp. 4 in The BCCI Affair: A Report to the Committee on Foreign Relations, United States Senate, 102nd Congress 2nd Session Senate Print 102–140 (December 1992). Penultimate version available online, see fas.org (2015).

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purchases of banks and real estate, and smuggling.72 The bank’s collapse was massive and affected huge numbers of depositors in many parts of the world. In the UK, for instance, the web of fraud and criminal activities associated with the BCCI scandal was so complicated that the files on the matter were finally closed only some 21 years after the collapse of the bank, when its liquidators held the final meeting between the creditors and their lawyers in 2012.73 The BCCI story has a Singapore chapter. Fortunately, this story had a happy ending for Singapore, as MAS refused to grant the bank an offshore banking licence. The handling of the BCCI case is one of MAS’s success stories, now unequivocally made public in a book commemorating the fortieth anniversary of MAS.74 The strict and consistent position taken by MAS in the BCCI case reflected its high regulatory standards and independence of judgment. MAS was acting against seemingly positive signs that had won over many in the finance industry internationally. BCCI had succeeded in establishing a presence in many other countries. It was also supported by high-profile initial investors such as Bank of America, then the world’s largest bank, as well as powerful rulers and wealthy persons from Middle Eastern countries such as Saudi Arabia and the United Arab Emirates. MAS’s cold response was even more remarkable given the persistence with which BCCI attempted to advance its application. BCCI first applied to Singapore for an offshore banking licence in 1973, a year after its establishment, but was rejected for lack of a track record. The bank sent representatives to Singapore regularly to try to persuade MAS and in 1980, re-applied for a license and was rejected again, on the grounds of its poor international standing. In 1982, and then in 1985, it reapplied and both times was rejected. MAS based its assessment on negative feedback that it had by then received about BCCI from other central bankers who had dealt with it. MAS was also troubled that BCCI might not have been adequately supervised as it lacked an ultimate home regulator. Despite having applied four times for a licence and failing to obtain one each time, BCCI persisted and made a final attempt for an appointment with the Managing Director of MAS in 1989. This too was declined. The bank collapsed a few years later. In addition to making repeated applications, BCCI also enlisted the assistance of a few high-level emissaries to advance the bank’s case in Singapore. These persons included Mr J. D. van Oenen who had helped Singapore to set up its ACU foreign currency business, and was therefore well-known to, and trusted 72  See also Whitby & Block (2001). 73  Bowers (2012). 74  Low, supra note 15. The discussion in this chapter on MAS’s dealings with BCCI draws upon information made available in this book.

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by, the Singapore authorities. BCCI was also assisted by former British Prime Minister Harold Wilson, who wrote to Singapore’s then-Prime Minister, Lee Kuan Yew, about how BCCI had failed to meet the requirement for a licence. This approach by Harold Wilson is mentioned in Lee Kuan Yew’s memoirs.75 It comes across as a light-hearted anecdote in the book, but the account highlights the seriousness with which the gatekeeping function of MAS was taken by the government. Perhaps Mr Lee might have been more welldisposed towards the merits of BCCI if he had believed that Mr Wilson had considered the matter carefully, truly held a high opinion of the bank and was vouching for its good reputation. But Mr Lee was a sharp man and he noticed something unusual about Mr Wilson’s letter. Instead of signing off in his own hand “Yours sincerely Harold” as he customarily did, in this letter, “Yours sincerely” was typed instead of handwritten and he signed off as “(Harold) Wilson of Rievaulx”. Mr Lee concluded that Mr Wilson was “writing pro forma, to oblige a friend”.76 He therefore supported MAS’s assessment of BCCI and the same negative answer was given to Mr Wilson. Despite BCCI’s persistence in making repeated applications and the third-party intercessions which must have added to the pressure faced by MAS to grant BCCI a licence, MAS was steadfast and consistent in sticking to its own assessment, and applying its usual high standards to refuse BCCI a licence. The strict admission standards applied by MAS as a gatekeeper—involving not just minimum liquidity and solvency requirements but whether the institution would be able to participate actively in, and contribute to, the development of the financial market—saved Singapore from falling victim when BCCI collapsed.77 5.1.2 Barings Bank While Singapore escaped the fallout from the BCCI scandal by not allowing the bank to operate in the country, it was precisely in Singapore that the scandal which brought down Barings Bank originated. The bank was founded in 1762 and was England’s oldest merchant bank. It collapsed in 1995 after suffering massive trading losses of some GBP 827 million, caused by unauthorised trades made by Nick Leeson, a trader based in Barings’s Singapore office and general manager of Barings Futures (Singapore) (BFS). Leeson was effectively his own supervisor in Singapore, being in charge of both Baring’s trading operations on the Singapore International Monetary Exchange (SIMEX) as well as of keeping proper accounts of them. He was able to conceal his rapidly escalating losses in the futures market by using a false trading account numbered 88888, through 75  Lee, supra note 11. 76  Ibid. 77  See, e.g., Stevenson (1995). Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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which he engaged in more unauthorised trading to try to gain back his earlier losses. Barings’ head office in London finally came to know of Leeson’s activities on 23 February 1995. The rescue package that the crisis team in London attempted to put together for Barings over the weekend, before the Tokyo markets opened on Monday, failed. Barings officially went bust and was eventually purchased by Dutch Bank ING for £1. Baring’s collapse did not pose a systemic threat to the financial sector in Singapore as MAS had earlier insisted that the bank’s futures trading activity should be conducted through a separate arm that reported directly to London. Baring’s problems in Singapore were therefore confined to its futures trading unit. Its two other units in Singapore, the merchant bank and stockbroking house, were not affected. MAS’s precautionary approach was matched by its swift response, in conjunction with SIMEX, to ensure that, after Barings’ collapse, market players continued to have confidence in SIMEX trades.78 This included SIMEX’s doubling of trading margins and requiring traders to put more cash upfront, and its immediate action in applying to the court to appoint judicial managers when BFS’s related party customers were unable to meet their margin calls, so that BFS’s liabilities could be settled properly. Whilst this response achieved its intended aim in shoring up market confidence amongst many market players, SIMEX’s announcement of substantially increased margin deposits was misinterpreted by the US futures commission merchants (FCMs) as a sign that SIMEX might be short of funds. This caused alarm in the USA as SIMEX was a key counter-party to the traders of the Chicago Mercantile Exchange (CME). The chairman of the Commodity Futures Trading Commission, Mary Schapiro, telephoned the Managing Director of the MAS, Koh Beng Seng, with the message that unless there was a written assurance from MAS that the additional margin deposits required by SIMEX would not be used to meet BFS’s liabilities, the FCMs would not remit funds before the Singapore markets opened the next day. This would have broken the mutual offset link that SIMEX had with CME and SIMEX would have been ruined. Mr Koh sprang into action at 3am in the morning to address this unexpected turn of events. The statement was drafted and sent on time, and SIMEX was saved. Investigations showed that the collapse of Barings was due to poor judgement and the failure of internal controls in Barings London.79 SIMEX could only ensure that proper margin requirements were met, and that BFS had the 78  MAS’s response to the Barings crisis, including internal steps that were taken at that time, is explained in Low, supra note 15, pp. 183–187, which forms the basis of the discussion in this part of the chapter. 79  Board of Banking Supervision, Report into the Collapse of Barings Bank, 18 July 1995. See gov.uk (2015). Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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support of its parent bank. Various changes have been made in Singapore to strengthen the regulatory regime that existed at the time of the events leading to the Barings scandal. For instance, legislation was passed to allow MAS to monitor more closely the traders dealing in futures contracts,80 and SIMEX conducted a thorough review of its rules and practices, leading to changes including a direction for the separation of duties so that the head of dealing is not also in charge of settlement.81 MAS also identified the need for greater coordination and sharing of information amongst regulators and exchanges. This might have alerted the Singapore authorities when Nick Leeson applied to register as a trader with SIMEX, that he had once been denied a broker’s licence in London.82 5.2 Single-Minded, Coordinated Government Policy-Making The Singapore government has been instrumental in ensuring the success of Singapore as a financial centre. It has implemented many policies directed specifically at promoting the banking and finance sector, including numerous tax incentive schemes, such as the Financial Sector Incentive Scheme;83 training support schemes such as the Financial Sector Development Fund;84 and legal reform, of which examples have been given above. In addition, it is prepared to embark on a single-minded pursuit of this aim by designing its policies in other areas under government purview so as to support the growth of the financial services industry. One example was seen in the earlier discussion of how the Government started to issue Singapore Government Securities although it had no need to raise funds. Another example of such coordinated and unified policy-making can be seen in the actions that the Government has taken to develop Singapore as an asset management centre. Asset management capabilities were an important foundation for Singapore’s growth as a wealth management centre, an economic development strategy proposed by the Economic Review Committee in 2002.85 The Government has played a direct role in developing the asset management industry by itself providing 80  Futures Trading (Amendment) Act 1995 (Act No. 9 of 1995). The changes have now been consolidated into the Securities and Futures Act 2001. 81  These rules are now found in the Futures Trading Rules issued by the Stock Exchange of Singapore. 82  Low, supra note 15, p. 186. 83  See, e.g., Income Tax (Concessionary Rate of Tax for Financial Sector Incentive Companies) Regulations 2005, No. S. 735. 84  This was established under s. 30A of MAS Act (Cap. 186, 1999 rev. ed.). 85  See recommendations of the Economic Review Committee Sub-Committee on Services Industries, Financial Services Working Group Report, “Positioning Singapore as a

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seed capital and placing a portion of the country’s reserves that were being managed by MAS and the Government of Singapore Investment Corporation (GIC) with reputable fund managers,86 despite the GIC having its own teams of investment officers specialising in various classes of investments. In addition, the Government put in place targeted tax incentives for funds and fund managers which makes it attractive for fund managers to be based in Singapore.87 Casting a broader policy net that went beyond the finance industry, the Government also took the major step of restructuring the Central Provident Fund (CPF) (Singapore’s mandatory national retirement savings scheme), to allow CPF members to invest progressively greater amounts of their provident fund money with private fund managers under the CPF Investment Scheme (CPFIS),88 potentially making available billions of dollars for this ­purpose.89 The advantage that the evolution and liberalisation of CPFIS brought to the fund management industry in Singapore could be seen as complementary to the main aim of CPFIS to allow CPF members to earn an investment return that could meet their long-term retirement needs.However, with potential for greater returns came greater risk for members, so, in another example of holistic policy-making, the government launched MoneySENSE in 2003. This is a national financial education programme for Singapore, which aims to equip people with the ability to perform key financial activities, including planning ahead to have sufficient income for retirement.90 To complement the fast-developing asset management industry and create more favourable conditions for the growth of the wealth management sector, additional steps were taken by the Singapore Government. One strategy was the development of Singapore as a hub for investment in alternative assets, including private equity, hedge funds, mezzanine securities, distressed debts and real estate investment trusts. Major legislative reform was carried out to modernise the Trustees Act in 2004.91 Prior to these amendments, trustees had been subject to relatively strict controls under the Act, which

86  87  88  89  90  91 

Pre-eminent Financial Centre in Asia,” September 2002, available from the Ministry of Trade and Industry website. See mti.gov.sg (2015). See mas.gov.sg, supra note 25. See generally, Tan & Oei (2015). CPF Investment Scheme, see mycpf.cpf.gov.sg (2015). For a summary of some of the changes to CPFIS, see Tan, supra note 1, chapter 15. For a table of member’s balances, see CPF Annual Report 2014, Annex C. For information on MoneySENSE, see moneysense.gov.sg (2015). The public can also find tools for financial planning on the CPF website. The Trustees (Amendment) Act 2004, No. 45 of 2004, came into force on 15 December 2004.

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had not been significantly amended since it was adopted in the 1920s. For example, they could only invest in a list of investments which were set out in the Act, unless the trust instrument specifically provided otherwise. This was stultifying, in view of the different investment options that had become available and the continually evolving wealth management scene. The 2004 amendments abolished the fixed list of permissible investments and expanded the discretionary powers of trustees to allow them a general power of investment and power to appoint agents, nominees and custodians. This was matched with safeguards to ensure that trustees exercised their new powers in accordance with certain prudential standards. One of the effects of this amendment was that trustees in Singapore became able to invest in alternative assets, which were an important asset class in mature markets such as the US and Europe, but were relatively undeveloped in Asian markets at that time. Another important legal change was the establishment of a new business structure under the Limited Partnerships Act 2008, which came into effect in May 2009. A limited partnership structure includes at least one general partner with unlimited liability, and a limited number of partners with limited liability, who are essentially passive investors. It is a structure which is popular with private equity and other fund investments businesses in more developed markets like Europe, and the availability of this form of doing business made it conducive for alternative investment firms to set up in Singapore. Another strategy to support the growth of the wealth management industry in Singapore was to develop ancillary trustee and custody services, which have become increasingly important as part of the wide array of wealth management services offered by financial institutions. Central to this was the repeal and re-enactment of the Trust Companies Act in 200592 with the aim of implementing a sound framework for the regulation of companies that provide trust services in Singapore. Under the new Act, trust companies must adhere to the standards of governance set out in the statute and the accompanying supervisory framework, in the same way that financial institutions providing wealth management services must meet appropriate standards of conduct. Moreover, whilst trust companies had previously been regulated by the Accounting and Corporate Regulatory Authority (ACRA), responsibility for regulating trust companies was transferred to MAS under the new statute. This streamlining of the supervisory responsibilities for trust companies ensured that the same regulator supervised the complementary activities of trust services, private banking and wealth management.93 92  Cap. 336, 2006 rev. ed. 93  See Singapore Parliament Reports (Hansard) 18 February 2005, columns 636–640.

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Further legislative developments which were positive for the wealth management industry included the abolition of estate duty for deaths which occurred after 15 February 2008.94 The Government decided to do this to “send a clear signal of encouragement for individuals to take risks, invest and grow their wealth in Singapore.”95 6

Response to Global Financial Crisis96

It was inevitable that the very open Singapore economy would be affected by the global financial crisis of 2007–2009. Manufacturing and exports went down and the Singapore economy contracted. Consumer and investor confidence shrank, and macroeconomic measures had to be taken to shore up the economy. The Government introduced a SGD 20.5 billion resilience package during the 2009 Budget to stimulate the economy by, for instance, implementing a Jobs Credit Scheme that paid companies to retain their workers, and encouraging bank lending by a risk-sharing initiative.97 MAS eased its monetary policy stance from a modest and gradual appreciation of the SGD NEER (nominal effective exchange rate) band to a zero per cent appreciation in October 2008.98 The Singapore economy rebounded quickly and grew by 14.7% in 2010.99 From the financial services point of view, it was fortunate that Singapore’s financial system emerged relatively unscathed from the crisis. To begin with, Singapore banks, in common with their Asian counterparts, did not have much exposure to the collateralised debt obligations that were at the root of the crisis. Further, because of the strict solvency and liquidity requirements imposed by MAS on banks, Singapore banks had to meet stringent capital requirements that were above the global norms. For example, the Banking Act in Singapore mandated a capital ratio of 12%100 whereas Basel II only required 8%. Although Singapore banks were not in any danger of being unable to meet their obligations, MAS acted pre-emptively to ensure the stability of the banking system and retain high confidence in the domestic banking system by announcing a guarantee of all Singapore dollar and foreign currency deposits 94  Estate Duty (Abolition) Act 2008, no. 13 of 2008. 95  Singapore Parliament Reports (Hansard) 25 August 2008, column 3028. 96  See generally Tjio (2013); Booysen (2015). 97  Das (2010), pp. 75–77. 98  MAS, Annual Report 2008/2009, p. 17. 99  bbc.com (2015). 100  S. 10, Cap. 19, 2008 rev. ed.

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of individuals and non-bank customers with banks, financial companies and merchant banks licensed to operate in Singapore.101 This enabled Singapore to remain competitive with other jurisdictions such as Australia, Hong Kong and Malaysia that had introduced deposit insurance,102 so that depositors in Singapore would have no reason to move their funds elsewhere. As expected, this guarantee expired on 31 Dec 2010 without being drawn. The main casualties of the crisis in Singapore were the almost 10,000 retail investors who had lost money in Lehman Brothers-linked structured products following its collapse. Many investors demanded their money back, claiming that they had been mis-sold the notes by financial institutions and did not understand the risks involved. MAS facilitated the complaints process by establishing a two-channel process which enabled investors to approach the financial institutions that sold them the products and if they were dissatisfied with the result, to take their complaints to the Financial Industry Dispute Resolution Centre (FIDReC), a forum which provides an affordable avenue for consumers to bring their disputes against financial institutions. To ensure that financial institutions took the complaints seriously, MAS directed that the complaints process should be overseen by the CEO of the institution. MAS also used moral suasion, warning the banks not to take too legalistic an approach towards resolving the disputes.103 Eventually, 58% of complainants were offered full or partial refunds from the financial institutions that sold them the products,104 and more than 4,000 complaints were resolved through FIDReC.105 After investigating the mis-selling claims, MAS found that some financial institutions had not complied with MAS’s notices and guidelines when they marketed Lehman-related products.106 In July 2009, MAS banned 10 financial institutions from selling structured notes for various periods ranging from six months to two years.107 Regulatory changes were also made in the form 101  See MAS, Annual Report 2008/2009, p. 27. 102  See MAS, “Ministerial Statement by Mr Lim Hng Kiang Minister for Trade & Industry and Deputy Chairman, MAS on Government Guarantee on Deposits,” 20 October 2008, see mas.gov.sg (2015i). For the regular deposit insurance scheme in Singapore see Booysen (2013). 103  For details of MAS’s facilitation of the claims process, see MAS, “Opening Remarks by HengSweeKeat, Managing Director, MAS, at the MAS Press Conference on the Sale of Structured Products to Retail Investors,” 17 October 2008, see mas.gov.sg (2015j). 104  Chan (2009). 105  Leong (2011). 106  See MAS, “Investigation Report on the Sale and Marketing of Structured Notes Linked to Lehman Brothers,” 7 July 2009, see mas.gov.sg (2015k). 107  See, e.g., Burton (2009).

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of changes to the Consumer Protection (Fair Trading) Act,108 the Securities and Futures Act,109 the Financial Advisers Regulations110 and MAS notices111 to strengthen the sale and advisory process for investment products. MAS’s response to the crisis illustrates aspects of its modus operandi as financial regulator, ranging from its precautionary high standards, shrewd action to counter competition from other jurisdictions, firmness in requiring financial institutions to do the right thing, strict prosecution of offenders and making amendments to the law where required. 7 Conclusion Although Singapore is not a natural financial centre, the Singapore Government has created the right conditions to enable Singapore to flourish and develop into one of the leading financial centres of the world over a period of 50 years. This has been done through a careful planning process that has led to rapid economic development in the country generally, which in turn has created favourable conditions for the continued growth of the financial industry. Attaining and maintaining this success is a continuing journey of hard work. In the Singapore context, survival is the strongest motivation. References abs.org (2015) http://www.abs.org.sg/aboutus_membership.php (accessed 1 July 2015). bbc.com (2015) http://www.bbc.com/news/business-12106645 (accessed 1 June 2015). Beaty, Jonathan and S. C. Gwynne (1991) “BCCI: The Dirtiest Bank of All,” Time, 29 July 1991. bis.org (2015a) http://www.bis.org/publ/rpfx13.htm (accessed 1 June 2015). 108  Cap. 52A, 2009 rev.ed. This statute has been amended to remove the previous exclusion of financial services from its ambit, see Act 15 of 2008. See also the new Consumer Protection (Fair Trading) (Regulated Financial Services and Products) Regulations 2009, No. S. 64. 109  See, e.g., new provisions s. 240AA; s. 265A; s. 268A; s. 296A; s. 309B; and s. 309C introduced by the Securities and Futures (Amendment) Act 2012, no.34 of 2012. These provisions are not yet in force at the time of writing. 110  See Rg. 2 G.N, No S. 462/2002, new regulation 18B; see also Low (2012). 111  See MAS, “Guidelines on Fair Dealing—Board and Senior Management Responsibilities for Delivering Fair Dealing Outcomes to Customers” (revised version 20 February 2013), and MAS Guidelines No. SFA 13-G10, “Guidelines on the Product Highlights Sheet” (21 October 2010).

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——— (2015b) http://www.bis.org/publ/rpfx13ir.pdf (accessed 1 June 2015). ——— (2015) “Financial Crises and the Changing Relationship Between Banks and Their Customers in Singapore,” F. Weiss & A. Kammel, eds., The Changing Landscape of Global Financial Governance and the Role of Soft Law, Leiden: Brill/ Nijhoff, 282–311. Booysen, Sandra Annette (2013) “Deposit Insurance in Singapore: Why Have It, Who Gets It, How Does It Work?” Singapore Journal of Legal Studies 76–99. Bowers, Simon (2012) “Files Close on BCCI Banking Scandal,” The Guardian, 17 May. Burton, John (2009) “Singapore in ‘Mis-selling’ Ban,” Financial Times, 7 July. Chan, Francis (2009) “Lehman fiasco: 2,974 Get Some Money,” Straits Times, 17 January. Das, Sanchita Basu (2010) Road to Recovery—Singapore’s Journey through the Global Crisis, Singapore: ISEAS Publishing. deloitte.com (2015) http://www2.deloitte.com/sg/en/pages/financial-services/articles/ deloitte-global-wealth-management-centre-ranking-2015.html (accessed 1 June 2015). fas.org (2015) http://fas.org/irp/congress/1992_rpt/bcci/04crime.htm (accessed 1 June 2015). gov.uk (2015) https://www.gov.uk/government/publications/report-into-the-collapseof-barings-bank (accessed 1 June 2015). Henley, Jon (2007) “Show us the Money,” The Guardian, 19 September. Lee, Chuan Teck (2006) “Developing Singapore’s Corporate Bond Market” Presented at Developing Corporate Bond Markets in Asia—Proceedings of a BIS/PBC, Kunming, China, 17–18 November 2005, BIS Papers No. 26, 1 February 2006, http://papers.ssrn .com/sol3/papers.cfm?abstract_id=1188782 (accessed 1 June 2015). Lee, Kuan Yew (2000) From Third World to First: The Singapore Story 1965–2000: Memoirs of Lee Kuan Yew, Singapore: Singapore Press Holdings: Times Editions. Lee, Sheng Yi (1990) The Monetary and Banking Development of Singapore and Malaysia, Singapore: Singapore University Press. Leong, Grace (2011) “Most Lehman-linked Disputes Settled or Nearly Resolved,” Business Times Singapore, 30 November. Lohr, Steve (1991) “World-Class Fraud: How B.C.C.I. Pulled It Off—A Special Report: At the End of a Twisted Trail, Piggy Bank for a Favored Few,” New York Times, 12 August. longfinance.net (2015), “GFCI 17 (2015),” http://www.longfinance.net/images/ GFCI17_23March2015.pdf (accessed 1 June 2015). Low, Ignatius et al. (2012) Sustaining Stability: Serving Singapore, Singapore: Straits Times Press. Low, Kee Yang (2012) “Product Suitability, Due Diligence and Managing Responsibility: The New Regime of Regulation 18B of the Financial Adviser’s Regulations.” Singapore Academy Law Journal 298–313.

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Mahbubani, Kishore (2015) Can Singapore Survive?, Singapore: Straits Times Press. mas.gov.sg (2015a) http://www.mas.gov.sg/news-and-publications/surveys/debt-mar ket.aspx (accessed 1 June 2015). ——— (2015b) http://www.mas.gov.sg/news-and-publications/speeches-and-mone tary-policy-statements/speeches/1998/fund-management-in-singapore-new-direc tions--26-feb-1998.aspx (accessed 1 June 2015). ——— (2015c) http://www.mas.gov.sg/news-and-publications/surveys/asset-wealthmanagement.aspx (accessed 1 June 2015). ——— (2015d) http://www.mas.gov.sg/news-and-publications/speeches-and-mon etary-policy-statements/speeches/2013/singapore-as-a-global-insurance-market place.aspx (accessed 1 June 2015). ——— (2015e) http://www.mas.gov.sg/Statistics/RMB-Statistics.aspx (accessed 1 August 2015). ——— (2015f) http://www.mas.gov.sg/news-and-publications/speeches-and-monetarypolicy-statements/speeches/1998/making-singapore-asia-s-premier-bankingcentre--08-jun-1998.aspx (accessed 1 June 2015). ——— (2015g) http://www.mas.gov.sg/News-and-Publications/Consultation-Paper .aspx (accessed 1 June 2015). ——— (2015h) http://www.mas.gov.sg/Regulations-and-Financial-Stability/Regulatoryand-Supervisory-Framework/Regulatory-Instruments-Issued-by-MAS.aspx (accessed 1 June 2015). ——— (2015i) http://www.mas.gov.sg/News-and-Publications/Speeches-and-MonetaryPolicy-Statements/Speeches/2008/Ministerial-Statement-by-Mr-Lim-Hng-KiangMinister-for-Trade-and-Industry-and-Deputy-Chairman-Monetary-Authority-ofSingapore-on-Government-Guarantee-on-Deposits.aspx (accessed 1 June 2015). ——— (2015j) http://www.mas.gov.sg/news-and-publications/speeches-and-monetary-policy-statements/speeches/2008/opening-remarks-by-heng-swee-keat-managing-director-mas-at-the-mas-press-conference-on-the-sale-of-structured-products-to-retail-investors.aspx (accessed 1 June 2015). ——— (2015k) http://www.mas.gov.sg/news-and-publications/enforcement-actions/ 2009/7-july-2009.aspx (accessed 1 June 2015). masnetsvc.mas.gov.sg (2015) https://masnetsvc.mas.gov.sg/FID.html (accessed 1 June 2015). moneysense.gov.sg (2015) http://www.moneysense.gov.sg/ (accessed 1 June 2015). mti.gov.sg (2015) https://www.mti.gov.sg/ResearchRoom/Pages/ERC%20Reports.aspx#4 (accessed 1 June 2015). mycpf.cpf.gov.sg (2015) https://mycpf.cpf.gov.sg/Members/Schemes/schemes/optimisingmy-cpf/cpf-investment-schemes (accessed 1 June 2015). pmo.gov.sg (2015) http://www.pmo.gov.sg/mediacentre/transcript-prime-minister-leehsien-loong-may-day-rally-speech-1-may-2015 (accessed 1 June 2015).

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sgs.gov.sg (2015a) http://www.sgs.gov.sg/The-SGS-Market.aspx (accessed 1 June 2015). ——— (2015b) http://www.sgs.gov.sg/Stats-Outstanding-SGS.aspx (accessed 1 June 2015). sgx.com (2015) http://www.sgx.com/wps/portal/sgxweb/home/about_us/overview/ !ut/p/a1/04_Sj9CPykssy0xPLMnMz0vMAfGjzOKNHB1NPAycDSz9TXwtDBwNHL3 MPUL9DI2MzYAKIoEKDHAARwNC-sP1o1CVuIe4GIKUBBv4h3gZGlgYoivwDzMw N_AM9XcKDg4LMwx0NYYqwOOGgtwIg0xPR0UAXlYW5g!!/dl5/d5/L2dBISEv Z0FBIS9nQSEh/ (accessed 1 June 2015). singapore.icbc.com (2015) http://singapore.icbc.com.cn/icbc/%E6%B5%B7%E5%A4 %96%E5%88%86%E8%A1%8C/%E6%96%B0%E5%8A%A0%E5%9D%A1% E7%BD%91%E7%AB%99/en/customerservice/announcement/ICBCSingapore CompletesFirstOnshoreRMBRepoTransaction.htm (accessed 1 August 2015). singstat.gov.sg (2015) http://www.singstat.gov.sg/statistics/latest-data#14 (accessed 1 June 2015). Stevenson, Richard W. (1995) “The Collapse of Barings: The Overview,” New York Times, 28 February. Tan, Chwee Huat (2005) Financial Markets and Institutions in Singapore, Singapore: Singapore University Press. ——— (2011) Financial Services and Wealth Management in Singapore, Singapore: Ridge Books. Tan, How Teck & Jimmy Oei (2015) CCH Singapore Master Tax Guide 2015/2016, Singapore: Wolters Kluwer. Tan, Swee Liang & Tan Gilbert Yip Wei (2006) “Financial Sector Liberalization and its Challenges to the Local Banks: The Experience of Singapore.” 1 Banks and Bank Systems 49–51. Tjio, Hans (2013) “Challenges to Singapore from the Global Financial Crisis: Actual and Suggested Legal and Regulatory Responses.” Singapore Journal of Legal Studies 168–191. Whitby, David & Alan A. Block (2001) The Organized Criminal Activities of the Bank of Credit and Commerce International: Essays and Documentation: In memoriam David Whitby, Dordrecht; Boston: Kluwer Academic Publishers. World Bank (2015) http://data.worldbank.org/indicator/NY.GDP.PCAP.CD (accessed 1 June 2015). World Economic Forum (2015), “The Global Competitiveness Report 2014–2015,” http:// reports.weforum.org/global-competitiveness-report-2014-2015/rankings/ (accessed 1 June 2015). Yahya, Yasmine (2015) “ICBC Singapore Clears 40 trillion Yuan since Becoming Sole Clearing Bank in 2013,” Straits Times, 6 January.

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Chapter 3

Hong Kong: Evolution and Future as a Leading International Financial Centre Douglas W. Arner Abstract By the beginning of the 21st century, Hong Kong had emerged as one of the world’s leading international financial centres, along with London, New York and Singapore. Its emergence as a major international financial centre is however relatively recent, dating only to the late 1980s. This chapter first considers Hong Kong’s evolution as an international financial centre from the 1800s to the global financial crisis of 2008. It then discusses Hong Kong’s regulatory system and structure before turning to changes to that regulatory system as a result of the global financial crisis. The chapter concludes with a discussion of current and future challenges for Hong Kong’s continuing role as a major international financial centre.

Keywords regulatory reform – securities industry – insurance industry – financial market – stock exchange – financial crisis

1 Evolution Hong Kong has undergone four stages of financial regulatory development that here are described as early, emerging and developed. Regulatory reforms of Hong Kong’s financial markets have typically been implemented after financial crises resulting from market failure. In fact, financial regulation in *  Professor, Co-Director, Asia America Institute in Transnational Law, and Member, Board of Management, Asian Institute of International Financial Law, Faculty of Law, University of Hong Kong. Contact: [email protected]. The author gratefully acknowledges the financial support of the Hong Kong Research Grants Council Theme-based Research Scheme (Enhancing Hong Kong’s Future as a Leading International Financial Centre).

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Hong Kong prior to the 1990s developed almost entirely as a result of posthoc responses to serious financial crises. Indeed, prior to the mid-1980s, Hong Kong had no public financial law; rather, cartels of financial sector corporations largely regulated themselves, mainly avoiding official interest and functioning as an informal club.1 According to one leading scholar, “[t]he banking crisis of 1982–1986 and the near bankruptcy of the futures market during the world stock market crash of October 1987, forced the authorities to undertake a far-ranging reform of the regulatory framework”.2 While Hong Kong has not always had effective systems of financial regulation, it has been steadily strengthening its regulatory framework both for financial markets and institutions, particularly since the late 1980s.3 The increasing effectiveness of its legal and institutional regulatory framework has enhanced its development as an international financial centre over the past two decades and will be vital to its continued success in the future. 1.1 Early Development (1840–1949) The stage of early development is the period up to the establishment of the People’s Republic of China in 1949. Throughout its history, the Pearl River Delta region of Southern China has always been involved in international trade, beginning with Canton, then centred on Macau, with Hong Kong emerging as the major centre of international trade from its establishment as a British colony in the early 1840s. Because international trade and finance are always interlinked, Hong Kong since its establishment has been an international financial centre. In its early years, it served as a centre for British banking institutions such as the Standard and Chartered Banks (established in Hong Kong in 1859 and 1862 respectively and continuing to operate in Hong Kong today as Standard Chartered Bank, which remains headquartered in London). Given travel times between London and Hong Kong, this situation posed increasing challenges to financing and payments in the context of trade between China and the rest of world via Hong Kong. As a result, in 1865, the Hong Kong and Shanghai Banking Corporation Limited (now HSBC) was established in Hong Kong and Shanghai to provide local financing to support international trade through Hong Kong and Shanghai. This was followed by the establishment of the first Hong Kong Stock Exchange in 1891 (now Hong Kong Exchanges and Clearing Limited (HKEx).

1  For a description of a similar system in the UK prior to 1979, see Hadjiemmanuil (1996). 2  Jao (1997), p. 26. 3  See generally Tokley (1996); Ho et al. (1991); Ghose (1987).

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During this period, common to other centres of international finance and trade, there was virtually no regulatory supervision of the financial markets.4 There were no statutory requirements regulating the listing of securities beyond general prospectus requirements for companies and limited provisions under other statutes. The securities industry was loosely regulated under the relevant provisions of the Companies Ordinance5 and the Stamp Duty Ordinance.6 Anyone could operate a financial market or institution. By the end of the 19th century, Hong Kong operated on the basis of English common law and statutory systems supporting international trade and finance. At the same time, by the end of the 19th century, Hong Kong had ceded its position as the premier financial and trading centre in China to Shanghai, a situation which would continue until 1948. 1.2 Emerging Market (1949–1987) From the establishment of the PRC in 1949, financial and trading activities shifted from Shanghai to Hong Kong. Likewise, the period from the end of the Second World War to the 1970s marked a period of rapid industrial, financial and economic development in Hong Kong. Capital and industrial expertise from Shanghai in particular combined with large volumes of Mainland immigration put in place the elements necessary for Hong Kong to develop as a major industrial centre for global exports. This combined with the need to build large volumes of housing to support the massive increase in population as well as development of transport and logistics infrastructure drove increased demands for financing, provided both by the influx of capital from the Mainland as well as domestic savings produced by workers out of necessity in Hong Kong’s highly capitalist environment. These factors led to growth in banking and securities in particular. In 1969 the Far East Stock Exchange was established to suit the interests of small companies. Several other stock exchanges were established in the early 1970s and several collapsed during the market crash in 1973, when the Hang Seng Index lost over 90 per cent of its value. The only commodities trading in Hong Kong from 1910 to 1977 was at the Chinese Gold and Silver Exchange Society, a self-regulated organization.7 At the same time, these markets remained largely unregulated, with the Hong Kong Bank acting as the territory’s de facto central bank and lender of 4  Rider & French (1979), pp. 329–31. 5  Cap. 32. 6  Cap. 117. 7  Report of the Securities Review Committee (Hong Kong: Securities Review Committee, May 1988), p. 399.

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last resort. Most investors were uninformed and unsophisticated individuals, and securities prices were highly volatile. According to the then Commissioner of Banking in 1973, “[t]here was very little real investing going on in Hong Kong; it was sheer gambling”.8 The problems were aggravated by a lack of expertise in this area.9 During this period, some interested parties even argued that regulatory control of the financial markets was unnecessary.10 They suggested that since there were few public companies, capital did not have to move through the financial markets.11 This situation gradually changed as a result of a series of financial crises, in particular in 1965, 1973 and 1987. Hong Kong’s first Banking Ordinance was enacted in 1948 and amended in 1964 and 1986 paralleling British developments. In April 1962 the Companies Law Revision Committee was commissioned, and published its first report in June 1971. However, few of its recommendations were enacted into law.12 In 1972 the Companies (Amendment) Ordinance was enacted to govern company prospectuses. It was the first legislative attempt in Hong Kong to provide a more solid foundation for the financial markets. The Stock Exchange Control Ordinance of 1973 restricted the number of stock exchanges to four, Hong Kong Stock Exchange (1891), Far East Stock Exchange (1969), KamNgan Stock Exchange (1971), and Kowloon Stock Exchange (1973). In the same year, the Commodity Exchange (Prohibition) Ordinance was also enacted, restricting the establishment and operation of commodities exchanges.13 However, regulatory control was still far from adequate. Withholding relevant information, misrepresentation, forgery, and fraud were prevalent in the financial markets. There was no regulatory control over investment advisers and dealers save for the ineffective anti-fraud and anti-theft provisions of the criminal law statutes.14 As a result of the financial market crash in 1973, thousands of people lost their life savings. The government then began to enact piecemeal legislation regulating the financial markets. In 1974 the Securities Ordinance15 was enacted establishing a watchdog body for financial markets, the Securities Commission, and providing a regulatory framework for the operation of the 8  Hartley (1973), p. 34. 9  Ujejski (1989), p. 283. 10  Higgins (1978), pp. 1–16. 11  Ibid., p. 3. 12  Ibid., p. 31. 13  Report of the Securities Review Committee, supra note 7, p. 429. 14  Ujejski, supra note 9, pp. 285–8. 15  Cap. 333.

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stock exchanges. The Securities Commission was vested with investigative powers. The ordinance classified market professionals as dealers, investment advisers, or representatives and required them to register with the Securities Commission. The ordinance also established a Stock Exchange Compensation Fund to partially compensate clients of defaulting securities firms. At the same time, the Protection of Investors Ordinance16 was enacted. This ordinance intended to protect investors by ensuring that accurate information was provided to them. It prohibited fraudulent and reckless advertisements. In 1976 the Commodities Trading Ordinance was enacted making provisions for establishing a commodities exchange and controlling trading in commodities futures contracts. This ordinance also established a Commodities Trading Commission with functions similar to those of the Securities Commission.17 This series of ordinances did provide some form of regulatory framework for the financial markets. At the same time, critics argued that an effective regulatory framework could not arise from these ordinances due to the general philosophy of non-intervention by the government and the lack of resources.18 In the 1970s and 1980s all financial markets underwent rapid growth but the regulatory framework of the financial markets in Hong Kong remained static. A number of new financial products were introduced into the financial markets, with increasing sophistication. As a result, the regulatory framework had to catch up with international trends. The four private stock exchanges continued to operate under their own listing rules and procedures. In consolidating their management and control, the Stock Exchanges Unification Ordinance19 was enacted in 1980. This ordinance provided a mechanism to merge the four stock exchanges into the Stock Exchange of Hong Kong Limited (SEHK), with the principals and traders of the constituent stock exchanges maintaining their rights to trade in the new exchange. The merger was completed in 1986. Under this ordinance, the trading activities of the SEHK were regulated by the Commissioner of Securities. The currency board was established in 1983 to help restore confidence after foreign exchange and banking crises. In October 1987 there was a worldwide stock markets crash and Hong Kong was not immune. Immediately after the crash, the SEHK was shut down for four working days. Many individual investors lost their life savings as they had to meet payments for margin calls and settle previous purchases but could not realize the value of their shares. In the meantime, large investors 16  17  18  19 

Cap. 335. Report of the Securities Review Committee, supra note 7, pp. 429–30. Ujejski, supra note 9, pp. 292–4. Cap. 361.

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continued to trade over-the-counter (OTC) or on a private basis. After the stock exchange resumed business, the Hang Seng Index fell to 2,242 points from its then all-time high of 3,950 points.20 The Hong Kong government had no legal authority to take any action during this crisis. According to the Financial Secretary at that time: The question of government approval does not arise since the exchange has the power to take such action under its own rules. The Government was, however, informed in advance of the proposed action, which it regards as a sensible response to the situation [. . .] The exchange considers that it will take four days to clear the backlog [. . .] I think it is preferable for self-regulatory bodies such as the exchange to make use of their own powers where these are available instead of resorting to government intervention. This is in line with our general philosophy towards the financial markets in Hong Kong.21 In a short time, this closure adversely affected Hong Kong’s international reputation and eroded confidence in its already fragile financial market.22 On a positive note, the 1987 crash prompted the government to reform the financial markets in line with international standards. In November 1987 the Securities Review Committee was formed and its conclusions are the source of the modern financial regulatory framework in Hong Kong. In 1989 the Securities and Futures Commission Ordinance23 was enacted in accordance to the Review Committee’s recommendations of creating a new and more effective regulatory agency to supervise the financial industry. The Securities and Futures Commission (SFC) was thus created with new powers of supervision, intervention, investigation, prosecution, and even adjudication.24 1.3 Developed Markets (1987 to 2008) Similar to other jurisdictions, the regulatory framework of finance in Hong Kong is a product of various attempts by regulators to address the deficiencies of the financial markets learned from each financial crisis, after compromising with market participants. The SFC (formerly a government department) was 20  Report of the Securities Review Committee, supra note 7, p. 352. 21  Proceedings of the Council (Hong Kong: Hong Kong Legislative Council (21 October 1987)), p. 138. 22  Report of the Securities Review Committee, supra note 7, 27n. 23  Cap. 24. 24  Ujejski, supra note 9, pp. 299–300.

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established in 1989 as a result of the market crash of 1987. The HKMA (formerly two government departments) was created in 1993 following the collapse of the Bank of Credit and Commerce International (BCCI). The demutualization and merger of the stock and futures exchange took place after the Asian financial crisis of 1997. The Securities and Futures Ordinance was belatedly and reluctantly enacted in 2002 after this crisis as a result of the review following the 1987 market crash and also in response to the events of 1997–98. Prior to the enactment of the composite Securities and Futures Ordinance,25 the securities regulatory framework was scattered across some twelve ordinances, including the Companies Ordinance.26 In 1991 the Securities (Insider Dealing) Ordinance27 was enacted replacing the relevant provisions in the Securities Ordinance of 1974 with more detailed and comprehensive provisions. The Securities (Disclosure of Interests) Ordinance28 was enacted in the same year imposing mandatory disclosure on those who acquire more than 10 per cent of a company’s shares. This was a new approach in preventing fraud and improper practices in the financial markets. In 1992 the Securities and Futures (Clearing Houses) Ordinance was enacted, which empowered the SFC to declare which clearing houses were to be recognized and make rules and procedures for their operation. However, the SFC did not normally intervene in the management and governance of the Stock Exchange of Hong Kong or the Hong Kong Futures Exchange. As a result of the 1987 crash, these exchanges voluntarily made significant reforms in their settlement, risk management, and trading systems.29 As a result of the recommendation by the Securities Review Committee, in April 1996, the SFC published A Consultation Paper on a draft for a composite Securities and Futures Bill which proposed consolidating and rationalizing eight of these ordinances, as well as updating certain other provisions.30 The objective was to provide a modern, simplified, and user-friendly ordinance. As expected, the Securities and Futures Bill met resistance from the financial sector and listed companies31 but finally was enacted in March 2002.

25  26  27  28  29 

Cap. 571. Cap. 32. Cap. 395. Cap. 396. The Securities and Futures Commission (Hong Kong: Securities and Futures Commission, 1986), p 15. 30  Hong Kong: Securities and Futures Commission, 1996. 31  Yiu (2000a); Yiu (2000b).

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The period from 1986 has been one of strengthening of regulation and supervision of financial institutions and markets, with the overriding goal of achieving ‘international standards’. Further, the period from 1986 to 1995 was a time of modernization and a search for standards of best practice, not only in Hong Kong but globally. Following the financial crises of the 1990s associated with Mexico, East Asia, Russia, Argentina, and elsewhere attention focused on the importance of developing such standards and upon their implementation into domestic legal systems and supervisory practice.32 This is an ongoing process that is likely to shape the development of public financial law in both Hong Kong and throughout China. A sound regulatory framework is vital for long-term stability. Hong Kong’s prosperity depends on its success as a centre for trade and finance. The question is what system should Hong Kong adopt and to what extent should the financial markets be regulated? As in other common law jurisdictions, Hong Kong has developed a number of regulatory agencies, each with its own specific jurisdiction, to enforce specific financial regulations. These are discussed in the following section. 2

Legal and Regulatory System

At the base of financial markets are Hong Kong’s economic, governance, legal, and taxation systems. Hong Kong’s legal and institutional framework is an interesting case: under British rule, it developed as a laissez-faire capitalist system based on English common law and imported British statutes, with a largely administrative government with few democratic features reporting to the colonial government in London. Since the 1997 reversion of sovereignty to the PRC, Hong Kong has continued to operate a capitalist system based upon common law and existing statutes but in the context of the socialist market economy and civil law legal system of the PRC, still with a largely administrative government now reporting to the central government in Beijing, though with some democratic features. As such, it is perhaps unique in terms of its economic, governmental, and legal foundations. Historically, Hong Kong has been known for its laissez-faire system of capitalism; however, this has never been a completely accurate picture. While Hong Kong has lacked the sort of linked financial and governmental systems of other Asian economies (e.g. South Korea, Japan, and Singapore), there has historically been a close working relationship between leading 32  See Arner (2007a).

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businesses and the government, with business typically assuming selfregulatory responsibility, largely as a result of government dependence on a property-based revenue system. This has changed over the past two decades with the relationship between government, business, and the financial system becoming increasingly rule-based and transparent though with continuing influence by dominant economic elites, coinciding interestingly with Hong Kong’s rise as a major international financial centre. Following the reversion of Hong Kong to the PRC, Hong Kong remains largely legally and administratively separate under the principle of ‘one country, two systems’. As a corollary in respect to financial systems, there exist ‘two markets, two monetary systems and two responsible monetary authorities’, one for the Mainland and one for Hong Kong. This suggests that the financial systems of the two will remain administratively separate, while becoming increasingly interlinked. 2.1 Basic Law and Common Law From 1 July 1997 Hong Kong became a Special Administrative Region (SAR) of the PRC enjoying a high degree of autonomy. The Basic Law, enacted by the PRC National People’s Congress, is the constitutional document of post-colonial Hong Kong and the blueprint for its future development. Specific provisions have been laid down in the Basic Law on the changes brought about by its new status and on the implementation of the concept of ‘one country, two systems’. The Basic Law is thus a PRC law establishing the framework for the SAR of Hong Kong. The Basic Law grants Hong Kong a high degree of autonomy and executive, legislative and independent judicial powers and guarantees the existence of its current political, economic and financial system until at least 2047. English statutes and judicial decisions are the primary source of existing Hong Kong law prior to the 1997 handover. The pre-existing legal framework continues under the Basic Law. As a former British colony governed by common law, judicial precedent has served to develop most aspects of financial law. English judicial decisions are no longer binding, but carry persuasive weight, as do decisions from other common law jurisdictions. Because of the importance of the Hong Kong economy to both Hong Kong and the Mainland, 70 of the Basic Law’s 160 Articles are related to economic matters.33 For instance, Articles 109, 112, 114, and 116 determine that Hong Kong remains a free port, a separate customs territory and an international 33  HKMA, Hong Kong—Pacific Powerhouse (Hong Kong—The Next Century by Donald Tsang (former Financial Secretary)), p. 13.

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financial centre, with its markets for foreign exchange, gold, and securities and futures remaining in place. According to Article 115, Hong Kong shall pursue a policy of free trade and safeguard the free movement of goods, intangible assets and capital. Hong Kong shall also have independent finances and use its financial revenues exclusively for its own purposes.34 Under Article 105, rights of individuals and legal persons to the acquisition, use, and inheritance of property remain protected in Hong Kong. The Basic Law ensures the continuation of the financial markets in Hong Kong by providing, inter alia, that the markets for foreign exchange, gold, securities, futures, and the like shall continue in Hong Kong. In ensuring that the SAR remains a centre of trade, commerce, and finance, it also provides that there will be free flow of capital within, into, and out of Hong Kong.35 Exchange control policies shall not be applied in Hong Kong. The Basic Law provides that Hong Kong shall manage and control its own exchange fund and that it shall pursue a policy of free trade and safeguard the free movement of goods, intangible assets and capital.36 Most significantly for present purposes, Article 109 requires the Hong Kong government to maintain the legal and economic foundations for Hong Kong’s continuation as a major international financial centre. 2.2 Financial Regulatory Structure Like other financial centres, Hong Kong’s financial regulatory system has developed gradually and, with some exceptions, largely in response to a range of financial crises, in particular major international financial crises of 1973, 1987, 1997 and 2008. Whilst it is strong in individual sectors, gaps and overlaps remain a factor in Hong Kong’s regulatory system, as shown in clear relief by the fallout from the current global financial crisis. Hong Kong’s financial regulatory framework, in general, is sectoral, operating through a ‘three-tier system’. Under the first tier, the Financial Secretary is responsible for overall policy and the Financial Services and the Treasury Bureau (FSTB) is responsible for translating policies into regulation. Under the second tier, specialist regulatory agencies are in turn responsible for the regulation and supervision of financial services activities. Under the third tier, self-regulatory organizations are responsible for oversight of the activities of their members, albeit under the supervision of the relevant specialist regulatory agency and (increasingly) pursuant to legislation.

34  Basic Law, art. 106. 35  Basic Law, art. 112. 36  Basic Law, arts. 113 & 115.

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Hong Kong’s sectoral regulatory structure for its financial system, which has developed largely in response to individual crises and specific objectives is based on separate supervisory bodies for each of the three major financial sectors, instead of there being one super regulatory body for the entire industry, as is the case in Singapore with the Monetary Authority of Singapore (MAS). Today, financial services are principally regulated by the HKMA (banks and banking), the Securities and Futures Commission (SFC) (securities and futures institutions and markets), the Office of the Commissioner of Insurance (OCI) (insurance business), and the Mandatory Provident Fund Schemes Authority (MPFA) (MPF and pensions schemes). Each regulatory agency operates within the framework of one or more major ordinances and each regulatory agency is autonomous (though necessarily not independent from the government) and issues its own rules and regulations, pursuant to an increasing array of rulemaking powers. This sectoral structure has one major caveat: the HKMA regulates all activities of banks, including activities involving securities, insurance, etc., though usually to standards identical to those of other sectoral regulators. At the same time, the SFC and HKMA have adopted a lead regulator approach to the supervision of financial groups which include both banking and securities activities, with the arrangements set out in a memorandum of understanding between the two. In addition, a Cross-Market Surveillance Committee, comprised of representatives of the FSTB, HKMA, SFC, and HKEx (and now including the OCI and MPFA as well) was established in October 1998 to exchange market information and to formulate prompt and appropriate actions where necessary, as well as facilitate supervision of financial groups. 2.2.1 Hong Kong Government The Government is not involved in the day-to-day regulation of the financial system. Under Articles 106–113 of the Basic Law, it is responsible for a range of aspects of public finance and monetary and financial affairs. The Financial Secretary is responsible for the monetary system, Exchange Fund, public finance, financial system and status of Hong Kong as an international financial centre.37 The FSTB implements the policies set by the Financial Secretary in relation to public finance, the financial system, and Hong Kong’s status as an international financial centre, including ensuring that Hong Kong’s regulatory regime is up-to-date and meets the needs of investors. To advise on related 37  HKSAR Chief Executive, Responsibilities of the Financial Secretary and the Secretary for Financial Services and the Treasury (27 June 2003); Financial Secretary, Policy Objectives in Financial Affairs and Public Finance (27 June 2003).

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issues, the Chief Executive established the Financial Services Development Council in 2013. 2.2.2 Hong Kong Monetary Authority The HKMA performs the functions of both central bank and regulator. In Hong Kong, the legal framework for banking is based on the Banking Ordinance (Cap. 155) and the Exchange Fund Ordinance (Cap. 66) supplemented by the Clearing and Settlements Systems Ordinance (Cap. 584), Companies Ordinance (Cap. 622), Bills of Exchange Ordinance (Cap. 19) and common law. This legal framework is further complicated by the division of authority between the HKMA and the Hong Kong Association of Banks (HKAB).38 Under the Exchange Fund Ordinance, the HKMA is responsible for administering the official monetary policy in ensuring the stability of the HKD and for managing the Exchange Fund. The HKMA manages the Exchange Fund under powers delegated by the Financial Secretary in accordance with the Exchange Fund Ordinance.39 Its mandate is to ensure the safety, stability, and effectiveness of the banking system40 and to maintain the stability of Hong Kong’s currency by regulating the banking business, by supervising banking institutions, and by managing the Exchange Fund.41 The Exchange Fund forms the basis of Hong Kong’s linked exchange rate mechanism.42 The HKMA also regulates all activities of ‘Authorized Institutions’ (i.e., banks, restricted license banks and deposit-taking companies) under the framework of consolidated supervision. Under the Banking Ordinance, the HKMA is responsible for banking business, defined to include only deposit-taking and cheque-related services.43 As a result, lending business is not addressed by the Banking Ordinance but rather by the common law, the Money Lenders Ordinance (Cap. 163) and the rules of the HKAB. Under its rule making powers, most importantly, the HKAB issues the Code of Banking Practice44 with the endorsement of the HKMA. The Code establishes standards, enforceable by the HKAB, for consumer-related aspects of banking business, including terms

38  Hong Kong Association of Banks Ordinance (Cap. 364). 39  See HKSAR Chief Executive, supra note 37. 40  Banking Ordinance s. 7(1). 41  Exchange Fund Ordinance s. 3(1), 3(1A). 42  The Exchange Fund was created by the Currency Ordinance 1935, later renamed as the Exchange Fund Ordinance. 43  Banking Ordinance s. 2. 44  hkab.org.hk (2008).

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and conditions, fees, use of customer information, marketing, handling of consumer complaints and loan recovery. In addition to the HKMA and HKAB, the HKDPB is responsible for the Hong Kong Deposit Protection Scheme (DPS), both established under the Deposit Protection Schemes Ordinance in 2004, with the DPS commencing operations in 2006. Under the DPS, in which all licensed banks are required to participate, deposit insurance of up to HK$500000 (in HKD, Renminbi (RMB) or foreign currency equivalent) per depositor per member is provided with funding through member contributions. The HKMA is also responsible for implementing the lender of last resort, in accordance with policy and the Banking Ordinance, with funding sourced from the Exchange Fund. Under the 2009 policy, support will be given when a local bank failure may pose systemic risk.45 The policy provides for the deployment of a wide range of financial instruments and eligible collateral over varying time horizons. Foreign bank branches are not normally covered by the policy. Further liquidity assistance is available to banks under various scenarios to help promote the smooth operation of the interbank lending market and enhance confidence in the banking system. These additional liquidity assistance instruments are available to banks in the form of foreign exchange swaps, term repos and credit facilities.46 2.2.3

Securities and Futures Commission and Hong Kong Exchanges and Clearing Ltd As a result of the 1987 market crisis, the Securities Review Committee was commissioned to develop a plan to upgrade Hong Kong’s securities market ­infrastructure to international standards in November 1987.47 This report, known as the ‘Davison Report’, served as a blueprint for the modernisation of capital market regulation in Hong Kong throughout the late 1980s and the 1990s. One fundamental aspect of this transformation has been the establishment of Hong Kong as the preferred market for mainland Chinese enterprises to raise capital. Following the recommendations of the Davison Report, the SFC was established on 1 May 1989 under the Securities and Futures Commission Ordinance (Cap. 24) (repealed) (now consolidated into the Securities and 45  hkma.gov.hk (2015). 46  Ibid. 47  See generally Securities Review Committee, The Operation and Regulation of the Hong Kong Securities Industry: Report of the Securities Review Committee (Hong Kong Government, 1988) [Davison Report].

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Futures Ordinance (Cap. 571) (SFO)). Under the SFO, the SFC is the regulator of the securities and futures industry in Hong Kong.48 The main objectives of the SFC are to maintain and promote the fairness, efficiency, competitiveness, transparency and orderliness of the industry; promote understanding by the public of financial services including the operation and functioning of the financial services industry; provide protection to the investing public; minimise crime and misconduct in the industry; reduce systemic risks in the industry; and assist the Financial Secretary in maintaining the financial stability of Hong Kong.49 It has the statutory duties to help maintain Hong Kong’s position as a competitive international financial centre, to facilitate innovation in financial products, to avoid restrictions on competition, act in a transparent manner, and needs to make efficient use of its resources.50 In addition to the SFC, Hong Kong Exchanges and Clearing Limited (HKEx) has also been vested with limited regulatory powers under the three-tier system. Under the Securities and Futures (Transfer of Functions—Stock Exchange Company Order) (Cap. 571AE, Sub.Leg.), the SFC’s functions, under the Companies Ordinance and the SFO, of vetting prospectuses relating to listings have been transferred to the HKEx. The HKEx is thus the frontline regulator of all listed and prospective listed companies. On 10 April 2014 the SFC and the China Securities Regulatory Commission announced the Shanghai-Hong Kong Stock Connect. Under the scheme, investors can directly access the Shanghai Stock Exchange through HKEx with the benefits of a free and open market with strong risk management standards.51 The SFC remains responsible for supervising, monitoring, and regulating all the activities of HKEx.52 2.2.4

Office of the Commissioner of Insurance and Hong Kong Federation of Insurers The legal and regulatory framework for the insurance market in Hong Kong comprises the Insurance Companies Ordinance (Cap. 41), a statutory body called the OCI headed by the Commissioner of Insurance (Insurance Authority), and self-regulatory measures. These are supplemented by a large body of common law. The OCI was established in 1992 and is the regulatory authority responsible for the insurance industry in Hong Kong. The OCI is headed by the Commissioner 48  SFO s. 5(1). 49  SFO s. 4. 50  SFO s. 6. 51  hkex.com.hk (2015). 52  SFO s. 5(1)(b).

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of Insurance, who has been appointed as the Insurance Authority for administering the Insurance Companies Ordinance. The main functions of the Insurance Authority are to authorise insurers to carry on insurance business in or from Hong Kong and to regulate insurers and intermediaries to ensure the financial soundness and integrity of the insurance market.53 While the OCI is responsible for regulation of insurance companies and intermediaries, securities activities of such firms and persons generally fall within the remit of the SFC, unlike the securities activities of banks.54 The Insurance Companies Ordinance does not provide the OCI with statutory power to intervene in cases of disputes between policyholders and insurers or insurance intermediaries. The industry has a self-regulatory system responsible for dispute resolution. Under this system, the Insurance Claims Complaints Bureau (established in 1990) handles disputes involving personal claims up to HK$800000 against insurers on behalf of policy holders. In addition to the OCI, the Hong Kong Federation of Insurers (HKFI), established in 1988, plays a key self-regulatory role in respect of insurance business in Hong Kong, similar in many ways to that of the HKAB in relation to banking. Most significantly, it is responsible for the Code of Conduct for Insurers,55 initially adopted in May 1999, which provides standards of insurance conduct enforceable by the HKFI against its membership. In 2015, legislation was enacted which will eventually result in the replacement of the OCI with a new Independent Insurance Authority (IIA), largely modelled on the SFC. Regulatory responsibilities of the OCI will be taken up by the IIA under key legislative amendments to the Insurance Companies Ordinance.56 Additional regulatory responsibilities shall include inter alia a new licensing regime for insurance intermediaries. The principle function of the IIA will be to regulate and supervise the insurance industry for the promotion of general stability of the insurance industry and for the protection of existing and potential policyholders.57 Strengthening of regulatory infrastructure by the IIA would help systemic stability and sustainable growth of the insurance sector. Promoting the stability and growth of the insurance sector is viewed by 53  Insurance Companies Ordinance s. 4A. 54  See SFC & Insurance Authority, Memorandum of Understanding between Securities and Futures Commission and Insurance Authority (20 December 2005). 55  hkfi.org.hk (2015). 56  Financial Services and Treasury Bureau, Press Release: Bill to Establish Independent Insurance Authority to be Gazette on 25 April 2014 (16 April 2014). 57  Financial Services and Treasury Bureau, Legislative Council Brief: Insurance Companies (Amendment) Bill 2014, Annex C (1).

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the Government as important to the economy of Hong Kong and its status as an international financial centre.58 2.2.5 Mandatory Provident Fund Schemes Authority The Mandatory Provident Fund Schemes Authority (MPFA) is responsible for major pension funds regulation under the Mandatory Provident Fund Schemes Ordinance (Cap. 485) and the Occupational Retirement Schemes Ordinance (Cap. 426) (ORSO). The MPFA was established in September 1998 to regulate and monitor the operation of privately managed provident fund schemes as mandatory retirement savings. The main functions of the MPFA are to ensure compliance with the Ordinance; register provident fund schemes and approve qualified persons as approved trustees; regulate the affairs and activities of approved trustees; and make rules or guidelines for the administration of registered schemes.59 3

The Global Financial Crisis of 2008

As can be seen from this brief overview, for a jurisdiction of seven million people, Hong Kong has a complicated system of financial regulation. In some cases, these complexities stem from piecemeal responses to previous crises and from accommodating (1) local consumers and businesses, (2) Hong Kong’s role as an international financial centre, (3) Hong Kong’s traditional role as an international trading port and entrepôt, and (4) especially from the late 1970s, Hong Kong’s role as the gateway to and from the PRC. At the same time, even before the global financial crisis of 2008, a number of weaknesses in Hong Kong’s financial system had been identified in the context of relationships between regulators and activities of a cross-sectoral nature. 3.1 Status at the Beginning of the 21st Century In 2003, the International Monetary Fund (IMF) published its review of Hong Kong’s financial regulatory system,60 as part of the Financial Sector Assessment Program (FSAP), a joint IMF/World Bank programme directed at improving the soundness of financial systems in member countries.61 It concluded that 58  Financial Services and Treasury Bureau, Legislative Council Brief: Insurance Companies (Amendment) Bill 2014, Annex E. 59  Mandatory Provident Fund Schemes Authority Ordinance s. 6E. 60  IMF (2003). 61  For a detailed discussion, see Arner (2007b), Chapter 2.

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Hong Kong largely had an appropriate legal and regulatory framework for financial stability, though with some weaknesses, particularly in relation to accounting practices, financial conglomerates, the relationship between the SFC and HKEx and independence of regulatory agencies. The global financial crisis has brought into clearer focus certain of these issues, as well as others which were not raised by the IMF. Of these issues, the two most significant are the relationship between the HKMA and SFC in relation to the securities activities of banks, and the relationship between the SFC, HKEx and the Listing Rules. 3.1.1

Financial Conglomerates and Securities Activities of Banks: Relationship between the HKMA and SFC Although Hong Kong has a primarily sectoral regulatory framework, an important qualification to this structure concerns the activities of banks. While in the context of insurance and pensions activities, the HKMA retains primary authority, in the context of securities activities of banks the role is divided between the SFC as the lead regulator for the securities industry and the HKMA as the main supervisor of banks undertaking securities business. This anomaly has been one of the central points of focus in considering the problems surrounding the sale of Lehman Brothers Minibonds to retail investors in Hong Kong. 3.1.2 Listed Company Matters: Relationship between the SFC and HKEx As already mentioned, HKEx, via its wholly-owned subsidiary the Stock Exchange of Hong Kong (SEHK), is empowered under the SFO to make rules for, inter alia, applications for the listing of securities and the requirements to be met before securities may be listed.62 The Listing Rules have been made under such provisions and the SEHK is responsible for administering them. The Listing Rules operate on a contractual basis between the SEHK and the issuer and its related parties. They are not themselves laws and so do not have the force of law. However, the Listing Rules do enjoy a measure of statutory backing by virtue of the Securities and Futures (Stock Market Listing) Rules (SMLR) which is subsidiary legislation under the SFO made by the SFC.63 The SMLR require an applicant for listing to comply with the Listing Rules and is specifically concerned with the quality of information disclosure by listed companies and listing applicants. Under the SMLR, companies that 62  Securities and Futures Ordinance s. 23. 63  The Securities and Futures (Stock Market Listing) Rules came into effect on 1 April 2003, the same time as the Securities and Futures Ordinance.

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disseminate information to the public have to file a copy of the disclosure materials, including prospectuses and listing documents, with the SFC (the ‘dual filing’ system).64 Further, the SMLR provides that a company may simply authorise the SEHK to make the filing on its behalf. The three-tier structure relating to listing matters was the subject of an external review which led to the publication of a report in March 2003.65 Although the dual filing regime was introduced as a means to improving the effectiveness of enforcement as regards the disclosures of listed companies by providing for an increased role for the SFC as regards the quality of disclosures, the Expert Report was critical of the dual filing regime as: (1) “inherently inefficient and costly” as a result of work duplication; (2) not dealing adequately with instances of non-disclosure; (3) a complicated delineation of responsibility between the HKEx and the SFC; and (4) giving rise to the possibility of exacerbating frictions between the SFC and HKEx.66 The Report recommended these issues be addressed with two primary changes. First, HKEx should be relieved of its listing responsibilities. This should instead be taken up by a new entity which the Report calls the ‘Hong Kong Listing Authority’, which would operate as part of, or under the auspices of, the SFC. While the Report expressed the hope that this would improve communication between the SFC and the HKEx, such a consequence is obviously far from certain. Second, the Listing Rules should receive further statutory backing than at present under the SMLR in order for a stronger array of statutory sanctions to be available to deal with instances of non-compliance. However, the Report considered that the Listing Rules should retain their present non-statutory status so as to preserve flexibility, for example, to deal with market developments. A further consultation was undertaken in 2005 which proposed amendments to the SMLR.67 Under that proposal, a number of Listing Rules were to be removed to form part of the SMLR. Such matters relate to disclosure, namely, as to price sensitive information, annual and periodic reports, and notifiable and 64  See Securities and Futures (Stock Market Listing) Rules rr. 3, 5, concerning listing applications and other disclosures to the public. 65  Report by the Expert Group to Review the Operation of the Securities and Futures Market Regulatory Structure (March 2003) (Expert Report). 66  Ibid., pp. 13, 45, 55. 67  Securities and Futures Commission, “A consultation paper on proposed amendments to the Securities and Futures (Stock Market Listing) Rules” (January 2005); Financial Services and the Treasury Bureau, “Consultation paper on proposed amendments to the Securities and Futures Ordinance to give statutory backing to major listing requirements” (January 2005).

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connected transactions. While the proposal would make no substantive changes to the provisions, the effect of removing them would be that they cease to be contractual matters between the SEHK and the issuer and its related parties and would instead become statutory requirements. As such, this proposal had the potential to enhance an area of weakness in Hong Kong’s regulation of listing and public offerings of securities. The 2007 Consultation Conclusions on Proposed Amendments to the SMLRs recommended the introduction of Part IIIA to the SFO to give statutory backing to the SMLR and thereby increasing Hong Kong’s competitiveness as an international financial centre. Part IIIA was to address the aforementioned weakness by placing an obligation on listed issuers to disclose price sensitive information, disclose periodic financial reports, and oblige listed issuers to seek shareholders’ approval for certain notifiable and connected transactions. However Part IIIA in this form was never promulgated. Statutory backing for inside information—the disclosure of price sensitive information—took until 1 January 2013 to take legal effect under Part XIVA, section 307B SFO, The inability to address all of these SMLR weaknesses erodes Hong Kong’s competitiveness as an international financial centre., Furthermore, there remain strong arguments for moving the Listing Rules from the SEHK to the SFC, as has been done in the UK in 2000 through the transfer of authority in this regard from the London Stock Exchange to the then Financial Services Authority (now Financial Conduct Authority). 3.1.3 Other Issues: Review of Banking Stability In July 2008, the HKMA released an external review of its work in the area of banking stability.68 Overall, echoing the IMF’s conclusion, the Carse Report concluded: No fundamental deficiencies in the regulatory and supervisory framework have been identified. But a number of enhancements can be made which will provide an even sounder foundation to cope with the challenges ahead.69 The report was prescient in the context of the need to review deposit protection arrangements70 and regulatory structure.71 It was also certainly correct in stating that ‘priorities over the next few years will be set to a large extent by the 68  69  70  71 

Carse (2008). Ibid., pp. iv–v. Ibid., p. 51. Ibid., p. 15.

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lessons learned internationally from the sub-prime crisis’ and at the same time that ‘[t]he future agenda in Hong Kong will also be set by local considerations, including particularly the need to manage the increasing business integration with the Mainland’.72 At the same time, the Carse Report did not anticipate the scale of problems which would emerge as the global financial crisis intensified and how these would highlight a range of particular problems beyond the context of banking stability. 3.2 The Global Financial Crisis Although certain problems were known to exist with financial regulation in Hong Kong, the global financial crisis highlighted certain of these and also brought to light new issues. The global financial system experienced its first systemic crisis since the 1930s in autumn 2008, with the failure of major financial institutions in the United States and Europe and the seizure of global credit markets. Although Hong Kong was not at the epicentre of this crisis, it was nonetheless affected. While the global financial system did not collapse as the result of a series of significant government interventions, the full extent of the economic impact of the global financial crisis of 2007–2009 was nonetheless severe, resulting in the worst recession since the 1930s. The causes of the global financial crisis are now generally understood, with major initiatives underway around the world to restructure financial systems and economies. Reform of financial regulation has also been initiated, with potentially far-reaching consequences for the future of banking and finance.73 Hong Kong was not immune from the impact of the global financial crisis. On 15 September 2008, Lehman Brothers filed for bankruptcy triggering the highest profile incident in Hong Kong flowing from the global financial crisis, though the insolvency of the firm caused less disruption to the wholesale markets in Hong Kong than in the other major financial centres. The near failure of American International Group (AIG) during this time triggered a rush by insurance policyholders of its subsidiary AIA (HK) to redeem their policies. While the US Government’s effective nationalization of AIG prevented serious consequences in Hong Kong, had AIG actually been allowed to fail like Lehman Brothers, in all likelihood Hong Kong’s financial regulatory system would have been hard pressed to cope.

72  Ibid., p. 2. 73  For detailed discussion, see Arner (2009); Arner et al. (2008).

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As a consequence of market turmoil, especially the rapid decline of the Australian dollar against the US dollar in foreign exchange markets, CITIC Pacific, the Hong Kong-listed and incorporated subsidiary of the major state-owned Mainland conglomerate CITIC, disclosed on 20 October 2008 that it had lost approximately HK$15.5 billion (US$2 billion) on long-dated structured foreign exchange option contracts derivatives popularly known as ‘accumulators’. Following the announcement, the SFC initiated a formal investigation. The bankruptcy filing of Lehman Brothers produced second order effects on individuals in Hong Kong, which led to popular disquiet and public protests, and produced lessons for effective financial regulation in Hong Kong. Both the SFC74 and the HKMA75 produced reports for the Financial Secretary addressing issues that have arisen out of the incident, which subsequently led to proposals of reform for which public consultation recently ended. The saga of the Minibond fiasco highlights include: 1. 2. 3.

The legislative, regulatory and supervisory weaknesses in respect of proper and orderly sales of complex investment products aimed at protecting retail investors; The lacuna in the current system of dual supervision by the SFC and the HKMA of securities brokers and bank distributors respectively, in respect of the sale of investment products to retail investors; and The lack of a system to quickly and effective bring a resolution to disputes, as is clearly highlighted by the disparities in levels of settlement, the unwillingness of Citibank Hong Kong to come to similar settlement, and the Legislative Council inquiry that continues to drag on despite being unlikely to add anything further to the compensation arrangements already reached.

3.3 Post-Crisis Evolution and Reforms In addressing the financial regulatory reactions to the crisis, the Financial Stability Forum (now renamed and reconstituted as the Financial Stability Board [FSB]—of which Hong Kong is a founding member) and the Group of Twenty (G-20) (of which China is a founding member) have been at the 74  Securities and Futures Commission, Issues Raised by the Lehman Minibonds Crisis: Report to the Financial Secretary (December 2008) [SFC Report]. 75  Hong Kong Monetary Authority, Report of the Hong Kong Monetary Authority on Issues Concerning the Distribution of Structured Products Connected to Lehman Group Companies (December 2008) [HKMA Report].

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forefront internationally.76 During the initial stages of the crisis in April 2008, the FSF detailed major regulatory reforms to be undertaken.77 Following the structure outlined by the G-7 in October 2008,78 Hong Kong focused its efforts in three areas: liquidity (expanding the HKMA’s liquidity mechanisms and swap arrangements with the People’s Bank of China), depositor protection (blanket guarantee of deposits with AIs via the Exchange Fund) and capital injections. At the international level, since 2008 the G-20 has assumed the leading role in coordinating post-crisis responses and financial regulatory reforms, and thus its responses over the last seven years logically provide the starting point for analysis of global financial reforms. While the G-20 is not a traditional treaty-based international organization and its pronouncements have no international legal character, it has become the main policy-directing body for discussing relating to international financial and economic policy. The impact of the G-20 on international financial regulation therefore results mainly from domestic implementation of internationally agreed approaches as well as through voting control of the more formal international organizations, such as the IMF and World Bank. Unlike areas such as trade and currency issues, the G-20 has arguably been quite effective in both agreeing and implementing its international financial regulatory agenda. In relation to improving financial infrastructure and prudential regulation, the G-20 and FSB have focused on five areas: (1) capital, leverage, liquidity, and procyclicality; (2) OTC derivatives markets; (3) accounting standards; (4) compensation arrangements; (5) expanding the regulatory perimeter to address hedge funds, credit ratings and credit rating agencies, and securitization; (6) systemically important financial institutions (SIFIs); and (7) financial institution resolution.79 In each of these areas, Hong Kong as an FSB founding member has been active in pursuing related legal and regulatory reforms. Although certain problems were known to exist with financial regulation in Hong Kong, the global financial crisis highlighted certain of these and also brought to light new issues. As a result, the Chief Executive announced

76  For detailed discussion, see Arner (2011). 77  Financial Stability Forum, Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience (7 April 2008). 78  G-7 Finance Ministers and Central Bank Governors, Plan of Action, Washington D.C. (10 October 2008). 79  FSB, Overview of Progress in the Implementation of the G20 Recommendations for Strengthening Financial Stability, at 2 (June 18, 2010) [hereinafter FSB Overview]. See financialstabilityboard.org (2010).

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in his 2008–2009 Policy Address80 the establishment of a new Task Force on Economic Challenges (TFEC) to monitor the impact of the crisis on local and global markets and to identify proposals to deal with long-term issues.81 In addition, at the request of the Financial Secretary, the SFC and HKMA produced reports addressing issues arising from the Lehman incident, following which the Financial Secretary announced that Hong Kong would undertake a comprehensive review of the financial regulatory system to address both existing weaknesses and support long-term competitiveness. This was followed by the submission of an Action Plan by the FSTB to the Legislative Council on the recommendations made in the SFC and HKMA’s reports on 2 February 2009.82 In accordance with the action plan, on 25 September 2009, the SFC published the Consultation Paper on Proposals to Enhance Protection for the Investing Public. The consultation paper dealt with proposals in respect of pre-sale documentation, disclosure and other matters during the sales process, ongoing disclosure post-sale, and a post-sale cooling-off period. Proposals in respect of the creation of an Investor Education Council and a Financial Services Ombudsman are to be separately consulted on by the Government later, whilst amendments to the SFO in respect of all unlisted structured products is to be separately consulted on by the SFC. During the financial crisis, in the context of financial stability provided through prudential supervision and mechanisms to address systemic risk, Hong Kong’s financial regulatory system has been acknowledged as having performed better than most.83 Yet, weaknesses in relation to deposit insurance and lack of compensation mechanisms for customers of failed insurance companies are now evident. However, financial stability, including prudential regulation, is not the only objective of financial regulation; market conduct (including disclosure and consumer protection) and competition are essential objectives. In these, especially market conduct, the weaknesses of Hong Kong’s regulatory system are clear. The most significant aspect is thus the performance of the regulatory system in the context of the Lehman Brothers Minibonds.

80  15 October 2008. 81  See fso.gov.hk (2015). 82  FSTB, “Action Plan on Recommendations in the Reports Prepared by the Hong Kong Monetary Authority and the Securities and Futures Commission on the Lehman Brothers Minibonds Incident,” CB(1)678/08–09(03) (2 February 2009). 83  IMF/FSTB (2008).

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As noted above, both the SFC84 and HKMA85 produced reports identifying and addressing issues raised by the Lehman Brothers Minibonds incident. The recommendations made by the SFC and the HKMA may broadly be divided into five categories: (1) the regulatory regime; (2) conduct of business; (3) information and disclosure; (4) risk assessment in the context of both customer suitability and products; and (5) dispute resolution and compensation. These recommendations have been the basis of a range of public consultations by the SFC and HKMA, addressing specific aspects of Hong Kong financial law and regulation. However, there has yet to be a comprehensive analysis under article 109 of the Basic Law, although as a related matter the Government established the Financial Services Development Council in 2013 as an advisory body on related issues. 4

Looking Forward

A second IMF Financial Systems Stability Assessment86 was published in 2014. The review concluded that Hong Kong’s financial sector was well regulated with the capacity to absorb a diversity of shocks. Major risks to Hong Kong’s financial stability included capital market volatility and reduced system-wide liquidity from the United States’ anticipated exit from unconventional monetary policy, a correction in property prices, and increasing economic integration with the Mainland could generate spillover effects. Large banks were viewed as having sufficient liquidity to manage sizeable deposit and interbank funding withdrawals, as opposed to smaller banks that were deemed more vulnerable to these risks. In the wake of the global financial crisis the financial regulatory and supervisory framework displayed a high level of compliance with international standards such as Basel III. The IMF also welcomed the creation of a comprehensive bank resolution framework. A notable weakness was the supervision of the insurance sector, with the IMF recommending the need to establish the planned independent insurance authority, enhancing the legal framework for associated groups, implement a risk-based capital regime, and bolstering the supervision of intermediaries. The IMF failed to raise the sig84  Securities and Futures Commission, Issues Raised by the Lehman Minibonds Crisis: Report to the Financial Secretary (December 2008) (SFC Report). 85  Hong Kong Monetary Authority, Report of the Hong Kong Monetary Authority on Issues Concerning the Distribution of Structured Products Connected to Lehman Group Companies (December 2008) (HKMA Report). 86  IMF (2014).

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nificance of the relationship between the insurance and banking sectors, and how systemic risks could be transmitted between these two financial markets, especially from the insurance activities that banks engage in. In the securities sector, regulation of markets, external auditors, and enforcement of securities regulation all needed to be strengthened. While the IMF review found Hong Kong’s financial and regulatory systems to be sound, it did not address challenges to Hong Kong’s role as a leading international financial centre. In looking forward, four issues are in all likelihood of greatest significance in this respect: its attractiveness as a location for regional and international financial institution headquarters; its role in asset management; its role in the linkage between technology and financial services (fintech); and its role in RMB internationalization. In the context of regional and international financial institution head­ quarters, today’s leading financial centres all provide approximately equivalent regulatory environments, in particular as a result of post-crisis inter­national regulatory reforms led by the G-20 and FSB (of which all major inter­ national financial centres are part). Thus, there is limited scope for competition in the context of regulatory content. However, there remains considerable scope for competition in terms of attractiveness as a business location. These factors include government effectiveness and responsiveness to the needs of the financial sector, close proximity to major markets, location in an attractive time zone, human capital availability, and lifestyle issues. In all of these areas (with the exception of time zone and proximity, physical factors over which it has limited control), there is considerable scope for Hong Kong to improve its competitiveness and constant need to do so when facing competition from New York, London and especially Singapore and Shanghai. In the context of asset management, Hong Kong has an important role and advantage as an independent well-governed jurisdiction within China under the terms of the Basic Law. Hong Kong has performed well in taking advantage of these attributes to become a major asset management centre for both Chinese funds going out of mainland China and foreign funds going into mainland China. Going forward, in addition to the Chinese market, in order to expand its role in asset management, Hong Kong must also look beyond this, in particular in the context of regional and global initiatives to support market access for funds products and also in the context of mainland China’s major One Belt One Road foreign policy initiative and the bilateral flows of funds this will underpin. In the context of fintech, while Hong Kong ceased to be a manufacturing centre by the end of the 20th century, it has nonetheless emerged as a leading international financial centre. While it is unlikely to develop a major technology

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sector, its position as a financial centre and the importance of technology to the financial sector ensures a strategic opportunity to support fintech developments. Likewise, its proximity to the emerging world class technology cluster in Shenzhen and the Pearl River Delta in conjunction with mainland China’s major initiative to support innovation provides a very important strategic opportunity to bring together technology and finance to drive the development of innovation leaders in Southern China. In the context of RMB internationalisation, Hong Kong’s role as an open well regulated world class financial centre provides the potential to serve as a global centre for RMB transactions going in and out of mainland China, particularly in the context of One Belt One Road, RMB internationalisation and innovation initiatives. All provide significant strategic opportunities which will underpin Hong Kong’s future development as an international financial centre. References Arner, Douglas W. (2007a) Law, Financial Stability and Economic Development, New York: Cambridge University Press. ——— (2007b) Financial Stability, Economic Growth and the Role of Law, New York: Cambridge University Press. ——— (2009) “The Global Credit Crisis of 2008: Causes and Consequences.” 43 International Lawyer 91–136. ——— (2011) “Adaptation and Resilience in Global Financial Regulation.” 89 North Carolina Law Review 1579–1626. Arner, Douglas W., Paul Lejot, & Lotte Schou-Zibell (2008) “The Global Credit Crisis and Securitisation in East Asia.” 3 Capital Markets Law Journal 291–319. Carse, David (2008) “Review of the Hong Kong Monetary Authority’s Work on Banking Stability,” July 2008. financialstabilityboard.org (2010) http://www.financialstabilityboard.org/publications/ r_100627c.pdf?frames=0FSB (accessed 14 August 2015). fso.gov.hk (2015) www.fso.gov.hk/tfec/eng/index.html (accessed 14 August 2015). Ghose, T. K. (1987) The Banking System of Hong Kong, Singapore: Butterworths. Hadjiemmanuil, Christos (1996) Banking Regulation and the Bank of England, London: LLP. Hartley, W. D. (1973) “Where the Action Is,” The Wall Street Journal, 29 March. Higgins, M. F. (1978) Securities Regulation in Hong Kong 1972–1977, Leiden: Sijthoff & Noordhoff. hkab.org.hk (2008) http://www.hkab.org.hk/PDF/rules_guidelines/code_e_2008.doc (accessed 14 August 2015).

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hkex.com.hk (2015) http://www.hkex.com.hk/eng/market/sec_tradinfra/chinacon nect/stockconnect.htm (accessed 14 August 2015). hkfi.org.hk (2015) http://www.hkfi.org.hk/en_tips_customer_conduct.htm (accessed 14 August 2015). hkma.gov.hk (2015) http://www.hkma.gov.hk/eng/key-functions/monetary-stability/ liquidity-support-to-banks.shtml (accessed 14 August 2015). Ho, Yan-ki, Rorbert H. Scott, & Kie A. Wong (eds) (1991) The Hong Kong Financial System, Hong Kong: Oxford University Press. IMF (2003) “People’s Republic of China Hong Kong Special Administrative Region: Financial Stability Assessment,” 27 June. ——— (2014) “People’s Republic of China-Hong Kong Special Administrative Region: Financial Stability Assessment,” 25 April. IMF/FSTB (2008) “IMF Commends Government’s Decisive Actions to Bolster Financial Stability,” IMF/FSTB Press Release, 9 December. Jao, Y. C. (1997) Hong Kong as an International Financial Centre: Evolution, Prospects and Policies, Hong Kong: City University of Hong Kong. Rider, B. A. K., & H. L. French (1979) The Regulation of Insider Trading, London: Macmillan. Tokley, I. A. (1996) Hong Kong Banking Law and Practice, Hong Kong: Butterworths. Ujejski, T. (1989) “Securities Regulation,” in R. Wacks, ed., The Law in Hong Kong 1969–1989, Hong Kong: Oxford University Press. Yiu, E. (2000a) “Securities Law Still in Grip of Bitter Bickering,” South China Morning Post, 9 December. ——— (2000b) “SFC Calls for Reform to Battle Coming Challenges,” South China Morning Post, 28 December.

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Chapter 4

Level Playing Field as an Institutional Challenge to China as a Socialist Market Economy Xianchu Zhang Abstract A new round of reform has been carried out since the Communist Party of China adopted its decision to promote comprehensive reforms for the country’s future development in 2013. However, there are daunting challenges ahead of the reform. In addition to the current economic downturn the ideological and political struggle in the course of further marketization and rule of law development may continue to subject the new campaign to a great deal of uncertainties. Given the imminent threat of the social, financial, and ecological crises the party state is facing a dilemma to maintain its political legitimacy or make historical breakthroughs.

Keywords competition – privatization – institutional reform – legal challenges

1 Introduction The economic taking off since late 1970s has thus far not only lifted China to the second largest economy in the world, but also taken it to a crossroad with serious challenges to its sustainable development. To a certain extent, the dynamic growth and institutional reform are losing their momentum in the economic downturn with outdated production capacity, ecological crisis, widened social gaps and conflicts, rampant corruption and deepened political struggle. To tide over the potential crisis, the party state has initiated a new round of reforms. On 12 November 2013, the Third Plenary Session of the 18th Communist Party of China (“CPC”) Central Committee adopted its * Professor of Law, The University of Hong Kong. Contact: [email protected].

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Decision on Certain Major Issues Concerning Comprehensively Deepening the Reform (“the Reform Decision”),1 which blueprinted the direction of the country’s future development with concrete reform measures and goals. One of the crucial tasks is to further marketization and improve the level playing field with equal and fair competition. This article critically examines the reform pledges made under the Reform Decision in this regard and their legal and political implications. Part I reviews the level playing field development in China as socialist market economy; Part II highlights the major reform measures reflected in the Reform Decision and their recent implementation; Part III considers the major difficulties and challenges facing the reforms; Part IV analyses some institutional implications of the reforms on the current legal system in China; and finally, Part V draws some concluding remarks. 2

Level Playing Field Development in China as Socialist Market Economy

The reform and opening since 1979 have liberalized China from a planned economy with the domination of state owned enterprises (SOEs) and dramatically changed the landscape of the market level playing field in China. According to the latest statistical survey, by the end of 2013 private enterprises and commercial households reached 12.53 million and 44.36 million respectively. The domestic private sector has employed 219 million workers and made its contribution to more than 60% of the national GDP.2 Mr. Lardy in his new book further pointed out that the private sector in fact had been the driving force of China’s economic taking-off since later 1970s as the major source of economic growth, the sole source of job creation, and the major contributor to China’s still growing role as a global trader. It has displaced SOEs with far better productivity and competitiveness.3 In the same period foreign investment has been another crucial engine of China’s dynamic development. Implementation of the opening police, particularly after China’s accession to the World Trade Organization (WTO) in 2001, has so far attracted more USD 1.5 trillion of foreign investment making China the developing country that receive most foreign investments

1  China.org.cn (2014). 2  Xinhua News Agency (2014). 3  Lardy (2014).

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for 22 years.4 In 2014, China even overtook the United States to become the country attracting the most direct foreign investments in the world.5 Behind this status is the contribution of foreign investment enterprises for more than 50% of both imports and exports of China in the past three decades.6 On the contrary, the state sector has been on retreat. By 2014, the number of SOEs has dropped to 155000. However, the very small fraction of state firms occupied more than 30% of the enterprise assets of the nation and all the key business sectors.7 Currently there are 113 giant SOEs directly under the control of the Central Government.8 Their total business income in 2014 reached RMB 25.1 trillion, or almost 40% of GDP of the year.9 The latest record shows that, on the one hand, the public economy is still in the firm leading position with all the top 37 and 60% of China 500 being SOEs in 2014; on the other hand, it has become more and more clear that most of SOEs profits are made from their domestic monopolistic positions, rather than from their real competitiveness on the market. They have neither created any product listed in the World Most Valuable Brands,10 nor maintained their earning capacity. Thus far, 42 SOEs of China 500 are in red with total loss of RMB 72.7 billion in 2014 and 16 SOEs from China in the World 500 also registered their serious loss as the largest country group.11 The records, however, do not tell the whole story of development of the nonpublic economy in China. As a socialist country, the rapid growth of the private sector may only be appreciated against a wide range of institutional barriers, including the discriminatory social and political environment, biased and restrictive laws, regulations, and political policies. Since 1949, the private sector in China was considered a force of capitalism threatening to the socialism regime and public ownership under the planned economy and thus became a target of political movements for a long time. This period witnessed the domination of the bureaucratic powers of the government and SOEs in the national economy and violent deprivation of 4  5  6  7 

“China Senior Officials Reassured Foreign Investors,” China News, 9 September 2014. “China Replaces US as Top Investment Destination,” Deutsche Welle News, 29 January 2015. “China Senior Officials Reassured Foreign Investors,” supra note 4. “Disclosure of State Owned Enterprises: Less than 1% in Number with More Than 30% of Total Assets”, Chanjing Xinwen Bao (Industrial and Economic Journal), 31 July 2014. 8  The list of these SOEs is available at the SASAC website. See sasac.gov.cn (2015). 9  “The Central Enterprises Realized Profits of RMB 1.4 Trillion in 2014,” China IRN, http:// big5.chinairn.com/news/20150123/150510981.shtml (accessed 29 April 2015). 10  Forbes (2014). 11  “The SOEs Becomes the Loss Disaster Area,” Jingji Cankao Bao (Economic Reference Journal), 19 September 2014.

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private properties and assets without any legal protection. As a result, China paid a very high price for the hard lessons of failure of the planned economy and was forced to set its reorientation to so-called socialist market economy.12 Such change demonstrates that the party state has taken a pragmatic approach to allow some room for non-state economy to develop while continuing their struggles and resistance to recognize its lawful status and equal entitlement to competition and property protection. For example, under the Constitution of China of 1982, the private sector was defined as a supplementary to the public economy within the scope stipulated by the law subject to the government administration, guidance, assistance and supervision.13 The Constitutional Amendments in 1988 further allowed the private economy “to develop”.14 It was not until 1993 that the private economy earned its status as an important component of the socialist market economy.15 Such political ideology and mentality have seriously affected market level playing field. To a considerable extent the dynamic achievements of private economy have been made more by its tenacity to strive for development in the crevice of the political regime than the formal institutional support. For a long time the private economy has been facing discriminatory regulatory framework, market access restrictions, biased finance environment, unequal and unfair market competition, insufficient legal protection, and abuse of government powers as well as rampant corruption. As a result, many devices have been developed to deal with these barriers, such as “wearing a red hat” (camouflaged as collective enterprises with government or SOE shares), bribing officials, joining the communist party to improve the political status, developing underground financial platforms, and pretending to be foreign investment by moving assets out of China and reinvesting back, etc.16 Such game-plays have led to unclear ownership and property rights, high cost of finance, unstreamlined operation with small size and low efficiency, lack of incentive to business expand with only short-term strategy, poor corporate governance with family control, and insufficient motivation to engage in research and innovation.17

12  13  14  15  16  17 

Wu (2009). Art. 11 of the PRC Constitution of 1982. Art. 1 of the Constitutional Amendment dated 12 April1988. Art. 16 of the Constitutional Amendment dated 15 March 1999. Tsai (2007); Zhang (2011), pp. 142–62. “Pressure or Motivation? A Map of Difficulties Facing Private Enterprises,” Qiye Guancha Bao ( Journal of Enterprise Observation), 18 February 2014.

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These informal ways of private entrepreneurs to circumvent the institutional barriers have led to many tragic incidents in practice. Sun Dawu’s conviction for unlawful fund raising for his community development, Dai Guofang’s questionable charge to stop his investment not in line with the central government policy, Shen Taifu’s death penalty after he filed lawsuit against the Central Bank for its excessive restriction against private finance, and the change of Wu Ying’s death penalty under the public pressure for her unlawfully raising capital are all landmark cases to illustrate the very dangerously uncertain environment facing private entrepreneurs in China. Such conditions have even been deteriorated in recent years. Since the worldwide financial crisis a phenomenon of “the state advances and the private sector retreats” has been widely discussed and raised serious concerns where SOEs initiated a wave to takeover private enterprises with the cash granted by the Central Government’s RMB 4 trillion stimulus package with little to the private sector, particularly in mining, iron and steel, and transport industries.18 This development not only reversed the course of SOE reform since 1980s, but also further enhanced the state monopoly in many fields.19 Thus, the space for private economic development and competition has been further compressed, although some officials insisted that such phenomenon was good to China’s economic development.20 Foreign investors, although in a sense in a better position due to China’s commitment to the non-discrimination principle of the WTO and their home countries’ support,21 have also to deal with the political ideology and biased regulatory environment in China. In a circular of the Central Government in 2006, it was made clear that the state should maintain “absolute control” in seven business sectors, including military industry, power, oil, coal supply, telecommunications, civil aviation and other transportation means. In other key industrials, such as equipment manufacturing, auto industrial, electronic information, construction, iron and steel production, non-ferrous metal, chemical industry, exploration and design, and science and technology

18  Rabinovitch (2012). 19  Yang & Jiang (2012), pp. 33–69. 20  “Officials Claim ‘Guojin Mintui’ Good to the National Development,” Diyi Caijing Ribao (China Business News), 19 January 2010. 21  Since its accession, China has been named as the respondent in more than 30 dispute settlement proceedings of WTO and lost some important cases. For detailed information, see WTO official Website: wto.org (2015).

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the state should keep “relatively strong control”.22 Such coverage has been criticized for lack of clear justification and deterrent to investment.23 More recently, implementation of the government policy and measures to promote indigenous innovation with various government verification, certification, subsidies, ownership control, forced technology transfer, and qualification for government procurement subjected foreign investors to further pressures and even resulted in a series of international disputes for their discriminatory effects in innovation incentive against foreign parties in violation of the WTO fundamental principles.24 The controversy was eventually settled when the then President Hu Jintao promised in his summit meeting with President Obama of the U.S. to eliminate discriminatory “indigenous innovation criteria”, to commit to “non-discrimination against innovation products made by foreign suppliers operating in China” and to “delink its innovation policies from its government procurement preferences”.25 The Central Government later further made an announcement to suspend implementation of the relevant measures and the related implementing provisions on contracting, budget and assessment concerning government procurement of “indigenous innovation” products at both the central and local levels.26 The incident, however, seems not to completely end the biased practice on the market. In some recent surveys, foreign investors shared their continued concerns with domestic private enterprises with the inconsistent and biased legal environment and the level playing conditions under the influence of the government and SOEs.27 After briefly highlighting the market and legal conditions in China as a socialist market economy, the current challenges and potential crises can be seen as the crucial impetus of the new round of reforms. The extensive way of growth without a level playing field and escalated social conflicts and unrests caused by unfair distribution of the reform gains, environmental and ecological crises as well as the current economic downturn all indicate nothing, but unsustainability of such model of development. Even the top leaders have

22  The Guiding Opinion to Promote Adjustment of State Assets and Reorganization of State Owned Enterprises promulgated by the State Council on 18 December 2006. 23  Baston (2014). 24  Zhang (2014). 25  White House Office of Press Secretary (2011). 26  The US-China Business Council (2011). 27  American Chamber of Commerce in China (2014); European Union Chamber of Commerce in China (2014a).

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openly admitted that “[t]he huge problem facing China remains its economic structure which is unstable, imbalanced and unsustainable”.28 As a result, the party state is under the increasingly built-up pressure to find a way to keep the economic growth and maintain the social stability as well as the legitimacy of the regime which has been based on the party state leadership for successful development of the country. President Xi Jinping made his clear statement immediately after he took his office that accelerating the economic structure transformation of the country through institutional reform and scientific innovation was the task that would brook no delay.29 Against this background, the article now turns to the newly adopted blueprint of further reform. 3

Brief Reflection of the Reform Decision

There is no doubt that the Reform Decision is the most important document adopted by the new leadership thus far after they were appointed in 2012 and will be for the years to come simply because it spells out their new goals for further reform and maps out the measures and strategies to reach these goals. From this perspective, the positive significance of the Reform Decision may hardly be overstated. However, the Decision may still be critically analyzed in the context of China’s socialist market economy. The overall goals set out by the Reform Decision are to comprehensively modernize the country’s governance, accelerate development of the socialist market economy as well as its democratic politics, advanced culture, harmonized society, and ecological civilization. The gains of the development should be enjoyed by all the people in a fairer way.30 In order to realize the goals the Decision mandates a decisive role of the market in resource allocation by improving the current economic system, transforming the country towards an innovative society with more efficient and sustainable growth.31 It identifies the relation between the government and the market as the key issue to tackle in the further reform, particular excessive bureaucrats’ intervention to the market.32

28  29  30  31  32 

Wen (2007). Xi (2012). The Reform Decision, Part 1 (2). Ibid. Ibid., Part 1 (3).

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As far as development of the private sector is concerned, the Reform Decision provided that non-public economy must be encouraged and supported unswervingly. More specifically, the Decision pledged to equally protect all types of ownerships and their property rights for their equal entitlements to utilize market factors and participate in market competition in a fair, just and transparent way. It was clearly stated that to non-public sectors the principle of “equal rights, opportunities and rules should be upheld and unreasonable regulations and hidden barriers shall be eliminated”.33 The Reform Decision further called for actively developing of mixed ownership as a way to allow private capital to participate in state investment projects and SOE reform.34 To response to the call, the State Council in its 2014 Working Report promised to accelerate development of mixed economy with more concrete measures. Finance, oil, power supply, railway, telecommunication, natural resource development and public utility were identified as the major areas to be opened to private investment.35 In addition to the promises reflected above, the Reform Decision further pledged to establish fair, just and transparent market rules and implement uniform market access framework with the so-called negative list, which refers to a new practice to limit the excessive government approval and administrative power within a clearly stipulated list, or in other words, to lock unlimited government powers in the old days into an institutional cage. On this basis different market players may enter into all the business sectors that are not subject to the restriction of the negative list.36 Moreover, local protectionism and market monopoly were identified as the obstacles to national market development. The Decision further mandates price formulation by the market, financial market reform, development of the innovative system and enhancement of intellectual property protection.37 As far as foreign investment is concerned, a new administrative model to combine the national treatment with the negative list of market access will be tested.38 Part 7 of the Decision entitled Building up a New Open Economic System specifically identified a series of service business sectors where market access restrictions to foreign investors, such as finance, education, medical service, construction, accounting and auditing, e-commerce and logistic service, 33  34  35  36  37  38 

Ibid., Part 2 (5) and (8). Ibid., Part 2 (6) and (8). Li (2014). The Reform Decision, Part 3 (9). Ibid., Part 3. Ibid., Part 3 (9).

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will be relaxed. The Decision also called for speeding up to domestic free trade zone development and improving investment protection, and government procurement negotiations within the international multilateral system.39 According to the Decision, rule of law construction is important part of the new round of reform, which includes promotion of the implementation of the Constitution to a new level with strict enforcement, comprehensive judicial reform, a better protection of human rights. One of the goals promised in this regard is to let the mass to feel fairness and justice in every judicial case.40 In the same direction, the Decision set out provisions to further limit power exercise and combat corruption so that all the powers would subject to institutional restriction.41 It was explicitly stated that all these key reforms shall see their decisive achievements by 2020.42 Indeed, the designs of the Reform Decision have soon been put into implementation in practice with concrete measures, including:

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Reform of government’s role on the market through abolition and decentralization of a large number of administrative approval and certification procedures to facilitate and activate business operation. Since the new government was appointed, the central government has swept off more than 700 administrative approval procedures in two tears and promised to reform more.43 Amendments to some laws and regulations to improve the regulatory environment. For instance, as a move to facilitate corporatization and innovative investment the revision of the Company Law at the end of 2013 abolished the statutory minimum capital requirements and the statutory cap on capital contribution by means of intellectual property rights entirely as well as the mandate to verify all the capital contribution by the state authority.44 The amendment to the Government Procurement Law has paved a way for other market players to participate by eliminating the old provision that government procurement could only be entrusted to the agencies certified

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39  Ibid., Part 7. 40  Ibid., Part 10. 41  Ibid., Part 11. 42  Ibid., Part 1 (4). 43  The Central Government Report (2015). 44  The Decision of the Standing Committee of the National People’s Congress on Amendments to the Company Law and Other Six Laws, 28 December 2014, Part 7.

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by the State Council or provincial governments.45 The State Council also revised the Individual Commercial Household Regulation to replace the government annual inspection with annual reports submitted by households themselves.46 Establishing China (Shanghai) Free Trade Pilot Zone (sFTPZ) in August 2013 as a trial field to lead China’s future reform with more measures to reform government functions, financial institutions, trade facilitation, foreign investment services, and taxation system as well as overseas business developments. The so-called negative list was first used in the sFTPZ as the administrative framework to limit the government powers. The two versions of negative list issued in 2013 and 2014 have liberalized more business sectors to foreign investors with less government approval.47 As the latest efforts, the State Council has further adjusted the application of the Foreign Investment Guiding Catalogue of 2011 to allow freer market access of foreign investment in the SFTPZ48 and expanded the SFTPZ practice to Guangdong, Tianjin and Fujian.49 Improving the level playing field for foreign investment. For example, with the national legislature’s authorization all three foreign investment enterprises laws, including Sino-Foreign Equity Joint Venture Law, Sino-Foreign Contractual Joint Venture Law and Wholly Foreign Owned Enterprises Law, were suspended for their application in the sFTPZ in order to exempt them from the government approval procedures. As a result, all domestic and foreign companies may all be governed by the Company Law as a more uniform legal regime. Moreover, the State Council through its regulation ­amendments has liberalized foreign investment from the compulsory provisions on capital contributions; instead, all the issues such as the total investment, the registered capital, capital contribution means and the amount from the each party, terms, transfer, and profit and loss distribution shall be

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45  The Standing Committee’s Decision to Amend the Government Procurement Law of 2002 (art. 19) on 31 August 2014. 46  The State Council Decision to Amend Certain Administrative Regulations dated 19 February 2014, Part 7. 47  All the detailed information in this regard is available at the official website of the Shanghai FTPZ. See china.shftz.gov.cn (2015). 48  The Decision of the State Council to Temporarily Adjust Application of Certain Administrative Regulations and Provisions on Access Administration dated 4 September 2014. 49  “China Announces Three New Free Trade ones in Tianjin, Guangdong and Fujian,” China Briefing, 25 December 2014.

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all decided by the articles of association of these enterprises concerned.50 This change apparently provides foreign investors with more business freedom and autonomy. Presently, the state authorities are drafting a uniform foreign investment law and further updating the foreign investment catalogue for further opening.51 Promoting mixed ownership development and supporting small enterprises. Since 2013, the State Council has suspended value-add tax and business tax on small firms52 and adopted the policy to provide small enterprises with more financial support.53 Moreover, on 24 March 2014, the State Council issued its Opinions on Further Optimizing Market Environment for Enterprise Mergers and Acquisitions, which called SOEs to bow out from competitive business sectors through shares transfer to private investment or capital increase. It is explicitly stated that SOEs shall not use their monopolistic positions to restrict private enterprises’ participation in market competition.54 In July 2014, the State-Owned Assets Supervision and Administration Commission (“SASAC”) initiated its trial scheme of further SOE reform, where China National Pharmaceutical Group Corporation and China National Building Materials Group Corporation as two business giants directly under the central government control were selected to pioneer a mixed ownership structure.55 Further supporting development of non-public economy. The Guiding Opinion on Solving Problems of High Costs of Enterprise Finance with Different Measures of the State Council for instance allows qualified private capitals to establish their small or mid-sized financial institutions.56 Benefited from this supporting policy thus far at least six private capital

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50  The Order of the State Council to Abolish and Amend Certain Administrative Regulations dated 19 February 2014, Appendix I and Appendix II, part 3, 4 and 5. 51  “China Releases Draft Foreign Investment Law, Signaling Major Overhaul for Foreign Investment,” China Briefing, 21 January 2015; “With Revised Guidance Catalogue, China Introduces Sweeping FDI Reforms,” China Briefing, 7 November 2014. 52  “The State Council: Temporary Suspension of Value-add Tax and Business Tax on Small Enterprises,” Zhongguo Xinwen Wang (China News Net), 24 July 2013. 53  Implementing Opinions on Financial Support Development of Small Enterprises of the General Office of the State Council dated 12 August 2013. 54  The Opinions of the State Council on Further Optimizing Market Environment for Enterprise Mergers and Acquisitions promulgated on 24 March 2014, Items 22 and 23. 55  “SASAC Initiates Four SOE Reform with Substantial Steps”, Xinhua News Agency, 15 July 2014. 56  The Guiding Opinion was issued by the General Office of the State Council on 14 August 2014.

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banks, including ones initiated by Alibaba, have been established.57 Most recently, even military procurement is opened to private investment.58 Further efforts to improve the market competition environment. The State Council promulgated its Certain Opinions on Promotion of Market Fair Competition and Safeguarding Normal Market Order dated 4 July 2014. As a general principle, the governments at all the levels are required to regulate the market with streamlined powers under rule of law in order to ensure market and regulatory transparency, business autonomy, equal and fair competition of various market players, consumers’ free choices, and effective and impartial market supervision. The CPC further promulgated its Decision on Comprehensively Advancing the Country Forward According to Law in 2014 (“2014 Decision”) where equality before the law, promotion of market economy through fair competition and contract and property rights protection of different ownerships and improvement of judicial independence are explicitly promised.59 The Supreme People’s Court also adopted a series of reform plans on work rationalization of the judiciary, enhancement of judiciary accountability and transparency, and measures to liberalize the judiciary from local financial control.60

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To a considerable extent, the adoption of the blueprint and its implementation has demonstrated the new leadership’s commitments to further reform. Some domestic scholars even considered that the new reform design was a leap forward comparable to Deng Xiaoping’s bold decision in 1970s and far more significant than the reform programs accomplished by Xi’s predecessors.61 Foreign commentators are also impressed with the new leaders’ ambition to move China much further toward marketization and economic modernization.62 However, from another angle, the new leadership has no alternative, but to take some reforms because of the unsustainable conditions as discussed above. The current development and governance model have 57  “China’s First Online Private Bank Opens for Business,” The Verge, 5 January 2015. 58  Clover (2015). 59  An English translation of the Decision is available at the Chinese government website. See genius.com (2014). 60  Such adoptions include the Implementation and Work Division Plan to Deepen Judicial and Social Institutional Reform in February 2014, the Framework Opinions on Issues Concerning Pilot Reforms of the Judicial System in June 2014, and the Fourth Five-year Reform Plan (2014–2018) in July 2014. 61  Kroeber (2013). 62  Armanovica (2012); Salidjanova & Koch-Weser (2013).

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almost come to an end. As the World Bank and the Development Research Center of the State Council as the leading official think tank in China have warned sternly in their joint report entitled China 2030, China has to accelerate its transition to a freer market system, or else face a serious crisis.63 4

Difficulties Facing the Reforms

The reform measures are undoubtedly impressive and significant for China’s to fight its worst economic downturn since the last worldwide financial tsunami in 2008 and to drive the country’s future development.64 Commentators also agree on the view that China’s new round of reform agenda represents huge and crucial changes to avoid crises in different areas and to safeguard the country for its’ long-term growth.65 However, the answer to the question whether China may successfully carry these reforms out has divided the international communities. For example, some studies so far have raised serious concerns with China’s successful implementation of the reform measures, some even predicted their failure.66 Indeed, in the history no massive political and economic reform would be easy. However, given China’s present conditions, some confrontation and resistance in the course of reform have even surprised the top leadership of the authoritarian regime. For example, it was reported that Premier Li Keqiang lost his temper several times in dealing with reluctance of the lower level officials to give up their powers according to the Reform Decision, or playing game with the central government as an exercise in bureaucratic blandness. The phenomenon that “the central government order may not go out of the Forbidden City” seems to continue in the new deal time.67 Given the long history and the very nature of the Chinese bureaucracy practical difficulty and resistance just cannot be underestimated from any aspect. Despite the reform measures taken since 2012, the central and local 63  The World Bank (2013). 64  Li (2013). 65  “Economic Reform Agenda ‘Key to Chinese Growth’,” BBC News, 14 July 2014; “The Great Transition,” The Economist, 22 March 2014. 66  Scissors (2014); de Jonquieres (2014); Yang (2014); Peters (2014). 67  “Five Questions to Reform of SOEs Directly under the Central Government,” Beijing Qingnian Bao (Beijing Youth Daily), 16 July 2014; “Let the Policy from the Forbidden City to Take Its Root”, The Central Government Website, 17 July 2014, http://www.gov.cn/ xinwen/2014-07/17/content_2718960.htm (accessed 29 April 2015).

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governments still maintain approval procedures as many as more than 17000. Moreover, the power abolished in the first batch of the reform measures are those affecting the bureaucratic interest the least.68 In that sense, giving up political powers on the social and market management would mean no less than a revolution. In fact, even the central government, while harshly criticizing the local governments, continues to play an active role in the market. For example, facing the serious market downturn the Central Government made its choice to prefer economic growth to the reform with a series of so-called mini stimulus plans as distinctive from the RMB 4 trillion stimulus package adopted in 2009. These plans have covered a wide range of sectors and further gained their momentum since 2014.69 As a result, some top leaders’ determination to “take painful reform like brave warriors to cut their wrist” has turned out to be more gestures than real move. The World Bank recently even warned that “delays in implementing coherent reforms could perpetuate resource misallocation, undermine the health of the banking system, threaten the debt sustainability of local governments and increase the fiscal costs of reforms”.70 The struggles in between market discipline and the political ideology are not merely confined to resource allocation. The pledge to better property right definition and protection are also facing serious challenges. Violent demolitions with casualties have continued nationwide, even after the State Council adopted its regulation on land taking in 2011 mandating fair compensation and judicial intervention and prohibiting any violent actions.71 According to a recent study, since 2009 land violation cases reported to the state authorities are as many as 570000.72 The delay of the draft uniform real property registration regulation may be another example in this regard. Despite the explicit provision of the Property Law of 2007 that a uniform registration system shall be implemented in China,73 its establishment has not been seen as the time of this due to the political reluctance and power struggle among different bureaucratic branches.74 68  Zhang (2013). 69  A list of major stimulus plans can be found in the following report: “Overview of China’s Mini-Stimulus Plans Since 2014,” Fenghuang Caijing (Phoenix Finance), 12 August 2014; see also Ping & Zhang (2014); Bradsher (2014). 70  Yao (2014); Feng (2014); Back (2014). 71  The Regulation of State Owned Land Taking and Compensation was promulgated on 21 January 2011. See Arts. 2, 3 and 27. 72  Chen, Wang & Ling (2014). 73  Art. 10 of the Property Law of 2007. 74  Zhou (2014).

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The progress of the Shanghai FTPZ seems not as smooth as many expected. Some investors have expressed their disappointment with what were achieved in the Shanghai FTPZ in its first two years. Besides abolition of some administrative procedures, other reforms may hardly be considered significant breakthroughs.75 Even the newly published negative list of 2014 seems to fail to cheer foreign investors up for not being very meaningful, particularly on its failure to address some key concerns, such as compulsory rule on Chinese majority holdings in joint venture automakers and further relaxation of restrictions on financial services.76 With respect to the improvement of market level playing field, the government’s promise has not generated much enthusiasm from the private sector and foreign investors. On the one hand, the SASAC has made it clear that opening up of the state monopolized business would be just tried on selected enterprises as pilot cases and would not be fast. The bottom-line condition emphasized by the SASAC is that no loss of state assets would be allowed in any reform.77 As another sign of the struggling, the two key guiding policy documents of the central government on deepening SOE reform and promotion of mixed ownership that were expected to be promulgated in September 2014 have been reportedly postponed due to lack of internal consensus.78 From the perspective of domestic private entrepreneurs, based on the hard personal lessons learned from the previous years, they have so far taken very cautious wait-and-see approach to avoid another round of “luring them in, then block their retreat and destroy them”.79 The recent research data has showed that in the period of 2012–2014 investments from the private sector have been slowing down by 4.7% which has become one of the major reasons of the national economy slowdown.80 At the same time, the unsafe, unequal and uncertain environment has been well reflected in a recent report that 27% of private entrepreneurs with more than RMB 100 million in investable assets have immigrated to foreign countries and 47% of them are preparing for leaving the country.81 Such insecurity vote and talent brain-drain are described 75  “Shanghai FTZ after One Year: Few Breakthrough, But Valuable Lessons”, BBC (Chinese Edition), 30 September 2014; Shen (2014). 76  Wildau (2014); Silk (2014). 77  “Carding Li Keqiang’s Anger,” Beijing Qingnian Bao (Beijing Youth Daily), 15 June 2014; “SASAC: Reforms Cannot Touch the No-loss Bottom Line,” Ta Kung Bao (Hong Kong), 15 July 2014. 78  He (2014). 79  Zhang (2014). 80  “Private Investment Slowdown,” Xin Jing Bao (The Beijing News), 8 October 2014. 81  Chang (2011).

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as a result of “structural uncertainty” with profound damages to China’s innovation reorientation82 and potential risk bringing down the regime as well as the economy.83 Some recent cases have further proved that the private sector’s deep worries are not groundless. In addition to the case of Zeng Chengjie who, as a private businessman, was executed secretly in July 2013 for unlawful capital raising after his good relationship with the local government broke down in the financial crisis,84 at least two more cases of the same nature have reached the Supreme People’s Court in the political course to purge Zhou Yongkang as the top party leader in charge of the legal system where Gu Chujun and Lan Shili as two leading private entrepreneurs were jailed more than seven years for unlawful purchase of state assets and three years for failed competition with state controlled airlines respectively. The matters for the Supreme People’s Court review include alleged abuse of political power, forged evidence and serious violation of legal procedures.85 In another case, although under the tremendous public pressure the intervention of the Supreme People’s Court saved Wu Ying from death penalty in 2012 for alleged fraudulent fund raising, most of her assets had been disposed by the local court and government before the delivery of the trial court decision. However, it was revealed recently that the largest creditor in this case received nothing from all the dispositions.86 Wu’s father and attorney were even detained after they raised their serious questions about corruptions and violations in the proceedings.87 Uncertainties in implementing reforms measures are equally concerned with foreign investors. In contrast to the party state promotion, the latest surveys of both American Chamber of Commerce and European Chamber of Commerce found confidence weakening among their members due to, in addition to China’s economic downturn, excessive administrative procedures, restrictions on freedom of expression, and market access.88 Moreover, the recent antimonopoly campaign has subjected many multinationals, ranging from automakers, auto part manufactures, telecommunication companies, baby formula producers, to pharmaceutical giants, to investigations 82  83  84  85  86  87 

Breznitz & Murphree (2011). Browne (2014). Lau (2013). Xun (2014). Zhang (2014). “Wu Ying’s Father Has Been Detained for 30 Days, But the Prosecutor Office Has Not Received Arrest Application Yet,” Jinghua Shibao (Jinghua Daily), 1 September 2014. 88  Silk (2014); European Union Chamber of Commerce in China (2014b).

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and penalties. The 2015 US-China Chamber of Commerce’s Survey on China’s Business Climate showed that a significant majority of the respondents felt targeted in the intensified government probes.89 There should not be any complaint if the law is applied equally and fairly. However, the campaign is carried out against the background where many SOEs are still free from the reach of the law, although they have been long complained and caught in wellestablished cases. For instance, the antimonopoly investigations against China Telecom and China Unicom as two domestic giants in 2011 thus far have not led to any concrete penalty;90 whereas foreign multinationals have paid more than three fourth of antitrust fines thus far.91 Such a condition has also been deeply concerned with by the EU Chamber of Commerce for lack of transparency, impartiality and consistence as focal points for further attention.92 Worse yet, in the course of reforms some new state monopoly continues to be created. For example, the SASAC has been harshly criticized for establishing a national tower company to control all the basic communication resources. According to the SASAC’s plan, all the Chinese major telecommunication companies shall no longer build their signal towers, but lease the facilities from the company under the SASAC control. As some scholars pointed out, such operation will put the national tower company in a “super monopoly” position, which will not only seriously hurt consumers’ interest, but destroy all the market developments in the past 20 years.93 Another telling example is the mega merger of CNR and CSR as two largest state-owned train makers ordered by the Central Government with a hope to win out in the international market over serious concerns with compliance with the antimonopoly law and return to the old fashion economy.94 5

Institutional Challenges

Although it is a common sense that no comprehensive reform in a huge country with great complexity like China could be easy, the difficulties facing the new round of reform reflect more the inherent contradictions of 89  90  91  92 

Harjani (2015); Burkitt & Murphy (2014). You (2013). Clover (2015). EU Chamber of Commerce Press Release on China AML-related Investigations, 13 August 2013. 93  Kan (2014). 94  Chang (2014).

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China’s socialist market economy than all practical odds. In fact, the concept of the socialist market economy itself is highly controversial from it being first raised.95 After its practice for more than 20 years, the tension between the socialist ideology and governance on the one hand and the market disciplines and freedoms on the other has reached a critical stage. The Reform Decision itself is a good example to illustrate such conditions. Although a call for deepening market reform was vigorously made, with the equal strength the Decision reiterated the traditional ideology, such as CPC’s firm leadership, further enhancement of the socialism and public ownership. The same struggling is also reflected in the 2014 Decision where the CPC leadership and rule of law were promoted together. It should be noted that unlike the CPC decisions adopted earlier with due emphasis on political reform,96 the task was little mentioned in the Reform Decision.97 Instead, a new social governance system with grid management and enhanced confidence on the socialist path, theory and system was strongly underscored.98 Such inherent contradictions have led to paradoxical practice. For instance, while decentralization, deregulation and de-administration are becoming the major themes of the government reform, the degree of power concentration of the top leaders has even surpassed the Mao-era;99 the pledge to let the market to play a decisive role and accelerate the economic restructuring thus far has to compromise with the government’s escalated stimulus;100 recognition of the Constitution and rule of law as the supreme authorities to guard the nation for its long term development in the Reform Decision has to be implemented with the party state insistence that its ruling power cannot be ever shaken101 so rendering constitutionalism even becoming a dirty word in China.102 The promotion for an innovative society is carried out together with tightened control over freedom of expression, communication, access to information,

95  Weil (1996); Suliman (1998); Cody (2005). 96  For instance, the political report of CPC 13th Congress mentioned political reform 13 times with a specific section and explicitly stated that “the success of economic reform cannot be achieved without political reform”. See cpc.people.com.cn (2015). 97  In the Reform Decision the term of “reform” was used 136 times, but reference made to political reform only once. See Chen (2013). 98  The Reform Decision, Part 1 (2) and Part 13. 99  Lam (2013); Huang (2014). 100  Ruan (2014); Chang (2013). 101  Xi Jinping’s speech delivered at the National Political and Legal Affairs Conference on 7 January 2014. 102  Qian (2013).

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and association at a unprecedented degree;103 rampant corruptions have been dealt more with a political campaign than institutional capacity building.104 The promise for improved level playing field for equal market competition has led to an antitrust enforcement campaign with more than three fourth of fines being imposed on foreign investment enterprises and even “inspired by the high level officials of the central government”.105 All these contradictions as Chinese characteristics represent the real challenges to the party state in the new round of reforms. A market economy has its built-in DNA and motivation of freedom, autonomy, equality, democratic politics, competition and rule of law. The history of capitalism development tells its victory by way of revolution over the feudalism with autocratic powers.106 As such market development in China is not riskless to the regime. Although the pragmatic strategy was adopted by Deng Xiaoping through opening and reform to learn from capitalism and use its mechanisms to develop China, the crucial “socialist” qualification has been firmly maintained to ensure the political correctness of the reorientation from the very beginning.107 Against this backdrop, the new round of reforms will be seriously tested in at least two aspects. First, the existing legal framework needs to be overhauled in order to pave a way for further marketization. Despite China’s rapid developments the Constitution has not been changed for more than a decade. Today it still explicitly guarantees the public ownership the fundamental and leading position in the national economy with state special protection108 whereas the private sector must be subject to the government guidance, supervision and administration with the worry on its disturb the order of the socialist market economy.109 Although after a long struggle the Constitution finally sets out a provision to protect private properties, but refuses to grant them the sacred status as enjoyed by the state assets.110 On this basis dual track legislations on business entities have been maintained and developed. On the one hand, business entities are subject to different enactments according to their ownership with different rights, duties 103  King, Pan & Roberts (2013); Zhang (2014). 104  Hatton (2013); Cheung (2007). 105  Liu & Li (2014); Yang (2014). 106  Fulcher (2004). 107  Deng (1994). 108  The Constitution of China, Arts. 6 and 7. 109  Ibid., Art. 11. 110  Ibid., Compare Art. 12 and Arts. 13 and 15.

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and obligations, such as Law of Enterprises Owned by the Whole People (the SOE Law), Law on State Assets of Enterprises, Township Enterprises Law, foreign investment enterprises laws,111 and Private Enterprise Regulation. On the other hand, Company Law, Partnership Enterprises Law and Sole Proprietorship Law have been introduced into China as the modern enterprise system. Such legislative framework has not only caused confusions and difficulties in practice, but also become an obstacle to develop a level playing field in the market. For example, unlawful embezzlement of state assets has been a legal trap for a long time with many convictions of private entrepreneurs in their dealing with SOEs.112 Moreover, although the Constitution explicitly recognizes the concept “private economy”,113 it has been rarely used in practice because the top leaders have repeatedly warned that privatization is not an option for China.114 Instead, civilian capital, civilian-run enterprises and civilian economy have been commonly used in order to avoid the political sensitivity. In addition to the legal framework and general principles, the political ideology is also reflected in various legislations. For example, the Law on State Enterprise Assets sets out detailed rules not for equal protection and entitlements of all the investors, but special privileges of state investment and assets. For example, the legislative purpose is clearly stated to enhance state owned economy for its leading role in the national development.115 As such, the state is empowered to take measures to promote state capital concentration to all important business sectors as the national lifelines and to enhance the influence and control of the state economy.116 To this end, directors and other senior offices of enterprises with state investment, under the Law, shall not only owe their fiduciary duties to their enterprises, but are explicitly prohibited from engaging any “activity harmful to the state investment.”117 This rule apparently violates the fundamental company law principles of joint venture, “equal share, equal right”, and directors’ duty to the company as a whole. Moreover, the Law clearly mandates preservation and increase of the value of state asset with violation penalties,118 although the 111  Foreign investment enterprises laws include Sino-Foreign Equity Joint Venture Law, SinoForeign Contractual Joint Venture Law, and Whole Foreign Owned Enterprises Law. 112  Zhong (2014). 113  The Constitution of China, Art. 11. 114  “China Says Western-style Democracy Impossible for CCP Dynasty,” China Daily Mail, 13 March 2013. 115  The Law on State Enterprise Assets of 2008, Art. 1. 116  Ibid., Art. 7. 117  Ibid., Art. 26. 118  Ibid., Art. 8.

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market discipline and competition have never guaranteed profit for any firm. Such examples may also be found in the Company Law as amended in 2013, which mandates establishment of CPC grassroots organizations in companies with their necessary conditions guaranteed119 and copies the SOE style of “democratic management” to companies of private investment;120 and the Anti-Monopoly Law, which protects state economy’s monopoly in all business sectors which are unclearly defined as national economic lifelines.121 Implementation of the new round of reforms will inevitably pose daunting challenges to the existing legal system and demand a comprehensive reform of the rules inconsistent with the new orientation. In this context, it should be noted that the Reform Decision also called for equality of rights, opportunities, and rules by abolishing various unreasonable provisions to non-public economies.122 Without such a top-down reform and design, the transformation to a real market economy cannot be successful for lack of legal foundation. The urgent needs of legislative reform also carry some serious implication on the party state’s long practice to use policy as a convenient means to control and influence the market. Thus far numerous policies have been adopted to promote various reforms, but received very limited success. For example, the central government has promised to improve the environment for private sector development with a series of policy documents, such as Certain Opinions to Encourage, Support and Guide Development of Non-Public Economy in 2005 (known as “the 36 Articles”), Certain Opinions on Encouraging, Certain Opinions on Further Promotion of Small Enterprises Development in 2009, and Guiding Healthy Development of Private Investments in 2010 (known as “the New 36 Articles”), and at least 42 circulars adopted by 45 state authorities under the State Council’s push for further promotion of private sectors in 2012, (known as “Implementing Provisions of the New 36 Articles”).123 Despite all the efforts, promulgation of a new set of policy to a large extent would indicate unsatisfactory, if not failed, implementation of the previous ones. As some experts pointed out recently, strong bureaucratic resistance and temporary gesture have rendered many of these policies merely lip service and empty

119  Art. 19 of Company Law of 2013. 120  Art. 16 of Constitution and Art. 18 of Company Law are virtually the same, although the latter are not SOEs. 121  Art. 7 of Anti-Monopoly Law of 2007. 122  The Reform Decision, Part 2 (8). 123  All these circulars as well as all local measures are listed at the central government website dated 24 July 2012. See gov.cn (2012).

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promises.124 As such, realization of the pledge “to let market to play a decisive role” will inevitably demand for stronger and clearer legal rules and institutions support, rather than policies as alms exercise of the party state. Secondly, the implementation of reform measures will really test the political will of the party state for what they has pledged. In this regard, the reform ambition has apparently compromised with other political and ideological considerations already. Before adoption of the Reform Decision, the SASAC raised its strong opposition against the World Bank Report of China: 2030 for its proposals to accelerate marketization with further reform SOEs and the financial system and promote social equality. The SASAC accused the reform measures were against the Constitution with the danger to overturn the socialism in China.125 In the course of implementation of the Reform Decision despite repeatedly warning of the World Bank and many experts on China’s running out of time to prevent the potential crisis,126 the party state seems to gain more self-confidence to continue to pursue the economic growth as the priority over the reform.127 In fact some experts have observed that, so far, more promises have been seen than delivered with growing reliance on the old model and fiscal stimulus at the cost of urgent reforms and rebalance because the party state has to first consolidate its political power and preventing social instability if the development momentum cannot be maintained. The stake here is the legitimacy of the party state, which has been built on the high economic growth. Such political pressure with potential crisis is so profound that would force the regime to delay the reforms in the race against time.128 Such struggle has also been well reflected in the judicial reform. Although, in general, the reform measures are welcome, a closer look would find the CPC’s firm and absolute leadership is equally emphasized as “the most fundamental safeguard”, “a basic need” and “being identical” of rule of law in China.129 Such “Chinese characteristic” may pose difficulties and uncertainties to adjudication when the judiciary may have to take side between market disciplines and political ideology.

124  See “Lip Service and Empty Promise,” Wen Wei Po (Wenhui Daily—Hong Kong), 8 March 2014. 125  Barboza (2012). 126  Qi & Silk (2014); Yao, supra note 70. 127  Browne (2014). 128  Kahn (2014). 129  The 2014 Decision, Part 1.

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For a long time, the party state control and intervention are the key challenges to judicial independence and justice. Without substantive reform, partially reducing financial power of local governments on the judiciary and imposing more responsibility on the judiciary, while on the right direction, may not be good enough. The reform to allow more judicial freedom with tightened political control may even subject judges to more pressure because they have to handle some high profile cases themselves with more political risks and less support that used to be provided routinely and openly by the leaders of the court. The 2014 Decision apparently notes such potential and thus, not only reiterates the CPC’s firm leadership and socialist road, but explicitly demands that the political ideology be in the first place in improving judicial quality.130 As Professor Stanley Lubman pointed out that the reference to the party control and “political character” itself suggest limits on the independence reform.131 As a result, the reform may stumble over its own paradox. Moreover, such struggle, as Professor Liebman observed, showed that the regime has not built up its full faith and trust on legal institutions as primary means to deal with social conflicts in rapidly transitional period. It is evident that extralegal means have still been widely used in China at least in the first two years after the new reforms were implemented.132 Such political impacts are also well reflected in judicial practice in dealing with normal commercial disputes. As Professor Howson found in his comprehensive study of handlings of company cases between 1992 and 2008 by Shanghai People’s Court as one of the best developed jurisdiction in China, although progress had been made, in a large number of cases, “the courts actually worked against the law in the service of state political aims”, particularly in cases with public concerns and the companies supported by the government. The party state policy often prevented them from accepting cases or took social stability as their key consideration in making their decisions.133 In this context the recent judicial reform may still fall short of the market demands for its impartiality and authority.

130  Ibid., Part 6. 131  Lubman (2014). See also Cohen (2014); Zhang (2014); Ji (2014); Tiezzi (2014). 132  Liebman (2014). 133  Calcina Howson (2010).

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Concluding Remarks

The Reform Decision has no doubt opened a new chapter of the historical reform in China. The implementations since 2013 have also demonstrated the serious efforts of the party state. However, given the mixed signals and measures as well as the ideological struggles manifested the political commitment to the comprehensive reform will be further tested and subject to uncertainties. A crucial problem facing the regime to further market development is that, to what extent, a real level playing field can be created for fair and equal competition. Such development will inevitably demand for less political control and more business freedom and autonomy. The fundamental paradox may, first of all, have to find its solution with political breakthroughs.134 As such it seems only time may provide the accurate answer to the current reforms to be another around of path dependent exercise, or a ground-breaking evolution. References American Chamber of Commerce in China (2014) “China Business Climate Survey 2014.” Armanovica, Marika (2012) “China Pledge to ‘Deepen’ Reforms, Though Implementations Remains to Be Seen,” European Parliament DG Expo/B/PolDep/Note/2013_322, 25 November. Back, Aaron (2014) “China Stimulus Comes with Reform Gestures, but Still Just Boosting Growth with More Banding,” The Wall Street Journal, 3 July. Barboza, David (2012) “Furor over Report Hints at a Chinese Policy Debate,” New York Times, 2 March. Baston, Andrew (2014) Fixing China’s State Sector, Chicago: The Paulson Institute. Bradsher, Keith (2014) “China Leans Toward More Stimulus Measures,” New York Times, 3 April. Breznitz, Dan, & Michael Murphree (2011) “Innovation in Emerging Economies: China’s Run of the Red Queen,” The World Financial Review, Sept.–Oct., 66–69. ——— (2011) The Run of the Red Queen: Government, Innovation, Globalization, and Economic Growth in China, New Haven: Yale University Press. Browne, Andrew (2014) “Reform Pace Suggests Beijing Thinks It Can Wait,” The Wall Street Journal, 19 August. ——— (2014) “China Business Leaders Hedge Bets on Xi,” The Wall Street Journal, 15 April. 134  de Jonquieres, supra note 66.

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Kan, Kaili (2014) “The National Tower Company Let China Telecommunication Industry Return to Monopoly,” BBC (Chinese edition), 8 May. King, Gary, Jennifer Pan, & Margaret E. Roberts (2013) “How Censorship in China Allows Government Criticism but Silences Collective Expression.” 107 American Political Science Review, 1–18. Kroeber, Arthur R. (2013) “Xi Jinping’s Ambitious Agenda for Economic Reform in China,” Brookings Research, 17 November, http://www.brookings.edu/research/ opinions/2013/11/17-xi-jinping-economic-agenda-kroeber (accessed 29 April 2015). Lam, Willy (2013) “Centralized Power Key to Realize Xi’s China Dream,” China Brief, 28 March. Lardy, Nicholas (2014) Markets over Mao: The Rise of Private Business in China Washington: Peterson Institute for International Economics. Lau, Mimi (2013) “Revealed Truth behind Tragic Secret Execution of Businessman Zeng Chengjie,” South China Morning Post, 30 July. “Let the Policy from the Forbidden City to Take Its Root”, The Central Government Website, 17 July 2014, http://www.gov.cn/xinwen/2014-07/17/content_2718960.htm (accessed 29 April 2015). Li, Keqiang (2013) “Speech at Summer Davos Opening Ceremony,” 12 September, http:// english.cntv.cn/20130912/100860.shtml (accessed 29 April 2015). ——— (2014) “Central Government Working Report of 2014 Delivered at the Second Plenary of the Twelfth National People’s Congress, 5 March 2014, Part 3 (1),” http:// news.xinhuanet.com/politics/2014-03/14/c_119779247_3.htm (accessed 29 April 2015). Liebman, Benjamin L. (2014) “Legal Reform: China’s Law—Stability Paradox.” 143 Daedalus 96–109. “Lip Service and Empty Promise,” Wen Wei Po (Wenhui Daily—Hong Kong), 8 March 2014. Liu, Zhongsheng, & Li Wei (2014) “Antimonopoly with the Chinese Style,” Tengxun Caijing (Tengxun Finance), 7 August. Lubman, Stanley (2014) “Power Shift: Hopeful Signs in China’s Legal Reform Plan,” The Wall Street Journal, 10 July. “Officials Claim ‘Guojin Mintui’ Good to the National Development,” Diyi Caijing Ribao (China Business News), 19 January 2010. “Overview of China’s Mini-Stimulus Plans Since 2014,” Fenghuang Caijing (Phoenix Finance), 12 August 2014. Peters, Katie (2014) “China Economic Reform Agenda Fails to Shift the Country’s Economic Structure from State to Market Driven,” Release of Center for American Progress, 1 May. Ping, Xiaoqing, & Josh Zhang (2014) “China’s Local Governments Pile on Stimulus Undeterred by $3Trillion Debts,” Bloomberg News, 15 July.

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“Pressure or Motivation? A Map of Difficulties Facing Private Enterprises,” Qiye Guancha Bao ( Journal of Enterprise Observation), 18 February 2014. “Private Investment Slowdown,” Xin Jing Bao (The Beijing News), 8 October 2014. Qi, Liyan, & Richard Silk (2014) “Biggest Risk for China Could Be Failure to Change, Economists Say,” The Wall Street Journal, 22 August. Qian, Gang (2013) “Uncertain Death of ‘Constitutionalism’,” China Media Project of the Hong Kong University, 2 September, http://cmp.hku.hk/2013/09/02/33944/ (accessed 29 April 2015). Rabinovitch, Simon (2012) “Private Sector Battles March of Chinese State,” Financial Times, 11 November. Ruan, Victoria (2014) “Beijing’s ‘Mini-Stimulus Fails to Excite Market,” South China Morning Post, 4 April. Salidjanova, Nargiza, and Lacob Koch-Weser (2013) “Third Plenum Economic Reform Proposals: A Scorecard,” U.S.—China Economic and Security Review Commission, 19 November. sasac.gov.cn (2015), http://www.sasac.gov.cn/n1180/n1226/ (accessed 29 April 2015). “SASAC: Reforms Cannot Touch the No-loss Bottom Line,” Ta Kung Bao (Hong Kong), 15 July 2014. “SASAC Initiates Four SOE Reform with Substantial Steps”, Xinhua News Agency, 15 July 2014. Scissors, Derek (2014) China’s Economic Reform Plan Will Probably Fail, Washington: American Enterprise Institute (AEI). “Shanghai FTZ after One Year: Few Breakthrough, But Valuable Lessons”, BBC (Chinese Edition), 30 September 2014 Shen, Hong (2014) “One Year On, Shanghai Free-Trade Pilot Zone Disappoints”, The Wall Street Journal, 28 September. Silk, Richard (2014) “In Shanghai, Free-Trade Zone Fails to Rev Up Car Makers,” The Wall Street Journal, 15 August. ——— (2014) “U.S. Business Group Plies China Agenda,” The Wall Street Journal, 22 April. Suliman, Osman (1998), China’s Transition to a Socialist Market Economy, Westport: Quorum Books. “The Central Enterprises Realized Profits of RMB 1.4 Trillion in 2014,” China IRN, http:// big5.chinairn.com/news/20150123/150510981.shtml (accessed 29 April 2015). “The Great Transition,” The Economist, 22 March 2014. “The Reform Promise Realized Ahead of Time”, The Central Government Website, 13 January 2015, http://www.gov.cn/xinwen/2015-01/13/content_2803775.htm (accessed 29 April 2015). “The SOEs Becomes the Loss Disaster Area,” Jingji Cankao Bao (Economic Reference Journal), 19 September 2014.

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“The State Council: Temporary Suspension of Value-add Tax and Business Tax on Small Enterprises,” Zhongguo Xinwen Wang (China News Net), 24 July 2013. The US-China Business Council (2011) “China Eliminates Three Key Regulations That Link Indigenous Innovation to Government Procurement,” 28 June. The World Bank (2013) China 2030, Washington DC: The World Bank. Tiezzi, Shannon (2014) “China’s Legal Reform: A Balancing Act,” The Diplomat, 12 March. Tsai, Kellee S. (2007), Capitalism Without Democracy: The Private Sector in Contemporary China, Ithaca: Cornell University Press. Weil, Robert (1996) Red Cat, White Cat: China and the Contradictions of the ‘Socialist Market Economy’, New York: Monthly Review Press. Wen, Jiabao (2007) “Statement—News Conference,” 16 March, http://www.fmprc.gov .cn/eng/zxxx/t304313.htm (accessed 29 April 2015). White House Office of Press Secretary (2011), “Fact Sheet: US-China Economic Issues.” 19 January, http://beforeitsnews.com/obama/2011/01/fact-sheet-u-s-china-economicissues-365453.html (accessed 29 April 2015). Wildau, Gabriel (2014) “Shanghai Free-Trade Zone Struggles to Live Up to Its Hype,” Financial Times, 2 September. “With Revised Guidance Catalogue, China Introduces Sweeping FDI Reforms,” China Briefing, 7 November 2014. wto.org (2015) http://www.wto.org/english/tratop_e/dispu_e/dispu_by_country_e.htm (accessed 29 April 2015). Wu, Jinglian (2009) “China’s Economy: 60 Years of Progress,” Caixin (Caixin Magazine), 30 September. “Wu Ying’s Father Has Been Detained for 30 Days, But the Prosecutor Office Has Not Received Arrest Application Yet,” Jinghua Shibao (Jinghua Daily), 1 September 2014. Xinhua News Agency (2014), “Private Sector’s Contribution to the National GDP Is More than 60% in 2013,” http://news.xinhuanet.com/fortune/2014-02/28/c_119558098 .htm (accessed 29 April 2015). Xun, Jiang (2014) “Cover Story: Zhou Yongkang as the Mastermind of Injustice Against Private Entrepreneurs in China,” Yazhou Zhoukan (Asia Weekly), 13 April. Yang, Dali L., & Junyan Jiang (2012) “Guojin Mintui: The Global Recession and Changing State-Economy Relations in China,” in Dali Y. Yang, ed., The Global Recession and China’s Political Economy, New York: Palgrave Macmillan, 33–69. Yang, Hengjun (2014) “Why Do China’s Reforms All Fail?,” The Diplomat, 30 May. Yang, Junfeng (2014) “Why the Antimonopoly Campaign in China Is Not Applauded.” Jingrong Shibao (Financial Times), 26 August. Yao, Kevin (2014) “World Bank Sees China Growth on Track, Urges Reform,” Reuters, 6 June.

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You, Yunting (2013) “China Telecom Anti-Monopoly: What Trouble is the China National Development and Reform Commission Meeting?,” Bridge IP Law Commentary, 30 September. Zhang, Bing (2014) “The Largest Creditor in Wu Ying’s Case: I Have Not Received Even a Cent from the Foreclosure Sales,” Zhongguo JIngji Zhoukan (China Economic Weekly), 2 April. Zhang, Qianfan (2014) “China’s Real Judicial Reform Lies on Power Division,” Zhongguo Pinglun Yuekan (China Review), 20 August. Zhang, Wenkui (2014) “Private Entrepreneurs Are Watching ‘Mixed Ownership’ and Worrying About ‘Shut the Dogs up to Beat Them’,” Fenghuang Caijing (Phoenix Finance), 3 March. Zhang, Xianchu (2011) “China’s ‘Dual Track’ Legislation on Business Organizations and the Effects of the Antimonopoly Law,” in J. Garrick, ed., Law, Wealth and Power in China, London: Routledge, 142–62. ——— (2014) “Institutional Challenges to China’s Innovative Capacity Building.” 11 US-China Law Review 1337–63. Zhang, Zhanbin (2013) “Simplifying Governance and Delegating Powers to Provide the Market with New Economic Impetus,” Jingji Cankao Bao (Economic Reference), 15 May. Zhong, Zhiyuan (2014) “The Strength and Sad Melody of a Generation of Private Entrepreneurs,” Shangye Caijing (Commercial Finance), 13 April. Zhou, Junsheng (2014) “Troubles to Adopt Real Property Registration Regulation Lie with Multi-Administrations,” Beijing Qingnian Bao (Beijing Youth Daily), 13 July.

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Chapter 5

Regulating Internationalization of Currency Comparative Experience in Asia Weitseng Chen Abstract The path to internationalization of the RMB concerns not only international collaboration but also implementation of somehow conflicting (at least in the short term) policy objectives in various regulatory areas such as capital markets, banking, stateowned enterprises and capital account management. This essay identifies these interdependent policies necessary for RMB internationalization and explores experiences of other Asian economies, particularly Singapore and Taiwan, with the aim of drawing useful lessons for the RMB.

Keywords RMB internationalization – China – banking reforms – capital controls – state capitalism

1 Introduction Renminbi (RMB) internationalization has been the latest buzzword generating a lot of excitement and discourse not only in the global business and financial scene but also in the academia. Being the world’s largest exporter of manufactured goods as well as the second-largest economy, it seems a logical step for China to try to establish itself as a leader in the global financial market as well. The surge in interest in RMB internationalization is manifested *  Weitseng Chen is Assistant Professor and Deputy Director of the Center for Asian Legal Studies (CALS), National University of Singapore (NUS) Faculty of Law; JSD (2007), Yale Law School; and Hewlett Fellow (2008), the Center on Democracy, Development, and the Rule of Law, Stanford University. The author thanks Michelle Dy and Wang Kai for excellent research assistance and gratefully acknowledges the financial assistance of NUS AcRF Tier 1 Grant (R-241-000-122-112). Contact: [email protected].

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in the opening of the Shanghai Free Trade Pilot Zone (SFTPZ), which is to promote full convertibility and capital account liberalization of the RMB. Structural reforms to achieve this goal did not begin with the SFTPZ. As early as China’s National 11th Five-year Plan made in 2005, reforms have been gradually introduced to promote the use of the RMB in commercial transactions and trade settlement. The path to internationalization sounds simple on paper but is complicated in practice, due not only to the need to identify the precise measures to be adopted to achieve internationalization but also the determination of the proper sequence of these measures to ensure a smooth transition. Basically, it is essential for the internationalization of a currency to be freely and widely used as a store of value, medium of exchange, and a unit of account. The achievement of these three prerequisites also means that the currency will be fully convertible and freely traded in international capital markets.1 However, full convertibility may make domestic markets vulnerable to inter­ national speculative attacks and, historically, it has indeed contributed to regional financial and economic crises in Europe and Southeast Asia. How to strike a balance between deregulation and re-regulation of capital account management is challenging but crucial to the success of internationalizing a currency. This chapter aims to examine the experiences of Singapore and Taiwan as to the rationale and implementation of their policy choices, which may provide useful lessons for the SFTPZ. This chapter begins with an analysis of challenges (Section II) and opportunities (Section III) for China’s RMB internationalization scheme. Section IV moves to a comparative analysis by examining the experiences of Singapore and Taiwan in terms of currency and capital control reforms. This chapter concludes in Section V by outlining the factors involved in choosing between the two competing models manifested by the experiences of Singapore and Taiwan as well as their implications for the SFTPZ. 2

Challenges for RMB Internationalization

2.1 Recent Developments To make the RMB freely and widely used as a settlement currency, investment currency, and reserve currency, China has recently adopted four significant reforms as of the end of 2014: 1  Kurien & Geoxavier (2013).

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The issuance of RMB-denominated bonds, commonly known as “dim sum” bonds; The signing of bilateral swap agreements with 22 countries or jurisdictions;2 Nationwide cross-border settlement of the RMB in China; and Partial relaxation of regulations on foreign exchange transactions.

In 2007, mainland China allowed domestic and Hong Kong banks to issue RMB-denominated bonds traded outside China. These bonds are commonly known as “dim sum” bonds. This has led to notable milestones such as the issuance of the first sovereign RMB-denominated bond in 2009.3 The market took off significantly in 2010 following further deregulation.4 Another measure adopted is the signing of bilateral swap agreements by the People’s Bank of China (PBOC) with the monetary authorities of more than twenty countries or jurisdictions, including Hong Kong, Korea, Malaysia, the United Kingdom, Australia, and Singapore. This is for the purpose of providing RMB liquidity outside of China and makes the establishment of offshore RMB settlement centres possible. The bilateral swap agreements, coupled with the deregulation of the dim sum bond markets, have paved the way for the development of RMB offshore markets.5 The third measure is the launching of a pilot program on RMB crossborder settlement in 2009. This kind of settlement was initially only permitted at designated domestic banks and banks located in Hong Kong. This pilot program was limited to five cities at the beginning, but was extended to 20 provinces and trading partners from around the world the following year.6 At present, cross-border settlement in the RMB is allowed throughout China, and it has been further extended to other RMB offshore settlement centres such as Singapore, Taiwan, and South Korea.7 The restricted use of foreign exchange in China has been partially lifted through measures such as removing the quota limit on the foreign exchange account of current accounts, lifting the ceiling on foreign exchange purchases 2  For example, Argentina, Australia, Belarus, Brazil, France, Hong Kong, Iceland, Indonesia, Kazakhstan, Korea, Malaysia, Mongolia, New Zealand, Pakistan, Russia, Singapore, Turkey, Thailand, United Arab Emirates, United Kingdom, Ukraine, and Uzbekistan. 3  Chen (2013). 4  Schuman (2011). 5  Volz (2013), p. 6. 6  Ibid. 7  Wang China Time editorial (2014); Liu (2014); Asia Briefing (2014).

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for overseas investments, and the Qualified Domestic Institutional Investors (QDII) and Qualified Foreign Institutional Investors (QFII) schemes. The QDII scheme allows domestic investors to invest outside of China but only in equities and fixed-income products.8 The QFII scheme, on the other hand, allows foreign investors to access the Chinese domestic securities market. The build-up of offshore RMB funds has led the Chinese government to introduce its latest scheme, called the Renminbi Qualified Foreign Institutional Investors (RQFII). This scheme provides a means to repatriate offshore RMB funds into the domestic market through various RMB-denominated products. All in all, the measures taken aim to increase the use of the RMB both domestically and internationally, paving the way for RMB internationalization. In China’s business world, there has been a long tradition that favours the use of “hard currencies” such as the US dollar in order to accumulate foreign reserves, a move in line with the country’s export-oriented growth strategy.9 Various policies have been implemented to change this status quo, however, including the most recent five-year plan. The ongoing shift towards a consumption-led economy also renders the domestic discriminatory policies obsolete and provides a great opportunity for increasing the use of the RMB as an international currency. 2.2 Challenges from the Inside The real challenges for RMB internationalization do not come from the outside but from the inside. The reforms necessary to achieve the internationalization are not clearly-cut and straightforward. The actual challenge lies in the proper identification and sequencing of domestic reforms of the regulation on the increase in capital inflow as a result of RMB internationalization. Such reforms concern China’s highly monopolized banking and finance sectors at home and the failure of these reforms is likely to give rise to economic turbulence after the introduction of RMB full convertibility. Several traits of the current banking system constitute the major obstacles to RMB internationalization. The first is the restrictions on the convertibility of the RMB. The full convertibility is the perquisite for the RMB as an international currency for settlement, investment and foreign reserve. Risk arises, however, along with the introduction of full convertibility, which enables foreign capital to flow freely into China’s domestic market and domestic capital to fly out. While capital flight may drain domestic capital markets and lead to credit

8  Kelleher (2014). 9  Chen (2014); Guilford (2013); The Brics Post (2013).

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crunch, quick capital inflow may give rise to various bubbles if deep capital markets are not present to absorb such capital. The second obstacle concerns a wide range of issues that have arisen in China’s banking and finance system as a result of “financial repression”. Financial repression originally referred to measures that many developing countries employed to channel funds to themselves or their affiliates, fund which would go elsewhere in a deregulated market.10 Financial repression replaces market mechanisms with state intervention to decide, for example, lending interest rates, savings interest rates, credit allocation and the threshold of entry into banking and finance markets. The capability of the banking system under financial repression is questionable in the face of genuine market competition after restrictions on the banking sector and capital controls has been lifted. For example, if China’s regulators decide to liberalize the savings rates, banks may start to compete for capital by increasing saving rates that have been kept at an extremely low level to reduce the capital costs of state-owned banks.11 Eventually, such increases may render banks that are used to governmental subsidies uncompetitive, if not in financial distress. Conversely, if the savings rate continues to be set artificially low, deposits may flow into the informal banking sector or the newly established private or foreign banks that offer better rates, such as those within the SFTPZ. The other obstacle lies in the informal banking sector, a natural outcome of financial repression. Individuals and firms that have failed to obtain credit from state-owned banks would look for alternative sources of funding in the informal sector. The risks lie in the increase in financial arbitrage as a result of the lifting of capital controls. Aiming at the interest rate differences, foreign capital may flow into the informal banking sector by offering capital to intermediaries therein or, directly, lending the end borrowers. As a matter of fact, along with the introduction of important reforms targeted at the domestic sphere, the past two years have seen such risks materialized in the process of facilitating RMB internationalization. The PBOC, for example, aims to discontinue the usual policy responses to cyclical events such as economic slowdowns. As fiscal stimulus measures have usually been ruled out in order to deflate the credit bubble, a number of undesirable

10  Shaw (1973); McKinnon (1973). 11  Another reason to keep interest rate low is to minimize the magnitude of hot money inflows from abroad. Lardy (2012), p. 99.

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consequences have emerged recently.12 In March 2014, an issuer default was permitted for the first time in China’s onshore bond market, as Chaori Solar, a solar-cell maker, failed to pay full interest on its bonds.13 Less than two weeks later, another company defaulted as a property developer was unable to repay almost $600 million in loans.14 It is feared that other companies that have relied on trust financing will suffer the same fate.15 It has been reported that this credit crunch was also crippling the operations of China’s steel mills and other industries,16 spreading distress in China’s gold market as prices have surged due to accumulation of the precious metal as a hedge mechanism against the uncertainties in the economy.17 Even the interbank rate was not spared; it surged to record highs by the end of 2013.18 2.3 Responses to Domestic Challenges Chinese regulators nonetheless appear to be determined to proceed with the RMB internationalization scheme by introducing further reforms. First of all, the issuance of licenses to five privately-owned banks in early 2014 was a strong signal that China is serious in opening up its economy to foreign players. These banks, completely funded by private investment, are allowed to conduct banking operations in Tianjin, Shanghai, Zhejiang, and Guangdong.19 They are encouraged to service small, medium, and micro-sized enterprises while subject to the same regulations as state-owned banks. Moreover, this tightening of credit was complemented by the removal of the floor on banks’ lending rates, giving them commercial discretion with respect to the pricing of the loans. Non-financial institutions are also allowed to offer online payment services in order to implement the PBOC’s policy to promote a modern payment system, one catering to the RMB.20 The result has been phenomenal so far: the total value of online transactions in 2012 grew to RMB 4 trillion ($660 billion) from almost nothing in 2008.21 Alipay, the mobile 12  13  14  15  16  17  18  19  20  21 

Volz, supra note 5. Chen &Yong (2014). McMahon & Fung (2014). Yong & Chen (2014). Keenan & Yuan (2014). Critchlow (2014). Zhang (2014). Xie & Wildau (2014); Luo (2014). Hille (2010). Watling (2014).

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payment service of Alibaba.com, which completed the biggest IPO ever in financial history, had 190 million users as of October 2014.22 More radical reforms have been being introduced within the SFTPZ. In July 2014, Cathay United Bank, a Taiwanese bank, was established in the SFTPZ and not to be subject to any limits on lending used to finance cross-border trade activity within the zone, or to foreign exchange controls.23 More impressively, reforms adopted for the SFTPZ are also starting to find their way into the rest of China, as seen by the removal of the ceiling on interest on foreign currency deposits and liberalization of capital account settlement for foreign-invested enterprises (FIEs).24 The latter, in particular, is a vital milestone, as it allows FIEs to be established within the other sixteen pilot zones across China to convert any foreign currency into the RMB at will.25 Previously, FIEs were allowed to make the conversion only if they needed to make payments in the RMB as evidenced by supporting documents, which were to be verified and approved by banks. While FIEs can now better hedge foreign currency risk and reduce costs for the conversion and settlement process, this change signals that China is slowly preparing for full-blown capital account liberalization. The measure is also a step towards deepening the financial markets, since it also allows FIEs to make domestic equity investments from converted RMB funds. Still within the SFTPZ, the opening of free trade accounts has been allowed not only for banks but also for non-banking financial institutions.26 As a consequence, these financial institutions are no longer subject to strict capital controls that remain applicable to the rest of China. This measure also facilitates the transfer of money across borders with ease. Despite the massive importance of the measures already adopted by the Chinese government, the path to RMB internationalization still has a long way to go. In short, three institutional settings are needed to cope with the legacy of financial repression: First, deep and liquid financial markets; second, full RMB convertibility; and, third, a regulatory regime providing checks and balances and accountability that fosters the trust of investors—domestic and foreign alike.27

22  23  24  25  26  27 

Osawa (2014). Chen & Yeh (2014). Hui (2014); Tam & Qi (2014). He & Gan (2014). Wang (2014); Qin (2014). Prasad (2014a); Volz, supra note 5, p. 6.

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Opportunities for RMB Internationalization

3.1 Global Political Economy after 2008 Financial Crisis The 1997 Asian financial crisis was a crucial event in setting the stage for China’s emergence as a player in the international financial scene. Its success in maintaining its currency’s stability amidst a spate of devaluations within the region fostered confidence in the RMB. This led to an increased regional financial cooperation that culminated with the Chiang Mai Initiative.28 Nonetheless, this initiative did not have much impact outside the region and the country’s sphere of influence remained limited to Asia. After 2008 when the international financial order nearly collapsed, however, calls for the end of the US dollar hegemony re-emerged. Since then, the rise of the RMB in the global financial scene has been phenomenal. From having an insignificant share of the global market three years ago, it has overtaken at least 22 currencies and claimed the fifth spot behind the US dollar, Euro, British pound, and Japanese yen among the most widely-used currencies.29 The present momentum in the global financial scene is arguably favourable for the RMB due to rising discontent with the present international financial order associated with the dozminance of the US dollar. Eswar Prasad, an economist at Princeton University, has proposed the notion of the “dollar trap”, arguing that the 2008 financial crisis has in fact strengthened the US dollar’s dominant role as the store of value.30 Developing countries have no better choice other than continuing to purchase US treasury bonds as a safe hedging vehicle, despite the US dollar’s depreciation as a result of expansionary monetary policy.31 This discontent has also been fuelled by increasing use of financial sanctions as an instrument of US foreign policy, taking advantage of the centrality of the US dollar in the global financial network.32 For example, in July 2014, US authorities imposed an $8.9 billion fine against France’s BNP Paribas for allegedly processing and transferring billions of dollars on behalf of countries blacklisted by the US such as Sudan, Iran, and Cuba. This marks the greatest 28  Gao & Yu (2011), p. 1. 29  Trivedi (2014); Jiang (2014). 30  Prasad argues the financial crisis has actually strengthened US dollar’s role as the international store of value rather than weakening it, as the supply of safe financial assets shrank while the demand for it grew stronger. With no other reasonable alternative, US government bonds as safe assets remained unchanged. See Prasad (2014b). 31  Ibid. 32  Kemp (2014).

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fine imposed on a financial institution by the US government for violating the law as well as the economic sanctions imposed by the United States. Other penalties such as the temporary suspension of its authority to transact in US dollars and perform dollar-clearing functions were also imposed.33 This has led to calls from France and Russia to weaken the world’s dependence on the US dollar in international financial transactions and to increase use of other available currencies.34 Due to these events, investors and regulators in other countries are starting to turn their heads towards China as a possible alternative to the greenback.35 3.2 China’s Comparative Advantage There is no denying that China lacks deep financial markets or transparent institutions cannot be denied. Nevertheless, this does not automatically eliminate its currency’s role as a possible contender against the greenback. In fact, it may be asserted that China is the only serious contender to United States’ hegemony over international currency. The reason lies in the size of its economy. While the challenge for RMB internalization comes from its large-scale economy with great variations among regions, the key to its successful unseating of the US dollar may also be attributed to its scale. China’s immense economy will be able to create sufficient demand for the RMB not just from its own market but also from overseas markets as foreign investors aim to benefit from China’s surging consumer market. As China’s annual import growth has averaged 18 percent over the past twenty years, it is expected to become the world’s top importer. The US has also benefited from China’s success as American exports to China have increased five-fold over the previous decade. The size of China’s economy is also huge enough to absorb the shocks and inefficiencies that could be caused by simultaneous application of numerous reforms in the domestic economy. The large scale of its market enables China to diversify institutional configurations according to regional conditions. An economy must be large enough in order to compel existing players to bend their accepted rules to accommodate new institutional changes, including the currency, because the switching costs can be compensated for by the economy of scale. One case in point is the Qianhai Free Trade Zone (QFTZ), a competitor of the SFTPZ located in Qianhai, Guangdong province, near Hong Kong. The QFTZ manifests China’s intention to take advantage of its large economy to 33  Barrett et al. (2014). 34  Dyer (2014). 35  Buell (2014).

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experiment with various institutional settings all geared towards a common goal. The SFTPZ and the QFTZ were both established to serve as the gateway to China for foreign investors through financial liberalization.36 The QFTZ aims to achieve this by copying Hong Kong’s economic model down to the latter’s preferable taxation, legal system, and professional standards.37 In comparison, the SFTPZ focuses on implementing institutional reforms that will eventually be rolled out to the rest of China rather than coming up with preferential policies.38 China is not the first beneficiary of the scale advantage, however. This phenomenon can also be observed in the process of the internationalization of the Euro. Before its rise, the Euro was thought to be the next international currency after the US dollar simply because the scale of the European Union’s (EU) economy was massive, accounting for about 31% of world output and 20% of world trade (excluding intra-EU transactions).39 Nonetheless, the difficulty and costs involved in the process of creating a single Euro zone indicates China’s scale advantage. The major mandate of the EU is to merge markets across Europe to create a large market to support the Euro as an international currency. However, the EU remains incapable of fully maximizing synergies due to various obstacles to the integration of non-homogenous economies in Europe. The aggregation of numerous small economies is the source of the problem as EU member states remain independent and are guided by different agenda and objectives. Integration of regulations still continues, such as the creation of a banking union indicating the progress of Euro internationalization.40 At the same time, difficulties are prominent, legally and financially. While debts are denominated in Euros, they are issued by separate national states that have different credit quality and liquidity risks and are subject to different legal procedures. There is also no benchmark Euro asset like the US treasury bonds; instead, twelve different issuers participate in the Euro government securities market.41 The Euro also is not able to break out of the cycle of path dependence, as switching costs proved too costly. The high cost of doing business in Euros, the ambiguous governance structure of the Economic and Monetary Union (EMU), and the conflicting multiple roles of the European Central Bank (ECB) 36  37  38  39  40  41 

Chatterjee & Chen (2013). Li (2014); Pomfret & Leung (2014). Ye (2014). Lim (2006), p. 10. Constancio (2013). Lim, supra note 39. (2006); Galati et al. (2009), p. 12.

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have all contributed to the Euro’s failure to eliminate dependence on the US dollar.42 Overlapping regulatory power among multiple regulators also affects the effectiveness of economic policies.43 Additionally, the EMU’s institutional structures negatively affect the Euro’s chances as a store of value, because the ECB’s sole mandate to maintain price stability and fight inflation comes at a cost of possibly stunting real growth and negatively affecting the returns on Euro-denominated assets.44 In this regard, China’s single market does not have to face similar problems of integration. 4

Struggling between Deregulation and Re-Regulation: Asian Experiences

The three institutional settings necessary for the RMB to be accepted as an international currency have already been set forth earlier in this paper: (1) deep and liquid financial markets; (2) full RMB convertibility; and (3) a regulatory regime that is transparent and accountable for investors. The crucial issue, however, still remains: how will these settings materialize in China? The answer is not as simple as the assertion that China needs to strike a balance between deregulation of various sectors (e.g., banking, capital markets, exchange rates, interest rates, and currency convertibility) and regulation of them in order to manage risks resulting from openness to global markets. First, a model for liberalization must be chosen, and second, the proper sequence of reforms prescribed by the model must be established. This section discusses the difficulty in sequencing and then moves on to examine the two competing models in East Asia, exemplified by the respective experiences of Singapore and Taiwan.

42  Cohen (2003). 43  Unlike the US, there is no single voice within the EMU because political concessions and compromises, which made the Maastricht Treaty possible, also fragmented decisionmaking between national governments and EU institutions. In setting the exchange-rate policy, for example, the primary responsibility is lodged with the ECB. However, such responsibility could be wrested by the Council of Ministers if a more general orientation of policy is involved. Having two decision-makers could lead to instability and confusion among those who intend to use the Euro. Ibid., p. 590. 44  Ibid., p. 585.

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4.1 Sequencing of Reforms Past economic crises like the Asian financial crisis of 1997 and the more recent 2008 global economic downturn demonstrated the connections between and within the domestic and international financial sector. The exposure of an economy to global capital and speculative attacks will eventually lead to a crisis if the regulators fail to identify either the proper reform measures or their sequencing for the purpose of implementation. This is particularly true in emerging markets where fast economic growth is not necessarily accompanied by sound financial systems. The development of the economy and inflow of capital usually do not keep pace with the development of the financial system; to varying degrees, for example, there may be lax lending standards, weak supervisory regimes, inadequate capitalization, excessively interconnected lending, and a more general lack of a credit culture.45 Experiences of some countries in Latin America and East Asia have illustrated the fatal outcomes of such failures. There are several competing views on how exactly the reforms should be undertaken. Ronald McKinnon proposed a system of priorities in liberalizing an economy in light of the failures of financial institution reforms in Chile, Argentina and Uruguay in the 1980s.46 First of all, fiscal controls must be put in place to ensure sufficient tax revenues and prevent the need for the government to cover deficits by increasing money supply. Fiscal controls that stabilize budget deficit and control inflation can then be followed by domestic financial liberalization, which should begin with liberalization of interest rates and end with decentralization of banking through private ownership or control of commercial banks.47 The next order of priority would be liberalizing policies towards the external sector such as the lifting of foreign exchange controls, import or export controls, and finally full capital account convertibility.48 In particular, the order of liberalizing capital controls is recommended as follows: capital inflow prior to capital outflow, long-term capital prior to short-term capital, direct investment prior to indirect investment, and institutional investors’ capital prior to that of individuals.49 These policies were eventually 45  46  47  48 

Nanto (1998). McKinnon (1991). Ibid. Interestingly, McKinnon and Schnabl suggested that China maintain exchange rate controls and certain level of capital controls, and not internationalize the RMB. For instance, purely financial transacting in the RMB should be kept resolutely offshore to avoid China from being inundated by hot money from abroad. McKinnon & Schnabl (2014). 49  Lu & Lo (2014).

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incorporated in the International Monetary Fund’s (“IMF”) official policy advice, which has been implemented by a number of developing countries.50 However, as will be discussed later, subsequent economic crises have led the IMF to re-examine this policy stance. In comparison, Hellman et al. also envisioned an eventual transition into a free market economy but proposed a more inclusive system of reform by creating incentives for the private sector to be an active instrument of liberalization.51 Specifically, they proposed a model of “financial restraint” in which the government plays an active role in creating rent opportunities for the players in the financial sector in order to induce economically-efficient actions that would not have been undertaken otherwise due to inadequate returns. Financial restraint, which relies on state intervention to facilitate the creation of rents for market players, is different from financial repression, which is common in emerging markets and allows the state to directly extract rents from the private sector (e.g., through keeping saving interests lower than inflation). Rent opportunities created by the model of financial restraint would eventually lead to financial deepening, which is the precondition of an eventual economic transition into a “free markets” paradigm. In essence, these strands of literature place emphasis on achieving financial deepening and the incremental integration of the domestic economy into the international financial market. Nonetheless, the crash of the Asian economy in 1997 and of the global economy in 2008 changed the way financial liberalization has been viewed and the possible risks brought about by the procyclicalities and volatilities in capital flows have become the focal point. Financial deepening and integration are still viewed as important goals after the 2008 financial crisis, but it has been recognized that with liberalization comes an increased vulnerability to volatile capital flows. Thus, before there can be talk of financial deepening and integration, macro prudential policies and a strong institutional and regulatory framework must first be in place in order to temper these vulnerabilities.52 Liberalization should therefore proceed gradually, taking into account and addressing the risks brought about by each stage of reform before venturing into another. In short, the order of liberalization of capital controls and the banking system not only matters but is vital for reforms. The challenge, however, is that there is no single, clear formula for liberalization. As each country is beset with different issues occurring at 50  Takagi et al. (2005), p. 58. 51  Hellmann et al. (1997). 52  Kokenyne & Weisfeld (2012), p. 13.

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different times, the sequence and extent of reforms would have to depend on the individual countries’ circumstances. Countries and international financial institutions alike were also forced to rethink the suitability of a full convertibility model over a model where certain capital control measures are retained in the process of liberalizing one’s economy.53 The post-crisis international financial world has seen a softening on the stance on full convertibility and embraced the idea of retaining a certain level of capital controls for developing economies. Even the IMF has begun to accept that full liberalization may not be apt for all countries at all times and that capital flow management measures, albeit temporary, may sometimes be necessary in order to restore stability in times of economic uncertainty.54 As such, the following sections aim to examine the experiences of Singapore and Taiwan regarding their choices with respect to sequencing capital control liberalization and related financial reforms. 4.2 Case Study: Singapore 4.2.1 Exchange Rate-Centric Model Singapore, a city-state with small domestic market scale, depends on imports due to the lack of resources necessary to support its population. In order to earn the foreign currency necessary to pay for such imports, the country has to export heavily as well. As a result, maintaining an open economy is its policy priority. In financial terms, the openness of the Singaporean economy means that the exchange rate bears a stable and predictable relationship to price stability as the final target of policy.55 To maintain a stable exchange rate, Singaporean policymakers had to determine their policy under what scholars call the “impossible trinity”. This trilemma means that the state can only choose two of the three policy options: fixed exchange rate, free capital flow, and independent monetary policy (e.g., by the means of interest rate adjustments). In other words, the state has to compromise either free capital flow or independent monetary policy if it intends to maintain a stable exchange rate. Considering its market conditions, Singapore decided to keep free capital flow and maintain a stable exchange rate, with interest rates fully decided by the markets.56 As a result, Singapore is not able to fully exert its monetary power by adjusting its interest rates. Singapore’s experiences demonstrate how policies on capital controls, exchange rate and currency convertibility should be decided in context 53  54  55  56 

Volz (2013), p. 368; Ostry et al. (2010, 2011). Kokenyne & Weisfeld, supra note 52, p. 19. Ong (2013), pp. 308–9. Ibid.

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depending on market development and institutional conditions. With Singapore’s vulnerability to exchange rate shocks, an exchange rate-centric regime as an instrument of monetary policy makes perfect sense. One of the undesirable consequences of the country’s heavy dependence on imports is that it imports inflationary pressures as well. Thus, domestic prices of goods are directly affected by their global prices. An exchange rate model ensures that prices remain stable domestically despite escalating prices elsewhere. Given the characteristics of the Singapore economy, direct intervention in the foreign exchange markets allows the government to manage macroeconomic outcomes such as GDP and CPI inflation and ensure that prices remain stable.57 As a result, the Singapore dollar (SGD) is pegged against a basket of currencies from Singapore’s trade partners and competitors. Each currency is further trade-weighted according to trade volume and its degree of importance to the Singaporean economy. Using a basket instead of pegging to a single currency allows the Monetary Authority of Singapore (MAS) to temper volatility more effectively.58 Aside from a basket, the MAS also utilizes a band in order to manage the float of the Singapore dollar. The band minimizes the need for active and constant interventions in the exchange rate and accommodates short-term fluctuations without causing disruptions. Speculative attacks are also discouraged by the band because its parameters and width are kept confidential, making it difficult for speculators to profit on arbitrage.59 Lastly, the MAS adjusts the band from time to time in accordance with the economy’s underlying fundamentals.60 Nevertheless, it takes years for Singapore to strike a balance between somehow conflicting policy goals. Extraordinary events like the 1997 Asian financial crisis also drove Singapore to pursue a more sophisticated regulatory regime, as these crises inevitably affected the stability of the domestic economy and caused market-driven depreciation of the Singapore dollar. Like many developing countries, in response to a weaker competitive position visà-vis its neighbors, Singapore initially depreciated the Singapore dollar against the US dollar to maintain its competitiveness. However, as the crisis became prolonged, Singapore opted not to tinker with the nominal exchange rate, and instead worked towards cost-cutting measures to restore its competitiveness. As a result, the authorities pressed ahead with financial reforms and liberalization to ensure its long-run international competitiveness, while 57  58  59  60 

Ibid. Ibid. Chow (2008), p. 15. Ong, supra note 55.

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introducing additional institutional mechanisms as a means to adjust costs and liquidity in the market.61 For example, during times of major economic downturns, the depreciation of the Singapore dollar was accompanied by a reduction in employers’ mandatory Central Provident Fund (CPF) contribution rate to 10 percent with a two-year wage restraint to cut down on employers’ labor costs.62 Such complementary actions enabled Singapore to maintain its international competitiveness by easing the need for greater depreciation. 4.2.2 Non-Internationalization Policy In a contrast to the RMB internationalization policy, the MAS opted for noninternationalization policy that was rooted in its decision to use the exchange rate as the principal tool of monetary policy.63 In order to become the financial center in Southeast Asia as well as to open its economy, Singapore had to dismantle most of its capital controls. Due to the smallness of its economy, however, the liberalization of capital controls would make the Singapore economy vulnerable to speculators. Thus, to make it harder for potential speculators to short the Singapore dollar and at the same time maintain the currency’s strength and stability, the MAS chose to discourage the international use of the Singapore dollar by dampening its use outside Singapore for activities unrelated to its real economy.64 At the same time, the MAS used the exchange rate to control and maintain a low level of inflation. By adopting this non-internalization of currency policy, Singapore joined the Germans and the Swiss, who had discouraged the use of their currency internationally due to the fear that demand for money would be less stable and therefore complicate the setting of the appropriate money supply growth rate.65 The outcome seemed satisfactory, as price stability and inflation had been well controlled in Singapore. However, it was unlikely that the noninternationalization policy was the dominant factor in protecting the currency against speculative attacks.66 Singapore’s strong domestic fundamentals (including the reserves of Brunei, which the country has a currency union with), balance of payments surplus, an adjustable wage system and the prudential

61  62  63  64  65  66 

Jin (2000), p. 2. Ibid., p. 16. Ong, supra note 55, p. 93. Ibid. Yi (2013), p. 1. Chow, supra note 59.

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supervision of financial institutions were also important contributions to price stability—the final policy target.67 At present, the non-internationalization policy no longer exists. Since 1998, restrictions have been progressively lifted and have since been reduced to a lending restriction—now known as the MAS’ policy on lending Singapore dollars to non-resident financial institutions. Thus, under MAS Notice 757, only two core requirements of the policy remain: (1) Financial institutions may not extend SGD credit facilities exceeding SGD 5 million to non-resident financial entities where they have reason to believe that the proceeds may be used for speculation against the SGD. This continues to be necessary to prevent offshore speculators from accessing the liquidity in our onshore FX swaps and money markets. (2) For a SGD loan to a non-resident financial entity exceeding SGD 5 million or for a SGD equity or bond issue by a non-resident entity that is used to fund overseas activities, the SGD proceeds must be swapped or converted into foreign currency before its use outside Singapore.68 To prevent any potential financial disturbance as a result of opening the domestic banking and financial market, with interest rates fully determined by the market, Singapore has established a number of supplementary institutions. Deposit insurance is arguably one of the most crucial mechanisms. The concept of deposit insurance in Singapore was first introduced in 2006, although moves to adopt a deposit insurance scheme in Singapore existed as early as 1998.69 Financial stability and maintaining its competitiveness became primary concerns in the aftermath of the 1997 Asian financial crisis. Deposit insurance was sought to address these concerns by increasing stability and augmenting the existing protective measures accorded to depositors.70 The adoption of deposit insurance was triggered by the increasing expansion of foreign banks’ operations in Singapore and that of local banks outside the country. Previously, due to the MAS’s strict regulation and supervision of banks as well as the conservative practices shared by many banks, regulators did not view a deposit insurance scheme as necessary. However, as foreign and local banks continued to expand, the MAS foresaw that this would result in

67  68  69  70 

Ong (2003); Ngiam (2000); Yi, supra note 65, p. 3; Chow, supra note 59. Ong, supra note 67, p. 94. Walker (2007). Ibid.

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exposure to additional risks beyond the reach and control of the Singaporean government.71 Previously, the implicit deposit protection for banks in distress, such as government bailouts, had the potential to create moral hazard, capable of growing along with the market expansion.72 Such implicit deposit protection, built into the Singaporean financial stability framework, included the ability of the “MAS to ring-fence a troubled bank’s assets and, in cases of insolvency, the Banking Act accords depositors priority claim, ahead of other unsecured creditors, over the assets of the bank in Singapore”.73 Without an explicit deposit protection scheme, the Singaporean government would also be more vulnerable to political pressures, since there were no black letter rules that limit the extent and coverage of deposit protection.74 Deposit insurance accounts for the financial stability in Singapore and also in Taiwan, where a different regulatory model has been adopted due to different market conditions. Currently, the creation of a deposit insurance system is also being explored in China.75 The next section examines Taiwan’s policy choices in comparison to those of Singapore, and explores the sequencing of its financial reforms over the past three decades. 4.3 Case Study: Taiwan The trajectory of currency regulations in Taiwan has been quite different from that of Singapore. The scale of market and political economy account for their differences and choice of governance strategy. First, Taiwan’s market size is larger than that of Singapore, so regulators in Taiwan have needed to diversify their policy tools according to the variety of market conditions. In theory, hegemony of market is likely to lead to a rule-based regulatory regime, whereas complex market conditions give rise to a mix of rule-based and private ordering structure.76 Regulations on exchange rates, interest rates, and capital controls need to be geared toward an equilibrium determined by a more complex industrial environment. Furthermore, the size of the market also determines the effectiveness of regulations. Compared to Singapore, irregularities were more prominent in Taiwan prior to its overhaul of capital control policies. Informal financial 71  72  73  74  75  76 

Lee (2001). Bank for International Settlements (2009). Monetary Authority of Singapore (2002). Lee, supra note 71. The New York Times (2014). Dowdle (2009).

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institutions and the state-dominated banking system mainly accounted for such irregularities. Consequently, the government was under immense pressure to conduct domestic reforms before opening its economy to global competition. Also, political economy is usually embedded in the banking sector, so path dependence determines the trajectory of reforms in various sectors. After its independence in 1965, Singapore created a number of state-owned companies and financial institutions to streamline the local political economy and take over assets from British,77 whereas Taiwan adopted a similar strategy after World War II when the Japanese submitted their assets to the Taiwanese government. Nevertheless, a significant part of the financial sectors in Taiwan remained subject to the influence of local politics. Like mainland China, Taiwan implemented a policy of financial repression prior to its financial reforms in late 1980s. All banks were owned by the state and provided cheap capital for state-owned enterprises and governmentlinked private enterprises, leading to a large amount of non-performing loans and corruption. In 1991, immediately prior to the privatization of state-owned banks, the government controlled 21 of Taiwan’s 24 banks and these statecontrolled banks accounted for 90 percent of total deposits.78 In comparison, normal private firms had difficulty obtaining sufficient loans from the state banking system and so they sought financial support from informal financial institutions.79 Prior to the financial reforms, the informal banking system was not only prominent but associated with political scandals, ponzi schemes, and white-collar crimes too. Eventually, both political and economic pressure gave rise to banking reforms in the late 1980s. Financial repression resulted in political pressure that made the government extremely vulnerable in the face of outcry from an increasing middle class calling for reforms. At the same time, Taiwan’s successful export industry had created a large trade surplus and an immense foreign reserve, and therefore led to appreciation pressure on the value of its currency vis-à-vis the US dollar. The government’s attempt to stabilize the exchange rate compromised the effectiveness of its interest rate and monetary policies, however. Also, large domestic savings needed to be channeled into better investment vehicles, domestically and internationally, but the stringent capital controls made it difficult for this to happen.80 Such domestic challenges 77  78  79  80 

Tan et al. (2015). Fields (1995), p. 149. Wedeman (2012), p. 43. Hsu (2001); Wang et al. (2014).

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confronting Taiwan’s regulators then are similar to what mainland China’s regulators are facing. 4.3.1 Reforms and Deregulation in the 1980s and 1990s Compared to Singapore’s exchange rate-centric model mainly based on consideration of international trade, Taiwan’s policies reflected more domestic factors and the political economy. The informal banking sector, which posed a great challenge to financial stability, is one case in point. If capital controls were lifted prior to reforms of the informal banking sector, a sudden increase in foreign capital flow would fuel underground banking and severely destabilize the banking system as a whole. To cope with these obstacles, the government began incrementally overhauling the banking sector in the late 1980s, liberalizing interest rates, lifting restrictions on currency convertibility, privatizing state-owned banks, opening financial markets for foreign banks, and granting foreign investors more room to invest in the domestic securities market. 4.3.1.1 Liberalization of Interest Rates Interest rate liberalization aims to introduce market mechanisms to replace various state-controlled mechanisms of pricing and various interest rates. In November 1980, the Central Bank issued and implemented the Guideline on the Adjustment of Bank Interest Rates, which allowed banks to set their own interest rates for negotiable certificates of deposit and debentures. The range between the regulated maximum and minimum lending rates was also expanded in order to introduce market-oriented pricing mechanisms that would better reflect the health of banking system and, therefore, strengthen its capacity in the face of genuine competition. Like mainland China, liberalization of lending rates went first, followed by deregulation of saving rates, as the latter would have a greater impact on the operation costs of banks. In the end, deregulation of capital controls was carried out after the interest rate reforms. 4.3.1.2 Full Convertibility of Currency Restrictions on capital controls and currency convertibility started to be loosened after domestic interest rate reform proved to be effective. After the introduction of market mechanisms to determine the rates of lending interests, savings interests and currency exchange, Taiwanese regulators amended the Act for Foreign Currency Exchange Regulation to cease capital controls in 1987.81 Ad hoc disclosure of foreign exchange operation by market players largely replaced the permission requirement. Beginning in 1989, the Central 81  Yang (2013).

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Bank adopted the “negative list” approach to incrementally replace the general permission system. Banks began operating in foreign currency trading and decided their prices based on market conditions. Under the new regime, domestic firms, individuals, and branches of foreign firms were allowed to freely wire capital overseas, while foreign entities could also freely open accounts in domestic banks and participate in the securities and capital markets. The Qualified Foreign Institutional Investors system, which is similar to mainland China’s OFII or RQFII, was introduced in 1994 as a tool to regulate capital inflow to the domestic securities market. As the deregulation and liberalization of capital markets proceeded, Taiwan’s QFII was subsequently replaced by the Foreign Institutional Investors (FINI) system, which eliminated the remaining quota limit for investments by foreign institutional investors in the domestic equity market. As a result, inward and outward remittances related to foreign portfolio investment became completely liberalized without any restrictions, and FINIs may freely convert between the New Taiwan dollar and foreign currency.82 Nevertheless, some restrictions remain in place to regulate the conversion of currency for non-trade-related transactions. For example, residents and foreign nationals with alien resident certificates can only freely remit foreign exchange up to an aggregate of USD 5 million per year, while residents or registered companies can remit up to an aggregate of USD 50 million per year. Foreign nationals who do not have an alien resident certificate can exchange foreign currency up to an equivalent of USD 100,000 per transaction. The Central Bank may nonetheless authorize all transactions above these limits.83 The market did not emerge from the reforms without paying a price, however. As predicted by Ronald McKinnon, lifting capital controls usually gives rise to quick appreciation of the currency and creates a great deal of uncertainty on the exchange rate. Between 1985 and 1989, New Taiwan Dollars (NTD) appreciated from 40 to 25 relative to the US dollar and had a great impact on Taiwan’s export industry.84 4.3.1.3 Liberalization of Exchange Rate Controls Similar to mainland China, Taiwan in the early years adopted foreign exchange controls to cope with problems of trade deficits and foreign exchange shortage, and it had the value of NTD pegged to the US dollar. In 1978, the government abandoned the fixed foreign exchange rate system and adopted managed 82  Central Bank of Taiwan (2011). 83  Taiwan Stock Exchange website. 84  McKinnon & Schnabl, supra note 48.

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f­ oreign exchange. The foreign exchange rate was determined not by the Central Bank but by the Center of Foreign Exchange, which was composed of five large Taiwanese Banks.85 A range of 2.25% around the previous day’s rate was set to prevent violent fluctuations.86 Along with the introduction of full currency convertibility in 1987, Taiwan decided to lift most restrictions on exchange rate controls too. This is partially because Taiwan’s trade surplus had increased substantially by the 1980s and foreign exchange was no longer a scare resource. The Interest Regulation Act was abolished in March 1985, and foreign exchange rate management was replaced with a floating rate in 1989. Banks were able to set their own rates on foreign currencies. This move indicates that Taiwan opted for independent monetary policy (e.g., interest rate adjustment) and free capital flow in the face of the policy trilemma. Under the “managed floating exchange rate regime”, the NTD exchange rate is mainly determined by the market. The Central Bank, however, will step in to maintain order in the foreign exchange market, considering any disruption due to seasonal or irregular factors (such as huge short-term capital flows) that threatens to undermine economic and financial stability.87 To do so, the Central Bank uses open-market operations to adjust for imbalances in the foreign exchange rate.88 4.3.1.4 Liberalization of the State-Controlled Banking Industry Finally, the banking sector started going through a process of privatization in the early 1990s. By the end of 1990, sixteen private banks had been established, while local credit cooperatives were also allowed to expand their businesses and create new local branches. Financial institutions can generally expand their businesses and diversify their sources of revenue in order to better sustain themselves in an increasingly competitive market. The unexpected consequence of privatization, however, is overbanking. Commentators have argued that privatization created too many banks, which in turn posed a threat to each bank’s profitability and the economy of scale of the banking sector as a whole. This is one of the major new challenges to be discussed in next session.

85  Namely, the Bank of Taiwan, the Chinese International Commercial Bank, the First Commercial Bank, Hua-Nan Commercial Bank, and Chang-Hua Commercial Bank. 86  Chinese University of Hong Kong ‘International Economics’ Project (online resources). 87  Central Bank of Taiwan, supra note 82. 88  Ibid.

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4.3.2 New Challenges after Deregulation Deregulation of banking regulations and capital controls has created new risks and challenges. Internationally, the quick appreciation of NTD had an impact on the export industry. Expectation of appreciation drove an immense amount of hot money to flow into Taiwan. Lack of a deep capital market and sound securities regulations worsened the impact of this speculative capital. In the 1990s, it was said “the money flood has covered everyone’s feet”. Speculative investment in the stock market became extremely popular among the general public. Eventually, the stock market bubble burst in the late 1990s, severely damaging the domestic economy. New challenges also came from within. One major problem was overbanking as a result of the policy to formalize the underground banking system. A sudden increase in private banks led to overcompetition and endangered the long-term sustainability of these banks. Also, the fragmentation of supervisory power and regulations compromised law enforcement and coordination between various regulators. The regulatory regime appeared to be inefficient and incapable in the face of an increase in speculative activities conducted by both foreign and domestic investors. In response to these new challenges, the second wave of reforms began in the early 2000s in order to centralize various regulatory regimes. A holistic review of various financial regulations was conducted, leading to a legislation package composed of six new financial laws in 2000. The objective of legislation was to centralize supervisory power, to facilitate coordination between various regulators, and to further stabilize the financial system by establishing deposit insurance and an emergency fund. The new regime also encouraged mergers of banks and incentivized such mergers by facilitating the disposal of nonperforming loans within financial institutions. 5 Conclusion The 2008 global financial crisis provided China with a great deal of momentum for internationalizing the RMB. China has also seized this opportunity to implement major reforms such as incrementally lifting capital account controls, increasing offshore RMB settlement platforms, and expanding RMB investment opportunities such as Shanghai-Hong Kong Stock Connect.89 The opportunities lie not only in China’s immense scale of market but also in a 89  Wang et al. (2014).

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welcoming global climate as a result of the oft-maligned “dollar trap”.90 The challenges, however, are mainly about obstacles at home. These domestic obstacles are the legacy of financial repression, or, broadly put, state capitalism that is commonly seen in the developing world. Here a dilemma exists: without full convertibility, it is inconceivable to make any currency an internationally acceptable currency for settlement, investment and reserve. Full convertibility, however, will trigger a cascade of capital flow into domestic banking and financial markets, formal or informal, and will cause financial turbulence if regulatory regimes are not in place. Incremental reforms and capacity building in relation to the lifting of capital controls are desirable. Recent financial crises in Europe also demonstrated how free capital flow might create asset bubbles in emerging markets and severely damage the economy when bubbles burst. In China, aggressive reforms of the banking system have begun, including liberalization of lending rates and establishment of private banks within the SFTPZ. Nevertheless, commentators and foreign firms do not seem to be satisfied with the current progress and have called for quicker liberalization and deregulation.91 It is indeed not easy to strike a balance. The foregoing dilemma can be coped with by determining the sequence of liberalization of the banking sector, foreign exchange, and capital controls in a wise manner. This article examines the experiences of two successful transitions from a highly regulated market to one characteristic of full currency convertibility and free capital flow. While both Singapore and Taiwan share a similar trajectory of transitions, they have adopted different implementation models based on their respective market conditions. Their experiences exemplify path dependence and demonstrate how the sequence of reforms has been, and should be, determined in the context of local market conditions. In early years, like China, both Singapore and Taiwan adopted a noninternationalization policy for their respective currencies, but they did so for different reasons. While Singapore concerned itself with speculative attacks from abroad on its domestic capital markets, Taiwan worried about the impact of deregulation on its monopolistic state-owned banks and informal banking sector. As a result, considering its export industries and high dependence on imported goods, Singapore chose to adopt an exchange rate-centred approach to limiting the impact of free capital flow, with interest rates fully decided by the markets. This policy choice seems to be different from the current scheme of RMB internationalization. In order to exert better monetary power through 90  Prasad, supra note 30. 91  Michelle Chen (2014).

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Ong, Chong Tee (2003) “Singapore’s Policy of Non-Internationalization of the Singapore Dollar and the Asian Dollar Market”, BIS Papers No. 15. ——— (2013) “An Exchange Rate-centered Monetary Policy System: Singapore’s Experience,” BIS Papers No. 73. Osawa, Juro (2014) “Alipay Wallet Hits 190 Million Active Users,” The Wall Street Journal, http://online.wsj.com/articles/alipay-wallet-hits-190-million-active-users1413430508 (accessed 29 April 2015). Ostry, Jonathan D., Atish R. Ghosh, Karl Habermeier, Marcos Chamon, Mahvash S. Qureshi, & Dennis B. S. Reinhardt (2010) “Capital Inflows: The Role of Controls,” IMF Staff Position Note No. 10/04, Washington D.C.: International Monetary Fund. Pomfret, Jame, & Alison Leung (2014) “China Plans Zone as Test Bed for Service-sector Reform,” Reuters, http://www.reuters.com/article/2012/06/29/us-hongkong-shenzhen-idUSBRE85S0AB20120629 (accessed 29 April 2015) Prasad, Eswar (2014a) “China’s Still Playing Catch-up,” The Wall Street Journal, http:// online.wsj.com/news/articles/SB10001424052702304831304579545451961210622 (accessed 29 April 2015). ——— (2014b) The Dollar Trap: How the U.S. Dollar Tightened Its Grip on Global Finance, Princeton: Princeton University Press. Qin, Dexing (2014) “FTZ Expands Free Trade Accounts,” ECNS, http://www.ecns.cn/ business/2014/09-04/132995.shtml (accessed 29 April 2015). Schuman, Michael (2011) “Is the Chinese Yuan Becoming a Rival to the Dollar?,” Time, http://business.time.com/2011/02/15/is-the-chinese-yuan-becoming-a-rival-to-thedollar/ (accessed 29 April 2015). Shaw, Edward S. (1973) Financial Deepening in Economic Development, New York: Oxford University Press. Taiwan Stock Exchange website (with respect to FINI regulations), http://www.twse .com.tw/en/about/company/guide.php#6 (accessed 29 April 2015). Takagi, Shinji et al. (2005) “The IMF’s Approach to Capital Account Liberalization: Evaluation Report,” Washington D.C.: International Monetary Fund. Tam, Betty, & Frank Qi (2014) “SAFE Circular 36: Liberalising Capital Account Settlement for FIEs,” http://www.mondaq.com/x/333560/Financial+Services/ SAFE+Circular+36+Liberalising+Capital+Account+Settlement+for+FIEs (accessed 29 April 2015). Tan, Cheng-Han, Dan Puchniak, & Umakanth Varottil (2015) “State-Owned Enterprises in Singapore Historical Insights into a Chosen Model for Reform.” 28 Columbia Journal of Asian Law (Forthcoming). The Brics Post (2013) “Renminbi to Compete with the Dollar and the Euro,” The Brics Post, http://thebricspost.com/renminbi-to-compete-with-dollar-and-euro/#.U_ FI8PmSz3g (accessed 29 April 2015).

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The New York Times (2014) “China Moves on Banking Reforms,” http://www.nytimes .com/2014/03/13/opinion/china-moves-on-banking-reforms.html?_r=0 (accessed 29 April 2015). The World Bank (2012) China 2030: Building a Modern, Harmonious, and Creative Society, Washington DC: The World Bank. Trivedi, Anjani (2014) “Use of Yuan as Global Payment Currency Fails,” The Wall Street Journal, http://online.wsj.com/news/articles/SB1000142405270230468810457946287 0399966210 (accessed 29 April 2015). Volz, Ulrich (2013) “RMB Internationalization and Currency Co-operation in East Asia,” Working Paper, University of Leipzig, Faculty of Economics and Management Science, No. 125. Walker, David. K. (2007) “Deposit Insurance in Selected Asian Countries: Before and After the Financial Crisis,” PDIC Occasional Paper No. 2, http://www.pdic.gov.ph/ files/Occasional_Paper_No2.pdf (accessed 29 April 2015). Wang, Aileen, Jianxin Lu, Gabriel Wildau, Lawrence White, & Michelle Chen (2014) “China to Allow Cross-border Hong Kong, Shanghai Stock Investment,” Reuters, http://www.reuters.com/article/2014/04/10/china-crossborder-idUSL3T0N248J 20140410 (accessed 29 April 2015). Wang China Times Editorial (2014) “Service Part a Must for Taiwan to Be an RMB Clearing Center,” http://www.wantchinatimes.com/news-subclass-cnt.aspx?id= 20140403000144&cid=1701 (accessed 29 April 2015). Wang, Li-Ron, Chung-Hua Shen, & Shao-Wei Li (2014) “The Comparison on the Process and Impacts of Interest Rate Liberalization in Taiwan, the US and Japan,” 2 CrossStrait Financial Journal (Chinese) 1–29. Wang, Mengzhen (2014) “China Authorizes Free Trade Account Opening in Shanghai,” CRI English, http://english.cri.cn/12394/2014/06/19/3684s832358.htm (accessed 29 April 2015). Wassener, Bettina (2014) “For China, a Shift from Exports to Consumption,” The New York Times, http://www.nytimes.com/2014/01/21/business/international/for-chinaa-shift-from-exports-to-consumption.html?_r=0 (accessed 29 April 2015). Watling, John (2014) “China’s Internet Giants Lead in Online Finance,” The Financialist, http://www.thefinancialist.com/not-just-a-paypal-clone-chinas-internet-giantschart-their-own-course/ (accessed 29 April 2015). Wedeman, Andrew (2012) Double Paradox: Rapid Growth and Rising Corruption in China, Ithaca: Cornell University Press. Xie, Heng, & Gabriel Wildau (2014) “China Makes Fresh Bid to Curb Shadow Banking, Contain Debt Risk”, Reuters, http://www.reuters.com/article/2014/01/06/ us-china-economy-shadow-banking-idUSBREA0503T20140106 (accessed 29 April 2015).

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Yang, Zhai Ping (2013) “Lessons from the Marketization of Interest Rates of Banks in Taiwan,” Caijing Magazine, http://economy.caijing.com.cn/2013-07-19/113064224 .html (accessed 29 April 2015). Ye, Zhen (2014) “Free Trade Zone: Merits vs. Risks,” Shanghai Daily, http://www.shanghaidaily.com/business/Benchmark/Free-trade-zone-merits-vs-risks/shdaily.shtml (accessed 29 April 2015). Yi, Tan-Shao (2013) “Currency Internationalisation of the Singapore Dollar and the Renminbi,” Working paper, Singapore Management University, http://www .technet.sg/writings/Currency%20Internationalisation.pdf (accessed 29 April 2015). Yong, David, & Judy Chen (2014) “China Defaults Sow Property Cash Crunch Concern: Distressed Debt,” Bloomberg News, http://www.bloomberg.com/news/print/201403-30/china-defaults-sow-property-cash-crunch-concern-distressed-debt.html (accessed 29 April 2015). Yu, Yongding (2014) “Comment from the Editor-in-chief on the Paper of R. McKinnon & G. Schnabl—China’s Exchange Rate and Financial Repression: The Conflicted Emergence of the RMB as an International Currency.” 22 China and World Economy 32–33. Zhang, Moran (2014) “China’s Cash Crunch: Lending Rate Spikes Won’t Hurt Growth in 2014,” International Business Times, http://www.ibtimes.com/chinas-cashcrunch-short-term-interbank-lending-rate-spikes-wont-hurt-growth-2014-1526230 (accessed 29 April 2015).

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Chapter 6

A Small Difference in Wording, but a Big Difference in Rule-Making A Retrospective and Prospective View on the Development of China’s Economic Zones Jiaxiang Hu Abstract From special economic zones to free trade pilot zones, China has transformed from the provisions of preferential policies to some selected tax enclaves into the making of uniform rules on market access across the country. The general background behind the replacement of those SEZs with the Shanghai Free Trade Pilot Zone is the national treatment requirement observed by China as a WTO Member. What matters more is that China, after all these years’ development, needs to liberalize its market further and provide equal treatment to all participants. The objectives of the SFTPZ are to expedite the functional transformation of government through streamlining the administrative approval procedures with more transparency and automation, expand the opening up of service sectors by releasing the limitations on market access, promote the reform of administrative regulations on foreign investment and attract more multinational corporation headquarters to reside in the SFTPZ. Unlike the free trade area defined by GATT Article XXIV, which is formed by two or more countries (separate customs territories), the SFTPZ is a domestic special economic zone delineated by the Chinese government. The crucial difference between the SFTPZ and all the previous SEZs is that there are no tax breaks or incentive policies designed for the SETPZ. The mission of the SFTPZ is to experiment on a set of innovative rules to widen the market access. As such, experience hence gained shall serve nationwide with new ideas and approaches in the next round of economic reforms.

* Professor and Director of the Asian Law Center, KoGuan Law School, Shanghai Jiao Tong University. This article is based on the national research project (14AGJ004) supported by the National Planning Office of Philosophy and Social Science of China. The author is grateful to the Asian Law Institute of National University of Singapore and its Director, Professor Andrew Harding, for their generous support in the writing of this article. Contact: jxhu@sjtu .edu.cn

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Keywords SFTPZ – innovative rules – market access – negative list – financial centre

1 Introduction The process for the resumption of GATT contracting party status in parallel to the Uruguay Round Negotiations and the application for WTO membership afterwards made China turn to a massive legislation. The rules concerned with economic activities have been given the priority for consideration since then. The impact of the multilateral trade system on China is comprehensive. With the requirements of Article XVI:4 of the WTO Agreement,1 WTO law has pushed China’s constitutional reforms by transforming the administration from the policy-orientation into the rule-orientation. For the first time, China accepted a complete set of international rules binding on its regulations of trade in goods, trade in services and trade-related aspects of intellectual property rights. The recommendations and rulings of the WTO Dispute Settlement Body have led to the amendments and annulment of relevant Chinese laws and regulations. While China has benefited from the integration into the global economy, it begins to reflect on how to upraise the levels of rule-making and administrative regulation. This seems to be more relevant when China becomes the world second largest economy and an important player to the multilateral trade regime. To keep the commitments for the conformity of domestic laws, regulations and administrative procedures with WTO rules is only the minimum requirement for a WTO Member. For a country like China, what is expected more is to integrate further into the global economy and guide the world trade in a more transparent and liberal way. China has developed from a lower-income country into a middle-income country. The current administration, formed since the initiation of the opening policy and transformed after its accession to the WTO, has encountered increasing challenges from both the inside and outside of China. To a large extent, the future development of Chinese economy will no longer be able to rely on the increasing inputs of production elements and provisions of preferential policies like those prevalent in the special economic zones in 1980s and 1990s, but on the release of restrictions 1  Article XVI:4 of the WTO Agreement provides that “Each Member shall ensure the conformity of its laws, regulations and administrative procedures with its obligations as provided in the annexed Agreements”.

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on market access and efficient regulations on the market activities like those currently adopted in the Shanghai Free Trade Pilot Zone. 2 From SEZs to the SFTPZ: More than a Conceptual Shift The basic objective to delineate a special economic zone (SEZ) is the provision of a “dual legal order” which separates a specialized policy enclave from the rest of the jurisdiction in which the zone is located.2 The rationale behind this policy is to import capital and expertise and promote local productions, especially those of labour-intensive industries. Nevertheless, empirical study indicates that SEZs “cannot and should not be viewed as substitute for a country’s larger trade and investment reform efforts. They are one tool in a portfolio of mechanism commonly employed to create jobs, generate exports and attract foreign investment through the provision of incentives, streamlined procedures, and custom-built infrastructure.”3 They implement a series of more preferential policies and cannot be taken as the models for the development of other parts outside the SEZs. The newly established Shanghai Free Trade Pilot Zone (SFTPZ) is built on the four existent customs supervision areas:4 Shanghai Waigaoqiao Bonded Zone,5 Waigaoqiao Bonded Logistics Zone, Yangshan Bonded Port and Shanghai Pudong Airport Free Trade Zone, with the area of 28 square kilometres in total. With regard to the title, there is nothing new for the SFTPZ as free trade zones have existed for centuries. They were originally established to encourage entrepôt trade, and mostly took the form of citywide zones located on international trade routes. Examples include Gibraltar (1704), Singapore (1819), Hong Kong (China; 1848), Hamburg (1888) and Copenhagen (1891). In the context of it, however, the SFTPZ is a new type of special economic zones,

2  S EZs are generally defined as geographically delimited areas administered by a single body, offering certain incentives (generally duty-free importing and streamlined customs procedures, etc.) to businesses which physically locate within the zone. See The Multi-donor Investment Climate Advisory Service of the World Bank Group (2008), p. 2. 3  Ibid., p. 5. (Emphasis as original) 4  The official title for the SFTPZ is “The China (Shanghai) Free Trade Pilot Zone”. 5  The Bonded Zone shall mainly develop import and export trade, transit trade, processing trade, goods storage, goods transport, commodity goods displays, commodity goods trade and business such as finance. See Article 3 of Shanghai Municipality, Waigaoqiao Bonded Zone Regulations.

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different from all previous SEZs in China6 or free trade zones in the world7 which have, more or less, received some tax breaks or provided reduced tariffs. The SFTPZ is entrusted with the mission to adopt a series of innovative rules including the provision of pre-establishment national treatment through a negative list and the internationalization of RMB currency. This breakthrough in market access makes the SFTPZ, on the one hand, function like a special economic zone. On the other hand, however, the target of the SFTPZ is not to be an export driver and investment magnet, but a rule innovator. This change signals a fundamental shift in China’s approach and practice towards the mode of economic development. In a nutshell, the new generation of Chinese leaders has decided to abandon the idea of investment enclaves with tax stimulations within a few delineated areas and use free trade pilot zones as the laboratories for the uniform rules on market access. Thus, the concept of the SFTPZ has been adapted into a new kind of administrative regime for the reorganization of social relations of production in China. If we take the previous SEZs as the sample of the first generation of opening policies for the creation of the new Chinese socialist market economy as Peter Muchlinski defined,8 the SFTPZ can be regarded as the mode of the second generation in this sense.9 The latter forms a pivotal part of China’s current rules for all market participants, which will lead the country’s further integration into the global world through the streamlining of government regulations and the reduction of thresholds for market access. The development of the SEZ policy and its practice is a story of the way in which China has abandoned its ideological constraints in the economic development and progressed in its efforts to attract foreign investment through opening the door to the world.10 The special economic zones were first chosen

6 

The concept of SEZs was introduced into China in 1979. The idea was modelled on export processing zones (EZPs) from other developing countries and they “were originally envisioned as areas where foreign investment would be both permitted and controlled in an effort to gain national economic advantage from world markets”. See Crane, G. (1994), p. 71. 7  The World Bank Report defines free trade zones as “small, fenced-in, duty-free areas, offering ware-housing, storage, and distribution facilities for trade, transshipment, and re-export operations, located in most ports of entry around the world.” See supra note 2, p. 10. 8  See Muchlinski (2011), p. 16. 9  See Hu (2014), pp. 246–69. 10  In 1978, China’s foreign currency reserve is only 167 million US dollars, behind many developing countries. Data source: People’s Bank of China.

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for their ideal geographic locations,11 close to Hong Kong, Macao and Taiwan,12 three successful centres of Westernized market-driven economies, all of which China claims are parts of its territories. The success of the first four SEZs ignited the lust of Chinese people for wealth and attracted a huge population across the country flowing into these cities.13 Shortly after that, the second wave of SEZs led to the further opening of the fourteen coastal cities in Eastern China, most of which had been prosperous trading ports before the turnover of power in 1949. These cities could enjoy similar treatments in tax and other investment policies offered to the first four special economic zones. Altogether, these opened cities have contributed greatly to the national economic development.14 In addition to the location and streamlined procedures for market access, tax break is the crucial factor in accounting for the rapid increase of FDI in these areas. The enterprises with some foreign investment in the SEZs are eligible to be exemptible for their income tax in the first two years after operation and half rate reduction for the next subsequent three years.15 Since the central government took the volume of FDI as the important indicator in assessing the performance of local officials, the SEZ fever had been continuously heating up in China before the amendment of Enterprise Income Tax Law. By 2004, there were 6686 special zones in China. Of these, 207 were operated at the national level and the others were operated either at 11  On August 26, 1980, the Standing Committee of China’s Fifth People’s Congress, at its 15th plenary session, approved the four coastal cities of Shenzhen, Zhuhai, Shantou and Xiamen (Amoy) as special economic zones which would enjoy more preferential laws and economic policies as a free port. 12  Shenzhen and Zhuhai were originally two small fishery villages bordering Hong Kong and Macao respectively. Shantou is a city where the majority of local people have their overseas relationships. These three cities are all in Guangdong Province. Xiamen is located in Southeastern Fujian Province. It is only about two miles away from the Kinmen Island which is in effective control of Taiwan. 13  Shenzhen, for example, has become one of the largest cities in China with the population over ten millions. 14  According the national statistics of 2014, the top four provinces in GDP volume are Guangdong, Jiangsu, Shandong and Zhejiang. Most of the opened cities are located in these provinces. Data source: National Bureau of Statistics of the People’s Republic of China. 15  Since the amended Enterprise Income Tax Law came into force in 2008, all types of enterprises have been required to pay the same level of income tax except those registered in the advanced and new technology development pilot zones where all enterprises would pay the tax of 15%, 10% lower than the normal level. See Enterprise Income Tax Law of China, Article 28(2).

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provincial or lower level.16 A year later, a joint campaign was conducted with several ministries, including the Ministry of Land and Resources, the Ministry of Construction, the Ministry of Commerce and the National Development and Reform Commission, to take stock of, clean up and reduce the multitude of areas labelling themselves “special zones”, many of which were operated in nefarious ways. In April 2006, the campaigners announced that there were then a total of 1115 legitimate zones in operation in China. Of these, 54 were economic and technological development zones, 53 were advanced and new technological development pilot zones, 46 were export processing zones, 14 were free trade zones, and 910 were special economic zones operated by provincial or lower administrative entities.17 As one scholar observed, the proliferation of SEZs was startling.18 People began to question the significance of SEZs in China’s economic development. Meanwhile, with the rapid increase of foreign currency reserve,19 the role of FDI has become less important to the Chinese economy. Many of China’s economic reforms have, ever since, aimed to phase out these incentive policies available in the SEZs, rendering them less special as they used to be.20 All these efforts, however, achieved limited effects in withholding the enthusiasm of local officials to set up SEZs. As some sinologists pointed out, although China appears to have a powerful centralized government, in reality, a substantial amount of operational power resides in the provinces and municipalities.21 The temptation for Chinese officials to set up SEZs is obvious. Besides the momentum to develop the local economy and release the pressure of unemployment, the cumbersome approval procedures for investment have made them feel something important and left the space for corruption. Since China began to choose the planned economy as its development strategy in early 1950s, the government has been playing the leading role in market operation. The state-owned enterprises (SOEs) are still dominating all important sectors of the national economy, which has reduced the competitiveness among the market participants. Being aware of these drawbacks, the Chinese government has decided to change the game rules through streamlining its power and widening market 16  17  18  19 

See China Statistical Yearbook (2006). See Investment Guide to Special Zones in China (2006). Carter (2011), p. 63. By the end of 2013, China’s foreign currency reserve has reached 3821315 million US dollars, more than triples of that of the second largest country Japan (1258809 million US dollars). 20  See Litwack & Qian (1998), pp. 117–41. 21  See Carter, supra note 18, p. 64.

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access for non-state entities to invest in those important sectors like finance. In order to reduce the radical fluctuations of national economy and unpredictable consequences brought by the shift of orientation, China has chosen to maintain the reforms in a controllable way. Shanghai, thus, is selected as the first testing ground for the innovation of market rules. This choice is made cautiously not only because of the leading role Shanghai has been playing in the whole national economy, but of its experience gained in the market development.22 Specifically, the SFTPZ has been entrusted with the following missions: during the course of two to three years of piloting reforms, it shall expedite the functional transformation of government, expand the opening up of service sectors, promote the reform of foreign investment approval procedures, develop headquarter economy and new trade forms; shall explore RMB currency convertibility under capital account items and through opening up of more financial services; shall explore to improve Customs’ supervision efficiency; and shall create a framework to support investment and innovation activities to cultivate an internationalized business environment. As such, experience hence gained shall serve nationwide with new ideas and approaches for the further opening up of national economy and deepen the economic reform.23 The missions are wide but clear. The focus is on inventing a package of government procedures to regulate the market in a more efficient and transparent way, which should be replicable to other parts of China. While we review the economic factors to the success of SEZs, the importance of regulatory relief to the investors is a crucial, yet overlooked aspect of SEZ programs. The host government would simplify investment approvals and work permits, remove import and export licenses, accelerate customs inspection procedures and automatic foreign exchange access. The SFTPZ, as the Chinese leaders have expected, should do better than the SEZs since all these goals will be 22  Different from the previous SEZs which were based on the processing and production enterprises with foreign investment, or high and new technology development pilot zones which promoted the adoption of new technologies in enterprises, Shanghai Pudong New Area and Tianjin Binhai New Area were chosen to experiment on more comprehensive administrative and economic reforms which were corresponding to the national reform strategies. The former was set up in 1990 and the latter was set up in 2005. The reform in these two areas included the merging of government departments, streamlining of administrative procedures for the registration of multinational corporation headquarters, further opening of service sectors with the set-up of various exchange markets of production elements. These policies have helped to rebuild Shanghai and Tianjin into the financial and shipping centres in China. 23  See the official website of The China (Shanghai) Free Trade Pilot Zone, http://en.shftz.gov .cn/FrameworkPlan.html (accessed 29 April 2015).

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achieved without the provision of any economic incentives.24 As a World Bank report suggests, the best-practice policy for SEZs is the streamlined framework for the government, encouraging zones to compete on the basis of facilitation and service rather than on the provision of incentives.25 Compared with the missions the SFTPZ bears, the only “preferential treatment” provided by the central government is the “deregulation of power” to marketize the access for all types of enterprises and internationalize the economy for further integration into the global world. The national legislature (the Standing Committee of the People’s Congress) has authorized the SFTPZ to suspend several provisions of Sino-Foreign Equity Joint Ventures Law, SinoForeign Contractual Joint Venture Law, Wholly Foreign-Owned Enterprise Law for three years.26 These authorizations are meant to equalize the market access for investment wherever the source is, changing the approach towards the application procedures. With the same benchmark to invest in the SFPTZ, all non-state entities including foreign investors will have a more transparent and equalized environment for their business. From the international law perspective, the SFTPZ has no independent legal status, different from a free trade area or a customs union as defined in GATT Article XXIV,27 which is normally formed by two or more countries or separate 24  As the Chinese President Xi Jingping has repeated on several occasions that China “cannot make any subversive errors” in its economic development, the SFTPZ functions as the laboratory for the next round of national reforms. See Xi (2013). 25  See Multi-donor Investment Climate Advisory Service of the World Bank Group, supra note 2, p. 5. 26  The Chinese national legislature consists of the People’s Congress and its Standing Committee. People’s Congress convenes once a year while the Standing Committee has its meeting on an average of once a month. According to the Legislature Law, the basic laws like Criminal Law, Procedural Law need to be approved by the People’s Congress while the others can be approved by the Standing Committee. See Hu (2012), pp. 226–52. 27  Which partly provides: “(a) with respect to a customs union, or an interim agreement leading to a formation of a customs union, the duties and other regulations of commerce imposed at the institution of any such union or interim agreement in respect of trade with contracting parties not parties to such union or agreement shall not on the whole be higher or more restrictive than the general incidence of the duties and regulations of commerce applicable in the constituent territories prior to the formation of such union or the adoption of such interim agreement, as the case may be; (b) with respect to a free-trade area, or an interim agreement leading to the formation of a free-trade area, the duties and other regulations of commerce maintained in each of the constituent territories and applicable at the formation of such free trade area or the adoption of such interim agreement to the trade of contracting parties not included in such area or not parties to such agreement shall not be higher or more restrictive than the corresponding

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customs territories. The SFTPZ, in nature, is a sort of SEZs delineated by the Chinese government. Apart from those general international obligations conferred on China as a WTO Member, China has no particular commitments as for what rules should be made on market access in the SFTPZ. It is within the jurisdiction of China to decide which national law will be suspended to apply in the SFTPZ and whether or when the suspension will be withdrawn. In this regard, it is impractical for China to sign a free trade agreement with other countries, which applies only to the SFTPZ, neither is it available for the investors of other countries to enjoy the preferential treatment deriving from a free trade agreement which is only applicable in the SFTPZ. From SEZs to the SFTPZ, the difference in wording indicates the changing approach of the Chinese government towards the rule-making on market access. The rationale behind this conceptual shift derives from the practical needs to deal with the emerging challenges: both endogenous and exogenous. 3

The Rationale behind the Shift of Approach in Rule-Making

Despite the high expectation of host governments for SEZs to help increase capital stocks, job opportunities, technology transfers, exports and foreign exchange earnings, and overall national economic activities, SEZs, in a general way, have produced mixed performances. Parallel to this, academic approaches towards SEZs are also diversified. At a public policy level, the fundamental debate has been whether SEZs have promoted country-wide economic policy reforms by serving as “demonstration areas” or catalysts, or whether, instead, they have just acted as “pressure valves” for unemployment, reducing the incentives to reform and, thereby, diverting reform energies.28 A 1992 World Bank study cautioned against the possibility that export processing zones (EPZs) could be used by developing countries to “muddle along without reforms”, and stressed the need to use zones as a supplement to the countrywide reform as opposed to creating isolated free market enclaves.29 Economists tend to suggest that SEZs are a “second-best solution” to compensate for the anti-export bias of trade policies and other policy distortions typical in many developing countries, which are short of foreign duties and other regulations of commerce existing in the same constituent territories prior to the formation of the free-trade area, or interim agreement as the case may be.” 28  See Multi-donor Investment Climate Advisory Service of the World Bank Group, supra note 2, p. 42. 29  World Bank (1992), p. 17.

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currency reserves but rich in natural resources and labour force. Using different hypotheses and parameters, they have either concluded that SEZs have led to distortions30 in the national economic development or, conversely, that the establishment of a special economic zone improves a country’s well-being.31 Among the approximately 3000 SEZs in 135 countries,32 the role of SEZs in recent years is diminishing as the average tariff rates have been falling around the world with the progressing of the multilateral trade negotiations. Others have foreseen a diminished role for SEZs now that the Multi-Fiber Arrangement has been dismantled due to the WTO rules,33 given the dependence of export processing zones in many developing countries on the apparel and textiles industry. Hooshang Amirahmadi and Weiping Wu used EPZs in Asian countries as samples in their study and concluded the following pitfalls of EPZs, apart from their attractiveness and effectiveness: (1) The very enclave nature of many EPZs has impeded the establishment of linkages and integration with domestic economic sectors. Because of their outward processing nature, EPZ products respond more to the demands and technical specifications of outside markets and have little affinity with the local development. (2) The firms in EPZs tend to rely on imported production inputs, usually of a higher quality and more price-competitive than those made domestically, and do not want to go through the various “red tape” to look for local suppliers. (3) Creation of these EPZs as a reaction to the global relocation of firms for cost reduction implies that most manufacturing activities are low-end and labour-intensive with little or no tech-innovation in the host countries. (4) Foreign investors registered in EPZs, in many cases, have little interest in assisting host economies. When the cost of production increases, the investment will move to somewhere else. (5) The impact of EPZs on the upgrading of local industry is minimal partially due to the lack of regional policy in many developing countries.34

30  See Hamada (1974), pp. 225–41. 31  See Miyagiwa &Young (1987), pp. 397–405. 32  See Multi-donor Investment Climate Advisory Service of the World Bank Group, supra note 2, p. 7. 33  Article 9 of WTO Agreement on Textiles and Clothing provides: “This Agreement and all restrictions thereunder shall stand terminated on the first day of the 121st month that the WTO Agreement is in effect, on which date the textiles and clothing sector shall be fully integrated into GATT 1994. There shall be no extension of this Agreement.” Therefore, the trade of apparel and textiles, after the ten years’ transition, has been integrated into the multilateral trade regime. 34  See Hooshang & Wu (1995), pp. 844–46.

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After the adoption of SEZ Policy for more than three decades, China is encountering another crossroad in its development. Whether should the central government, as before, continue to play a dominating role to manipulate the market, or simply serve the market as a doorkeeper in future? This is a serious question for the new leadership. When the door was first opened in 1978, the role of the central government was essential to the law-making, resourceallocating, facility-building and maintaining the order of the market. Nevertheless, many changes have taken place since then, especially, when China amended its Constitution in 1993, changing the orientation for development from the planned economy to the socialist market economy. The inefficiency in administrative regulation has been an obstacle for its further development. This is becoming more critical with the challenges emerging from both inside and outside China. 3.1 Internal Factors While the proliferation of SEZs has promoted the overall economic development in China, regional disparity has increased remarkably since 1990s. These disparities have led to the migration of a magnitude population from the hinterland to the coastal regions and left many inland areas even poorer. In the words of Professor Angang Hu, an advocate for the abolition of SEZs, that “[i]f Deng Xiaoping knew the disparities were as big as they are, he would be more militant than I am in trying to eliminate them”.35 Radical as it might be, Hu’s argument still sounds logical. Empirical study indicates that the gap in the economic development between coastal provinces and inland areas is widening since the adoption of the Open-Door Policy, which presumably aimed not only at the export-oriented industrialization in the SEZs but at the promotion of national economic development through these pioneering reforms. The SEZs have simplified the administrative approval procedures that appeal to foreign investors, and the viability of SEZs has depended on getting a sufficient number of investors in a reasonably short period of time. This form of concentrated development is rooted in the concept of the growth centre, which is considered an efficient way to generate economic development at less cost to the public. But there is a potential danger in viewing the SEZs as growth centres with regard to the general picture of China’s national economy. Instead of producing a trickledown effect, the SEZs in China have, de facto, become isolated enclaves whose developments are disjoined from the links to the national economy. 35  New York Times (1995).

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Despite the diversity of data and methodologies used, studies on China’s economic development of 1980s and 1990s have yielded rather consistent observations about interprovincial and interregional inequalities; namely, interprovincial inequality declined during 1980s and showed signs of increase in 1990s, while inequality between the eastern coastal region and the rest of China was on an upward trajectory since 1980s.36 These studies have also identified a variety of determinants that explained changes in regional inequality. While some researchers highlight factor endowments such as location, labor, and infrastructure,37 many more conclude that factors related to policy are most crucial to the regional development. These factors include preferential policies that boosted capital investment in the SEZs and most coastal provinces;38 decentralization of the central government control,39 industrialization and economic agglomerations,40 and improved factor mobility due to market expansion. The central role of policy in driving regional economic growth suggests that broad-brushed notions of divergence and convergence, such as those based on the inverted-U model, are of limited utility for explaining changes in regional inequality in China.41 Because of their outward processing nature, the structuring of SEZs responds more to the demands and technical specifications of overseas markets and has little affinity with local developments. Domestically produced inputs in many cases cannot meet the quality requirements and are not priced competitively. Firms in the SEZs thus tend to rely on imported materials and components from their own global networks, which are usually of higher quality, a tendency that largely precludes the creation of backward linkages with the local economy.42 The “Matthew Effect” of the SEZ policy has haunted the Chinese economy in all these years. With the accession to the World Trade Organization, the focus of China’s development strategy has shifted from those isolated areas development towards the overall trade liberalization. The importance of SEZs has been declining as they can no longer enjoy preferential policies from the central 36  See Lyons (1991), pp. 471–506; Chen & Belton (1996), pp. 141–64; Long (1999), pp. 59–70; Fujita & Hu (2001), pp. 3–37; Zhang & Zhang (2003), pp. 47–67. 37  See Hare & West (1999), pp. 475–97; Demurger, Sachs, Woo, Bao & Chang (2002), pp. 444–65. 38  See Fan (1995), pp. 421–49; Kanbur & Zhang (1999), pp. 686–701; Wei & Fan (2000), pp. 455–69. 39  See Wei (1996), pp. 329–44; Lin (1999), pp. 670–96. 40  See Tsui (1998), pp. 502–28; Yao & Zhang (2001), pp. 466–84. 41  See Fan & Sun (2008), pp. 1–20. 42  See Hooshang & Wu, supra note 34, p. 844.

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government as the tax enclaves. This indicates that the set-up of SEZs is only a transitional strategy in the shift from import-substitution to export-oriented industrialization, or a means to sustain the promotion of manufacturing exports. When the government gains more revenue and the country possesses more national reserve, China shifts its priority from the regional development to the overall national development. Although a major part of law-making in the recent years is related to the equalization of market access and the protection of market participants,43 in reality, the non-state entities often meet some invisible barriers in the competitions with the state enterprises.44 Government officials have been accustomed to exercising their power under the current administrative approval procedures, which is prone to the abuse of power due to the lack of efficient supervision.45 This may partly account for the phenomenon that there have been an increasing number of university graduates competing for the civil servant posts in recent years. In the eyes of those young people, to work in the government is a stable job with potential interests.46 The central government has tried several times to streamline its power, including the large-scale merging of government departments and agencies in 1998, which was pushed by Premier Zhu Rongji. All these efforts, however, have achieved little success. The number of civil servants has not declined as expected, but increased steadily. The government has accumulated huge power in regulating the market with the proliferation of departments, which has reduced the efficiency of administration and increased the national budget. With the strengthened dominant position of the SOEs, the non-state 43  On 10 March 2011, Bangguo Wu, Chairman of the National People’s Congress (NPC) of China, declared at the Fourth Plenum of the 11th National People’s Congress that the Chinese legal system had been established. 44  During a high-level conference of September 2014, Premier Li Keqiang criticized the prevalence of “glass door” and “revolving door” set for the non-public entities in the administrative approval procedures. See the report, State Council (2014). The glass door is referred to those invisible barriers through which the non-public entities can see the market but cannot enter into it. The revolving door is referred to the situation in which the application of a non-public entity has been accepted but refused eventually without a substantive step into the market. 45  Although the government administrative approval procedures have been regulated by the Administrative Permission Law since 2004, the various administrative departments are still enjoying much power in issuing the permits. See Articles 12, 14, 15 and 16. 46  According to the data released by the relevant department, the number of applicants for the posts of governments at various levels in 2014 is 1.57 million. The success rate for some posts is 1000:1.

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entities are finding more difficult to compete with them. All of these have led to the dissatisfaction of common people with the government and jeopardized the foundations of the ruling party. 3.2 External Factors Besides these internal factors mentioned above, the pressure for China’s administrative reforms also comes from the outside. Since the accession to the World Trade Organization, China has passed one deadline and will meet another in a few years for its transitional period. These two deadlines are connected with the extra restrictions upon China or its legal status as a WTO Member. Paragraph 16.1 of the Accession Protocol of China provides other WTO Members a more flexible tool in preventing the imports from China.47 What distinguishes these “special safeguard measures” from those provided in GATT Article XIX and the Agreement on Safeguard Measures is the consequence of the imports. Injury and causation are issues of essential importance in the application of safeguards, as their determination constitutes the core of safeguard investigations.48 While the cause for safeguard measures required in GATT and SM Agreement is serious injury, the consequence for special safeguard measures is the “market disruption”. Market disruption can be interpreted in a broad way, which includes the decline of national income, the change of consumers’ taste, the mismanagement of domestic business, etc. Serious injury, however, is normally assessed according to some objective criteria.49 In the case that there are no similar products manufactured in the importing country, it is difficult to identify the impact of imports on the domestic industries. Therefore, it is comparatively easy for the importing 47  Paragraph 16.1 of the Protocol provides that “In cases where products of Chinese origin are being imported into the territory of any WTO Member in such increased quantities or under such conditions as to cause or threaten to cause market disruption to the domestic producers of like or directly competitive products, the WTO Member so affected may request consultations with China with a view to seeking a mutually satisfactory solution, including whether the affected WTO Member should pursue application of a measure under the Agreement on Safeguards”. 48  See Lee (2005), p. 81. 49  Article 4.2(a) of the Safeguard Agreement provides that “In the investigation to determine whether increased imports have caused or are threatening to cause serious injury . . . the competent authorities shall evaluate all relevant factors of an objective and quantifiable nature having a bearing on the situation of that industry, in particular, the rate and amount of the increase in imports of the product concerned in absolute and relative terms, the share of the domestic market taken by increased imports, changes in the level of sales, production, productivity, capacity utilization, profits and losses, and employment.” (Emphasis added)

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Member to restrict Chinese products in the name of “market disruption”. According to paragraph 9 of Article 16 of the Protocol, application of the special safeguard measures shall be terminated 12 years after the date of China’s accession to the WTO.50 Another deadline is provided in Article 15 of the Protocol, which is about the approach of other WTO Members towards China as a market economy or nonmarket economy. The issue of non-market economy is not a legal one. The text of GATT 1947 was silent on this issue because none of the 23 original signatories belonged to this group. Therefore, the GATT system was presumably based on market mechanism. With the addition of new entrants and in some of which the “the centrally planned economy” was dominated, the GATT contracting parties later adopted Ad Article VI which provides that “It is recognized that, in the case of imports from a country which has a complete or substantially complete monopoly of its trade and where all domestic prices are fixed by the State, special difficulties may exist in determining price comparability for the purposes of paragraph 1, and in such cases importing contracting parties may find it necessary to take into account the possibility that a strict comparison with domestic prices in such a country may not always be appropriate.”51 No further guidance from the GATT contracting parties has been given on the application of the above provision. Article 2.7 of the Anti-Dumping Agreement acknowledges the validity of this supplementary provision.52 WTO Members have generally taken advantage of this provision to reject cost and price information provided by those countries considered to be non-market economies. Such a practice has been consolidated by Article 17.6(i) of the AntiDumping Agreement, which provides that “in its assessment of the facts of the matter, the panel shall determine whether the authorities’ establishment of the facts was proper and whether their evaluation of those facts was unbiased and objective. If the establishment of the facts was proper and the evaluation was unbiased and objective, even though the panel might have reached a different conclusion, the evaluation shall not be overturned.” Since many WTO Members including the U.S. and the EU have not recognized China as a market economy, they may, in the calculation of price 50  By 11 December 2013, Article 16 of the Protocol has expired. 51  See GATT BISD, Volume IV, at 64. This provision dates from the 1954–55 Review Session of the GATT and has its origins of consideration of issues relating to the Working Party on the Accession of Poland. 52  Article 2.7 of the Anti-dumping Agreement provides that “this Article is without prejudice to the second Supplementary Provision to paragraph 1 of Article VI in Annex I to GATT 1994”.

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and cost of the imports from China, “use a methodology that is not based on a strict comparison with domestic prices or costs in China if the producers under investigation cannot clearly show that market economy conditions prevail in the industry producing the like product with regard to manufacture, production and sale of that product”.53 The importing Member may select the price and cost of a third country as the comparable factors to decide whether the dumping exists. Nevertheless, the provisions of subparagraph (a) (ii) of the Protocol shall expire 15 years after China acceded to the WTO,54 which is dated on December 11, 2016. The “special safeguard measures” clause and the “non-market economy” status have degraded China as a “second-class citizenry” in the multilateral trade regime as its exports are more likely to be punished by the importing Member country.55 As a matter of fact, ten of the eleven complaints brought by China to the WTO Dispute Settlement Body, so far, are connected with these two issues.56 With the termination of “special safeguard measures” clause and the coming end of “non-market economy” status, China is expecting a better environment for its exports.57 This, however, may not become true as China is encountering another situation similar to that in the days while the relevant two clauses of the Protocol are effective. The United States and some APEC members are negotiating a regional trade regime under the framework of Trans-Pacific Partnership Agreement (TPP) with a more integrated market of goods and services.58

53  54  55  56 

See Article 15(a)(ii) of the Accession Protocol of China. See Article 15(d) of the Accession Protocol of China. As for the reference of “second-class citizenry”, see Tyagi (2012), pp. 391–441. The relevant cases include DS252, DS368, DS379, DS397, DS399, DS405, DS422, DS437, DS449 and DS452. 57  China has achieved magnificent progress through the international trade. The gross domestic production and foreign trade volume have ranked number two and number one respectively in the world. The GNI per capita has risen from $220 in 1980 to $5680 in 2012, raising China from a low-income country to an upper-middle-income country. The accession to the WTO has contributed much to this progress. It is only natural that China expects to achieve more from the multilateral trade system when the extra restrictions are to be released in the coming years. 58  The attraction of the TPP negotiations is increasing. Besides the initial four parties Brunei, Chile, New Zealand, and Singapore, the United States, Australia, Peru, Vietnam, Malaysia, Mexico, Canada and Japan have participated in the negotiations, plus Taiwan and South Korea which have announced their interests in the negotiations.

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The project of TPP is related to the US dissatisfaction with the current multilateral trade system and the ongoing Doha negotiations.59 Although the recently-concluded Bali Ministerial Conference shed some light on the Doha Round and the Ministerial Declaration adopted on 7 December 2013 contains an ambitious package of decisions including the issues of trade facilitation, agriculture and least-developed countries, the current negotiating mechanism and the huge disparities among WTO Members will scare any ambitious negotiators and render their proposals impotent. Therefore, the United States, with some like-minded partners, is proposing for a closer trade regime with more liberalization. From the perspective of investment rule-making, the TPP is a vital test as the US’s negotiating interest has been incorporated into the TPP as a model agreement for future regional cooperation. The negotiated draft of TPP essentially draws on the US BIT model, rather than the existing regional FTAs.60 ­Article 12.16 (Implementation) includes provisions to enhance the transparency of investment regimes, which requires the publication of countries’ international investment agreements and domestic investment measures. US negotiators have taken a strong stance against capital controls in current TPP trade talks,61 indicating a more rigid position than the International Monetary Fund and the previous US regime towards currency manipulation.62 One of the significant features exposed from the released version of TPP is the high threshold for accession including the minimum levels of labour standard and environment protection.63 The latter two issues have long been debated within the World Trade Organization.64 During the Uruguay Round negotiations, developed countries tried to embrace these issues into the multilateral trade regime but encountered strong resistance from developing countries. As a compromise, part of their contents has been incorporated into the SPS and TBT Agreements while the key points are still left untouched. The regional agreements like TPP will make up for them.

59  The other unspoken but substantive factor is the worrying of the United States about the rising position of China in the Asia-Pacific area. 60  See Kelsey (2012). 61  See Anderson (2011). 62  See the response from the US Treasury Secretary Timothy Geithner to Ricardo Hausmann, Director of the Harvard University Center for International Development. See Geithner (2011). 63  See Article 12.15. 64  See Hu (2005), Chapter Three.

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The TPP negotiations have brought China into another dilemma. On the one hand, it is obvious too early for China to join them since most of its domestic enterprises are incapable of meeting the environment-protection and energysaving standards as some scholars predict.65 On the other hand, most TPP negotiators are China’s major trading partners. Back to 1980s, part of China’s momentum to resume its GATT contracting party status was to normalize the trade relations with the western world under the most-favoured-nation clause.66 When China set the exportation as one of the engines for its economic development, it began to realize the dependence on the overseas markets. The western world, however, seemed reluctant to provide them for free of charge. They conditioned the MFN treatment on the improvement of human rights in China and pressed for other demands. This became more relevant after the Tiananmen Square Incident which occurred in early summer of 1989. In order to get rid of this unfavourable situation, China spent sixteen years of tough negotiations for the entrance ticket to the WTO. The formation of a regional regime under TTP and the potential marginalization from it will impede China’s progress in fulfilling its globalization strategy and reduce the significance of China as a leading Member in the WTO. If China still keeps hovering outside the TPP talks, it will probably incur more challenges and pressures. As more countries are engaged in the TPP negotiations and a new freer trade regime is taking shape, China’s foreign trade will likely encounter those new regulations. Therefore, it is high time for China to consider when to get involved in the TPP negotiations. Although this might bring some negative impact upon its national economy, it is only in this way that China can take the initiative in the formation of new trade rules. It is clear that the Chinese leaders are fully aware of this situation and the SFTPZ is part of China’s strategy to cope with these challenges. As the mission 65  The TPP negotiations on environment reflect the shared view that the environment text should include effective provisions on trade-related issues that would help to reinforce environmental protection in all members. To this end, negotiations so far have focused on developing effective institutional arrangements to oversee implementation and a specific cooperation framework for addressing capacity building needs. See Stoler, Pedersen & Herreros (2012), p. 27. 66  When the GATT was used under a protocol to replace the still-born International Trade Organization, China was one of the original signatories of it. Although the Nationalist Party government decided to withdraw from the GATT in the early 1950s after it retreated to Taiwan, the Beijing government never accepted this decision. Therefore, China insisted on the resumption of its original status in the GATT. Unfortunately, China’s efforts failed before the GATT was replaced by the WTO in 1995. From then on, China began its negotiations for the WTO membership until 2001 when it became the 142nd Member.

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of the SFTPZ is to serve the whole country with a new set of rules on market access, the current measures adopted will be copied by other parts of China in due time. All these efforts are the warm-up exercises for China to further integrate into the world economy, either global or regional. 4

From Post-Establishment NT to Pre-Establishment NT: A New Approach towards Market Access

To a great extent, the fate of the SFTPZ is determined from the outset, by the choices made in the establishment of policy frameworks, incentive packages, and various other provisions and bureaucratic procedures. Experience has suggested that maximizing the benefits of any sort of SEZs depends on the degree to which they are integrated with their host economies and the overall trade and investment reform agenda. In particular, when SEZs are designed to experiment on the legal and regulatory reforms within a planned policy framework, they are more likely to reach their objectives.67 Given its contributions to the national economy and accumulated experience in government regulations, Shanghai will continue to serve as a viable tool for China, especially when the innovations in the SFTPZ are ex ante integrated into the overall strategy. Unlike the reform of thirty-six years ago, which started from the bottom to the top,68 the free trade zone strategy is initiated from the top to the bottom. The roadmap drawn for the SFTPZ is to streamline the government power by increasing transparency and automation in administrative approvals on market access. One substantial step to achieve this is the use of negative lists and default mechanisms that confer automatic approvals within a predetermined time-period. By doing so, investment approvals have been transformed from a case-by-case evaluation process to a simple registration process, meeting explicit criteria. Customs procedures have been simplified with the use of single forms, automated systems and other technologies. All these indicate that the administrative power will be limited significantly with more transparency and the duration spent on the application will be expedited greatly with more automation in the SFTPZ. 67  See The Multi-donor Investment Climate Advisory Service of the World Bank Group, supra note 2, p. 1. 68  In 1978, eighteen farmers in Xiao Gang Village of Anhui Province risked their lives to sign their names on the contract to rent the land. This event, which was eventually accepted by the central government, ignited the nationwide campaign to allow framers to rent State land for farming.

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The change of listing approach towards market access is the key factor to manage the tension between liberalization and regulation. The basic choice is between a positive list and a negative list. The positive-list approach is said to be “bottom up: there is no liberalization unless the host country volunteers commitments. The WTO Members adopted this approach to make their commitments under the GATS. The core provisions of the GATS in this context relate to market access (Article XVI) and national treatment (Article XVII). These provisions apply only to sectors explicitly included by a Member in its schedule of commitments—a “positive list” approach—and they too are subject to the limitations that a Member has scheduled. The negative-list approach is the “top down” practice: the host country must liberalize the market except those sectors for which it has secured reservations. The shift in onus is clear. The positive-list approach means that whole sectors, sub-sectors or activities may be withheld from exposure to the national treatment and market access norms. By withholding, the host country keeps open its options to regulate in the future, but the other party receives no guarantee of liberalization. In contrast, the negative-list approach exposes all sectors to the norms, which become substantive obligations for market access from the start and not just on the decision to inscribe them. Although, in reality, the “negative list” is often used to translate an across-the-board legal assurance of access for service suppliers and investors at the level of existing regulations, unlike the mistaken understanding as meaning a complete withdrawing of service and investment restrictions, the host country must actively list all the existing non-conforming measures it wishes to retain. From the outset, a “list it or lose it” onus applies, though the entries can be sweeping.69 The current approval procedure for foreign investment in most parts of China is still regulated under the positive list which is referred to the Guideline of Industries for Foreign Investment.70 Through this practice, most sectors, subsectors or economic activities are still withheld from exposure to the national treatment and market access norms. The foreign investors can get the access and receive the national treatment for their business only in the sectors listed in this Guideline. Even so, the regulation on market access is not transparent and the application does not necessarily lead to the approval. The shift from the positive-list to the negative-list approach reflects China’s determination to streamline government activities. The authorization to suspend some provisions of the three foreign investment laws in the SFTPZ 69  See Arup (2008), pp. 168–69. 70  The current version of the Guideline was jointly revised by the National Development and Reform Commission and the Ministry of Commerce in 2012.

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is a substantial step in this regard, which intends to equalize the treatment to investment wherever the source is. All non-state entities including foreign investors will be awarded the same market access within the sectors unlisted. This practice, after a short period of experiment, has already been adopted by the central government for administrative approval in some selective sectors outside the SFTPZ. In this sense, the SFTPZ can be regarded as the model of future China. The adoption of the negative list has moved the national treatment from the post-establishment period to the pre-establishment stage. In the former situation, national treatment will be offered provided that the application for investment has been approved. While in the latter, applicants will only need to inform the local authorities rather than seek approval as in the past. National treatment is given automatically since the market is destined to be open except those sectors explicitly listed. Therefore, the negative list will serve as a blacklist for applicants in the SFTPZ, citing sectors that are off-limits. Investment in the sectors within the off-limits will be managed under current laws, which will be processed according to the case-by-case procedure. The provisions of relevant laws for administrative approvals include Article 6 of Company Law, Article 3 of Sino-Foreign Equity Joint Ventures Law, Article 5 of Sino-Foreign Contractual Joint Venture Law, Article 3 and Article 6 of Wholly Foreign-Owned Enterprise Law. A similar approach will also apply to the contract regulations and the setting up of foreign-funded enterprises.71 The negative-list approach is a reasonable option, indicating that China has accepted the practice of international rule-making in the investment sectors. Traditionally, bilateral investment treaties did not offer any pre-establishment right to investors from another State party to the treaty concerned. Most BITs cover only investments that are already established. However, some of the recent BITs, especially those concluded by the U.S. and Canada with developing countries, and regional trade agreements of the NAFTA-type like TPP choose to offer certain key protections such as national treatment and MFN treatment to cover the entry and establishment of investments, i.e. to cover the stage when an investor is attempting to make its investment in the host country.72 Several articles of the EU Treat of Amsterdam include provisions concerning the 71  Tian (2013). 72  See Article 1102 of the NAFTA and Article 12.4 of the draft TPP. The negative list approach was first adopted in the NAFTA, which required that all service sectors be included within the disciplines of the agreement (other than air transport and services provided by government authorities on a non-competitive basis). See Stephenson & Maryse (2011), p. 9.

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freedom of establishment and free movement of capital.73 Other agreements concluded between the EU and central and eastern European countries also provide national treatment with regard to the establishment and operation of companies and nationals.74 In addition to the transparency and expedition in administrative approvals, another merit of the negative-list approach is the increasing possibilities for market access. With the development of science and technology, the means to trade goods or supply services may change rapidly. The commitments on the market access will also be increased accordingly. This is in conformity with the technological neutrality principle,75 which was first raised in the WTO Gambling Case.76 While in defining the sphere of “cross-border service supply”, the Panel assumed that mode 1 under the GATS encompassed all possible means of supplying services from the territory of one WTO Member into the territory of another. Therefore, a market access commitment for mode 1 implies the right for other Members’ suppliers to supply a service through all means of delivery, whether by mail, telephone, Internet etc., unless otherwise specified in a Member’s Schedule.77 Based on this reasoning, the Panel concluded that the US Wire Act, which prohibited the service suppliers from supplying gambling and betting services through telephone, Internet and other means of delivery using wire communication, contained a limitation to the service “in the form of numerical quotas” within the meaning of Article XVI:2 (a) and a limitation to the service “in the form of quotas or requirement of an economic needs test” within the meaning of Article XVI:2 (c) of the GATS.78

73  See Articles 43, 44, 47, 48, 56 and 58. 74  See Subedi (2012), p. 99. 75  The principle of technological neutrality originates from the electronic commerce, referring to the presumption that the law should have the same application to electronic commerce regardless of its transaction means. Paragraph 4 of the Work Program on Electronic Commerce—Progress Report to the General Council adopted by the WTO Council for Trade in Services on 19 July 1999 provides that “[i]t was also the general view that the GATS is technologically neutral in the sense that it does not contain any provisions that distinguish between the different technological means through which a service may be supplied”. See S/L/74, 27 July 1999. 76  For useful analysis, see Trachtman (2005), pp. 861–67. 77  United States—Measures Affecting the Cross-Border Supply of Gambling and Betting Services, Report of the Panel, WT/DS285/R, para.6.285. 78  In view of the sensitivities associated with the subject-matter of the US-Gambling Case, the Panel emphasized that its conclusion was directly linked to the particular circumstances of this dispute and its role was to interpret and apply the GATS in light of

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This principle was quoted again in the China Trading Rights Case. In regard to the US arguments, the Panel provided that “we have already found that the core meaning of China’s commitment on these services includes the distribution of audio content on non-physical media. The principle of technological neutrality might have come into play, had we found that China’s commitment covered distribution on physical media and that there was doubt about whether it also covered the distribution of content on non-physical media. But this was not the case here.”79 In other words, the Panel did not deny the applicability of this principle in defining the means of supplying services. As a matter of fact, it basically accepted the Panel’s conclusions of the US-Gambling Case on the relevant issue that a commitment including all means of delivery was in line with the principle of technological neutrality.80 Although the DSB used the technological neutrality principle to interpret the GATS commitments contained in the positive list, leading to the increase of WTO Members’ commitments for market access, the same rationale for interpretation applies to those activities not contained in the negative list, which means that the possibilities for market access will be increased with the development of science and technology. The same rationale applies here in the interpretation of the sectors not inscribed in the negative list. Following this way, the investors in the SFTPZ will have a better environment for their commercial activities. The SFTPZ has listed all the sectors which are prohibited or restricted to foreign investment. Among the twenty sectors classified by the National Bureau of Statistics,81 twelve of them have been listed in the Guideline of Industries for Foreign Investment and open to foreign investment to a certain extent. The current Guideline excludes the following six industries: Architecture and Construction, Finance, Real Estate, Lodging and Catering, Information Transit the facts and evidence, not to second-guess the intentions of the United States at the time the commitment was scheduled. Id, para.7.3. 79  See China—Measures Affecting the Trading Rights and Distribution Services for Certain Publications and Audiovisual Entertainment Products, Report of the Panel, WT/DS363/R, para.7.1258. 80  Following the reasoning of the US-Gambling Panel, the Panel in charge of the China Trading Rights Case considered that the principle of technological neutrality had established that any differences between the supply of the sound recording distribution services on physical, as compared to non-physical, media were merely “technological”, and thus should not, unless specified in China’s Schedule, serve to narrow the scope of China’s commitment. Ibid., para.7.1256. 81  Public Management, Social Security and Social Institutions (S) and International Organizations (T) are the two categories of industries not open to foreign investment.

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and Services for Software and Information Technology, House-keeping and Maintenance. Based on the Guideline, the negative list adopted by the SFTPZ has kicked out two more sectors and removed some restrictions in the rest to foreign investors.82 The first version of the negative list, made in 2013, covered 18 fields which are divided into 1069 sub-sectors, and include 190 special regulatory measures. The second version, made in 2014, has reduced the number of special regulatory measures to 139. The negative list will be updated every year and the regulatory measures will be released more in future.83 Although the SFTPZ has launched the first successful step, there is still long way to go before it meets the expectation of all concerned. The more specific issues the SFTPZ encounters, the more complicated relationships it will deal with. Therefore, the mission of it as a testing ground for the national reforms is destined to ups and downs. 5 The SFTPZ: How Far Can It Go? Although the newly revised Regulations of the People’s Republic of China on Administration of Foreign-funded Banks and Rules for Implementing the Regulations of the People’s Republic of China on Administration of Foreignfunded Banks have ensured that the juridical-person banks with foreign fund can receive the national treatment as that of their Chinese counterparts, they still contain some restrictions on the business of foreign bank branches.84 Therefore, the essence of the objectives set for the SFTPZ is to phase out the restrictions on market access for trade in financial services and build Shanghai as one of the regional financial centres. This liberalization process will be achieved in conformity with China’s commitments under the GATS plus China’s own incentive policies. The liberalizing contents of the GATS depend on the extent and nature of sector-specific commitments assumed by individual Members. The World Trade Organization does not prevent its Members from liberalizing faster than they have promised in their schedules. GATS commitments are basic guarantees of WTO Members. The absence of such guarantees does not mean

82  The two more sectors completely open to foreign investors are Lodging and Catering and Housekeeping and Maintenance. 83  Mayor of Shanghai, Yang Xiong, expressed to the press at an international forum that the negative list was expected to be shortened in the following years. See Yang (2013). 84  See Hu (2009), pp. 417–38.

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that access to a particular market is denied.85 A Member like China may choose to open more sectors than scheduled when it considers appropriate. Even so, China still retains large degrees of freedom with respect to the framework of domestic regulations in its financial market, and the reform in this area will be conducted in a coherent way with its overall economic strategy. Since the accession to the WTO in 2001, China has followed its commitments to open the banking sector to foreign-funded banks by phasing out restrictions on their business in China.86 China has released geographic restrictions on foreign currency business to foreign-funded banks on the date of its accession. As for the local currency business, China had removed all geographic restrictions before the end of the transitional period, i.e. 11 December 2006. In regard to the clients of foreign-funded banks, China has extended them from Chinese enterprises to all individuals. Meanwhile, China has lifted the ban on the local currency debt of foreign-funded banks in no more than 50% of their foreign currency debt and raised the percentage for foreign-funded banks to absorb foreign currency savings in China. China has not made a step further forward on the financial market access ever since it fulfilled the scheduled commitments. The idea of establishing the SFTPZ has generated a lot of excitement and imagination about accelerating China’s economic reforms, increasing financial market access for foreign investment, providing more flexible capital account convertibility and quickening the steps of RMB currency internationalization. The innovative measures which the SFTPZ is currently trying are stepping stones leading to the deeper changes for China’s future development, which will shift from a closed capital market to an open one. Rhetoric and excitement aside, however, no one is asking the fundamental question of whether the incentives for various local stakeholders are compatible with this ambitious project. This is the single most important issue in determining whether the SFTPZ can play as the catalyst to deepen China’s structural reforms. As one analyst observed, the SFTPZ will not be a game changer until the incentive problem is resolved.87 In other words, the success of the SFTPZ will be assessed, to a great extent, on the opening of its 85  See Mattoo (2003), p. 301. 86  See Report of the Working Party on the Accession of China (Schedule CLII—The People’s Republic of China: Part II—Schedule of Specific Commitments on Services, List of Article II MFN Exemptions), Part II (Specific Commitments): Banking and Other Financial Services (excluding insurance and securities), WT/ACC/CHN/49/ADD.2 (distributed on 1 October 2001). 87  See Chi (2013).

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financial market. Unlike the previous SEZs which were operated either with tax breaks or other incentive policies which benefited the local economy with the substantial increase of foreign investment and government revenue, the SFTPZ has not received any preferential treatment in economic terms, but is encouraged to experiment on the limits to government power and test the risks after further opening the market. The local government of Shanghai has not gained any material benefits from the SFTPZ. Instead, it is prone to the risks in testing those innovative measures. After more than three decades of economic development, a new class consisting of the wealthy and intellectuals has emerged in China. Many of the vested interest groups that used to support economic reforms are becoming suspicious of radical changes as deeper reforms will take away their rentseeking opportunities. The incentive incompatibility problem will haunt the development of the SFTPZ. Many Chinese intellectuals have lost their ideals and pioneering spirit as they possessed in 1980s and early 1990s.88 They have realized that the upward mobility is almost capped and any promotion one manages to gain through hard work, or even at the cost of taking a risk like the early days of 1980s, can be taken away by the elite group. Therefore, most of them are turning away from the reforms for the suspicion that more reforms would only benefit the elites. In addition to this incompatibility issue, a more technical one deserves questioning: are the policies to liberalize capital account and internationalize RMB currency designed to make Shanghai a regional financial centre? Some emerging economies may find it necessary to internationalize their local currencies in order to successfully construct regional financial centres and attract foreign capital flow into their soil. This strategy works sometimes, but currency internationalization does not surely lead to the establishment of a financial centre within the boundaries of the issuing country. For instance, in the case of euro, a fully developed international financial centre is located neither in Frankfurt nor in Paris although Germany and France are the two important engines of EU economy. Instead, London deals with a large share of cross-border financial transactions in euros.89

88  There were two massive waves of Chinese intellectuals leaving the governments to do business in the recent years. The former lasted the whole 1980s when many of them migrated to the special economic zones. The latter occurred in 1992 after the former Chinese leader Deng Xiaoping delivered his famous speech in Shenzhen, indicating his strong support to the market economy. 89  See Park & Shin (2009).

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Capital account liberalization is the most difficult issue and the last stage of financial market opening in China. Compared with its commitments in finance sectors under the GATS, China’s decision in this regard is really a bold one. Since its effect on the national economy remains unknown, it is necessary for the SFTPZ to weigh up the benefits and costs of capital account deregulation before embarking on currency internationalization. Potential capital flight is the single most important obstacle for the Chinese government to permit fund flows between the SFTPZ and the outside world. This is because, by allowing free access to the SFTPZ from other regions, China would effectively open up its capital account and risk massive capital outflow. Unlike the practice in many other countries, finance is a heavily protected sector in China. Nearly all banks are dominated by State capital, which has led to less competition and inefficient supervision. The worsening of China’s overinvoicing problem may be indicative of an ever increasing incentive for capital flight if the floodgates were opened. If such a hypothesis becomes a reality, the consequence will be beyond anybody’s imagination. When over-invoicing, a Chinese firm inflates its import bill by charging the import price of some commodity much higher than the actual cost. By reporting an inflated import bill to the Chinese customs, this allows the passing of capital overseas, with the foreign (exporting) entity crediting the excess amount into its Chinese counterpart’s bank account outside of China. Establishing rules for financial institutions to supervise capital flow in the SFTPZ is complicated in the face of this loophole problem, which will be aggravated by the incentive incompatibility among the SFTPZ’s stakeholders. To play safe, China will likely keep its asymmetric stringent control on the capital outflow, which is to allow capital to come into the country much more easily than allowing it to escape. At the current stage, the SFTPZ is likely to be a restrictive experiment zone for onshore RMB currency convertibility and capital account liberalization. This practice is meant to minimize the possibility of massive capital flight that could destabilize China’s financial system.90 It is clear that the Chinese leaders are fully aware of these potential risks. This is why the current liberalization of capital account is strictly limited within the ring-fenced SFTPZ. However, if the regulators are able to completely segregate the SFTPZ from the outside, it will just be an isolated laboratory with a limited impact on the drive towards national structural reforms. The relevance of the SFTPZ to other places will be reduced significantly. The best example in this regard is Hong Kong, which is a de facto free trade zone of China since 90  See supra note 88.

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its reversion to the motherland in 1997. Hong Kong has already developed a world-class financial system, which runs on the rule of law with a high level of credibility and integrity. It has a fully convertible capital account and currency, and its economy is running on free market principles. All these are exactly what the SFTPZ is trying to emulate right now. But Hong Kong is ring-fenced from the rest of China with limited free flow of investment and capital. In contrast to Hong Kong, Singapore’s well-known non-internationalization policy tells another story that currency internationalization is not a necessary condition for the development of a financial centre. Shortly after its independence, the Singaporean government began to provide special regulatory and tax treatment for foreign commercial banks to promote offshore deposits. The Singaporean government, however, realized the size of the Singapore’s economy to be too small compared to the rapidly growing volume of foreign ­currency deposits and unable to meet the demands of currency in emergent situations. Since Singapore used the exchange rate as a benchmark policy instrument, its government was especially concerned about the possibility of speculative attacks on the Singaporean dollar. It would believe that, by restricting the international use of the domestic currency, the Singaporean dollar could be protected from speculative attacks.91 To open or not to open, this is a question for China. On the one hand, it is a bold policy for the Chinese government to liberalize the capital account and internationalize RMB currency at the time when its supervision to the financial market is not full-fledged and the whole national economy is still unstable. On the other hand, however, it will be very difficult for China to upgrade its economic development if the government still discourages the capital flow and restricts the currency convertibility, especially at the moment that China is the second largest economy and has the largest reserve of foreign currency. With the Chinese products becoming less competitive in the world market and the continuing sluggishness of domestic consumption, China urgently needs to replace the production-driven economy with a service-driven economy. An efficient capital market is essential to achieving this. Therefore, the issue of how far the SFTPZ can go actually depends on how farsighted the Chinese government can be.

91  See Chow (2008).

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Hooshang, Amirahmadi, & Weiping Wu (1995) “Export Processing Zones in Asia.” 35 Asian Survey 828–49. Hu, Jiaxiang (2005) WTO and its Dispute Settlement Mechanism—From a Developing Country Perspective, Hangzhou: Zhejiang University Press. ——— (2009) “Market Access or Market Restrictions.” 1 Goettingen Journal of International Law 417–38. ——— (2012) “The Role of WTO Law in the Construction of the Chinese Legal System.” 4 Yonsei Law Journal 226–52. ——— (2014), “Shanghai Free Trade Pilot Zone, the Model for Future China?,” in J. Hu & M. Vanhullebusch, eds., Regional Cooperation and Free Trade Agreements in Asia, Leiden: Brill Academic Publishers, 246–69. Kanbur, Ravi, & Xiaobo Zhang (1999) “Which Regional Inequality? The Evolution of Rural-Urban and Inland-Coastal Inequality in China from 1983to 1995.” 27 Journal of Comparative Economics 686–701. Kelsey, Jane (2012) “Investment Developments in the Trans-Pacific Partnership Agreement,” http://www.iisd.org/itn/2012/01/12/investment-developments-in-thetrans-pacific-partnership-agreement/ (accessed 29 April 2015). Lee, Yong-Shik (2005) Safeguard Measures in World Trade: The Legal Analysis, The Hague: Kluwer Law International. Lin, George C. S. (1999) “State Policy and Spatial Restructuring in Post-Reform China, 1978–95.” 23 International Journal of Urban and Regional Research 670–96. Litwack, John, & Yingyi Qian (1998) “Balanced or Unbalanced Development: Special Economic Zones as Catalysts for Transition.” 26 Journal of Comparative Economics 117–41. Long, Gen Ying (1999) “China’s Changing Regional Disparities During the Reform Period.” 75 Economic Geography 59–70. Lyons P., Thomas (1991) “Inter-provincial Disparities in China: Output and Consumption, 1952–1987.” 39 Economic Development and Cultural Change 471–506. Mattoo, Aaditya (2003) “China’s Accession to the WTO: The Services Dimension.” 6 Journal of International Economic Law 299–339. Miyagiwa, Kaz, & Leslie Young (1987) “Unemployment and the Formation of Duty-Free Zones.” 26 Journal of Development Economics 397–405. Muchlinski, Peter (2011) “SEZs: A Policy Tool in Search of a New Agenda?,” in C. Carter & A. Harding, eds., Special Economic Zones in Asian Market Economies, New York: Routledge, 15–37. The Multi-donor Investment Climate Advisory Service of the World Bank Group (2008) “Special Economic Zones: Performance, Lessons Learned, and Implications for Zone Development,” Washington: World Bank Group. New York Times (1995) “Deng’s Economic Drive Leaves Vast Regions of China Behind,” 27 December.

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Park, Yung Chul, & Kwanho Shin, Internationalization of Currency in East Asia: Implications for Regional Monetary and Financial Cooperation” Presented at BoK/ BIS Seminar on Currency Internationalization: Lessons from the Global Financial Crisis and Prospects for the Future in Asia and the Pacific, Seoul, Korea, 10–20 March 2009. State Council (2014) “Break Down the Glass Door Against the Non-public Entities and Put Forward Reform Measures in Due Time,” http://finance.china.com.cn/news/ gnjj/20130906/1794266.shtml (accessed 29 April 2015). Stephenson, Sherry, & Robert Maryse (2011) “Innovations of Regionalism in Services in the Americas,” Working Paper for Swiss Center of Competence in Research, No.2011/34. Stoler, Andrew L., Peter Pedersen, & Sebastian Herreros (2012) “Negotiating Trade Agreements for the 21st Century,” Working Paper for the UN Division of International Trade and Integration, Santiago: UN. Subedi, Surya P. (2012) International Investment Law: Reconciling Policy and Principle, Oxford: Hart Publishing. Tian, Wei (2013) “ ‘Negative List’ Will Shepherd Investors,” China Daily, 30 September. Trachtman, Joel (2005) “United States—Measures Affecting the Cross-Border Supply of Betting and Gambling Services.” 99 American Journal of International Law 861–67. Tsui, Kai Yuen (1998) “Factor Decomposition of Chinese Rural Income Inequality: New Methodology, Empirical Findings, and Policy Implications.” 26 Journal of Comparative Economics 502–28. Tyagi, Mitali (2012) “Flesh on a Legal Fiction: Early Practice in the WTO on Accession Protocols.” 15 Journal of International Economic Law 391–441. Wei, Yehua (1996) “Fiscal Systems and Uneven Regional Development in China, 1978– 1991.” 27 Geoforum 329–44. Wei, Yehua, & C. Cindy Fan (2000) “Regional Inequality in China: A Case Study of Jiangsu Province.” 52 Professional Geographer 455–69. World Bank (1992) “Export Processing Zones, Policy and Research Series,” 20 Industry Development Division. Xi, Jinping (2013) “Deepen Reform and Opening up and Work Together for a Better Asia Pacific,” http://www.fmprc.gov.cn/eng/zxxx/t1088517.shtml (accessed 29 April 2015). Yang, Xiong (2013) “The Negative List of SFTPZ Will Be Shortened Gradually,” Daily Economic News, 28 October. Yao, Shujie, & Zongyi Zhang (2001) “On Regional Inequality and Diverging Clubs: A Case Study of Contemporary China.” 29 Journal of Comparative Economics 466–84. Zhang, Xiaobo, & Kevin H. Zhang (2003) “How Does Globalization Affect Regional Inequality within a Developing Country? Evidence from China.” 39 The Journal of Development Studies 47–67.

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Chapter 7

Finance, Rule of Law and Human Rights in China Matthias Vanhullebusch Abstract Finance has become an indispensable vehicle for economic development in emerging economies. Such economic progress involves a number of human rights implications which affect financial products, the entitlements of the banking sector itself as well as broad matters of socio-political and -economic justice. Such asymmetries and inequalities find their way into those debates on financial reform and regulation where a tension persists between the sustainability of economic objectives and political stability in fast-developing economies and especially in mainland China. Thus, financial governance and regulation has to take into account these various stare- and stakeholders to match both the short-term profit goals of the financial sector and the longterm socio-economic, environmental, political objectives of the nation in question. Such balancing act will proof to be crucial to ensure further market access, financial innovation and accountability for bankers, investors, regulators, and policy-makers alike. It remains to be seen how China will be in the position—both ideologically and economically—to offer such guarantees in the short or long-term and resist or accommodate the forces of the international financial markets.

Keywords financial governance – equator principles – socio-economic justice

1 Introduction China’s economic growth has been slowing down for a number of years and indicates to be the “new normal” as reassured by its leadership. Such economic prognosis necessarily takes into account a number of economic factors both *  Associate Professor, KoGuan Law School, Shanghai Jiao Tong University—PhD, University of London. Contact: [email protected].

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international and domestic alike, which justify the current reorientation of China’s economic growth model. The latter should be capable to move from an investment- and export-oriented towards an innovation- and consumer-based model on the long-term. While on the one hand, the former model heavily relies on state—central and provincial alike—investment causing an explosion of government debts as well as an expansion of foreign currency reserves and bonds, its costs have been sufficiently absorbed by a so-called cheap ecology where environmental and labour conditions have been poorly taken into consideration. While on the other hand, the latter model in the making advances domestic consumption above export, it needs to be driven by domestic innovation if it pursues to alleviate the pressures on its environment and shrinking labour force due to changing demographic conditions which is increasingly challenging its previous abundance of human resources. Such innovation is not only essential to turn its manufacturing model to be more energy efficient and produce more products in an environmentally friendly manner, it equally is crucial to reduce the carbon-footprint if domestic consumption and manufacturing wish to go hand in hand in contributing to China’s economic growth and thus GDP.1 Innovation however is not only confined in technological terms, research and development, it equally extends to financing such development in the first place. In this respect, the financial industry plays an important role in putting at the disposal those resources which are necessary to advance technological progress on all other fronts as to ensure a successful transformation of China’s economic growth model.2 Institutional investors and bankers—state and private alike—on their turn can benefit from such investments which are gearing China’s economic model towards long-term innovation. Indeed, enduring gains can be secured since a sustainable transition will take up many decades to come. At the same time, China’s commitment to its two Centenary Goals in 2021 and 2049—commemorating respectively 100 years of the existence of the Communist Party of China (CPC) and the proclamation of the People’s Republic of China (PRC). By those deadlines, China aims to achieve respectively a moderate level of prosperity for all and a “prosperous, democratic, culturally advanced and harmonious modern socialist country”. The pursuit of technological and financial innovation and transformation in light of such goals is intimately linked with a strong governing authority.3 1  Grinin, Tsirel & Korotayev (2015). 2  Hu (2006), pp. 23–4. 3  Xi (2014), p. 7; Ji (2014), pp. 309–10.

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These reforms are joined by another simultaneous phenomenon within the transformation of China’s economic model, namely the introduction of the new era of domestic rule of law as announced at the 18th National Congress of the Communist Party of China in 2012. In this regard, China has strongly recommitted itself in building “a socialist country based on the rule of law, [establishing] a sound mechanism for conducting checks and oversight of the exercise of power, and thus [advancing] socialist political progress”.4 Therefore, given the construction of a law-based and -abiding China, its government and society will necessarily “bring the rule of law to a new stage” of its economic and social development as argued by President Xi Jinping.5 Thus, the respect for rule of law within the context of finance is inherently connected with such socio-economic and political trajectories and objectives. As a socialist country, the present day’s inequalities, which are intrinsically part of the economic disparities between coastal and inland provinces as well as between cities and the countryside, would within those Centenary Goals become part of the past. It is against the background of such long-term goals that the experiment of the Shanghai Free Trade Pilot Zone (SFTPZ) needs to be seen. The liberalization and internationalization of China’s financial sector would maximize the potential benefits to advance economic progress in an age of global and national economic downturns. China’s economic opening-up to the outside world however has until now not been entirely witnessed in its financial plans within the free trade zone in Shanghai which on the long-term would serve to expand across the entire territory of China. This involves a number of sensitive decisions which could affect the economic growth as well as the political stability of the country. The Chinese government has thus remained off-guard to implement such reforms which would allow the international financial markets to take the overhand in its monetary policy—hence the reluctance to internationalize its RMB—and alter the socio-economic fabric of Chinese society and domestic markets. While international finance may be 4  Xinhuanet.com (2012). 5  See Xi, supra note 3, pp. 160–61 and 103: “To modernize our national governance system and capacity we should adapt properly to the changing times, and reform outdated systems, mechanisms, laws and regulations, while building new ones to make our institutions in all respects more appropriate and complete the governance of Party, state and social affairs more institutionalized, standardized and procedure-based. We should pay more attention to building our governance capacity, enhancing our awareness of the need to act in accordance with institutions and the law, and our skills in running the country with institutions and the law, transforming our institutional advantages into greater governance, effectiveness, and enhancing the Party’s capacity to govern in an effective and democratic way, and in accordance with the law.”

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relentless about those local socio-economic conditions, they too enjoy certain prerogatives if they wish to operate from such free trade zones, such as the access to (internet) information to stay connected with the outside world and exercise their financial activities as part of their operations.6 While still a developing country, China will be cautious in implementing certain human rights entitlement in the socio-economic and environmental sphere. Yet, the political aims set forward in the Centenary Goals of the leadership necessarily implicate the realization of a human rights agenda with Chinese characteristics. The transformation of China’s economic model with the assistance of the financial industry ought to eventually incorporate those environmental and labour standards given the boundaries which those parameters in the process of China’s spectacular growth have superseded. Therefore, this chapter will firstly address how financial instruments can comply with certain environmental and social standards, secondly examine why individual bankers may wish to exercise some fundamental human rights in the exercise of their respective activities, and thirdly analyse how the promotion of more equitable and just socio-economic conditions—in particular with reference to the present inequalities in international financial centres like Hong Kong—may proof to be a precondition for political stability across the nation—especially in light of the full incorporation and integration of the Hong Kong Special Administrative Region (HKSAR) into mainland China by 2047—and show proof of China’s evolving role both domestically and internationally alike to advance new recipes of economic development and finance in and towards a new international economic order (NIEO). 2

Human Rights and Financial Instruments

Conditioning the realization of certain human rights standards in financing vehicles to streamline economic development in developing economies are not new.7 International financial development institutions such as the World Bank have been leading the efforts to hold borrowers responsible for the protection of environmental standards when using such funds to finance the development of particular industries within a developing country.8 The International Finance Corporation—a member of the World Bank Group

6  Shen & Vanhullebusch (2015). 7  Likosky (2012), p. 113. 8  Head (1991).

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advancing private sector financing in development projects,9 has developed its so-called Equator Principles which serve as a benchmark to allocate funding to responsible environmentally friendly and socially acceptable development projects through a thorough review process by independent assessors. Rather than evaluating project financing on the basis of financial risks and liabilities to the financing institutions, sustainability on the side of the borrowers was used as a primary concern yet such commitments were only voluntary.10 Understandably, borrowers would submit their financing to higher risks since compliance with those environmental and social prerequisites on behalf of the lender may increase the costs to operate a project and reduce its financial viability.11 Human rights risks as well as violations by borrowers—even with a strong commitment on behalf the financial institutions—may eventually occur since the latter may not exercise enough leverage to change such behaviours in all circumstances.12 While private sector financing and corporations are not bound by international human rights law—unlike state parties to particular human rights instruments,13 the emerging body of soft law principles under international law including the 1998 International Labour Organisation’s Declaration on Fundamental Principles and Rights at Work, the 1992 Rio Declaration on Environment and Development and the 2013 Equator Principles have located responsibility with financial institutions who are financing particular projects that have detrimental effects on the environment and socio-economic wellbeing of communities affected by such projects or of individual workers as well.14 Moreover, the issue of climate change has further incentivized international financial institutions to take into account environmental standards in their project financing especially in energy-sensitive industries. The private finance sector has equally been exposed to the perils of climate change and has accounted those in their operation costs and loans.15 Nonetheless, such move towards socially responsible investment has yet to be crystalized into binding regulations which can be enforced on behalf of governments rather than corporate actors themselves in the pursuit of their own economic and financial interests. Instead, voluntary norms have further prioritized the 9  10  11  12  13  14  15 

Ifc.org (2015). See also Woicke (2005). Kamijyo (2004), pp. 35–6. Lawrence & Thomas (2005), p. 22. The Thun Group of Banks (2013), p. 5. Caliari (2010), pp. 142–43. McBeth (2005), pp. 27–33. Herbertson & Hunter (2007), pp. 6–7.

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b­ usiness aspects above ethical considerations to investing into environmentally friendly products16 and were designed to pre-empt unwarranted intensification of state regulations instead.17 The global financial crisis of 2007–2008 has only accelerated the latter process.18 As a result, voluntary codes of conduct will not be precursors to changing the financial industries’ policies. To the contrary, the global financial crisis revealed the systemic risks which the deregulated financial sector naturally propels. Such market distortions were not cancelled out by efficiency measures on behalf of the banking sector but were rather symptoms of behavioural psychologies of overzealous speculators which were previously unaccounted for,19 whose losses have been shifted to society instead20 and were hidden in financial risks models inaccessible to the outsiders and regulators in particular.21 Moreover, others have argued that the increasing income gaps have driven the banks to finance the general populace’s consumer and housing needs as reflected in the mortgage crisis in the United States. Such income inequalities have been equally the outcome of a deregulated labour market which eliminated collective bargaining powers resulting in a power vacuum which has been filled by powerful corporations instead.22 The latter labour regulations in China however had not reached such development in the first place and would also rely on corporate social responsibility (CRS) instead—which leaves the wellbeing of workers subject to the goodwill of the employer. Nonetheless, China’s integration in the world economy has also introduced such standards through the production and supply chain of goods manufactured in China yet manipulation of data and the absence of enforcement have often left such initiatives in vain.23 Internally, the lack of enforcement of environmental and social standards has increasingly moved employers and government alike in moving the transformation of its economic model forward towards a consumer-oriented economy and thus ensuring partial socio-economic stability.24 Also the global financial crisis was a turning point for the Chinese government to initiate those 16  17  18  19  20  21  22  23  24 

Richardson (2009), p. 602. Richardson (2010), p. 492. Stevelman (2009), p. 207. Avgouleas (2009), p. 30; Baradaran, p. 1285. Black (2010), p. 94; Williams & Conley (2014), p. 468. Reddix-Smalls (2012); Lovett (2012), pp. 55–6; Baxter (2012), p. 777. Silvers & Slavkin (2009), p. 304. Wang (2013). Lin (2010), pp. 89–94.

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necessary reforms in furtherance of those socio-economic objectives.25 Yet, promoting growth at that time—with declining export numbers—resulting in supporting excess capacities and accumulation of government debts appeared to have taken the upper hand over those sustainability goals.26 The latter need to enhance those objectives has also been advanced by the financial sector whose contribution to economic growth partly explains the exponential growth numbers of the past decades. Yet, much of those financing vehicles were used to fund state owned enterprises and thus less efficient sectors—contributing however to social stability which itself fostered an economic environment conducive to economic growth in the first place.27 While the call for innovation was launched as early as in the 2011 12th FiveYear Plan in a number of crucial industrial and emerging strategic sectors, other financial instruments, taxation regimes and legal measures ought to be taken in addition to those innovative forces which the market may engender by its invisible hand.28 Laying down more sustainability goals in financial regulations, could have geared the banking sector in advancing its awards when developing such financial products in their portfolio which could match with the innovation goals in the central government’s plan.29 As another source of economic growth, foreign direct investment (FDI) whose capital can be channelled through the Chinese banking system30 and reinforced with other sources of investment such as sovereign bonds, domestic savings, institutional investors, are powerful forces to advance capital markets who can finance China’s economy and its transformation towards an innovation and consumerbased society. Such internal and external financing vehicles further integrate China into the global financial markets.31 FDI can on its turn be leveraged to invest in such activities which protect environmental and social standards. Absent the realization of such goals, the right to development has often been invoked on behalf of developing states or emerging economies to reclaim their share in the annals of economic history. They have usually done so at the expense of the environmental and social standards developed earlier on by Western financial and global governance institutions and which are accused

25  26  27  28  29  30  31 

Chow (2011), p. 48. Breslin (2012), pp. 236–37; Shen (2014), p. 7. Aziz (2010), p. 245. Roach (2011). Freeman & Yuan (2011), p. 12. Chantasasawat et al. (2010), p. 125. Sarkar (2009), pp. 414–5.

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as impediments to their development.32 From the Chinese perspective, such arguments are no longer evoked in absolute terms despite its commitment to postpone implementing a reduction of its carbon dioxide emission after it has reached its peak in 2030.33 Financial institutions are indispensable actors to invest in the implementation of such goals on the long-term. Absent their (voluntary) commitment, they may be considered to act irresponsibly on such environmental concerns like climate change. Moreover, respect for social standards of sectors in which particular portfolios of financial institutions are investing can positively affect the productivity of such work force, its health and overall competencies thus benefiting the investors as a result. Social stability and productivity are interdependent.34 Thus, corporate social responsibility guidelines sponsored and surveyed by the Chinese government can be a possible avenue to further implement those socio-economic and environmental standards in the delivery of financial products offered by financial institutions to its investors’ and consumers’ base.35 In this regard, Article 5 of the China’s 2005 Company Law enacted that “[i]n its operational activities, a company shall abide by laws and administrative regulations, observe social morals and commercial ethics, persist in honesty and good faith, accept supervision by the government and the public, and assume social responsibility”. Yet such responsibilities have diverged significantly in terms of sectorial differences where financial services rank still below average.36 Or as Shen adds: While the Company Law recognises social and environmental responsibility, the CSR provision is by large a window-dressing term that does not sufficiently identify the appropriate manner that a company should be operated so as to promote or achieve CSR. [. . .] The current regulatory approach is still to rely solely on corporate conscience. Unfortunately, this approach fails to draw a clear line between activities that are unethical or disadvantageous to society and those explicitly prohibited by law.37

32  33  34  35  36  37 

Lang (2011), p. 51; Vanhullebusch (2014), p. 235. Whitehouse.gov (2014). Cherneva (2012); Cata Backer (2013), p. 664. Harper Ho (2013), pp. 431–32. Zhang & Liang (2014), p. 242. Shen (2015), pp. 90–1.

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In this respect, as early as 1995, the Chinese government had launched its first environmental regulations for the banking sector. The People’s Bank of China and the State Environmental Protection Administration respectively made their “Announcement on Credit Policy for Environmental Protection” and “Announcement on Making Use of Credit Policy for Promoting Environmental Protection”. Yet, those early measures were set aside by the nation’s economic growth objectives. Only from 2004, the National Development and Reform Commission together with the People’s Bank of China and the China Banking Regulatory Commission made a new “Announcement on Further Strengthening Industrial Policy and Credit Policy to Control Credit Risks” whose annex banned and restricted a number of polluting sectors which could receive credit for further development. The State Council’s 2005 “Regulation on Accelerating Adjustment of Industrial Structure” and 2006 “Announcement on Accelerating Adjustment of Industrial Structure with Excess Capacity” only put restrictions on lending practices to projects suffering from serious pollution. None of these policies however imposed clear obligations on behalf of the banking sector to identify environmental risks and assume due diligence obligations accordingly.38 Only from 2007 onwards, the Ministry of Environmental Protection adopted the first real “Green Credit Policy” taking into account environmental standards in bank lending. Such measures have also been translated in the voluntary codes of conduct adopted by the China Bank Association in 2009. Those latter “Guidelines on Corporate Social Responsibility for the Chinese Banking Sector” required banks to assume environmental and social responsibility in furtherance of the nation’s industrial policies which were gearing towards innovation in the first place.39 3

Human Rights and Bankers

While financial institutions—whether domestic or international—operating in China can contribute significantly to the modernization and innovation process of China’s current economic and manufacturing model by virtue of the diverse policies and financial instruments described above, they too enjoy certain human rights entitlements in the exercise of their activities and normal functions as banking and financing institutions. Much of the exercise of such functions may at face value appear remote from the traditional human rights debates in particular within a Chinese context, yet they can proof to 38  Bai, Faure & Liu (2014), p. 105. See also Aizawa & Yang (2010). 39  Bai, Faure & Liu (2014), p. 106.

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be equally crucial in determining the future of China’s as well as the nature and character of Shanghai’s international financial centre. The competitiveness of financial and other services industries relies on the availability and access of information up which investors, bankers and financial institutions can act upon to invest in particular products or dispose of certain activities after cost-benefit analyses. In this regard, Article 19 of the 1966 International Covenant on Civil and Political Rights (ICCPR) may be used in this context and states that: “Everyone shall have the right to freedom of expression; this right shall include freedom to seek, receive and impart information and ideas of all kinds, regardless of frontiers, either orally, in writing or in print, in the form of art, or through any other media of his choice.” Rather than focusing on the dissemination of information as one component of the right to freedom of expression, financial institutions in general and individual bankers in particular—as bearers of such human right—are concerned with the freedom to search and receive relevant information for their financial services and transactions regardless of the kind of media by which such information is transmitted. Those sources are generally accessed through the medium of the Internet. China’s familiar practice of censorship and blocking of foreign websites40—temporarily or permanently—including more recently Bloomberg News and New York Times—which constitute important sources of information for business and banking communities alike—make it more difficult for those financial sectors to make appropriate decisions when correct information is not available or can be verified. In China internet freedoms have been—pursuant to Article 19 of the ICCPR “subject[ed] to certain restrictions, but these shall only be such as are provided by law and are necessary: (a) For respect of the rights or reputations of others; (b) For the protection of national security or of public order (ordre public), or of public health or morals”. The latter has been imposed by China’s State Internet Information Office.41 However, in terms of human rights obligations, China—while a signatory party to the ICCPR since 1998, has not yet ratified the Covenant and therefore is not formally bound to assume such obligations. Nonetheless, the absence of China’s ratification of the present Covenant— in spite of its repeated intention to do so, China pursuant to Article 18(a) of the 1969 Vienna Convention of the Law Treaties which it has ratified on 3 September 1997, “is obliged to refrain from acts which would defeat the object and purpose of a treaty” unless it has “made its intention clear not to become a party to the treaty” after all. In addition, within the context of financial services 40  Freedomhouse.org (2014a). 41  Freedomhouse.org (2014b).

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it remains unclear whether or not the denial of internet access or other relevant information in the normal exercise of individual bankers’ activities and functions can be justified upon grounds of national security or public order—even in the virtual space. This situation can also be envisaged in the context of international trade law. In this regard, the trade angle of the freedom of expression and in particular the right to have free access to information needs to be seen in the utilitarian pursuit of economic and market efficiency and perfection. A proper human rights perspective would assert such right as an end in itself unlike the trade perspective which sees such right rather as means to an end.42 Restriction on the access of information could equally be construed under the Article XX (a) of the 1994 General Agreement on Tariffs and Trade which permits exceptions to the national treatment clause when such measures are “necessary to protect public morals”. Censorship within the World Trade Organization’s (WTO) framework has not used human rights considerations as a benchmark to assess compliance with its regulatory and governance framework but rather as a constraint on world trade.43 In the field of financial information services, a dispute between the European Union and China before the WTO in 2008 showed proof of such tension between trade and human rights concerns. In this regard, China’s measures to channel all news by foreign news agencies as well as financial information services through a government agency—namely the state-run Xinhua News Agency—faced opposition on behalf of the European Union which was concerned with the protection of such information—of commercial value and belonging to a foreign supplier of such service in the first place. China argued that in light of its new regulatory framework to address these specific concerns it would allow those foreign suppliers to share information without any intermediary. While, evidently, those suppliers ought to “comply with all relevant Chinese laws, regulations, and departmental rules”, Chinese authorities have remained unclear about how it will protect such commercial information from unauthorized persons, entities or the authorities themselves.44 Canada also had a similar case against China before the WTO and like the European Union it settled the dispute with China and adopted a Memorandum of Understanding on the very same day.45 Such restrictions on the access to information both from a trade and human rights perspective have major implications upon the nature of the Shanghai 42  43  44  45 

Broude & Hestermeyer (2014), p. 304. Chen (2014), p. 51. Trade.ec.europa.eu (2008). www.wto.org (2008).

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Free Trade Pilot Zone and its ability to attract foreign enterprises and financial institutions in order to develop the zone into an international financial centre. They appear to be at odds with the 2013 Framework Plan for the China (Shanghai) Pilot Free Trade Zone which aims at deepening and accelerating innovation in the financial sectors and enhancing their functions. In addition to these functional limitations, the lack of transparency of the general regulatory framework of the SFTPZ has been symptomatic of the post-financial crisis where foreign investment in China has also negatively affected market access for overseas financial institutions.46 While Hong Kong has traditionally enjoyed the status of an international financial centre and serves as a model of financial stability—also for mainland China,47 it has inadvertently experienced similar restrictions in the face of the demonstrations in the end of 2014. If restrictions on Internet access for all users in the Special Administrative Region are affected, this can have serious repercussions on the exercise of financial activities— which are at the heart of the city’s economy and which cannot be put on hold in a global financial system which runs around the clock. Information access and technology are thus essential ingredients for success within a “competitive global financial system” which Weber predicted to continue to be more favourable for Hong Kong as an international financial centre.48 Indeed, the 1990 Basic Law of Hong Kong—which entered into force in 1997 with the handover of power of the United Kingdom to the Chinese authorities—explicitly acknowledges the very nature of Hong Kong as an international financial centre. In its Article 109 it imposes obligations upon the Government of the HKSAR to “provide an appropriate economic and legal environment for the maintenance of [such] status”. Its Article 110 continues that the Government of the HKSAR “shall, on its own, formulate monetary and financial policies, safeguard the free operation of financial business and financial markets, and regulate and supervise them in accordance with law”. The free exercise of financial services including information services which have been challenged on the mainland may continue to constitute a source of concern in light of the further integration of both economies and thus financial industry by 2047. Yet, access to information—in the meaning of Article 19 of the ICCPR—is equally applicable by virtue of the Covenant which, according to Article 39 of the Basic Law of Hong Kong, remains in force and shall only be

46  Shen & Vanhullebusch, supra note 6. 47  Norton (1998), p. 214. 48  Weber (2001), p. 128.

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restricted by law pursuant to the conditions prescribed in the same Article 19 of the ICCPR and thus for reasons of public order.49 More recently, another attempt of the China Banking Regulatory Commission (CBRC) and the Ministry of Industry and Information Technology was made to put further restrictions on the free operation of financial services in mainland China. In September 2014 they issued the Guiding Opinions of the China Banking Regulatory Commission on Strengthening the Banking Network Security and Information Technology Construction through the Application of Secure and Controllable Information Technologies. This CBRC Opinion No. 39 was further defined in Guide (No. 317) to Promote Banking Application of Secure and Controllable Information Technology (2014 to 2015) jointly issued by both authorities. Both Opinion No. 39 and Guide No. 317 were formulated to protect the financial security of the country by on the one hand advancing further development of the security of the banking network as well as improving its information technologies and on the other hand demanding domestic and overseas banks to transform their existing IT infrastructure to one which can which be controlled by the respective Chinese authorities alone.50 Arguably, the move towards a financial operating system—independent from overseas IT infrastructure as witnessed in other areas where use of foreign servers such Dropbox and Google has been blocked—is also seen as a measure to boost domestic enterprises to develop and sell such new equipment to any financial institutions on Chinese territory. Certainly, cyber security has been a growing concern globally since the revelations surrounding the National Security Agency of the United States.51 While the Obama Administration did not challenge China on improving its cyber security—even in the field of a financial IT infrastructure, it decided to bring the issue before the WTO on the basis of the violation of the national treatment clause whereby Chinese developers would be favoured over foreign competitors to supply their own so-called “secure and controllable” technology to the banking sector operating in the mainland.52 The reputational costs accompanying those measures may even further undermine the development of Shanghai’s international financial centre since both information access and technology have been compromised thus affecting the city’s competitiveness and attractiveness for the world’s financial institutions.

49  50  51  52 

Freedomhouse.org (2014c). Chen (2015). Oliver & Mitchell (2015). Miles (2015).

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Beyond the trade implications of these restrictive measures, Article 19 of the ICCPR can equally be construed to evaluate their adherence to this provision. While individual bankers should be free to seek and receive information—as part of their right of the freedom of expression, the same right also prescribes that such freedom extends to the choice of media to thus seek and receive such information freely. Opinion No. 39 and Guide No. 317 however have prevented the use of certain technology to perform financial activities and as a result have impeded the free choice of the medium to exercise the functions which financial institutions in the normal circumstances are mandated to perform in the first place. Yet again, China’s moves to strengthen its cyber-space in general and national financial security in particular would be allowed under the same article which provides for restrictions protecting national security or public order. In light of the full integration of HKSAR into mainland China by 2047, anxieties may as well persist amongst the share- and stakeholders of the financial industry which will eventually be bound by those regulations in the long-term. 4

Human Rights and Socio-Economic Justice

Within the specific context of financial architecture which propels arguments in favour of sophistication and modernization of China’s banking industry and regulations, there is a tendency to solely consider such processes as part of the further integration of China within the global financial and world trade system. Given the obvious interdependency and interconnectedness of financial markets in a globalized economy, China is expected to further lift some of its sovereign prerogatives if it pursues to (continue to) be part of the game. Yet, the closed nature of China’s banking system has survived several financial crises including the Asian one in 1997 and the global one in 2007–2008 though the collapse of mainland China’s stock market—its so-called bull market—has casted further doubts about the sustainability of its transitional model towards domestic consumption and innovation even in the financial industry. Nonetheless, China’s current trajectory towards 2016—the end of the Shanghai experiment of its free trade zone and liberalization—and 2017—10 years after the latest financial crisis and a possible beginning of a nation-wide liberalization of China’s financial industry may well be further streamlined by the country’s state ideology, i.e. communism, and its economic status, i.e. that of a developing country. One needs to be reminded of the past spirit of China’s opening-up and its current configuration in a much more open yet more vulnerable financial and economic system. Such openness and vulnerability have

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respectively empowered the peoples around the world to develop themselves yet have subjected them to global economic and financial forces potentially pushing them (further) back into poverty. For the sake of China’s rejuvenation and its Chinese Dream, such global conditions are opportunities and challenges for the ruling party to capitalize in such a way to strengthen its leadership in light of its Centenary Goals.53 The current leadership has no doubts about the pursuit of a moderately prosperous society by 2021 and a democratic country by 2049. While the latter will depend on the former social and economic conditions of the country by that time on the long-term, such calls for democratization have been voiced more recently in the context of the upcoming election of the new leadership in the HKSAR by 2017. Such events may appear to be disconnected from the financial industry and banking sector within the city of Hong Kong but have affected as mentioned earlier on the operation of their financial services not only over electronic platforms but also in terms of physical accessibility of the employees to the banks. Those political instabilities which have undermined the core activities of the city may on the long-term further spur deeper concerns about the competitiveness of Hong Kong as an international financial centre facing difficulties to manage political processes and overall public order which are generally conducive to financial institutions to operate peacefully and without distractions of such kind.54 Beyond the democratic aspirations of the people of Hong Kong, the social and economic inequalities between the different social classes of the city have further fed the call for socio-economic justice. Indeed, the economic prosperity and growth has over the decades created wealth for yet a minority of the population not only in Hong Kong but also across mainland China. Nonetheless, China has showed growing concerns about the widening gap between the rich and the poor. In this regard, China’s 2012 official release of its Gini coefficient55—statistical data measuring the income gap between the poorest and richest person in China—marks a new step in the leadership 53  See Xi, supra note 3, p. 7: “[O]nly Chinese socialism can lead our country to development—a fact that has been fully proved through the long-term practice of the Party and the state. By upholding socialism with Chinese characteristics can we bring together and lead the whole Party, the whole nation and the people of all ethnic groups in realizing a moderately prosperous society by the centenary of the CPC in 2021 and in turning China into a prosperous, democratic, culturally advanced and harmonious modern socialist country by the centenary of the People’s Republic of China in 2049, so as to ensure the people greater happiness and the nation a brighter future.” 54  Fong (2014). 55  Worldbank.org (2015).

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to address the gap for the sake of social and political stability across the nation and its constitutive parts.56 Unsurprisingly, the SFTPZ is set up to boost China’s economy and use finance as a vehicle to accelerate and reform the transition of its current economic growth model. While such innovative measures seek to further open up the Chinese economy to the world’s investment, capital and financial markets thus benefiting from its global pole position, they equally are meant to contribute to the socialist and development goals of the country in the first place—thus creating a moderately prosperous society for all and not just a few. Those older foundations may well revive within China’s Road towards Rejuvenation57 and show proof of China’s traditional political culture whose imperatives to long for a glorious future to come may supersede much of the lessons to be learned to steer its current economic model in a rough period of transition.58 In the light of these long-term domestic socio-economic as well as geopolitical and geo-economic goals, China’s renewed commitment to rule of lawbased governance—domestically and internationally alike—necessarily takes into account its own communist guiding principles and its Five Principles of Peaceful Coexistence and are seen to contribute to its economic growth59 by virtue of eliminating corruption and establishing more justice on the international plane that reflect such principles including sovereign equality and mutual benefit. Material inequality at the global economic level—commonly measured by GDP—is catching up in favour of China’s position, giving it the leverage to reassert its role and, potentially, its leadership amongst developing countries to shape the rules of the international legal and political order accordingly in favour of a NIEO. Instead of using and accepting the law to maximize the (financial) market in the allocation of resources thus optimizing prosperity for all—commonly mistaken by economists,60 China’s initiatives to 56  The Economist (2013); Bardhan (2008), p. 363. 57  See Guiding Principles in the 2013 Framework Plan for the China (Shanghai) Free Trade Pilot Zone: “We should hold high the great socialism banner with Chinese characteristics, take Deng Xiaoping Theory, ‘Three Represents’ important thought and scientific development approach to guide this national strategy. We should further unleash our minds, dare to pilot, and promote reform and development by opening up the economy. The China (Shanghai) Free Trade Pilot Zone will create a regulatory environment on cross border investment and trading that is in line with international practices, enhance China’s economic position globally, and contribute to achieving the revival of the Chinese People’s China Dream.” 58  Pye (1986), p. 221. 59  Peerenboom (2002), pp. 450–51. 60  Kuttner (2005), p. 22.

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reform its financial sector have shown a distinctive set of distributive objectives necessary to meet its commitment to narrow the inequality gap. Unmistakably, China’s opening-up and accession to the WTO has met with resistance from local bureaucracies and domestic competitors which may be respectively unwilling to give up their privileges and unable to compete with overseas companies and thus comply with the global trade and competition rules. Despite the controlled liberalization of China’s financial sector, fiscal and institutional limitations have persisted.61 Moreover, the risks resulting from financial instabilities—driven by speculation—could no longer be diverted to the public,62 thus leading to socio-economic instability undermining China’s so-called harmonious society as well as legitimacy of the CPC as the guarantor of such harmony.63 Access to China’s financial markets by overseas financial institutions would have to take into account those fundamental parameters of China’s economic and political reality. Reactionary forces however such as international litigation before the WTO or national protectionism are most likely to produce more adverse consequences affecting global markets as a whole. Fears exist on behalf of Western economies about the means employed by China to claim its future role as the biggest economy in the world in terms of GDP. Meanwhile, such attitudes may change as global disparities are undergoing fundamental corrections. In particular, some Western governments decided more recently to join rather than oppose the establishment of the Asian Infrastructure Investment Bank—a development bank initiated by China—as a means to foster more channels of diplomatic interaction with Asia in the economic, development and finance sphere. Asia remains the largest market for future Western products and services for the coming decades to come. Containing its biggest neighbour through a variety of trade regulations whether global or regional—like the Transpacific Partnership—will not bear any fruits for both sides.64 Accepting the principle of sovereign equality on behalf of Western 61  Mertha & Zeng (2005), p. 320, 325. 62  Wyplosz (1999), p. 158. 63  See also 2006 Communiqué of the Sixth Plenum of the 16th CPC Central Committee on harmonious society: “[D]evelopment is the prerequisite of social harmony. We must adhere to solving problems on the road ahead through promoting development and make great efforts to develop social productive forces and constantly consolidate the material base for social harmony. Meanwhile, we must put more attention to developing social services and push forward economic and social development in a coordinated way. Social equity and justice is a basic condition of social harmony, while a sound system provides the fundamental guarantee to social equity and justice.” 64  See also Emmers & Ravenhill (2011).

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states—whether reluctantly, forcibly or naturally—in the economic relations with China may as well create mutual benefits for China and the West. Globalization in the first place ought to serve these common objectives yet the rules governing the economic and political relationship between developed and developing countries had institutionalized certain historical inequalities which mandate a differential interpretation and if possible lead to the creation of new norms which reflect the current balance of power between states. Emerging economies like China appear to reconcile their economic liberalization with their growing national power in international society.65 As a result, China is able to put more weight in its participation in international forums and institutions66 including the WTO and UN to assume more autonomy in the enunciation and realization of its development goals which it pursues to carry out within such interdependent economic and political context. Developing countries like China wish to have more “national policy space” and thus assert their sovereignty to define their means to create a more just global economic and financial system rather than emulate it in its current form.67 Developed nations however have accused such demands as a way to supersede their international obligations—the Chinese restrictions on access of information as well as the technologies in their financial sector were seen as examples thereof.68 Such regulatory powers are not only the prerogatives of national governments to set out a path towards economic growth and development, it equally enhances the role of the state in general and that of CPC in particular to continuously reclaim its political legitimacy in the course of the opening-up of China’s economy and throughout the numerous consecutive reforms and modernization efforts to further secure its development goals.69 Therefore, external pressures to liberalize China’s financial markets may not necessarily contribute to more growth but rather lead to more economic inequalities 65  Hurrell (2007), p. 215. 66  See also Clegg (2011); Grimes (2012), p. 93. 67  See also Deng (1984), p. 396: “We will unswervingly follow a policy of opening to the outside world and actively increase exchanges with foreign countries on the basis of equality and mutual benefit. At the same time, we will keep clear heads, firmly resist corrosion by decadent ideas from abroad and never permit the bourgeois way of life to spread in our country. We, the Chinese people, have our national self-respect and pride. We deem it the highest honour to love our socialist motherland and contribute our all to her socialist construction. We deem it the deepest disgrace to impair her interests, dignity and honour.” 68  Salomon (2007), pp. 148–49. 69  Ploberger (2009), p. 238.

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and thus political instability.70 Yet, pragmatism should continue to prevail and give room to the law and its institutions to create those conditions which are fair, favourable, acceptable and accessible to the financial markets—given as opposed to China’s current regulations and dominant state bank sector,71 to manage and reduce financial risk within the sector and for society as well as to establish “fundamental property rights”.72 The latter rights have been put into question in terms of the future of Hong Kong’s integration into mainland China by 2047. The 2017 forthcoming elections in the city may well prove to be a test for the leadership to offer guarantees which will protect the property rights of financial institutions upon foreclosure of mortgages on property within the city and mainland China after new mortgages for a duration of 30 years will have been signed between international financial institutions and their clients in both jurisdictions from 2017 onwards. In this regard, China’s 2007 Property Law provides that only fixed constructions on land can be mortgaged (Article 180) whereas land itself— which belongs to state—cannot be mortgaged (Article 184). In case of default, the differential application of Chinese bankruptcy laws for state-owned enterprises which dominate the financial industry in the mainland might not lead to a fair competition with international banks. Conversely, 2017 is also expected to be the beginning of the implementation of the financial sector reforms initiated in the experiment of the SFTPZ across the entire country. A reform of the current system must reconcile the international practice of creditors to have collateral in case of default of the debtor and the potential burden for a society as a whole to support the security risks inherently present in the same practice as testified in the latest financial crisis of 2007–2008. 2017 and 2047 may well be decisive turning points in Greater China’s financial sector reforms and regulations where a balance needs to be struck between the overall macro-economic goals of the state domestically and internationally alike, the role of the market to (re)allocate prosperity, and the well-being of the Chinese people. The recent collapse of the mainland China’s stock exchanges and state interventions in the Summer of 2015 have not bred more confidence in the markets nor in the regulatory frameworks. As a result, the transformation of China’s economic model and the sophistication of its legal system and practice in the financial industry will be a daunting task to incorporate all of these variables in respect of China’s principles of sovereign equality and mutual benefit. Or, as Sarkar concludes: 70  Stiglitz (2013), p. 98. 71  Allen et al. (2010), p. 140. 72  Arner (2007), p. 323.

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Certainly, not all legal change in terms of standardizing or conforming to Western practices is necessarily a bad (or an inherently good) choice. However, a developing country should give full consideration to the implications of some of these proposed changes and to whether they really serve the country’s broader development objectives. The above discussion illustrates how legal modernization is often driven by a desire to more fully integrate developing countries into global financial markets. The modernization of law is an intricate, complex, domestic political process. By no means should legal modernization be resisted in an unthinking fashion, but, on the other hand, conforming to Western standards and practices should not be viewed as the panacea for all development ills. Developing nations (in partnership with the industrialized world, where appropriate) need to come to terms with which of their domestic laws need to be created, modernized, or abolished, and why.73 5 Conclusion China’s modernization of its financial sector, governance and regulation faces a number of reforms which directly and indirectly impact the protection of the human rights of its people, individual bankers as well as its right to development in matters of socio-economic justice in broader terms. China’s developmental trajectory has shown proof of an unsurpassed ability and willingness to transform its economy from a rural to industrial and from an export to consumption society. At each juncture innovation initially driven by the state and now advanced by the private sector has produced new market forces which have progressively assumed distributive roles in the allocation of resources. In that process of economic progress, environmental and social standards have increasingly become indispensable benchmarks to secure sustainable development and socio-economic and political stability. In addition to China’s efforts in the economic realm, the current and future economic edifice hinges upon the construction of a rule of law-based governance which puts accountability at the cornerstone of regulating economic life between the state and its citizens and amongst private actors themselves.74 China’s current opening-up and reforms in the financial industry are laying down the essential foundations to enhance economic progress on the long-term—in light of its Centenary Goals—and to instil greater confidence in 73  Sarkar (2009), p. 442. 74  Xiao (2004), p. 4.

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the soundness of China’s legal system to adhere to its international economic obligations. Such will be a long-term endeavour where China has to overcome both its economic and institutional constraints as a developing country and a one party state. Therefore, on the one hand, as a vehicle for economic development, the creative forces of international financial institutions should be given enough space to generate that prosperity—yet, the current regulations both from a trade and human rights perspective have undermined respectively open competition with domestic banks and access to information by a medium of their choice. On the other hand, the financial industry should equally be bound by regulations—not merely by voluntary codes of conduct— which put environmental and social standards at the heart of their financial activities which on the long-term bring about socio-economic justice and political stability in China. These apparent contradictions however have casted doubts about the way ahead of China in its economic and rule of law reform processes and generated further suspicion and anxieties on the side of Western financial institutions and governments and the Chinese government that are curtailing each other’s ambitions to generate more prosperity for their respective constituencies alone. Evidently, within a financial sector which thrives on those very goals, money persists to be the uniting and divisive force for both stakeholders to secure their ends. Such struggle for power may itself create further confusion as to how China itself sees the financial market liberalization as a means or rather an end to itself. Yet, China’s exercise of its right to development displays a new pathway whose dynamic transitions have ever dispelled some of the illusions where the narratives of modernity traditionally lead. Financial reform may not be an exception to that. References Aizawa, Motoko, & Chaofei Yang (2010) “Green Credit, Green Stimulus, Green Revolution? China’s Mobilization of Banks for Environmental Cleanup.” 19 Journal of Environment and Development 119–44. Allen, Franklin, Rajesh Chakrabarti, Sankar De, Jun ‘QJ’ Qian, & Meijun Qian (2010) “Law, Institutions, and Finance in China and India,” in B. Eichengreen, P. Gupta & R. Kumar, eds., Emerging Giants: China and India in the World Economy, Oxford: Oxford University Press, 126–83. Arner, Douglas W. (2007) Financial Stability, Economic Growth, and the Role of Law, Cambridge: Cambridge University Press.

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Mallesons, http://www.chinalawinsight.com/2015/03/articles/finance/quake-invokedthe-guide-to-promote-banking-application-of-secure-and-controllable-informationtechnology-issued/?utm_source=Mondaq&utm_medium=syndication&utm_ campaign=View-Original (accessed 25 May 2015). Chen, Ge (2014) “Piercing the Veil of State Sovereignty: How China’s Censorship Regime into Fragmented International Law Can Lead to a Butterfly Effect.” 3 Global Constitutionalism 31–70. Cherneva, Iveta (2012) “The Business Case for Sustainable Finance: Beyond Public Relations, Ethics, and Philanthropy.” 36 The Fletcher Forum of World Affairs 93–102. Chow, Daniel (2011) “China’s Response to the Global Financial Crisis: Implications for U.S.-China Economic Relations.” 1 Global Business Law Review 47–81. Clegg, Jenny (2011) “China at the Global Summit Table: Rule-taker, Deal-wrecker or Bridge-builder?” 17 Contemporary Politics 447–65. Deng, Xiaoping (1984) Selected Works of Deng Xiaoping (1975–1982), Beijing: Foreign Languages Press. Emmers, Ralph, & John Ravenhill (2011) “The Asian and Global Financial Crises: Consequences for East Asian Regionalism.” 17 Contemporary Politics 133–49. Fong, Brian C. H. (2014) “The Partnership between the Chinese Government and Hong Kong’s Capitalist Class: Implications for HKSAR Governance, 1997–2012.” 217 China Quarterly 195–220. Freedomhouse.org (2014a) “China 2014,” https://freedomhouse.org/country/china (accessed 25 May 2015). ——— (2014b) “China 2014—Freedom on the Net,” https://freedomhouse.org/country/ china (accessed 25 May 2015). ——— (2014c) “Hong Kong 2014,” https://freedomhouse.org/country/hong-kong-0 (accessed 25 May 2015). Freeman, Charles W., & Wen Jin Yuan (2011) China’s New Leftists and the China Model Debate After the Financial Crisis, Washington D.C.: Center for Strategic and International Studies. Grimes, William W. (2012) “Financial Regionalism after the Global Financial Crisis: Regionalist Impulses and National Strategies,” in W. Grant & G. K. Wilson, eds., The Consequences of the Global Financial Crisis: The Rhetoric of Reform and Regulation, Oxford: Oxford University Press, 89–103. Grinin, Leonid, Sergey Tsirel, & Andrey Korotayev (2015) “Will the Explosive Growth of China Continue?” 95 Technological Forecasting & Social Change 294–308. Head, John W. (1991) “Environmental Conditionality in the Operations of International Development Finance Institutions.” 1 Kansas Journal of Law and Public Policy 15–26. Herbertson, Kirk, & David Hunter (2007) “Emerging Standards for Sustainable Finance of the Energy Sector.” (Spring) Sustainable Development Law and Policy 4–9.

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Harper Ho, Virginia (2013) “Beyond Regulation: A Comparative Look at State-centric Corporate Social Responsibility and the Law in China.” 46 Vanderbilt Journal of Transnational Law 375–442. Hu, Angang (2006) Economic and Social Transformation in China: Challenges and Opportunities, London/New York: Routledge. Hurrell, Andrew (2007) On Global Order: Power, Values, and the Constitution of International Society, Oxford: Oxford University Press. Ifc.org (2015) “Our Goals and Values,” http://www.ifc.org/wps/wcm/connect/CORP_ EXT_Content/IFC_External_Corporate_Site/About+IFC/Vision/ (accessed 25 May 2015). Ji, Weidong (2014) “The Rule of Law in a Chinese Way: Social Diversification and Reconstructing the System of Authority.” 1 Asian Journal of Law and Society 305–38. Kamijyo, Miki (2004) “The ‘Equator Principles’: Improved Social Responsibility in the Private Finance Sector.” (Summer) Sustainable Development Law and Policy 35–9. Kuttner, Robert L. (2005) “Development, Globalization, and Law.” 26 Michigan Journal of International Law 19–38. Lang, Andrew (2011) World Trade Law after Neoliberalism: Reimagining the Global Economic Order, Oxford: Oxford University Press. Lawrence, Robert E., & William L. Thomas (2005) “The Equator Principles and Project Finance: Sustainability in Practice?” 19 Natural Resources and Environment 20–6. Likosky, Michael B. (2012) Law, Infrastructure and Human Rights, Cambridge: Cambridge University Press. Lin, Li-Wen (2010) “Corporate Social Responsibility in China: Window Dressing or Structural Change?” 28 Berkeley Journal of International Law 64–100. Lovett, William A. (2012) “Transnational Finance Regulation and the Global Economy.” 20 Tulane Journal of International and Comparative Law 43–64. McBeth, Adam (2005) “Holding the Purse Strings: The Continuing Evolution of Human Rights Law and the Potential Liability of the Finance Industry for Human Rights Abuses.” 23 Netherlands Quarterly of Human Rights 7–34. Mertha, Andrew C., & Ka Zeng (2005) “Political Institutions, Resistance and China’s Harmonization with International Law.” 182 China Quarterly 319–337. Miles, Tom (2015) “U.S. Questions China at WTO on Banking Technology Restrictions.” Reuters, 26 March, http://www.reuters.com/article/2015/03/26/us-china-tech-usaidUSKBN0MM26320150326?feedType=RSS&feedName=technologyNews (accessed 25 May 2015). Norton, Joseph J. (1998) “Towards an International Financial Centre for Greater China: Hong Kong and Infrastructural Reform.” 28 Hong Kong Law Journal 209–29. Oliver, Christian, & Tom Mitchell (2015) “China Pressed to Halt Cyber Security Rules,” Financial Times, 27 February.

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Peerenboom, Randall (2002) China’s Long March toward Rule of Law, Cambridge: Cambridge University Press. Ploberger, Christian (2009) China’s Integration into a Global Economy: A Case of Natural Economic Development or the Deliberate Outcome of Political Decisions to Re-legitimise the Leading Role of the CCP?,” in Z. Wu, ed., Financial Sector Reform and the International Integration of China, London/New York: Routledge, 224–42. Pye, Lucian W. (1986) “On Chinese Pragmatism in the 1980s.” 106 China Quarterly 207–34. Reddix-Smalls, Brenda (2012) “Credit Scoring and Trade Secrecy: An Algorithmic Quagmire or How the Lack of Transparency in Complex Financial Models Scuttled the Finance Market.” 12 UC Davis Business Law Journal 87–123. Richardson, Benjamin J. (2009) “Reforming Climate Finance Through Investment Codes of Conduct.” 27 Wisconsin International Law Journal 483–515. ——— (2009) “Climate Finance and its Governance: Moving to a Low Carbon Economy Through Socially Responsible Financing.” 58 International and Comparative Law Quarterly 597–626. Roach, Steven S. (2011) “China’s 12th Five-Year Plan: Strategy vs. Tactics” Presented at 12th Annual China Development Forum, Beijing, 20–21 March. Salomon, Margot E. (2007) Global Responsibility for Human Rights: World Poverty and the Development of International Law, Oxford: Oxford University Press. Sarkar, Rumu (2009) International Development Law: Rule of Law, Human Rights, and Global Finance, Oxford: Oxford University Press. Shen, Wei, & Matthias Vanhullebusch (2015) “Where Is the Alchemy? The Experiment of the Shanghai Free Trade Zone in Freeing the Foreign Investment Regime in China.” 16 European Business Organisation Law Review 321–52. Shen, Wei (2014) The Anatomy of China’s Banking Sector and Regulation, Hong Kong: Wolters Kluwer. ——— (2015) Corporate Law in China: Structure, Governance and Regulation, Hong Kong: Sweet & Maxwell. Silvers, Damon, & Heather Slavkin (2009) “The Legacy of Deregulation and the Financial Crisis—Linkages Between Deregulation in Labor Markets, Housing Finance Markets, and the Broader Financial Markets.” 4 Journal of Business and Technology Law 301–48. Stevelman, Faith (2009) “Global Finance, Multinationals and Human Rights: With Commentary on Backer’s Critique of the 2008 Report by John Ruggie.” 9 Santa Clara Journal of International Law 101–45. Stiglitz, Joseph E. (2013) “Creating the Institutional Foundations for a Market Economy,” in D. Kennedy & J. E. Stiglitz, eds., Law and Economics with Chinese Characteristics:

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Institutions for Promoting Development in the Twenty-First Century, Oxford: Oxford University Press, 72–102. The Economist (2013) “Gini Out of the Bottle,” The Economist, 26 January. The Thun Group of Banks (2013), “UN Guiding Principles on Business and Human Rights (2013),” October Discussion Paper for Banks on Implications of Principles 16–21. Trade.ec.europa.eu (2008) “Memorandum of Understanding Between the People’s Republic of China and the European Communities Regarding Measures Affecting Foreign Suppliers of Financial Information Services,” 4 December, http://trade .ec.europa.eu/doclib/docs/2008/december/tradoc_141667.pdf (accessed 25 May 2015). Vanhullebusch, Matthias (2014) “Searching for Human Rights: Free Trade Agreements in Asia,” in J. Hu & M. Vanhullebusch, eds., Regional Cooperation and Free Trade Agreements in Asia, Leiden/Boston: Brill Academic Publishers, 219–45. Wang, Alex L. (2013) “The Search for Sustainable Legitimacy: Environmental Law and Bureaucracy in China.” 35 Harvard Environmental Law Review 365–440. Weber, Rolf H. (2001) “Repositioning Hong Kong as a Regional and International Financial Centre in View of China’s Imminent Accession to the WTO.” 31 Hong Kong Law Journal 122–40. Whitehouse.gov (2014) “U.S.-China Joint Announcement on Climate Change,” https:// www.whitehouse.gov/the-press-office/2014/11/11/us-china-joint-announcementclimate-change (accessed 25 May 2015). Williams, Cynthia A., & John M. Conley (2014) “The Social Reform of Banking.” 39 The Journal of Corporation Law 459–92. Woicke, Peter (2005) “Putting Human Rights Principles into Development Practice through Finance: The Experience of the International Finance Corporation,” in P. Alston & M. Robinson, eds., Human Rights and Development: Towards Mutual Reinforcement, Oxford: Oxford University Press, 328–51. Worldbank.org (2015) “GINI Index (World Bank Estimate),” http://data.worldbank.org/ indicator/SI.POV.GINI/countries/CN-EU-HK?display=default (accessed 25 May 2015). Wto.org (2008) “China—Measures Affecting Financial Information Services and Foreign Financial Information Suppliers,” 4 December 2008, https://www.wto.org/ english/tratop_e/dispu_e/cases_e/ds378_e.htm (accessed 25 May 2015). Wyplosz, Charles (1999) “International Financial Instability,” in I. Kaul, I. Grunberg & M. Stern, eds., Global Public Goods: International Cooperation in the 21st Century, Oxford: Oxford University Press, 153–85. Xi, Jinping (2014) The Governance of China, Beijing: Foreign Languages Press. Xiao, Yang (2004) “Economic Development and Legal Evolution in China.” 16 Singapore Academy of Law Journal 1–8.

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Part 2 Governing Financial Markets in Asia: Innovation and Financial Products

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Chapter 8

Positioning Singapore as an International Centre for Fund-Raising Alexander F. H. Loke Abstract The Singapore fund-raising regime has changed dramatically in the last 20 years. The fund-raising modelled on the basic template drawn from the UK Companies Act 1948 was radically overhauled to plug Singapore into the international capital markets, and to position Singapore as an international financial centre. There are a number of components which make up the sophisticated financial services industry in Singapore, of which fund-raising is an integral—and important—component. With a view to better understanding how Singapore developed to be the international financial services hub it is today, this chapter examines how the fund-raising regime found today in Part XIII of the Securities and Futures Act has been progressively changed and fine-tuned in the bid to enhance Singapore as an attractive international centre for fund-raising. A prime example is the subdivision providing for carve-outs to the general prospectus requirement (Subdivision 4 to Part XIII). The author argues that the process is demonstrative of the responsiveness of the lawmakers and the regulators to reconsidering the necessary protections offered by securities law to the different types of investors.

Keywords Singapore – securities regulation – capital markets

*  Professor, School of Law, City University of Hong Kong; Adjunct Research Professor, Centre for Banking & Finance Law, National University of Singapore. Contact email: afhloke@cityu .edu.hk. I am grateful for the insightful comments of Hans Tjio and the participants at the Symposium on Asian Financial Centres’ Development and Regulation. All errors remain my responsibility.

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The Watershed in 1998: The Move from a Merits-Based Securities Listing Regime to a Disclosure-Based Securities Listing Regime

The history of the Singapore capital market has no lack of significant dates. The collapse of Pan-El in October 1985 resulted in the unprecedented 3-day closure of the Stock Exchange of Singapore and the Kuala Lumpur Stock Exchange.1 The crisis ushered in the Securities Industry Act 1986, which conferred on the Monetary Authority of Singapore (“MAS”) greatly increased powers over the intermediaries in the capital market, in particular the power to review the disciplinary actions of the stock exchange2 and the capital requirements of broker-dealers.3 From the perspective of corporate fund-raising, however, the modern watershed is found in the report issued by the Corporate Finance Committee (“CFC”) in October 1998. Despite the increased government regulation over capital market intermediaries, the de facto regulator over the capital market was the stock exchange. Its listing department determined whether an aspiring issuer was accorded the privilege of listing. The management of the stock exchange had hitherto regarded itself as a gatekeeper of securities worthy of public investment. In essence, it practised merits-based review over securities listings. The CFC was a private sector led committee organized under the umbrella of the MAS to make recommendations with the aim of developing Singapore into a key financial centre for international corporate fundraising activity.4 The central thrust of its recommendations was that Singapore should move away from the merits-based regulatory philosophy toward a disclosurebased regulatory system for securities listings: The disclosure based philosophy, fosters a market driven environment which reduces the cost of capital and avoids the cost of missed opportunities from delays, lowers moral hazard, and encourages innovation and business flexibility.5

1  The crisis is the subject of a staff paper prepared by the Monetary Authority of Singapore (“MAS”). See mas.gov.sg (2004). 2  Securities Industry Act 1986 s. 19(3). 3  Securities Industry Regulations 1986, reg. 17 and 18. 4  Report of the Corporate Finance Committee, The Securities Market: Final Recommendations (21 October 1998) (“CFC 1998”). See mas.gov.sg (1998a). 5  Ibid., p. 5.

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The government accepted the recommendations of the CFC.6 While the move toward a disclosed based system is undergirded by the policy impetus to liberalise access to the capital market and to grow the Singapore financial industry, it does not connote deregulation. The Singapore experience demonstrates the obverse—for the disclosure-based system required a wholesale revision of both the law as well as the institutional arrangements pertaining to the regulation of the capital market. The MAS, which had hitherto concentrated on banking regulation, had to expand the capacity of Securities and Futures Department, which was set up only in 1998.7 The MAS was to be the regulator in the single securities regulator model envisaged by the CFC.8 It was to be responsible for the consolidation of securities regulation, its administration as well as its enforcement. While investigations and prosecutions were to be carried out by the Commercial Affairs Department (CAD) and the Attorney General’s Chambers (AGC) respectively, the MAS was to become the key regulator in the new regulatory regime. 1.1 The “Reasonable Investor Test” A key amendment in the move toward a disclosure-based regime was the disclosure obligation imposed on the person carrying on the fund-raising exercise. Until 2000, the statutory disclosure obligation was found in section 45 and the checklist found in the Fifth Schedule of the Companies Act.9 These were ­modelled on the cognate provision of the UK Companies Act 1948.10 Compared to the prescribed disclosures found in Regulation S-K of the Securities Act of 1933, the disclosures required by these UK-inspired provisions were much less exacting. The statutory disclosures do not, however, provide a complete picture of what was required for a fund-raising exercise to be carried out in Singapore. If a corporation sought a listing on the Stock Exchange of Singapore, the approval for listing by the stock exchange was critical. The disclosures exacted by the SES Listing Manual—from December 1999, the Singapore Exchange (SGX) Listing Manual—exerted additional disclosure discipline on issuers in Singapore.

6  Government’s Response to the Corporate Finance Committee Recommendations (9 November 1998). See mas.gov.sg (1998b). 7  Tjio (2011), p. 81. 8  Recommendation 6, CFC 1998, p. 5. 9  Cap. 50, Singapore Statutes. 10  c. 38.

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The move toward a disclosure-based regime necessarily required an update of the statutory disclosure obligation imposed on issuers seeking to raise funds from the market. A general test of disclosure—the “reasonable investor test” was introduced by the Companies (Amendment) Act 2000 vide section 45 of the Companies Act. This was migrated to the Securities and Futures Act 2001 (“SFA”), which was passed by the Singapore Parliament on 5 October 2001. Materially, the reasonable investor test found in SFA s. 243 requires that the prospectus contain “all the information that investors and their professional advisers would reasonably require to make an informed assessment” of all of the following matters: (a) the rights and liabilities attaching to the shares or debentures, or units of the shares or debentures; (b) the assets and liabilities, profits and losses, financial position and performance, and prospects of the corporation that is to issue or has issued the shares or debentures, or units of the shares or debentures; (c) if the person making the offer or invitation is one who controls the corporation whose shares or debentures underlie the offer or invitation, the assets and liabilities, profits and losses, financial position and performance, and prospects of that corporation; and (d) in the case of options over shares or debentures, the capacity of the person making the offer or invitation to issue or deliver the relevant shares or debentures.11 The “reasonable investor test” is thus a very broad test, one that catches any information that might affect the informed assessment, whether of one’s rights and liabilities, or of the risk and prospects of the issuer. In addition to the “reasonable investor test”, a checklist of items to be disclosed is prescribed by regulation 8(2)(a) and Seventh Schedule of the Securities and Futures (Offers of Investments)(Shares and Debentures) Regulations 2005.12 1.2 Residual Merits Regulation In theory, a disclosure base regime does not scrutinize the substantive merits of the security or the issuer. In practice, however, the merits do continue to feature in the regulator’s decision whether to register the prospectus.

11  SFA s. 243(3). 12  S. 611/2005.

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In Exeter Group v Australian Securities Commission,13 the company sought to register a prospectus which solicited funds so that it could search for an appropriate target company. The prospectus made it clear that the venture was “speculative in nature”.14 The directors had not identified any targets and were candid in admitting that neither they, the issuer nor the manager had taken any steps to identify any potential or proposed target company.15 The regulator refused registration of the prospectus on the ground that the disclosures were insufficient for the reasonable investor to make an “informed assessment” of the stipulated aspects of the corporation. The corporation argued that the test required disclosure of known information, or that which could reasonable be obtained through making inquiries;16 accordingly, all the information available to the applicant had been set out. The issue before the Administrative Appeals Tribunal, therefore, was whether the ‘reasonable investor test’ was satisfied. In the words of Deputy President of the Tribunal, Mr B. J. McMahon, “[i]n effect, the subscriber is being asked to contribute to a cash box and to take a ticket in a lucky dip”.17 Yet, this much was clear from the prospectus—for, apart from the mission and strategy which was set out in the prospectus,18 it should be clear to the investor that the venture he was asked to invest in was highly speculative. On one view, that would be the “informed assessment” of the prospects of the corporation. Yet, it was upon the “informed assessment” element that the adjudicator agreed with the ASC that the prospectus could not be registered. There was, it was said, insufficient information relating to the manager—and its sole director and secretary—for the reasonable investor to make an informed assessment of the stipulated matters.19 The information concerning the directors was also considered insufficient, for there was no indication whether the directors had been concerned in a venture of this nature in the past.20 Moreover, the prospectus did not make it clear that “no steps have been taken in any way to identify the target”.21 All in all, the disclosures were inadequate for making the requisite “informed assessment”.22 13  14  15  16  17  18  19  20  21  22 

(1998) 16 ACLC 1,382. Ibid., at [8]. Ibid., at [19]. Ibid., at [23]. Ibid., at [31]. Ibid., at [10], reproducing “1.4 Mission and Strategy” from the prospectus. Ibid., at [32]. Ibid., at [32] and [33]. Ibid., at [35]. Ibid., at [40].

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Both the Australian Securities Commission and the Deputy President of the Administrative Appeals Tribunal were probably driven by their antipathy to the notion that the small investor was signing up for a lucky dip in an undertaking with “no history and unknown prospects”.23 The Deputy President of the Tribunal was quite evidently looking out for faults in the disclosures made so as to prevent the fund-raising from unsophisticated small investors. The Monetary Authority of Singapore encountered a similar challenge soon after the implementation of the disclosure-based regime. Nagacorp, a Cayman Islands-registered company which operated a casino in Cambodia, lodged its prospectus with the MAS on 19 August 2003. MAS had two reservations. First, the operations of Nagacorp were not subject to the rigorous legal and supervisory framework for money laundering expected by the Financial Action Task Force. Second, Nagacorp could not demonstrate that it had an established track record of independent audits relating to the effectiveness of its internal controls over money laundering risks. After providing Nagacorp the opportunity to make submissions on its intended course of action,24 the MAS exercised its discretion under SFA s. 240(13)(f) to refuse registration on grounds that it was “not in the public interest to do so”.25 There is necessarily some degree of merits review in a disclosure-based regime. This may take place through the discretion to refuse registration on grounds of public interest as seen in Nagacorp, or on the ground that the disclosure falls short of the material necessary to support “informed assessment” of the stipulated matters as in Exeter Group. To be fair, the two cases deal with corporations that can be characterized as “dodgy” in colloquial terms. They do not portend a wide-ranging discretion residing in the regulator to determine whether the security or the issuer is worth investing in. The move toward a disclosure-based regime is best seen as reducing the merits review to one of a residual nature. Between the two, the decision in Nagacorp relying on the public interest caveat, is a more satisfying one. Indeed, it attests to the necessity of the regulator having the discretion to refuse registration on grounds of “public interest”. 1.3 The Limits of Caveat Emptor The shift from a merits-based regulatory regime to one based on disclosure was of course animated by the desire to grow Singapore as an international fund-raising hub. Equally important was the signal conveyed to the public that 23  Ibid., at [37]. 24  See mas.gov.sg (2003a). 25  See mas.gov.sg (2003b).

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the paternalism hitherto exercised to ensure that only worthwhile investments were publicly sold would change. Corollary to this was the signal that investors have to take the responsibility to scrutinize the nature of the investments they enter into. Caveat emptor (buyer beware) was much referred to as the new regulatory regime was rolled out.26 A fundamental premise to the notion that investors are to scrutinize the investments they enter into and take responsibility for their decisions is that they have the capacity to do so. The requirement to make disclosures that enable the investor to make an “informed decision” on the prospects, etc. of the issuer assumes that the investors have the ability to process the information provided, and thereby to arrive at such an “informed decision”. A consequence of the working out of the caveat emptor maxim is that the investors are presumed in law to take responsibility for their decisions— even if they are incapable of processing all the information given to them. It therefore conceals the gap between imputed informed decision-making and informed decision-making in actuality. The problems with this legal approach were revealed in the Lehman Minibonds episode in Singapore. In the period leading up to the Global Financial Crisis in 2008, many subprime mortgages made by US banks were repackaged into mortgage backed securities (MBS) and collateralized debt obligations (CDOs). These were sold to institutional and sophisticated investors as well as the public so that the risks could be transferred from the loan originators to other market participants. These took the form of Credit Default Swaps (CDS) in which investors in effect provided insurance to the banks against default of the CDOs. The CDS were, in turn, repackaged into structured products which were given the familiar sounding label—“bonds”. As such, investors bought ‘bonds’ in specially structured vehicles holding underlying pools of assets which generated cash flow. Amongst the many terms of the “bonds” was a term which amounted to the investor providing insurance to the counterparties. Upon a default taking place in a reference debt obligation or by a reference entity—euphemistically termed a “credit event” in the documentation—the interest payable on the bonds ceased. The “bond” was revalued according to a formula in which the credit event would result in a steep devaluation of the bond and hence the amount repayable (if any). The globalization of finance led to the marketing of these products around the world. In both Hong Kong and Singapore, the “bonds” were sold to retail investors over the counter by various banks. The most notorious of these in 26  Lee (2015).

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Singapore were the Lehman Minibonds sold as DBS High Notes.27 These were marketed undiscriminating to customers, many of whom were assuredly not recognizant of the complexities embedded in the “bonds”. The customers included the barely literate, the non-English speaking, and pensioners who came to renew their fixed deposits.28 The risks inherent in the sub-prime mortgages made by US banks spread around the world, and in the case of Singapore and Hong Kong, to retail investors who were not in a position to appreciate that they were “providing insurance” in addition to lending money to a special investment vehicle. When the investors were informed that the fall of Lehman was a credit event which seriously devalued their investment, the shock and the public anger were by no means surprising. As the editorial of the (Singapore) Business Times pointed out: [I]nvestors were led to believe they were buying a bond-like instrument that paid a regular, relatively riskless coupon when, in reality, they were providing Lehman with insurance for its exposure to the inflated US housing market.29 The limits of caveat emptor were thus tested.30 It is all very well to speak of the buyer taking responsibility for his decisions. However, when the investor is presented with a prospectus written in incomprehensible defensive language which also obscures the true nature of the risks he is undertaking—but packaged in a way to suggest that it is low risk product suitable for retail investors— caveat emptor wears very thin. Indeed, if one takes the protective approach adopted in Exeter Group, it is a good question whether the threshold posited there for a security fraught with such risks was met. The Lehman minibonds showed up the meager legal protections that retail investors were afforded under the disclosure-based regime.31 While claims 27  The minibonds were sold under various programs, including: DBS High Notes 5, Lehman Minibond Programme Notes and Merrill Lynch Jubilee Series 3 LinkEarner notes. 28  Chan (2008). 29  “Disclosure: Quality Counts, Not Just Quantity,” Business Times, 26 February 2010. 30  Social geographers term the treatment of investors as financial subjectification. Karen Lai, for example, argues for the “recognition of the incomplete and contingent nature of subject formation” which she sees as “vital for identifying potential spaces for dissent and reinforces the importance of spatial sensitivity in understanding the geographies of financialisation and financial subjects”. See Lai (2013), p. 280. 31  A synopsis of the Lehman Brothers Minibond saga can be found in this summary article commissioned by the National Library Board (Singapore). See eresources.nlb.gov.sg (2010).

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in misrepresentation could in theory be made if the bank representative made misleading statements which were relied on by the customer, their proof is necessarily a fact-intensive exercise. Given the costs of litigation, it is questionable whether litigation was a worthwhile proposition even for an investment loss of $50000 or even $100000. There were also many obstacles that could be thrown in the way of the investor. These include: whether what was said amounted to a misrepresentation, whether he relied, and of course, the signed promise that the customer does not rely on the statements made by bank representatives i.e. the non-reliance clause which brings into play the contractual estoppel doctrine.32 This will explain why the investor class action suit which was prosecuted was made on the basis that there was an uncertainty in the pricing formula which rendered the contract void for uncertainty.33 This issue, which was common to all the investors for the bond issue in question, could be litigated with all investors contributing toward the legal costs. In other words, the cause of action was economically efficient to pursue, even if the seasoned contract lawyer will appreciate the difficulty with this line of argument and the slim chances for success.34 In the event, the investors lost the suit.35 The investors involved in the lawsuit were those who did not benefit from the internal review that MAS required of each distributor when the problem came to light. In the immediate aftermath of “credit event”, MAS directed the distributors to appoint independent third parties to oversee their complaints handling process and put in place a rigorous time-table for the resolution of complaints.36 Indeed, the MAS conducted “on-site visits to assess the handling and review of complaints”.37 These extended to observing the proceedings of the 32  Peekay Intermark Ltd v Australia & New Zealand Banking Group Ltd (2006) 2 Lloyd’s Rep 511, [2006] EWCA Civ 386; Springwell Navigation Corporation v JP Morgan Chase Bank [2010] All ER (D) 08, [2010] EWCA Civ 1221. Adopted in Singapore: Orient Centre Investments Ltd v Société Générale [2007] 3 SLR(R) 566; [2007] 3 SLR 566 (the documentation defeated the bank customer’s claim against the bank for misrepresentation, breach of fiduciary and other duties, and negligence in relation to structured products.) However, the Singapore Court of Appeal has issued an invitation to re-consider this area: Als Memasa v UBS AG [2012] 4 SLR 992 at [50]. 33  Soon Kok Tiang v DBS Bank Ltd [2012] 1 SLR 397 (Singapore Court of Appeal). 34  The threshold for proving that a contract is void for uncertainty is a high one: Scammell v Ouston [1941] AC 251. This is especially so where the contract is no longer a mere executory contract: Sudbrook Trading Estate Ltd v Eggleton [1983] 1 AC 444. 35  Soon Kok Tiang v DBS Bank Ltd [2012] 1 SLR 397 (Singapore Court of Appeal). 36  See mas.gov.sg (2008a). See also mas.gov.sg (2008b). 37  mas.gov.sg (2008c).

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internal review panels.38 Moreover, the MAS required the financial institutions to give priority and pay particular attention to the aged, the uneducated or those with little education, and those with little or no investment experience.39 As a result of the internal review process that the MAS required of all financial institutions involved in the distribution of the Lehman bonds, the Minister for Trade and Industry was able to report on 19 January 2009 that 58% of the complainants could expect full or partial settlement.40 Amongst these, 25% of the complainants were to receive full settlement while the remaining 33% could expect partial settlement.41 A thorough investigation into the marketing of the Lehman bonds was conducted. The outcome was a Report which detailed the shortcomings of the financial institutions and the remedial actions which were taken.42 If there is a lesson to be learnt from the Lehman episode, it is that the regulatory strategy cannot stand on disclosure alone. Indeed, burying investors in information does not help them, much less protect them. Accordingly, MAS introduced “Guidelines on the Product Highlights Sheet” on 21 October 2010, in which it created a soft-norm requiring the preparation and distribution of a Product Highlights Sheet to investors.43 This draws on the insights of the behavioural sciences on the limits of human recognition and the importance of salience in drawing material matters to the attention of the subjects.44 If the material features of a financial product cannot be summarized accurately in a Product Highlights Sheet, it is probably not suitable for marketing to the retail market. One should not sell “bombs” to grandma—full disclosure notwithstanding. Similarly, very complex products which are beyond the understanding of the common man should not ordinarily be sold to them. As the Lehman Minibonds debacle demonstrates, operating on the flawed factual premise—that the public is able to understand a financial product when a large segment probably does not—leads not only to social costs, but to political costs. The requirement for a Products Highlights Sheet will be rendered a hard norm when section 240AA, which was created in 2012 and provides a statutory 38  39  40  41 

Ibid. mas.gov.sg (2009a), at [6]. Ibid. Ibid. Further breakdown of the settlement offers for different financial products can be found at [7] and [8]. 42  mas.gov.sg (2009b). 43  Guideline No. SFA 13-G10. 44  Tversky & Kahneman (1981).

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basis for such a requirement, comes into operation.45 One can also expect further advertising restrictions to ensure that the advertisements convey a fair and balanced impression of the product.46 In the context of securities marketed by financial intermediaries to existing clients, imposing an obligation on the part of the financial intermediary to assess the suitability of a financial product for the client will adjust the balance away from the single-minded imperative to sell products. By mandating that the bank take the client’s interest into account when recommending financial products, it will importantly mitigate the notion built up in the aftermath of the Lehman crisis that banks take advantage of their superior knowledge and the caveat emptor principle to exploit the vulnerable and the less knowledgeable. Such suitability assessment indubitably affects operating costs. However, since banks already profile their clients, the suitability requirement would merely require the bank taking responsibility for matching the products to the right client profile. Such a suitability requirement should be mandatory, so that the banks cannot by contractual devices like the non-reliance clause negate or waive its operation. 2

The Move toward Greater Clarity—Dispensing with the Notion of “Offer to the Public”

Until 2005, the question whether corporate fund-raising by the issue and sale of securities required a prospectus turned on whether there was an offer to the public. As noted by the Company Legislation and Regulatory Framework Committee (“CLRFC”) which recommended that the boundary between public and private offers be dropped and replaced by a general requirement for a prospectus when securities are offered, subject to comprehensive exemptions or safe harbours: The existing imprecision in defining and distinguishing between public from private offerings, coupled with piecemeal exemption amendments, has resulted in practical difficulties for structuring private and exempted offerings which do not require full prospectuses. This is unsatisfactory

45  SFA s. 240AA, was inserted by Securities and Futures (Amendment) Act 2012, Act 34 of 2012. As at April 2015, its commencement date had not been gazetted. 46  mas.gov.sg (2013).

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and clearly in need of reform to facilitate more efficient capital raising in a modern economy.47 The public offer-private offer conceptual dichotomy draws its inspiration from section 38 of the UK Companies Act 1948. It is a discriminant of respectable vintage; indeed, it is employed in section 4(2) of the US Securities Act 1933 to exempt an offering to sell securities from the requirement to file a registration statement. The problem with the discriminant is that it lacks a clear definition, and indeed a common approach. In the US, a purposive approach was taken by the Supreme Court in SEC v Ralston Purina.48 Ralston Purina had some 7000 employees, but the employee stock ownership scheme in issue was available only to “key employees”.49 In 1951—when the offering was interrupted by the litigation brought by the Securities and Exchange Commission—the estimated number of offerees was 500; of these, 165 employees applied to take up stocks under the scheme. The purposive approach taken by the Supreme Court looked at the mischief sought to be addressed by the requirement to file a registration statement. Did the employees require the protection afforded by the registration statement? As the employees were “rank-and-file” employees who did not have access to the kind of the information disclosed by a registration statement, the offering was found to be a public offering. In contrast, a more analytical approach was adopted by the High Court of Australia in Corporate Affairs Commission (SA) v Australian Central Credit Union.50 In determining whether there was an offer to the public, the High Court of Australia took the view that the first step in the inquiry is to determine whether there is a rational connection between the offeror and the offerees; alternatively, whether there is a special relationship between the offer and the common characteristics of the offerees. If such connection or relationship cannot be identified, there is little or no basis for the offer being regarded a private offering. On the other hand, if such connection or relationship exists, 47  Report of the Company Legislation and Regulatory Framework Committee, October 2002, at [2.1.1]. 48  (1953) 346 US 119. 49  Ralston Purina argued that a key employee would include “an individual who is eligible for promotion, an individual who especially influences others or who advises others, a person whom the employees look to in some special way, an individual, of course, who carries some special responsibility, who is sympathetic to management and who is ambitious and who the management feels is likely to be promoted to a greater responsibility”. Ibid., at 121–22. 50  [1985] HCA 64, at [8].

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the next step is to examine their nature. This is carried out by considering a number of factors, the most important of which are: the number of persons comprising the group, the subsisting relationship between the offeror and the members of the group, the nature and content of the offer, the significance of any particular characteristic which identifies the members of the group and any connection between that characteristic and the offer. ACCU was the entity formed by merging three independent credit unions and had some 23,000 members at the time of the litigation. It acquired some land for the purposes of its headquarters which was held by a unit trust, all of which units were initially held by ACCU. At issue before the High Court of Australia was whether the proposal to offer a proportion to its 23000 members amounted to an offer to the public. The High Court of Australia held that it did not. The members already had an indirect interest in the property through the ACCU. The offer was made to them in their private capacity as members of ACCU. As such, it arises from their membership, and relates to property they were already indirectly interested in. There was a perceptible and rational relationship with their membership in ACCU. In the premises, the offer was held not to constitute an offer to the public.51 The number of offerees in ACCU was exceptional for a private offering. While the decision provides a nuanced approach to what amounts to an offer to the public, it does not provide the bright lines and certainty that the transactional lawyer craves for the purpose of advising his clients. The City Country Club saga in Singapore demonstrates the risks that attend an aggressive approach to the interpretation of “offer to the public”. A group of businessmen were interested in developing a piece of land as a country club and selling club memberships. For tax reasons, they did not wish to proceed through the normal route of selling membership in a club. Instead shares in a club company were sold conditional upon the aspiring member acquiring qualifying shares in the property holding company. The shares in the property holding company to be sold to aspiring members were bonus shares which were issued to the promoters after a revaluation of the land. The promoters wished to avoid the offer being one involving an offer to the public not only because of the costs involved, but also because they wished to offer club membership over an extended period of more than six months and at prices which varied with the demand. To do so, the offers were individually addressed. Moreover, the lawyers explained to the Assistant Registrar of Companies the nature of the transaction and obtained a letter to the effect that the obligation to issue a prospectus was not triggered. 51  Ibid., at [10].

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The sale of club membership through acquisition in the club company and the property holding company was proceeded with. After complaints surfaced, investigations took place. The directors were charged for breaching the prospectus requirement. Following the conviction, the directors were disqualified from acting as directors for a period of 5 years under what was then section 130 of the Companies Act. The fines were not unbearable for the businessmen, who were men of means. That which hit them hard was the 5-year director disqualification period.52 Such was the burden of the director disqualification that the appeal was made all the way to the Privy Council,53 only to find the disqualification affirmed. The lawyer who assisted with the scheme pleaded guilty to abetting the directors in the commission of the offence, for which he was made to pay a fine of $4000. More seriously for the lawyer was the disciplinary proceedings commenced against him. The Law Society Disciplinary Committee found him guilty of grossly improper conduct; fortunately for him, this was reversed by a three-member panel of the High Court.54 However, it was a good 5 years between the conviction for abetment (1983) and the final resolution of the disciplinary proceedings (1988). The replacement of the public offer—private offer dichotomy with the general requirement for a prospectus is accompanied by an exhaustive list of clearly specified exemptions. The current regime thus provides the clarity which the former did not afford. The corollary issue is whether the exemptions or safe-harbours balance well the regulatory costs-social benefits consideration. 3

Safe Harbours

The strong norm requiring a prospectus to accompany any offer for the sale of securities risks exacts a heavy cost on small issuers who have modest capital requirements. The burdens of complying with the prospectus requirement are not light. Indeed, the costs are considerable. Unmitigated, the strong norm would deny the smaller issuers access to the capital market. From a competitiveness perspective, the strong norm without appropriate safe exemptions would also compromise the desire on the part of the Singapore to be an integrated node in the global capital and financial market—for it would partition 52  AG v Chong Soon Choy Derrick [1983–1984] SLR(R) 530 (Court of Appeal), Huang Sheng Chang v AG [1983–1984] SLR(R) 182 (High Court). 53  Quek Leng Chye and another v Attorney-General [1985–1986] SLR(R) 282 (Privy Council). 54  Re Chen Chung Ying Winston [1988] 2 SLR(R) 419.

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the Singapore market from the global capital market as issuers planning transnational offerings bypass Singapore. The sensitivity of the regulators to the needs of the small issuers is seen in the creation of two exemptions that accompanied the creation of the strong norm. Section 272B inserts into the “Exemptions” subdivision (SFA Part XIII Division 1 Subdivision (4)) an exemption for private placement. The prospectus requirement and the onerous obligations which attend the prospectus regime are disapplied if the private placement exemption can be called upon. The exemption for private placement contemplates offers which are made to no more than 50 persons within a period of 12 months.55 There must also be no advertisements and no selling or promotional expenses—except within tightly defined circumstances.56 The latter include administrative or professional services,57 as well commissions or fees for services rendered by professionals licensed to deal in securities.58 The second exemption introduced in 2005 to provide further counterbalance to the strong norm is the small offer exemption—s. 272A. This exemption pertains to personal offers in which the total amount raised in any 12-month period does not exceed S$5 million. A personal offer is defined as one that (a) may only be accepted by the person to whom it is made; and (b) is made to a person who is likely to be interested in the offer, regard being had to previous contact, connection or indication given by the offeree.59 However, there is a resale restriction applicable to the purchasers who acquire the securities under the small offer exemption.60 The strong norm pertaining to the requirement for a prospectus applies to the purchaser seeking to sell the securities unless the purchaser is able to rely on one of the exemption found in Subdivision (4).61 In order for the purchaser to rely, in turn, on the small offer exemption, either six months must have elapsed from the time of the initial sale,62 or it must comes within the conditions applicable to the resale transaction.63 55  56  57  58  59  60  61  62  63 

SFA s. 272B(1)(a). SFA s. 272B(1)(b) and (c). SFA s. 272B(1)(c). SFA s. 272B(1)(c). SFA s. 272A(3)(a) and (b) respectively. SFA s. 272A(8). SFA s. 272A(8)(a). SFA s. 272A(8)(b). SFA s. 272A(8)(c). The terms of this provision are in pari materia with those applicable for the initial personal offer. Cf. s. 272A(3) (persons to whom offers made be made), s. 272A(1)(b) (mandated disclosures) and s. 272A(1)(c) (prohibition against advertisement and selling or promotional expenses).

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Perhaps the most useful exception for banks seeking to market securities to their high net worth individuals is SFA s. 275, which may be labelled the exemption for accredited individuals and their associates.64 The “accredited person” is key to the operation of s. 275(1). An individual qualifies as an “accredited person” if his net personal assets exceed S$2 million or his annual income is no less than S$300000.65 A corporation qualifies as an accredited investor if its net assets exceed $10 million in value.66 The exemption in section 275(1) relates to accredited persons and persons related to them;67 together they are referred to as “relevant persons”. There is no numerical limit to the number of persons who can be offered should the marketing of the securities proceed through s. 275. Financial institutions who have documented the net worth of their clients and are satisfied that the conditions are satisfied may thus safely market securities to these clients under this exemption. The usefulness of this exemption for financial institutions cannot be overstated, for it allows financial institutions to introduce to their Singapore clientele transnationally marketed securities obtained through their overseas correspondent financial institutions. Together with the exemption for offers to institutional investors (s. 274), the s. 275 exemption usefully creates a highly significant space for the marketing and sale of securities to the market segment above the retail investor. They contribute in no small measure first, to the growth of private banking business operations in Singapore and second, to plugging Singapore into the international financial system. Section 274 extends beyond accredited investors and their associates—for s. 274(1A) involves an exemption for large transactions. These are transactions where the securities may only be acquired at a consideration of not less than $100000. The assumption presumably is that an investor who is prepared to invest this much money has either the sophistication or the incentive to do due diligence on the securities offered. The current threshold for the large offer exemption was lowered in 2009 from $200000 as a testament to the sensitivity 64  This is, of course, not a totally accurate label since s. 275(1A) deals not with the characteristics of the investor, but the size of the transaction. 65  SFA s. 4A. 66  SFA s. 4A. 67  These include: (a) an investment corporation wholly owned by accredited investors; (b) a special purpose investment trust of which all beneficiaries are accredited investors; (c) the officer in a accredited (corporate) investor; (d) the spouse, parent brother, sister, son or daughter of such an officer; and the (e) the spouse, parent brother, sister, son or daughter of a natural person making the offer: s. 275(2) (definition of “relevant person”).

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of the Singapore government to global norms and the need to face up to the competition. The Minister moving the amendment for the change in the threshold cited the European Union (EUR50000) and Hong Kong (HK$500000) as reasons for the change in the threshold.68 As s. 275(1A) does not require documentation of the offerees’ financial profile, marketing securities through the s. 275(1A) exemption avoids the due diligence costs that attend s. 275(1). The s. 274 and s. 275 exemptions are supported by the assurance of liquidity provided in s. 276. There are necessarily restrictions on the subsequent sale of the securities acquired under these provisions; otherwise, the exemptions become the backdoor by which securities slip into the retail market. The strong norm requiring a prospectus to accompany an offer continues to apply to an investor who acquires securities under these exemptions (“the s. 274/275 investor”). If he wants to on-sell his acquisition, he needs to prepare a prospectus, or come under an exemption. Naturally, such a person is unlikely to prepare a prospectus. The exemptions available to him are thus critical to liquidity, and accordingly to his willingness to invest. Within 6 months of the time from which the securities were first acquired, the s. 274/275 investor can only offer to sell the securities to another s. 274/275 investor. Other exemptions found in Subdivision (4)—e.g. the small offers exemption (s. 272A) and the private placement exemption (s. 272B)—are disapplied by s. 276(1).69 The most obvious person to whom (and by whom) the sale can be made is the financial intermediary which first sold him the shares, for it would be an “institutional investor” under s. 274. Beyond a 6-month period, the exclusion of the other subdivision (4) exemptions no longer apply. This is significant—for the purchaser of a security under the s. 274/275 exemptions can now freely make “personal offers” under the Small Offer Exemption (s. 272A). However, if he chooses to utilize the Small Offer Exemption, he must take care that he complies with the requirement to provide written notice of the matters specified in s. 272A(1)(b) viz. a disclosure that the offer is made in reliance on the s. 272A exemption and the resale restrictions that apply. It should be noted that the resale restrictions apply even if the securities under s. 274/275 exemptions are of the same class as other securities which are currently listed for quotation on a securities exchange.70 After 6 months from the initial acquisition made pursuant to an offer under a s. 274 or s. 275 exemption, an investor holding the securities is permitted to rely on s. 273(1)(d); this exempts an offeror from complying with the prospectus requirement 68  Second Reading of the Securities and Futures (Amdt) Bill, 19 Jan 2009. 69  SFA s. 276(1). 70  SFA s. 273(1)(d) is disapplied by s. 276(1).

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if the offer relates to securities which “have been previously issued and are listed for quotation or quoted on a securities exchange”. With the assurance of liquidity provided by the securities market after the 6 month period, an investor will presumably be more willing to take up placements under a s. 274 or s. 275 exemption. Corporations can thus raise funds at a lower cost than if a prospectus is required. On the other hand, if the securities are publicly listed after the s. 274/275 investor acquires the securities, the 6-month resale restriction will cease to apply after the public listing.71 As such, an investor who takes up securities under a s. 274/275 exemption can expect full access to the liquidity afforded by a public listing even if this takes place within 6 months of the initial acquisition under the exemption. The s. 274 and 275 exemptions were first introduced as section 106C and 106D under a newly introduced Part IV Division 5A of the Companies Act in 1989.72 Prior to the Securities and Futures (Amendment) Act 2003, the issuer or vendor seeking to invoke the exemption was required to lodge with the MAS offering material like the information memorandum before the securities could be marketed. There was also the obligation to maintain a register of the securities sold under the exception.73 These were removed to streamline the fund-raising process and to remove unnecessary procedural requirements that present obstacles to the integration of Singapore into the global capital market.74 The rationale for removing the obligation to file can be found in the recommendations of the Company Legislation and Regulatory Framework Committee (“CLRFC”): The s. 275, SFA exemption is frequently invoked as part of a global offering and in such cases, the information memorandum content is determined by international market demands. In a marketplace of sophisticated investors, we see no continuing value in the MAS taking on the role of a depository of information memoranda of exempted offerings, whether the offerings are listed or unlisted. The issuers and their advisers would, as a matter of prudence, maintain the same records and evidence as they have hitherto filed with the MAS so as to be able to establish their

71  72  73  74 

Section 276(7). Companies (Amendment) Act 1989 (No. 40 of 1989) SFA s. 280(2) (prior to its deletion in 2003) (originally CA s. 106I(2)). Securities and Futures (Amendment) Act 2003 s. 80, deleting SFA s. 280 (which first appeared as Companies Act 106I(1) in 1989).

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c­ ompliance with the exemption if investigated or challenged by regulators, investors or the public.75 The filing obligation and the obligation to maintain a register would have provided data for monitoring the use of the exemptions. The filing requirement was regarded by the CLRFC as an unnecessary procedural hindrance to fundraising from institutions, accredited investors and related persons covered by s. 274 and 275. The requirement in the form to state the amount or number of shares was thought to present a problem to advanced shelf registration.76 Accordingly, the CLRFC recommended the removal of the filing requirement. 4

Securities Hawking and Regulating the Marketing of Securities

An important adjunct to the general norm requiring a prospectus to accompany fund raising by a corporation is the prohibition against securities hawking: 309-(1) No person shall make an offer to any person of securities for subscription or purchase, or an invitation to any person to subscribe for or purchase securities, in the course of, or arising from, an unsolicited meeting with that other person. More than consumer protection against pressure selling, the provision proscribes the very marketing of securities, except within the terms of the safe harbour provided by the provision. In this regard, s. 309(2) significantly exempts from the scope of s. 309(1) the marketing of securities to investors under SFA s. 274 and 275. As we have seen, s. 274 and 275 relate to offers made to institutional investors and accredited investors respectively. However, should the cost of the securities offered cross the threshold of S$100000 (approximately US$75700 in April 2015), the exemption under s. 275(1A) is also available. The obvious consequence of this exemption is that the marketing of securities involving minimum consideration of $100000 to the public may be carried out without any strictures imposed by s. 309. This is similar to the marketing of securities to “institutions”, as defined by the SFA. Should a salesperson be able 75  Report of the Company Legislation and Regulatory Framework Committee (October 2002) at [2.4.1]. For the recommendation and rationale to remove the obligation to maintain a register, see Recommendation 2.8 and [2.4.2] (“adds a layer of administration cost without commensurate public interest or protection”). 76  Form 3 (before it was abolished).

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to obtain a list of persons who meet the criteria set out in s. 275, he would have a ready pool of potential clients to whom he can market securities. The provision finds its origins in the UK Companies Act 1928.77 The conception of hawking was of a roving salesman marketing securities in physical location. In ex parte Lovell,78 the New South Wales Supreme Court interpreted the cognate provision widely to catch not only the itinerant roving salesman who hawking securities at different physical location, but also when the salesman hawks securities at one’s front door. This was effected by reading “place” to include “house”, so that the offence could be committed whether the salesman was marketing the securities in a public place or at one’s door step. Advances in telecommunications technology challenge the adequacy of the original provision which ingredients of the offence are strongly grounded in terrestrial activity. Today, many marketing efforts are conducted across borders using telephony and emails. The current form of the prohibition against securities removes the requirement to prove that the salesman moved “from place to place”. Nonetheless, the offence continues to be predicated on an “unsolicited meeting” taking place. Given this ingredient, it is difficult to envisage the provision catching unsolicited telephone marketing, or email invitations to purchase securities. The policy intent does not, therefore, involve a blanket prohibition against all kinds of solicitation to purchase securities. As the prohibition currently stands, the less intrusive forms of solicitation which do not entail unsolicited face-to-face interactions are excluded. The protection of the public against unsolicited meetings for the sale of securities, however, is only one facet of investor protection. To obtain a fuller picture of the regime against the marketing of financial products, it is necessary to have some regard for the licensing regime for financial services. Under section 6(1) of the Financial Advisers Act, it is necessary (unless one is exempted) to obtain a financial adviser’s license if one seeks to act as a financial adviser in respect of any financial advisory service.79 Importantly, s. 6(2) prescribes that:

77  UK Companies Act 1928. 78  (1938) 38 SR (NSW) 153. 79  See Financial Advisers Act, s. 6.—(1):  “No person shall act as a financial adviser in Singapore in respect of any financial advisory service unless he: (a) is authorised to do so in respect of that financial advisory service by a financial adviser’s licence; or (b) is an exempt financial adviser.”

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A person shall be deemed to be acting as a financial adviser in Singapore if he engages in any activity or conduct that is intended to or likely to induce the public in Singapore or any section thereof to use any financial advisory service provided by the person. Much hinges on the scope of “financial advisory service”. Under paragraph 1 of the Second Schedule, this includes “advising others, either directly or through publications or writings, and whether in electronic, print or other form concerning any investment product”. The definition of “investment ­product” includes “capital market product”, which follows the definition found in section 2(1) of the Securities and Futures Act.80 Amongst other financial products, the definition includes securities and futures contracts. As such, to the extent that the marketing of securities amounts to “advice” concerning the security within the meaning of the FAA, the absence of a financial adviser’s license will mean that the salesman is exposed to criminal liability for breach of section 6(1) of the Financial Advisers Act. 5 Conclusion The evolution of the Singapore fund-raising regime in a past 20 years demonstrates the political will of the Singapore Government to develop Singapore into an international hub for fund-raising and financial services. As a first step, in moving to a disclosure-based regulatory regime, Singapore had to jettison the paternalistic approach to securities listing that it had long practised. It then set about refashioning the rules consistent with the new regulatory approach. As observed from the changing contours of the law, the regulations were methodically worked out to plug Singapore into the global capital markets. Grey areas were reworked to produce the bright lines and the certainties that bankers and transactional lawyers crave; the removal of the public offer— private offer must be seen against the sophisticated exemptions which attempt to facilitate capital formation while protecting the retail investor. Thresholds were adjusted to keep up with its competitors. The Singapore fund-raising regime today can fairly be assessed as state-of-the-art. It is a testament to the responsiveness of the Singapore government to the demands of the market, while keeping a sure eye on the integrity and soundness of the market. Whether the current regime strikes a right balance between investor protection and market development is a question which will attract differing 80  Definition (a) of “investment product” as found in Financial Advisers Act (Cap. 110) s. 2(1).

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assessments. Embedded within the current regime are certain value judgments made by the legislature; indeed, the operationalization of what is adequate disclosure involves a value judgment on the part of the regulator. If there is one lesson that the Lehman bond debacle holds, it is that the right degree of tension between investor protection and market development cannot turn on only a disclosure-based strategy, and that market development must be embarked upon conscious of human frailties. New norms like suitability need to be incorporated to render the regime a robust one. One should not sell bombs to grandma—full disclosure notwithstanding. References Chan, Francis (2008) “$100,000 Life Savings Gone,” Straits Times, 16 October. “Disclosure: Quality Counts, Not Just Quantity,” Business Times, 26 February 2010. eresources.nlb.gov.sg (2010) “Lehman Brothers Minibond Saga,” http://eresources.nlb .gov.sg/infopedia/articles/SIP_1654_2010-03-19.html (accessed 29 April 2015). Lai, Karen (2013) “The Lehman Minibonds Crisis and Financialisation of Investor Subjects in Singapore.” 45 Area 273–82. Lee, Hsien Loong (2000) “Opening Address by at Monetary Authority of Singapore Work Plan Seminar (3 April 2000),” http://www.mas.gov.sg/news-and-publications/ speeches-and-monetary-policy-statements/speeches/2000/financial-sector-liberal isation-going-global--03-apr-2000.aspx (accessed 29 April 2015). mas.gov.sg (1998a) “Report of the Corporate Finance Committee—The Securities Market: Final Recommendations (21 October 1998) (“CFC 1998”),” http://www.mas .gov.sg/~/media/resource/publications/consult_papers/1998/21%20October%20 1998%20The%20Securities%20Market%20Final%20Recommendations.pdf (accessed 29 April 2015). ——— (1998b) “Government’s Response to the Corporate Finance Committee Recommendations (9 November 1998),” http://www.mas.gov.sg/news-and-publications/media-releases/1998/government-s-response-to-the-corporate-finance-com mittee-recommendations--09-nov-1998.aspx (accessed 29 April 2015). ——— (2003a) “MAS Intends to Refuse Registration of Nagacorp Limited’s Prospectus—Media Release (8 September 2003,” http://www.mas.gov.sg/news-andpublications/media-releases/2003/mas-intends-to-refuse-registration-of-nagacorpltd.aspx (accessed 29 April 2015). ——— (2003b) “MAS Refuses Registration of Nagacorp Limited’s Prospectus—Media Release (21 October 2003),” http://www.mas.gov.sg/news-and-publications/mediareleases/2003/mas-refuses-registration-of-nagacorp-21-oct-03.aspx (accessed 29 April 2015).

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——— (2004) “Case Study on the Pan-Electric Crisis (June 2004)—MAS Staff Paper No. 32,” http://www.mas.gov.sg/~/media/resource/publications/staff_papers/MAS_ Staff_Paper_No32_Jul_2004.pdf (accessed 29 April 2015). ——— (2008a) “MAS Sets Out Resolution Process and Timeline for Investors of Structured Products—MAS Press Release (10 October 2008),” http://www.mas.gov .sg/news-and-publications/media-releases/2008/mas-sets-out-resolution-processand-timeline-for-investors-of-structured-products.aspx (accessed 29 April 2015). ——— (2008b) “Reply to PQs on the Sale of Structured Products to Retail Investors— MAS Press Release (20 October 2008),” http://www.mas.gov.sg/news-and-publica tions/parliamentary-replies/2008/reply-to-pqs-on-the-sale-of-structured-productsto-retail-investors.aspx (accessed 29 April 2015). ——— (2008c) “MAS Ensures Progress in Complaints Resolution—MAS Media Release (17 December 2008),” http://www.mas.gov.sg/news-and-publications/media-releases/ 2008/mas-ensures-progress-in-complaints-resolution.aspx (accessed 29 April 2015). ——— (2009a) “Reply to PQ on Complaints Resolution on the Sale of Structured Products (19 January 2009),” http://www.mas.gov.sg/News-and-Publications/ Parliamentary-Replies/2009/Reply-to-PQ-on-Complaints-Resolution-on-the-Saleof-Structured-Products.aspx (accessed 29 April 2015). ——— (2009b) “Investigation Report on the Sale and Marketing of Structured Notes linked to Lehman Brothers (7 July 2009),” http://www.mas.gov.sg/~/media/resource/ news_room/press_releases/2009/INVESTIGATION%20REPORT_7%20JUL%2009 .pdf (accessed 29 April 2015). ——— (2013) “Consultation Paper on Draft Regulations pursuant to the Securities and Futures Act and Financial Advisers Act (17 September 2013),” http://www.mas.gov .sg/~/media/MAS/News%20and%20Publications/Consultation%20Papers/SF_ FA%20Reg%20Consult%2017Sep13%20FINAL.pdf (accessed 29 April 2015). Tjio, Hans (2011) Principles and Practice of Securities Regulation in Singapore, Singapore: Lexis Nexis. Tversky, Amos, & Daniel Kahneman (1981) “The Framing of Decisions and the Psychology of Choice.” 211 Science 453–58.

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Chapter 9

A People’s Market of Hong Kong Facilitating Crowdfunding of SMEs

David C. Donald, George Mok and Adrian Fong Abstract This chapter proposes a regulatory framework for the introduction of equity crowdfunding into the Hong Kong financial framework. Part II examines the state of SME financing in Hong Kong and shows that a significant gap exists between the availability of and need for start-up equity financing. This gap affects companies too large to be funded by personal assets of the founder, her friends or family, but too small to attract venture capital. Such companies are of a size well served by equity crowdfunding. Part III then turns to a review of crowdfunding regulation in the US, the UK, Singapore and China, showing different stages of development and regulatory techniques. Part IV surveys the early data on the economic impact of crowdfunding in those same jurisdictions. Part V presents our proposals for Hong Kong: (i) crowdfunding should be restricted to issuers organized under Hong Kong law, (ii) a class exemption from the prospectus requirement should be created for those companies offering shares through a licensed crowdfunding platform, provided that they publish all annual disclosures required under the Hong Kong Companies Ordinance for the AGMs of public unlisted companies, and (iii) a condition for licensing of crowdfunding platforms should be that it receive declarations from investors that they have will not invest more than 10% of their annual income on the relevant equity offering, including any crowdfunding investments they have made during the preceding twelve months.

* Professor, Faculty of Law, The Chinese University of Hong Kong. I would like to thank the Hong Kong Research Grants Council for the generous funding of this work under the Theme Based Research Project, “Enhancing Hong Kong’s Future as a Leading International Financial Centre” (T31–717/12-R). Contact: [email protected]. ** J.D. Candidate, Faculty of Law, The Chinese University of Hong Kong. Contact: george [email protected]. *** L.L.B. Candidate, Faculty of Law, The Chinese University of Hong Kong. Contact: adrian [email protected].

© koninklijke brill nv, leiden, ���6 | doi ��.��63/9789004315815_010 Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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Keywords crowdfunding – Hong Kong – corporate finance – venture capital – funding start-ups

1 Introduction Markets thrive on network externalities, which is a synonym for liquidity. In the past, the only way that such network effects could be achieved was either to exploit existing connections between people (such as family or club ties) or to gather people together in a single place at an agreed upon time (such as on the floor of a stock exchange). Technology has changed this dramatically. At any moment any person can use freely available networks like Facebook or LinkedIn to communicate instantly with a vast number of other users. Today an ordinary college student could use such networks to invite people to a graduation party or sell an old laptop on eBay, and likely be able to contact more people than might belong to an official stock exchange in an average developing country. These same network tools can also be used by an entrepreneur to invite investors to participate in her inchoate business without the medium of a stock exchange. Technology has enabled changes in finance to an extent that we are only just beginning to grasp. Hong Kong is a business centre. It was created purposely for international trade, and has carried on that activity for over a century and a half. After World War II, it became a manufacturing centre, and in the 1970s it began to develop as a financial centre. Currently, Hong Kong enjoys high international rankings for its financial centre,1 the competitiveness of its economy,2 the businessfriendly aspect of its regulatory framework,3 and the quality of its rule of law.4 1  Hong Kong has been ranked in the third or fourth position globally as an international financial centre since 2007. Long Finance, The Global Financial Centres Index, nos. 1–16, (2007– 2014). For example, on a scale of 800, since 2010 Hong Kong has been rated semi-annually as follows: 2010—739, 760; 2011—759, 770; 2012—754, 733; 2013—761, 759; 2014—761; 756. The Global Financial Centres Index, Numbers 7–16. See Global Financial Centres Index (2015). 2  Hong Kong led the world in the World Economic Forum’s “The Financial Development Report 2011” and “The Financial Development Report 2012.” See World Economic Forum (2011/12). 3  The Heritage Foundation ranked Hong Kong as the freest economy in the world for 20 consecutive years. See heritage.org (2015), Index of Economic Freedom. 4  The World Justice Project in 2013 ranked Hong Kong above France, Belgium and the United States for access to civil justice. See World Justice Project (2013), Rule of Law Index 2012–2013.

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Although Hong Kong has for decades been famous for its laissez-faire approach to economic development, the government of Hong Kong has usually been well-disposed to provide the necessary law to allow business to develop. This is particularly true of the financial sector, where a regulatory framework whose content and operation meet international best standards has been constructed and staffed in only 25 years.5 During more than half of that time, Hong Kong has been a Special Administrative Region of the People’s Republic of China (referred to as the HKSAR). Given Hong Kong’s character and history there is little doubt that the HKSAR will eventually provide an effective framework so that business can freely benefit from technological advances in networking capacity for finance. It is the purpose of this paper to explain why and how this should be done. Part II examines the role of small and medium enterprises (SMEs) in the Hong Kong economy, and the currently available avenues of financing. It shows that the addition of crowdfunding is a next logical step in the development of Hong Kong’s corporate finance infrastructure. Part III presents a survey of how crowdfunding has been regulated in select jurisdictions around the world. It focuses on regulation in the United States, the United Kingdom, Singapore and China. Part IV looks at the benefits that crowdfunding has brought and is expected to bring in these same jurisdictions. Part V contains our recommendations for Hong Kong. We propose three regulatory changes. The first proposes a class exemption from the prospectus requirement for offerings on a licensed crowdfunding platform. The second proposes that crowdfunding platforms be treated as automated trading services, a type 6 regulated activity. The third proposes that a cap be placed on the amount that an investor can place on crowdfunding issues in a given year. We believe that crowdfunding could operate safely and efficiently on the basis of these adjustments. Ultimately, we see equity crowdfunding as a community activity, a type of engagement that falls outside of the paradigm of public offerings as regulated during the 20th century, and rather as a social activity with significant positive externalities, a social good of collective action.

5  The Securities and Futures Commission began operation in 1989 and the Hong Kong Monetary Authority was established in 1993. The Securities and Futures Ordinance came into effect in 2003. For a discussion of this history, see Donald (2014), pp. 117–23. By contrast, the US Securities and Exchange Commission has existed for 80 years, and the US Federal Reserve Bank has existed for over 100 years.

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2

The Place of Crowdfunding in Hong Kong SME Finance

2.1 Innovation in the Hong Kong Economy Since the 1950s, Hong Kong entrepreneurs have been a driving force of innovation in its economy, and where possible the HKSAR Government has done what it could to facilitate this activity. As will be discussed below, both the government and private associations have taken steps to stimulate business start-ups and to help them gain access to financing for their operations, research and development. Progress in information technology has dramatically changed the possibility of creating networks of investors and matching the needs of investors and entrepreneurs starting a new enterprise. These changes open opportunity for further facilitative action by the HKSAR government. Hong Kong is a leading hub for innovation and entrepreneurship, especially in the increasingly-important information and communications sector (ICT). As part of its Digital 21 Strategy, Hong Kong seeks to become one of the leading information and technology hubs in the world.6 ICT employs around 78000 people and constitutes roughly only 2% of the total labour force. However, it has an outsized impact on the economy and contributes around 6.1% of the GDP.7 In particular, according to statistics by the Census and Statistics Department, the number of companies engaged in “information technology services,” which encompasses areas such as computer software, mobile application development and online services, grew from 6512 in 2012 to 7139 in 2013, a year-on-year increase of nearly 10%.8 The number of people employed by the industry subsector also grew by about the same percentage, from 37139 in 2012 to 40671 in 2013.9 Fostering innovation and technology companies in Hong Kong has been one of the Government’s primary focuses. In the 2014 Policy Address, the Government noted its recent efforts to create an “environment conducive to the development of innovation and technology, encourage investment in this area and enhance co-operation among the Government, industry, academia and research sectors.”10 While the preferred form of finance for a going concern is its revenues from operations, access to external capital is vital to the formation and growth of the new companies that advance technology and bring innovation. Corporate finance is therefore one of the most important areas of a young business’s 6  See generally Digital 21 Strategy (2015). 7  Ibid. 8  Hong Kong Census and Statistics Department (2014), p. 35. 9  Ibid. 10  Policy Address (2014).

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operations, ensuring it can employ the people and produce the products or offer the services that will allow future expansion. Corporate finance is particularly important for technology-based start-ups, as they need cash to finance the basic activities of R&D and marketing. A survey undertaken by the Hong Kong Trade and Development Council (“HKTDC”) in 2011 shows that 81.9% of would-be entrepreneurs did not proceed with their plans for starting a business due to a lack of start-up capital.11 Likewise, another survey taken in 2014 found that obtaining capital was a challenge which start-ups ranked second only to discovering new business opportunities and customers.12 It is a disheartening thought that in one of the world’s leading financial centres the economy for young, innovative enterprises is operating at 20% of capacity simply because of lacking access to finance. While government agencies and bodies have promoted Hong Kong as a centre for financing, much of the focus has been placed on Hong Kong’s role financing large corporations at the IPO stage.13 The IPO process is an extremely valuable tool to allow relatively established corporations to make the transition to global competitors, and it should be supported. However, focus on the finance of such companies does little for the enterprises that are still too small to participate in IPOs. Even the Growth Enterprise Market (GEM), which aims to promote innovative businesses, requires two years of business activity with a cashflow of at least HK$20 million in aggregate for the two years preceding listing and a market capitalization of at least HK$100 million at the time of listing.14 Such prerequisites often shut out SMEs. Recently, the Hon. Mr. Charles Mok, the Legislative Councillor for the Information Technology constituency, also suggested that the Hong Kong Government “consider formulating relevant financial policies and legislation to facilitate investments from angel investors, venture capitalist firms or crowdfunding in financing the start-ups at various stages, so as to build an effective and sustainable technology start-up ecosystem”.15 In a like manner, Andrew Leung, of the Industrial Sector constituency, has stated in Legislative Council proceedings that: 11  Hong Kong Trade Development Council (2011), p. 6. 12  Hong Kong Trade Development Council (2014a), p. 35. The question posed was ‘how difficult to overcome business management challenges’. On a scale of 1 to 5 with 1 being “very easy” and 5 being “very difficult”, “seek loans/funds for business operation/development” was rated 3.49 only slightly below “find new business opportunities/customers” which was given a rating of 3.56. 13  See for example Financial Services Development Council (2014). 14  Stock Exchange of Hong Kong (2014) Growth Enterprise Market Listing Rules, Chapter 11. 15  Legislative Council of Hong Kong (2014), p. 22. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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Young people of Hong Kong have bright ideas, only that they lack the experience and funds to start up a business. We therefore suggest the authorities to promote a new concept called “crowdfunding”. Crowdfunding seeks to make use of the Internet platform to display and brief on publicity proposals, in the hope of bringing their products to mass production. People who are interested to render their support, take part in the production or purchase the products may help the young people realize their dreams by offering sponsorship. I think the Government may enact legislation on crowdfunding and provide legal support for people seeking funding.16 2.2 Existing Avenues for Financing Start-Ups 2.2.1 Introduction The current sources of finance for start-ups are limited and insufficient. Although the Hong Kong market does present all traditional means of finance, and does so at a high level of professional quality, the current menu does not meet real needs. The HKTDC survey discussed above clearly shows that. In this section, we will present the types of financing currently available and highlight their strengths and weaknesses. The challenges faced by SMEs in receiving funding are different from those of large companies. Start-ups, especially, may not have an adequate credit history, security, or business plan to convince professional investors or loan officers to provide backing. According to the HKTDC survey, the capital requirements for most start-ups ranged from HK$10000 to HK$200000, with figures varying in relation to the business type (i.e. retail or wholesale companies needed to purchase inventory while online/mobile service providers mainly required funds for server and communication costs). The survey also listed the most common sources of finance for the start-ups as personal, family, or friendship-based finance. The entrepreneurs responding to the survey found the pressure from debt (an unwavering duty to repay principle and interest) created so much risk that they “would rather defer their plans in order refrain from borrowing as far as possible”.17 Currently, SMEs have access to three main forms of corporate finance: debt, grant, and equity financing. In a 2011 survey, new entrepreneurs indicated that they received their capital from the following sources shown in Chart 9.1.18 16  Legislative Council of Hong Kong (2013), p. 348. 17  Hong Kong Trade and Development Council (2014), p. 28. 18  Hong Kong Trade and Development Council (2011), pp. 12–13. See Hong Kong Trade and Development Council (2014), p. 28, where another survey was done on new entrepreneurs which found that they received the their start-up capital from the following sources: own or partners’ funds (96%), family or friends (34%), financing from investors or investment Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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chart 9.119

Debt financing is provided mainly by commercial banks and entails the legal obligation to repay principal with interest, regardless of the fortunes of the business. Grant financing is bestowed on a business by government or private sources with liberal or no repayment obligation, but is both very limited in amount and tends to involve an extensive and long application process. Equity financing involves the investor or financier taking an equity position in the company in exchange for share of the company. Equity carries no repayment obligation and forces investors to share the risk of business failure, but as discussed above, infrastructure to facilitate such funding beyond circles of friends and family investment focuses on well-established businesses. 2.2.2 Debt Financing Debt finance for companies will take the form of a loan or debentures. The main elements of debt finance are the requirement to repay the amount borrowed within a certain period with interest. The simplest form of debt financing is a loan, and at the lower end of the scale, start-up founders may seek to use existing sources of debt financing, such as credit card or personal bank loans to finance the company. SME financing from banks is common for companies with a steady cash flow that can be applied to loan repayment instalments. Loans from banks may also be security-linked loans, involving a charge over assets such as property, which again assumes that the entrepreneur beginning a project has assets at her disposal. However, such commitments are often institutions (12%), bank/finance company loans (11%), government/public organization finance schemes (8%). 19  The content of this chart has been re-created from the data published in: Hong Kong Trade and Development Council (2011), pp. 12–13. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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impractical for start-ups, especially if they need significant time to develop their product before being able to repay a loan. As mentioned above, a founding entrepreneur may seek loans from family and friends to avoid either the lending requirements of a commercial bank for the potential consequences of default. In the 2014 HKTDC survey discussed above, it was found that approximately 10% of responding youth entrepreneurs and would-be entrepreneurs raised or borrowed funds from their relatives and friends.20 The Hong Kong Government has taken steps to address the lack of bank loans by introducing a SME Financing Guarantee Scheme, which assists SMEs in obtaining bank financing by guaranteeing a percentage of the loan to participating lenders.21 According to the statistics published by the Hong Kong Mortgage Corporation, during the two years between the Scheme’s launch in 2012 and 2015, a total of 9717 out of 10841 applications received were approved.22 However, this guarantee scheme requires a minimum of one year of operation, and is thus unlikely to be given to assist a fresh start-up in need of access to immediate financing. For smaller companies, the Hong Kong Mortgage Corporation has also established a “Micro Business Start-up Loan”.23 New businesses with an age of up to five years can apply for a start-up loan which requires a credit report, business plan and training stage, as well as a formal loan application and vetting interview. Between the program’s launch in 2012 and 2014, 143 of 294 applications received were approved with the average loan size of $260000 and the average loan term of 4.5 years.24 The interest rate per annum applied in the programme is not higher than either 8% with guarantor or 9% without. The minimum amount of the loan, which prevents scalability, has been criticized.25 Another programme is the Youth Business Hong Kong and Microfinance Scheme, which is targeted towards youths (18–35) who have a “viable business idea” that can start in one year or is already in operation for no more than three years.26 The programme allows a maximum of $100000 to be provided interestfree for business start-ups following approval by a vetting committee. Issuances of either corporate bonds or convertible notes are unlikely both for the reasons discussed above with regard to loans and because of the legal 20  Ibid., p. ii. 21  Hong Kong Mortgage Corporation (2015a). However, as the average loan amount is $4.5 million dollars, this is unlikely to assist start-up entrepreneurs. 22  Hong Kong Mortgage Corporation (2015b). 23  Hong Kong Mortgage Corporation (2015c). 24  Hong Kong Mortgage Corporation (2015d). 25  The Women’s Foundation (2014), p. 49. 26  Hong Kong Federation of Youth Groups (2015). Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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complexity and distribution problems they entails. As such, it is unlikely that SMEs can afford or would prefer to issue debt instruments. Thus, debt finance, while useful for larger companies, does not adequately meet the needs of start-ups. The OECD’s report on SME Financing notes that: “debt is generally considered not to be an appropriate form of financing for innovative SMEs, or other entities with projects characterised by higher riskreturn profiles, at least not during the early stages when revenue generation and profitability are still at best uncertain and as debt servicing necessitates regular payments of interest and principal.”27 Among the significant risks the debt presents to entrepreneurs include having to pledge personal assets, risk credit damning credit ratings, and pay unreasonably high rates of interest. Moreover, even if a start-up wanted to avail itself of credit, banks “remain quite traditional [. . .] they almost always demand collateral to support a loan for business investment [. . .] lending based on just a sound business plan is almost unheard of”.28 This corroborates two HKMA surveys on SME business financing undertaken in 1999 and 2000 which found that most SMEs found it difficult to borrow from banks to finance business development. The 2009 GEM Report concluded that financiers, bankers, and investors alike were sceptical of loan financing due to the lack of its availability to start-ups.29 The remaining alternative is thus to raise capital through allotment of equity stakes. 2.2.3 Equity Finance For the reasons explained in the previous subsection, equity finance is the more popular financing option for start-ups. It is attractive from both sides of the relationship: the entrepreneur has no duty to repay a fixed sum and the investor acquires the possibility of participating in very significant value growth as the inchoate business concept progresses into a viable enterprise. The drawbacks are of course that the investor takes on very significant risk, and such risk is in most cases reduced by requiring a certain period of stable business operations before the investment is made. From the perspective of the entrepreneur equity brings with it the unattractive aspect of ceding a certain amount of control, but this can be addressed through the custom creation of preference shares with a negotiated balance of voting and dividend rights.30

27  OECD (2006), p. 34. 28  Au & White (2014), p. 25. 29  Center for Entrepreneurship (2009), p. 34. 30  See Klein & Coffee (2004) pp. 302–6.

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chart 9.2 Relationship between informal investors and their investees (Hong Kong).31

The need for a stable business history can be circumvented by approaching investors, such as family, friends or neighbours, who have information about the company’s founder unrelated to the start-up and therefore have achieved a level of trust. The progress of an equity issuer from one source of financing to the next can be regarded as a movement up stages of a “chain”, whereby an issuer’s exhausting capital received from one source will encourage the founder to seek more capital higher up the chain.32 As with debt financing, the first targeted investors for sales of equity stakes may be from the founder herself, co-founders, family and friends—i.e. a personal network. The Global Entrepreneurship Monitor Report 2009 found that the rate at which informal investors backed businesses in Hong Kong dropped dramatically after the 2008 recession, and more so than in other economies.33 However, as can be seen from Chart 9.2 above, the percentage of investment provided to a “Stranger with a Good Business Idea” increased from 0% in 2004 to 5% in 2009. This increase may demonstrate a trend towards investor willingness to back founders with whom they have no previous affiliation. The trend could be a positive sign that Hong Kong investors would be willing to use a crowdfunding network to seek higher returns from their accumulated savings, even without the bonding that comes from the relationship of family or friendship. 31  This chart is recreated from the exact figures presented in Center for Entrepreneurship, infra note 32, p. 45 (Figure 24). 32  Au & White, supra note 28, p. 22. 33  Center for Entrepreneurship (2009), p. 45.

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While ordinary investors in Hong Kong may be more willing today to back a start-up enterprise, the wealthy have seen the advantages of such investments for decades, and earned angelic accolades for their efforts. Business angels are investors who can make equity investments (or sometimes convertible debt) at a company’s early stage of development, and this essential capital can yield high returns. Business angels may invest alone or as a syndicate, depending on the amount needed and the advisory skills which the business angels can offer. According to the Hong Kong Business Angel Network, between 2011 and 2014, Network and non-Network angels funded 22 successful cases.34 While 22 cases are indeed better than none, it is far too little in an economy where over 100000 new companies are incorporated each year.35 Venture capital firms also provide attractive terms of financing for start-up enterprises, but in order to reduce both risk and the period before a company can be flipped through public offering, they usually invest in companies that are well established and have a detailed business plan. The Hong Kong Venture Capital and Private Equity Association (HKVCA) reports investment size ranges of $30000 USD to $50 million USD in Hong Kong’s venture capital market.36 Another, and growing, source of corporate finance is private equity, which has the favourable characteristic that investments tend to be longer term, but like venture capital, private equity tends to prefer investments in more established companies. A private equity firm would need to cash out of its investment, and this is often accomplished by selling their shares in connection with an IPO or the placement of a share packet with another private equity firm. In 2013, Hong Kong was “home to the second largest private equity centre in Asia”, with 376 private equity firms holding approximately $98.5 billion of capital under management.37 While this benefits larger companies in the final stages of development before going public, it does not offer significant support to local start-ups. From the above, we can see that equity is useful not only because it is a source of capital that does not require repayment, but also because the equity investor takes a stake in the businesses’ success and can bring talent to its leadership. The resulting participation, oversight and mentoring, as well as advertising through the investor’s own networks, can be of great benefit to the company and significantly boost the venture’s chances of success. However, the availability of such financing is much lower than needed, even in “the second 34  Hong Kong Business Angel Network (2015). 35  See Hong Kong Companies Registry (2014). 36  See Hong Kong Venture Capital and Private Equity Association (2014). 37  Hong Kong Trade Development Council (2014b).

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largest private equity centre in Asia”. Au and Smith find the general perception by entrepreneurs and the general public that venture capital will be able to provide funding needs of around USD 1 million to a firm between the seed and start-up stage to be mistaken and exaggerated.38 The result is that start-ups are often in need of additional sources of funding to carry them through from the start-up phase to the point where they are ready to attract injections of capital from professionals. Au and Smith report that “many early-stage entrepreneurs cannot find funding to bridge the ‘equity gap’ between what they can gather from personal sources initially and what they could solicit from venture capital funds”.39 This gap in funding between the beginning, seed stage and the point where the start-up can begin to solicit venture capital based on a demonstrably viable business model with a proven track record can be deadly for the incipient business.40 This period could potentially be bridged by angel investors, but Hong Kong’s network of such investors is insufficiently broad and deep. 2.2.4 Grant Financing The government has also entered the field, replicating the advantages of angel investment to a certain degree. The Innovation and Technology Fund operated by the HKSAR’s Innovation and Technology Commission supports the Small Entrepreneur Research Assistance Programme (SERAP). Under the programme, start-ups in the technology field can carry out research and development with funding support received on a dollar-for-dollar matching basis, with the funds recouped if revenue is generated or there is third-party ­investment.41 Between the programme’s launch in 2012 and November 2014, a total of 398 projects had been funded with total of HKD 480 million.42 This programme is also supplemented by the Hong Kong Science and Technology Parks Corporation, which operates multiple incubation programmes.43 The market has stepped forward in recent years to provide additional sources of financing for start-ups and entrepreneurs. Jack Ma, of the Alibaba Group, announced a 38  Au & White, supra note 28, p. 20. 39  Ibid. 40   The stages of equity investment are usually (1) founder and/or co-founders; (2) family and friends; (3) angel investors [a person with HKD$8000000 net worth or HKD$1600000 in annual income]; (4) venture capitalists [investments usually starting around HKD$4,000,000]; (5) initial public offering and investment banks. See Fundersandfounders.com (2013). 41  Innovation and Technology Fund (2015a). 42  Innovation and Technology Fund (2015b). 43  See Startmeup.hk (2015).

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HKD 1 billion foundation to encourage and boost entrepreneurship amongst youths in Hong Kong.44 2.3 Government Measures to Facilitate Financing 2.3.1 A History of Facilitating the Market The continued strength of Hong Kong as a leading innovation and entrepreneurial hub is contingent on start-ups having multiple avenues of financing suited for their different stages of development. There are limitations associated with debt financing as loans are clearly not the preferred way for start-ups. We have seen that there is a gap in the equity financing that is available after the family, friends and neighbours of entrepreneurs have exhausted their disposable savings. The government programmes like the SME Financing Guarantee Scheme, the Micro Business Start-up Loan, the Youth Business Hong Kong and Microfinance Scheme, and the Innovation and Technology Fund are useful, but insufficient. It is time for the government seriously to take on the task of facilitating an alternative, market-driven source of start-up financing through adjustment of the regulatory framework. Equity crowdfunding offers a source of corporate finance that can potentially fill the gap between the initial support of friends and family and the institutional investment that can precede an IPO. This source has been brought to the market through advances in communications technology, and is purely market-driven. Recourse to the market is not only highly complementary with Hong Kong’s traditional philosophy of marketdriven development, but it could also be more efficient than the existing funding programs, which require significant grant application lead time and where the decision to grant funding to a particular firm and deny it to another might be conceptually sound but in practice erroneous. While the government’s funding programs remain an essential component in the stimulation of innovative enterprises in Hong Kong, a solution from the market can therefore provide an excellent supplement. The introduction of financing platforms using new data transmission technology can also have latent benefits for Hong Kong’s IT sector, and could become a source of expertise and knowhow in itself.45

44  Ng & Yu (2015). Many details still remain unclear at the date of writing. 45  It is no accident that an economy in which a specific type of product is used avidly also becomes a manufacturer and exporter of that product. Examples are Italy which has cultural passions for food and fashion that have shaped its export industry, and Germany which hosts one of the only highway systems in the world allowing high-performance

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2.3.2 A Natural Next Step—Crowdfunding As noted in Part I, advances in the type of data transmission platforms made famous by social media firms like Facebook and LinkedIn now enable individual entrepreneurs starting or expanding a business to reach out directly to investors and solicit equity financing. These changes are altering the stages of corporate finance discussed above, creating a network of investors at the gap between the personal and the institutional networks that are currently used. The discussion in the preceding subsections shows that Hong Kong needs an additional avenue to source financing for start-up enterprises, and we believe that it should take advantage of the current opportunities technology offers to make the regulatory adjustments necessary to facilitate crowdfunding. The International Organization of Securities Commissions (IOSCO) defines “crowdfunding” as “an umbrella term describing the use of small amounts of money, obtained from a large number of individuals or organisations, to fund a project, a business or personal loan, and other needs through an online webbased platform”.46 The financing network that a crowdfunding platform can bring to a start-up enterprise can effectively bridge the gap between a circle of personal acquaintances and the larger community of the international capital market, as represented on the stock exchange. The difficulty, as will be discussed in Parts III and IV, arises in regulating an activity that resembles an IPO without imposing the same, in this case prohibitive, regulatory costs of an IPO. Although the concept of crowdfunding is still new to Hong Kong, the market’s interest in it is growing. In May 2014, the Hong Kong Securities and Futures Commission (SFC) issued a notice warning persons engaging in activity like crowdfunding that absent proper licensing and compliance measures they may be running afoul of existing investor protection and market supervision provisions.47 Investment through crowdfunding platforms both provides start-ups with sorely needed finance and gives ordinary savers an opportunity to benefit from the kind of high-return investment previously reserved for wealthy angel investors and sophisticated institutions. This return of course comes with increased risks, and our regulatory framework exists to protect investors from the unnecessary risks of fraud, misconduct and negligence. For this reason, it automobiles to be driven at very high speeds, rendering the country a de facto test-track for its automobile industry. 46  IOSCO (2014), p. 8. 47  SFC (2014).

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will be necessary to find a proper balance in the regulation between opening up to beneficial financial activity and shutting out abusive behaviour. The following Parts III and IV will discuss how a number of jurisdictions have taken regulatory action to introduce crowdfunding into their financial systems, and evaluate on the basis of available data the success they have had in attracting capital from many small investors. 3

A Comparative View of Existing Crowdfunding Regulatory Regimes

3.1 Introduction As discussed above, the term “crowdfunding” is used to refer to a number of ways in which advances in communication technology allow dis-intermediated collectives of investors to interact with persons in need of capital. The basic activities to be achieved in this way have long been present; what is new is the facility with which collective action problems can be overcome through technology. If we examine the four types of crowdfunding that IOSCO sees as relevant,48 we find standard types of transactions framed in a more high tech context:

• Donation crowd-funding, which in the past was performed through infor-

mal networks, gatherings like dinners and balls, or even through televised appeals with a bank of phones to receive pledges; Reward crowd-funding, which in the past was also performed through informal networks, similarly to the gathering of donations; Peer-to-peer lending, which is essentially a disintermediated form of a classical cooperative arrangement where members seeking savings opportunities lend to other members in need of capital; Equity crowd-funding, which is essentially an offering of equity shares to a group of investors on analogy to an IPO, whether that be large enough to constitute a public offering or small enough to remain a private placement.

• • •

Equity crowdfunding, which is the main focus of this paper, allows ad hoc networks of investors and entrepreneurs to be assembled in a manner that, in the past, required either the kind of networks that have long existed between financial institutions or an organization like an exchange trading floor. It

48  IOSCO, supra note 46, pp. 8–9.

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therefore resembles the process of an IPO because it creates network externalities to allow aggregation of both funds and information to solve a collective action problem inherent in focusing small investments into a single enterprise. However, there are significant differences between the scale and purpose of an IPO and that of crowdfunding, and this leads to the regulatory choices that we discuss in this paper. Not only will the issuer not “list” its securities on the crowdfunding platform—so that there will be no secondary market for the shares—but neither the issuer nor the investor is prepared to bear the regulatory costs associated with a traditional public offering. For the purposes of the initiatives advocated in this paper, the aspect of equity crowdfunding that should be stressed is its need to reduce the regulatory rigor traditionally applied to public offerings of securities while inviting investment in high-risk enterprises. Crowdfunding brings a large collective of unsophisticated investors together to purchase securities offered by a small issuer that is unable to make a public offering requiring a full securities prospectus and perhaps the guidance of a regulated sponsor and a listing on a recognized stock exchange. Rephrased in an unflattering way, equity crowdfunding is a public offering of shares in a high-risk enterprise without standard regulatory protections. Seen in a more positive manner, equity crowdfunding allows retail investors to benefit from holdings in potentially high growth enterprises while making small investments that together allow young companies to grow and thrive, concomitantly supporting the economy. While individual exposure may be small, social benefits are great. The latter characterization highlights both the democratic aspect of the funding model (in that retail investors can benefit in ways often reserved to wealthy and sophisticated venture capital investors) and the likely limits on exposure (given the small shares that would arise from the participation of many investors in a small enterprise). Although the IOSCO characterizes the first two types of crowdfunding as “community” oriented and the second two as entailing “financial return,” we think that equity crowdfunding can also be understood as a community exercise: investors support and bet on the fortunes of an entrepreneur not far removed financially from themselves. Surely such communal support of job-generating businesses has greater social relevance than, say, betting a like amount in a day at the horse races. It would be highly peculiar for such betting to be supported through substantial, legal infrastructure in any jurisdiction, while crowdfunding remains prohibited. Perhaps this is why leading markets are providing regulatory frameworks in which equity crowdfunding, which previously would have only been possible through contacts with a venture capital firm or a private network of investors, can begin and develop.

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Crowdfunding has three major components: the issuer entrepreneur, the platform through which the issuer seeks to raise funds, and the investors who provide funding through this platform. The comparative discussion presented in this Part III is thus organized by addressing the regulation of each of these aspects in relevant jurisdictions. 3.2 Regulation of Platforms Crowdfunding is enabled through online platforms, on which start-ups pitch their ideas to attract investment. Regulators should ensure that investors are only invited to invest through a platform that is trustworthy. Thus, mandating the safe and orderly operation of such platforms is extremely important to crowdfunding. 3.2.1 United States In 2012, the US enacted specific legislation to help young start-ups raise capital, and one of these capital formation measures includes regulating crowdfunding.49 As its name and acronym suggest, the 2012 Jumpstart Our Business Startups (JOBS) Act was meant to change the regulatory framework to facilitate the access of start-up companies to corporate finance, thereby stimulating employment. As with all such laws, it is being implemented with detailed rules issued by the Securities and Exchange Commission (SEC). According to the SEC, the JOBS Act mainly intends to “reduce barriers to capital formation, particularly for smaller companies”.50 US securities laws require that before a company offers securities to the public, the securities must be registered with the SEC,51 through a registration process that is generally deemed thorough, but complicated and expensive, especially for small start-ups.52 The registration statement constitutes the bulk of a prospectus that is the primary document to be used in communicating with potential investors. Issuers can be exempted from registration if they do not use general solicitation to market the securities. Traditional routes to sell equity securities without the burden of registration have been private

49  Gerber (2012). 50  Sec.gov (2013). 51  See §5 US Securities Act of 1933. Under §5, all issuers of non-exempt securities must register their securities with the SEC, and issue a prospectus—which meets the requirements under §10 of the Securities Act—where necessary. 52  Lynn & Pinedo (2012).

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placements under Regulation D53 and offerings to qualified institutional buyers (so-called QIBs) under Rule 144A under the Securities Act.54 Title III of the JOBS Act created a new category of exemption from the registration requirement for crowdfunding. It allows offerings to ordinary investors—regardless of income—without registration and a prospectus, provided that the offering takes place through a licensed broker or funding portal, the amount raised during a 12 month period does not exceed $1 million, and no one person invests too large a portion of their annual income.55 Rules that the SEC proposed in 2013 were adopted in late 2015.56 Licensing of the platform will overlap with existing licensing of brokerdealers under the Securities Exchange Act of 1934. However, the Act contains specific requirements that portals educate investors regarding potential risks of the investment,57 and the SEC’s Rules set forth an extensive body of requirements for the registration of a funding portal,58 including prohibitions on offering investment advice or recommendations, directly or indirectly soliciting purchases or sales of the securities displayed on its portal, and managing or otherwise handling investor funds.59 The portal would have to “determine whether and under what terms to allow an issuer to offer and sell securities” following criteria “reasonably designed to highlight a broad selection of issuers offering securities . . . applied consistently . . . and . . . clearly displayed.”60 Portals will also have to be a member of the Financial Industry Regulatory Authority (FINRA, formerly the NASD), which is a self-regulatory organization under the Exchange Act and issues further regulations for such portals. These regulations would constitute part of the FINRA Funding Portal Rules, which 53  See 17 CFR §230.501 et seq. Title II of the JOBS Act allows “general solicitation or general advertising” to “accredited investors” under Reg D, §230.506(c). An “accredited investor” is an institution or a physical person with a net worth over $1 million or annual income exceeding $200,000. 54  See 17 CFR §230.144A. 55  See JOBS Act, §302(a), codified at 15 USC §77d. The restrictions on investment will be discussed in subsection III.C.1, below. 56  S EC Release Nos. 33-9974; 34-76324, “Crowdfunding,” 80 Federal Register 71388 (16 November 2015) (SEC Crowdfunding Rules), codified at 17 CFR Part 227. 57  See JOBS Act, §302(b), insertion of a new §4A into the Exchange Act and SEC Crowdfunding Rules, 17 CFR §227.302(b). 58  SEC Crowdfunding Rules, 17 CFR §§227.400–404. 59  17 CFR §227.402(a). 60  17 CFR §227.402(b).

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regulate the licensing of portals, their conduct, and ongoing monitoring for compliance.61 These rules will be separate from the current FINRA By-laws, but unless circumstances require otherwise, any funding portal members or people associated with funding portal members shall be subject to both the By-laws and the Funding Portal Rules.62 The membership requirements for portals in the proposed rules are based on those for broker-dealers, but are “simplified to reflect the limited nature of their business”.63 The conduct rules would require portals to behave in a manner reflecting “high standards of commercial honor and just and equitable principles of trade,” while refraining from engaging in activity constituting “any manipulative, deceptive or other fraudulent device”.64 Each portal would then have to establish an internal monitoring system to supervise the activities of each associated person of the funding portal member, so that they comply with SEC regulations and with the Funding Portal Rules.65 3.2.2 United Kingdom The UK Conduct of Business Sourcebook (COBS) requires that equity crowdfunding platforms meet requirements for “suitability” and “appropriateness.” These standards have been achieved through collaboration between the UK Financial Conduct Authority (FCA) and the UK Crowdfunding Association (UKCFA), a private association. The UKCFA was founded by 14 UK crowdfunding businesses in 2012 and has published a binding Code of Practice designed to protect investors by increasing transparency and ensuring ­honesty.66 However, membership in the UKCFA is not mandatory for crowdfunding platforms, even if most platforms do join the UKCFA to enhance their reputation by showing investors that they are part of an organization that aims to protect consumers and promote the growth of crowdfunding.67 The FCA regulates equity crowdfunding platforms by requiring all platforms that deal with transactions involving the sale of securities to be authorized and licensed by the FCA. The licensing requirements are set forth in Sections 19 (for platforms dealing with regulated activities) and 21 (for platforms dealing with 61  FINRA (2013). 62  Ibid., Background & Discussion. 63  Ibid., also see proposed Funding Portal Rule 110 at Finra.org (2013). 64  See proposed Funding Portal Rule 110, Ibid. 65  See proposed Funding Portal Rule 300, Ibid. 66  Ukcfa.org.uk (2014). 67  Ibid.

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“financial promotions”—essentially investment activities) of the Financial Services and Markets Act (FSMA) of 2000.68 However, platforms engaging in both of the aforementioned activities may qualify for exemptions from licensing under the FSMA (Financial Promotion) Order 2005 (FPO).69 There are over 65 such exemptions, which include the scenario that the financial promotion is made to only one investor or a small group of investors and the promotion is tailored for these recipients,70 and that in which all investors are certified high net worth individuals or sophisticated investors.71 Many equity crowdfunding platforms were “structured using a combination of exclusions and exemptions from the regulated activities regime” because the FCA had not yet taken action on their regulation, but this has become increasingly unnecessary in the wake of the FCA recognizing crowdfunding as a legitimate way to raise capital and thus amending rules that specifically deal with this activity.72 The “suitability” and “appropriateness” requirements are designed to be flexible. 3.2.3 Singapore In February of 2015, the Monetary Authority of Singapore (MAS) published a consultation paper in which it expresses the opinion that crowdfunding would be an “offer of securities” regulated pursuant to the Securities and Futures Act (SFA).73 Platforms that are deemed to be facilitating any securities offerings may be subject to licensing requirements under the SFA and would be monitored by the MAS.74 The framework proposed in the consultation paper is that any platform on which crowdfunding takes place would have to be licensed for “facilitating offers of securities to investors,” and perhaps for other activities, depending on its business model.75 In light of the differences in risk profiles between a platform and a broker-dealer, the MAS proposal would “lower the base capital requirement and remove the security deposit requirement for intermediaries.”76 The MAS proposes to do this by lowering the minimum 68  Fca.org.uk (2014a). 69  Mutimer (2013). 70  See Article 28 FPO legislation.gov.uk (2005). 71  See Article 48 and 50 FPO at ibid. 72  Osborneclarke.com (2014). 73  Hawksford Singapore Pte Ltd (n.d.) 74  Insightlegalasia.com (n.d.). 75  MAS (2015), p. 7. 76  Ibid.

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base capital requirement for such intermediary crowdfunding platforms from S$250000 to S$50000 and to remove the S$100000 lodgement normally posted to protect damaged investors.77 International crowdfunding platforms have set up branches in Singapore. An example is Swedish-based FundedByMe, which offers all forms of crowdfunding for the companies listed on its platform, depending on the company’s place of incorporation and operations.78 For this reason, equity crowdfunding has been offered in Singapore only for European-based start-ups.79 The fact that FundedByMe chose Singapore for its Asian hub indicates a certain optimism that the jurisdiction will soon facilitate crowdfunding through express regulation or derogating tolerance. 3.2.4 China Shenzhen, whose 2014 economic output overtook Hong Kong’s,80 was also in 2014 named China’s most competitive business environment by the Chinese Academy of Social Sciences, largely because of its climate of stimulating innovation through start-up companies.81 China is in the process of adapting its legal and regulatory framework to equity crowdfunding,82 and concrete measures can be expected. In fact, in July 2015 the People’s Bank of China issued guidelines targeting Internet financing. One such guideline is that the China Securities Regulatory Commission (CSRC) will regulate equity ­crowdfunding.83 Despite this, Chinese equity crowdfunding platforms currently operate either as private placements to qualified investors or in the shadows of financial ­regulation. Popular crowdfunding platforms like DemoHour and Dreamore are mostly rewards-based, and equity crowdfunding platforms like SeedAsia are rare.84 With 600 million Internet users, China has the world’s largest online population. When regulations catch up with the rising crowdfunding

77  Ibid., p. 8. 78  Fundedbyme.com (2015). 79  Ibid. 80  BloombergBusiness (2015). 81  Chang (2015). 82  In July 2015 the People’s Bank of China issued guidelines assigning responsibility for a number of newer financing techniques to the various overseers of the financial sector. The China Securities Regulatory Commission will regulate equity crowdfunding. See Yoshimura (2015). 83  Chen Jia (2015). 84  Lin (2014).

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trend, start-up firms will be able to benefit from the potentially enormous dimensions of China’s investment pool. If even 1% of these 600 million people were to invest in the Chinese economy through properly regulated equity crowdfunding platforms, they could inject hitherto unseen amounts of capital into innovative ventures that will aid China’s technological competitiveness and labour market. 3.2.5 Conclusions The jurisdictions compared above display four different states of regulatory treatment of equity crowdfunding platforms. Legislation in the US has created a clear regulatory framework for crowdfunding, with a 200 page implementing regulation that specifies exact requirements for licensing and operation of the platform, and a duty to submit to the regulation of a self-regulatory organization, FINRA. The UK has addressed crowdfunding with a typically lighter touch, using existing law, with regulatory monitoring and governance through a trade association code of conduct. Singapore has proposed a model in which the platform will be licensed like a securities dealer and is relying on existing exemptions for sophisticated investors. China has mapped out the future jurisdiction over new financial techniques, and we can expect future rules or guidelines from the CSRC. 3.3 Regulation of Issuers The issuers of securities and in particular their public offerings of shares are at the centre of the traditional regulatory scheme for public offerings, which demands registration of the securities with the regulator or the creation and publication of a prospectus disclosing facts about the issuer and the issue, or both registration and publication. It is specifically this aspect of the ­regulatory framework that should be lightened in order to allow crowdfunding to serve start-ups as an alternative to formal public offerings. However, given the heightened risk of failure in young enterprises, regulators must attempt to achieve a delicate balance between facilitating the crowdfunding activity and subjecting retail investors to the twin dangers of overly risky investments and securities fraud. 3.3.1 United States The JOBS Act introduced an exemption to the registration requirement for public offerings,85 so that crowdfunding issuers can offer securities through general solicitation without full SEC registration. Instead, issuers must—under 85  JOBS Act, §302.

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the new regulations—file with the SEC and provide investors with information regarding the company, its management and business model, p ­ articular risks that the investment presents, the amount of the offering and the purpose for fundraising, and a description of the financial condition of the issuer, among other things.86 In October 2013 FINRA proposed rules for funding portals with a view to effectively implement the JOBS Act, and these would also require equity crowdfunding platforms to pre-screen issuers for robust organization and a reasonable belief of the absence of fraud.87 The Rules also make sure that such platforms implement anti-money laundering programs, and subject the platforms to investigations and sanctions by the FINRA.88 These new rules thus ensure that it is in the best interests of the platform to maintain its own integrity, and to ensure its business is conducted honestly. Through these proposals, issuers are regulated by the platforms, and not directly by FINRA. Thus it appears—at least on the basis of the regulatory proposal—that the US is willing to accept a somewhat lightened prospectus requirement partly in exchange for a reasonable degree of screening of issuers by the platform. Although the burden of screening seems to fall squarely on the platform, any issuer attempting to raise funds through a crowdfunding platform should try to provide all potential investors with the kind of information they would expect before making an investment decision, as doing so would enhance their reputation. 3.3.2 United Kingdom The FCA has not introduced any exemptions to the prospectus and disclosure rules for equity crowdfunding, and expects full compliance from both offerors and platforms (FCA (2014) p. 40). However, the FCA points out that existing exemptions may be fully exploited in the context of crowdfunding. An example is where the total of “offers fall below the 5 million Euro limit, they may be exempt from the need for a prospectus under the Prospectus Directive.” (FCA (2014) p. 41, note 5).

86  17 CFR §227.201. 87  See proposed Funding Portal Rule 300(b) at Finra.org, supra note 66. FINRA filed a notice of amendment and immediate effectiveness of this rule in October 2015. See SEC Release No. 34-76238: Self-Regulatory Organizations; Financial Industry Regulatory Authority, Inc.; Notice of Filing and Immediate Effectiveness of a Proposed Rule To Establish Fees for Funding Portals, 80 Federal Register 66342 (28 October 2015). 88  See proposed Funding Portal Rule 800(a), Ibid.

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3.3.3 Singapore In its 2015 Consultation, the MAS points out that a prospectus would be ­necessary if a crowdfunding opportunity were offered to the public, and for these reason the MAS proposes that such offers beyond a limited circle of sophisticated investors be prohibited within the facilitated ambit of crowdfunding.89 Beyond that, the MAS makes no special provision for issuers in its proposed rules. 3.3.4 China As in other jurisdictions, China makes a distinction between an issuer’s offering of securities that is public and one that is non-public.90 As such, it is conceivable that a crowdfunding offering structure like that proposed in Singapore, which is also available in the US as a private offering, would be possible in China. A platform that has raised capital in China, SeedAsia, pre-screens issuers before they are then introduced to accredited investors. The start-ups that are featured “would have ideally gone through some sort of incubation program and would have shown promise”.91 Because SeedAsia implements a filtering system for candidates of start-ups and investors who want to be featured on their platform, co-founder Tom Russell has said that SeedAsia is “kind of a hybrid between Kickstarter and private investment”.92 The current situation in China thus resembles a private of QIB offering in the US. 3.3.5 Conclusions In the US, issuers are pre-screened to some extent by the platform that decides to facilitate the purchase of that issuer’s shares. As things currently stand in the UK, Singapore and China, only the type or size of offering made by the issuer and the possibility of a private offering to qualified investors are expressly dealt with by law or proposed regulation to create prospectus free offerings in crowdfunding. 3.4 Regulation of Crowdfunding Investors Securities laws sometimes regulate investors as opposed to issuers or intermediaries, but this is unusual and reverses the normal regulatory arrangement focusing on the person undertaking the regulated act (here an offering 89  MAS, supra note 75, p. 9. 90  Law of the People’s Republic of China on Securities (2005), Articles 10, 13. 91  Ho (2013). 92  Ibid.

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of ­securities) rather than the addressee of that act. This occurs, for example, when prospectus requirements are waived if securities are offered only to sophisticated investors, or when hedge funds are not subjected to full investment fund regulation because they only offer their products to wealthy individuals or institutions. In such circumstances, it is deemed that the investors can protect themselves, so that the government need not act on their behalf. Crowdfunding presents a different situation. If a jurisdiction agrees to allow open-ended crowdfunding with light regulation of issuers and offerings, then it exposes ordinary investors (a group that might also be referred to as “consumers”) to financial risk. In other areas where consumers are given access to potentially dangerous products and services, such as the consumption of alcoholic beverages or participation in betting on sports, age requirements are introduced. In the financial services area, special warnings are also used, such as when derivative instruments are sold to ordinary investors in some jurisdictions. Similar protections can be introduced in a regulatory regime for crowdfunding so that ordinary investors can be allowed open access to crowdfunding investments while also receiving protection against serious financial risk. 3.4.1 United States The JOBS Act introduces tight controls on the permitted financial exposure of investors. It provides that: the aggregate amount sold to any investor by an issuer’ during a given 12-month period may not exceed: (i) the greater of US$2000 or 5% of the investor’s annual income or net worth (for investors with income or the net worth less than US$100000), or (ii) 10% of the investor’s annual income or net worth, and in no case more than US$100,000 (for investors with income or net worth exceeding US$100000).93 The SEC appears to propose enforcing this requirement simply by passing the requirement of the law on to the intermediary, so that if the intermediary is found to have accepted investors who violate the limit, the crowdfunding would lose its exempted status,94 triggering various violations of law for both the intermediary and the issuer. 93  JOBS Act §302, to be codified at 15 USC §77d. 94  17 CFR §227.100(a)(2).

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3.4.2 United Kingdom The FCA only allows offers of unlisted securities to investors who meet one of a number of different criteria. These are that the investor is a “professional client,” or a retail client who confirms that s/he is investing with professional advice, is a venture capital or corporate financial professional, is a certified or self-certified “sophisticated investor” or “high net worth investor,” or certifies that s/he “will not invest more than 10% of their net investible financial assets” in the unlisted securities.95 The UKCFA focuses on the “sophisticated investor” criterion, and allows anyone who sufficiently understands the risks of equity crowdfunding to engage in it. To enforce the requirement of investors understanding the risks, member platforms require a potential investor to complete a questionnaire that assesses whether s/he fully understands the risks of investing in start-ups.96 Depending on the results of the questionnaire, the investor will be classified as sophisticated or ordinary on the platform. An ordinary investor would have to meet another of the FCA criteria listed above. 3.4.3 Singapore The 2015 MAS consultation paper proposes that equity crowdfunding offers be made only to accredited investors and institutional investors,97 that is, to those falling within private offering exemptions already contained in Part XIII of their Securities and Futures Act. 3.4.4 China As explained above, we are now waiting for issue of the Chinese rules on crowdfunding, but its securities law does contain the possibility of a private offering exemption similar to that found in Singapore. In practice, platforms engaging in crowdfunding without official endorsement have allowed only accredited investors to participate in equity crowdfunding. For example, potential investors through SeedAsia need to apply to the platform to be screened, establishing that they have the financial capability to adhere to SeedAsia’s minimum investment of USD$2,000 per investor.98 As is the case in the US, one simply needs to prove financial capability in order to be an equity investor through crowdfunding in China, and experience is not determinative.

95  F CA (2014), pp. 35–36. Codified in the UK COBS, 4.7.7. 96  Seedrs.com (2014a); Fca.org.uk (2014b). 97  MAS, supra note 75, pp. 9–10. 98  Ho, supra note 91.

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3.4.5 Conclusions Each jurisdiction examined limits investors’ access to crowdfunding. Singapore uses the “professional investor” category to exclude investors without the required experience and financial standing. The UK also uses various investor screening mechanisms, including self-certifications of sophistication or professional skills. The US approach overlaps with that of the UK and resembles consumer protection used in other areas: an investor’s net worth together with a proportion of exposure, will determine his or her ability to invest in a crowdfunded offer, and the size of such investment. It is likely that China’s CSRC is watching each of these jurisdictions—and Hong Kong—in formulating its own investor restrictions for crowdfunding. 4

A Comparative View of Crowdfunding Benefits

4.1 United States Examining the benefits of adopting equity crowdfunding is a large part of understanding why Hong Kong should take concrete steps to facilitate equity crowdfunding through reasonable regulation. In the US, evidence already exists that initial equity crowdfunding activity supports small businesses, boosts job creation, and encourages innovation. Crowdfund Capital Advisors (CCA) released a report in January 2014 with findings that companies experienced a 351% quarter-to-quarter increase in positive cash flow from successful equity crowdfunding campaigns.99 Additionally, 48% of the companies polled said they intended to use the crowdfunding proceeds to hire new staff, and 39% of the responders did hire an ­average of 2.2 new employees with the capital raised from crowdfunding.100 These benefits were realized even before the full approval of equity crowdfunding—as mentioned previously, currently such fund raising is restricted to accredited investors (i.e., institutions and high net worth individuals). Once equity crowdfunding becomes an established part of the financial system, it could be expected to focus a significant amount of the society’s savings on innovative start-ups. 4.2 United Kingdom The true impact of early crowdfunding activity in the UK may be difficult to gauge because in April 2012 the UK government also launched the Seed Enterprise Investment Scheme (SEIS), offering up to 50% individual income 99  Crowdfundcapitaladvisors.com (2014). 100  Ibid.

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tax relief, up to 28% capital gains tax relief, and capital gains tax re-investment relief to investors who provide capital to eligible start-up companies, most of which are offered through crowdfunding platforms.101 This strong incentive to utilize the new platforms may have led to an early jump in platform use that could recede if the tax incentives are later removed. The Crowdfunding Centre has reported that crowdfunding injected over £9 million into UK ­start-up companies during the brief period between January and March 2014.102 Breakdowns of this figure are that rewards-based crowdfunding raised £4.3 million, while equity-based crowdfunding raised more than £5 million during the same period. 4.3 Singapore The Singaporean government has begun to recognize the economic potential of equity crowdfunding. In a Budget Speech in February 2014, equity crowdfunding was described as “an alternative source of financing for start-ups and small companies”.103 However, as crowdfunding has not yet been regularized in Singapore, it is understandable that there are no statistics on its impact. Despite having no formalized position under law, Singapore projects have reported successfully raising capital through US-based rewards crowdfunding platforms, such as:

• Project Silverline, which provides senior citizens with second-hand smartphones with healthcare and personal safety apps, and raised USD$54000 on Indiegogo; and Bamboobee, a business venture to produce handcrafted bamboo-made bicycles, which raised a total of USD$63,879 on Kickstarter.

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4.4 China As in Singapore, because regulation or supervision have not been provided for crowdfunding yet, no studies or reports have to date measured the economic impact of the activity undertaken in the shadows, distinguishing growth from that funded through traditional venture capital channels. However, it has been reported that rewards-based crowdfunding platforms in China have already shown promise:

101  Seis.co.uk (2015); Crowdcube.com (2015b); Seedrs.com (2014b). 102  Alois (2014). 103  Singaporebudget.gov.sg (2014). See §C.38 of the Budget Speech.

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• DemoHour, founded in 2011, has helped more than 2,000 projects raise

funds from small contributors, with each contributor donating an average of 300 yuan; and Dreamore, founded in September 2011, has raised more than six million yuan for over 300 projects.

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These crowdfunding platforms have also encouraged technological innovation by successfully funding projects that benefit that sector. DemoHour, for example, focuses on innovative household gadgets, and has supported an ecologically friendly blue-tooth sound box made from bamboo, an anti-pollution air control system for cars, and a sensor cup that records the user’s daily water intake.104 This last project, referred to as “Cuptime”, has been one of the most successful projects on DemoHour, receiving 1.35 million yuan from over 2,600 contributors in a month.105 Such projects highlight the potential of crowdfunding to boost China’s technological innovation and economic growth. A 2013 study commissioned by a World Bank project predicts that the Chinese market for crowdfunding investments could reach a staggering USD$50 billion annually by 2025.106 4.5 Similar Benefits for Hong Kong? Regulating equity crowdfunding is the only way a market can fully and safely reap its benefits. As we explained in Part I, a lack of funds is nearly as challenging to Hong Kong start-up companies as finding the central business concept on which to base the company. As such, there can be little doubt that additional sources of funding for start-up enterprises would bring significant benefit. Sound regulation will bring safety and legal stability, encouraging more and more savers to join the “crowd”. A good regulatory framework would also be highly complementary to the aims of existing projects, like Cyberport and the Science and Technology Park. Both facilities were designed to form part of the Hong Kong ecosystem for start-ups, but since there are so few technology start-ups, this domestic ecosystem—consisting mainly of those two facilities and NEST, a start-up incubator—has not yet been effectively used. Equity crowdfunding can significantly broaden this ecosystem by bringing more investors to start-ups and more investment opportunities to savers, while

104  Sun (2014). 105  Ibid. 106  Information for Development Program/The World Bank (2013).

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serving to create companies that fully utilize Cyberport and the Science and Technology Park, thus reinvigorating these facilities while creating new jobs. In this new field, if Hong Kong were to develop a regulatory framework of notably high quality, it could aspire to supplement its current status as a leading international financial centre with that of Asia’s hub for dynamic start-up capital, a title which it may have to wrest from Shenzhen.107 If this framework were to incorporate the recommendation expressed in Part V, requiring start-ups to be formed under Hong Kong company law, crowdfunding could also serve to showcase the fact that the level of transparency achieved in its company law far exceeds international standards. Currently, Hong Kong could still snatch first-starter advantage from other Asian jurisdictions. This may allow Hong Kong both to set standards and dictate the terms of play in this new and dynamic sector. In conclusion, there are many benefits to be gained from regulating equity crowdfunding in Hong Kong. These benefits have been seen and proven in the US and the UK. Equity crowdfunding, despite being a new phenomenon in Asia, has already been viewed favourably as an important new avenue to increase investment. In Part V, we propose adjustments to the Hong Kong regulatory framework to facilitate equity crowdfunding. 5

Proposed Regulation of Crowdfunding in Hong Kong

5.1 Regulatory Alternatives in Light of the Existing Framework Hong’s Kong’s existing legal and regulatory framework does not specifically address any form of crowdfunding. As mentioned in Part II, the SFC is monitoring the advance of this new form of financing, and in May 2014 issued a notice warning that absent proper licensing and compliance with possibly overlapping regulations, crowdfunding may run afoul of existing investor protection and market supervision provisions.108 In light of the significant advantages crowdfunding can offer and the limited risks it presents, we propose in following some relatively simple adjustments to how the regulatory framework should be interpreted and applied in order to accommodate equity crowdfunding. The SFC has pointed out that equity crowdfunding transactions could cause friction with the existing regulations in two respects: the offerings of securities do not attempt to comply with full protections required for offerings of shares 107  See BloombergBusiness (2015); Chang (2015). 108  S FC (2014a), p. 2.

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to the public, and the platforms themselves do not attempt to achieve the status of registered exchanges.109 We propose that the SFC provide official interpretations and make adjustments with regard to these activities. This would allow crowdfunding to develop in a safe and supervised environment, and given the special properties of Hong Kong company law, would not reduce the protection offered investors. The adjustments would include an exemption from the prospectus requirement, a classification of crowdfunding platforms as type 6 regulated activity, automated trading services, and a cap on the amount that investors could place on any given issuer through crowdfunding. With these changes, we are confident that the crowdfunding model could flourish safely. 5.2 Recommended Adjustments to Regulate Crowdfunding 5.2.1 Offerings of Securities The core activity of equity crowdfunding is to facilitate offers to the public to purchases shares issued by a start-up company and investors’ acceptance of such offers. Offers of securities to the public are subject to prospectus and registration requirements expressed in the Companies (Winding Up and Miscellaneous Provisions) Ordinance (CWUMPO) and the Securities and Futures Ordinance (SFO). Pursuant to s. 38D CWUMPO any document used to offer shares of a company to the public is deemed a prospectus and must contain prescribed content and be registered with the SFC. Pursuant to s. 103(1) SFO any offering of securities to the public must be approved by the SFC. The content of the required prospectus is set forth in the third schedule of the CWUMPO. This base requirement is subject to a number of exemptions. The exemption most pertinent here is that s. 38A(2) CWUMPO expressly provides the SFC with power to create and publish general exemptions “for any class of prospectuses issued by companies”.110 The SFC has already done so with respect to a number of types of prospectuses, and of particular interest here is that one of these exemptions frees young companies listed on the Growth Enterprise Market (GEM) from reporting a multi-year economic track record and producing a number of otherwise required reports.111 We propose that a like exemption be formulated for crowdfunding. The exemption should 109  Ibid. 110  The SFC is expressly given power to determine the set of requirements from which it may create an exemption. See CWUMPO ss. 38A(3), (4) and (5). 111  See Companies (Exemption of Companies and Prospectuses from Compliance with Provisions) Notice, CAP 32L, s. 5.

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only apply to prospectuses used by companies formed under the Hong Kong Companies Ordinance in offerings made on a licensed crowdfunding platform, and be conditioned upon the company providing potential investors with all reports and statements it would have to provide members at an annual general meeting. If the exemption under s. 38A(2) CWUMPO is met, the offering would also be covered by the exemption provided in s. 103(3) SFO.112 In most jurisdictions, the switch from disclosure through formal prospectus to disclosure of the type provided by unlisted companies at an ordinary meeting would bring a dramatic decrease in transparency. This is not the case in Hong Kong, which has one of the world’s most extensive set of disclosure requirements for public companies that are unlisted. At every annual general meeting, a public company formed under Hong Kong law must issue to its shareholders:

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Audited financial statements meeting Hong Kong accounting standards;113 A directors report setting forth114 – The company’s principal activities during the financial year, – Principal risks and uncertainties facing the company, – Important events that have affected the company in the past year, – An indication of the company’s future development, – An analysis of the key performance indicators, – Key relationships with employees, customers and suppliers, – Information on arrangements enabling a director to acquire shares, – Directors’ direct and indirect interests under significant transactions entered into by the company, – Shares issued and equity-linked agreements entered into by the company, – Reasons for any resignation of a director, and – A permitted provision indemnifying a director. An auditor’s report, which is expressly subject to criminal sanction for express misstatement.115

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112  The exemption is that the prospectus requirement of s. 103(1) “does not apply to the issue [. . .] of a prospectus which complies with or is exempt from compliance with Part II of the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap. 32)”. See SFO s. 103(3)(a)(i). 113  See Companies Ordinance (CO), CAP 622, s. 380, Sch 4. 114  These requirements are set out in CO ss. 388, 390 and Sch 5, as well as in the Companies (Directors’ Report) Regulation, CAP 622D. 115  See CO s. 408.

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An exemption from issuing a prospectus in connection with a crowdfunded offering would thus neither increase the regulatory burden of a public company (which must produce the required reports in any case) nor materially reduce the significant information made available to investors. It would take advantage of the exceptional disclosure requirements of Hong Kong company law, creating a simple avenue to crowdfunding with low transaction costs and low risk. As the exemption would only be available for companies formed under Hong Kong law, it would discourage the costly and opaque round-trip organizational forms (incorporation in the Cayman Islands or Bermuda for a company that has operations in mainland China and seeks to raise capital in Hong Kong) that now characterizes about 75% of the companies listed on the SEHK. 5.2.2 Platform for Automated Trading Services The second component of the regulatory framework would be the licensing of the platform through which equity crowdfunding activities would be conducted. While a crowdfunding platform would not aspire to the status of a “stock market”,116 it would perform a similar activity on a smaller scale, particularly is a secondary market is contemplated. The SFO provides for such small-scale matching venues in the form of “automated trading services” (自動化交易服務), which are defined as the use of “electronic facilities” employing “established methods” to make offers to sell or purchase, or introduce buyers and sellers, regularly leading to binding transactions in securities.117 A crowdfunding platform would unquestionably introduce buyers and sellers, regularly leading to binding transactions in securities. As such, crowdfunding platforms would be a type of entity to be licensed for the activity of providing “automated trading services” under Part V of the SFO,118 as further articulated by the SFC’s Guidelines for the Regulation of Automated Trading Services (ATS Guidelines). 116  See SFO Sch 1, Pt 1, definition of “stock market” (證券市場), which is either a venue where people meet or facilities that bring orders together “to negotiate sales and purchases of securities (including prices)” specifically excluding the offices of exchange participants or recognised clearing houses. 117  See SFO Sch 5, Pt 2. 118  Under the SFO, the SFC authorizes ATS activity in two different ways, depending upon whether it is performed by an entity otherwise engaged in a “regulated activity”, such as dealing in securities or futures contracts. Platforms the are so engaged must seek “­licensing” or “registration” from the SFC under Part V of the SFO, while other entities— which are mostly links with foreign stock exchanges—will be authorised under a more open-ended process specified in Part III SFO. For a more detailed discussion of the authorization process, see Donald (2012) pp. 64–9. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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The type of requirements necessary for licensing generally derive from ss. 114–116 SFO, as fleshed out by the ATS Guidelines and the various other SFC Guidelines,119 in particular new rules on electronic trading systems120 and alternative liquidity pools (ALPs),121 which the SFC uses as a synonym for an ATS provider. Regulatory requirements go to having specified financial resources and risk management policies, adequate operational facilities ensuring secure provision of the regulated service, the characteristic of being a “fit and proper” person, which is a general rule including both skill and moral standing, and applies to the entity and to its management.122 For ongoing operations, the ATS platform must keep full records and audit trails of its activity, provide users with adequate transparency of its operations, and participate in ongoing surveillance of its ATS operations in a manner consistent with Hong Kong and international market practices.123 The SFC licensing requirements are clearly set out in standardised detail that should not present surprises to a crowdfunding platform, and for various regulated activities, approximately 38,000 firms were licensed under them at the close of 2013.124 For ATS platforms licensed to provide crowdfunding, we propose that two requirements, as discussed immediately below, be added through supplementation of amendment of SFC guidelines. First, the platform should be held to receive a declaration from each investor in connection with each crowdfunding that he or she understands the risks of the offering, has read the materials published by the issuer, and will not invest more than 10% of his or her annual income (including all such investments made during the preceding 12 months) in the offering (the 10% threshold could also be adjusted to apply to total assets, particularly for retired or unemployed persons). Second, the platform should be held to provide materials, and if possible, workshops on investor and financial education. 5.2.3 Capping the Risk Exposure of Investors To allow crowdfunding to function effectively and safely, Hong Kong should not only place requirements on the offerings of securities and the platforms, but also on crowdfunding investors. This is necessary because certain other

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protections available for public offerings and on a recognised stock exchange are being waived. Under the US model, two numerical and percentage limits are set depending on whether the investor’s income is more or less than US$100000 (about HK$800000). Further, the SEC appears to be drawing this legal limit as a bright line for eligibility of crowdfunding, and leaving it to the platforms to see it is observed. As an alternative, we propose that a single quantum limit of 10% of an investor’s annual income (or total assets, for investors without a regular income) be used, that the investor be personally responsible for ascertaining compliance, and that the platform be held to collect and archive a declaration on this fact from each investor as an ongoing condition of licensing. The primary weakness of this proposal is that investors could make false declarations, engage in bad investments, and go bankrupt—damaging themselves and the community. However, the threat of such damage to investors would encourage platforms to adequately vet the accuracy of investor declarations, such as by asking the investors to provide copies of their annual tax returns or monthly pay statements at the time of subscription. It would be highly problematic for the SFC to demand disclosure of such private data from ordinary investors, but if the platform needs this information in order for the investor to enter into a contact, the investor would both have an incentive to comply and be free to seek out an alternative platform so that any disclosure of private date would be completely voluntary. If the investor desired to invest more than 10% of annual income or assets in a given company, there would be nothing preventing the investor from contacting the company directly. 5.2.4 Conclusions The above proposals and suggestions are not intended to be a definitive statement, but rather starting points from which discussion of a Hong Kong framework for equity crowdfunding can begin. We have seen that corporate finance of the type provided by crowdfunding is necessary, and would be highly beneficial to the Hong Kong economy. We have also seen that major financial centres have introduced frameworks for crowdfunding. Singapore’s approach is minimal, with little or no distinction between crowdfunding and the existing exemption for offers to professional investors. China has not yet acted definitely, although it has declared a clear intention to do so. With relatively minimal action under the current regulatory regime, Hong Kong could gain a first-starter advantage in this very important new area of corporate finance with a robust regime for genuine crowdfunding activity while strengthening its own economy for start-up businesses.

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Summary of the Regulatory Proposals

1.

Crowdfunding should be restricted to issuers organized under the company law of Hong Kong. 2. The SFC should issue a class exemption from the prospectus requirement for Hong Kong companies that offer shares to the public through a licensed crowdfunding platform, provided that they publish the annual disclosures required under the Companies Ordinance for an AGM. 3. A condition for licensing a crowdfunding platform should be that the platform receive declarations from each investor that he or she will not invest more than 10% of annual personal income on the equity offering in questions, including any crowdfunding investments made in the preceding 12 months. References Alois, J. D. (2014) “Report: Crowdfunding Boosts UK Economy over £9 Million in Past Three Months,” http://www.crowdfundinsider.com/2014/04/35236-report-crowdfunding-boosts-uk-economy-9-million-past-three-months/ (accessed 29 April 2015). Au, Kevin, & Steven White (2014) “Hong Kong’s Venture Capital System and the Commercialization of New Technology,” http://www.savantas.org/wp-content/ uploads/2014/06/5-Au-White.pdf (accessed 29 April 2015). BloombergBusiness (2015) “The Little Village That Could: Shenzhen Set to Surpass Hong Kong,” http://www.bloomberg.com/news/articles/2015-05-11/the-little-­ village-that-could-shenzhen-set-to-surpass-hong-kong (accessed 20 May 2015). Center for Entrepreneurship (2009) “Global Entrepreneurship Monitor Hong Kong & Shenzhen 2009,” http://entrepreneurship.bschool.cuhk.edu.hk/sites/default/files/ project/global-entrepreneurship-monitor-hong-kong-and-shenzhen-2009/gem 2009reporteng.pdf (accessed 29 April 2015). Chang, Gordon G. (2015) “Move Over, Hong Kong, Shenzhen Now China’s Best City For Business,” Forbes, http://www.forbes.com/sites/gordonchang/2015/05/17/move-overhong-kong-shenzhen-now-chinas-best-city-for-busines/ (accessed 20 May 2015). Crowdcube.com (2015a) “Investing Just Got Excited,” https://www.crowdcube.com/pg/ investing-your-money-1513 (accessed 29 April 2015). ——— (2015b) “The Seed Enterprise Investment Scheme (SEIS),” https://www.crowd cube.com/pg/seis-tax-relief-42 (accessed 29 April 2015). Crowdfundcapitaladvisors.com (2014) “How Does Crowdfunding Impact Job Creation, Company Revenue and Professional Investor Interest?” (accessed 29 April 2015).

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Digital 21 Strategy (2015) “Digital 21 Strategy,” http://www.digital21.gov.hk/eng/ (accessed 29 April 2015). Donald, David C. (2012) The Hong Kong Stock and Futures Exchanges: Law and Microstructure, Hong Kong: Sweet & Maxwell. ——— (2014) A Financial Centre for Two Empires: Hong Kong’s Corporate, Securities and Tax Laws in its Transition from Britain to China, Cambridge: Cambridge University Press. Fca.org.uk (2014a) “Do I Need to Be Authorised?,” http://www.fca.org.uk/firms/aboutauthorisation/do-i-need-to-be-authorised (accessed 29 April 2015). ——— (2014b) “Crowdfunding,” http://www.fca.org.uk/consumers/financial-servicesproducts/investments/types-of-investment/crowdfunding (accessed 29 April 2015). Finra.org (2013) “Regulatory Notice 13–14: Jumpstart Our Business Startups (JOBS) Act—FINRA Requests Comment on Proposed Funding Portal Rules and Related Forms,” https://www.finra.org/web/groups/industry/@ip/@reg/@notice/docu ments/notices/p370743.pdf (accessed 29 April 2015). ——— (2015) “Testimony to the House Subcommittee on Capital Markets and Government Sponsored Enterprises Committee on Financial Services” on 1 May 2015, by FINRA CEO Richard G. Ketchum, available at http://www.finra.org/news room/speeches/050115-testimony-subcommittee-capital-markets-andgovernment-sponsored-enterprises (accessed on 19 May 2015). Fundedbyme.com (2015) “What Countries Does FundedByMe Operate in?,” https://www .fundedbyme.com/en/what-is-fundedbyme/#countries (accessed 29 April 2015). Fundersandfounders.com (2013), “How Funding Works—Infographic,” http://funder sandfounders.com/wp-content/uploads/2013/05/how-funding-works-infographic .png (accessed 29 April 2015). Gerber, Scott (2012) “The JOBS Act Signing: A Giant Step for Entrepreneurship in America,” http://business.time.com/2012/04/06/the-jobs-act-signing-a-giant-stepfor-entrepreneurship-in-america/print/ (accessed 29 April 2015). Global Financial Centres Index (2015) http://www.zyen.com/research/gfci.html (accessed 29 April 2015). Hawksford Singapore Pte Ltd (n.d.) “Crowdfunding and Singapore Startups,” http:// www.guidemesingapore.com/doing-business/finances/crowdfunding-singaporestartups (accessed 29 April 2015). heritage.org (2015), “Index of Economic Freedom,” http://www.heritage.org/index/ (accessed 29 April 2015). Ho, Victoria (2013) “China’s SeedAsia Opens For Business, An Online Equity Crowdfunding Platform For Startups Across Asia,” http://techcrunch.com/2013/05/14/equitycrowd-funding-site-seedasia-launches/ (accessed 22 March 2015). Hong Kong Business Angel Network (2015) “Statistics,” http://hkban.org/page/statis tics (accessed 29 April 2015).

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Hong Kong Census and Statistics Department (2014) Hong Kong Annual Digest of Statistics, Hong Kong: Hong Kong Census and Statistics Department. Hong Kong Companies Registry (2014) “Statistics—Number of Local Companies Incorporated,” http://www.cr.gov.hk/en/statistics/statistics_02_a.htm (accessed 29 April 2015). Hong Kong Federation of Youth Groups (2015) “Microfinance Scheme,” http://ybhk .hkfyg.org.hk/page.aspx?corpname=ybhk&i=4949 (accessed 29 April 2015). Hong Kong Mortgage Corporation (2015a) “Hong Kong Mortgage Corporation,” http:// www.hkmc.com.hk/eng/ops/ourbusiness/sme.html (accessed 29 April 2015). ——— (2015b) “The Hong Kong Mortgage Corporation Limited SME Financing Guarantee Scheme,” http://www.hkmc.com.hk/sites/default/files/eng/ops/publica tion/sfgs_statistics_eng.pdf (accessed 29 April 2015). ——— (2015c) “Microfinance Scheme,” http://www.hkmc.com.hk/eng/pcrm/ourbusi ness/mf.html (accessed 29 April 2015). ——— (2015d) “Key Statistics of Microfinance Scheme,” http://www.hkmc.com.hk/ sites/default/files/eng/pcrm/ourbusiness/mf_key_stat_eng.pdf (accessed 29 April 2015). Hong Kong Securities and Futures Commission (SFC) (2003) “Guidelines on Competence” (March 2003). ——— (2003a) “Guidelines for the Regulation of Automated Trading Services” (November 2003). ——— (2006) “Fit and Proper Guidelines” (September 2006). ——— (2014) “Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission” (March 2014). ——— (2014a) “Notice on Potential Regulations Applicable to, and Risks of, Crowdfunding Activities” (7 May 2014). ——— (2014b) “Annual Report, 2013–14”. Hong Kong Trade Development Council (2011) Unleashing Hong Kong’s Creative Youth, Hong Kong: Hong Kong Trade and Development Council. ——— (2014a) Start-ups Taking Off—2014 Report on Youth Entrepreneurship in Hong Kong, Hong Kong: Hong Kong Trade and Development Council. ——— (2014b) “Private Equity Industry in Hong Kong,” http://hong-kong-economyresearch.hktdc.com/business-news/article/Hong-Kong-Industry-Profiles/PrivateEquity-Industry-in-Hong-Kong/hkip/en/1/1X000000/1X003VKV.htm (accessed 29 April 2015). Hong Kong Venture Capital and Private Equity Association (2014) “How Venture Capital and Private Equity have provided Vitality to the Hong Kong Economy post Global Financial Crisis: 2009–2014,” http://web.hkvca.com.hk/upload/Enews/ Banners/2014/How-VCPE-provides-vitality-to-HK-Economy(1).pdf (accessed 29 April 2015).

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Information for Development Program/The World Bank (2013) “Crowdfunding’s Potential for the Developing World,” http://www.infodev.org/infodev-files/wb_ crowdfundingreport-v12.pdf (accessed 29 April 2015). Innovation and Technology Fund (2015a) “Small Entrepreneur Research Assistance Programme (SERAP),” https://www.itf.gov.hk/l-eng/SERAP.asp#Note1 (accessed 29 April 2015). ——— (2015b) “Distribution of Approved Projects among Different Technology Areas,” http://www.itf.gov.hk/l-eng/StatView107.asp (accessed 29 April 2015). Insightlegalasia.com (n.d.) “Crowdfunding (equity-based) in Asia-Pacific: Legal and Regulatory Ambiguities Without an Analogous US JOBS Act Exemption,” http:// www.insightlegalasia.com/blog/crowdfunding-equity-based-asia-pacific-legal-andregulatory-ambiguities-without-analogous-us (accessed 29 April 2015). International Organization of Securities Commissions (IOSCO) (2014) “Crowd-funding: An Infant Industry Growing Fast,” Staff Working Paper SWP3/2014. Klein, William A. & John C. Coffee (2004) Business Organization and Finance: Legal and Economic Principles, New York: Thomson Reuters/Foundation Press. Legislation.gov.uk (2005) “The Financial Services and Markets Act 2000 (Financial Promotion) Order 2005,” http://www.legislation.gov.uk/uksi/2005/1529/contents/ made (accessed 29 April 2015). Legislative Council of Hong Kong (2013) “Official Record of Proceedings,” http://www .legco.gov.hk/yr13-14/english/counmtg/hansard/cm1016-translate-e.pdf (accessed 29 April 2015). ——— (2014) “Panel on Commerce and Industry: Minutes of Meeting,” http://www .legco.gov.hk/yr13-14/english/panels/ci/minutes/ci20140318.pdf (accessed 29 April 2015). Lin, Lillian (2014) “Crowd-Funding Concerts Catch on in China,” http://blogs.wsj.com/ chinarealtime/2014/01/06/crowd-funded-concerts-catch-on-in-china/?mod=WSJ_ LatestHeadlines (accessed 29 April 2015). Lynn, David M., & Anne T. Pinedo (2012) “A Quick Guide to the JOBS Act,” http://www .mofo.com/~/media/Files/PDFs/jumpstart/120416-PLI-Quick-Guide-JOBS-Act.pdf (accessed 29 April 2015). Monetary Authority of Singapore (MAS) (2015) “Facilitating Securities-based Crowdfunding,” http://www.mas.gov.sg/~/media/MAS/News%20and%20 Publications/Consultation%20Papers/Facilitating%20Securities%20Based%20 Crowdfunding.pdf (accessed 29 April 2015). Mutimer, Tristan (2013) “Financial Promotion—Key Considerations for Private Companies,” http://gdknowledge.co.uk/financial-promotion-key-considerationsfor-private-companies-seeking-investment/ (accessed 29 April 2015). Ng, Joyce, & Sophie Yu (2015) “HK$1b Fund Open to All Youngsters, Jack Ma Says,” South China Morning Post, 3 February.

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OECD (2006) The SME Financing Gap, Volume 1: Theory and Evidence, Paris: OECD. Osborneclarke.com (2014) “The Regulation of Crowdfunding in the UK,” http://www .osborneclarke.com/connected-insights/publications/regulation-crowdfundinguk/ (accessed 29 April 2015). Pekmezovic, Alma, & Gordon Walker (2016) “The Global Significance of Crowdfunding: Solving the SME Funding Problem and Democratising Access to Capital.” 7 William & Mary Business Law Review 1. Policy Address (2014) “2014 Policy Address: Innovation and Technology Industries,” http://www.policyaddress.gov.hk/2014/eng/p34.html (accessed 29 April 2015). Sec.gov (2013) “Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings,” http://www.sec.gov/info/ smallbus/secg/general-solicitation-small-entity-compliance-guide.htm (accessed 29 April 2015). Securities and Futures Commission (SFC) (2003) “Guidelines for the Regulation of Automated Trading Services”. ——— (2014) “Notice on Potential Regulations Applicable to, and Risks of, Crowdfunding Activities”. ——— (2014b) “Annual Report 2013–14”. ——— (2015) “Consultation Conclusions Concerning the Regulation of Alternative Liquidity Pools”. Seedrs.com (2014a) “What Are the Eligibility Requirements in Order to Make Investments Through Seedrs?,” https://www.seedrs.com/faq/items/65_what_are_ the_eligibility_requirements_in_order_to_make_investments_through_seedrs (accessed 29 April 2015). ——— (2014b) “Tax Relief: SEIS,” https://www.seedrs.com/seis_eis_tax_relief (accessed 29 April 2015). ——— (2015) “Seedrs’ Declaration of Investor Protection,” https://www.seedrs.com/ invest/investor_protection#invest (accessed 29 April 2015). Seis.co.uk (2015) “Seed Enterprise Investment Scheme,” http://www.seis.co.uk (accessed 29 April 2015). Singaporebudget.gov.sg (2014) “Transforming Our Economy: Crowdfunding for Startups,” http://www.singaporebudget.gov.sg/budget_2014/pc.aspx (accessed 29 April 2015). Startmeup.hk (2015) “Home,” http://www.startmeup.hk/en/resources/incubationprogramme/ (accessed 29 April 2015). Stock Exchange of Hong Kong (2014) Growth Enterprise Market Listing Rules, Chapter 11. Sun, Celine (2014) “Chinese Get Taste for Crowd Funding with Local Flavour,” South China Morning Post, 11 March.

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The Women’s Foundation (2014) “Women’s Economic Empowerment Through Entrepreneurship in Hong Kong,” http://www.thewomensfoundationhk.org/down load/Women%20Economic%20Empowerment3.pdf (accessed 29 April 2015). Ukcfa.org (2014) “FAQs,” http://www.ukcfa.org.uk/faqs (accessed 29 April 2015). World Economic Forum (2011/12), “The Financial Development Report 2011/2012,” http://www.weforum.org/reports?filter[type]=Competitiveness (accessed 29 April 2015). World Justice Project (2013) “Rule of Law Index 2012–2013,” http://worldjusticeproject .org (accessed 29 April 2015). Yoshimura, Midori (2015) “Just Released: China’s New Guidelines For Online Finance Market,” Crowdfund Insider, 19 July.

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Chapter 10

New Risk Management Requirements in Hong Kong’s Corporate Governance Code “More than Just a Box to Tick” Angus Young and Coral Huo Abstract On 1 January 2016, Hong Kong’s listed entities will be regulated by an amended Corporate Governance Code and Corporate Governance Report. The core changes contain the re-situating and revamping of risk management requirements along slide internal control systems from the recommended best practices to code provisions. Whilst the proposed changes seem to be in line with international trends, new risk management obligations should not be treated as another set of procedures and processes for the board. The code provisions oblige the board to manage and monitor the company’s risks. This code also expects risk management to be embedded in the issuer’s organization. Failure to comply not only attracts sanctions from the exchange, but has legal implications for directors under statutory duty of care. Therefore, any omissions by directors in the managing and monitoring of the company’s risk will find themselves exposed to legal risks.

Keywords corporate governance code – risk management – internal control systems – directors’ duty of care

* PhD, CCP, F Fin, CRP, MHKSI, FCA (Aust.), Senior Lecturer, Department of Accountancy & Law, Hong Kong Baptist University and Distinguished Research Fellow, German-Sino Institute of Legal Studies, Nanjing University. Contact: [email protected]. ** LLB, JD. Solicitor, NSW, Australia and Tutor, School of Law, University of Western Sydney. Contact: [email protected].

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1 Introduction The recent Global Financial Crisis (GFC) has left a clear mark in people’s minds about the vulnerability of international financial markets and the interconnectedness as well as interdependency of markets around the world. More importantly, the bad governance of a few companies in one corner of the world could have a tsunami effect on economies around the globe. Furthermore, financial crisis has long lasting effects on the international community as a whole. In particular, it unsettled investors’ confidence in international equity markets, which would have wider socio-economic implications. Whilst there are many causes leading to the GFC, one of the symptoms was that company boards had been complacent in managing corporate and related risks. Following a review of the Code on Corporate Governance Practices and Associated Listing Rules in 2010 and 2011, in June 2014 HKEx published a consultation paper to sought comments on proposed amendments to the Hong Kong corporate governance code (Code) relating to risk management and internal controls. The conclusions to the consultation on the review of the Code were published in December 2014. According to for the proposed amendments the current Code seems to lag behind international developments in the area of corporate risk management. The HKEx will amend the Code to be in line with international best practices so as to secure its position as an international financial centre. Yet, risk management is not as simple and straightforward as a matter of putting in place procedures and processes. Corporate risks in the 21st century can be a challenge given that risk, uncertainty, and threats are not always predictable. It can be said that risk management is like trying to foresee and manage the unforeseen and capricious. The report, Global Risks 2015 published by the World Economic Forum, now in its tenth edition examines economic, societal, geopolitical, technological, and environmental risks. It notes that risk identification alone might not reveal the interconnection and the potentially cascading effects of global risk.1 The 2015 Global Audit Committee Survey drew its conclusions from 1,500 audit committee members. The survey finds that the top five risks pose the greatest challenges for companies are: 1. uncertainty and volatility (economic, regulatory, political); 2. government regulation/impact of public policy initiatives; 3. legal/regulatory compliance; 4. operational risk/ control environment; and 5. talent management and development.2 A year earlier the 2014 Global Audit Committee Survey finds that the top five risks 1  World Economic Forum (2015), p. 8. 2  K PMG’s Audit Committee Institute (2015), p. 7.

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differ slightly: 1. government regulation/impact of public policy initiatives; 2. uncertainty and volatility (economic, regulatory, political); 3. operational risk/control environment; 4. legal/regulatory compliance; and 5. talent management and development.3 What these two surveys have shown is the dynamic and ever changing nature of risks. In short, risk management is more than just ‘ticking boxes’; it requires vigilance and due diligence. This chapter will examine and discuss the new proposed amendments to the HKEx’s Code that will take effect early next year. It is divided in six sections. Following this introduction, section II will discuss the characteristics and general concerns of Hong Kong’s Code and Corporate Governance Report. Section III will examine the risk management requirements in the proposed new amendments to the Code. This is followed by section IV that attempts to make sense of risk management beyond a conceptual framework. Section V will explore the links between risk management and directors’ duty of care as it is imperative the directors are aware of potential liabilities. Section VI concludes with some observations and recommendations. 2

Hong Kong Corporate Governance Code and Report

The Code for entities listed on the HKEx was first introduced in 2005. The last major review was done in December 2010.4 In the executive summary of that review it states that: Our principal objective is to promote the development of a higher level of corporate governance among issuers, the importance of which was highlighted in the recent financial crisis. Other major markets and international financial centres have already implemented, or are currently implementing, reforms on corporate governance. The changes that we propose are generally in line with international best practice.5 Therefore, the combination of international trends and recent financial crisis prompted the HKEx to amend their codes. Whilst this is not inspiring news, it goes to reassure investors that the HKEx does respond to international events and best practices.

3  K PMG’s Audit Committee Institute (2014), p. 2. 4  H KEx (2010), p. 1. 5  Ibid.

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The HKEx’s approach to providing a sound regulatory framework appropriate is to adopt a combination of Listing Rules, Code Provisions (CPs) and Recommended Best Practices (RBPs). The combination of regulatory instruments is designed to offer flexibility to issuers on the one hand, and on the other hand, safeguards investors’ interests without compromising on the vigour of regulatory requirements. Such regulatory framework is the generally accepted benchmark that has been the norm in many countries to institute effective corporate governance processes in listed entities. Different from legislation, a code generally is not intended to be a set of hard laws, but a collection of best practices for issuers to adopt or adapt.6 They are intended to provide issuers with guidance to either comply, or to explain why they do not wish to comply with those code provisions, which is often labelled as a “comply or explain” approach. Besides, unlike listing rules where failure to comply may lead to sanctions, companies may choose to deviate from the Code. All it requires is the explanation for its decision not to comply, and the alternatives it adopts be stated in the Corporate Governance Report. Further, RBP are best practices which issuers are encouraged to comply, but they are not obliged to do so.7 Another issue that is inherent in CP and RBP as regulatory instruments is that it is expected to foster and nurture good corporate governance norms for listed entities. There are in essence, meant to be ex ante. Whilst legal reforms become prevalent in the wake of these corporate collapses, legal obligations are ex post regulatory tools, intending to hold individuals and corporations accountable to misdeeds and neglect. Evidently, from corporate collapses of major corporations like Enron in the northern to HIH Insurance in the southern hemispheres, bad corporate governance was a central factor in their demise. Laws had appeared to be ineffective in preventing bad corporate governance norms and practices. Therefore, the international consensus and expectations of CPs and RBPs are to safeguard investors’ interests and market integrity. However, transplanting these regulatory instruments meant that HKEx is mimicking, rather than performing the frontrunner of international trends in regulation. Whilst Hong Kong, a former British colony, has a long history of transplanting international laws and regulations to maintain its position as an international financial centre, it is hard to gauge if the instigators and stakeholders in Hong Kong are able to comply with those new measures beyond a tick box mentality. This is partly because much of those international benchmarks were developed in the West, where major corporate collapse and international financial crisis 6  Aguilera, Cuervo-Cazurra, & Kim (2011). 7  hkex.com.hk, Appendix 14. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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occurred. As such, the regulatory solutions sorted and formulated were made on the back of those governance failures. Even though, advocates would argue that governance concerns are universal, Hong Kong is in effect transplanting regulations that were meant for the West. This could mean that issuers are obliged to comply because of events that were inspired overseas rather than matters originated in Hong Kong. More importantly, there possibility of mismatch between governance problems in the West and those in Hong Kong could spawn creative and superficial compliance, defeating the purpose of transplanting those measures. Furthermore, although CPs are meant to offer flexibility for issuers, it is unlikely that companies in Hong Kong are able provide adequate explanation to assure investors by introducing alternative self-regulatory arrangements because of its long held practice of transplanting laws and regulations from the West. Thus, CPs and RBPs would be de facto rules in Hong Kong. Furthermore,, boards of listed entities in the territory might comply for the sake of compliance with little appreciation for the specificities of the transplanted regulatory measures. 3

Latest Amendments to Hong Kong’s Corporate Governance Code

In June 2014, the HKEx released a consultation paper on risk management and internal control. The aim is to seek market and stakeholders views on reviewing the Code and Corporate Governance Report to include risk management requirements for listed entities. In the executive summary of the consultation paper, it states that: Since the introduction of the Code in 2005, corporate governance codes, rules and regulations in overseas jurisdictions have evolved and now place greater emphasis on risk management, rather than just on internal controls. The existing Code does not properly reflect this emphasis. The Code may also be improved to better delineate the roles and responsibilities of the board, the management and the internal audit function, as well as to set out the minimum specific disclosures that issuers should make so as to enhance transparency.8 Even though the text of this consultation paper omitted references to the GFC, earlier review in 2010 already made that explicit. This review also mentioned the previous changes in 2010 which did not include internal controls and risk management. The text in the executive summary also articulated that 8  H KEx (2014a), p. 1. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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risk management should be an integrated part of internal controls. This in turn places risk management as part of internal controls critical to enhancing accountability of boards. In addition, the paper situated risk management and internal control as an internal audit function.9 This indicates the higher importance of risk management in the proposed changes because in the current version of the Code risk management is touched on under internal controls section as a RBP in C.2.3.10 The consultation paper explicitly re-categorised risk management as CPs, as well as included new RBPs about disclosing the board’s view about the effectiveness of the issuer’s risk management in the Corporate Governance Report.11 Furthermore, the proposed changes in effect, create a positive duty for board and management to include risk management considerations in their deliberation processes and outcomes.12 By the end of the consultation on 31 August 2014, there were a total of 57 submissions. The HKEx noted that, “With a few exceptions, the proposals received substantial majority support. We conclude that most of the proposals outlined in the Consultation Paper should be adopted, with certain modifications or clarifications set out in this paper.”13 This suggests that these transplanted recommendations were well received by issuers and the stakeholders. According to the Consultation Conclusions, the proposed main changes are as follows:

• incorporating risk management into the Code where appropriate; • revising Principle C.2 to define the roles and responsibilities of the board and management; • clarifying that the board has an ongoing responsibility to oversee the issuer’s risk management and internal control systems; • upgrading to Code Provisions (“CPs”) the recommendations in relation to the annual review and disclosures in the Corporate Governance Report; and • upgrading to a CP the recommendation that issuers should have an internal audit function, and those without to review the need for one on an annual basis.14

9  Ibid. 10  Note that the above refers to the current 2015 version of the Corporate Governance Code in Appendix 14 of the HKEx. 11  HKEx (2014a), pp. 1, 2. 12  Ibid. 13  HKEx (2014b), p. 1. 14  Ibid., pp. 1, 2.

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The main changes only reflect those changes in broad strokes. The details offered more insights into some of the modifications to boards’ responsibilities, corporate governance report requirements, and internal audit procedures. Apart from discussions about the proposed amendments to the Code and Report, this section would also make some comparison with the codes in Singapore, UK and Australia. This is expected to provide more insights as to the implications of the new changes to the HKEx’s code for boards and directors of listed entities. 3.1 The Role of the Board in Risk Management The new text of the Code in Appendix 14 of the HKEx which lists rules under the headings of C.2 under the headings of “Risk management and internal control” states that: The board is responsible for evaluating and determining the nature and extent of the risks it is willing to take in achieving the issuer’s strategic objectives, and ensuring that the company establishes and maintains appropriate and effective risk management and internal controls systems. The board should oversee management in the design, implementation and monitoring of the risk management and internal control systems, and management should provide a confirmation to the board on the effectiveness of these systems. The stipulated “Principle” in the above clearly is aimed at consigning risk management responsibilities onto boards. In particular, C.2.1 mandates that boards should, “oversee the issuer’s risk management and internal control systems on an ongoing basis, ensure that review of the effectiveness of the issuer’s and its subsidiaries’ risk management and internal control systems has been conducted at least annually and report to shareholders that it has done so in their its Corporate Governance Report.”15 Plainly, the issuer has to report the effectiveness of risk management and internal control systems to shareholders at least annually, in the Corporate Governance Report. Failure to comply would constitute a breach of CP. In addition, C.2.3, C.2.4 and C.2.5 have been upgraded from RBPs into CPs. Former RBPs C.2.6 has been replaced and new RBPs. The amended and newly added RBPs state that the board may disclose in the Corporate Governance Report details of significant areas of concerns about the issuer’s risk management and internal control systems. 15  Ibid., p. 17.

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In comparison, similar risk management provisions are stipulated under Principle 11 in the Singapore code and section C.2 in the UK code respectively, except the UK Code where certain specificities are stipulated. The board should confirm in its report the company’s, “business model, future performance, solvency or liquidity.”16 Singapore’s code includes further guidelines. Under 11.3b, the board should comment on whether assurances from CEO and CFO about, “the effectiveness of the company’s risk management and international control system.”17 In Australia, Principle 7 of the Corporate Governance Principles and Recommendations stipulates that a listed company should establish a sound risk management framework and periodically review the effectiveness of that framework. The Australian recommendations provide more detailed specificities in terms of risk committee requirements.18 The commentaries of Principle 7 point to the board is ultimately responsible for deciding the nature and extent of the risks the company is prepared to take on. In comparison, the revised Hong Kong code requires the board to oversee the company’s risk management and internal control systems on an ongoing basis, but the day-to-day is the responsibility is in the hands of management. Therefore, the HKEx’s CPs offers less specificity in stipulating risk management arrangements. However, on the 1 January 2016, the new CPs and RPBs do not deflect the requirements for boards to monitor and manage a company’s risks. 3.2 Disclosure Relating to Risk Management Under the revised of provision C 2.1, it is the board’s responsibility to ensure that an annual review of the effectiveness of the company’s risk management and internal control system is conducted and report to the shareholders that it has done so in its Corporate Governance Report. Currently, it is a RBP that directors include a statement that they have conducted a review of internal control system in the annual report. As well, they are encouraged to disclose an explanation of how the internal control system in the annual report, whether the issuer has an internal audit function, and a statement by directors about the effectiveness of internal control system.19 The revised Code further sets out that the board’s annual review should consider, they are listed in C 2.3. They include the following:

16  Financial Reporting Council (2014), p. 17. 17  SGX (2012), p. 20. 18  ASX Corporate Governance Council (2014), pp. 28–9. 19  HKEx (2014b), p. 21.

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1) 2)

the changes in the nature and extent of significant risks, the company’s ability to respond to those changes in its business and the external environment, 3) the scope and quality of management’s ongoing monitoring of risks and of the internal control, 4) the extent and frequency of communication of monitoring results to the boards, 5) significant control failings or weakness that have been identified and the material impacts on the company’s performance 6) the effectiveness of the company’s process for financial reporting and List Rule compliance Furthermore, in the proposed changes to Corporate Governance Report, mandatory disclosure requirements on risk management and internal controls state that: Where an issuer includes the board’s statement that it has conducted a review of its risk management and internal control systems in the annual report under code provision C.2.1, it must disclose the following: (a) whether the issuer has an internal function; (b) how often the risk management and internal controls systems are reviewed, the period covered, and where an issuer has not conducted a review during the year, an explanation why not; and (c) a statement that a review of the effectiveness of the risk management and internal control systems has been conducted and whether the issuer considers them effective and adequate.20 Evidently, the new proposed disclosure requirements meant that boards must take risk management and internal control systems seriously. In Singapore, a mandatory disclosure requirement was introduced by the Singapore Exchange (SGX) in 2011. The board is required to comment on the adequacy of internal controls in annual report. Thus, the board is explicitly required to consider financial, operational and compliance risks. This mandatory requirement is enforceable under Section 199 of the Securities and Futures Act, which states that directors are liable for omissions and misleading or deceptive statements in disclosure documents. In Australia, a listed company is required under Listing Rules 4.10.3, to produce a corporate 20  Ibid., pp. 21–2.

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governance statement annually disclosing the extent to which it has followed the recommendations set by the ASX Corporate Governance Council. In addition, Section 299A of the Corporations Act 2001 (Cth) obliges a company to include a discussion of the main internal and external risk sources that could adversely affect the company’s prospects for future financial years in its directors’ report. Even though, Hong Kong’s proposed amendments to CPs are not listing rules or legislation like those in Singapore and Australia, Section 277 of the Securities and Futures Ordinance (cap. 571) does impose legal obligations about the accuracy of disclosure made by companies. 3.3 Statement on Compliance C 2.4 is a new CP were formerly RBPs setting out the particulars that a company should disclose in its Corporate Governance Reports in relation to its compliance with the risk management and internal control CPs. In essence, C 2.4 requires a company to provide a narrative statement on the structure of its risk management system and the process used to review the effectiveness of these systems. In comparison, Singapore code’s the board’s opinion on the adequacy and effectiveness of the internal controls must be disclosed in the company’s annual report. Disclosure of opinion must include financial, operational and compliance risks.21 In addition, disclaimer or negative assurance such as “absence of evidence to the contrary” and the use of words “believe” or “is satisfied” are not acceptable.22 Evidently, HKEx’s approach is not as robust as Singapore. Even if there is no evidence to suggest that Singapore’s approach works better than Hong Kong’s, a statement of compliance does compel issuers to perform due diligence before releasing such statements because serious consequences for any possible errors or omission will ensue. 3.4 Internal Audit of Risk Management C 2.5 of the revised Code has introduced an internal audit function. A listed company without an internal audit function should review the need for an internal audit function on an annual basis, and should disclose the reasons in the Corporate Governance Report. The annotations to C 2.5 further states that the internal audit function generally carries out the analysis and independent appraisal of the adequacy and effectiveness of the company’s risk management and internal control systems. Similar provisions, but not specifically on risk management could be found in Principle 13 of the Singapore code. It states that a company should 21  SGX (2012), p. 20. 22  SGX-ST Listing Rules, Practice Notes 12.2: Adequacy of Internal Controls.

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establish an effective internal audit function that is adequately resourced and independent of the activities it audits. In addition, the Risk Governance Guidance in Singapore states that the board’s annual assessment should consider, where applicable or not, consider the work of its internal audit function and other providers of assurance.23 In Australia, a listed company is required under Principle 7.3 to disclose if it has an internal audit function, how the function is structured and what role it performs. If there is no internal audit function, the listed entity has to state the facts and the processes it employs for evaluating and continually improving the effectiveness of its risk management and internal control processes. The UK code states, under C 3.6 states that if there is no internal audit function, the audit committee should consider annually whether there is a need for one and make recommendation to the board, and the reasons for the absence should be explained in the annual report. The Financial Reporting Council’s guidance on risk management further provides that, in addition to the board’s own monitoring activities, the board may consider obtaining assurance from internal audit functions within the company. As such, differences between the various jurisdictions are not too pronounced and distinctive. 3.5 Audit Committee’s Role in Risk Management The revised Code states in C 3.3 that the audit committee also has responsibility to oversee the company’s risk management and internal control systems, unless expressly addressed by a separate board risk committee, or by the board of directors. The wording “unless expressly addressed” indicates that the audit committee is responsible for the oversight of risk management “by default”. Under P 12.4 of Singapore’s code, the audit committee is required to review and report to the board at least annually the adequacy and effectiveness of the company’s internal controls, including financial, operational, compliance and information technology controls. In Australia, Recommendation 7.1 states that the board of a listed company should have a committee or committees to oversee risks. The commentary to the recommendation further explains that while ultimate responsibility for a listed company’s risk management framework rests with the full board, having a risk committee can be an efficient and effective mechanism. The code adopts flexible approach on the forms of a risk committee, a stand-alone risk committee, a combined audit and risk committee or a combination of board committees addressing different elements or risks. Whilst there are no major differences between Australia, Singapore and Hong Kong’s approaches to this issue, a report published by KPMG Audit Committee 23  Financial Reporting Council (2014), p. 37.

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Institute in 2010 points out that effective implementation of risk management and internal control requires the board’s involvement. If the board simply delegates the role of oversight risk management to the audit committee out of convenience, without a push to implement and adhere to the risk management principles from the board, risk management is in danger of turning into empty symbolism.24 In summary, the new proposed risk management and internal control systems amendments to the HKEx Code and Corporate Governance Report will come into effect on 1 January 2016, but the above analysis has only revealed the need to include risk management in the governance of listed entities and not how it is implemented or actualized in the boardroom beyond the ideals and symbolism. Then again, there appears to be no definition of risk management in both the Consultation Paper and the Consultation Conclusions of what constitute risk management. Besides, the proposed amendments are transplants, as such it is uncertain whether issuers and stakeholders understood what risk management involves. Therefore, it is critical to examine this further. 4

Making Sense of Risk Management

The ISO 31000 International Standard on Risk Management: Principles and Guidelines offer the following definitions: risk is the “effect of uncertainty on objectives” and risk management refers to the “coordinated activities to direct and control an organization with regard to risk”.25 Another way of describing risk is “the chance of sometime happening that will have an impact on objectives often specified as an event or set of circumstances and the consequences (both positive and negative) that will flow from this.”26 Risk management is “the process involved in managing risk in order to achieve objectives, by maximizing potential opportunities and minimizing potential adverse effects.”27 And risk management process is defined as “the systematic application of management policies, procedures and practices to the tasks of communicating, establishing the context, identifying, analysing, evaluating, treating, monitoring and reviewing risk”.28 This functional conceptualisation of the subject matter characterizes risk and risk management as a ‘technico-scienfic’ product 24  Low (2010), p. 9. 25  International Organization for Standardization (2009), pp. 1–2. 26  Drennan & McConnell (2007), p. 2. 27  Ibid. 28  Ibid.

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of probabilities and consequences of adverse events.29 Lupton argues that, “[i]n the technico-science literature on risk there is sometimes evident an illmasked contempt for lay people’s lack of what is deemed to be ‘appropriate’ or ‘correct’ knowledge about risk”.30 So how are boards going to implement a robust and effective risk management regime? This is where risk management standards by various international organizations could be of assistance. 4.1 Making Sense of Risk Management Standards At the core, risk management standard is a collection of best practice and guidelines with focus on laying the groundwork for an organization’s risk management framework, processes and systems. There are numerous competing risk management standards, Risk Management—Practice and Guidelines ISO 31000: 2009 (ISO standard), Enterprise Risk Management—Integrated Framework COSO: 2004 (COSO standard), A Risk Management Standard FERMA: 2002 (FERMA standard), just to name a few. The distinction between risk management provisions in a code and a standard is that the former may be mandated while the latter is voluntary. As such the tone in the text and specificity in achieving certain preconceive objectives would differ. However, it is important to note that requirements in corporate governance codes concerning risk management are usually grounded with certain risk management standards as a reference point for board to have a grasp on what is expected of them. For example, the Australian Principle and Recommendations contain reference to ISO standard and COSO standard, so does the Singapore Guidance. Then again, standards could be somewhat vague in spite of the rationalist rhetoric assisted by simple diagrams to systematize the entire process. As Leitch puts it: It is not easy to evaluate ISO 31000:2009 by reading it. The intended meaning of its rather abstract text is frustratingly hard to pin down. Key words and phrases are either too vague, have meanings different from those of ordinary language, or even change their meaning from one place to another. The definitions provided rarely help.31 This meant that risk management standards could offer boards some clues as to achieving the intended and stipulates outcomes in the Corporate Governance Codes, but is not the ‘silver bullet’ to monitor and control risk of a company. 29  Lupton (2013), p. 27. 30  Ibid., p. 28. 31  Leitch (2010), p. 887.

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It was not linked to corporate strategy, did not articulate how to respond to risk, and failed to take into account wider stakeholders.32 Therefore, the notion of risk management has to go beyond, a ‘to do’ into a ‘doing it’ by embedding risk management systems, processes, and treatments through an organization, this is where ‘Enterprise Risk Management’ (ERM) is a step in the right direction. 4.2 Embedding ERM in an Organization ERM is defined by COSO as: [A] process, effected by an entity’s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives.33 They went further by postulating that ERM comprises of eight interrelated components. They are: 1.

Internal environment: it encompasses the tone of an organisation, and sets the basis for how risk is viewed and addressed by an entity 2. Objective settings: objectives must exist before management can identify potential events affecting their achievement 3. Event identification: internal and external events affecting achievement of an entity’s objectives must be identified, distinguishing between risks and opportunities 4. Risk assessments: risks are analysed, considering likelihood and impact, as a basis for determining how they should be managed 5. Risk response: management selects risk responses developing a set of actions to align risks with the entity’s risk tolerance and its risk appetite 6. Control activities: policies and procedures are established and implemented to help ensure the risk response are effectively carried out 7. Information and communication: relevant information is identified, captured, and communicated throughout the organisation in a form and timeframe that enable people to carry out their responsibilities 8. Monitoring: the entirety of enterprise risk management is monitored and modifications made as necessary.34 32  OECD (2009a), p. 38. 33  Committee of Sponsoring Organisations of the Treadway Commission (2004), p. 13 34  Ibid., pp. 5–6.

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From the above, it demonstrates that risk management is an organizational wide function entailing internal and external risks of a company. It is more than ‘keeping an eye on things’, and more than ‘having processes and procedures in place’. Therefore, ERM is a holistic risk management framework and processes with clear risk identification, assessments, monitoring, control, treatment, and review systems for organizations. All of which could be feed up to the boards to make risk management operative and effective. According to Branson, company boards has to embrace ERM because, The company’s ERM system should function to bring to the board’s attention the company’s most significant risks and allow the board to understand and evaluate how these risks may be correlated, the manner in which they may affect the company and management’s mitigation or response strategies. It is critically important for board members to have the experience, training, and intimate knowledge of the business required in order to make meaningful assessments of the risks that the company encounters. The board must also consider the best organizational structure to give risk oversight sufficient attention at the board level. In some companies, this has driven the creation of a separate risk management committee of the board. For other organizations, it may be reasonable for these discussions of risk to occur as a regular agenda item for an existing committee such as the audit committee, enhanced by periodic review at the full board level. No one size fits all, but it is vitally important that risk management oversight be a board priority.35 To ensure boards take on risk management as part of their decision making, this is where making it mandatory or at least taken seriously via corporate governance codes or guidelines is crucial. The argument for doing this is simple, if risk management is an explicit requirement for boards, failure to comply could result in serious consequences. 4.3 Risk Management and Corporate Governance The recent emphasis on risk management as an integral part of corporate governance codes and guidelines could be traced to lessons drawn from the GFC. In 2009 the OECD published a paper, Corporate Governance and the Financial Crisis: Key Findings and Main Message, aimed at analysing corporate governance failures and weakness that contributed to the GFC. With regards to risk management it states that: 35  Branson (2010), p. 52.

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Perhaps one of the greatest shocks from the financial crisis has been the widespread failure of risk management in what were widely regarded as institutions whose specialty it was to be masters of the issue. The evidence is documented in Corporate Governance from Financial Crisis and incoming evidence from parliamentary inquiries etc. [sic] has only served to underpin the case. In many cases, risk was not managed on an enterprise basis but rather by product or division [. . .] [F]ailure to deal with the corporate governance aspects of risk management is not confined to financial companies with a number of companies in the past surprised by negative shocks while others have found themselves not in a position to respond to positive ones.36 Furthermore, this publication noted that risk management only played a lesser role under internal controls and disclosure of material information on foreseeable risk factors under the Corporate Governance Principles in 2004.37 In the following year the OECD published a paper on Corporate Governance and Financial Crisis: Conclusions and Emerging Good Practices to Enhance Implementation of the Principles. It states that: An important conclusion is that the board’s responsibility for defining strategy and risk appetite needs to be extended to establishing and overseeing enterprise-wide management systems [. . .] [A]long the lines of the Principles which recommend that internal control functions report directly to the audit committee or equivalent, the report directly to the board [. . .] [I]t is important that the process of risk management and assessments about its effectiveness be appropriately disclosed, although the report also notes that experience up till now with such disclosures has not been good.38 This realisation of the importance risk management plays in effective corporate governance in the aftermath of the GFC is significant in putting risk management at the heart of Code reviews in many parts of the world. In 2014 the OECD report on Risk Management and Corporate Governance went further by pointing out that:

36  OECD (2009a), p. 31. 37  Ibid., p. 33. 38  OECD (2010), p. 4.

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Existing risk governance standards for listed companies still focus largely on internal control and audit functions, and primarily financial risk, rather than on (ex ante) identification and comprehensive management of risk. Corporate governance standards should place sufficient emphasis on ex ante identification of risks. Attention should be paid to both financial and non-financial risks, and risk management should encompass both strategic and operational risks.39 It further commented that: Currently, risk governance standards tend to be very high-level, limiting their practical usefulness, and/or focus largely on financial institutions. There is scope to make risk governance standards more operational, without narrowing their flexibility to apply them to different companies and situations. [. . .] [I]t is not always clear that boards place sufficient emphasis on potentially ‘catastrophic’ risks, even if these do not appear very likely to materialise.40 What this report has revealed is that risk management was not taken seriously by boards, especially non-financial risks leading to compliancy. Therefore, the boards take risk management obligations as a prudent undertaking and directors must be held accountable for failure to play their part. In a rejoinder to the OECD report published in 2009, it echoed sentiments in the 2014 report where implementation of risk management by boards have lagged, and in the US court rulings appeared to indicate that directors who have not overseen enterprise risk management system, “might leave themselves open to charges of breach of fiduciary duties”.41 The report in 2010 however notes that fiduciary duties are fact dependent and, “[s]hareholders have widely diverging views and the notion of acting in the best interest of the company is also not clear cut. In such situations, a simple approach to define duties and then enforce them might not be appropriate to improve board performance.”42 This does not suggest that directors are not legally accountable for risk management failures. The 2010 report notes that, “The duty of care does, however, offer a way forward by making the board liable for not having assurance systems in place such as risk management and internal 39  OECD (2014), p. 7 40  Ibid., pp. 7, 8. 41  OECD (2009a), p. 39. 42  OECD (2010), p. 22.

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financial controls.”43 Therefore directors could be liable for failure to exercise their duty of care in managing the risk of a company. 5

Risk Management and Director’s Duty of Care

The links between risk management and directors’ duty of care could be understood from two converging trails. The first is an ex ante preventive measure, and the second is an ex post obligation to hold directors accountable. The object of risk management, as noted in the above is to ensure effective corporate governance processes and practices are embedded in an organization. Since the first aspect in terms of embedding risk management in corporate governance codes were discussed at great lengths, in this section the focus is on the directors’ duty of care, skill and diligence. Duncan and Traves argue that, “the management of risk is at the heart of the exercise of due diligence”.44 Whilst due diligence is applicable to a wide range of transactions and obligations, risk management is often associated with tortuous liability where duty of care is central to establish whether due diligence was performed.45 Due diligence according to Duncan and Traves is a concept of description rather than definition as it describes systems and processes to achieve compliance with legal obligations, and the undertaking of specific verify the existence or otherwise of a requisite state of affairs.46 To achieve this, the identification, analysis and minimisation of risk because ignoring them may lead to losses.47 Hence, directors as officers charged with the responsibility of governing and managing a company might be liable for failure to monitor and manage the organization’s risks. Such obligations are encapsulated in the duty of care that involves taking steps to avoid risk and reduce the probability of incurring losses, or if it did occur to reduce the magnitude of lose.48 Directors’ duty of care had been a general law duty in Hong Kong until last year, where new statutory duty of care came into effect.49 It is set out under Section 465 of the Companies Ordinance (Cap. 622): 43  Ibid. 44  Duncan & Traves (1995), p. 39. 45  Ibid., p. 54. 46  Ibid., p. 420. 47  Ibid., p. 35. 48  Ibid., p. 419. 49  Young (2014), p. 67.

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(1) A director of a company must exercise reasonable care, skill and diligence. (2) Reasonable care, skill and diligence mean the care, skill and diligence that would be exercised by a reasonably diligent person with— (a) the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company; and (b) the general knowledge, skill and experience that the director has. (3) The duty specified in subsection (1) is owed by a director of a company to the company. (4) The duty specified in subsection (1) has effect in place of the common law rules and equitable principles as regards the duty to exercise reasonable care, skill and diligence, owed by a director of a company to the company. (5) This section applies to a shadow director as it applies to a director. (6) For the purposes of subsection (5), a body corporate is not to be regarded as a shadow director of any of its subsidiaries by reason only that the directors, or a majority of the directors, of the subsidiary are accustomed to act in accordance with its direction or instructions. This statutory duty in section 465 of the Companies Ordinance (Cap. 622) encompasses the mixed objective and subjective test for directors to satisfy. In deciding whether a director has breached the duties, the knowledge, skill and experience that may reasonably be expected of a person in holds that position (the objective limb), and the knowledge, skill and experience of that particular director (the subjective limb) have to be considered. However, without case law in Hong Kong interpreting section 465, how the mixed objective/subjective test will be determined by the court remains an open question. Nevertheless, guidance could be drawn from the Australian case laws because of similar tenets in the statutory obligations of this duty; as well both jurisdictions share a common colonial legal heritage.50 Comparable to Hong Kong’s experience, Australia’s general law standards concerning directors’ duty of care had been low.51 Since its enactment in 2001 Australia has amassed a number of case laws in interpreting statutory duty of care, skill and diligence. Young notes that, “the Australian s180(1) of the Corporations Act 2001 (Cth) has clear ramifications for the interpretation of the new Hong Kong statutory duties, as the text of the new s465(2) of CO (Cap. 622) are comparable”.52

50  Ibid., p. 68. 51  Ibid., p. 69. 52  Ibid.

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In determining whether a director has exercised reasonable care and diligence, the Australian courts will consider the circumstances of the particular company, including: the type of company, the provisions of its constitution, the size and nature of the company’s business, the composition of the board, the director’s position and responsibilities within the company, the particular function the director is performing, the experience or skills of the particular director, the terms upon which he or she has undertaken as a director, the competence of a company’s management, the competence of the company’s advisors, the distribution of responsibilities within the company and the circumstances of the specific case.53 Harris, Hargovan and Adams remark that, “the courts have recognised that while the standard is objectively assessed (that is, what would a reasonable person has done, not what the individual company director was in fact capable of doing), the actual requirements of that standard will depend on what sort role that person was performing in the company”.54 For example, it is recognised that chairmen or other directors who hold special positions like CEO or CFO may assume special responsibilities.55 The case of ASIC v Healey provides an example of holding directors liable for failing to adequately manage a company’s financial risk and carry out their due diligence as members of the board’s audit committee. The defendants in this case were directors of Centro Properties Group (CNP) and Centro Retail Group (CER). The allegations against the defendants concerned the approval of the consolidated financial statements in the 2007 annual reports of CNP and CER. Both of these reports failed to disclose about $ 2 billion short-term liabilities by classifying them as non-current liabilities and failed to disclose guarantees of short-term liabilities of an associated company of about US$1.75 billion. There were a number of sub-committees of the board which assisted with the implementation of corporate governance practices within CNP and CER, including the Board Audit and Risk Management Committee, a Compliance Committee, a Nomination Committee, a Remuneration Committee, and a set of well formulated procedures. However, with all these procedures, processes and committees in place, the directors still failed to detect the “obvious errors” in the financial statements. Justice Middleton notes that each director was sufficiently financially literate, with many years of experience analysing financial statement and they were not distracted by the various so-called complicated issues. The failure was that each director adopted the same 53  A SIC v Healey (2011) 278 ALR 618, 657; ASIC v Rich & Ors (2003) 44 ACSR 341. 54  Harris, Hargovan & Adams (2013), p. 534. 55  Ibid., p. 626.

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approach, near absolute reliance upon the board’s processes and advisors knowledge. No director stood back, armed with their own knowledge to look at and consider for themselves as a director the accuracy of the financial statements.56 For directors of listed companies with the HKEx, as discussed previously, code provisions have singled out directors should oversee the company’s risk management, either through the formation of a risk management or the board as a whole. In addition, the Corporate Governance Report obliges the board to include the board’s statement about a review of the company’s risk management and internal control systems. These new obligations, even though it falls under the “Comply or Explain” category, in effect, increases the potential liability of directors should the company makes substantial losses or driving to point of financial distress. As failure of directors to monitor, treat, and disclose the veracity of its risk management and internal control systems might be deemed, if sued by the company breach section 465 of the Companies Ordinance on directors’ duty to exercise care, skill and diligence, or shareholders under derivative action for negligence.57 Besides, if Australian case laws are applied to future litigation in Hong Kong, Chairpersons, CEOs, and CFOs will be held to a higher standard. Therefore, directors of listed entities on the HKEx should not downplay risk management responsibilities in the new HKEx Code as a task to undertake and another box to tic. Risk management requires vigilance and due diligence. Directors’ failure to comply could expose themselves to litigation risk. 6

Conclusions and Recommendations

At its core this chapter examined Hong Kong’s pending new amendments to the Code re-situating and revising existing RBPs on risk management to CPs with a handful of amended RBPs, as well making risk management a permanent feature in the Corporate Governance Report. In addition, the language of the text in the new CPs concerning risk management has created clear obligations for boards of listed entities with the HKEx to comply. This is because, in spite the fact that CPs falling under the ‘comply, or explain’ sets of regulatory obligations, it is unlike local issuers are able to come up with alternatives as they are transplants from the West. This is not to assert that these new ­amendments 56  A SIC v Healey (2011) 278 ALR 618, 751. 57  See Sections 731–8 of the Companies Ordinance (cap 622) on shareholders’ derivative action.

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are not likely to make a positive impact on the governance of issuers in Hong Kong. To the contrary, it is expected to be widely accepted by issuers because their submissions were generally positive. Aside from the fact that HKEx’s proposed new amendments might not be as specific in terms of obligations place upon boards, directors, CEO and CFO like those in Singapore, Australia and the UK (as discussed in section III), the central tenants about the importance of an effective risk management regime in place is clear. However, the concern is: are issuers fully aware of the implications for them because the CPs was transplanted from jurisdictions afar? Even though, the answer is anyone’s guess, the Code did not offer definition of what effective risk management is, apart from demanding process and procedures to be put in place, the boards are ultimately responsible for risk management of the company. More importantly, failure of listed entities in Hong Kong to meet the expectations of investors and shareholders in delivering an effective risk management regime could have negative consequences for boards and companies. Consequently, prior to the new amendment coming into effect in 1 January 2016, one would expect local issuers in Hong Kong would be scrambling to look for ‘off the shelf’ risk management solutions. However, issuers must be warned that risk management obligation is not just a ‘box to tick’. A survey and discussion on risk management standards revealed that these standards, whilst helpful for boards in offering certain pointers, they did not reveal a complete picture of what risk management involves. ERM did however provide more assistance for organizations to embed risk management norms and culture. Again, it is not a ‘silver bullet’. It is a step in the right direction. This chapter also discussed the links between risk management and corporate governance, as well as its intertwining relationship with directors’ duty of care, skill and diligence. OECD reports about the GFC have pointed to failures of companies to adequately manage corporate and financial risks left companies vulnerable to negative internal or external shocks. Thus, companies with an effective risk management regime would invariably have good governance practices. What was little known and not being explored sufficiently is the fact that risk management is at the heart of directors’ duty of care. And given that section 465 of the Companies Ordinance (cap 622) stipulates mixed objective and subjective standards of care, managing risk is a fundamental responsible of every director, but the scope and extend of the liability will depend on the director’s position in the company, experiences he/her has, and expertise they possess. Therefore, failure of directors in Hong Kong to manage the risk of a company adequately could be liable for breach of directors’ duty to exercise

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care, skill and diligence, if the company suffers from financial losses or exposed to substantial liabilities. As such, effective risk management requires directors to be vigilant and perform their due diligence. Since the new amended Code did not provide specificity as to how boards are to manage risk, directors in Hong Kong might not be sufficiently prepared beyond introducing new processes and procedures at the board level. Therefore, it is recommended that directors undergo training in risk management. Back in December 2010 the HKEx’s consultation paper did proposed that directors should undertake eight hours of compulsory training per year.58 However, after the consultation process, HKEx concluded that “All directors should participate in continuous professional development to develop and refresh their knowledge and skills. [. . .] [T]he issuer should be responsible for arranging and funding suitable training, placing an appropriate emphasis on the roles, functions and duties of a listed company director.”59 This is presently a CP under A.6.4 of the Code. Thus, it would appear that there is no excuse for directors to claim they are not prepared for the new obligations on 1 January 2016. In short, if directors do not proactively manage and monitor the risks of the company, they will expose themselves personally to excessive levels of legal risks. References

Corporate Governance Codes

ASX Corporate Governance Council (2014) “Corporate Governance Principles and Recommendations”, 3rd edition, Sydney: The Australian Securities Exchange. Corporate Governance Council (2012) “Risk Governance Guidance for Listed Board”, Singapore: Corporate Governance Council. Financial Reporting Council (2010) “The UK Approach to Corporate Governance”, London: The Financial Reporting Council Limited. ——— (2014) “Guidance on Risk Management, Internal Control and Related Financial and Business Reporting”, London: The Financial Reporting Council Limited. ——— (2014) “The UK Corporate Governance Code”, London: The Financial Reporting Council Limited. Hong Kong Exchanges and Clearing Limited (2010) “Consultation Paper on Review of the Code on Corporate governance Practices and Associated Listing Rules”, Hong Kong: Hong Kong Exchanges and Clearing Limited. 58  HKEx (2011), p. 24. 59  Hkex.com.hk (2015), Appendix 14.

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——— (2011) “Consultation Conclusions on Review of the Code on Corporate governance Practices and Associated Listing Rules”, Hong Kong: Hong Kong Exchanges and Clearing Limited. ——— (2014a) “Consultation Paper on Risk Management and Internal Control: Review of the Corporate Governance Code and Corporate Governance Report”, Hong Kong: Hong Kong Exchanges and Clearing Limited. ——— (2014b) “Consultation Conclusions on Risk Management and Internal Control: Review of the Corporate Governance Code and Corporate Governance Report”, Hong Kong: Hong Kong Exchanges and Clearing Limited. SGX (2012) Code of Corporate Governance 2012, Singapore: The Singapore Exchange.



Case

ASIC v Healey (2011) 278 ALR 618. ASIC v Rich & Ors (2003) 44 ACSR 341.

Legislation

Companies Ordinance (cap 622). Corporations Act (2001) (Cth).

Report

Anderson, Richard (2008) Risk Management and Corporate Governance, Paris: OECD Publishing. Haskovec, Nolan (2012) Codes of Corporate Governance, a Review, New York: the Millstein Center for Corporate Governance and Performance. International Organization for Standardization (2009) ISO 31000:2009—Risk Management: Principles and Guidelines, Geneva: International Organization for Standardization. OECD (2004) OECD Principles of Corporate Governance, Paris: OECD Publishing. ——— (2009a) Corporate Governance and the Financial Crisis: Key Findings and Main Messages, Paris: OECD Publishing. ——— (2009b) The Corporate Governance Lessons from the Financial Crisis, Paris: OECD Publishing. ——— (2010) Corporate Governance and the Financial Crisis, Conclusions and Emerging Good Practices to Enhance Implementations of the Principles, Paris: OECD Publishing. ——— (2014) Risk Management and Corporate Governance, Paris: OECD Publishing RIMS Standards and Practices Committee & RIMS ERM Committee (2011) An Overview of Widely Used Risk Management Standards and Guidelines, New York: Risk and Insurance Management Society Inc. The Committee of Sponsoring Organisations of the Treadway Commission (2004) Enterprise Risk Management—Integrated Framework Executive Summary, North Carolina: Committee of Sponsoring Organisations of the Treadway Commission. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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Literature

Aguilera, Ruth, Alvaro Cuervo-Cazurra, & Soyoung Kim (2011) “Taking Stock of Research on Codes of Good Governance,” http://papers.ssrn.com/sol3/papers .cfm?abstract_id=1773087 (accessed 19 January 2015). Branson, Bruce (2010) “The Role of Board of Directors and Senior Management in Enterprise Risk Management,” in J. Fraser & B. Simkins, eds., Enterprise Risk Management, New Jersey: John Wiley & Sons, 51–68. Drennan, Lynn, & Alan McConnell (2007) Risk and Crisis Management in the Private Sector, London: Routledge. Duncan, William, & Samantha Traves (1995) Due Diligence, Sydney: LBC. Harris, Jason, Anil Hargovan, & Michael Adams (2013) Australian Corporate Law, Sydney: LexisNexis. Hkex.com.hk (2015) “Corporate Governance Code and Corporate Governance Report,” https://www.hkex.com.hk/eng/rulesreg/listrules/mbrules/documents/appen dix_14.pdf (accessed 18 January 2015). KPMG’s Audit Committee Institute (2014) “2014 Global Audit Committee Survey,” http://www.kpmg.com/AU/en/IssuesAndInsights/ArticlesPublications/globalaudit-committee-survey/Documents/global-audit-committee-survey-2014.pdf (accessed 18 January 2015). ——— (2015) “2015 Global Audit Committee Survey,” https://www.kpmg-institutes .com/content/dam/kpmg/auditcommitteeinstitute/pdf/2015/2015-global-auditcommittee-survey.pdf (accessed 18 January 2015). Low, Irving (2010) “Scaling Greater Heights in Corporate Governance,” http:// www.kpmg.com/SG/en/IssuesAndInsights/ACI-publications/Documents/ ScalingGreaterHeightsCorporateGovernance.pdf (accessed 16 January 2015). Lupton, Deborah (2013) Risk, London: Routledge. World Economic Forum (2015) “Global Risk 2015: 10th Edition,” http://www3.weforum .org/docs/WEF_Global_Risks_2015_Report15.pdf (accessed 8 February 2015). Young, Angus (2014) Family Business and Corporate Governance in Hong Kong, Hong Kong: Wolters Kluwer.

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Chapter 11

Regulating P2P Lending in China

Industrial Landscape and Regulatory Approaches Shen Wei Abstract Peer to peer lending or P2P lending is a transactional mode in which lending is conducted on an individual-to-individual basis. The online lending company provides the platform for the lending transaction. The borrower’s need for funding is published on the platform after it is vetted, and lenders are free to provide funding. In foreign countries, this transaction mode is referred to as disintermediation, which is both popular and cost effective. Since 2011, the P2P sector has experienced an explosive growth, a phenomenon that can be explained by its supplemental nature to the formal banking sector. The emergence of the P2P sector has satisfied the financing needs of borrowers.

Keywords P2P lending – systemic risks – financial regulation

1 Introduction Monetary circulation using the Internet as the service platform falls within the scope of internet finance, including but not limited to online payment, online fundraising, online banking and other online financial activities. In terms of different stages of monetary circulation, namely fundraising, payment and settlement of funding, internet financing can be divided accordingly into the following three categories of service platform: the fundraising category, the financing category, and the third-party payment category. Their key ­features are outlined in Table 11.1 below.

* KoGuan Chair Professor of Law, Shanghai Jiao Tong University Law School. The author thanks Mathias Siems, Iris Chiu, Casey Watters, and Nathanael Schneider for their helpful comments on an earlier draft of this article. Contact: [email protected].

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Regulating P2p Lending In China Table 11.1 Key features of key categories of internet financing Type

Content

Fundraising P2P online lending Category Crowdfunding

E-commerce online lending

Financing Category

Industrial characteristics

Example

Individual investors make loans via online lending platforms Originator of creative projects raise funds from investors through online platforms The credit auditing and lending required by e-commerce enterprises’ interests platform data to finish microfinance

Renrendai1

Internet-based banking Use of the online platform to develop bank financing businesses Internet-based Use of the online platform securities industry to develop securities businesses Internet-based fund Use of the online platform industry to develop fund businesses Internet-based Use of the online platform insurance technology to develop insurance businesses

Dajiatou2

PPmoney3

China Merchants Bank4 Guotai Junan Securities5 Celestica Fund6 Zhongan.com7

1  Renrendai.com (2015). 2  Dajiatou.com (2015). 3  Ppmoney.com (2015). 4  Cmbchina.com (2015). 5  Gija.com (2015). 6  Thfund.com (2015). 7  Zhongan.com (2015).

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Table 11.1 Key features of key categories of internet financing (cont.) Type

Content

Industrial Characteristics

Example

Payment Category

Third party payment

Online payment and settlement platform independent of the merchants and banks

PayPal8

Others

Virtual currency

Non-physical currency generated by computer technology

Bitcoin9

P2P credit is a person-to-person lending mode, and does not use traditional financial institutions as the intermediary. It usually does not require approval from financial regulatory agencies. An Internet platform may be set up via P2P credit companies, where both borrowers and lenders can register. Individuals who require funds will deliver information (tender a bid for short) and individuals with idle funds will participate in the bidding. Once both sides agree on the amount, duration, and interest rate, the transaction will be done. In this process, information, funds, contracts, procedures and all other items are completed through the internet platform. Therefore, P2P lending is a new model generated in the wake of the rise and development of internet and private lending. At the same time, P2P credit companies are responsible for inspecting the credit status of the borrowers, and collect account management and service fees. It thus should be characterized as a kind of private lending in essence. P2P credit typically has the following characteristics: (1) Online transaction. Information and funds, contracts and lending processes are all conducted through the internet. (2) A low borrowing threshold. Anyone can become a communicator and user of credit. Credit transactions can be easily carried out. Anyone can get involved at a low transaction cost. (3) P2P credit companies only play an intermediary role, meaning that lenders and borrowers are autonomous. 8  Paypal, Inc. (2015). 9  Bitcoin.org (2015).

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(4) The lender requires a small sum of money for a single investment, and the risks are shared among a group of lenders. A lender will distribute funds to more than one borrower while providing a small amount of the lending so that the risks can be dispersed to the greatest degree. P2P lending originated with P2P micro-lending. P2P micro-lending is a commercial mode in which tiny amounts of funding are gathered as to lend to those who require funds. Its social value lies mainly in meeting the financial needs of individuals, the development of personal credit system and the improvement of utilizing socially idle funds. It was first created by Professor Yunus, winner of 2006 “Nobel Peace Prize,” who in 1983 founded the Grameen Bank in Bangladesh.10 With the rapid development and popularization of the Internet, P2P microlending gradually evolved from a single “offline” model, into the coexistence of “offline” and “online” models. P2P lending platform emerged accordingly. In P2P lending, individuals with idle funds and investment willingness rely on the third-party financing platform to lend their own funds in the form of credit to those individuals in need of money; the third-party platform then acquires and analyzes the borrower’s credit quality, economic strength, mode of operation, management level, borrowing purpose as well as other information, to determine the borrower’s credit rating and credit lines. In addition, the third party platform collects a certain amount of service fees for both lenders and borrowers. Drawing lessons from foreign cases on P2P lending platforms, in August 2007 China established the first P2P credit company: ppdai.com. ppdai.com was mainly modeled on Prosper.com’s pure intermediary business model.11 Its operation adopted a bidding mode. The borrower with financial needs first releases demands (issuing of bidding documents) through the P2P platform. When the lenders see the information, according to the risk considerations, they will choose different tenders and tender-bidding proportion to conduct in full or partial tender with their own funds. However, the bidding interest rate cannot be higher than the highest value set by the borrowers. After the fundraising term expires, if the total bidding amount meets or exceeds the borrower’s requirement, one or several funds that can meet the requirements with the lowest annual interest rate will win the bid; in the case that the funds needed by the borrowers cannot be collected after the expiration of the fundraising term, the effort to borrow fails. Once the loan succeeds, the 10  Wikipedia.org (2015). 11  Ppdai.com (2015).

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platform will automatically generate an electronic promissory note. During the lending term, the borrower will repay the capital with interest monthly to the lender. Pursuant to the data provided by P2P eye, a third party research institute with a focus on the P2P platforms, as of July 2014, the total number of operational P2P online lending platforms in China with the annual lending amount of 10 billion RMB in the first half of 2014 was 1,286, which almost equaled the annual figure of 2013.12 It has been estimated that the annual lending volume may exceed 30 billion RMB in 2014.13 Meanwhile, pursuant to Wang Yanyou, director of the Innovation and Supervision Coordination Committee of the CBRC, the number of traceable P2P platforms in aggregate is around 1,200. Among them, only 150 platforms have experienced a “bank run” as of July 2014.14 Crowdfunding refers to a micro fundraising mode adopted by initiators or small and micro enterprises, and other project sponsors make use of the internet and SNS (Social Networking Services, the social network) to gather public funding, capacity and channels and subsidize individuals, charitable organizations and commercial enterprises. Crowdfunding is a platform to raise small amounts of funds from each individual of a large group of investors for financing to support the efforts of achieving specific goals or participating in certain activities. Based on the different forms of returns promised to the investors for their contribution, crowdfunding can be divided into different types, among which equity crowdfunding has the attributes of both financing and equity investment for providing the equities of companies or projects the investors invest in. Equity crowdfunding provides new investment channels for the ordinary investors with surplus funds, and provides new financing channels for the start-ups and small businesses in deep trouble of getting financed, thus enjoying great popularity among investors and entrepreneurs. Crowdfunding can also be in the form of donation-based, reward-based, and lending-based. Crowdfunding has the following features: (a) Low Entry Barriers Judging from the restrictions on the fundraiser qualifications, any person with an idea can initiate projects as long as they are approved through the identity authentication of an online crowdfunding platform to raise funds for a cause. Compared to the creditor’s review on a non-listed company’s financing, the restrictions a crowdfunding platform may impose on the project sponsors are 12  Liu (2014). 13  Liu (2014). 14  Sohu Stock (2015). Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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extremely relaxed. For the sake of convenience in raising funds, crowdfunding has a short process, a simple operation, and a flexible time frame. Compared to traditional financing, the threshold for the fundraisers has been reduced further. This low threshold is a common feature of internet finance. The development of internet finance, including crowdfunding, will contribute to the achievement of an “inclusive financial system” advocated by the United Nations. (b) Grassroots Participants Due to the low threshold of the crowdfunding, the fundraiser and investors are generally ordinary grassroots individuals, rather than those for-profit companies, enterprises or ventures capitalists with professional backgrounds. Although dispersed, they are large in number. Therefore, if there are proper projects, all the funds gathered together can be a considerable financing, which is also the essence of crowdfunding. However, due to the grassroots nature of the participants, it is difficult for the funders and investors to be professional. Consequently, this inevitably leads to an increase in financial risks, which also presents a challenge to the regulation of the crowdfunding industry. (c) Object Diversity The business objects of the crowdfunding are varied, spanning design, technology, music, film, food, comics, publishing, gaming, photography and other fields. Currently however, they are mainly applicable to the products with a high degree of standardization and an obvious market demand in the retail industry. Temporarily at least, crowdfunding has been unable to reach the bottom line of the financing field, where there is a high degree of professionalism and a large-scale financial operation. (d) Emphasis on Creativity First, the project sponsor must first present creative ideas to the extent that such ideas can be displayed. Only in this way, the proposal can go through the platform auditing. A concept or an idea alone is not sufficient. Second, the crowdfunding helps the sponsors put the creative ideas into practice and at the same time, the target audience can experience the creators’ ideas, the effect of creativity, and the power of ambition and entrepreneurship. This helps broaden the horizons of the audience, and creates a social atmosphere that encourages innovation. (e) Marketing Crowdfunding platform is primarily a fundraising platform. However if it is used properly, it can also become a marketing platform utilized to display ­creative ideas and expose brands to the general public. The crowdfunding Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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platform attracts the attention not only of scattered small-scale investors, but also professional investors. Thus, if a project manages to raise a previously unimaginable large investment, the successful financing itself can serve as a great advertising campaign. A crowdfunding’s basic structure is as follows: (1) The investors make an unpaid investment without any return conditions in the project or company. (2) Investors invest in the project or company, and after the project goes into operation, the financing party provides returns to investors in the form of products or services. (3) Investors invest in the project or company to obtain a certain percentage of its debt, and in the future, investors will get interest income and principal repayment. (4) Investors invest in the project or company to obtain a certain percentage of its stock right. In April 2011, China’s first crowdfunding website Demohour.com was established, and made first exploration into the new field. In the first year, Demohour. com launched a total of 77 projects and completed 52 projects. Out of the 52, 29 were successful projects, a success rate of 55%.15 Since 2011, it has helped finance around 2000 projects without access to formal banking.16 Likewise, Dreamore, another crowdfunding platform, has raised more than 6 million yuan for over 300 projects. In early 2012, after analyzing the operational data in the first half of the year, Demo Hour found that the support rate for all the projects and the conversion rate of the websites exceeded those of many electronic business platforms. The largest project fundraising surpassed 50 million RMB. Since then, Demo Hour started to probe the field of intelligent hardware industry. In early 2013 it formally focused on the intelligent hardware field. Beginning in late 2013, it no longer accepted non-intelligent hardware projects. As of now, the “Demohour 10X10 Assembly” with more than 2,000 attendants per conference, has become an essential meeting within the intelligent hardware industry.17 In just three years, the crowdfunding pattern emerged in China and attracted widespread attention.

15  Ma (2015). 16  Ma (2015). 17  Economy.gmw.cn (2015).

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As equity crowdfunding in China has been taking shape, Dajiatou, AngelCrunch and Yuanshihui have become the standard-bearers of the industry. They share certain characteristics in operation modes, including adopting an investor membership system, a lead-investment + co-investment mode, and online + offline modes. Table 11.2 below outlines some key differences among a number of key players in the marketplace. Table 11.2 Comparison of major players in the market Main perspectives

Dajiatou.com18

Anglecrunch.com19

Yuanshihui.com20

Membership

Yes

Yes

Yes

Investor’s qualification

No

Yes, with angle Yes, annual income is investor’s experience not less than half million or net assets are not less than 10 million

Cap on the number Yes, usually for of investors a single project, the number of investors is no more than 40

Yes, usually for a single project, the number of investors is no more than 30

Not disclosed

Leading investment Yes plus follow-up investment

Yes

Yes

Online + offline modes

Yes

Yes

Yes

18  Dajiatou.com (2015). 19  Angelcrunch.com (2015). 20  Yuanshihui.com (2015).

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Table 11.2 Comparison of major players in the market (cont.) Main perspectives

Dajiatou.com

Anglecrunch.com

Third-party bank

Using Industrial No Bank as a third party payment bank,

Yuanshihui.com

No, mainly offlinepayment, may involving a third party payment platform

Equity participation Limited liability partnership

Not disclosed Less than 3 people, nominee relationship, if more than 3, limited liability partnership

Charges

5% of equity returns

On average 5%, case-by-case

No

Yes, case-by-case

5% of the funding

No Platform’s participation in the project

Thus far, the P2P lending sector is placed within the spoke of the CBRC’s regulation agenda. Pursuant to the roadmap drawn up by the government, the P2P lending business will fall within the jurisdiction of the CBRC, which has outlined some basic guidelines.21 First, the legal nature and identify of platform must be clarified. Second, the platform itself should be involved in the security providing business. Third, the platform should not be used as a capital pool. Fourth, the platform should be used to collect funds from the general public. The regulatory regime may outline some detailed, supplementary rules. For instance, the platform should only be used as an information intermediary. There can also be market entry requirements imposed on the platforms. These conditions can be either capital requirements or qualification requirements. Disclosure is also used as a key regulatory device so that the investors and borrowers will make commercial decisions on an informed basis. Based on such criteria, regulators appear to support increased industrial self-discipline. 21  Forbeschina.com (2015).

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The development of crowd-funding has become vigorous. Among the projects currently on crowd-funding websites, include bonus crowd funding modes which includes group purchase + pre-buy mode, donations crowd funding, and news crowd funding. Furthermore, equity crowd funding has been listed on zhongchou.cn. However, crowdfunding’s potential legal status has also become increasingly prominent. Equity crowd-funding involves varied risk, including commercial risk and legal risk. The commercial risks include the volatility of start-ups and small businesses, the possibility of fraud, the low liquidity of the investment, opportunism and moral hazard, and the vulnerability of the investors; the legal risks include the illegal issuance of securities, illegal fund-raising, and fraudulent fund-raising. It has become necessary for the regulators to introduce corresponding regulatory measures to provide a sound legal basis for equity crowdfunding, and prevent the occurrence of the potential systemic risks. The American JOBS Act creates a crowdfunding exemption, sets a limit on the investment amount, provides funding portal registration, and imposes the obligation of information disclosure on the issuers. This legislation provides a foreign model for crowfunding regulation. Based on the principles of seeking a balance between protecting investors, facilitating equity crowdfunding, and maintaining regulatory focus on the crowdfunding platforms, the competent regulatory authority must set up reasonable investor admittance and investment caps, strengthen fundraiser and project reviews, conduct investor education, maintain the neutrality of crowdfunding platforms and establish the differentiated information disclosure system, thus providing comprehensive and systematic support for the development of equity crowdfunding. The theoretical basis of such regulatory principles and guidelines, as well as their applicability in China, is disputable. For instance, it has been argued that the P2P lending platforms should be regarded as lending companies rather than as mere intermediaries. However, as demonstrated by China’s practice, few P2P lending companies serve as mere information intermediaries. Most such intermediaries provide security, either by themselves or through third parties, thereby turning them into credit intermediaries after a credit exchange. Therefore, it is not desirable to have a one-size-fits-all approach to the legality of platforms. The regulator, while designing the regulatory devices, should be cognizant of the status quo in China’s financial market and regulatory environment. The first part of this article will briefly discuss the current status of the P2P lending sector in China as well as some basic modes. The second part will discuss some main thoughts on the potential regulatory regime in China, namely, bottom line regulation or classified regulation. When suffocating the

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illegal fund raising activities, the P2P companies will be classified into two main types, information intermediary and credit intermediary. The former group can be further divided into P2P platforms for personal loans and P2B platforms for enterprise loans, thus carrying out different regulatory modes. In part three, the different regulatory modes for information intermediary, P2P lending intermediary and P2B lending intermediary will be discussed. A brief conclusion will follow. 2

P2P Lending in China

In 2007, PPDAI22 became the first P2P lending company in China. There have been no existing rules regulating its operation. In fact, it has been difficult to determine which watchdog agency should be the regulator. Consequently, due to the fact that P2P platforms are not subject to any market entry rules, industrial criteria or regulator’s monitoring, P2P lending businesses have grown extremely fast. As there is no explicit requirement of regulatory filing for P2P lending platforms, the numbers and scale of P2P lending companies in China can only be calculated on the basis of some incomplete data. According to the 01 Data Storage Co.,23 the number of P2P lending platforms had reached close to 700 with an annual turnover about 110 billion RMB, by the end of 2013.24 According to a third party research institute on P2Ps in China, the Wangdai Tianyan China,25 P2P platforms are in existence in every province except for Tibet. The total number of P2P platforms nationwide was 1,286 by July 2014. The turnover of the whole industry approached 100 billion RMB in the first half year of 2014, which was close to the entire turnover in 2013. It is estimated that the annual turnover in 2014 would have been 300 billion yuan. Chart 11.1 below shows the number of the P2P platforms established during the period from 2007 to 2014.26

22  Ppdai.com (2015). 23  Data.01caijing.com (2015). 24  01 Caijing & 01 Statistic (2014), p. 8. 25  Wangdaizhijia.com (2015a). 26  Wangdaizhijia (2015b).

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Chart 11.1 Annual number of P2P platforms.* *COMPILED by the author.

The other way of looking at the prosperity of the P2P lending sector is the rising annual lending amount in this sector. Chart 11.2 and Chart 11.3 demonstrate this growing trend in terms of the annual lending amount27 and annual outstanding loan28 respectively.

Chart 11.2 Annual lending amount.* (Billion Yuan) *COMPILED by the author. 27  Wangdaizhijia (2015b). 28  Wangdaizhijia (2015b).

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Chart 11.3 Annual outstanding loans through P2P platforms.* (Billion Yuan) *Compiled by the author.

Although the P2P sector is a relatively new industry, it has grown fast in China. The UK and the US had P2P lending much earlier than China, but the development of the P2P industry in these two countries has been quite limited. Thus far, both markets have hosted less than a dozen P2P lending platforms. The lending amount in the US and the UK are only 2.5 billion and US$1.7 billion US$ respectively.29 The jurisdictions where P2P net lending first emerged only have net lending platforms in single digits, and loan amounts on an order of magnitude of billion dollars (2.4 billion dollars in the US and 1.7 billion dollars in the UK). The development of P2P net lending is on a much smaller scale than in China.30 In theory the P2P lending platforms should have incomparable advantages, as it is a sector with an apparent monopoly, due to the potential of internet use to expand the size of market and users. However, regardless of what business models are involved, the fact that China already has more than 1,000 online lending platforms is quite striking. The abnormal prosperity of China’s P2P lending platforms owes mainly to the financial repression. Under the Chinese government’s financial repression strategy, the financial system is mainly under the control of large state-owned financial institutions, and naturally financial demand and consumer credit for small and medium-sized companies are undeveloped. As a result, there

29  P2pfa.info (2015); The Economist (2014). 30  The Economist, supra note 29.

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is a great shortage of investment channels, which in turn restrict investment opportunities, with the exception of bank deposits. Financial repression has also created a strong informal financial market in addition to persistent illegal fund-raising activities. The key reason is that the informal lending market is less regulated than the formal banking sector. Meanwhile, due to the lack of trust and regulation, the informal financial market experienced several abnormal distortions and bubbles that have burst. The turmoil in China’s informal financial market in Wenzhou in 2010, and the financial crisis in Erdos and Shenmu in 2012 are good examples. The P2P sector’s booming growth has changed the classic model of it to some extent and resulted in some Chinese characteristics. The main purpose of the P2P lending is to finance small and medium-sized enterprises rather than provide personal consumer credit. In other words, P2P lending is mainly used to satisfy the financial demands of small and mediumsized enterprises as commercial lending, a completely different function from that of personal lending activities. Therefore, the Chinese P2P lending can be divided into two general types, lending from person to person (the real Peer to Peer internet lending), and lending from individuals to enterprises (which is actually Peer to Business lending and could be named as P2B lending). The second type of lending is more significant than the first type in China. Given the credit environment in China, the model of combining both online and offline lending has been popular for many P2P lending platforms. Often P2P platforms attract investors via the internet to obtain funding, while also soliciting borrowers offline and examining the borrowers’ creditability. Offline businesses even constitute the majority portion of some P2P lending platforms. However, offline services drastically increase the transaction costs of P2P lending. Overall, the interest rate offered by P2Ps is comparatively higher than the rate offered by commercial lenders in China. In order to attract more investors and funding from the market, many Chinese P2P platforms have a security mechanism to guarantee the investors’ capital and earnings. There are a number of collateral arrangements. For instance, some platforms offer collateral by extracting risk reserve capital, whereas others introduce third-party collateral enterprises. In some cases, P2Ps ask for collaterals through small loan enterprises. Nevertheless, these security mechanisms are likely to transfer the credit risk of lending transactions from the platforms to other third-parties. Credit risks are then concentrated into the collateral institutions. The public investors have no motivation to select borrowers but entirely rely on the collateral institutions, making the core protection method of public investors fall on the regulation of the collateral institutions.

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Some P2P lending platforms realized the maturity transformation by splitting the debt or equity. In this business model, the creditor and debtor do not have a direct debtor-creditor relationship. Rather, a third party that is closely related to the platform lends money in advance, and the loan is then divided into smaller loans with shorter terms for sale. Alternatively, the platform divides the loan into smaller portions with shorter terms, which facilitates the sale of divided loans. In this model, the maturity transformation is realized through the lending platforms. However, the liquidity risk exists due to the mismatch between terms and amounts. 3

Regulatory Design

The transformation of the P2P sector in China has been caused by China’s unique financial market, featuring a weak creditability system. Whether the P2P sector can be successful as a business model depends on three major factors: those are, the decentralized transactional structure, the Internet technique, and the digital loan auditing mechanism. This booming sector is not risk free. Chart 11.4 below indicates an increasing number of P2P platforms which have been in various troubles.31

Chart 11.4 Annual number of “In-trouble” P2P platforms*

31  Wangdaizhijia.com (2015b).

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The risks the whole sector is facing are more or less related to China’s lack of creditability system in the financial sector. China does not have a strong creditability system that can be used to support financial transactions. Furthermore, the Chinese market is full of financial repression.32 Under this circumstance, the P2P lending companies have to devote a large pool of money and human resources to building up offline risk control teams, thereby forming a so-called online to offline (O2O) business model. When the creditability system is backward, investors tend to be risk averse and are only able to bear very little risk. In order to attract enough investors P2P companies have to offer various investor-protection plans, or even provide security schemes to guarantee the repayment of the principal and interest.33 The essence of P2P lending can be equated with illegal fund-raising. However, in China’s environment of financial repression, P2P lending is an undoubtedly positive supplement to the formal financial institutions’ shortage of financial services. Therefore, the regulatory structure should be put in place to promote P2P lending’s utility and benefit, while at the same time reducing its potential risks. On the one hand, potential regulation should preserve P2P lending’s supplementary function to the formal financial sector. On the other hand, the regulation should crack down on illegal fund-raising, fraud, and the lack of investor and consumer protection. To this end, two regulatory instruments can be introduced: bottom-line regulation and classified regulation. 3.1 The “Bottom-Line” Regulation The nature of P2P lending is public financing, which means that the borrowers collect money from the public by repaying principal and interest, a practice which is strictly regulated by most nations, and characterized as illegal fundraising in China. At different levels, illegal fund-raising may be further divided into absorbing public deposits illegally (or in a disguised form), and unlawfully issuing securities or funds in a public manner. These actions can lead to charges of criminal liability for the crime of absorbing deposits from the public illegally, the crime of fund-raising, or other related crimes. However, since P2P lending to a certain extent supplements the formal banking system, the regulators should provide enough room for the P2P lending business to survive without imposing too many risks. The bottom line of the P2P lending regulation is that there should be no crime or fraud in the P2P lending businesses. In other words, the bottom line is that convicting illegal fund-raising should not be allowed through the P2P 32  01 Caijing & 01 Statistic (2014), pp. 5–6. 33  01 Caijing & 01 Statistic (2014), p. 7.

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platform. Right now the standard for illegal fund-raising is determined by the interpretation of the Supreme People’s Court. According to the Interpretation of the Supreme People’s Court of Several Issues on the Specific Application of Law in the Handling of Criminal Cases about Illegal Fund-raising in 2010 (hereinafter “the Interpretation of Illegal Fund-raising 2010”),34 Article 3, “Whoever absorbs public savings illegally or in disguised form under any of the following circumstances shall be subject to criminal liability according to law: (1) An individual absorbs public savings of not less than 200,000 yuan illegally or in disguised form, or an entity absorbs public savings of not less than 1 million yuan illegally or in disguised form; (2) An individual absorbs public savings from not less than 30 depositors illegally or in disguised form, or an entity absorbs public savings from not less than 150 depositors illegally or in disguised form. . .”. Therefore, in order to avoid the illegal fund-raising crimes, the upper line of the amount borrowed by an individual can only be set as 200,000 yuan and for an entity (micro-sized, small, and medium-sized enterprises) 1 million. For the same reason, the upper line of the number of lenders for an individual can only be set at 30 depositors and at 150 depositors for an entity (micro-sized, small, and medium-sized enterprises). However, due to the special feature of P2P lending, the above standards are problematic. Firstly, the trend of more investors with small amounts is a better method of risk diversification. In other words, the cap on the borrowed amount is necessary, but the limit on the number of lenders is improper when the amount is little, as diversification can reduce risks effectively. For example, a 1 million yuan loss has different effects when the lending involves 10 lenders or 1,000 lenders. In the former circumstance, everyone would lose 100,000 yuan, not a small amount. In the latter circumstance, everyone would only lose 1 thousand yuan, an amount unlikely to cause severe harm for the community, not even to mention the whole society. Secondly, since the lenders themselves belong to the community and are less experienced in analyzing and bearing risks in the lending business, the investment amount should also be limited in addition to the limit on the borrowed amount. This is a similar principle to limiting the investment money in equity-based crowdfunding. P2P lending is one form of crowdfunding, the debt-based crowdfunding. Since the above standard is only an interpretation by the Supreme People’s Court rather than a statute, it can be adjusted. The regulator may cooperate with the Supreme People’s Court and change the above standard when applying it to P2P lending. Besides a limit on the borrowed money, the regulator can 34  Full text is available at http://www.lawinfochina.com/display.aspx?lib=law&id=8523&CGid (accessed 14 June 2015).

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remove the upper limit on the number of lenders and set a floor instead. At the same time, the regulator can set a cap on the largest investment amount a lender can lend through the P2P platform per year. In addition to a limit on the specific amount of money and the number of people, some typical illegal fund-raising modality should also be explicitly banned by regulatory agencies. In fact, given the limit on the amount of money and the number of people, P2P pending may only have three types of fundraising modalities. The first modality is that the P2P company provides false information and is actually engaged in self-financing. The second is that the P2P company is involved in credit transformation and maturity transformation by providing collateral or segmenting terms or credit. Therefore, the P2P platform is turned into a shadow bank, which creates systemic risks and deserves to be regulated. The last form is that a P2P platform is a public fund, collecting money from the general public and then investing money into the project. This is typically a capital pool. The determinative factor to identify the nature of a P2P platform is the nature of the transactions that P2P platform is engaged in. Certainly it is not impossible to completely get rid of the limit of illegal fund-raising. The primary criterion to characterize an activity to be illegal fund-raising is to engage in the business of collecting money without due approval.35 In other words, if the P2P company can legally collect money with due approval from the competent regulatory agencies, the risk of being charged with the crime of illegal fund-raising would be quite minimal. From the legal perspective, it is difficult to obtain the approval under the current supervisory regime. According to relevant laws, only a few types of financial institutions, including commercial banks, insurance companies, and securities investment funds, can legally raise money from the public.36 The only possible way of obtaining approval for the P2P platforms is for the regulators to set up a new administrative licensing system for P2Ps. In essence, were the P2P platforms regarded as financial institutions, they could legally collect funds from the 35  McMahon (2015). 36  See Paragraph 1, Article 167 of Chinese Criminal Law. The paragraph is “Whoever illegally takes in deposits from the general public or does so in disguised form, thus disrupting the financial order, shall be sentenced to fixed-term imprisonment of not more than three years or criminal detention and shall also, or shall only, be fined not less than 20,000 Yuan but not more than 200,000 Yuan; if the amount involved is huge, or if there are other serious circumstances, he shall be sentenced to fixed-term imprisonment of not less than three years but not more than 10 years and shall also be fined not less than 50,000 Yuan but not more than 500,000 Yuan. ” The full text of Chinese Criminal Law can be reached at http://www.npc.gov.cn/englishnpc/Law/2007-12/13/content_1384075.htm (accessed 12 June 2015).

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general public. Achieving these necessary reforms under the current financial regulatory regime is nearly impossible. However this is due to P2P lending being far from a finished product, and the business model of P2P lending still not fully comprehended in the financial industry. Therefore, upgrading this new business model to financial intermediation is obviously too soon. On the other hand, the national government in China could delegate or decentralize administrative power to the lower governments, thereby simplifying the administrative approval processes. To this end, the State Council is in a process of gradually reducing administrative intervention and the ever-present need for administrative licenses. That is to say, the likelihood of the government establishing a new administrative licensing system to monitor the P2P sector is small. Instead, the State Council may adopt a registration system to regulate the internet financing sector. 3.2 Classified Regulation After several years’ rapid development, the P2P lending sector in China is becoming increasingly prosperous. In terms of the scale of participating investors, the number of institutions, and the amount of money borrowed through the P2Ps, the P2P lending sector is much larger than its counterparts in the developed world. According to 2013 statistics, the number of the P2P platforms in China reached 1,000 and the total amount money lent through the P2P platforms exceeded 100 billion Renminbi, while the number of P2P platforms in the UK or the US stood at only single digits and the amount of money involved in the P2P sector is in mere billions of dollars (specifically, US is 2.4 billion, UK is around 1.7 billion).37 These numbers would only constitute 1/10 of P2P platforms in China, and therefore don’t warrant comparison. The prosperity of P2P online lending in China is inseparable from the change of classical modes undertaken by the P2P companies in order to adapt to the market. The term “information brokers” does not entire encapsulate the variety of commercial modes in existence.38 Therefore, the prospective supervision mode of P2P online lending cannot simply adopt the foreign mode of supervision on the information brokers.

37  Statistics about the development of Chinese P2P lending Sector, please refer to Boao Review and Lufax (2015). While figures about US and UK, please refer to Quinn (2014). 38  In reality, most P2P lending platforms provide their clients with services more than “information broker”. Some have questioned this P2P model’s legality, given that pooling and lending funds gathered through P2P channels is tantamount to gathering deposits from the public without a banking licenses. See Jingu (2014).

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This paper argues that transformation of the P2P online lending industry has led to a fundamental change in P2P online lending models in China. Based on their different functions and service objects, the P2P online lending models should be distinguished by at least two variables. Only by making these proper distinctions can we design a regulatory mode in China to meet actual needs. First we need to distinguish the functions of P2P online lending. Is it just an information brokerage, or does it provide the functions of information brokers in addition to other services? Determining the answer involves the problem of the guarantee during the P2P online lending process. Typical P2P lending does not provide guarantees. The lender undertakes the credit risk of the borrower. The P2P online lending platform only investigates the borrowers and their borrowing information according to the platform’s own standard. Then the platform gives each borrower a risk mark and a basic price. To some extent the investigation process functions as a credit analysis, but without assuming the credit risk. Therefore, this function looks more like an investment consultation. Based on the credit environment in China, the ability of the lender to recognize risk and undertake risk is very poor. Most P2P online lending companies in China relieve lenders’ credit risk by the way of providing a guarantee to them.39 There are many ways to provide a guarantee, including by means of the P2P online lending platform itself, setting up loan loss provision, through a small loan company of the third party, or by a financing assurance company. Currently an online lending platform cannot provide a guarantee by itself or its related company, because the online lending company would undertake all the credit risk from borrowers. The online lending company allocates its money from the public, not like a small loan company, which funds itself. A P2P online lending platform provides guarantees to its clients through a third party, a practice difficult to ban entirely. This is because amidst financial repression, an extraordinary credit intermediary (financing guarantee agencies) becomes exceptionally prosperous. At the same time, under the current financial system, the financing guarantee agencies are regarded as legal financing institutions and are supervised by the government to some extent. It is currently legal for them to provide a guarantee.40 If it were banned completely, this would be a heavy blow to the industry. 39  My089 is one of the oldest P2P lending platforms in China, founded in 2009. It was the first to offer a guaranteed return to investors. See Jones (2014). 40  See Interim Measures for the Administration of Financing Guarantee Companies. The regulation was co-issued by China Banking Regulatory Commission, Ministry of Commerce, Ministry of Finance, Ministry of Industry & Information Technology, People’s Bank of China, State Administration for Industry & Commerce and State Development &

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In the event that third-party guarantee activities couldn’t be prohibited, censorship and supervision should be focused on the guarantors, who shoulder a large amount of credit risk. Under this mode of operation, P2P online lending platforms as well as the third party guarantee institutions would together constitute so-called credit intermediaries. They would be supervised in a different way from the so-called information intermediaries. At the meantime, what institutions providing credit guaranty face at this moment is the information asymmetry problem other commercial lenders may not face. If a risk arises and the market was to flare-up, this would impact public affairs. Even localized systematic risk would be incurred, if the guarantors were to shoulder responsibility for bank financing and P2P online lending. From a risk management perspective, the method of supervising P2P online lending platforms should be different from that of supervising the financial guarantee companies. Second, among the credit intermediary patterns, there is a need to make a distinction between personal loans and small-medium enterprise loans. On its face, the distinction between them regards the different identities of the borrowers. In essence, the primary difference is the purpose of each loan, which is naturally reflected in differentiated treatments under the law. Small-medium enterprise loans are commercial loans in nature. Although they may need certain special treatment based on policy considerations, they do not usually differ from commercial loans. Personal loans, on the contrary, are different. The main objective of a personal loan is for personal consumption. Therefore, it is consumer credit in nature. Borrowers would be deemed financial consumers in law and then require special protection under the law.41 In theory, it is not contentious that borrowers in consumer loans are the consumers who receive financial services from the banks and financial institutions. Essentially, the Consumer Protection Law may apply when the borrowers’ rights have been damaged. In developed countries there are special laws on consumer credit and special protections for borrowers.42 With the establishment of specialized consumer protection agencies under China’s “one bank and three commissions,” there is a need to take into account consumer protection while designing a monitoring system for P2P platforms in China.

Reform Commission. Full text can be reached at http://www.lawinfochina.com/display .aspx?lib=law&id=8348&CGid (accessed 14 June 2015). 41  Issues relating to the consumer protection in consumer credit services, see Li (2000). 42  Such as US’s Truth in Lending Act and Equal Credit Opportunity Act. See Citytowninfo .com (2015). Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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Possible P2P Monitoring Model in China

In the so-called bottom line regulation and classification regulation, a possible P2P regulatory regime may include a number of components. Firstly, a negative list should be crafted to enumerate all the activities P2P platforms cannot be engaged in so as to prevent illegal fund-raising activities. Secondly, regulation should be maintained at the minimum level for those P2P lending platform that function as pure information intermediaries. Regulation is required to ensure information safety and investor protection. Thirdly, if P2P platforms also provide security services, then the fact that personal and small-medium enterprise loans are offered by the platforms must be taken into account in order to apply different regulatory tools owing to differentiated business models and risks. 4.1 “Negative List” Approach The “negative list” approach is reflective of a so-called bottom line monitoring scheme with the aim of preventing P2P platforms from being involved in illegal fund-raising activities, which constitute crimes under Criminal Law.43 P2P platforms may avoid a criminal charge by satisfying two requirements. First, P2P platforms are subject to two caps: the cap on the monetary value for the lending and the cap on the parties involved in the transaction. Currently, the monetary limitation is 200,000 yuan for an individual investor and 1,000,000 yuan for a company investor.44 The monetary upper limit also applies to small and medium-sized enterprises. While 1,000,000 yuan as an upper limit may seem reasonable, 200,000 yuan as the upper limit for a personal loan appears to be on the low side. As discussed above, the monetary limitations should not be used to limit the loan amount, but instead to limit the total amount that lenders can engage in the P2P lending business. This is more relevant to the risk control and investor protection. The same concept for equity crowdfunding applies to the P2P lending platform, that of crowdfunding platforms, a loan-type crowdfunding. Thus, it is logical to have a cap on the annual credit amount an investor may lend through the P2P platform. This credit amount can be calculated on the basis of the investor’s annual income. For example, if an investor’s annual income is 200,000 yuan, then the amount he can invest into the P2P platform should not exceed 20% of his annual income. Through this regulatory mechanism, the investor can be well protected from potential risks involved in the P2P lending activities. 43  See Article 167 of Chinese Criminal Law, supra note 36. 44  See Lee (2011). Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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Regarding the cap on the number of investors, the current rule dictates that no more than 30 lenders should be involved in a personal loan and no more than 150 lenders in a company loan.45 As a general rule, the risk in decentralized investments is much less than the risk in concentrated investments. Further, with the monetary limitation, the fact that a large number of borrowers are involved in the business does not constitute being a stakeholder in an illegal fund-raising activity. By the same logic, the regulator should encourage more lenders to invest in dispersed amounts. The upper limit on the number of lenders in a single loan could then be abolished. Also, the regulator could consider introducing a floor of the number of lenders in each loan, forcing lenders to disperse investments. On the other hand, some restrictions can be explicitly imposed on the business mode: (1) the P2P platform itself or its connected company needs to provide security; (2) the P2P platform needs to finance its own business; (3) the P2P platform needs to play a role as a publicly offered fund, which is commonly known as the capital-pooling business. 4.2 Regulating Intermediaries Information intermediary is the role a P2P platform is expected to play in the lending business sector. Accordingly, a P2P platform can only to disseminate information and not assume any credit risk itself. It would therefore be reasonable to expect a minimum level of regulation with a focus on information disclosure. In order to obtain relevant information and also fulfill its regulatory function, the P2P platforms should file their basic information with the regulators. The P2P platforms also need to provide regular reports to the regulatory agencies. For example, in the UK, the platforms are required to submit a summary report regularly to the regulator and the reported information includes financial statements, customer funds status, complaints, litigation, and detailed information regarding quarterly loan arrangements. In addition, the platform has notification obligations when the total lending amount experiences a fluctuation of 25% or more.46 P2P platforms should vet the borrowers in order to avoid fraudulent transactional information. They should also possess certain technical conditions to ensure the smooth exchange of information and network safety.47 45  See Article 3 of Interpretation of the Supreme People’s Court of Several Issues on the Specific Application of Law in the Handling of Criminal Cases about Illegal Fund-raising. The Interpretation was issued by Supreme People’s Court. Full text available, see lawinfochina.com (2015). 46  See Renton (2013). 47  Ibid. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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Due to this requirement, the regulator could even set a minimum capital rule requiring a P2P platform to maintain a minimum level of capital. It would be advisable for P2P platforms to establish an independent depository system for clients’ funds. This would require P2P platforms to provide clients’ funds to independent, third-party custody. P2P platforms would also bear liability to investigate the third parties. Under English law, a third party must be a bank.48 Chinese regulators may consider adopting similar rules. 4.3 Full Information Disclosure and Risk Disclosure System P2P platforms should not only disclose information regarding interest, duration, fees and charges but also warn the lenders and investors of potential risks including the credit risk, the borrowers risk of default, and the risk that is covered by the deposit protection scheme. The UK regulators require platforms to disclose information in 10 aspects as specified in Table 11.3 below.49 Table 11.3 Key aspects of information disclosure Information Content

Borrower

Lending risk, i.e., the borrower’s borrowing threshold Assessment of the borrower

Default

Prospective and actual default rate based on past and future performance Hypothetical conditions in applying future default rate The way to deal with default in repayment or breach of borrowing terms

Return rate Fixing an actual return rate on the basis of fees, default rates and tax Security

Any security arrangement, if yes, what it looks like

Others

Tax calculation Procedural steps for repayment Consequences of the P2P platform’s liquidation; deposit insurance scheme; the lender’s and borrower’s rights and obligations in liquidation

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When a platform goes bankrupt or encounters any other difficulties, some borrower’s loan may be still outstanding, and the lenders may not know any information about the borrower. Therefore, platforms should take some measures to protect the lenders’ rights in advance. 4.4 Regulating Credit Intermediaries As discussed above, the special status of a credit intermediary in personal loans relates to the fact that the borrower is a consumer in the consumer lending and his interests are specially protected under consumer protection law. However, in a typical P2P lending, consumer protection is not the key issue, as the investor may also be regarded as a consumer due to his non-professional status. Thus, it is debatable if the borrower should even be protected as a consumer.50 Being a credit intermediary, a P2P platform may provide a third party security mechanism, which would help transfer potential risks to the guarantee company. The lender itself does not bear credit risks. The investors only provide funding, but it is the P2P platform and the third party guarantee company that supply credit services. The individual borrower under such circumstance should in fact be protected like a consumer. The recently amended Consumer Rights and Interests Protection Law, coming into effect in 2014, clearly sets out consumers’ rights and business operators’ obligations.51 The below provisions are relevant to the P2P lending business: Marking the price clearly: P2P platforms ought to make terms and conditions as well as fees and charges clear to the borrowers, including interest rate, security cost, fees and other charges. Collection and usage of consumers’ personal information: Article 29 of the Consumer Rights and Interests Protection Law states that “business operators must collect and use consumers’ personal information legally, properly and necessarily, indicating the objective, method and scope of their collection and usage, which should be agreed upon by the consumers. Business operators should make their rules of collection and usage of consumer information open to the public and these rules cannot violate the law or the agreement between the parties. Consumers’ personal information must be kept in secret 50  The debate of whether borrowers in P2P lending can be protected as consumers, see Lichtenwald (2015). 51  The newest version of PRC Protection of the Rights and Interests of Consumers Law can be reached at http://www.chinalawandpractice.com/Article/1968135/PRC-Protection-ofthe-Rights-and-Interests-of-Consumers-Law.html.

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by business operators and their staff, who should not divulge, tamper or destroy the information or provide such information to others. Operators shall adopt technical measures and other necessary measures to ensure security of consumers’ personal information, preventing it from leakage, damage and loss. When leakage, damage and loss of the information happens or may happen, the business operators should take immediate steps to correct it.” According to this rule, if a P2P platform needs to collect consumer information, consent from the consumer must be obtained in advance. Moreover, the business operators would need to keep such consumer information confidential. Basically the platform has no right whatsoever to deliver borrowers’ personal information to lenders.52 As a matter of fact, in the mode of credit intermediary, the transmission of consumer information is not necessary, as it is the guarantee company that bears the credit risk. 4.5 Credit Intermediary for Micro, Small and Medium Enterprises Micro, small and medium-sized enterprises were originally not supposed to be the beneficiary of the P2P lending sector.53 In China, nevertheless, the P2P sector has become an important source of funding for these enterprises. A number of reasons explain why this is the case. First, these enterprises need only a small amount of funding. Financing of micro, small and medium sized enterprises is always a challenge worldwide owing to their low loan sum (relative to the commercial bank loans, yet it is higher than individual loans), incomplete disclosure and high risk of business failure. Through the P2P platforms, micro, small and medium sized enterprises obtain funding directly from the public with a third-party guarantee. Due to the systemic risk involved in this sector, the regulator must be careful in containing potential risks. The key is the third party guarantee company. In theory, this kind of third-party guarantee company should be financing guarantee companies. In 2010, the Tentative Rules on the Administration of Financing Security Companies were promulgated and the financing guarantee companies were placed under the regulatory regime.54 Different from usual guarantee companies, financing guarantee companies become the conduit between small and medium-sized enterprises and the general public. Naturally, they are also a source of risk. Consequently, regulation regarding the financing guarantee companies in the P2P sector should be more severe than usual. 52  Eiger & Mandell (2015). 53  Reuters (2015). 54  For more information about Chinese Financing Security Companies, see Allenovery.com (2015).

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Regulatory function should also be returned to the CBRC (China Banking Regulatory Commission). Currently provincial governments have territorial jurisdiction over the financing guarantee companies.55 Local governments completely control their market entry, exit, daily operation, and risk management. Yet, in the P2P sector, the guarantee companies confront a large number of public investors, who are likely to be dispersed throughout the country, as they only need to transact through the Internet. Once risk breaks out, there is the potential for a nation-wide systemic crisis. Therefore, it is necessary for the CBRC to take away the regulatory function over the guarantee companies in the P2P sector from the local governments. An easy way to monitor these guarantee companies would be to apply a licensing system to them. High quality guarantee companies would be granted with licenses to continue their businesses nationwide. Adjusting financial ratios. At present, there are a number of financial ratios in the existing regulatory measures applicable to financial guarantee companies. The financing guarantee liability for a single secured party by a financing guarantee company should be no more than 10% of its net assets; and similarly, the outstanding liability of a financing guarantee company should be no more than 10% of its net assets; a financing guarantee company would be required to allocate at least 50% of its income as its undue liability reserve and also allocate the guarantee compensation reserve at the proportion of 1% of the outstanding liability at the end of the relevant fiscal year.56 These financial ratios are designed and applied to financing guarantee companies. Attention should be paid to having more sensible financial ratios. Regulators should consider the necessity of adopting higher ratios for those guarantee companies in the P2P sector. Based on notions of fairness and risk aversion, guarantee companies in the P2P sector should be pressured to become more specialized. Financing guarantee companies’ main business is to provide bank loan guarantees. When involved in the P2P business, they encounter the general public. As creditors, banks are more capable of containing risks. As a consequence, if a problem were to arise with the guarantee company, a creditor bank would be better able to claim for liquidation preference than other creditors would. Currently when a guarantee company serves several bank creditors and other creditors in the P2P lending business at the same time, there is a possible transmission of risks. With a cap on the amount of money and investors, risks in the P2P sector 55  World Bank (2011). 56  Elliott & Yan (2013).

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could neither spread too widely nor too quickly. Systematic risks could thus be avoided. However, when guarantee companies concentrate risk in their lending and guarantee businesses, the cap on the number of investors and the amount of lending makes little difference in terms of regulatory effectiveness. Further, if such guarantee companies were involved in the banks’ lending businesses, risks would be more likely to transmit, rendering the current regulatory regime less effective. One possible regulatory instrument would be to apply professional qualifications to the guarantee companies’ managers, so that they could bear professional liability in their trading businesses. 4.6 Other Laws and Regulations At present, China has no specific laws regulating crowdfunding. Relevant laws include the illegal fund-raising provisions in the Supreme People’s Court’s Interpretation of Law Application on Hearing Criminal Cases of Illegal FundRaising.57 Other laws such as the Securities Law, Company Law and Intellectual Property Law may be relevant on specific legal issues. In addition, in terms of the payment intermediary and consumer rights and interests protection, the law has clearly defined relevant provisions. According to Article 174 of the PRC Criminal Law, only financial institutions “established without the approval of the competent authorities” constitute a “crime of unauthorized establishment of financial institutions”.58 P2P online lending platform lacks “competent authorities” and there is no corresponding “establishment approval system”. Naturally, there is no need for getting the approval from the relevant authorities. The P2P online lending platforms do not necessarily constitute illegality. From the perspective of the legal nature of the business behavior, the P2P lending in its pure sense refers to no more than a lending contract concluded between individuals through the Internet platform, and it is a typical form of private lending. The Internet platform only provides an intermediary service for the lending. Neither party is the party under the binding force of the lending 57  See Interpretation of the Supreme People’s Court of Several Issues on the Specific Application of Law in the Handling of Criminal Cases about Illegal Fund-raising, supra note 45. 58  Article 174 of Chinese Criminal Law is “Whoever establishes a commercial bank or any other banking institution without the approval of the People’s Bank of China shall be sentenced to fixed-term imprisonment of not more than three years or criminal detention and shall also, or shall only, be fined not less than 20,000 Yuan but not more than 200,000 Yuan; if the circumstances are serious, he shall be sentenced to fixed-term imprisonment of not less than three years but not more than 10 years and shall also be fined not less than 50,000 Yuan but not more than 500,000 Yuan.” Full text available at http://www.npc.gov. cn/englishnpc/Law/2007-12/13/content_1384075.htm (accessed 12 June 2015).

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law, so he shall not assume any rights and obligations under the loan contract. Therefore, the P2P lending platform is considered only as an intermediary services provider for the loan contract signed between the lender and the borrower. The platform does not engage in the “currency credit business and financial services business”. However, according to the “Non-Bank Financial Institutions Administrative Licensing Matters Implementation Measures” and “Money Brokers Pilot Management Approach” issued by the CBRC, those currency brokerage companies that “by electronic technology or other means to promote financial institution specialize in the brokerage services which aim to promote the financing of financial institutions and foreign exchange transactions and get the payment of commission” are non-bank financial institutions.59 Because the P2P platform provides financing intermediary peer-to-peer services, it is difficult to incorporate them into the range of other financial institutions under the category of the money brokers company. The Supreme People’s Court’s Interpretations of Law Application on Hearing Criminal Cases of Illegal Fund-Raising came into effect from 4 January 2011. Article 1 of the Interpretations stipulates that: those behaviors in the violation of state financial supervision law, to absorb funds from the general public (including the units and individuals) along with the following four conditions being satisfied simultaneously, unless otherwise provided in the Criminal Law, shall be identified by the Section 176 of the Criminal Law as illegal deposits from the public or disguised deposits from the public:60 (1) Without the approval from the relevant departments in accordance with laws or gathering funds in the form of disguised legitimate operation; (2) To publicize to the society through the media, promotion meeting, flyers, SMS and other means; (3) To promise to repay capital with interests or offer returns within a certain period by means of money, in-kind materials, or equity; (4) To absorb funds from the general public, namely, the not-specific objects in the society. The current operating models of crowdfunding many have crossed the socalled “red line” of illegal fund-raising activities.61 Publicizing to society by means of media and promising returns in the form of in-kind materials and 59  See Interpretation of the Supreme People’s Court of Several Issues on the Specific Application of Law in the Handling of Criminal Cases about Illegal Fund-raising, supra note 45. 60  Ibid. 61  Hsu (2014).

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other ways to attract capitals to the public and so on is illegal. In a survey, the head of the zhongchou.cn said that the risk of illegal fund-raising can be avoided through certain means, thus creating a challenge to the applicability of legislation.62 With the diversification of financing modes, regulating illegal fund-raising activities remains a significant challenge. Crowdfunding is defined temporarily as a non-public offering. The principle of issuing only to a particular object needs to be adhered to per usual. The number of investors cannot exceed two hundred people. Any violation in the form of a limited partnership or alternative shareholding is deemed illegal. Because an issuance of securities to an accumulated number of over 200 people is regarded as a public issuance, unauthorized public offerings may be hidden illegal financing.63 At the same time, the Securities Law stipulates that the non-public offering securities shall not use advertising, public solicitation and disguised public approaches. Some domestic platforms of crowdfunding are trying to circumvent this red line. For example, some crowdfunding websites only adopt the form of a limited partnership.64 Namely, investors firstly establish a limited partnership, which as a whole will subsequently join in a start-up company. Through these means, they can ensure that the number of investors does not exceed the functions of a securities industry association. Meanwhile, this can also improve self-management authority, and guide the healthy operation of the exchange and kerb markets. China’s crowdfunding platform has long been removed from the regulatory space of the CSRC, the CBRC and the People’s Bank of China.65 The CSRC takes charge of the regulation over securities and futures companies and it is linked to the share issuance so that it is difficult to cover all the forms of crowd funding. The CBRC oversees the banking institutions, but it is difficult to define the collective form of crowdfunding as “banking financial institutions”. It is also difficult to conduct direct supervision over the crowdfunding. Similarly, the crowdfunding also bypasses the People’s Bank of China’s regulations on 62  Zhao (2014). 63  See Article 10 of Chinese Securities Law. The Article is “Public offerings of securities shall meet the conditions prescribed in laws and administrative regulations and shall, in accordance with law, be reported to the securities regulatory authority under the State Council or the department authorized by the State Council for verification or examination and approval. No unit or individual may make a public offerings of securities if the same has not been verified or examined and approved according to law.” Full text available at http://www.npc.gov.cn/englishnpc/Law/2007-12/11/content_1383569.htm (accessed 12 June 2015). 64  Pillsbury (2013). 65  Alois (2014).

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financial markets. Accordingly, it is conveniently placed in circumstances where no one can regulate it, and moreover no one is willing to exercise regulatory control. Article 10 of the PRC Securities Law provides that the public offering of securities must comply with the conditions of laws and administrative regulations, and should be reported to the securities regulatory authority or receive approval from the State Council’s authorized department; without the approval of the law, no unit or individual can issue securities to the public.66 Any one of the following circumstances are be deemed as public offering: those, in which securities are issued to non-specific objects; in which securities are issued to specific objects of more than two hundred people; and other insurance behaviors stipulated by laws and administrative regulations. Accordingly, any above-mentioned case must be verified by the securities regulatory authority under the State Council for approval. Therefore, the financing behaviors of China’s existing equity crowdfunding platforms are still in the gray area, and their legitimacy needs to be further clarified. Including the P2P platform into the securities regulator’s jurisdiction originated with the SEC, which issued a Cease and Desist Order to Prosper.com arguing that Prosper was selling securities. As a result, Prosper should have registered itself as a public company with the SEC and sold notes only through a prospectus with an effective registration statement.67 The SEC’s involvement fundamentally changed Prosper.com’s business model. Previously, Prosper effected transactions through a third party bank. Once the borrower and lender matched, Prosper would signal a third party bank to make the loan to the borrower. The bank would then assign the note to Prosper, which in turn would assign it to the lender. In this model, the lender was not likely to experience any credit risk with respect to the intermediary. In the wake of the SEC’s order, a P2P platform now has to file annual and quarterly reports, and sell their notes by prospectus.68 Those notes become the platform’s own obligation, payable contingent upon borrower repayment. This means that when the third party bank lends to the borrower, the platform retains ownership of the borrower’s indebtedness. The lender then becomes the platform’s creditor as the platform sells its debt instrument to the lender. Apart from the change to the contractual relationship among the lender, borrower and platform, it also changes the nature of the legal relationship. In the new model, the loan is 66  See Article 10 of Chinese Securities Law, supra note 63. 67  See Prosper Marketplace, Inc., Exchange Act Release No. 8984, 2008 WL 4978684, available at http://www.sec.gov/litigation/admin/2008/33-8984.pdf (accessed 12 June 2015). 68  Verstein (2011), p. 488.

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unsecured and nonrecourse to any other assets of the platform. On the other hand, the lender must now consider the creditworthiness of the platform other than the borrower. Proponents of regulating the P2P sector by relying on the securities regulations argue that the disclosure regime under the securities regulations protects financial consumers better by squeezing more information out of the platforms.69 This may be a misperception. As a matter of fact, P2P consumers may prefer safe and clear returns and privacy as opposed to disclosed information. The more expensive transaction costs and compliance costs involved in the filing and disclosure exercises under the securities regulations may impose more transactional burdens on the platforms. What consumers are really looking for is a more accessible channel for funding.70 The increased compliance burden may destroy this young industrial sector and effectively cut off the funding channel for small and medium sized enterprises, hence harming the entrepreneurial ability of these enterprises. The mandatory disclosure regime may harm the P2P sector largely because the amount of disclosed information may be enormous and consumers may not make use of or digest such information. Such information technically is available on the platform’s website, and is repetitive in the disclosure process. Bringing the P2P lending sector under securities regulation would be to normalize this nonconventional lending market and equalize it with the conventional banking sector. Article 24 of the Company Law states: Limited Liability Company shall be set up and funded by less than fifty shareholders.71 That is, in the equity crowdfunding, the number of public shareholders attracted by the crowdfunding project shall not exceed 50 people. If exceeded, those unregistered shall not be registered as a limited liability company; for those already registered, the additional funders cannot be recorded as part of the stock transfer books to enjoy the rights of shareholders. The vast majority of people who have interests in equity crowdfunding are willing to provide only a small amount of idle funds to invest. Therefore, if the number of shareholders is limited within fifty, it will be unable to raise sufficient funds to conduct corporate operating. In reality, in order to raise sufficient funds to be able to set up a limited liability company, many of the crowdfunding projects sponsors circumvent 69  Manbeck & Franson (2015). 70  Ibid. 71  See Article 24 of Chinese Company Law. Full text available at http://english.wzj.saic.gov. cn/laws/061027085055-0.htm (accessed 12 June 2015).

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the Company Law restrictions on the number of shareholders by means of alternative shareholding. This does not violate the law in form, but in the spirit of legislation, and is thusly discouraged. According to Article 125 of the Company Law, the capital of a limited liability company shall be divided into shares and every share shall have an equal amount of money.72 The company’s shares shall adopt the form of stocks. Stock is a certificate issued by the company to prove the shares held by the shareholders. Therefore, the stock is a unique form of shareholding of a limited liability company. The meaning of the stocks is to make the limited property securitization, so that the physical form and value form of the limited liability company will be separated, and they will exist and run independently.73 Stocks tend to be associated with the stock market and may have a stronger liquidity. Precisely because of this, stocks are usually in the form of style-required securities, and both their contents and formats are fixed. It is easy to see that there is a fundamental difference among stocks, other equity certificates and investment certificates. In stock issuance, usually a large number of people are involved, and may exert influence on the liquidity of the securities market. Once the unauthorized shares issued by a limited liability company flow into the circulation market, investors could accordingly suffer from losses. This would directly affect the stable operation of the securities market, and constitutes the reason why the Criminal Law explicitly prohibits the issuance of unauthorized stocks. The modification of the Company Law further relaxed the conditions for setting up a limited liability company.74 As a result, the establishment of a limited liability company usually does not need to undergo a rigorous approval. Because of the shareholder-based character of a limited liability company, there are legal restrictions on its shareholders ability to transfer their shares. An Investment Certificate issued to the shareholders of a limited liability company is not prohibited by the Criminal Law. Therefore, in judging whether the equity crowdfunding project constitutes unauthorized stock issuance, we cannot judge it simply by absorbing equity investment and issuing equity certificate and investment agreement. Instead, whether it constitutes a “stock” in essence shall be taken into account.

72  See Article 125 of Chinese Company Law. Full text available at http://english.wzj.saic.gov. cn/laws/061027085055-0.htm (accessed 12 June 2015). 73  Zhou (2007), p. 51. 74  Jiang (2014).

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Tentative Conclusions

The rise of online banking has become an indisputable fact. Online financial innovation has increasingly become a governmental attention. In August 2013, the State Council issued the Implementing Opinions on the Financial Support for the Development of SMEs and proposed to “make full use of the internet and other new technologies and new tools to innovative online financial services model constantly”.75 In the State Council’s Opinions on Promoting Information Consumption to Expand Domestic Demand, it also pointed out “to promote the internet finance innovation and regulate internet finance services”.76 Compared to the European and American countries with a mature development of the P2P lending sector, China’s regulation of the P2P lending business is vague and insufficient, relying solely on self-discipline, which is formed unconsciously by several enterprises and the associations but nonetheless has not been unified on a national scale. There are no strict and effective supervisory measures to protect the business operation of P2P platforms. Currently China has not yet issued a top-down regulatory system covering the entire sector. Shenzhen, Shanghai, Jiangsu, Shandong and other places have begun the exploration for P2P lending industry’s regulatory approaches.77 In August 2011, the CBRC issued the Notice to Remind Risks in the Peer-to-Peer Lending, which mentioned seven risks in relation to the P2P lending. It also required the banking institutions to establish a “firewall” between peer-to-peer lending intermediary companies.78 It is China’s first formal document issued by financial regulators regarding P2P lending risks. The overwhelming prosperity of the P2P lending sector in China reflects the financing needs in a depressed financial market and is a natural result of adjustments to the current economic growth model. The mode of operation for P2P platforms in China has larges changed the nature of P2P platforms, and successfully transfers the credit risks by providing security and guarantee to transacting parties. Therefore, continuing to regard the P2P platforms as a credit intermediary, in a typical Western way of thinking, is not the right approach to regulating the P2P lending sector. This article thus proposes two regulatory approaches to the P2P lending sector in China. First, the legal risk of being characterized as illegal funding 75  Han, Huang & Wang (2015). 76  China Briefing (2013). 77  Jingu, supra note 38. 78  Alois, supra note 65.

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collection can be eliminated through a negative list. This would cap the number of participating investors and the amount of total investment. Any transaction beyond the two caps would be viewed as an illegal funding collection crime. For the platforms that only act as information intermediaries, the regulator could impose regulatory conditions and requirements that would require strict compliance. More attention should also be paid to the borrowers under the legal framework of consumer protection law when they borrow money from the platforms for personal loans. These platforms can be credit intermediaries. In contrast, for those credit intermediary-type platforms for small and medium sized enterprise loans, the regulatory focus should be placed on security providers. As these platforms provide security to the general public, the requirements should be more stringent than those for the general financing security companies. References 01 Caijing & 01 Statistic (2014) White Papers of China’s P2P Lending Industry 2014, Beijing: Economic Press China. Allenovery.com (2015) “Financing Security Companies,” http://www.allenovery.com/ publications/en-gb/Pages/Financing-Security-Companies.aspx (accessed 12 June 2015). Alois, J. D. (2015) “China Banking Regulatory Commission is Circulating Peer to Peer Lending Rules,” http://www.crowdfundinsider.com/2015/03/64658-china-bankingregulatory-commission-is-circulating-peer-to-peer-lending-rules/ (accessed 12 June 2015). Angelcrunch.com (2015) http://angelcrunch.com/ (accessed 14 June 2015). Bitcoin.org (2015) https://bitcoin.org/en/ (accessed 14 June 2015). Boao Review & Lufax (2015) “White Paper Chinese P2P Market,” http://blog.lendit .co/wp-content/uploads/2015/04/Lufax-white-paper-Chinese-P2P-Market.pdf (accessed 30 June 2015). China Briefing (2013) “China to Boost Domestic Demand by Facilitating Information Consumption,” http://www.china-briefing.com/news/2013/08/19/china-to-boostdomestic-demand-by-facilitating-information-consumption.html#sthash.fPritt7e. dpuf (accessed 12 June 2015). Citytowninfo.com (2015) “Mortgage Laws and Regulations to Protect the Consumer,” http://www.citytowninfo.com/mortgage-articles/mortgage-process/mortgage_ laws_and_regulations_to_protect_the_consumer/ (accessed 12 June 2015). Cmbchina.com (2015) http://english.cmbchina.com (accessed 14 June, 2015). Dajiatou.com (2015) http://www.dajiatou.com (accessed 14 June 2015).

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Data.01caijing.com (2015) http://data.01caijing.com/p2p/website/count.html (accessed 14 June 2015). Dunkley, Emma (2015) “FCA to Target Peer-to-Peer Marketing,” http://www.ft.com/ cms/s/0/59cc24da-a31f-11e4-bbef-00144feab7de.html#axzz3cucN0zL3 (accessed 12 June 2015). Economy.gmw.cn (2015) “Demohour Developed the Intelligent Hardware Industry by Exploring Methods,” http://economy.gmw.cn/2014-08/28/content_12853623.htm (accessed 14 June 2015). Eiger, Ze’-ev Eiger, & Jeremy Mandell (2015) “P2P Lending Basics: How it Works, Current Regulations and Considerations,” http://www.mofo.com/~/media/Files/UserGuide /2015/150129P2PLendingBasics.pdf (accessed 12 June 2015). Forbeschina.com (2015) “Ten Rules of P2P Lending Regulation,” http://www.forbes china.com/review/201409/0037811.shtml (accessed 14 June 2015). Gtja.com (2015) http://www.gtja.com/portal/channel/indexen.jhtml (accessed 14 June 2015). Han, Wei, Huang, Wenhui, & Qionghui Wang (2015) “Made in China No More,” http:// www.slate.com/articles/news_and_politics/caixin/2015/05/china_s_state_council_is_cracking_down_on_internet_companies_that_evade.html (accessed 12 June 2015). Hsu, Sara (2014) “China’s Ongoing Battle with Illegal Fundraising,” The Diplomat, 28 April. Jiang, Rongqing (2014) “The Interpretation of Recent Amendments to the Company Law of the Peoples Republic of China,” http://www.mondaq.com/x/287106/ Corporate+Commercial+Law/The+interpretation+of+recent+amendments+to+ the+Company+Law+of+the+Peoples+Republic+of+China (accessed 12 June 2015). Jingu, Takeshi (2014) “Risk and Opportunities in China’s Growing P2P Lending Market,” Nomura Research Institute Report, https://www.nri.com/~/media/PDF/global/ opinion/lakyara/2014/lkr2014202.pdf (accessed 30 June 2015) Jones, Jason (2014) “The Most Important Chinese P2P Lending Companies,” http:// www.lendacademy.com/the-most-important-chinese-p2p-lending-companies/ (accessed 12 June 2015). lawinfochina.com (2015) http://www.lawinfochina.com/display.aspx?lib=law&id=8523 &CGid (accessed 14 June 2015). Lee, Jane Lanhee (2011) “Shadow Looms over China’s Internet Lending Market,” http:// mobile.reuters.com/article/internetNews/idUSTRE7AO03U20111125 (accessed 12 June 2015). Li, Lingyan (2000) Legal Research on Consumer Credit Service, Beijing: Law Press China. Lichtenwald, Ryan (2015) “Top 5 Issues in Consumer P2P Law and Regulation,” http:// blog.lendit.co/top-5-issues-in-consumer-p2p-law-and-regulation/ (accessed 12 June 2015).

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Ma, Chao (2015) “Online for 5 Months, the Domestic Creative Platform Demohour Shares its Statistics,” http://36kr.com/p/76312.html (accessed 14 June 2015). Manbeck, Peter, & Marc Franson (2015) “The Regulation of Marketplace Lending: A Summary of the Principal Issues (2015 Update),” http://www.chapman.com/ media/publication/146_Chapman_Regulation_of_Marketplace_Lending_White_ Paper_040815.pdf (accessed 12 June 2015). McMahon, Dinny (2015) “Making P2P Lending Work in China—What’s Your Model,” http://blogs.wsj.com/chinarealtime/2015/06/04/making-p2p-lending-work-inchina-whats-your-model/ (accessed 12 June 2015). P2pfa.info (2015) “Peer-to-peer Lending Sets the Pace in UK Alternative Finance Sector,” http://p2pfa.info/peer-to-peer-lending-sets-the-pace-in-uk-alternative-financesector (accessed 14 June 2015). Paypal, Inc. (2015) https://www.paypal.com/ (accessed 14 June 2015). Pillsbury, Adam (2013) “Crowd-funding with Chinese Characteristics,” http://www .theguardian.com/british-council-partner-zone/crowd-funding-chinese-characteristics (accessed 12 June 2015). Ppdai.com (2015) http://www.ppdai.com/ (accessed 14 June 2015). Ppmoney.com (2015) http://www.ppmoney.com (accessed 14 June 2015). Quinn, Georgia (2014) “UK & US Peer-to-Peer Regulation: Enlightened Touch vs. Square Peg Round Hole,” http://www.crowdfundinsider.com/2014/05/38461-uk-us-peer-peerregulation-enlightened-touch-vs-square-peg-round-hole/ (accessed 12 June 2015). Renrendai.com (2015) http://www.renrendai.com (accessed 14 June 2015). Renton, Peter (2013) “New UK Regulation Provides a Best Practices Template for P2P Lenders,” http://www.lendacademy.com/new-uk-regulation-provides-a-best-prac tices-template-for-p2p-lenders/ (accessed 12 June 2015). Reuters (2015) “China’s P2P Lenders Offer Relief to Small Entrepreneurs,” South China Morning Post, 31 May. Sohu Stock (2015) “How Big Is the Risk of P2P: 150 out of 1200 P2P Platforms Have Run Away,” http://stock.sohu.com/20140818/n403531375.shtml (accessed 14 June 2015). The Economist (2014) “Peer-to-Peer Lending: Banking Without Banks,” The Economist, 1 May. Thfund.com (2015) http://www.thfund.com.cn/ (accessed 14 June 2015). Verstein, Andrew (2011) “The Misregulation of Person-to-Person Lending.” 45 U.C. Davis Law Review 445–530. Wangdaichina.com (2015a) http://www.wangdaichina.com/loandata/ (accessed 14 June 2015). Wangdaizhijia.com (2015b) “The Annual Report of China’s P2P Lending Industry,” http://news.wangdaizhijia.com/20150106/16305.html (accessed 14 June 2015). Wikipedia.org (2015) “Muhammad Yunnus,” https://en.wikipedia.org/wiki/ Muhammad_Yunus (accessed 14 June 2015).

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World Bank (2011) Reducing Inequality for Shared Growth in China: Strategy and Policy Options for Guangdong Province, Washington D.C.: The World Bank Publication. Yuanshihui.com (2015) http://www.yuanshihui.com/ (accessed 14 June 2015). Zhao, Yashan (2014) “The Crowds Cash in: Popular New Fundraising System Has Winners and Losers,” Global Times, 4 August. Zhongan.com (2015) https://www.zhongan.com/ (accessed 14 June 2015). Zhou, Yousu (2007) The New Law on Securities, Beijing: China Law Press.

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Chapter 12

Regulating China’s Internet Money Market Funds An Economic Perspective Xiaoye Jin Abstract Ever since the launch of Yu’E Bao, there has been a vigorous debate among academics, policymakers, and banking industry about the urgency of establishing the legal regulatory regime for internet money market funds (iMMFs) with Chinese characteristics. The author believes that the balanced regulatory regime based on the twin peaks model should be established for the purpose of unifying risk controls, market conducts and consumer protections. The primary task is to enact the “Law of Financial Services and Markets” and “Law on Protection of the Rights and Interest of Financial Consumers”, in which the principles of information disclosure and appropriateness of investors should be enshrined. We further discuss four policy options for reducing iMMFs’ susceptibility to runs. Our analysis suggests that these options may not be applicable or sufficient to address the instabilities associated with iMMFs.

Keywords iMMFs – financial regulation – economic analysis

1 Introduction Although money market funds have been at the centre of attention during the global financial crisis of 2007–2010,1 it has not been noticed by Chinese ­ordinary * Lecturer of Finance at International School of Finance Law, East China University of Political Science and Law Contact: [email protected]. 1  When the Primary Reserve Fund “broke the buck” on 16 September 2008 after the failure of Lehman Brothers, it precipitated a massive run on prime MMFs. In response to large redemptions from MMFs, the US government intervened with the guarantee of MMF shares by the Department of the Treasury and the Securities and Exchange Commission (SEC)

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investors until two significant trends have been observed in money market funds in 2013. First, internet companies are running into the money market fund sector. Second, traditional fund management companies are migrating to the internet. Against such a backdrop, China’s internet-based money market funds (iMMFs) burst onto the scene in the second quarter of 2013.2 The first iMMF to launch was named Yu’E Bao offered through the Chinese biggest e-commerce giant Alibaba Group Holding’s third-party payment affiliate, Alipay.com. Yu’E Bao allows customers of Alipay to capitalize on the cash balances they leave in Alipay through investing in a money market fund without resorting to traditional financial service providers. Alipay account holders can buy into the money market fund with a minimum investment of one yuan and redeem their fund holdings at any time to pay for online purchases.3 Within twelve months, Yu’E Bao has more investors than China’s equity markets and propels Tianhong Asset Management to on its way overtaking China Asset Management to become China’s biggest mutual fund manager.4 In response to Yu’E Bao’s success, similar products, such as Baifa and WeChat wealth management products, have been rolled out by internet companies partnering with fund management companies.5 Although the media called it a “new bottle for old wine”:6 Yu’E Bao is a money market fund with a pair of flying online wings, it did make the advent of iMMFs in China and has been viewed as a successful example of internet companies marching into financial industry. The era of iMMFs does not automatically descend without a cost. Widespread support and praise received by Yu’E Bao comes with a barrage of criticism from academics, policymakers, and banking industry surrounding the s­ ubsequently implemented an overhaul of MMF regulation through changes to Rule 2a-7 of the Investment Company Act that were adopted on 27 January 2010. 2  See for example the first internet-based money market fund, namely Yu’E Bao. 3  Most iMMFs in China promise T+0 cash withdrawal. The functionality of the iMMFs in China has matched that of the MMFs in the US, or even better as investors of China’s iMMFs could directly make online payments with the outstanding balance in the iMMFs. 4  Tianhong Asset Management is the sole partner of Alibaba in the sale of money market funds on the company’s e-commerce platform. The mainland’s biggest online money market fund had attracted more than 81 million investors by the end of February, a figure that represents an increase of nearly 20 million users within half a month, according to Tianhong data. 5  Baifa is launched in December 2013 by Baidu Harvest Fund Management and WeChat wealth management products are launched in January 2014 by Tencent Holdings and four fund managers (China Asset Management, Huitianfu Fund Management, E Fund Management and GuangFa Fund Management). 6  See tech.sina.com (2013).

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role of iMMF.7 Chen Zhiwu, a professor from Yale University said, “[e-finance is taking advantage of the loopholes in the regulatory system. Its success was not unexpected”.8 Financial regulators appear to have been keeping a close eye on iMMFs and attempt to tradeoff between not to hinder financial innovations and safeguarding the interests of the financial system and ordinary investors.9 Yan Qingmin, a panellist from the China Banking Regulatory Commission, said the government needs to launch a series of fundamental supervisory policies to ensure the fairness of the market.10 Banking industry holds a complicated attitude towards the expeditious development of various Baos and has been breeding and marketing their own Baos.11 The CEO of China Minsheng Bank asked Ma Yun, the founder of Alibaba, to stop the revolution due to the detriment Yu’E Bao brings to the entire financial industry.12 The editor-in-chief of CCTV’s Stock and Information Channel, Wenxin Niu, even demonized Yu’E Bao and called it a vampire sinking its teeth into Chinese banks’ veins and a parasite living in China’s financial system. He argues that Yu’E Bao will siphon off idle funds which have existed in the commercial banking system and then reenter into the commercial banking system through investing in various financial products launched by commercial banks. This extra circulation process will negatively affect liquidity in the money market and cause interest rates to spike, thus increasing both the cost of production and prices in the larger economy. In addition, Yu’E Bao’s fast growth comes with increased legal risk, liquidity risk, operation risk, credit risk and market risk that must be tackled with regulation and supervision to protect consumers and avert systemic volatility. The rapid proliferation of Yu’E Bao and its siblings and various controversies it brought up have prompted Chinese authorities to consider how to perfect 7  See xudanei (2013). 8  Professor Chen expressed his opinion at the Boao Forum for Asia annual Conference (2014). Sheng and Zhang (2014) indicate that the origin of Yu’E Bao was regulatory arbitrage, which gives an ordinary investor the opportunities to bypass the restrictions placed on traditional deposits. 9  On the whole, government policy and regulators appear to be broadly receptive to this innovative and popular financial service. For example, Zhou Xiaochuan, governor of the People’s Bank of China, on the side-lines of the annual National People’s Congress (2014), said that the central bank will improve regulations on internet finance but will not ban products like Alibaba’s online money market fund Yu’E Bao. 10  Yan’s speech was recorded at the Boao Forum for Asia annual Conference (2014). 11  For example, Ping An Ying, Huo Qi Bao and Xin Jin Bao were launched by Ping An Bank, Bank of China and Industrial and Commercial Bank of China, respectively. 12  Dong Wenbiao is the CEO of China Minsheng Bank and his opinion was circulated at the Boao Forum for Asia annual Conference (2014). Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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or enact laws and regulations and take targeted measures to strengthen and improve supervision to achieve the sustainable and healthy development of iMMFs and protect consumers.13 Although it is not easy to formulate regulatory objectives and on which to establish a regulatory framework, it is well accepted and featured in most regulatory frameworks that the primary policy objectives pertaining to regulating money market funds are mitigating systemic risk, ensuring proper market conduct, and ensuring adequate protection for end-users of money market funds. This mandate has also been adopted by Chinese authorities in terms of regulating iMMFs.14 Subject to this objective, there are two competing schools of regulatory thought. The first school argues that iMMF is essentially a bank and should be regulated as such.15 There needs to be a regulatory framework for consumer protection that clearly identifies the responsibilities and obligations of iMMFs providers. The second school is averse to bringing iMMFs under the bank regulatory umbrella, instead advocating for subjecting them more fully to market forces. Within this context, abundant research has been conducted to address some of the legal implications of these regulatory thoughts. However, little has been done from an economic perspective. Drawing lessons from the US and European authorities, we will attempt to address the issue of how to regulate China’s iMMFs and conduct an economic evaluation of the viability of various proposals, analysing them in terms of this overarching debate. The remainder of this paper is organized as follows. In the next section, we examine the deficiencies of the existing regulatory framework in terms of the regulatory objectives. In Section 3 we analyse various regulatory approaches and reform proposals from an economic perspective that may be adopted by Chinese authorities, and Section 4 offers some concluding comments. 2

iMMFs’ Regulation Dilemma

2.1 Background on iMMFs In essence, Yu’E Bao and its siblings are “money market funds distributed online, i.e. iMMFs. While Tianhong acted as the first pioneer to cooperate with Alipay to develop the Yu’E Bao, several other asset management companies have joined the market by providing tailor-made money market funds to 13  For example, China Banking Association has proposed to cancel the policy that exempt MMFs from early withdrawal fines. Other regulatory measures are under discussion. 14  This regulatory objective is summarized from various regulation documents. 15  In section 3.2.3 we have provided a comprehensive discussion with regard to why iMMFs should not be regulated as a bank. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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­distribution online.16 Differing from traditional MMFs in China which didn’t draw much attention to retail investors, online-distributed iMMFs are accessible to mass retail investors and depositors. According to Macquarie’s (2014) estimation, with the help of rapid growth of online-distributed products, money market funds have accounted for up to 40% of the assets of funds in China by March 2014. The fast development of iMMFs may also attribute to the innovation initiated by Yu’E Bao and its siblings in two aspects. First, they mark the MMF returns to demand deposit rates (almost nil in China) rather than term deposit or equity/bond funds, and provide daily return updates to investors. These innovative features in marketing strategy and investor communication lure a lot of pure depositors and so-called Diaosi17 to MMF investors. Second, they emphasize the extreme convenience by combining MMFs with an online payment system, a completely virtual environment with same day bank transferability, no transaction fees and importantly the ability to invest any small amount of money. However, both iMMFs and traditional MMFs pursue the identical investment strategy in terms of what iMMFs invest in. Although iMMFs are allowed to invest in cash and cash equivalents, for example short-term bank deposits, negotiable certificate of deposits, short-term bonds, bond purchase, and central bills, under Chinese regulations, in practice iMMFs invest 80–90% of their assets under management (AUM) in short-term interbank negotiated deposits and the rest in low-risk, high-investment-grade bonds. The concentrated investment portfolio of iMMFs mean the strong correlation between returns of iMMFs and the interbank rates, i.e. SHIBOR,18 as negotiated deposits are the only type of deposits that are not subject to interest rate controls but depend on the demand-supply balance of interbank liquidity.19 Therefore, the supply shortage in the interbank market will enable MMFs to wield strong bargaining power and then as a result reflects in their ­daily-updated returns. However, it should be noted that MMFs are participants

16  For example China Universal, China AMC and Harvest. 17  The word Diaosi (屌丝) was first coined by single, young men who feel they have deadend lives. Later on, it is referred to the men in this category as those who do not earn enough, are not good looking, and have difficulties making promotion. 18  SHIBOR, the abbreviation of Shanghai Interbank Offered Rate, is the average interest rate at which term deposits are offered between prime banks in the Shanghai wholesale money market or interbank market at China. 19  The positive correlation indicates that the returns of iMMFs will fall along with SHIBOR when liquidity becomes abundant in the interbank market. As in the case of PayPal, iMMFs’ investors could easily shift to alternative investments if the yields of iMMFs fall dramatically. This is already happening given the meaningfully lower SHIBORs after the latest Chinese New Year. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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but not the market makers in the interbank markets, so their influences on the interbank interest rates are very limited. The emergence of iMMFs in China seems a repeat of history that occurred in the US in 1970s. In fact, there are several similarities between the drivers of fast growth of the US MMFs in 1970s and China’s iMMFs in 2013. First, bank deposit rates are highly regulated in both countries. As of 1970s, according to the Regulation Q of the Glass-Steagall Act of 1933, the Federal Reserve set interest rate ceiling on time deposits and US banks were prohibited from paying interest on demand deposits. In China, banks are only allowed to offer 10% premium to the benchmark deposit rates which are strictly regulated by the People’s Bank of China (PBOC).20 Second, MMFs are lightly regulated in both countries. In the US, MMFs are beyond the reach of the strict interest rate controls as they are registered as investment companies under the Investment Company Act of 1940 and therefore are regulated by the Security and Exchange Commission (SEC). In China, MMFs are regulated by the China Security Regulatory Commission (CSRC) and enjoy unusual freedom of interest rates liberalization as their returns peg with the liberalized SHIBOR rather than benchmark interest rates. Third, increasing and volatile shortterm interest rates impose positive impact on the fast proliferation of MMFs in both countries. Particularly, higher interbank rates prompted by the interbank liquidity crunch in June 2013 significantly facilitate the rapid expansion of iMMFs in China. Considering these similarities, it may be suggested that the prosperity of MMFs in both countries is derived from regulatory arbitrage, building on which financial innovations can bypass the restrictions placed on traditional deposits and bring new opportunities to ordinary investors. However, the uncertainty of regulatory arbitrage also casts a huge shadow on the sustainable and healthy development of MMFs in China even though for the moment Chinese authorities appear to be broadly receptive to the innovative iMMFs. Some academics and financial practitioners argue that the prosperity of iMMFs in China could be thrown into doubt if some proposals for iMMFs reforms, which have been discussed for a while, are implemented by Chinese regulators.21 However, if history can be repeated, from the US experience, we may conclude that the growth of iMMFs in China could continue as long as at 20  In fact, since 2004, the commercial banks were not restricted by the ceiling of the lending rates or the floor of deposit rates although the floor of lending rates and the ceiling of deposit rates were not yet relaxed. The introduction of SHIBOR in 2007 indicates the interest rate liberalisation is on the way although the process is rather slow. 21  Some regulatory changes, such as to increase provision for risk, to apply requested reserve ratio, or to cancel exemptions of early withdrawal fines, could be one of the major obstacles to future developments of iMMFs. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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least one regulatory advantage toward iMMFs can be kept.22 Actually, if the rise of iMMFs in China continues to attract away deposits from banks and then undermine the profitability of banks’ short-term business lending, it would likely facilitate the process of financial disintermediation and accelerate the pace of interest rate liberalization in China. This unexpected effect may become the most critical factor Chinese authorities would consider when proposing iMMFs reforms. 2.2 Risk Anatomy of iMMFs By agreeing to synchronize their Alipay and Yu’E Bao’ accounts, Yu’E Bao’ investors actually enjoy the convenience of a single deposit-like account with a diversified pool of deposit-like instruments (cash and cash equivalents).23 However, iMMF is not a deposit account in a commercial bank and therefore is not implicitly guaranteed by governments when suffering a run even if investors generally regarded iMMF as a riskless or low-risk investment that was almost as safe as cash. Empirical analysis suggests that in the US MMF experienced an expansion in their risk-taking opportunities starting from August 2007 and had strong incentives to take on risk.24 Similar trend has also been observed in China. For example, following the gradual decline of Yu’E Bao’s annualized rate of return, the fund manager, Tianhong Asset Management, has been allocating more sources into longer-term debt securities in an attempt to reverse the downward spiral, which results in the mismatch between the fund’s assets and its liabilities and that liquidity risks have become a serious issue.25 Moreover, the aggressive “T plus 0” (transaction date plus zero days) approach to settling orders, in comparison to the standard “T plus 1” approach with settlements occurring a day after transactions adopted by most traditional MMFs, could be more dangerous if there is a run on deposits, even though daily and monthly withdrawal limits have been set up by most iMMFs. Considering the vast customer base of iMMFs and the fast spread of contagion when liquidity shortage occurs, iMMFs may also exacerbate the risk of widespread runs 22  After the lift of Regulation Q of the Glass-Steagall Act of 1933 in 1980s, several other regulatory advantages helped US MMFs stay competitive relative to banks. For example, MMFs do not need to maintain capital buffers as banks do. 23  Hanson et al. (2013) indicate that the synchronization essentially adds additional link in the intermediation chain through which MMFs provide scale efficiencies for small-­ balance savers along with a set of transactional services. 24  See Kacperczyk & Schnabl (2012). 25  Tianhong argues that the massive data collected from the internet platforms help them to predict daily fund subscriptions and redemptions behaviours and better manage liquidity to avoid asset-liability mismatch.

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on the broader financial system, which will have negative impacts on the real economy. Systemic MMF runs have occurred twice in the past twenty years in the USA.26 Although it did not occur in China, without tentative reform measures and prudent regulatory framework in place, the run would likely rather than unlikely occur in the foreseeable future. Along with the systemic risk iMMFs could bring to the broad financial system, the successful story of iMMFs actually camouflages some distortive and abusive business practices and inadequate information disclosure iMMFs investors have to confront. These problems have existed from the birth of iMMFs and have been selectively ignored by iMMFs investors. For example, only past yields and account opening procedures are highlighted in Yu’E Bao’s website. There is not any information on the fund’s underlying assets, investment scope, management strategy and associated risks. Investors may misunderstand the product and treat it as cash like in terms of investment risks. Actually, Yu’E Bao employs bold and bigger font to highlight its advantages including competitive annualized rate of return, insured safety and complete convenience. By contrast, it only displays risk disclosure in a small and light font, i.e. “MMF is not a demand deposit. Past performance does not indicate future performance. Discreet investment is suggested for the risk of MMFs.” This biased and selective information disclosure is the common feature of iMMFs and is the congenital deficiencies of marketing strategy building on third-party payment platforms. Therefore, it is unlikely that Yu’E Bao’s investors fully and carefully read and accept detailed prospectus as the prospectus is not shown in Yu’E Bao’s website. By highlighting its convenient operation process into disproportionate scope, Yu’E Bao implicitly ignore the gatekeeping process, i.e. investors should be required to fill specific information when attempting to open a fund account and read and accept additional risk disclosure, such that investors only receive biased and incomplete information, i.e. low threshold and high returns. Furthermore, Yu’E Bao’s website may inadvertently give investors the impression that this product is provided and managed by Alibaba rather than Tianhong even though more detailed information could be found when investors click the web link and are diverted to Tianhong’s website. This is actually the common problem of various Baos. The initial design of iMMFs embedding into third-party payment platforms makes it difficult to differentiate consumers of third-party payment platforms and fund 26  The first occurrence was in 1994 when concerns over exposures to interest rate derivatives led investors to withdraw from a particular fund that had taken excessive risk. The second occurrence was in 2008 when the Primary Reserve Fund “broke the buck” after the failure of Lehman Brothers.

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investors of money market funds. Last but not least, iMMFs’ customer identify verification systems are also looser than those of banks, which may lead to fraudulent withdrawals and raise the concern of illegal fund flows, i.e. money laundering.27 2.3 iMMFs’ Regulation Dilemma: Approach, Attitude, and Toolkits As an innovative financial product combining internet-based third-party payment platforms with money market funds, iMMFs cater for the development trend of the global financial industry and push the era of financial mixed operation in China into a new level. Unfortunately, financial regulation has failed to keep up with iMMFs’ rapid growth and meets the requirement of the new normal, the era of financial mixed operation. The current financial regulatory system in place is based on the principle of “separated operation, separated regulation”, with different sectoral regulatory authorities supervising different sectoral financial institutions. This is the institutional approach acknowledged by Masciandro and Quintyn28 to supervision, which assigns a regulator to a firm according to the financial firms’ legal status (i.e. bank, insurance company, etc.).29 Within this setup, the People’s Bank of China oversees Alipay and the China Security Regulatory Commission (CSRC) supervises Tianhong and the funds it manages. The problem with this approach is that the era of financial mixed operation makes it difficult to regulate on a functional basis, since the institutional approach is not compatible anymore with the variety of products and the structure of the financial firms. Continuing to use the institutional approach without adjustments to the changes in the market might bring us to a regulatory overlap or vacuum as no supervisor has the relevant expertise to supervise the financial products sold by the financial institutions which are supervised by him. Clearly, the mismatch between financial mixed operation and fragmented regulation need to be addressed by Chinese authorities for the sake of the sustainable and healthy development of financial industry. According to The Group of Thirty (2009),30 regulators using the institutional approach to supervision can remedy the mismatch through establishing a 27  A good summary of the discussion and new evidence is provided by Liu (2014). 28  Masciandro & Quintyn (2008). 29  The principal models of supervisory oversight were initially classified by the Group of Thirty, an international body composed of central bank governors, private financial sector experts, and leading economists, on October 6, 2008, in a report entitled “The Structure of Financial Supervision: Approaches and Challenges in a Global Marketplace”. See Group of Thirty (2009). 30  Ibid.

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meaningful coordination mechanism such as information exchange, supervisory board meetings in which delegates from the different supervisory bodies take part to discuss their supervisory work and coordination etc. In 2000, the joint conference on financial regulatory coordination mechanism was initiated by the central bank, the securities commission and the banking commission with the intent to share regulatory information and coordinate regulatory issues in a timely manner. The establishment of the joint conference contributes to the coordination between financial regulatory policies and laws and regulations, as well as cross-market innovations and hybrid financial products coordination, such that in a certain degree to prevent regulatory arbitrage induced by fragmented regulation.31 However, the joint conference is neither a standing body nor a unified financial regulatory agency and a legally binding official regulatory coordination mechanism remains on paper. In fact, after its second performance in March 2004, the joint conference has been in the suspended status. Therefore, it is unrealistic to rely on the loose, non-statutory mechanism to supervise financial mixed operations.32 Through effectively utilizing internet-based techniques, i.e. big data processing techniques, cloud computing and mobile payment, iMMFs, as one kind of internet-based financial innovations, immensely ameliorate agency conflicts, reduce transaction costs, provide a shield against burdensome regulations, improves service to consumers and in a certain degree address market inefficiencies or imperfections. For the abovementioned effects, it may be suggested that internet-based financial innovations are good and have the potential to provide for a more efficient allocation of resources and thereby a higher level of capital productivity and economic growth. Therefore, regulators may adopt a positive attitude towards internet-based financial innovations and reluctantly consider their detrimental side. This subtle attitude that starts from a presumption of benefit until detriment is proven should be carefully debated as internet-based financial innovations are neither inherently good nor inherently bad. While many innovations prove to be beneficial, others can result in adverse outcomes, for example products that are misrepresented or simply inappropriate for end-users or products that are mismanaged with respect to liquidity risk they entail and result in broader systemic problem for the financial system or the economy at large.33 With regard to iMMFs, Zhou Xuedong, deputy to China’s National People’s Congress and Head of the Nanjing 31  Hu (2013). 32  A good summary of the discussion is provided by Liao (2011). 33  Lumpkin (2009) argues that many financial innovations prove to be beneficial, on net, but some others result in adverse outcomes. Because of the net benefit, many policymakers

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branch of the People’s Bank of China, said “[a]t the moment the authorities should encourage this newly born industry to develop and innovate, but the authorities [. . .] should introduce regulations against potential harm”.34 This caveat argues against a completely hands-off approach to internet-based financial innovations and indicates that authorities should actively seek ways to ensure that harmful aspects of internet-based financial innovations are appropriately contained while preserving the benefits of innovative activities. Admittedly, this balance is not an easy one to achieve. First, it is questionable whether Chinese authorities have the ability to distinguish beneficial from harmful innovations at an early stage, especially when a fragmented regulation system appears to be inadequate in reacting to the rapid development of internet-based financial innovations and then hybrid financial products. This is why Chinese authorities take a permissive, laissez-faire attitude to financial innovations at an early stage. Second, in the era of internet finance, dynamic financial innovations have been outpacing static legal adjustments, which results in the serious delay when regulators attempt to distinguish beneficial from harmful innovations. Some academics even put forward a new idea that ex post supervision instead of ex ante supervision is more suitable for internet-based financial innovations. Obviously, such second-guessing is not a responsible and practical attitude. Third, were potentially harmful innovations to be identified, under the existing fragmented regulatory framework, different sectoral regulatory authorities would likely have different views as to the appropriate degree of containment. The fragmented regulatory framework makes it possible that the regulatory chain has been stretched to the degree that any favourable attitude adopted by at least one regulator would put the effectiveness of the whole regulation system into doubt. Of course, on the other hand, any attempt to subject innovative activities to stringent regulatory oversight would no doubt suffocate them in the first place and would do no good to the financial industry and the economy at large. The iMMFs’ regulatory dilemma cannot be fully attributed to the inappropriate regulatory approach and biased regulatory attitude Chinese authorities adopted. Insufficient and ineffective development of corresponding regulatory toolkit is another cause for iMMFs’ regulatory dilemma. In the era of financial mixed operations, sector- or products-based regulatory toolkit is incapable of facing the challenge brought by internet-based financial innovations and then hybrid financial products. If we only consider iMMFs as may wish to adopt a positive attitude towards innovative activities; that is, to start from a presumption of benefit until detriment is proven as opposed to the reverse construction. 34  Internet Finance (2014).

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internet-based fund activities and intentionally ignore its features of internetbased third-party payment, siphoning off demand deposit from commercial banks, and highly undiversified portfolio that are mostly invested in the interbank negotiated deposits, the existing regulatory toolkit can still cope with the regulatory demand for iMMFs. But it is clear that this is inconsistent with the reality. Moreover, if we treat iMMFs as one kind of special-purpose bank and then utilize the regulatory toolkit for commercial banks, we may fall into the trap that classifies iMMFs and commercial banks into the same category in terms of regulation. This may not be helpful in promoting the sustainable and healthy development of iMMFs. For example, Sheng Songcheng, Director of the Statistics and Survey Division of the People’s Bank of China, indicates in his paper “Yu’E Bao and Reserve Requirements Management”35 that there is no difference between iMMFs’ interbank negotiated deposits and personal and enterprise deposits in terms of contractual nature and their influence on money creation such that iMMFs should not have been exempted from the reserve requirements imposed on the banks. He also argues that such reserve requirements should be applied indirectly—only on those amounts held by banks on behalf of iMMFs. The withdrawal of the exemption would significantly reduce the attraction of interbank negotiated deposits for iMMFs. According to Sheng’ calculation, the annualized return of Yu’E Bao would be reduced by one percentage point if there were 20% reserve requirement on the portion of its money placed as negotiated deposits with banks. The reduced profit margin would force iMMFs to invest in other higher return but more risky assets to keep their attraction for investors. The changes in the risk characteristics of iMMFs’ portfolio may not be desirable for both investors and regulators. On the other hand, without reserve requirements in place, a possible bank run on iMMFs can lead to problems with liquidity and a massive bankruptcy that shakes the entire Chinese economy. Obvious, it is imperative that Chinese authorities recognize the lack of sufficient and effective regulatory toolkits in implementing an approach to regulate iMMFs. 3

An Economic Evaluation of iMMF’s Regulation

3.1 A Balanced Regulatory Approach Following the fast development of financial industry in China, there is a large body of opinion in favour of establishing some form of integrated regulatory structure or single-regulator model, the most of which were elaborated in the 35  Global Finance (2014).

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form of “general speaking” rather than “detailed economic explanation”. There is no answer with regard to why an integrated regulatory approach should be adopted and how a balanced regulatory approach would be achieved. In fact, although adopting an integrated approach has been the most visible developments in financial regulation in the last twenty years around the globe, it does not indicate that an integrated approach is the inevitable choice for Chinese authorities. Martinez and Rose argue that whether having a single regulator is the ideal option is far from being resolved.36 How to choose an appropriate regulatory approach depends much on the maturity of financial market as well as the abundance of regulatory practice. Liao thus argues that China does not seem to be well prepared for shifting from the traditional sector-bysector approach to supervision toward a greater cross-sector integration of financial supervision.37 Moreover, even if the circumstance and global trend makes it compulsory to adopt some kind of integrated regulatory approach, it is not an easy task to build up a balanced regulatory approach that gives proper weight to each of the three primary policy objectives, i.e. mitigating systemic risk, ensuring proper market conduct, and ensuring adequate protection for end-users of financial services. Actually, several factors, for example the financial system’s size, development of structure, as well as presence of financial groups, strong industry lobby and other political economy factors, can influence a particular supervisory structure for a given financial system.38 In addition, even for the same set of factors, due to different weight, similar countries may choose different supervisory structure for financial services. For instance, supervisory structures differ so much across the United States, Germany and UK in their degree of integration, the proximity of micro-prudential and macro-prudential supervision, and the development of business conduct supervision. This helps to explain why there is no “one solution fits all” approach to financial supervision as well as why we see countries shifting from one supervisory structure to another from time to time.39 Before proceeding with our analysis of a balanced regulatory approach to iMMFs’ regulation, it is important to be clear what types of financial 36  Martinez & Rose (2003). 37  Liao, supra note 32. 38  A good summary of the discussion and new evidence is provided by Melecky & Podpiera (2013). 39  Masciandaro (2009) points out that there is no “one solution fits all” for a supervisory oversight structure and that in the end it is a political choice. The empirical findings mentioned by Masciandaro claim that there is no strong theoretical argument in favour of one supervisory structure over another.

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supervisory structures exist in the world and their applicability to China’s financial industry. According to the Group of Thirty (2008), there are four principal approaches to supervisory oversight: the institutional approach, the functional approach, the integrated approach and the twin peak approach.40 The institutional approach, which is currently adopted by Chinese authorities, divides the market into clear regulatory segments leaving each regulator responsible for a certain type of financial institution.41 The problem with this approach is that the interaction of different financial products and the elimination of the traditional separation between different types of firms over the years make regulation overlap and vacuum an inevitable outcome. For example, the emerging iMMFs in China has challenged the traditional wisdom underlying institutional regulation and served as a major contributor to the regulatory chaos. It is possible that this approach’s shortcoming could be overcome via an effective regulatory coordination mechanism. However, even if some sectoral laws have required the sectoral regulators to cooperate with one another and set up appropriate information-sharing and coordination mechanisms,42 without top-level design and political wills, such a requirement remains on paper as every regulator is self-interested when deciding upon regulating and coordinating.43 In fact, the fast development of internet-based financial innovations has substantially intensified regulatory conflict among various sectoral regulators. The functional approach divides the market into products such that the supervisory oversight is determined according to the business performed by the regulated entity without regard to its legal status. Therefore, one regulated entity, for example a financial conglomerate, may be 40  See also Masciandro & Quintyn, supra note 28. A similar classification was adopted in their research on financial supervisory structures in 102 different countries. 41  Under this structure, the Banking Commission is responsible for the supervision of commercial banks and trust and investment companies, the Securities Commission for the supervision of securities and fund management companies, and the Insurance Commission for the supervision of insurance institutions. 42  Pertinent provisions can be found in the Banking Regulation Law and the Central Bank Law. For example, the requirement for establishing a mechanism for sharing regulatory information between the Banking Commission and other financial regulators is clearly enacted at Article 6 of the Banking Regulation Law. A similar provision is found in the Insurance Law requiring the Insurance Commission to set up a regulatory informationsharing mechanism with other financial regulators. 43  This is a strong but reasonable assumption. Enriques & Hertig (2010) claim that these interests, varying from interests to increase their personal powers, their reputation or their future potential career opportunities, are accompanied by the desire to reduce reputation and legal risk.

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subordinated to a few different regulators, each regulating a different part of its activity. The problem with this approach is that not only it is very difficult to cover all the possible products in the financial markets such that there is always the risk of having unregulated “grey areas” in which no regulator has a mandate to regulate, but also the emergence of hybrid financial products may lead to regulatory overlap such that there is the risk of having overregulated “red areas” in which every regulator has a mandate to regulate. Parisi and others state that regulatory overlap or vacuum is normal rather than unusual when two or more regulators act independently.44 A meaningful coordination mechanism is also a key assumption to the smooth operation of this approach, which is seemingly not supported by current conditions in China. Given the blurring of demarcation lines between several types of financial institutions and the formation of all-encompassing financial conglomerates, the integrated approach to supervision, which states that one single regulator oversees the entire financial market, was increasingly considered the most effective solution.45 This approach attempts to internalize cost of coordination that can occur under both the institutional and functional approaches, but also creates the risk of a single point of regulatory failure due to a high concentration of regulatory powers. It seems that this approach works well in smaller markets as well as some larger, complex markets, i.e. Germany, Japan, Singapore and UK, where it is viewed as a flexible and streamlined approach to regulation. The difficulty with this regulatory structure is that not only does it not prevent regulatory overlap or vacuum as it just internalizes them but also it might even increase the problem as under this regulatory structure any tiny weakness, misconduct, wrong-doing or unpopular behaviour against the public or political opinion will always bring the blame to the shoulders of one regulator rather than sharing the burden with another regulatory authority. Moreover, empirical evidence suggests that a mature financial market and abundant regulatory practice are essential precondition for successfully adopting this approach to supervision, which may not be the case of China.46 The twin peaks approach is a particular version of the integrated approach and consists of two sectorally integrated agencies, where one supervisory agency is in charge of prudential supervision in all the sectors in the financial system 44  Parisi et al. (2006). 45  Abrams & Taylor (2002); Llewellyn (2006). 46  This viewpoint is expressed in Liao’s article (2011) stating that China does not seem to be well prepared for such big change and the establishment of a meaningful coordination mechanism based on separated functional regulation and focused on resolving major regulatory conflicts is a better choice.

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and another one is responsible for business conduct, consumer protection and corporate governance in all the sectors.47 In other words, there are two sectorally integrated agencies, each with different functions. The dichotomy attracts a growing interest and support as it inherits the desirable features of the integrated approach while at the same time addressing the inherent conflicts that may occur from time to time between objectives of prudence and business conduct and consumer protection. In fact, over the past decade, there has been a tendency to unify prudential supervision as well as an increased proportion of countries that implemented integrated business conduct and consumer protection supervision.48 Through comparing abovementioned four approaches to supervision, we may draw the conclusion that the partial integrated approach, i.e. the twin peaks approach, is the inevitable choice for Chinese authorities because there is growing importance of business conduct and consumer protection supervision in overall supervisory efforts as well as the emergence of financial mixed operation and regulatory challenges posed by this have prompted Chinese authorities to consider the integrated prudential supervision for a more effective and harmonized oversight.49 However, we are still concerned whether such an approach suits China and wish to understand which underlying factors have been driving the evolution of regulatory approach to supervision in China. In terms of prudential supervision, Melecky and Podpiera find a country’s level of development (GDP), financial sector development, trade openness, quality of governance and the number of past financial crises positively influence the likelihood of prudential integration.50 Is this finding applicable to China? First, the fact that China has become the world’s second largest economy suggests that Chinese authorities could easily 47  Depending on the degree of integration, the integrated approach can be classified as: 1. Full sectoral integration: (1) Full sectoral and functional integration: one agency is responsible for not only prudential supervision but also for business conduct and consumer protection supervision; (2) Twin peaks: one agency is in charge of prudential supervision and another one is responsible for market conduct and consumer protection supervision; (3) Full sectoral, partial functional integration: some countries have integrated supervisory agencies, but some of the functions may be shared with other agencies, in particular with central banks. 2. Partial sectoral integration: this framework includes authorities that are prudentially supervising two of the three main segments. See Cihak & Podpiera (2008). 48  See Melecky & Podpiera, supra note 38. 49  A great monopoly powers of the unified prudential supervisor as well as the unified business conduct and consumer protection is the main concern for Chinese authorities. 50  Melecky & Podpiera, supra note 38.

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mobilize resources necessary for developing and implementing the integrated structure for prudent supervision. Second, the more sophisticated financial system characterized by the presence of financial conglomerates and the era of internet-based financial innovations entails the integrated prudential supervision of main financial subsectors, which subsequently could increase the effectiveness of prudential supervision. Third, the globalization and liberalization of China’s financial industry as well as the open door policy firmly implemented by Chinese authorities make an integrated prudential supervision necessary as increased capital flows in and out of China need a holistic monitoring and managing of exposures to capital flow reversals. Fourth, Chinese authorities have taken firm measures to improve the quality of governance and significant improvements have been observed in the area of government accountability, government effectiveness, regulatory quality, rule of law, and control of corruption. This progress creates a favorable environment for the integration of prudential supervision. Fifth, even though China does not experience a lots of severe financial crises, it surely learns lessons from other countries that an integrated prudential supervision, which provides for close proximity of micro- and macro-prudential supervision, is better prepared to prevent, or cope with financial crisis than sector-by-sector supervisors. On the other hand, three factors, i.e. the income level, financial depth, and banking sector concentration, play a key role in affecting China to establish and integrate business conduct and consumer protection supervision. First, the increase in the deposable personal income in China and subsequently more commercial activities indicate that more integration of business conduct and consumer protection supervision is desired to presumably ensure holistic and consistent oversight of business conduct and consumer protection in the provision of financial services. Second, the greater development of financial conglomerates and shadow banking in China could prompt the decision to integrate business conduct and consumer protection supervision to a greater degree to eliminate possible regulatory vacuum in fragmented sectoral supervision. Third, the declining trend of banking sector concentration induced by the emergence of non-state-owned banks and the shadow banking system weakens the banking sector’s market monopolistic and lobbying power that could be used against the introduction of a more holistic approach to business conduct and consumer protection supervision. Overall, the author argues that, at present, China’s financial sector characteristics suggest a balanced regulatory approach based on implementation and integration of prudential supervision as well as business conduct and consumer protection supervision is the best choice. In the era of internet finance, the balanced regulatory approach to supervision based on the twin peaks model should facilitate financial

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i­nnovations, risk controls and consumer protections, which is also the desirable requirements for regulating iMMFs. The current financial regulatory system in China is based on the principle of “separated operation, separated regulation”, which is the so-called institutional approach to supervision, and appears to be inadequate in reacting to the development of internet finance that usually includes cross-sector as well as hybrid financial products. Therefore, the author suggests that Chinese authorities should proceed from two collaborative directions in terms of financial regulation amendment and enaction: (1) divide the regulatory tasks between two integrated regulators: one is in charge of the safety and soundness supervisory function while the other is in charge of conduct of business regulation and consumer protection; (2) accelerate the set-up of a regulatory regime for internet finance and step up the supervision of internet finance to create an orderly internet finance regulatory regime. In addition, although it is not an easy task to attain the balance among enabling innovations, controlling risks and protecting consumers as well as some academics hold forth a new idea that ex post supervision instead of ex ante supervision is more suitable for internet-based financial innovations, the author believes that internet finance’s characteristics of fragmentation, openness and proliferation make it compulsory for risk control at the centre of the legal regulatory regime for internet finance such that the regulatory system should work on the principle that risk control has priority over financial innovations and consumer protection. That is to say, when prudential supervision appears to conflict with consumer protection or financial innovations, the prudential supervisor in the twin peaks system may give precedence to safety and soundness because there are closely intertwined with financial stability. In view of this, the author suggests that the following paths for regulating iMMFs should be considered. First, Financial Supervisory Authority (FSA), which is an integrated prudential supervision outside the central bank and is responsible for microprudential51 supervision in all the sectors in the financial system, should be established to maintain the sustainable and healthy development of financial market in China.52 The separation of micro-prudential supervision and monetary policy will reduce the potential for conflict of interest between

51  The term “micro-prudential” refers to the safety and soundness of individual financial institutions. 52  The prevalence of central banks in prudential supervision has diminished. According to Melecky & Podpiera (2013), the number of integrations of prudential supervision in a FSA outpaced those in a central bank: there were 14 new unifications of prudential supervision in a FSA and five unifications in a central bank since 1999.

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monetary and micro-prudential supervision goals.53 For instance, the central bank will find itself in a dilemma if it raises interest rate to restrain inflation as it fears that higher interest rates would lead to bank failures. Moreover, public opinion always puts the blame of bank failures on the shoulders of the supervisor and then the credibility of the central bank in monetary policy would suffer as well if its credibility as a bank supervisor is undermined. The separation of macro-prudential54 and micro-prudential supervision is not only in line with the goal of building a sound macro-prudential supervisory framework initiated in the “Development and Reform of China’s Financial Industry” of the twelfth five years plan but also facilitates FSA to concentrate on dealing with the challenges of financial innovations. The rapid proliferation of financial innovations not only blurs the boundaries among financial subsectors but also results in the traditional financial products classification somewhat out of date. Therefore, there is need to integrate law and regulations related to banking, securities, trusts and insurances into a comprehensive “Law of Financial Services and Markets”, in which the concept of financial instruments should be proposed and used to replace the classification of equities, bonds, futures as well as other financial derivatives. Following that, a multilevel micro-prudential regulatory system should be established to determine the regulatory scope, form and strictness for different financial instruments depending on their degree of socio-economic impact or potential systemic risk. In addition, regulatory coherence and transparency should be observed for all financial service providers no matter whether they are traditional financial institutions or emerging internet enterprises such that they can compete on a level playing field. Second, Financial Conduct Authority (FCA) should be established to look after all aspects of business conduct and consumer protection across financial subsectors and the “Law on Protection of the Rights and Interest of Financial Consumers” should be enacted to strengthen the protection of the rights and interests of consumers engaged in financial activities, step up education for these consumers as well as raise their risk awareness and self-protection capabilities through taking information disclosure and appropriateness of investors as the central task. The variety and complexity of financial instruments are far beyond the reach of non-financial products such that financial consumers, in comparison to financial service providers, are inherently disadvantaged groups and are in a more unfavourable position in the era of internet finance due to i­nformation 53  The arguments for and against the central bank being involved in microprudential supervision have been summarized by Goodhart & Schoenmaker (1995). 54  The term “macro-prudential” refers to the analysis of strengths and vulnerabilities of financial system as a whole. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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asymmetry and inconsistency. As a result, we should do well to remind ourselves that over-insistence on the principle of caveat emptor would not only hinder the state from taking appropriate measures to ensure financial consumers’ legal rights and interests but also unintentionally trigger systemic risk. Therefore, the “Law on Protection of the Rights and Interest of Financial Consumers” should clearly state that information disclosure is the responsibilities and obligations of financial services providers. In addition, financial services providers should fully assess a financial consumer’s financial situation, investment objectives, level of risk tolerance, financial need, knowledge and experience before advising him to purchase a particular financial instrument. The compliance with the suitability requirements is fundamental to compliance with general business conduct standards and is essential to good business practice. The first step in satisfying the suitability requirements is to satisfy the new account application and “know your client” requirement. Particularly, the information collected should be sufficiently precise to enable the financial services providers to meet their suitability assessment obligations. The author suggests that the principles of information disclosure and appropriateness of investors should be enshrined in the “Law on Protection of the Rights and Interest of Financial Consumers” and be legally binding and enforceable such that if financial services providers do not fully comply with these principles, thereby causing loss to financial consumers, they should be liable for damages unless they prove that they deal fairly, honestly and in good faith with clients. 3.2 Policy Options for Reducing iMMFs’ Susceptibility to Runs 3.2.1 Capital Buffers for iMMFs A capital buffer is designed to decompose a traditional MMF into two separate components—a capital buffer (subordinate shares) and a stable value claim (ordinary shares). The basic idea of the capital buffer is that the providers of the capital buffer bear first loss on some portfolio assets such that the ordinary MMF shares would effectively be over-collateralized and then protected from the risk of loss. In return, due to the readjustment of risks and rewards between subordinate and ordinary shares, the buffer investors would absorb all gains on the portfolio in excess of the amortized cost of the underlying assets as the compensation for bearing the financial risk associated with the leverage implicit with specific buffer levels, while the stable value claim investors would receive a pay-out that is equal to the amortized cost of the underlying assets less the capital charge as long as the buffer remains solvent.55 The capital ­buffer 55  MMFs are permitted to use amortized cost accounting when valuing their portfolios rather than market-marked valuations. This method allows a money market fund to value its assets at acquisition cost, adjusting for any premium or discount over the asset’s life. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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has been proposed by the Financial Stability Oversight Council (FSOC) to the US Securities and Exchange Commission as an additional option to further reform the MMF industry in November 2012.56 Following that, various papers have been published to discuss this option’s applicability and effectiveness.57 The general findings are twofold. On the one hand, the capital buffer could generate significant financial stability benefits and reduce incentives for fund manager to take excessive risks. On the other hand, a significantly larger and more costly capital buffer would reduce the utility of MMF to ordinary shares investors. As the rapid proliferation of iMMFs in China and lack of appropriate regulatory regime for iMMFs in place have raised the concerns about the potential systemic risks iMMFs could bring to the broad financial system, Chinese authorities and academics have been considering to borrow the capital buffer proposal to address the potential systemic risk problem associated with investor tendencies to redeem shares during periods of stress. However, is this proposal applicable for China’s iMMFs? What are the implications of this proposal? In order to answer these questions, we will illustrate the economic effects of requiring an iMMFs to be supported by a capital buffer. Specifically, we will describe the benefits and costs of such a proposal, and characterize the implications of capital buffers. It is clear that the capital buffer is designed to absorb the fluctuations in the value of the fund’s underlying assets relative to their amortized cost such that it is the first line to defend the ordinary iMMF shares from the risk of loss. In terms of containing systemic risk, this design brings two potential benefits: it reduces both the incentive for iMMFs investors to run ex post and the incentive of iMMFs to take on excessive portfolio risk ex ante. Due to shielding from the first loss by the capital buffer, the stable value claim investors have the lower chance to suffer a loss in normal times. The capital buffer would significantly reduce the probability of a systemic risk stemming from iMMFs’ susceptibility to runs when the stable value claim investors experience a loss or observe this phenomenon happened elsewhere. Moreover, as long as the size of the capital buffer is large enough to absorb all losses an iMMF would bear, a stable value claim investor would be fully insulated from suffering a loss even if the iMMF has sustained a loss, and thus would unlikely

56  See Financial Stability Oversight Council (2012). Capital buffers were originally proposed by the Squam Lake Group (2011), a non-affiliated group of academics who offer guidance on the reform of financial regulation. 57  See Hanson et al. (2013); Lewis (2013); ICI (2013).

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flee from iMMFs in any crisis.58 Thus, capital buffer means that the risk of a run may be less likely to become a self-fulfilling prophecy, in which investors strategically choose to run because they anticipate that others will run.59 In addition, holding asset portfolio risk constant, the ordinary shares would be less attractive to investors due to the lower yield that can be offered to as the capital buffer investors could require higher yields to bear first loss on a riskier pool of assets. Thus, the capital buffer would have an incentive to reduce risk. The findings summarized by Kacperzyck and Schnabl support the idea that capital buffer can discourage MMF from risk-taking, and thereby precipitate MMF’ susceptibility to runs when poor outcomes are later realized.60 Capital buffers have drawbacks, however. First, the first line defence sponsored by the capital buffer could effectively discourage iMMFs portfolio managers from implementing prudent risk management strategy as well as blunt ordinary shares investors’ incentives to monitor risks in their funds. Second, as the size of the capital buffer determines its inherent risk absorbing capacity, only large enough buffer could effectively mitigate systemic risks, but subordinated iMMF shares could be expensive and raising sufficient capital to absorb the losses would be challenging during periods of financial distress when market participants are reluctant to offer. Third, capital buffer could in fact be a source of instability. The ICI (2013) analysis suggests that the capital buffer investors may prefer not to roll over their positions during periods of financial stress, and thus subject iMMFs to the risk of having to find new sources of capital. It is obvious that capital buffer is a double-edged sword. So, is this proposal applicable for China’s iMMFs? Although both the US and EU have proposed to impose capital buffer requirements on MMFs, the author believes that this proposal is not applicable for China’s iMMFs. First, capital buffer requirements will reduce iMMFs’ appeal to investors and alter fundamentally the money market fund business model, which will significantly hold back the rapid proliferation of iMMFs in China. However, the fast development of iMMFs is the desirable driver pursued by Chinese authorities as it would likely facilitate the process of financial disintermediation and accelerate the pace of interest rates liberalization in China. The US experience indicates that in the next stage China banks will probably lobby the regulators to speed up deregulation on 58  If the size of a buffer were not large enough, the stable value claim investors would likely flee from iMMFs in any crisis out of fear that losses would exceed the size of the buffer. Therefore, the size of the buffer does determine how likely it is to succeed and its inherent risk absorbing capacity. 59  Hanson, supra note 57. 60  Kacperzyck & Schnabl, supra note 24.

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deposit interest rates and finally remove the interest rate controls.61 Moreover, commercial banks have the danger of being pushed out of the short-term business financing market due to the rise of iMMFs, and thus have to proactively seek opportunities in alternative businesses and further plunge into financial mixed operations.62 Actually, the rapid growth of iMMFs is beneficial to both iMMFs and commercial banks. Second, capital buffer is not a practical way to provide cost-effective mitigation of the systemic risks associated with iMMFs. A small capital buffer would do little to mitigate systemic risks and only a large enough capital buffer could protect ordinary shares investors from losses such that it may be a costly mechanism from the perspective of the opportunity cost of capital.63 In addition, a substantial capital buffer enables iMMFs to offer ordinary shares investors’ returns that mimic those available for government securities, which effectively converts iMMFs into “synthetic” Treasury funds from the perspective of ordinary shares investors. The indifference between iMMFs and Treasury funds in terms of yield would significantly reduce the attractiveness of iMMFs to investors, push investors to less-regulated products, and reduce choice and competition. Moreover, if retail investors shift their assets from iMMFs to less-regulated products, which are typically less transparent and less constrained than iMMFs, their growth would likely pose systemic risks as these products are more vulnerable to runs. In general, if capital buffer is not a useful measure to mitigate systemic risks, is detrimental to financial innovations and competition, and is not helpful in attaining the goals of interest rates liberalization as well as finance modernization, why Chinese authorities should adopt it?64 3.2.2 Floating NAV for iMMFs iMMFs do not guarantee investors to make profits, but, by issuing demandable shares, it does guarantee them an “exit right”, the right to redeem their shares at any time at the current net asset value of the shares (NAV). What makes iMMFs different from other open-ended mutual funds, i.e. equity funds and 61  Alternatively, Chinese banks may lobby the regulators to limit the size of iMMFs. 62  For example, since 1970, the money market funds have emerged as the most important sources of short-term financing in the US, according for 35% of commercial paper market financing between 1992 and 2008. See Macquarie (2014). 63  According to Lewis (2013), a 3% buffer would be required if complete loss absorption is the objective. Hanson et al. (2013) suggest that a capital buffer in the range of 3% to 4% would be preferable for a well-diversified portfolio. 64  According to IOSCO (2012), there was strong opposition to the establishment of capital buffers. Most of respondents declared that capital buffer would cost more than the expected value of a loss and convert MMFs into a banking product.

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bond funds, is that they seek to maintain a stable NAV,65 usually of ￥1. In order to maintain a stable NAV, iMMFs rely on two mechanisms: the computation of the NAV and sponsor support.66 The CSRC allows iMMFs to use amortized cost valuation and penny-rounding pricing to compute the NAV. The securities in which iMMFs invest, i.e. short-term money market instruments, lack readily available market prices and thus there is no single “correct” fair value. As a fair way to value these assets, amortized cost method allows iMMFs to value their asset’s fair value changes in a straight line from purchase to maturity to reflect the implicit interest generated by the asset during that time period. As long as the deviations between the ￥1 and the “shadow price”, which is the mark-tomarket per-share value of iMMF’s assets, is less than one-half of one percent (or ￥0.005 per share), the price per share of an iMMF can be rounded to ￥1.67 However, the expectations of safety fostered by the stable NAV may not be sustainable without the discretionary intervention by iMMF sponsors, i.e. fund advisers, their affiliates, and their parent firms.68 Thus, when a fund incurs even a small loss, the stable, rounded NAV may subsidize shareholders who choose to redeem at the expense of the remaining shareholders. Empirical evidence suggests that at least 21 MMFs in US would have broken the buck if they had not received sponsor support during the last financial crisis.69 In fact, as shown by Schapiro, sponsors have intervened more than 300 times to support MMFs since the funds were introduced in the 1970s.70 The feature of maintaining a stable NAV provides investors with an embedded put option to sell assets for ￥1, and thus causes iMMFs’ susceptibility to runs through contributing to the incentive for a representative investor to be the first to redeem shares when asset values drop. In the light of systemic risk stemming from iMMF’s susceptibility to runs, Chinese authorities have been considering to force iMMFs to abandon the stable NAV in favour of a floating NAV that reflects the mark-to-market values of their shares more 65  The NAV could be calculated through assigning a value to each of the iMMF’s portfolio assets, aggregating these amounts, and then reducing the sum by any outstanding debts of the iMMF. Then, an NAV per share is obtained through dividing the NAV by the number of shares outstanding. 66  See Moody’s (2010); Schapiro (2012). 67  If the shadow price of an iMMF is below ￥0.995, the iMMF must re-price its shares, an event colloquially known as “breaking the buck” in the US. 68  The current regulatory regime does not require sponsors to explicitly commit to support an iMMF in advance. Instead, sponsor support remains expressly voluntary, and not all iMMFs have a sponsor capable of fully supporting its iMMFs. 69  Brady et al. (2012). 70  Schapiro, supra note 66.

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precisely. They believe that adopting a floating NAV would diminish the risk of sudden redemption by making iMMFs like any other mutual funds and by eliminating the possibility of breaking the buck. Is this reasoning correct? In other words, will a floating NAV disincentivize each shareholder of iMMFs to redeem shares before other shareholders when there is a perception that the iMMF might suffer a loss? Advocates for such a change, such as the Group of Thirty and Lacker, argue that switching to a floating NAV would eliminate the incentive for such strategic runs.71 As it is not unusual that amortized cost valuation may result in periods during which the value of an iMMF’s portfolio, as determined by amortized cost, is lower than the price the iMMF would receive if it liquidated the portfolio at prevailing market prices, the stable NAV effectively offers redeeming shareholders an arbitrage opportunity by paying more for the shares than the shares are worth and by doing so reduces the value of the fund’s assets, imposing costs on non-redeeming shareholders who might not get ￥1 for their shares. Therefore, the stable NAV may accelerate runs by amplifying investors’ incentives to redeem shares quickly if a fund is at risk of a capital loss.72 By contrast, a floating NAV will eliminate some of the incentives for investors to redeem first because losses incurred by a fund with a floating NAV are borne on a pro rata basis by all shareholders. However, it should be pointed out that a floating NAV is unlikely to entirely forestall such strategic runs. Rational investors would still have the incentives to withdraw quickly from a distressed iMMF, even at a reduced NAV, because nonredeeming investors would be left holding a portfolio of less-liquid, longerdated securities and incur losses. That is why we would say that a floating NAV could reduce rather than eliminate the incentives for such strategic runs. Some academics also argue that a floating NAV that might make fluctuations in iMMFs’ share prices a regular occurrence would unveil the risk characteristics of iMMFs, improve investors’ understanding of inherent riskiness of iMMFs, enhance investors’ tolerance on iMMFs’ price fluctuations, and force more risk-averse investors to seek more appropriate investment opportunities. Indeed, the stable NAV has been termed as a “myth” by Sheila Bair and has been leaving investors operate in an artificial bubble ignorant of growing systemic risks.73 However, it should be acknowledged that a floating NAV may fluctuate little in normal times because of the nature of iMMFs assets. 71  Group of Thirty (2008); Lacker (2011). 72  PWG (2010). 73  The stable NAV has fostered investors’ expectation that iMMFs are risk-free cash equivalents. However, this false belief has been shattered when the Reserve Primary Fund failed to maintain those expectations in September 2008.

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Thus, it is unclear whether moving to a floating NAV would substantially alter investors’ perceptions about the risks inherent in iMMFs. In addition, the improved understanding of inherent riskiness of iMMFs might reduce iMMFs’ attractiveness to investors who initially believe that iMMFs are riskfree investment and thus lead to a shrinking of iMMFs’ assets and of iMMF’s capacity to provide short-term funding. And last but not least, a floating NAV may be difficult to implement given the absence of active secondary market for many money market instruments. The CSRC acknowledges that some of these instruments have a less active secondary market and that others are nonmarketable. Although the floating NAV is theoretically correct and thereby, by standardizing the method of valuation, gives investors greater ability to compare yields of different iMMFs when making an investment decision, it is inevitable that it will yield different results as different iMMFs boards in good faith make varying estimates since fair value depends upon the circumstances of each individual case. In general, the author believes that forcing iMMFs to use a floating NAV will substantially jeopardize the continued vitality of the iMMFs market. ICI argues that “[i]f money market funds are forced to abandon the stable NAV, many investors will be forced to abandon money market fund”.74 In fact, if the goal is preventing runs, forcing iMMFs to abandon a stable NAV might well prove counterproductive. 3.2.3 Other Reform Proposals In view of the fact that a floating NAV or capital buffers are not capable of mitigating iMMFs’ susceptibility to runs, a range of alternative options have been considered by Chinese authorities. Some academics believe that the functional similarities between iMMFs and deposits provide a rationale for reorganizing iMMFs as special purpose banks (SPBs) with appropriate prudential regulation and supervision, government insurance and access to central bank lender-of-last-resort facilities. It has been argued that iMMFs has been competing with banks on an unfair basis as they are able to offer investors comparable services without the costs of regulation borne by banks. In other words, regulatory arbitrage is the original driver of iMMFs’ prosperity as well as the rotten root of iMMFs’ susceptibility to runs. As a result, mandating that iMMFs be reorganized as SPBs might subject these iMMFs to banking’s regulatory framework specially designed for mitigating systemic risks. Nonetheless, the suggestion that bank regulation will reduce the incidence of runs is indeed questionable. First, the stable ￥1 per share price of iMMFs not only gives investors the perception that iMMFs are 74  ICI, supra note 57.

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virtually riskless but also leads many financial practitioners to equate them to bank deposits. There is fundamental difference between claims held by bank depositors and iMMFs’ shareholders. As the contractual counterparties and creditors of banks, bank depositors have the statutory and enforceable rights to the timely payment of interest and principal in full. By contrast, iMMFs shareholders have fractional ownership interests in a pool of capital such that their interests are equity claim conveying a right to receive dividends and other distributions if, and only if, the iMMFs themselves earn returns on their investment.75 This fundamental difference means that converting iMMFs to SPBs requires legislative changes and complex interagency regulatory coordination. In terms of mitigating iMMFs’ susceptibility to runs, the net benefit of this transformation depends on how exactly this transformation would be implemented and how the new SPBs would be structured, which is a crucial uncertainty in China. Second, the simple transformation of iMMFs into depository banks might reduce the appeals of iMMFs to many investors as the regulation of iMMFs become too burdensome and meaningfully reduce iMMFs returns. This might result in the potential flight of assets from iMMFs to less regulated or unregulated vehicles. These vehicles could take on more risks than iMMFs, but such risks are not necessarily transparent to investors. Accordingly, the growth of these vehicles may pose even greater systemic risks than iMMFs. Thus, converting iMMFs to SPBs might displace or even increase systemic risks, rather than mitigate them, and make such risks more difficult to monitor and control. Third, reorganizing iMMFs as SPBs might bring the benefits of explicit capital buffers, access to a liquidity backstop, and implicit deposit insurance to their investors at a price similar to that currently paid by depository institutions. However, the requirement for meeting specific capitalization standards through raising substantial equity would be a considerable challenge and a costly strategy to implement. Overall, uncertainties about the implementation, effect as well as market prospect of reorganizing iMMFs as SPBs raise some important concerns about whether such transformation would provide a substantial degree of systemic-risk mitigation. An alternative to turning iMMFs into banks is to allow iMMFs, under certain circumstances, to impose fees or restrictions on redemptions. For example, Tianhong’s prospectus states that investors’ redemptions might be suspended for a given period when its daily net return or cumulative undistributed net return is negative. Alternatively, fees might be levied to discourage redemptions 75  See Fisch & Roiter (2011).

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and ensure that redeeming investors bear the liquidity costs of their actions. Such conditional restrictions could give fund managers time to respond to sudden outflow and thus potentially control runs in the event of a crisis. One potential benefit of such restrictions or fees is that they might correct investors’ misperception that iMMFs shares are perfect substitutes for deposits with guarantees of interest, principal and liquidity. However, such restrictions or fees would undermine the liquidity of iMMFs shares (i.e. the exit right) that is critical for many iMMFs investors. Particularly, conditional restrictions or fees might increase the susceptibility of iMMFs to runs when an iMMF is under strain as preemptive actions could be taken by panic-stricken investors. Moreover, in light of the fact that restrictions or fees on redemptions could be imposed conditionally as well as the preemptive actions might be taken by iMMFs’ investors, iMMFs would likely keep shorter maturity commercial paper in their portfolio assets to avoid concern about triggering redemption fees or restrictions, which in return would force financial institutions to fund themselves with shorter term financing and make them more vulnerable to destabilizing runs. In short, redemption restrictions or fees would have some potential benefits, but those benefits would have to be weighted carefully against the risks that such a change would entail. 4 Conclusion iMMF is a financial innovation that has the profound impact on the development of China’s financial industry. Chinese authorities should keep a very tolerant attitude towards internet-based financial innovations at large, acknowledge the active role they play in the course of interest rate liberalization as well as finance modernization, and pay close attention to the systemic risk they may pose. In the meantime, Chinese authorities should take this opportunity to establish the legal regulatory regime for iMMFs with Chinese characteristics and thus attain the balance between efficiency and fairness as well as innovation and supervision. On the basis of establishing international competence modern financial industry for China’s real economy as well as considering the advent of the era of internet finance as well as financial mixed operations, the author believes that the balanced regulatory regime based on the twin peaks model should be established for the purpose of unifying risk controls, market conducts and consumer protections. The primary task is to enact the “Law of Financial Services and Markets” and “Law on Protection of the Rights and Interest of Financial Consumers”, in which the principles of

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information disclosure and appropriateness of investors should be enshrined. We further discuss four policy options for reducing iMMFs’ susceptibility to runs. Our analysis suggests that these options may not be applicable or sufficient to address the instabilities associated with iMMFs. References Abrams, Richard K., & Michael W. Taylor (2002) “Assessing the Case for Unified Sector Supervision,” FMG Special Papers No. 134, Financial Markets Group, LSE, London. Brady, Steffanie A., Ken E. Anadu, & Nathaniel R. Cooper (2012) “The Stability of Prime Money Market Mutual Funds: Sponsor Support from 2007 to 2011,” Federal Reserve Bank of Boston, Risk and Policy Analysis Working Papers, RPA 12–3. Cihak, Martin, & Richard Podpiera (2008) “Integrated Financial Supervision: Which Model?” 19 North American Journal of Economics and Finance 135–52. Enriques, Luca, & Gerard Hertig (2010) “The Governance of Financial Supervisors: Improving Responsiveness to Market Developments,” European Corporate Governance Institute Law Working Paper. Financial Stability Oversight Council (2012) “Proposed Recommendations Regarding Money Market Mutual Fund Reform,” http://www.treasury.gov/initiatives/fsoc/ Documents/Proposed%20Recommendations%20Regarding%20Money%20 Market%20Mutual%20Fund%20Reform%20-%20November%2013,%202012.pdf (accessed 22 May 2015). Fisch, Jill, & Eric Roiter (2011) “A Floating NAV for Money Market Funds: Fix or Fantasy?,” University of Pennsylvania Law School, Institute for Law and Economics, Research Paper No. 11–30. Global Finance (2014) “PBOC Official: Bank should Hold Reserves on Yu’e Bao Deposits”. https://www.gfmag.com/topics/syndicate/19175905-pboc-official-banks-shouldhold-reserves-on-yue-bao-deposits (accessed 22 May 2015). Goodhart, Charles, & Dirk Schoenmaker (1995) “Should the Functions of Monetary Policy and Banking Supervision Be Separated?” 47 Oxford Economic Papers 539–60. Group of Thirty (2008) “The Structure of Financial Supervision: Approaches and Challenges in a Global Marketplace,” http://www.group30.org/images/PDF/The %20Structure%20of%20Financial%20Supervision.pdf (accessed 22 May 2015). ——— (2009) “Financial Reform: A Framework for Financial Stability,” http://fic.whar ton.upenn.edu/fic/Policy%20page/G30Report.pdf (accessed 22 May 2015). Hanson, Samuel G., David S. Scharfstein, & Adi Sunderam (2013) “An Evaluation of Money Market Fund Reform Proposals,” http://www.hbs.edu/faculty/Pages/item .aspx?num=43864 (accessed 22 May 2015). Hu, Jiaxiang (2013) “The Influence of Internet Finance on Securities Industry.” 16 China Finance 70–71. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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ICI (2013) “A Bad Idea: Imposing Capital Requirements on Money Market Funds,” http://www.ici.org/pdf/13_mmf_cap_buffer.pdf (accessed 22 May 2015). Internet Finance (2014) “Yuebao will not be proscribed, says Zhou Xiaochuan”. http:// huxiu.me/post/78542224297/yuebao-will-not-be-proscribed-says-zhou-xiaochuan (accessed 22 May 2015). IOSCO (2012) “Policy Recommendations for Money Market Funds,” http://www.immfa .org/assets/files/publications/IOSCO%20Policy%20Recommendations%20for%20 Money%20Market%20Funds%20-%20Final%20Report%20-%20Oct%202012.pdf (accessed 22 May 2015). Kacperczyk, Marcin, & Philipp Schnabl, (2012) “How Safe Are Money Market Funds?,” http://pages.stern.nyu.edu/~sternfin/mkacperc/public_html/mmfs.pdf (accessed 22 May 2015). Lacker, Jeffrey M. (2011) “Letter to the Securities and Exchange Commission re: File No. 4–619; Release No. IC-29497 President’s Working Group Report on Money Market Fund Reform,” http://www.sec.gov/comments/4-619/4619-54.pdf (accessed 22 May 2015). Lewis, Craig M. (2013) “The Economic Implications of Money Market Fund Capital Buffers,” http://www.sec.gov/divisions/riskfin/workingpapers/rsfi-wp2014-01.pdf (accessed 22 May 2015). Liao, Fan (2011) “Regulation of Financial Conglomerates in China: From de Facto to de Jure.” 12 European Business Organization Law Review 267–313. Liu, Yan (2014) “Regulating Yu’E Bao: A True or False Question?” Internet Finance and Law. Llewellyn, David (2006) “Integrated Agencies and the Role of Central banks,” in D. Asciandaro, ed., Handbook of Central Banking and Financial Authorities in Europe, Cheltenham: Edward Elgar, 109–140. Lumpkin, Stephen A. (2009) “Regulatory Issues Related to Financial Innovation. Financial Market Trends,” Paris: OECD. Macquarie (2014) “Yu E Bao’ and Its Siblings: Whose Cheese Is Stolen?,” Macquarie Equities Research. Martinez De Luna, & Thomas A Rose (2003) “International Survey of Integrated Financial Sector Supervision,” World Bank Policy Research Working Paper 3096. Masciandaro, Donato (2009) “Politicians and Financial Supervision Unification Outside the Central Bank: Why Do They Do It?” 5  Journal of Financial Stability 124–46. Masciandaro, Donato, & Marc Quintyn (2008) “Helping Hand or Grabbing hand? Politicians, Supervision Regime, Financial Structure and Market View.” 19 North American Journal of Economics and Finance 153–73. Melecky, Martin, & Anca Maria Podpiera (2013) “Institutional Structures of Financial Sector Supervision, Their Drivers and Historical Benchmarks.” 9  Journal of Financial Stability 428–44. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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Moody’s (2010) “Sponsor Support Key to Money Market Funds,” http://www.alston .com/files/docs/Moody’s_report.pdf (accessed 22 May 2015). Parisi Francesco, Norbert Schulz, & Jonathan Klick (2006) “Two Dimensions of Regulatory Competition.” 26 International Review of Law and Economics 55–66. PWG (2010) “Report of the President’s Working Group on Financial Markets: Money Market Fund Reform Options,” http://www.treasury.gov/press-center/pressreleases/Documents/10.21%20PWG%20Report%20Final.pdf (accessed 22 May 2015). Schapiro, Mary (2012) “Testimony on ‘Perspectives on Money Market Mutual Fund Reforms’ Before U.S. Senate Committee on Banking, Housing & Urban Affairs,” http:// www.sec.gov/News/Testimony/Detail/Testimony/1365171489510#.VAALkdzLd9U (accessed 22 May 2015). Sheng, Song Cheng, & Xiu Zhang (2014) “Yu’E Bao and Reserve Requirements Management: 21st Century Economy,” http://finance.21cbh.com/2014/jrgc_318/ 1101436.html (accessed 22 May 2015). Squam Lake Group (2011) “Reforming Money Market Funds,” http://www.sec.gov/ comments/4-619/4619-57.pdf (accessed 22 May 2015). Tech.sina.com (2013), http://tech.sina.com.cn/i/2013-12-23/09409031538.shtml (accessed 22 May 2015). Xu, Da Nei (2013) http://xudanei.baijia.baidu.com/article/5137 (accessed 22 May 2015).

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Chapter 13

Liberalizing Capital Market Entry in China Building a Registration System Jing Leng Abstract As the world’s second largest economy, China’s fast growing capital markets seem to be matching the escalating stature of its real economy, with a total market capitalization also ranked No. 2 in the world in 2014. However, at their current stage of development, the capital markets have yet to realize their full potential to contribute proportionately to the real economy. This can be seen from the moderate ratio of the total market capitalization of listed companies to the country’s GDP, as well as long waiting lists of anxious intending issuers hoping to tap the tremendous but not yet realized fund-raising opportunity. The main hindrance lies in the rigid control of capital market entry through a stringent merit-based system for IPO review and approval, which is still heavily driven by objectives of administrative governance not necessarily aligned with market forces. The Chinese government has set out its goal of gradually phasing out this much criticized system and moving toward a disclosure-based registration system within the next few years. The purpose of the reform is to substantially liberalize capital market entry to accommodate ever growing financing needs of domestic companies as well as investors’ expectations for expanded choices of investment returns. This article evaluates the effects of the IPO reform measures taken so far to move closer to that goal, and clarifies some of the widely shared misunderstandings surrounding the concept of the “registration system” among domestic academic and policy circles. It also offers a critique of some of the reform proposals for the design and implementation of the registration system that China would have, including those that have already found their way to the draft revisions to the PRC Securities Law. The main argument of this article is that if properly designed and supported by complementary reforms, the registration system will serve as a vigorous impetus for a paradigm transformation of the regulatory approach toward China’s capital market development to realize the government reform task of letting the market play a decisive role in resource allocations.

* Professor of Law, East China University of Political Science and Law. Contact: 2456@ecupl .edu.cn.

© koninklijke brill nv, leiden, ���6 | doiJiaxing ��.��63/9789004315815_014 Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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Keywords IPO – CSRC – quota system – review and approval system – registration system

1 Introduction As the world’s second largest economy, China’s fast growing capital markets seem to increasingly match the escalating stature of its real economy: as of the end of 2014, there were 2,613 listed companies on the two stock exchanges, including 1475 on the main board, 732 on the Small and Medium-sized Enterprise Board (SME Board), and 406 on the Growth Enterprise Board (GEB, or ChiNext); the market capitalization of all outstanding shares exceeded 37.25 trillion RMB yuan (USD 6 trillion), second only to that of the United States (Table 13.1); the free-float market capitalization represented 84.72 percent of the total; the amount of market capitalization of the Shanghai Stock Exchange (SSE) was ranked No.5 and the Shenzhen Stock Exchange (SZSE) No. 9 among their international peers, making them two of the 10 largest exchanges in the world (Table 13.2).1 Since 2005, listed companies have raised a total of 6.73 trillion RMB yuan in the market. For the first three quarters of 2014, business income of the listed companies amounted to 20.94 trillion RMB yuan, or 50 percent of the GDP; for the same time period, they also contributed 28 percent of the national enterprise income tax revenues.2 Table 13.1 Market capitalization of global markets in 2014 Country/Jurisdiction Rank Name

1 2 3 4

United States China Japan United Kingdom

Market Cap (USD billion)

26,330.6 6,004.9 4,378 4,012.9

1  C SRC (2015a), pp. 11–2. 2  Law Committee of the National People’s Congress (2015).

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Country/Jurisdiction Rank Name

5 6 7 8 9 10

France Hong Kong Canada Germany India Switzerland

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Market Cap (USD billion)

3,319.1 3,233 2,093.7 1,738.5 1,558.3 1,495.3

Source of data: World Federation of Exchanges, cited from CSRC (2015a), p. 12.

Table 13.2 Market capitalization of global exchanges in 2014 Country/Jurisdiction Rank Name

1 2 3 4 5 6 7 8 9 10

NYSE Euronext (US) NASDAQ OMX Tokyo Stock Exchange London Stock Exchange Shanghai Stock Exchange NYSE Euronext (Europe) HKEx Toronto Stock Exchange Shenzhen Stock Exchange Frankfurt Stock Exchange

Market Cap (USD billion)

26,33 19,351.4 6,979.2 4,378 4,012.9 3,932.5 3,319.1 3,233 2,093.7 2,072.4 1,738.5

Source: World Federation of Exchanges, cited from CSRC Annual Report 2014, p. 12.

Apart from the two stock exchanges, there is a new national stock trading venue called the National Equities Exchange and Quotations (NEEQ), or the so-called “new third board,” which was established in September 2012 by

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the State Council’s Decision on Relevant Issues Concerning the NEEQ. The NEEQ system is a consolidation of pilot local experiments with share transfer quotations for non-listed companies in the high-tech industrial zones of several large cities, including Beijing, Tianjin, Wuhan and Shanghai, and has been extended to a nationwide application since June 2013.3 By the end of 2014, the number of companies whose shares are quoted on the NEEQ was 1,572, with a total market capitalization of RMB 459.142 billion yuan. Of these companies, 8 had transferred to the SME board and the GEB after meeting the qualifications for a public listing.4 The statistics reported above are spectacular in that the capital markets in China only have a short history, starting from humble beginnings in the early 1990s. In December 1990, both the SSE and the SZSE were established by the authorization of the State Council. At the end of 1991, the SSE had 8 listed stocks and 25 members, while the SZSE had 6 listed stocks and 15 members.5 In a span of just 25 years, China’s capital markets have grown so exponentially that the country now boasts a gigantic population of public investors who have opened more than 142 million share trading accounts.6 At their current stage of development, the capital markets may have grown large in absolute size and arguably have even gained certain global prominence, but have yet to realize their full potential to contribute proportionately to the real economy. This can be seen from no further evidence than the moderate ratio of the total market capitalization of listed companies to the country’s GDP, which stood at a meager 58.5 percent at the end of 2014, already a huge increase over the past several years.7 As Table 13.3 demonstrates, in 2012, compared with its BRIC peers, China recorded a roughly equal percentage (43.7 percent) to that of Russia (43.4 percent), trailing behind Brazil (51.0 percent) and India (69.0 percent). It was below the average ratio not only of the world (73.7 percent), but also of the East Asia & Pacific region (50.2 percent).8

3  C SRC (2014), p. 2. 4  C SRC (2015a), supra note 1, p. 2. 5  C SRC (2008a), p. 159. 6  C SRC (2015a), supra note 1, p. 74. 7  Ibid., p. 14. 8  Worldbank.org (2013).

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Liberalizing Capital Market Entry In China Table 13.3 Market capitalization of listed companies to GDP in 2012 Country/Region

Market capitalization (USD millions)

% of GDP

No. of listed domestic companies

Germany Russia China Brazil Japan France India South Korea Thailand Philippines Canada United Kingdom United States Singapore South Africa Malaysia Hong Kong World East Asia & Pacific

1,486,315 874,659 3,697,376 1,229,850 3,680,982 1,823,339 1,263,335 1,180,473 382,999 264,143 2,016,117 3,019,467 18,668,333 414,126 612,308 476,340 1,108,127 53,163,894 5,263,020

42.1 43.4 43.7 51.0 61.8 68.0 69.0 96.5 104.7 105.6 110.0 115.5 115.5 142.8 154.1 156.2 421.9 73.7 50.2

665 276 2,494 353 3,470 862 5,191 1,767 502 268 3,876 2,179 4,102 472 348 921 1,459 47,520 5,311

Source of data: World Bank (2013).

It can be seen that although the absolute size of China’s capital markets is now ranked among the world’s leaders, their relative weight in the national economy still has huge room for strengthening. The lagging progress in the liberalization of capital market entry, mainly due to the rigid IPO regime which features a tight government control of new listings, has unquestionably contributed to this unsatisfying situation. The limitations of China’s capital markets are now felt in a particular context. The Chinese government aspires to build Shanghai as an international financial center by 2020. The upgrading of the capital markets from an “emerging and transition” market to a mature and developed market within

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the next 5 to 10 years is one of the key components of the policy blueprint for achieving that ambitious goal.9 The government has a valid expectation that the capital markets would need to become a critical supporting institution for the national economy at later stages of transition. As China is entering a new orbit of slowing and more balanced growth, having seen off the heydays of stellar growth rates over the past two decades, the need for fundamental changes to securities regulation to fix long-standing structural problems in the capital markets has become ever more urgent. In May 2014, the State Council promulgated the Opinions on the Sound Development of Capital Markets, a policy guideline to paint a roadmap for capital market reform for the next 5–10 years. Of the priority tasks, the Opinions laid out the principles and direction of introducing a registration-based system for IPO (initial public offering).10 Aiming at that goal, the Chinese government has set a progressive timetable for implementing this reform within the next few years. As a prerequisite, the Securities Law has been under revisions to formally endorse the registration system (zhuce zhi) as the principal regime for IPO, in replacement of the existing merit-based review and approval system (hezhun zhi). The main difference between these two systems is that in screening the eligibility of IPO applicants, the former is focused on the quality of information disclosure while the latter is concerned with pre-IPO profits and their perceived sustainability post IPO. The anticipated thrust of the registration system is a substantial liberalization of capital market entry as well as a cultivation of a “buyer beware” investment culture. Compared to the current mode of administrative governance for IPO regulation centered on CSRC review, the registration system is expected to put market forces in the driver’s seat for determining the supply of new share offerings. In short, the new system will highlight a paradigm shift of regulatory philosophy from merit-based regulation to disclosure-based regulation. In particular, the CSRC will retreat to the back seat of entry regulation, delegating the task of IPO review to the exchanges. The quality of information disclosure, instead of the ability for making continuing profits, would be the primary consideration in judging firms’ qualifications for an IPO. The concept of the registration system is borrowed from overseas markets, particularly the United States where it started to be put in practice in the 1930s. It has received heightened attention in China only recently when the agenda for a market-oriented IPO reform began to accelerate under the leadership of the new CSRC chairman, Xiao Gang, who has shown a solid determination to bring 9   National Development and Reform Commission (2012). 10  CSRC (2015a), supra note 1, p. 1.

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about difficult but necessary changes. This resolve on the part of the regulators has prompted a wave of research seminars and academic conferences across the country as people are trying to figure out what “registration” means. There have also been orientation talks at the CSRC and stock exchanges on different IPO regimes practised in representative jurisdictions, including the disclosurebased registration system in the United States and the merit-based (but at the same time also market-oriented) review system in Hong Kong. These talks were usually given by overseas regulators, who were invited to come educate their Chinese counterparts on the institutional design and operative details of the IPO regulation and practices in their home jurisdictions. Aided by such learning efforts, it is hoped that China’s IPO reform could take on an informed and enlightened path. Despite all of these endeavors for nurturing a common understanding, however, the substance of the registration system most suitable for China’s domestic conditions is still being debated among various circles. There has emerged a consensus among policy makers that the introduction of the registration system would adhere to three principles. First, it would be a gradual process, divided by steps of initiation, progression and completion, to give market players and regulators time for adjustments and adaptations. Second, its operational niceties would combine borrowed practices from overseas markets which are suitable for domestic applications, as well as retained experiences accumulated under the existing system which have proven to be effective. Third, a successful registration system cannot work alone, but requires complementary institutions to support its functioning, such as competent sponsors for assisting with issuer compliance and enforceable channels of shareholder remedies. Given the delicate background mentioned above, this chapter will analyze the reasons for, and progress in, in introducing the registration system in China, especially the legislative and regulatory initiatives designed to facilitate its installation and implementation. It will also review various understandings of the concept of registration, particularly some misconceptions surrounding overseas experiences, to propose local responses and solutions to the entry liberalization of capital markets based on the disclosure-based regulatory philosophy. At the operational level, this chapter will also examine the debate over the upcoming redrawing of boundaries of powers, responsibilities and liabilities among various players who have a stake in this reform. In addition, this chapter will also envision how complementary reforms should proceed. The central argument of the chapter is that if properly designed and supported by complementary reforms, the registration system will serve as a vigorous impetus for a paradigm transformation of the regulatory framework for

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China’s capital markets. It will relieve the government of the undue burden of judging firms’ investment value for investors and enable the market to play a key role in helping investors make their own decisions through information disclosure mechanisms and associated liability rules. While administrative authority, namely the power of the CSRC to review IPO qualifications, will retreat from the frontline of merit-based IPO review, the role of self-regulatory organizations, particularly the exchanges, will feature prominently in selecting qualified issuers on the basis of information disclosure. As a result, the CSRC will likely play a more active role in policing post-IPO behaviour of disclosure and trading. 2 Prior IPO Reforms 2.1 The Quota System Being the target of ongoing reform, the review and approval system nevertheless has had advantages over its predecessor, the curious quota system which was implemented through 1990 to 2000. The quota system had two wings. On the one hand, the regulator of the central government, firstly the Securities Committee of the State Council and later the CSRC, stipulated a maxim amount of new shares that could be issued to the public (later changed to the maxim number of newly listed companies) for each year. The central regulator then allocated a quota of the pool to each of the provinces supervising local SOEs and ministries of the State Council overseeing central SOEs, depending on their respective needs.11 On the other hand, local governments and the supervising ministries had the power to select potential issuers, conduct an initial review of their qualifications, and submit recommendations to the CSRC for final approval, which were never rejected during the 1990s.12 The quota system worked like a typical planning mechanism used in a command economy for the purpose of supply control. It was designed mainly out of considerations for issuer quality assurances and investor protection at an early stage of capital markets development.13 The quota system was regarded by some observers as an example of the so-called “administrative governance” of economic activity commonly pracrised in China during its earlier transition to a market 11  For example, the aggregate pool of quota was USD 0.8 billion, USD 0.6 billion, USD 1.8 billion, and USD 3.6 billion in 1993, 1994, 1996 and 1997, respectively. See CSRC (2008a), supra note 5, pp. 165–66. 12  Shen (2010), p. 641. 13  CSRC (2008a), supra note 5, p. 166.

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economy, as compared to the mode of “legal governance” of capital markets in developed economies.14 Despite its seemingly inconvenient characteristics, the quota system was initially employed for legitimate reasons. In particular, it was used to address the severe problem of information asymmetry between the central regulator and potential issuers when the legal and regulatory framework for the capital markets was just emerging.15 Not only did the CSRC have few dispatched local offices to conduct on-site inspection of potential issuers, but financial intermediaries with the function of information authenticity were also in bare existence, or simply incompetent. Such practical constraints resulted in serious difficulties for the CSRC to distinguish good firms from inferior ones. By comparison, the selection task was thought to be best executed by local governments and industry regulators as they had a marked information advantage in knowing the genuine quality of firms’ assets and business, which was derived from their routine exercise of tax collection and approval of investment projects associated with local firms.16 Of course, the quota system had its inherent flaws associated with the moral hazard for local governments which sometimes recommended uncompetitive companies they favored, and which also at times ignored, or even joined, the efforts of unqualified issuers to window-dress or doctor financial books for fraudulent listings. An often practised strategy was to package the assets and businesses of several local firms to form a listing vehicle at the discretion of local governments against the firms’ wishes, namely to arrange “forced marriages.” Such irregularities may be seen as a result of undesirable vicious competition among local governments. However, local governments calculated their choices as rational responses. Their motive was to retain precious listing resources in the market for local financing needs under a tight entry regulation. This and other weaknesses served to discredit the quota system and eventually led to its demise.17 However, there is a counter argument based on empirical evidence suggesting local governments may not have engaged in a “race to the bottom” in their selection of favored issuers. This is because the CSRC rewarded better performance of local companies in the capital markets in a particular year, measured by their total market capitalization and the market capitalization of their tradable shares, with an increased quota in the subsequent year to their 14  See, for example, Pistor & Xu (2005); Caragliano (2009). 15  Qian & Jiang (2012). 16  Shen (2011a); Qian & Jiang, ibid., pp. 55–6; Jiang (2014), pp. 50–1. 17  Leng (2009), p. 163.

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home jurisdictions. Conversely, the CSRC would penalize local governments by reducing the quota allocated to them in the next year, for the poor performance of their recommended issuers which usually had recorded an ST (special treatment) status, meaning that their shares were no longer eligible for public trading due to consecutive losses over extended periods of time.18 In any event, the quota system had eventually become no longer suitable for China’s capital market development at the turn of the century and was subsequently replaced by the review and approval system in 2001. 2.2 The Review and Approval System When it was instituted in 2001 to replace the quota system, the review and approval system was considered a significant institutional improvement. The original intention of this reform was to establish a market-oriented mechanism for IPO regulation centered on mandatory ex-ante information disclosure and based on recommendations by lead underwriters (or, since 2004, by sponsors) of potential issuers. The purpose was to reduce the level and intensity of administrative governance and input more market forces, particularly from financial intermediaries and external experts, into the IPO regulation, thus bringing it closer to the mode of “legal governance” practised in developed countries. 2.2.1 Legal and Institutional Framework The institutional framework of the regulatory arrangements is spelled out in the Securities Law, which authorizes the CSRC to exercise the review and approval power.19 At the same time, for the purpose of shifting a portion of the regulatory burden from the CSRC to financial intermediaries, the law imposes the responsibilities on sponsors to coach intending issuers on compliance matters and to conduct due diligence investigations of their IPO documents and information disclosure.20 The sponsor typically is a securities company 18  Pistor & Xu, supra note 14. 19  Securities Law, Article 10: “Any public issuance of securities shall satisfy the requirements of the relevant laws and administrative regulations and shall be reported legally to the securities regulatory authority under the State Council or any department authorized by the State Council for examination and approval; Without legal examination and approval, no entity or individual may issue securities to the public.” 20  Securities Law, Article 11: “Any issuer that files an application for a public issuance of stock or convertible corporate bonds in accordance with the law and adopts an undertaking manner in accordance with the law, or for a public issuance of any other type of securities that are subject to a sponsorship system as prescribed in any law or administrative regulation shall engage an institution with the sponsorship qualification as its sponsor.

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licensed by the CSRC for conducting sponsorship and underwriting services, which would also act as the lead underwriter in the IPO if the application succeeds. Under the review and approval system, an application for an IPO needs to go through a carefully designed process composed of multiple checking and monitoring steps, during which the key and decisive role is played by the Public Offering Review Committee (PORC).21 The PORC commands a key role in the organizational structure of the CSRC and is considered perhaps the most powerful organ within the agency. It carries the critical function of judging whether intending issuers meet the standards of IPO qualifications. These standards generally fall within two categories: (1) basic compliance standards, such as having a clear shareholding structure, proper corporate governance arrangements, stable management and stable core business, as well as independence of business entity, assets, personnel and operations; (2) substantive qualifications on investment value, i.e., having sustained profitability and viable projects for the use of IPO proceeds.22 Clearly, the second category of qualifications imposes rather demanding requirements on the issuers’ performance, as well as on the PORC as it has to exercise meticulous and labouring review to distinguish quality issuers.

A sponsor shall abide by operating rules and industry standards, act in good faith, perform due diligence, carry out a thorough examination of the issuer’s application materials and information disclosure documents, and supervise and urge the issuer to conduct standard operation. Sponsor qualifications and the relevant administrative measures shall be specified by the securities regulatory authority under the State Council.” 21  See CSRC (2015b) “Flow Charts and Procedures of the Department of Public Offering Supervision of the CSRC for Review and Approval of Initial Public Offering of Shares”; also see the flow charts describing both the offering process (from preparations to final listing) from the perspective of the issuer and its sponsor, as well as the process of review and approval by the CSRC from the perspective of the regulator, in CSRC (2008b), pp. 21–2. 22  The specific regulation governing PORC’s functions, composition, and working procedures is stipulated in the CSRC Measures on the Public Offering Review Committee. It prescribes the following responsibilities for the PORC: “The Public Offering Review Committee shall examine and verify whether the application for share issuance meets the conditions for public share issuance; it shall examine and verify relevant documents and opinion papers presented by such securities intermediaries as the sponsors, accounting firms, law firms and asset appraisal institutions as well as those presented by relevant personnel for the share issuance; it shall examine and verify the preliminary audit reports issued by relevant functional departments of the CSRC, and shall propose examination and verification opinions on the share issuance according to law.” Also see CSRC (2008b), supra note 21.

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2.2.2 Evolution of the PORC As a powerful organ charged with the substantive reviewing responsibility, it is worthwhile to recount the history and evolution of the PORC. It was first established in September 1999 within the CSRC to assume the responsibility of substantive IPO review, with the good intention of taking over the decisionmaking power from few people with concentrated authority. It initially had 80 members, including representatives from the relevant ministries and commissions of the State Council, the stock exchanges and industry experts.23 In subsequent years, membership in the PORC was reduced significantly (to 25 for the Main Board and 35 for the GEB). Members work in divided groups, with each group consisting of seven members. In a normal year, a single PORC member can review up to 50 companies, and about 80 percent of the applications are approved.24 Unfortunately, the PORC had operated in an opaque and non-transparent manner until significant reforms to strengthen its effectiveness had taken place, beginning in 2004. For example, since the PORC works in groups, for many years the names of the seven group members who participated in the review of a particular IPO application were not disclosed to the public, neither to the issuer, nor to the sponsor. The names, then, were eagerly sought by IPO sponsors and agents hired to help companies win IPO approvals. It is claimed by some insiders that once identified, PORC members can be lobbied. They may also be offered money in exchange for favorable decisions. According to insiders in the industry of financial public relations, a sponsor or IPO applicant in the past would hire an agent to sniff around the CSRC for the names of people in a particular PORC group. The agent might post several people at CSRC’s front door for several days in hopes of picking up clues. Clues could be found by following the boxes of IPO application materials brought from CSRC offices and dispatched to other places. For example, if one box of materials was seen being carried out of the building en route to a Ministry of Finance office, it could mean that a PORC member was from that ministry. While this kind of amateurish espionage may not be the smartest way of getting the information, it turned out to be effective, and, according to industry insiders, lucrative (since a full list of the seven members of a PORC group could be worth as much as one million RMB yuan).25 Major steps of reform include the reduction of memberships, now at 25 for the Main Board (including 5 internal members and 20 external members) and 23  CSRC (2008b), supra note 21, p. 23. 24  Lu (2013a). 25  Lu (2013b).

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35 for the GEB (5 internal members and 30 external members), and the injection of professionalism through external appointments of legal and financial experts. There have also been important improvements on accountability and transparency. For example, since 2007 the CSRC has been posting the names of PORC members participating in each review meting and the decisions of PORC review meetings on its website, including reasons for rejections.26 In addition, before an IPO hearing opens, each of the seven group members should make a pledge that he or she has no connections to an applicant. Furthermore, CSRC rules stipulate that a group member should end his or her role if any connections with an applicant are discovered.27 According to media revelations, in pursuit of warm relations, some company executives with an IPO ambition have played along with rent-seeking CSRC officials. They have also paid intermediaries which charge enormous fees for access to key CSRC officials. Tens of millions of yuan may have traded hands in recent years. Since taking office in October 2011, former CSRC chairman Guo Shuqing had tried to clean up the agency via a large-scale personnel reshuffle. As part of the change, many offering department and PORC officials have traded their positions with other CSRC staffers. But problems still persist.28 Other efforts have also been taken by the CSRC to make the IPO review process less opaque. The shift to heightened transparency began in 2010, when the CSRC decided that any company whose IPO application was rejected during a review process must be notified of the reasons within a month. Moreover, CSRC in April 2012 promised to make public more information about the entire review process, by releasing the names of each PORC member and issuing a monthly progress update on companies under review. Rules that require PORC members to participate in preliminary hearings convened by the offering department also came into force in 2012, helping them better understand each applicant and its needs. Nevertheless, specific information about exactly how the CSRC resolves to decide whether to approve or reject an application is still carefully guarded. Practitioners and scholars have called for more transparency in the IPO review process. For example, they have requested that the PORC’s voting records be made public.29 Another development is that the waiting period after a company has filed its IPO application has also been shortened on average, but is still unpredictable due to frequent halts of IPO activity when market conditions fluctuated, or 26  CSRC (2008a), supra note 5, p. 220; CSRC (2015b), supra note 21, p. 23; CSRC (2013), p. 85. 27  Lu, supra note 25. 28  Lu, supra note 25. 29  Ibid.

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particular regulatory reforms and enforcement campaigns interrupted. It is not uncommon, therefore, for an issuer to wait for two to three years, or even four years, before getting a final approval.30 Empirically, it is difficult to calculate the average time length of each review because a number of application materials and review documents are not publicized. 2.2.3 Steps of the Review Process As earlier pointed out, the procedure of an IPO review process entails a delicate review and approval system. It is characterized by multiple levels of risk control and quality assurances provided by the sponsor, the local branch office of the CSRC, the offering department of the CSRC (called the Department of Public Offering Supervision), and the PORC. After completing an organizational restructuring to transform to a proper type of shareholding company (i.e., a company limited by shares), a potential issuer needs to undergo the coaching and guiding on compliance matters by a sponsor for a period of three to six months, before it could apply to the CSRC for an IPO with the recommendation of the sponsor.31 An endorsement of the local branch office of the CSRC on the completion of the sponsor’s coaching and guiding work is also a prerequisite. In the following text, the major steps of the review and approval system are outlined so that readers can have a clear understanding of the meticulousness of the review work, all on the wellmeaning intention of upholding a certain level of issuer quality to enhance market conditions and investor protection.32 2.2.3.1 Acceptance of Application The general office of the CSRC would accept an application for IPO if the application satisfied certain formal requirements, such as the completeness of the submission package in terms of required documents. The general office would then forward the application to the offering department for processing. Upon receiving the application, the offering department would distribute it to its two review divisions: the first division is responsible for reviewing public offering documents and legal opinions while the second division for financial documents. Depending on the nature of the issuer’s industry and the review workload, the two review divisions will assign case officers to conduct a preliminary review of both the financial and non-financial aspects of the application. 30  Chen & Liu (2015), p. 93. 31  Ibid., p. 91. 32  The detailed explanation of these steps is based on a summary provided in Zhou (2014), pp. 16–18. Also see CSRC (2015b), supra note 21.

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Usually, two case officers will be assigned to each application, who then would collaborate with the heads of the two review divisions on this application throughout the review process. Accordingly, usually there are four individual staffers of the CSRC tracking the progress of each case. During this stage, the offering department sends the application to the National Development and Reform Commission (NDRC), the government agency overseeing the implementation of national industrial policies, for feedback on whether the industry in which the issuer operates is on the “black list” of discouraged sectors. In some cases, an opinion letter from the Ministry of Commerce (MOFCOM) is also required for regulatory clearances when concerns about compliance with foreign investment regulations are at stake.33 2.2.3.2 Preliminary Meeting with Issuer This meeting is aimed at establishing an initial contact between the issuer and the CSRC. It is attended by the representatives of the issuer, heads of the two review divisions, as well as the director of the offering department. At the meeting, the issuer will introduce its general situation while the CSRC staff would explain rules on the review procedure, qualification standards, and disciplinary requirements. 2.2.3.3 Inquiry and Checking Meeting with Sponsor This is a meeting between the sponsor and the CSRC staff, for the purpose of reminding and urging the sponsor to conduct due diligence investigations of its recommended issuer. Participants include the case officers of the two review divisions responsible for examining the particular application, two representatives of the sponsor who personally sign off on the recommendation, as well as senior management of the sponsor. 2.2.3.4 Feedback Meeting and Follow-Up Exchanges When the case officers have completed their preliminary review of the application documents, they will produce a report on their findings on both legal and accounting dimensions. The report will then be tabled for discussion at the internal feedback meeting, attended by the case officers and the heads of the two review divisions. Issues discussed include key regulatory concerns arising from the preliminary review, typically leading to requests for necessary additional disclosures and explanations by the issuer, as well as identification of areas of further checking and investigation by the sponsor. 33  CSRC (2008b), supra note 21, p. 22.

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After this meeting, written comments will be returned to the sponsor, specifying requests for further submissions and investigations. The sponsor will then coordinate follow-up efforts by the issuer and relevant intermediaries to address those regulatory concerns. After the sponsor submits replies to the CSRC with supplementing materials, which must be done within 30 days, the case officers will conduct another round of review. Typically, such kind of exchange runs two rounds on average. During this process of interaction, the issuer and its sponsor may contact the case officers for clarifications of specific regulatory requests, or contact the heads of the two review divisions and the director of the offering department for assistance if necessary. 2.2.3.5 Ex-Ante Disclosure For those issuers who have satisfied the offering department with their feedback and follow-up actions, and have obtained regulatory clearances from other government agencies regarding industrial policy considerations, an ex-ante disclosure of IPO documents, including a draft prospectus, would be released for public scrutiny. The documents are posted on the CSRC website for public access. Those government agencies include the National Development and Reform Commission (NDRC), the Ministry of Commerce, tax authorities, environmental protection agencies of the provincial governments, and regulators of particular industries such as the General Administration of Press and Publication and the China Banking Regulatory Commission.34 During the period of ex-ante disclosure, public oversight typically finds its way into the regulatory radar through whistle blowing or tip-off reports to the CSRC of questionable or allegedly illegal conducts of the intending issuers. The purpose is to obstruct the review process. The general policy of the CSRC on responding to such reports is to continue the review process while initiating a separate procedure of investigation, if there are clear clues of the violations, real name signatures and contact details provided by the reporters.35 The sponsor is usually delegated the responsibility to complete the investigation with the joint efforts of other intermediaries. The issuer is obliged to explain whether the accused violations had taken place. Before the reports of accusations have been properly dealt with, the IPO application in question will not be processed for subsequent PORC review at later stages.36

34  Chen & Liu, supra note 30, p. 94. 35  Ibid., p. 100. 36  Ibid.

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Another example of increasingly forceful public scrutiny of the ex-ante disclosure is the questioning from the news media, which has become rather aggressive in recent years and has generated real deterring consequences.37 The following table (Table 13.4) illustrates some high profile cases of aborted IPO attempts by otherwise successful issuers who had already passed the PORC review, as a result of negative media exposures.38 Table 13.4 Aborted IPOs due to media scrutiny Name of company

Alleged questionable event

Result

Ningbo QL Electronics Co., LTD

CSRC revoked listing Application passed by PORC on March 5, 2008, but accused approval on April 3, 2009. of tunneling assets from its subsidiary listed company Zhejiang Haina on July 7.

Hunan Shengjingshanhe Bio-Technology Co., LTD

Accused of untrue disclosure in prospectus with inflated business incomes on December 17, 2010, just before launching an IPO on the Shenzhen Stock Exchange.

CSRC suspended listing; issuer applied for postponing IPO but failed subsequent PORC review on April 6, 2011.

Hunan Tianmu Intelligent Technology Co., LTD

Questioned for dubious business dealings on February 6, 2012

CSRC terminated review on April 12, 2012.

Jiangxi Silinco Co., LTD

CSRC refused to Passed PORC review on arrange for a second March 15, 2011 but accused round of PORC review of significant omissions and false disclosures in prospectus.

37  Lu (2012b); Lu (2013c); Wang (2014); Mu (2014). 38  Source of data: Lu (2012a).

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Table 13.4 Aborted IPOs due to media scrutiny (cont.) Name of company

Alleged questionable event

Result

Shenzhen Fortune Trend Technology Co., LTD

Accused of significant false financial disclosures on May 31, 2012, just one day before scheduled PORC review meeting.

CSRC cancelled PORC review on June 1, 2012.

Guangdong Xindadi Biotechnology Co., LTD

Passed PORC review on May 18, 2012 but questioned for false profits, concealing of related-party transactions, and faked performance statistics.

CSRC terminated listing process on July 16, 2012.

However, this media oversight has taken an ugly turn over the past couple of years as the exercise of “IPO blackmailing” proliferated, leading to intending issuers buying media silence during an IPO review by the CSRC. This is a new kind of corruption in the news media, still not subject to effective regulation.39 I elaborate below on this issue. 2.2.3.6 Staff Review Meeting This internal meeting is centered on a presentation by the case officers to the CSRC staff, on the basic situation of the issuer, major problems and concerns discovered in the preliminary review, and the follow-up actions taken by the issuer and its sponsor to address them. Participants include the director of the offering department, the heads of the two review divisions, the case officers, as well as members of the PORC. This meeting is aimed at consolidating all of the preceding reviewing work to produce a revised report of the preliminary review. If an application, with its follow-up refinements, has to this stage satisfied the offering department, it would be transferred to the PORC for subsequent review, together with the final text of the preliminary review

39  Lu (2012b) and Lu (2013c), supra note 37; Wang (2014), supra note 37; Mu (2014), supra note 37; Chen & Liu, supra note 30, p. 101.

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report. At the same time, the sponsor is informed by a written notification of the p ­ reparations it needs to undertake for the upcoming PORC review, including addressing matters pending further explications. Applications considered by the staff meeting as not yet ready for the subsequent PORC review would be returned to the issuers and their sponsors for further follow-up actions, together with opinions in the writing indicating areas of concern. 2.2.3.7 PORC Review Meeting The review of IPO applications by the PORC is designed as a mechanism of expert decision-making. There are 25 members of the PORC for the Main Board (5 CSRC employees and 20 external appointments) and 35 members of the PORC for the GEB (5 CSRC employees and 30 external appointments). Memberships of the two PORCs do not overlap. PORC members are divided into several groups. For each IPO application, a seven-member group is assigned. The PORC functions through meetings where members vote on individual IPO applications which have passed the staff preliminary review. Every PORC review meeting is attended by 7 members. They vote in their own names and the voting results are recorded in writing. An application needs to receive 5 votes to pass the PORC review. Other participants include representatives of the issuer, representatives of the sponsor who personally sign off on the IPO recommendation, and case officers from the two review divisions of the offering department. At the meeting, the PORC members would firstly express their review opinions. This is followed by a 45-minute hearing of the presentation by the issuer’s representatives and the sponsor’s representatives. At the hearing, PORC members read the offering department’s staff report on the operational legality and financial soundness of the applicant. Then, each member can comment and representatives from the applicant and the sponsor can answer questions from the PORC members. All remarks are on the record. Afterwards, the PORC members would vote on the qualifications for IPO of the issuer. If the PORC considers there to be remaining problems requiring issuer’s attention and follow-up actions, it would issue a written opinion to return to the sponsor, suggesting remedial solutions. After the PORC review meeting, all relevant documents including records of PORC members comments are sealed and closed to public access. In recent years, the PORC has increasingly functioned with enhanced transparency and procedural regularity. For example, before the PORC holds a review meeting, the CSRC would post a prior notice on its website, usually five days in advance, publicizing the name of the issuer concerned, the time of the meeting, and the names of attending PORC members. After the review meeting,

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the CSRC again would post the results of the PORC review and the reasons for rejection in each case. While these publications are relatively brief and short of elaborate explanations and reasoning, they nevertheless represent a significant improvement of previous practice in early years of the PORC operation. For example, until the end of 2004, the names of the PORC members had been kept confidential and their votes anonymous, leaving room for arbitrary exercise of the review power and even regulatory corruption, as insiders tried to sell the name list to potential issuers for a profit, as the infamous “Wang Xiaoshi case” demonstrated.40 Therefore, one should not deny the fact that the institution of the PORC has been under constant improvement, despite its remaining deficiencies, as discussed later in this chapter. Another issue concerns the relationship between the staff preliminary review and the PORC review. Does the PORC have to accept the judgment formed on an application by the case officers? In practice, decisions of the PORC rarely deviate from that of the case officers. But exceptions did exist. One example is the infamous case of fraudulent listing by Xindadi. In May 2012, six out of seven PORC group members said “yes” to an IPO application filed by Guangdong Xindadi Biotechnology Company, which specializes in processing tea tree oil. The green light was given despite the fact that the case officers who had conducted a preliminary review of the application found three major problems they thought should disqualify the issuer. Xindadi’s draft prospectus cited what many accused was an unbelievably high profit margin. The document later attracted strong criticism from financial analysts after it was published on the CSRC’s website, and triggered an investigation that ended with the firing of each of the six PORC members who voted in favour of the company’s IPO application.41 2.2.3.8 Dealing with “Significant Events” Post PORC Review After an application has passed the PORC review, the issuer is not yet permitted to initiate its IPO immediately. Instead, it is obliged to report any significant events arising from its business operation after the conclusion of the PORC review and before the formal release of its prospectus which may have a material impact on investors’ decisions, such as a lawsuit involving the issuer. The issuer must provide explanations for these events to the CSRC, which are processed by the original case officers who will suggest a solution to the new situation. If the newly arising events indeed are of a material nature, the case 40  CSRC (2008a), supra note 5, p. 220; Leng, supra note 17, p. 173. 41  Lu, supra note 25.

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officers would recommend a new round of the PORC review, attentive to the new situation of the applicant. This step holds sponsors accountable for an application’s truthfulness. Undisclosed “significant events” that come to light later can have serious consequences. For instance, the CSRC chastised the securities company Guotai Junan in 2012 after its underwriting client, a Shenzhen-based manufacturer of solar batteries called Jiawei Corp., reported financial troubles a few months after listing on the GEB. The company posted a 94 percent decline in net profits, undermining the credibility of its prospectus. The CSRC banned Guotai Junan from undertaking underwriting services for three months. It was found by the CSRC that the underwriters knew about the profit slump for the first quarter but did not disclose it. What is more outrageous is that all of the accountants and lawyers who had signed off the prospectus did not read it.42 2.2.3.9 Final Approval After an application has gone through all of the preceding steps, a final approval would be issued by the CSRC to the issuer based on the decision of the PORC. This means that the issuer finally obtains a formal permission to launch its IPO. However, IPO preparations could be disrupted by suspensions of listing by the CSRC when significant reform initiatives are implemented or market conditions fluctuate. The timing of IPO, therefore, is not completely within the issuer’s own control. 2.2.4 Listing Qualifications The criteria of listing qualifications applied by the PORC address the following five concerns, which signal a strong tilt toward a meticulous, merit-based examination of issuer quality.43 2.2.4.1 Issuer Eligibility A qualified issuer must be a company limited by shares (CLS) that has already operated for three years or more. A CLS with less than three years of existence could offer shares to the public only upon approval by the State Council, which only grants important SOEs such an exemption. In addition, the issuer must also meet requirements on capital adequacy and integrity, business legality, stability of management and operations, and clarity in shareholding structure.44 42  Lu, supra note 24. 43  CSRC (2013), pp. 87–89; Wang (2014), pp. 252–58. 44  Wang, supra note 43, p. 254.

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2.2.4.2 Independence of Issuer The CSRC requires the issuer to be both organizationally and financially independent from its parent company. This is largely a response to the ambivalent relationship between the two which is susceptible to the tunnelling of both the issuer’s assets and IPO proceeds by the parent company. Related party transactions and assets stripping to expropriate the listed subsidiary have been serious problems long standing in the capital markets, severely infringing public investors’ interests. To address this pathology, the issuer is required to have its own assets, an integral business operation system, and the ability to engage in independent market operations. In addition, it also needs to have its own personnel and senior management which are not overlapping with that of its parent company. An independent financial account is also required. Furthermore, no related-party transactions and competing business are permitted between the issuer and its controlling shareholders, actual controllers, or affiliated enterprises.45 2.2.4.3 Compliance of Operation The issuer must have established a sound corporate governance structure with all necessary organs, including a shareholder’s general meeting, a board of directors, a board of supervisors, independent directors, and a board secretary. Members of senior management must have qualifications prescribed by the law. A sound internal control system must have also been put in place. There must not be any illegal business and financing operations as well, such as loans or guarantees extended to outsiders or controlling shareholders unauthorized by the articles of association.46 2.2.4.4

Finance and Accounting Requirements: “Capacity for Making Continuing Profits” The issuer should maintain a sound financial status, measured by quality assets, a reasonable assets-to-liability ratio, good profitability, and a stable cash flow. An unqualified report by a certified public account endorsing the effectiveness of the issuer’s internal controls is required. All related-party transactions must be disclosed. There are also a set of stringent financial qualifications to be met, including prescribed profits margins, cash flow and revenue targets, a minimum threshold of share capital, a maximum ratio of intangible assets to net assets, and clearances of previous losses. The most controversial criteria is

45  Ibid., p. 255. 46  Ibid., p. 256.

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on the ability to “make continuing profits,” which is substantiated by a detailed list of benchmarks.47 2.2.4.5 Use of Proceeds The CSRC demands that the issuer must have specific projects for the use of IPO proceeds, which should be associated with its core business. Financial investments are disqualified as appropriate projects. Meanwhile, the amount of proceeds proposed should match the issuer’s business profile, including its production capacity, operational scale, financial position, level of technological sophistication, and managerial capabilities. The amount of the IPO proceeds considered oversized for the issuer’s digesting ability would be curtailed. These criteria are strictly upheld by the CSRC, especially the PORC, in examining whether an applicant is ready for going public and whether it is worth investing. The essence of the review and approval system is that the CSRC not only examines and approves a company’s credentials at every step of the IPO procedure, it also takes upon itself the job of verifying the company’s worthiness of investment in addition to examining whether the application materials are complete. Consequently, the CSRC is held accountable to some extent for the performance of a listed company because it is seen as endorsing the company’s “sustained profitability” by granting it a green light to the capital markets. 2.2.5 Progress Made under the Review and Approval System The review and approval system was the first reform attempt at streamlining IPO regulation to ensure fairness, rationality, professionalism and transparency in the selection of issuers.48 Indeed, it has worked to remove the arbitrariness and lack of predictable criteria in the selection process under the quota system. As commentators have noted, although the review and approval system is still merit-based, two positive trends have emerged over the years which indicate a gradual move to the mode of “legal governance” of capital markets.49 Firstly, IPO regulation has become increasingly institutionalized and rule-based. Although the CSRC still has the final approval power, the use of the PORC has made the review process more rationalized and transparent. In particular, the incorporation of professionalism and expert participation has replaced previously broad administrative discretion, and the collective

47  Ibid., pp. 256–257. 48  CSRC (2008b), supra note 21, pp. 23–24. 49  Wang, supra note 43, pp. 273–74.

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decision-making via review meetings has removed the concentration of power within the hands of too few officials. Secondly, the review and approval system has been greatly aided by the sponsor system in relying on market forces and financial intermediaries for the fulfilment of certain regulatory objectives, especially in compliance training, information authenticity and risk control toward the issuers. The legal, financial, and industrial expertise lent from the sponsor to the issuer’s listing preparations and to a lesser extent its post-IPO compliance is highly valuable in improving the overall quality of the market and injecting disciplines. Since the sponsor is also under an obligation to continuously monitor and guide the issuer in information disclosure and corporate governance practices for up to four years post-IPO, notwithstanding instances of substandard performance or dereliction of duty on the part of the sponsor at this stage, the CSRC has succeeded in shifting a substantial portion of its previous supervising burden to the market intermediaries.50 2.2.6 Constraints of the Review and Approval System Nevertheless, the review and approval system still features a heavy-handed regulatory approach where administrative governance has persisted, although with the establishment of the sponsor system the CSRC is now aided by financial intermediaries in quality control at earlier stages of the IPO process. Mostly notably, the CSRC, and not the stock exchanges, is at the centre of sanctioning eligibility for public offerings and listings. The CSRC review is designed as a merit-based, comprehensive, and professional evaluation of firms’ suitability for going public, judged mainly by pre-IPO profits and their perceived sustainability post-IPO.51 2.2.6.1 Capacity Restraints and Lack of Predictability in Time Expectation To meet the demanding requirement for both manpower and skills in the conducting of reviews, the CSRC has established and over the years refined delicate internal procedures and mechanisms to ensure professionalism, effi-

50  Chen & Liu, supra note 30, p. 131; Wang, supra note 43, pp. 273–74. 51  For a detailed explanation of the procedures of IPO review by the CSRC under the review and approval system, see Wang, supra note 43, pp. 262–65. Wang also provides a critical assessment of the substantive qualifications potential issuers must meet, including threeyear establishment, capital adequacy and integrity, legality of business operation, stability of management and business, and clarity in shareholding structure. See Wang, supra note 43, pp. 252–54.

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ciency, and transparency.52 In particular, it has staffed its offering department as well as the PORC with seasoned regulators, financial industry practitioners and experts, including expertise loaned from the exchanges.53 However, given the heavy ex-post regulatory responsibilities of policing behaviour on the capital markets assumed by the CSRC, its burden of ex-ante IPO reviews has become increasingly challenging and resource-constrained. This is partly due to its relatively small staff size compared to the huge size of the capital markets: at the end of 2014, the CSRC had a total of 3,167 employees, including only 769 at its headquarters in Beijing and 2,398 spreading in dispatched local ­offices.54 With the limited human resources, the CSRC is overloaded with its task of reviewing hundreds of applications each year. 2.2.6.2 Suspensions of IPOs China is not a western-style market economy. Nor does it seem intent on becoming one. Economic and financial crises and breakdowns that have erupted in the developed world in recent years, highlighted by the 2007–08 subprime crisis in the United States, have sent alarming signals of the downsides of a free market economy based on the philosophy of “laissez-faire”. The government’s visible hand still exercises considerable control and influence in the macro economy, including efforts to regulate the supply of capital, including the funds raised in the securities markets. For purposes of macro-managing the economy and finances, the government has frequently resorted to suspensions of IPO review and approval, as a way to control the aggregate flows of capital in the economy. The following table (Table 13.5) records the nine suspensions of IPOs throughout the operation of the capital markets since the 1990s.55 It can be seen that there were two suspensions which lasted more than one year (#6 and #8), resulting in a huge pool of intending issuers on the waiting list, including those whose applications had already been submitted but had to be put on hold. Although the government may have had legitimate reasons for each of the suspensions, for intending issuers this may translate into a loss of the best time window for going public, the waste of preparation work as financial data compiled became out-of-date, a mismatch of firm’s development strategy and delayed funds, etc. All meant detrimental losses and high costs to the issuer.

52  CSRC (2015a), supra note 1, p. 11. 53  Lu (2013d). 54  CSRC (2015a), supra note 1, p. 11. 55  Xing (2015).

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Table 13.5 Suspensions of IPO (1994–2014) #

Period of suspension mm/dd/yyyy

Duration of suspension (days)

1 2 3 4 5 6 7 8 9

07/21/1994–12/07/1994 01/19/1995–06/15/1995 07/05/1995–01/03/1996 08/08/2001–11/05/2001 08/26/2004–01/23/2005 05/25/2005–06/04/2006 09/17/2008–06/28/2009 10/27/2012–01/07/2014 01/25/2014–06/16/2014

139 147 182  89 150 375 284 437 142

Source of data: Xing (2015)

2.2.6.3 Questionable Independence of PORC In addition, although buttressed by the domination of expert opinions instead of administrative discretion under the quota system in delivering decisions, the PORC has been questioned for lack of independence from the financial industry from which it draws external appointments. Members of the PORC hired from outside of the CSRC generally come from financial intermediaries, and they still work full-time at their home institutions while serving on the PORC on a part-time basis. These members are seen as channels of rent transfer to their home employers because these financial intermediaries are hotly sought by potential issuers so their business tends to prosper. For example, some PORC members are hired from law firms and accounting firms. As soon as a partner is named a PORC member, his or her company’s business is guaranteed to boom. Insiders in the securities industry revealed an “open secret” that since outright bribes of a PORC member is too obvious and risky, “so all kinds of rewarding measures are used to favor his or her business”.56 Critics have accused that that this double identity of the external PORC members is detrimental to regulatory integrity as it breads rent seeking and corruption.57 However, calls for a severance of the tie between the PORC memberships and employments at financial intermediaries have not been heeded. 56  Lu (2013b) and Lu (2013c), supra note 37. 57  Chen & Liu, supra note 30, p. 133.

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2.2.6.4 IPO Blackmailing Another ill-developed phenomenon is the so-called “IPO blackmailing”. Under the Securities Law, the CSRC assumes responsibility for investigating any report of fraudulent activities involving an applicant. As a consequence, an entire service sector, centred on powerful financial media outlets, has grown up around this rule. The sector has a dark side, however. For example, a number of public relations companies, media outlets and law firms have profited by sniffing problems at IPO hopefuls and then using this information for extortion schemes centred on threats of negative media coverage.58 As the foregoing reveals, there have been some ugly manifestations of abused media scrutiny during the ex-ante disclosure stage of IPO review, leading to public outrage over the so-called “IPO blackmailing”. The extortion was so rampant that insiders revealed that nearly three-quarters of enterprises with plans to list on the Shenzhen Stock Exchange’s growth enterprise board (GEB) had been targeted. This assessment was to some extent corroborated when a CSRC official admitted that “Every GEB-listed enterprise has spent an average 6 million RMB yuan” fending off potential blackmailers. This is a stunning revelation of the gravity of the harmful practice. Although the CSRC has warned that it would take action against the practice, it has had a hard time pinning down the perpetrators as few victims were willing to step forward to discuss the matter.59 One recent scandal involved two top editors at 21cbh.com (the 21st Century Business Herald), the website of the 21st Century News Group which had ceased existence, who were arrested by the Shanghai police in January 2013 for economic crimes. They admitted that the website had targeted firms preparing to go public, by collecting fees for positive coverage and punishing those who would not pay with damaging reports. In this case, police investigators identified more than 100 companies allegedly extorted by this well-known financial news outlet in China. The investigators’ preliminary findings showed that the website had signed advertisement contracts with more than 100 companies every year since 2010 and received several hundreds of millions of RMB yuan in return. The most typical threat was that if the companies would not come along, they could be hit by bad publicity ahead of their IPO or other major events.60 Scandals of this sort reveal a serious ethical deterioration of the financial news industry in recent years. According to some insiders, in 2005, a few media 58  Mu, supra note 37. 59  Ibid. 60  Wang, supra note 37.

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firms started realizing that they could make money by blackmailing the great number of companies hoping to go public. As the extortion spread, firms increasingly wanted their PR agencies to be able to quiet potentially damaging media reports. Five years later, more and more media outlets had become blackmailers and now the extorting business is booming. Many companies preparing for IPOs were so preoccupied with handling media relations that they did not even have much energy for organizing road shows.61 2.2.6.5 Lack of Electronic Filing System Another inadequacy associated with the review and approval system is its lack of technical support from an electronic filing system in facilitating issuer submissions and exchanges with the regulator. One such example is the EDGAR (Electronic Data Gathering, Analysis, and Retrieval) system used by the Securities and Exchange Commission (SEC) in the United States.62 2.2.7 Characteristics of the Review and Approval System From the foregoing discussion, one can see that three characteristics have distinguished the review and approval system from prevailing practices observed in advanced capital markets. Firstly, a CSRC approval for IPO is by nature an administrative grant or permission, an exercise of government licensing power, and a merit judgment on whether an IPO issuer meets a set of substantive standards for good corporate governance as well as good business, therefore carrying an “investment value”. These standards contain some unique benchmarks tailored made for the specific market conditions and investors’ structure at the current stage of capital market development in China, such as having an ability to make continuing profits and having viable business projects for the use of IPO proceeds.63 Secondly, the current IPO regime merges two separate steps in a single process: the review and approval of share offering qualifications as well as of share listing qualifications are both conducted by the CSRC.64 This means that

61  Ibid. 62  Chen & Liu, supra note 30, p. 95. 63  It is worth noting that the listing qualifications adopted in Hong Kong also show a strong tilt toward an emphasis on the ability to achieve sustained profits, although much implicitly. See HKEx (2015a); also SSE (2012), pp. 9–10. 64  Indeed, one quick example to demonstrate this fusion of regulatory jurisdictions for both initial public offerings and subsequent listings is the title of the primary governing

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the exchanges are not empowered to conduct their own assessments of firms’ listing qualifications even if their listing rules set out substantive standards in that regard. Once a firm has passed the CSRC review for an initial public offering, its shares will automatically be listed on one of the exchanges. In other words, the CSRS is doing the piece of job traditionally reserved for the domain of the exchanges’ self regulation in other markets. Under the review and approval system, the stock exchanges have a legal authority to conduct a formal review of listing qualifications of the issuers who have passed the CSRC review of IPO qualifications. However, in practice, IPO qualifications and listing qualifications are not distinguished. Issuers passed by the CSRC review have never been rejected by the exchanges for a listing status. Conversely, during the whole period of its operation, the CSRC has revoked its IPO approvals from four issuers for reasons associated with fraudulent information filings, all of which would have otherwise met the listing qualifications set out in the exchanges’ listing rules.65 Thirdly, due to the strict control of the timing (by slowing down review and halting IPOs) and to a lesser extent also the volume (by placing price ceilings) of new listings by the CSRC for reasons never convincingly explained, it is very costly and cumbersome for firms to go through the review process and finally obtain the approvals, resulting in a long waiting list of eligible issuers. To gauge the degree of the scarcity of the listing resources, the following figures may give some preliminary indications: the numbers of newly listed A-share companies are 120 (2007), 75 (2008), 99 (2009), 347 (2010), 282 (2011), 154 (2012), 0 (2013, due to a prolonged suspension of new IPOs), and 124 (2014).66 Considering the size of the Chinese economy and the total number of enterprises operating across the country, the supply of newly listed companies to the capital markets is indeed very small.67 The limited supply has made every new listing a scarce commodity in the market and a hotly pursued investment, commonly resulting in absurdly high share prices of the newly listed companies on the second day ­regulation on IPO, the CSRC Administrative Measures on Initial Public Offering and Listing of Shares, promulgated in 2006. 65  See Cheng & Zeng (2014), p. 316. 66  Sources of data: CSRC annual reports in various years. See CSRC (2008b), CSRC (2009a), CSRC (2010), CSRC (2011), CSRC (2012), CSRC (2013), CSRC (2014), and CSRC (2015a). 67  Whether the number of annual new listings is “small” or not requires international comparisons. For example, some commentators point out that the in the United States, the number of IPOs dropped from an average of 311 per year during 1980–2000 to only 99 per year since 2000, as reported in Gao, Ritter & Zhu (2013). In this light, China’s performance on producing IPOs in recent years is perhaps not so moderate. But this assessment is subject to debate.

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of trading. Not surprisingly, this system is prone to the breeding of corruption and rent-seeking typically associated with government licensing power in a still evolving legal and regulatory environment.68 Such hands-on approach to entry regulation certainly has worked to some extent in weeding out bad apples as it has turned away unqualified IPO applicants with weak performance in the product market or suspicious accounting records. Sponsors also have incentives to carefully coach potential issuers to abide by legal rules and practise good corporate governance, and to monitor the truthfulness and completeness of the disclosure documents submitted by their client firms to the regulators. But it also has displayed worrying inadequacies in ensuring the efficiency and reducing the costs of firms’ fund-raising activity, most notably due to the lack of predictability in the CSRC review process, which could last as long as two to three years.69 Meanwhile, the reality of weak exit mechanisms, especially the delisting mechanism, has exacerbated the vulnerability of investors who are faced with generally poor protections of shareholder rights. The need for reform has been keenly noted by policy makers and regulators for a long time, but has not materialized into a fundamental change of the regulatory mode from its top-down, paternalistic pattern. There have only been marginal patchups to tinker with the pricing mechanism, which were aimed at injecting market forces in setting the issuing prices, only with limited results.70 2.3 The Sponsor System Since 2004, to help firms better prepare their corporate restructuring and listing filings, a sponsor system was established to input more market forces in the IPO process so that it would be less dominated by administrative governance, oriented toward professionalism and regularity, and more streamlined in procedural steps. The sponsor system was borrowed from Hong Kong, for the similar purposes of imposing compliance discipline and risk control over potential issuers by financial intermediaries at earlier stages of the listing process. The CSRC issued the Measures on the Sponsor System for Securities Offering and Listing in December 2003, subsequently revised in 2008 and 2009, to spell out rules on the nature and scope of sponsor responsibilities in the IPO and listing processes, which are subject to a single qualification review by the CSRC, as explained earlier. The sponsors shall guide potential issuers to 68  See, for example, Lu, supra note 24; Lu, supra note 25. 69  Jiang, supra note 16. 70  CSRC (2013), pp. 86–7.

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properly conduct organizational restructuring, corporate governance building, standardized business operations and regulatory compliance for a period of time (three to six months in practice).71 The coaching is carried out through the training of senior management and major shareholders of the issuers and is typically organized by the sponsors’ representatives, who are securities professionals who have passed the CSRC’s qualification test and completed the agency’s training. The sponsors assume the responsibility of due diligence investigations of issuers’ financial status directly concerning their ability to make profits. When the sponsors are satisfied with the effectiveness of coaching, they would recommend intending issuers for an IPO application to the CSRC and sign an agreement with the issuers on underwriting matters.72 Typically, the prospectus is drafted by the sponsor. Sponsors would be held responsible for poor quality or fraudulent filings of IPO applications by their client companies for failing the responsibility of due diligence.73 This has added a strong incentive for the sponsors to perform. There have been only four cases where the sponsors were held responsible for flawed IPO applications.74 Over the past decade, the sponsors’ professional and reputational services have proven to be a valuable asset in improving the overall quality of IPO activity, despite the weaknesses that have been revealed in their conducting of business, mainly arising from mismatched incentives and lax internal controls. For example, there is a prevailing emphasis across the sponsorship industry on success rates, measured by issuers’ performance in the PORC review. Bonuses are distributed on that single basis, without taking into consideration of subsequent execution of the continuous post-IPO guiding responsibility. Another weakness lies in the risk control over compliance within the sponsor institutions which has deteriorated in recent years. There are also widely expressed complaints in the industry about lack of clear regulatory guidance on the scope and boundaries of due diligence investigations and the standards of “significant aspects” of the issuer which require such investigations. As a result, there are ambiguities regarding the division of job responsibilities among the relevant intermediaries including the sponsors, accountants, lawyers, and assets appraisal professionals.75

71  Ibid., pp. 84–85; Chen & Liu, supra note 30, p. 89. 72  Chen & Liu, supra note 30, pp. 91–2. 73  CSRC (2013), p. 84. 74  Chen & Liu, supra note 30, pp. 121–29. 75  Ibid., pp. 131–33.

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2.4 The NEEQ Experiment with the Registration System The latest developments in the capital markets indicate some positive progress in building a registration system for capital market entry. Over the past two years of rapid development, the NEEQ has become the de facto third national stock exchange in China.76 It has the same institutional function and legal status as that of the two stock exchanges: as a component of the multilayered capital markets in China, it provides a platform for the transfers of shares issued by public companies. What differs is with the characteristics of the target issuers: the NEEQ serves to finance non-listed public companies of small and medium size in the growth and high-tech industries by quoting their shares for public trading, as well as facilitating the private placement of their shares. The threshold for entering this market is much lower than the IPO qualifications for entering the two stock exchanges. The NEEQ relies heavily on the recommendations from qualified securities companies of potential issuers. On that basis, it only conducts a formal review of issuers’ compliance with regulations on shareholding structure, business operation and corporate governance, as well as of their disclosure documents. Importantly, the NEEQ does not impose entry conditions on profits, as required of IPO issuers. In other words, the NEEQ adopts a registration-based system for admitting issuers. Since the companies quoted on the NEEQ are usually small and operate in high tech industries, often without profits at their current growth stage, to accommodate to the relatively high level of investment risk there is a stringent qualification for investor suitability, which encourages participation of institutional shareholders but turns away individual investors with less than 5 million RMB yuan in personal assets.77 Another interesting characteristic of the NEEQ is that it uses an electronic filing system to receive issuer submissions and disclosures, which has greatly reduced their filing costs. This is a widely acknowledged advantage of the NEEQ review of entry applications over the CSRC review of IPO applications which is still paper-based.78 Notably, the companies quoted on the NEEQ are not “listed” companies. However, they all have more than 200 shareholders and fall within a distinct category of shareholding companies: they are “non-listed public companies” as they are not listed, nor are they privately held. The existing Securities Law does not permit a shareholding company to have more than 200 shareholders without going public. Therefore, if a non-listed shareholding company reaches 76  Jiang (2015). 77  Ibid. 78  Chen & Liu, supra note 30, p. 95.

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that ceiling, it either has to reduce the number of its shareholders or has to apply for an IPO with the CSRC. Otherwise, it may violate the Securities Law and even commit the criminal offence of illegal fund-raising.79 The advent of the NEEQ has therefore relieved these companies of the dilemma of having more than 200 shareholders yet not being qualified for an IPO. Although these companies generally aspire to a public listing on the stock exchange in Shanghai or Shenzhen, they are not yet ready for it either because they have difficulty meeting the stringent listing qualifications or because they do not wish to wait in the pipeline of intending issuers queuing up at the door of the CSRC. To help meet the financing needs of this particular category of companies, the CSRC issued the Measures for the Supervision and Administration of Non-listed Public Companies in September 2012.80 This regulation has essentially filled out a gap in the Securities Law as it legitimizes the legal status of non-listed shareholding companies with more than 200 shareholders and recognizes the legality of their financing activity on the NEEQ. Although short in time, the operation of the NEEQ has laid down a valuable foundation for the ongoing IPO reform as experiences with the registration system are being accumulated. 2.5 Limitations of Prior IPO Reforms China has walked a long way toward a market-oriented IPO system, and is still on the march. When the capital markets were revived in the early 1990s with the establishment of two national stock exchanges, a quota system for IPO was installed to allocate listing resources at local governments’ discretion, to their favored firms. The quota system had its roots in the then underdeveloped legal and regulatory environments. With bare existence of active market players, especially institutional investors and financial intermediaries, inexperienced regulators could hardly overcome or mitigate information asymmetry to distinguish qualified issuers due to very limited regulatory capacity. By comparison, local governments were in a better position to judge on the genuine performance and assets quality of IPO issuers from their jurisdictions. The quota system was also a handy tool to help implement the industrial policy of recapitalizing ailing local state-owned enterprises, by finding them a new source of funds other than the insolvent state banks. When powers and responsibilities for securities regulation became centralized on the CSRC, the government agency overseeing capital markets with the authorization of the State Council, the influence of local governments 79  Securities Law, Article 10, para. 2. 80  CSRC (2013), p. 106.

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faded over IPO review and eventually diminished to a stature of non significance. As a result, the quota system was abolished in 2001 and replaced by the review and approval system administered by the CSRC, which has remained in use to the present day. Under the review and approval system, the CSRC conducts a substantive evaluation of firms’ eligibility for IPO by a range of performance standards on corporate governance and pre-IPO profits. There have been reform attempts at rationalizing this merit-based system by injecting market forces in the selection and pricing processes. An important step was the introduction of a sponsor system in 2004 to enable financial intermediaries to play an assisting role in nurturing suitable IPO issuers and preparing them for information filings. While efforts have been made to tighten sponsor accountability in maintaining the quality of issuers and reducing fraudulent filings, CSRC sanction of IPO qualifications has remained a determinant apparatus. In recent years, this monitoring power has become more delicately exercised with enhanced technical precision and procedural transparency, yet still substantially influenced by administrative governance and not dominated by market forces. What China has now, therefore, is a mixed IPO system blending elements of both administrative governance, through the CSRC scrutiny of pre-IPO performance, and market mechanisms for information authentication, channelled by the sponsors. Under the review and approval system, regulatory rigidity often manifests itself in a lengthy and cumbersome procedure for IPO admission as the government’s visible hand zealously guards the door to the capital markets. On the other hand, scandals of fraudulent listings and disclosures have broken out repeatedly, ripping investors of their wealth who had put faith in the quality of culprit companies by presuming an implicit government pledge to firms’ investment value.81 As a result, a value-based and “buyer-beware” investment culture has been hard to gain currency in China as investors usually blame the government, not themselves, for picking the wrong firms for investing when post-IPO fiascos of corporate failure are exposed. This moral hazard on the part of the investors is rooted in the defining characteristic of the review and approval system, which is that the CSRC examines and approves a company’s

81  There is a counter argument that the exposures of poor-quality or even fraudulent listings are actually an indication of relaxed regulatory zeal over merit-based review of issuer qualifications, which is a positive sign of the CSRC efforts to try to move closer to a formal, disclosure-based review system. In addition, the very fact that there have been more exposures of such market misconduct is exactly a reflection of tightened enforcement efforts by the CSRC to punish wrongdoers and improve transparency. See Wang (2013), p. 6.

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credentials at every step of the IPO procedure. It takes upon itself the job of verifying the company’s worthiness of investment in addition to examining whether the application materials are complete. In this system, the CSRC was held accountable to some extent for the performance of a listed company because it is seen as endorsing the company’s “sustained profitability.” The major drawbacks of the review and approval system have been fully documented. The most cited deficiencies are summarized below, and are to various degrees already elaborated in the preceding text. (1) Misallocation of resources: This merit-based approach to entry regulation has obstructed market forces in effectively allocating financial resources. The painfully long process to gain regulatory approval to go public has cost many companies the best opportunity to list their shares. (2) Breeding of corruption: The review and approval system has bred corruption which is of institutional nature. It was well-known that companies would go to great lengths, including bribing the PORC members, to ensure their listing successes. (3) IPO blackmailing: There was a whole network of underground businesses that thrived on blackmailing IPO hopefuls, as the scandal of the 21cbh. com, mentioned in the preceding text, demonstrated. (4) Adverse selection: Because it was so difficult to get listed, zombie companies with virtually no operations are still often traded at high prices as investors speculate that they will be taken over by a company that balks at the regular IPO channel. With these flaws, the review and approval system has been blamed for lack of efficiency in capital allocation and for encouragement of distorted investor incentives. At the same time, as listings on stock exchanges have become a scarce commodity due to tight control of market entry, corruption has spread to various sectors of the market, breeding rent-seeking and unscrupulous behavior. For example, the reputation of the financial press is now tainted by accusations of IPO blackmailing as threats of negative news coverage to frustrate IPO efforts are silenced by payment of bribes from affected firms, who are afraid of losing precious opportunity for fund-raising. 2.6 Broader Implications of the Registration System As the review and approval system has long displayed signs of inadequacy, it has prompted repeated calls for reform over the years, including those from the CSRC itself. For example, Guo Shuqing, Xiao Gang’s predecessor as CSRC chairman, had even publicly begged the question of whether it is possible to

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abolish the merit-based review system altogether.82 However, decisive moves toward fundamentally amending the existing system only started to speed up after Xiao Gang took over in November 2013. Notably, in November 2013, with the new chairman just freshly installed in his office, the CSRC released a new policy on IPO reform, for the purpose of making transitional arrangements from the review and approval system to a registration system. Under the new policy, companies would still need the CSRC’s approval to go public, but they no longer need to prove their ability to make continuing profits. This judgment now rests with the market. This is a significant enough change to make the IPO system look like the one based on registration, which the CSRC indicated it would eventually adopt as reform deepens.83 In accommodation to the ongoing revisions to the Securities Law to formally endorse a registration system, the CSRC has drafted and submitted to the State Council a preliminary action plan, which is aimed at designing a “market-led, accountability-based, disclosure-centred, reasonably expectable and effectively regulated IPO system that suits China’s realities.”84 The introduction of the registration system is therefore seen as a paradigm shift in the regulatory approach. It promises to let investors decide whether a company has investment value after it satisfies the regulators with the quality of information disclosure at its IPO application. Regulators will move to the back seat to oversee the functioning of the market by ex-post enforcement against untrue disclosures and fraudulent trades. To accomplish that, the employment of new mechanisms for investor protection will become a parallel task as the layout of the registration system is being mapped out in the draft revisions to the Securities Law. More importantly, the registration system is expected to play a critical role not only in channeling market forces to firms’ fund-raising activity, but also in precipitating broader structural reforms to transform the philosophy and pattern of securities regulation in China, which has exhibited a sustained tilt toward government paternalism. This would bring the country into closer line with established international practices so that the capital markets will serve China’s economic development as a reliable supporting institution. It is no overstatement, therefore, that a successful transition to the registration system would be another breakthrough in China’s march to the market in the 21st century.

82  Caixin (2012). 83  Wang (2013c). 84  CSRC (2015a), supra note 1, p. 26.

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Clarifying the Concept of Registration System

As I have already explained, although the direction of ongoing IPO reform has been set as eventually moving toward a disclosure-based registration system, this concept does not yet have a generally accepted definition among China’s policy and business circles. Strictly speaking, the notion of the “registration system” is not a legal term, but a common description of the securities issuing regimes in some of the advanced overseas markets such as the United States.85 In the course of discussions regarding China’s move to the registration system, prominent misunderstandings of the US-style registration system for IPO regulation have emerged. I now seek to outline and answer these misunderstandings in order to present a more complete picture of the regulatory landscapes in overseas markets. 3.1 Registration System vs. Review and Approval System A registration system typically has three characteristics: (1) convergence to international standards of disclosure rules adopted in the IPO review process; (2) efficiency, transparency and friendliness of the review process; and (3) restraints and limitations of government licensing and regulatory powers.86 In fact, the demarcation between the disclosure-based registration system and the merit-based review and approval system is not clear-cut as their names may suggest. There are commonly shared attributes: both involve a strict and meticulous review of the regulatory agencies, both emphasize the principle of mandatory information disclosure as the prerequisite for a public listing of securities, both highlight the information on the issuer’s ability to make continuing profits and the revelation of risk factors in the prospectus as key concerns in the review process.87 Both require the accuracy and completeness of information disclosure; both impose civil and criminal liabilities on financial intermediaries involved in the preparation of the prospectus and other disclosure documents.88 The main differences lie in the direction of major input of regulatory resources. For example, in the United States and Hong Kong, regulators only conduct a very limited review of intending issuers’ substantive credentials, and put their attention almost entirely to a close examination of disclosure in the prospectus and imposition of liability ex-post. Once approved on the 85  Wang (2015), p. 4. 86  Tang (2014), p. 37. 87  Wang (2013a). 88  Li (2014).

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basis of adequate information disclosure, intending issuers can decide when to enter the IPO market based on their respective needs, leaving the market to decide on the size of the offering and the level of the offering price. Once listed, if false disclosures or other violations of honesty and creditworthiness are discovered, regulators and the rights-protection mechanisms embedded in the market would pursue the wrongdoing issuers and financial intermediaries, to the exhaustion of their defending resources, until they are driven out of the market.89 3.2 What is “Registration”? What is “Registration System”? It is important to note that the concepts of “registration” and a “registration system” are each two different things. In the United States, the “registration” process overseen by the SEC for public offerings of securities is only a component of the “registration system” which the country practises.90 The complete set of legal and institutional arrangements under the registration system in the United States have two dimensions: (1) the filing and a formal review of registration statement at the SEC in a national public offering under the Securities Act of 1933, with exemptions from the registration requirement, and (2) state regulation of securities offerings under state “blue sky” laws which usually mandate a merit-based review of issuer qualifications and contain strict antifraud clauses.91 This pattern of IPO regulation is sometimes called “double registration” by observers, which entails the review of information disclosure by federal regulators, namely the SEC, as well as the review of substantive listing qualifications by state regulators.92 In addition, on the basis that IPO and listing are two separate processes subject to different arrangements of regulatory oversight, there are three layers of the entry regulation to ensure quality control.93 Firstly, the SEC conducts a formal but meticulous review of registration statements for public offerings, in the sense that the SEC puts a strong emphasis on the truthfulness, completeness, accuracy, and readability or intelligibility of the prospectus. Upon an initial review of the registration statement, multiple rounds of follow-up questions and requests for supplementary submissions addressed to the issuer are a normal practice. Before the SEC is satisfied with 89  Ibid. 90  Any textbook on the US securities regulation would include a detailed explanation of the registration system. See, for example, Coffee Jr & Seligman (2003), pp. 176–305. 91  Shen (2011b), p. 15. 92  Liu (2013). 93  Wang (2013b).

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the quality of the registration statement, it can keep this process of continuing dialogue for as long as necessary. On the other hand, the SEC would not reject an application simply because the issuer has inferior performance or unflattering financial numbers on its books. Secondly, the stock exchanges, such as the New York Stock Exchange and the Nasdaq, conduct a merit-based review of issuer qualifications for IPO, as well as for the maintenance of the listing status failing which a delisting prospect would ensue. The exchange review is underway at the same time the SEC is conducting its formal review of the registration statements. In this process, the exchanges adopt the listing standards set out in their respective listing rules. The exchanges can, at their discretion, reject listing applications considered not meeting threshold performance requirements, including the lack of an ability to make continuing profits.94 The SEC will only approve the coming into effectiveness of the registration statements after the relevant exchanges have issued their confirmations acknowledging acceptance of the listing applications. Thirdly, there are supporting institutions backing up the proper functioning of the registration system, including an institutional investors’ base that is the dominant force in the market and acts on rational investment decisions, the threat of class action, short selling institutions, and effective civil remedies for violations of investors’ rights and interests.95 Accordingly, there are four salient characteristics of the US-style registration system which distinguish it from practices in other markets. (1) The government does not consider its job to make a judgment on the investment value of a securities offering, nor does it consider it appropriate to spell out performance standards, especially profitability requirements. Any issuer can file the registration statement regardless of the nature and level of its business risks. An application is eligible for SEC approval as long as it satisfies requirements of full and truthful disclosure.96 (2) The registration process is a transparent process of continuing dialogue between the SEC and the issuer, with all the corresponding documentations posted in EDGAR for public access and scrutiny. The timeframe for concluding the registration process could be predicted.97 94  Ibid. 95  Ibid. 96  Liu, supra note 92. 97  Ibid.

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(3) In cases of false disclosure later coming to light, the SEC does not engage itself in the work of ex-ante checking and verifications. The job is left to financial intermediaries, such as underwriters, accountants and lawyers. Because there is a well established culture in the capital markets of reputational disciplines, the intermediaries have strong incentives for risk control and prevention of fraud.98 (4) owerful enforcement mechanisms are the fundamental guarantee of the functioning of the registration system, including civil anti-fraud actions, particularly the intimidating threat of the class actions, SEC enforcement actions, as well as criminal prosecutions by the Ministry of Justice against wrongdoings.99 3.3 Other Approaches to IPO Regulation If we shift our attention to other markets, we would discover that there are a variety of different modes of entry regulation other than the US-style registration system. Outside of the United States, the review and approval system is commonly used in other developed economies, including the UK, Hong Kong, and the continental European countries, but with differing characteristics.100 3.3.1 UK For example, in the UK, public offerings and listings of securities are separate processes. With regard to public offerings, the Financial Services Authority (FSA) is the competent regulatory authority.101 The UK Listing Authority (UKLA) within the FSA conducts a formal review of the prospectus, which is also a process of continuous dialogue between the UKLA, the issuer, and its sponsor. Usually, the UKLA provides feedback within 10 days to the application, which is specified in a Comment Sheet. The issuer and its sponsor then would join hands with other intermediaries in revising the prospectus for a second round of submission, which would be replied within 5 days. This kind of exchange can go on for three to four rounds until the UKLA issues its preliminary approval of the IPO. The average duration of such repeated feedback is six to eight weeks. With the preliminary approval, the issuer at this point may issue a “pathfinder prospectus” for promotion and marketing of the offering. After the road show and book-building for price setting have completed, the sponsor 98  Ibid. 99  Ibid. 100  Wang, supra note 87. See also Guo (2013), pp. 161–86. 101  Ferran (2008), p. 425.

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would submit the final prospectus to the UKLA specifying the issuing price and the amount of funds to be raised, which concludes the formal review process for a public offering. Afterwards, the issuer must submit a listing application to both the UKLA and the London Stock Exchange (LSE) for approval, a kind of “dual filing” practice. After respective approvals from both of the UKLA and the exchange have been granted on the basis of a merit-based review of issuer quality, the shares newly offered can start to be listed for trading on the exchange.102 Therefore, both formal and merit-based reviews are used at different stages of an IPO and the subsequent listing. 3.3.2 Hong Kong In Hong Kong, a system called “dual filing” has been in operation since 2003 under the Securities and Futures Ordinance whereby a listing application is submitted to the Stock Exchange of the Hong Kong (HKEx). Commentators have characterized the Hong Kong practice as a “review and approval system with a market orientation.”103 After the listing division of the exchange decides to accept the application for review, it would send a copy of the prospectus and other application documents to the Securities and Exchange Commission (SFC). Both the SFC and the exchange have the authority to review the application, but the exchange exercises a more substantive review power as the frontline regulator of the securities market which adopts a range of standards on assets quality and performance record. By comparison, the review by the SFC is mainly concerned with whether the issuer and its sponsor have truthfully disclosed significant events and risks of the issuer. The SFC usually returns its feedback to the issuer and the sponsor within three weeks via the exchange, specifying its doubts over the disclosure gaps it has discovered, for the issuer and the sponsor to address in follow-up submissions. Such back-and-forth exchange is conducted in writing and could go on for several rounds. After the SFC is finally satisfied with the quality of the submission, it would issue a “No Comment Letter” so that the listing division of the exchange can carry on with its meritbased review.104 Afterwards, the listing division assigns the application to a review team composed of three or four staffers, which would be the main contact point for the issuer and its sponsor for the exchange feedback to the application. Follow-up questions and requests for supplementing submissions are sent 102  U BS (2013). 103  Wang, supra note 93. 104  S SE, supra note 63.

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back to the issuer and the sponsor by the review team, to be addressed in both written and oral responses. This exchange can go on for three to four rounds. After the review team is satisfied with the revised application, it would transfer the application to the listing committee for final review via a listing hearing, which is participated by members of the listing committee and staffers of the review team.105 With only about 20 members, all seasoned financial professionals and experts whose names are published on the exchange website, it is not possible for the listing committee to conduct on-site inspection of the applicant and collect information.106 Therefore, the listing committee heavily relies on the quality of application documents submitted by the issuer and the sponsor to form its judgment.107 At the listing hearing, after the staffers of the review team have made a presentation and answered questions from the committee members, the listing committee will offer its opinions on the application, including identifications of the matters in need of further clarifications. Such feedback would be returned to the issuer and the sponsor by the listing division for further follow-up actions. After the issuer and the sponsor have addressed the concerns of the listing committee to its satisfaction, the listing division would finally issue its approval document on behalf of the exchange.108 At this point, in theory and according to law, the SFC could reject the listing applications which have passed by the exchange review. However, there has never been a single case of such rejection, showing a sustained deference of the SFC to the professional judgments of the exchange.109 3.3.3 Lessons for China From these examples of different approaches to IPO regulation, it can be seen that alternative institutional designs exist to serve the same purpose of quality assurances for capital market entry that the US-style registration system is performing. The alternative IPO regimes cater to domestic settings of legal, institutional, and cultural attributes, and accommodate specific conditions of market and regulatory developments. For example, in both the UK and Hong Kong, the “dual filing” and “dual review” by the securities regulator and the exchange are exercised to provide an extra level of oversight from public authorities, primarily due to the transformation of both the LSE and HKEx from previous not-for-profit self regulatory organizations to for-profit 105  Ibid., p 9. 106  H KEx (2015b). 107  Wang, supra note 87. 108  S SE, supra note 63, pp. 8–9. 109  Shen, supra note 91. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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commercial corporations in recent years, both having become listed companies themselves. Therefore, in both jurisdictions, the arrangements for IPO regulation have added an element of institutional check to monitor possible deviations from regulatory integrity resulting from potential conflicts of interest on the part of the exchange. Generally speaking, on the one hand, a disclosure-based registration system, such as the one adopted in the United States (as well as in Japan), is most suitable for mature capital markets; on the other hand, some mature markets also adopt a merit-based review and approval system, similar to what China now practises, such as in the UK and Hong Kong.110 For China’s reformers, this lesson should be learned that any movements to the registration system should be attentive to its domestic conditions, not necessarily by copying the complete set of the designs under the US-style registration system, which seems to be much admired by many Chinese commentators as a successful model. 3.4 Two Common Misunderstandings of the US-style Registration System There have emerged some widely shared misunderstandings in China’s academic and policy circles of the US-style registration system, which have been noted and criticized in the literature by more careful commentators. 3.4.1

Only Disclosure Is Needed, No Need for Review of Issuer Qualifications One of the prevailing misunderstandings is that under the US-style registration system there is no need for a review of issuer quality as long as it makes proper information disclosure. Actually, the SEC scrutinizes the prospectus, which is the most important component of the registration statement, and does so even more closely than the CSRC does. There are more follow-up questions from the SEC than the CSRC after the initial review, which tend to be rather pointed and challenging. While it is not uncommon for the SEC to only give one or two rounds of feedback if the prospectus has good quality, multiple rounds, sometimes even a dozen rounds of follow-up questions may be posed before the SEC is satisfied with the completeness of the prospectus disclosure.111 3.4.2 Loss-making Issuers Can Also Make IPOs Another misunderstanding is the claim that the IPO requirements in the United States are relaxed on performance threshold and that companies not

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yet ­having made a profit can still get listed. A recent example is the ­successful IPO of JD.com Inc., China’s largest e-retailer, on the Nasdaq in May 2014. Although still running at a loss at the time of IPO, USD 1.78 billion was raised from enthusiastic subscribers. The prospectus showed that for the first quarter of 20014, the company’s total loss was RBM 3.795 billion yuan. Its market value reached USD 26 billion immediately after the IPO, making JD.com Inc. the third largest listed internet company in China, after Tencent and Baidu. The IPO was the largest ever for a Chinese internet company listing in the United States by then.112 The example of JD.com Inc. seems to lend support to the claim that indeed IPOs of loss-making issuers are permitted in the United States. However, if we explore deeper beyond superficial indications of relaxed performance threshold, we discover that this phenomenon only occurs on the two big stock exchanges in the Unites States, the NYSE and the Nasdaq, and not elsewhere across developed markets. For example, in Hong Kong, it has been rarely the case that loss-making issuers can obtain their IPO approvals from the HKEx. There was one single exception of the IPO of the Russian company UC RUSAL in December 2009 which received an IPO approval from the SFC despite of high risks associated with its loss-making business. However, to impose risk control and protect retail investors, in that case unusual restrictions were imposed on private investor participation in the USD 2 billion IPO of UC RUSAL on the HKEx, the first initial public offering by a Russian company in Hong Kong. The SFC insisted on a minimum entry level of HKD 1 million (USD 130,000) for those wishing to buy into the aluminum company’s IPO. Furthermore, to discourage small investors further from participating in the secondary market, RUSAL was traded on the exchange in lots of 200,000 shares.113 Meanwhile, even in the United States where loss-making issuers are still hosted, these companies are invariably the leading flagships in their industries, typically the growth and high-tech sectors, with a good prospect of realizing profits in the foreseeable future. Examples include the three leading Chinese internet companies, Sina, Sohu and Netease, all completed IPOs in 2000 when they were still making losses. They have since improved performance and realized stable and sustained profits in recent years.114 JD.com was met with the same investor expectation that it would turn into profits soon judged by its potential when its IPO was hotly received in New York. 112  Caixin (2014). 113  Mitchell (2009). 114  Wang, supra note 83, p. 10.

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Despite, therefore appearance of a US-style registration system allowing any intending issuer to file an IPO application, in reality the market is highly selective and with implicit entry thresholds that are stringent and, sometimes, even prohibitive and intimidating. Unless the issuer is absolutely confident that it is capable of affording the substantial costs of an US listing, including expensive fees of concluding the IPO process and maintaining a listing status on the exchange, winning the recommendations of top-rating underwriters and other financial intermediaries, and dealing with the treats from class action lawsuits, short selling institutions, and SEC enforcement actions when problems arise.115 This is why that in US capital markets, very few small companies are listed on the two leading stock exchanges.116 3.4.3 Direction of IPO Reform in China In that light, China’s reformers need to consider whether a radical or a gradualist approach is best suited for the countries needs and existing levels of market and institutional development. Were a disclosure-based registration system to replace the current merit-based review and approval system, supporting and complementary mechanisms would also have to be put in place to ensure its proper functioning. Such mechanisms would include strengthening ex-post regulatory enforcement by the CSRC against fraudulent listings and other types of market misconduct, combating fabrications of financial and accounting records, improving the quality of information disclosure. With these supporting reforms, the overall transformation of the regulatory paradigm to relaxed entry restrictions and at the same time strengthened, more powerful and effective ex-post monitoring and supervision may be realized.117 4

Designing a Registration System for China

In April 2014, China’s legislators put forward a first draft of revisions to the Securities Law. Among other changes, a formal endorsement of the registration system has been introduced for discussion by the National People’s Congress Standing Committee (NPCSC), which is the country’s principal law maker. As a result, the merit-based review and approval system will be abolished. The defining characteristic of the registration system spelled out in the draft revisions to the PRC Securities Law is the message that the CSRC will ease 115  Ibid. 116  S EC (2011). 117  Wang, supra note 93.

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out of the role of paternalistic guardian in the ex-ante review and transform to a gatekeeper in ex-post enforcement against market abuses and fraud. The reviewing power will rest with the exchanges, which will be responsible only for checking whether the application materials and other information disclosure conform to legal standards. The exchanges will not have to make a merit-based judgment on the “sustained profitability” and “investment value” of an IPO applicant. The judgment will instead be left to the market and investors.118 In the process of trying to figure out the appropriate operative details of the registration system suitable for domestic application, it is necessary for Chinese legislators and regulators to look at the experiences of mature capital markets and to learn from their successes. However, it is equally desirable to also take into consideration the specific market structure, investor attributes, levels of the sophistication and professionalism of financial intermediaries, strengths of regulatory capacity, and the progress of government reform relating to business regulation and oversight. Some elements and designs of overseas practices termed a “registration system” may not be suitable for China’s domestic conditions due to the lack of supporting or complementary institutions. Meanwhile, under the merit-based review and approval system, some mechanisms and practices have been proven to be effective and useful, which could be retained for continuing implementation.119 The draft revisions to the Securities Law spell out preliminary designs on five aspects of the forthcoming registration system. 4.1 Clarification of the Registration Procedure The PORC would be abolished, to be replaced by a formal review of the registration documents by the exchanges for their completeness, coherence and intelligibility. Once the exchange issues its approval, it should send to the CSRC a copy of the registration documents and its review decision. The registration would become effective if the CSRC does not express an objection within 10 days.120 4.2 Amendments to IPO Qualifications The prior requirements of a sound financial status and an ability to make continuing profits would be removed. An intending issuer would only need to meet a set of compliance standards for filing a registration with the exchange. 118  Law Committee of the National People’s Congress (2015). 119  Lu (2015). 120  Law Committee of the National People’s Congress (2015), draft revisions to the Securities Law, article 23. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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These include a clean record on criminal offences in the preceding three years of the issuer as well as its controlling shareholder and actual controller, a corporate governance structure in compliance with the law, and unreserved auditor endorsements of the issuer’s financial and accounting reports for the three consecutive preceding years.121 4.3 Elaborations of Obligations and Liabilities of Participating Parties The issuer and its sponsor are obliged to ensure the truthfulness, accuracy and completeness of the registration documents, including subsequent amendments and follow-up explanations, which should all be made public.122 Securities service providing institutions and their employees must adhere to professional ethics and industry disciplines, perform due diligence and responsibility, as well as ensure the truthfulness, accuracy and completeness of the documents they provide.123 The underwriters shall conduct checking and authenticate work to ensure the truthfulness, accuracy and completeness of the offering documents.124 At the same time, the draft revisions also provide for a revocation system for fraudulent IPOs and prescribe related civil liability and enforcement actions.125 4.4 Establishment of Exemptions to IPO Registration With reference to the practices in the United States, the revised law also permits exemptions to the mandatory registration requirement for IPO, granted in specific situations where qualified investors, crowd-funding activity, small offerings, and incentive mechanisms for employment stock option or shareholding plans are at issue.126 4.5 Introduction of the System of Share Transfer Restrictions As an inherent requirement under a disclosure-based, market-oriented registration system, the system for share transfer restrictions involving company insiders and significant shareholders is commonly adopted. The revised law tries to import such a system with added elements suited to domestic conditions, addressing the much-criticized abusive practice whereby controlling ­shareholders often cash out themselves by selling their shares immediately after IPO issuance, to the detriment to small public investors. The revised law 121  Ibid., Article 20. 122  Ibid., Articles 21, 22, 27 and 28. 123  Ibid., Articles 29–31. 124  Ibid., Article 44. 125  Ibid., Articles, 24, 32, and 33. 126  Ibid., Articles 13–16. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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therefore imposes ­restrictions on such selling conduct by requiring registration for public offering of previously unregistered shares, or selling of such shares in the open market under “safe harbor” conditions.127 5 Conclusion Upon passage of the revised Securities Law, subsequent CRSC enactments and amendments to the exchanges’ listing rules will elaborate operative details of the registration system. But this will not happen any time soon, judging from the current progress of the revision work which has been disrupted, and indeed put on hold, by recent market turmoils in the summer of 2015, resulting in a breakdown of the stock market as share prices of more than 1000 listed companies dropped to hit the floor, dragging down the whole market to a standstill.128 In this market crash, more than USD 3.5 trillion in investor wealth had evaporated. By the end of July 7th trading in over 90 percent of the 2,774 shares listed on Chinese exchanges was suspended or halted. The CSRC has since moved swiftly to bail out the market and try to bring the investor sell-off to a stop.129 Prospects for a return to positive market conditions and the resumption of legislative reform remain uncertain. Nevertheless, reformers should not be deterred by the recent unfavorable market conditions from continuing their efforts to push forward the regulatory changes necessary for the next stage of China’s capital market development. The goal of building Shanghai as an international financial center by 2020 remains, pending concrete initiatives to make that happen, including the widely expected introduction of the registration system for liberalizing stringent entry restrictions. At the next stage, along with the coming into effectiveness of the revised Securities Law, the introduction of the registration system should proceed on a gradual basis. While the exchanges will take over from the CSRC to become the reviewing authority and follow a formal, disclosure-based approach toward IPO review, complementary reform initiatives should also be put forward in providing enhanced investor protection. I have in this chapter outlined some general directions of these supporting reforms, some of which are reflected in the revised Securities Law and will need implementing rules to effectuate their functions.

127  Ibid., Articles 51–57. 128  Jiang, Liu & Yue (2015). 129  The Economist (2015).

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For example, in case of fraudulent IPOs, the revised law spells out remedial measures such as a revocation of registration approval. In addition, future legislative and regulatory adjustments might consider the mechanism of share buy-back to provide restitutions to the investors. The CSRC had proposed such a mechanism in November 2013 which would strengthen punishment for issuing companies and underwriting intermediaries should they mislead or cheat other investors. The CSRC stipulated that in case IPO materials are found to be false, misleading or contain important omissions that significantly impact whether the issuing company meets IPO requirement, the issuing company must buy back all new shares sold in the IPO. Also, both the company and its underwriters will be punished by fines and other sanctions, including criminal sanctions.130 Other examples include enhanced mechanisms of shareholder litigation, exit and delisting from the market, tightened sponsor accountability and responsibility, improved policing of information disclosure, a multi-layered structure of the capital markets accommodating different categories of issuers at differing stages of growth, a more independent and disciplined financial press, exchange reform for enhanced independence, self-discipline and professionalism, and importantly, the self reform of the CSRC to relieve itself of heavy ex-ante oversight and monitoring, and of its licensing power. Understandably, the reform of the regulator itself would be of a revolutionary nature and most difficult and challenging. But the prospects for this reform remain bright, as the Chinese government has restated its resolve to continue moving forward with market-oriented reform. All that is needed most is the government’s determination to bring real but painful changes to itself to eventually let market forces in the allocation of economic resources. With the current leadership staying firm on its reform agenda, one has good reason to expect positive results down the road. References Caixin (2012) “Editorial—It Is Worth Trying to Abolish Merit-Based Review of IPO,” 7 Caixin New Century Weekly, 20 February, http://magazine.caixin.com/2012-0217/100358121.html (accessed 20 September 20 2015). ——— (2014) “Graphic: JD.com IPO,” Caixin Online, 22 May, http://english.caixin .com/2014-05-22/100681095.html (accessed 22 September 2015).

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——— (2013d) “How Bourse Workers Staff an Equities Regulator”, Caixin Online, 4 March, http://english.caixin.com/2013-03-04/100496649.html (accessed September 18, 2015). Mitchell, Tom (2009) “Cubs on RUSAL’s HK Debut,” Financial Times, 21 December. Mu, Wei (2014) “Media, PR Executives ‘Arrested over IPO Blackmail Schemes’,” Caixin Online, 4 September, http://english.caixin.com/2014-09-04/100725214.html (accessed 20 September 2015). Pistor, Katharina, & Chenggang Xu (2005) “Governing Stock Markets in Transition Economies: Lessons from China.” 7 American Law and Economics Review 184–210. Qian, Kangning, & Jianrong Jiang (2012) “A Global Comparison of IPO Regimes and Its Implications for China.” 2 Shanghai Finance 55–63. SEC (2011) “Rebuild the IPO on-Ramp,” http://www.sec.gov/info/smallbus/acsec/ ipotaskforceslides.pdf (accessed 15 September 2015). Shen, Zhaohui (2010) “IPOs of Enterprises and Local Governments.” 3 Securities Law Review 632–656. ——— (2011a) “The Theory of Regulation by Market Forces and Evolving Administrative Governance: From the Perspective of the Legal Relationships between the CSRC and the Sponsors.” 23 Peking University Law Journal 849–869. ——— (2011b) “Dispelling Conventional Misunderstandings: Distinguishing and Explicating the Concept of the ‘Registration System” and the ‘Review and Approval System’.” 9 Securities Market Herald 14–23. SSE (2012) Division of Public Offering and Listing of the Shanghai Stock Exchange, “A Comparative Study of Regimes for IPO and Listing on the Main Board in PRC and Hong Kong,” unpublished research report, on file with the author. Tang, Yingmao (2014) “How Far Is China Away from the Registration System?: A Discussion of the Reform Measures to Push Forward IPO Reform toward the Registration System.” 7 Shanghai Finance 37–41. The Economist (2015) “China Embraces the Markets,” The Economist, 11 July. UBS (2013) “A Study of the IPO System in the United Kingdom,” research memo provided to the Shanghai Stock Exchange on 22 November 22, on file with the author. Wang, Jiangyu (2014) Company Law in China: Regulation of Business Organizations in a Socialist Market Economy, Cheltenham: Edward Elgar Publishing. Wang, Xiao (2013a) “Several Misunderstandings Regarding IPO Reform,” Shanghai Securities News, 8 November, A05. ——— (2013b), “What Kind of Registration System Do We Need?,” Shanghai Securities News, 20 November, A05. ——— (2013c) “An Attempt at Analyzing IPO Reform toward the Registration System: Issue-Oriented Thoughts and Explorations.” 12 Securities Market Herald 4–13. ——— (2015) “The Four Difficult Issuers under the US-style Registration System and Implications for Capital Market Reform in China.” 1 Securities Market Herald 4–12.

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Wang, Yuqian (2013) “Caixin Explains: New Rules for IPOs Let Market Forces Do the Talking,” Caixin Online, 2 December, http://english.caixin.com/2013-12-02/100612530. html (accessed 20 September 2015). ——— (2014) “Media Outlet Blackmailed over 100 Companies, Xinhua Reports,” Caixin Online, 11 September, http://english.caixin.com/2014-09-11/100727437.html (accessed 20 September 2015). Worldbank.org (2013) “World Development Indicators: Stock Markets,” http://wdi .worldbank.org/table/5.4 (accessed 15 September 2015). Xing, Liquan (2015) “An Analysis of the Time Cost of Domestic IPOs for Enterprises,” research report published by the Shanghai Stock Exchange Capital Market Research Institute, http://www.aiweibang.com/yuedu/44872936.html (accessed 18 September 2015). Zhou, Hong (2014) A Complete Guide to Enterprise IPO, Beijing: Citic Press Group.



Laws, Regulations, Legislative Documents

CSRC (2006) CSRC Administrative Measures on Initial Public Offering and Listing of Shares (enacted in 2006). ——— (2009b) CSRC Measures on the Public Offering Review Committee (enacted in 2003, revised in 2006 and 2009). ——— (2015b) CSRC Flow Charts and Procedures of the Department of Public Offering Supervision of the CSRC for Review and Approval of Initial Public Offering of Shares (enacted in 2015). Law Committee of the National People’s Congress (2015) “Explanatory Notes on the Draft Revisions to the Securities Law of the PRC” (released on 20 April 2015). Standing Committee of the National People’s Congress (2014) PRC Securities Law (enacted in 1999, amended 2004, 2005, 2013 and 2014).

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Part 3 Financial Crimes in Asia: Anti-Corruption Enforcement

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Chapter 14

Anti-Corruption Enforcement in Singapore Chee Kun Thong and Muslim Albakri Abstract Singapore has consistently maintained its reputation as one of the most uncorrupted countries in the world. In 2013, Singapore maintained its position of 5th out of 176 countries in the Corruption Perceptions Index scores, making it the most uncorrupt country in the whole of Asia. Singapore continues to enjoy such success through the efforts of the unwavering Corrupt Practices Investigations Bureau (“CPIB”), which is the primary institution responsible for combating corruption offences. Singapore’s zero-tolerance towards corruption can also be seen from the wide-ranging statutory laws, such as the Prevention of Corruption Act (“PCA”), the Penal Code and the Corruption Drug Trafficking and Other Serious Crimes (Confiscation of Benefits) Act. The legislative intent to effectively snuff out corruption at all levels is highly prevalent in the PCA; where the ambit of corruption offences is especially broad and includes the soliciting, receiving, giving, promising or even offering of a bribe. This paper explores the active role played by the relevant authorities in their respective capacities in dealing with corruption in Singapore. From the investigative powers of the police to the unfettered discretion of the government to detain suspected offenders; the criminal process instils a sense of deterrence at every level. By specifically examining the measures taken by the relevant authorities in light of the recent spate of high-profile corruption cases in the public sector which have rocked Singapore in recent years, this paper will discuss the extent of the enforcement powers open to the relevant authorities in Singapore. This paper also aims to raise serious questions on the necessity and constitutionality of these enforcement powers, especially given the far-reaching and detrimental consequences. One thing is evident, however, and that is no one person, regardless of his profile, is above the law.

* Equity Partner, Rajah & Tann Singapore LLP. Contact: [email protected]. ** Associate, Rajah & Tann Singapore LLP. Contact: [email protected].

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Keywords Singapore – corruption – history – legislation – enforcement

1 Introduction Singapore is consistently ranked as one of the least corrupt countries in the world and the most uncorrupted country in Asia. In 2013, Singapore maintained its rank of 5th out of 176 countries in Transparency International’s Corruption Perceptions Index scores,1 a significant ten places higher than Hong Kong, the nearest Asian contender. In 2014, Singapore was once again ranked first in the annual poll by Political and Economic Risk Consultancy as the least corrupt of 16 major Asia-Pacific economies. Singapore has developed from a once sleepy fishing village into a booming economic and financial hub, both essential and attractive in today’s global market. The correlation between Singapore’s unprecedented growth spurt and its consistently low levels of corruption cannot be understated; an unflinching stand against corruption was always going to be absolutely integral to Singapore’s national interests. Singapore’s strong attitude towards corruption is also hardwired into its political will and can be traced back to the roots of the ruling People’s Association Party (“PAP”) upon forming the first government of newly independent Singapore. Prime Minister of Singapore, Mr. Lee Hsien Loong remarked at the 60th anniversary celebrations of the Corrupt Practices Investigation Bureau (“CPIB”): First, strong political leadership, beginning in 1959, when the newlyelected PAP government started to build a clean and incorrupt Singapore. The PAP decided to fight to win the general election that year and to form the first government of self-governing Singapore, instead of just aiming to be a strong Opposition in the Legislative Assembly. Not because conditions were propitious, but to ensure that corruption did not set in after British handed over and become a problem that would be impossible to eradicate afterwards. The PAP government was determined to build an honest public service that would serve the people of Singapore, and not a public service that would take care of itself at the expense of public interest.2 1  transparency.org (2013). 2  pmo.gov.sg (2012). Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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An in-depth assessment of the anti-corruption framework will reveal a recurring theme of pragmatism and dynamism. The enforcement agencies work closely to adopt a consistently pragmatic approach in the interpretation and application of anti-corruption legislation. Armed with the flexibility to take on inventive and complex forms of corruption, enforcement in Singapore is able to assume a dynamic form which allows it to adapt continuously to new challenges. Additionally, Singapore has demonstrated the political will to maintain this unwaveringly high standard of law enforcement; a key advantage that can be attributed to the political, economic and social stability that Singapore has enjoyed over the past half-century. 2

The Historical Context of Corruption in Singapore

Singapore’s first piece of anti-corruption legislation, the Prevention of Corruption Ordinance (“POCO”), was enacted in 1937, even though corruption was first made an offence in 1871. The POCO was to prevent both corruption in the public and private sectors but it proved to be ineffective for two main reasons; firstly, the powers granted under the POCO were limited and largely stifled the enforcement of corruption and, secondly, the prescribed penalties proved to be insufficient deterrence.3 Furthermore, the POCO made the Singapore Police Force’s Anti-Corruption Branch the main body responsible for investigating corruption offences. This too proved to be an erroneous decision as the task force was inadequate and ill-equipped, resulting in corruption offences being given considerably less priority and attention. The ineffectiveness of the corruption laws then was further exacerbated by the rampancy of police corruption at the time.4 The PAP was quick to recognise the defects in this system and, upon assuming government in 1959, made a concerted effort to rectify these defects. Mr. Lee Kuan Yew, the first Prime Minister of Singapore, explained in his memoirs: When the PAP government took office in 1959, we set out to have a clean administration. We were sickened by the greed, corruption and decadence of many Asian leaders. [. . .] We had a deep sense of mission to establish a clean and effective government. When we took the oath of office [. . .] in June 1959, we all wore white shirts and white slacks to ­symbolize purity and honesty in our personal behaviour and our public life. [. . .] We made sure from the day we took office in June 1959 that every 3  Quah (2013), p. 5. 4  Ibid. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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dollar in revenue would be properly accounted for and would reach the beneficiaries at the grassroots as one dollar, without being siphoned off along the way. So from the very beginning we gave special attention to the areas where discretionary powers had been exploited for personal gain and sharpened the instruments that could prevent, detect or deter such practices.5 A major feature of Singapore’s success in maintaining a largely corrupt-free society is its emphasis on meritocracy and adequate remuneration thereby disincentivising corruption. This emphasis on meritocracy dates back to Singapore’s formative years, when the British colonial government established the Public Service Commission (“PSC”) in January 1951. The PSC was created with the main goal of refining and strengthening the quality of the civil service in Singapore. This it did by ensuring that recruitment and promotion of civil servants was conducted according to merit rather than patronage. Upon assuming power in 1959, the PAP government decided to continue the tradition of meritocracy by retaining the PSC to attract the “best and brightest” citizens to join the Singapore civil service by awarding scholarships to the best students in each cohort. The importance of these measures cannot be understated and have contributed monumentally to Singapore’s success in its fight to eradicate corruption completely. In fact, it has been said that corruption is an economic crime that can be curbed by “making the calculations less favourable to a bribe”.6 Singapore’s success can also be attributed to its emphasis on competitive remuneration for its public servants. In 2000, then Deputy Prime Minister Lee Kuan Yew announced a revamping of the salary structure of senior civil servants and ministers which had the effect of raising the Prime Minister’s salary to well over a million US dollars a year; he stated: Singapore will remain clean and honest only if honest, able men are willing to fight elections and assume office. They must be paid a wage commensurate with what men of their ability and integrity are earning for managing a big corporation or successful legal or other professional practice. [. . .] If we underpay men of quality as ministers, we cannot expect them to stay long in office earning a fraction of what they could outside. With high economic growth and higher earnings in the private sector, ministers’ salaries have to match their counterparts in the private sector. 5  Lee (2000), pp. 182–4. 6  Oon (2008).

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Underpaid ministers and public officials have ruined many governments in Asia. Adequate remuneration is vital for high standards of probity in political leaders and high officials.7 With political and civil service officers receiving as remuneration up to 70–80% of what their counterparts are receiving in the private sector, Singapore has embraced a very practical solution to curb the temptation of corruption whilst insisting on a consistently high level of integrity and performance. As such, Singapore’s success can be surmised into two complementary factors: competitive remuneration in Singapore which guarantees a “high enough wage to attract honest people who are very good” and “very strong enforcement [where there is] very high probability of being caught”.8 3

Key Elements of Enforcement in Singapore

The Wide Reaching and All-Encompassing Anti-Corruption Legislation 3.1.1 Definition of the Offence In Singapore, corruption is regulated primarily by the Prevention of Corruption Act (“PCA”) (Chapter 241, 1993 Revised Edition). The PCA is an extensive piece of legislation covering wide-ranging areas of corruption such as the requisite elements of a corruption offence, powers of enforcement and investigation and the penalties for a corruption offence. It applies equally to corruption in both the private and public sector. The provisions in the PCA were enacted specifically to cover the various forms and schemes in which corruption could take place in. Even where the PCA seemingly falls short, the courts have shown a clear willingness to interpret the provisions in light of the broad spirit of the Act. In one of several recent high-profile cases of public sector corruption,9 it was argued by the Defence that sexual intercourse between consenting adults in an intimate relationship cannot amount to “gratification” for the purposes of the PCA. The District Judge disagreed and was reluctant to unnecessarily limit the scope of “gratification”. Section 5 and section 6 of the PCA are the main provisions which penalise corrupt transactions and apply specifically to general corrupt transactions and corrupt transactions involving agents respectively. That the two situations 3.1

7  Lee (2000), pp. 192–193 8  Ibid. 9  Public Prosecutor v Ng Boon Gay [2013] SGDC 132.

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are classified separately to provide further clarity is typical of the PCA; a close examination will reveal it to be an incredibly detailed and all-encompassing piece of legislation. This can also be seen in the deliberately extensive scope of the offence which includes the soliciting, receiving, giving, promising or offering a bribe. Section 5 of the PCA prohibits anyone from: 1. 2.

corruptly soliciting or receiving, or agreeing to receive for himself, or for any other person; or corruptly giving, promising or offering to any person whether for the benefit of that person or of another person, any gratification as an inducement to or reward for, or otherwise on account of: i) any person doing or forbearing to do anything in respect of any matter or transaction whatsoever, actual or proposed; or ii) any member, officer or servant of a public body doing or forbearing to do anything in respect of any matter or transaction whatsoever, actual or proposed, in which such public body is concerned.

The term “agent” is defined broadly in section 2 of the PCA as “any person employed by or acting for another, and includes a trustee, administrator and executor, and a person serving the Government under any corporation”. As such, the parameters of section 6 are unequivocal and the section is confined to situations involving an agent-principal relationship whilst section 5 would be able to capture acts of corruption outside the typical agent-principal paradigm, such as the offering of money in order to escape criminal liability in an attempt to subvert the course of justice, payments made to secure a scapegoat to assume criminal responsibility and the exchange of money to obtain a confession. 3.1.2 Definition of Gratification under the PCA The PCA criminalises the corrupt giving of gratification as an inducement to do or omit to do any particular matter or transaction. The term gratification is given a wide definition under section 2 of the PCA: 1. 2. 3.

Money or any gift, loan, fee, reward, commission, valuable security or other property or interest in property of any description, whether movable or immovable. Any office, employment or contract. Any payment, release, discharge or liquidation of any loan, obligation or other liability whatsoever, whether in whole or in part.

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4. Any other service, favour or advantage of any description whatsoever, including protection from any penalty or disability incurred or ­apprehended or from any action or proceedings of a disciplinary or penal nature, whether or not already instituted, and including the exercise or the forbearance from the exercise of any right or any official power or duty. The definition of gratification for the purposes of proving a corruption offence under the PCA is drawn as broadly as possible. In fact, some of the more unorthodox gifts which the Singapore courts have deemed to fall under the definition of gratification for the purposes of the PCA include sexual intercourse,10 the provision of sexual services through a third party,11 loans12 and the presentation of exclusive opportunities.13 3.1.3 Definition of Corruption Bearing in mind the comprehensive and thorough nature of the PCA, it may come as a surprise that the term “corrupt” is defined nowhere within the act. This is especially curious given that the term “corruptly” inserted in sections 5 and 6 of the PCA serves to qualify the offence in a significant manner.14 It may well be because there can be no exhaustive definition of the term “corrupt” and both the enforcement agencies and the courts prefer to examine closely the intention of the parties in each transaction. It is evident, however, that the legislature’s reticence to apply a working definition to “corrupt” allows it to take on a more dynamic form without being constrained to a specific pre-defined understanding. The Courts have also shown a similar hesitancy to define the term “corrupt” in light of the multitude of factual permutations in which corruption can take place. In Chan Wing Seng15 the High Court proposed a valuable starting point derived from the New Shorter Dictionary (1993 Edition) which defines “corrupt” as “[to] induct to act dishonestly or unfaithfully; bribe”, and corruption as the “perversion of a person’s integrity in the performance of (especially official or public) duty or work by bribery”. The High Court, however, was quick to stress that this was

10  Ibid. 11  Ding Si Yang v Public Prosecutor [2014] SGDC 295. 12  As seen in the matter involving the former Media and Development Authority Assistant Director Lai Wai Khuen (unreported). 13  Teo Chu Ha v Public Prosecutor [2013] SGHC 179. 14  Public Prosecutor v Khoo Yong Hak [1995] SGHC 101, at [11]. 15  Chan Wing Seng v Public Prosecutor [1997] SGHC 97.

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meant to be no more than a “preliminary guide” and reemphasised the need to examine each case on its own facts. 3.1.4 The Two-Stage Test Therefore, the Singapore courts have applied a two-stage test to determine whether an offence under the PCA is established. The first test involves a largely objective assessment of whether there is a corrupt element inherent within the transaction in question. This involves an assessment of the intention of the giver or recipient of the gratification in question. This is followed by an objective assessment of whether the said intention taints the transaction with a corrupt element. The court will look at various factors surrounding the transaction including the purpose behind the giving of the gratification, any prior communication before the payment of the gratification, proximity of time between the act of the recipient and the actual giving of gratification, nature and frequency of the gratification, relationship between the parties and whether the recipient has shown or has the power to show favour to the giver of the gratification. For instance, in Chan Wing Seng,16 the appellant was charged with giving a gratification of a sum of S$3000 (about US$2400) to two jockeys, on two separate occasions, as a reward for riding his horse to win their respective races. In assessing whether there was a corrupt element behind the gift, the High Court confirmed that the Defence could cast a reasonable doubt by showing that the gratification was intended as a bona fide gift. As the gifts were given only after the races, in the form of cheques made in the appellant’s own name, and without notice beforehand, the High Court ruled in favour of the appellant and concluded that there was no corrupt element involved. In one of the most high profile cases of public sector corruption,17 the accused person was one Ng Boon Gay, the Chief of the Central Narcotics Bureau (“CNB”). Ng claimed trial to four charges under section 6(a) of the PCA for corruptly obtaining sexual gratification in the form of fellatio from one Cecilia Sue Siew Nang. The sexual gratification was said to have been obtained as an inducement for showing favour in relation to CNB’s affairs, by assisting to further the business interests of Ms Sue’s employers as a vendor for information technology products. It was argued by the Defence that sexual intercourse between consenting adults in an intimate relationship cannot amount to “gratification”. The District Court disagreed and held that:

16  Ibid. 17  Public Prosecutor v Ng Boon Gay [2013] SGDC 132, supra note 9.

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It would be erroneous to define gratification by the reason such gratification takes place [. . .] and that the relationship between the giver and receiver would only be relevant if at all for the purposes of establishing the intention behind the gratification and if there was any corrupt intent or guilty knowledge.18 Ultimately, Ng was acquitted of the criminal charges as the District Judge was satisfied that there was neither a corrupt element nor any guilty knowledge on his part. Crucially, it was held that Ng had no ulterior motive, let alone a corrupt intent and the four instances of sexual gratification were obtained in the context of an intimate relationship. The existence of an intimate relationship between Ng and Ms Sue negated the presence of any corrupt element in this instance. Another headline-grabbing case involved the former Chief of the Singapore Civil Defence Force (“SCDF”), Peter Lim.19 In June 2012, Lim was charged with corruptly obtaining sexual gratification in the form of oral sex from one Ms Angie, then the general manager of Nimrod Engineering Pte Ltd (“Nimrod”), which was a vendor to the SCDF. It was the Prosecution’s case that the sexual gratification was obtained as an inducement for showing favour in relation to his principal’s affairs, by advancing Nimrod’s business interests. The Defence, on the other hand, contended that Lim had no corrupt intent whatsoever and described the gratification as a sexual act between two consenting adults in a purely personal relationship. In assessing the status of the relationship between Lim and Ms Angie, the District Court found that their friendship was largely superficial and their interaction limited. There was no depth or substance in their relationship to support the Defence’s case that the parties shared a personal and intimate bond. Both parties knew each other’s position in their respective companies, as Ms Angie only resumed contact with Lim after a gap of almost a decade and only after he had been made a high-ranking senior in the SCDF. Lim had also been found to have breached several SCDF guidelines regarding its procurement process, thereby putting himself in a position of conflict. In the circumstances, the District Court found that Lim had failed to rebut the presumption of section 8 of the PCA and that there was sufficient evidence to show that there was a corrupt element and guilty knowledge on his part. The second test involves a more subjective assessment; that is whether the accused person himself possessed the relevant guilty knowledge that what he 18  Ibid., at [16]. 19  Public Prosecutor v Peter Benedict Lim Sin Pang [2013] SGDC 192.

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did was corrupt. This is measured, however, against a very objective standard as affirmed by the High Court in Chan Wing Seng: There can also be instances where the accused’s actions are so obviously corrupt by the ordinary and objective standard that he must know his conduct is corrupt. Clearly, an accused cannot claim that he is not corrupt if he knows that he will be regarded as corrupt by that standard.20 Pursuant to the broad and pragmatic approach in Singapore, it has also been readily accepted that there is no need for an express reference to a bribe for the transaction to be tainted with a corrupt element. In fact, the courts have readily looked beyond the face-value of any particular transaction in question: There is no necessity in law for an express request for a bribe or an express reference to a favour to be shown. Such a requirement has been held to be undesirable and unduly restrictive [. . .] the transaction has to be viewed in a broad and pragmatic perspective. The Prosecution need not prove that the receipt of money was an inducement for a specific corrupt act or favour, it being sufficient that it was given in anticipation of some future corrupt act being performed.21 The courts’ approach is best exemplified in the matter involving Professor Tey Tsun Hang,22 an associate professor employed by the National University of Singapore (“NUS”) attached to the Faculty of Law. Tey was charged with corruptly receiving six acts of gratification from one of his students at the material time, Darinne Ko Wen Hui, as an inducement for showing favour in his assessment of her academic performance. At first instance, the District Court found that there was an obvious imbalance of power between Tey and Ms. Ko in clear favour of him and that he had breached the NUS Code of Conduct requiring him to declare any conflict of interest. Tey was consequently found guilty of corruption in the District Court. Following an appeal to the High Court,23 however, Tey was acquitted of the six counts of corruption. The Singapore High Court based its decision on the basis that his former student had given him gifts and was physically intimate with him solely because she had been in love with him and not for the 20  Chan Wing Seng v Public Prosecutor [1997] SGHC 97, supra note 15. 21  Pandiyan Thanaraju Rogers v Public Prosecutor [2001] 2 SLR(R) 217, at [38]. 22  Public Prosecutor v Tey Tsun Hang [2013] SGDC 165. 23  In Tey Tsun Hang v Public Prosecutor [2014] SGHC 39.

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purpose of influencing him to give her better grades. This was based on several greeting cards where Ms Ko had expressed her love for him during the time of the gratification. The cards were contemporaneous evidence of her feelings and intentions at the time of the acts of gratification. It was further highlighted by the High Court that, evidentially, the intention of the giver of the gratification is important as it sheds light on the state of mind of the recipient. Although it was still possible for a recipient to be guilty of corruption even if the giver of the gratification had no corrupt intention, the High Court held that the offence of corruption was not made out on these facts. The High Court concluded that Ms. Ko did not have any intention to seek favour from Tey in her academic pursuits in return for the acts of gratification. The High Court agreed that he had exploited Ms. Ko and that his conduct was morally wrong, but this was not clear evidence of a corrupt intention; and the offence of corruption was not made out on the evidence. The High Court’s decision to acquit Tey of his criminal charges shows that the courts will always look at the intention behind the transaction in question instead of being hampered by any strict definition of the term “corrupt”. 3.1.5 The Pragmatic Approach of the Courts The courts have also demonstrated a very open and pragmatic approach in interpreting the legislation. In essence, the courts will not hesitate to expand the scope of the offence if a corruption crime is clearly committed. In Teo Chu Ha,24 the accused person, Teo, entered into an arrangement to incorporate a new company (“Biforst”) for the purpose of securing his principal company’s lucrative trucking contracts (“Seagate Contracts”). As Teo sat on the tender committee, he was able to directly influence the decision-making process to ensure that Biforst appeared to be the most attractive vendor. Accordingly, Biforst was duly awarded the Seagate Contracts. In exchange for a beneficial interest in Biforst, Teo provided consideration in the form of S$6000 (about US$4800) for 20000 shares and, throughout the material period, Teo received regular payouts termed as “director’s fees” which formed the bulk of his criminal charges. The case was novel in its own right given that Teo had provided consideration in exchange for ownership of the shares in Biforst. This raised questions as to whether the shares in Biforst could be construed as gratification for the purposes of the PCA. The High Court placed considerable emphasis on the fact that consideration was given and highlighted that the Prosecution had failed to adduce any evidence to suggest that the consideration paid was insufficient 24  Teo Chu Ha v Public Prosecutor [2013] SGHC 179, supra note 13.

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or that the transaction was a sham in essence. As such, the High Court concluded that the situation resembled a breach of fiduciary duties in which Teo was earning secret profits without his principal’s knowledge or consent. Accordingly, this fell short of the threshold for an offence of corruption. In May 2014, the Prosecution referred the case to the Court of Appeal to decide a question of law,25 namely whether the Prosecution was required to prove that the consideration was inadequate or that the transaction was a sham where consideration was paid for the gratification, in determining if the said transaction was objectively corrupt. The Court of Appeal came to the conclusion that the definition of “gratification” in the PCA is broad and nonexhaustive and the idea of consideration was not foreign to the PCA. It pointed out that the idea of consideration was in fact inherent in some of the examples of gratification found in section 2 of the PCA. Furthermore, the Court of Appeal highlighted that when determining if an offence under the PCA has been committed, it would not hesitate to look at the substance of the entire scheme and its context rather than only at the individual transactions which make up the scheme. As such, the Court of Appeal concluded that requiring the Prosecution to prove that the share transaction was a sham or that inadequate consideration was paid would be contrary to the policy of the PCA which seeks to prevent corruption in its various forms and schemes. The decision of the Court of Appeal in Teo Chu Ha marks a welcome development in Singapore jurisprudence and legislative interpretation. In looking beyond the actual transaction of the shares and assessing the substance and context of the scheme in question, the Court of Appeal addressed the pressing need for the law to remain relevant and up-to-date with more modern and sophisticated forms of corruption, in accordance with the spirit and purpose of the PCA. A similar question of law on the issue of corruption in the form of secret profits arose in the matter involving one Leng Kah Poh,26 the former Food and Beverage Manager at IKEA Singapore. With the help of another, one Gary Lim, Leng came up with the idea of becoming the exclusive food suppliers to IKEA, leveraging on the insider’s knowledge and influence. Gary then approached one Andrew Tee to register two companies, AT35 and Food Royale Trading (“FRT”), in his name. Leng’s role in this arrangement was straightforward: he would give AT35 insider tips on how to make AT35’s and FRT’s products attractive to IKEA Singapore and he would exercise his influence to approve

25  Public Prosecutor v Teo Chu Ha [2014] SGCA 45. 26  Public Prosecutor v Leng Kah Poh [2013] SGDC 123.

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AT35 and FRT as the exclusive food suppliers to IKEA Singapore. AT35 and FRT became the exclusive suppliers of chicken wings and dried food products to IKEA at a highly profitable mark-up. Over a period of seven years, the three made a profit of S$6.9 million (about US$5.5 million) from the food supply contracts. Leng was eventually charged with 80 counts of corruption under s. 6 of the Prevention of Corruption Act. Despite being convicted of the corruption charges in the District Court, this was overturned in the High court. The High Court disagreed with the conviction and concluded that the elements of corruption were not satisfied. The High Court Judge likened the immediate situation to that of a breach of fiduciary duties by a servant. The court noted that broadening the scope of the offence of corruption to include cases such as these would mean that every time an employee or director gained secret profits by virtue of a conflict of interest, he would have committed an offence under the PCA. In May 2014, the Prosecution referred the case to the Court of Appeal to determine legal questions of public interest. Deputy Public Prosecutor Tan Ken Hwee argued that the High Court’s reasoning meant that a person who actively sought gratification, such as a traffic policeman asking for a bribe to overlook an offence, would never be guilty of corruption. Accordingly, he argued that the lack of an inducement should not necessarily indicate the absence of a corrupt element. At the time of writing, the Court of Appeal has yet to respond and the case is ongoing. 3.2 The Dichotomy of Private Sector and Public Sector Corruption Singapore’s approach towards corruption applies entirely across the board which means that no exceptions are made whether it is petty corruption or high level corruption. It is evident, however, that public sector corruption is dealt with more harshly by the law than cases of corruption in the private sector. As with any criminal proceedings under Singapore law, the prosecution has the burden of proof to establish an offence of corruption. Under section 8 of the PCA, however, there is a presumption of corruption against the offender if it is proved that gratification has been paid to or received by a government official or any person in the employment of a public body. When triggered, the requisite elements of the offence of corruption will be presumed to have been proven and the burden of proof to rebut the presumption lies with the offender. What this means is that a public officer charged in court has the duty to explain to the court that what he or she received was not received corruptly. If he or she fails to explain to the satisfaction of the court, he or she will be presumed to have received the money corruptly.

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This distinction between public and private sector corruption evidently sends out a stronger message of deterrence to individuals employed in public and official bodies as they are almost automatically guaranteed a more onerous burden under the PCA. In Tey Tsun Hang,27 the District Court held that the National University of Singapore was a public body under section 8 of the PCA. As such, the rebuttable presumption in section 8 of the PCA was triggered as the giver of the gift was at the material time a student of the university. A further example of public sector corruption being dealt with more harshly is seen in the prescribed punishments for corruption in the Act. Under the PCA, the penalty for violating section 5 or 6 of the PCA is a fine not exceeding S$100000 (about US$80000) or a term of imprisonment not exceeding five years; or both a fine and imprisonment term. Whilst the PCA does not explicitly restrict this provision to cases of private sector corruption, section 7 of the PCA states that where the matter or transaction in question was a contract or a proposal for a contract with the Government or any department thereof or with any public body, the offender is liable to an increased maximum term of imprisonment of seven years instead of five. In certain cases, however, private sector corruption may be deemed just as serious as public sector corruption and dealt with just as harshly. The “public service rationale” is extended to corruption offences occurring in the private sector where the breach in question impacts a public service or results in the loss of confidence in Singapore’s public administration. This has been extended to cover such industries as the bunkering28 and banking and finance29 industries. In Lim Teck Chye, the then Chief Justice Yong Pung How stated: It cannot, however, be said that only corruption offences committed by public servants or officers of public bodies run afoul of the public service rationale. Corruption offences committed in the private sector may do so as well, although there is no similar presumption that they do. Private corporations today provide many public service functions; the direct and indirect impact that these private sector organisations have on the lives of our citizens as well as the smooth running and administration of this country can be palpable. An example where a private sector organisation can have a direct impact on such matters is where it is awarded the tender for a government contract for the provision of public services and/or utilities. The impact of corruption offences on the public service ­rationale, as 27  Public Prosecutor v Tey Tsun Hang [2013] SGDC 165, supra note 22. 28  Lim Teck Chye v Public Prosecutor [2004] 2 SLR(R) 525. 29  Wong Teck Long v Public Prosecutor [2005] 3 SLR(R) 488.

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articulated in Chua Tiong Tiong v PP, may therefore be similarly applied to include instances where it is directly or indirectly infringed by private sector organisations.30 In such cases, the Court will generally take a stricter approach in the imposition of a sentence and will usually find that the custody threshold is breached. Although triggering the public service rationale is one way in which a private sector offender may be subject to a custodial sentence, it is not the only way. Any sentence imposed would necessarily entail an assessment of the applicable policy considerations, the gravity of the offence in question and the surrounding circumstances in which it occurred. 3.3 The Extra-Territorial Effect of the PCA One essential feature of the PCA is that it is one of the few pieces of legislation that has extra-territorial effect and applies to offences committed both within and outside Singapore by Singaporeans. Section 37 of the PCA reads: The provisions of this Act have effect, in relation to citizens of Singapore, outside as well as within Singapore; and where an offence under this Act is committed by a citizen of Singapore in any place outside Singapore, he may be dealt with in respect of that offence as if it had been committed within Singapore. This ensures that Singaporeans doing business overseas are still caught in its ambit and may be prosecuted accordingly. As such, the bribery of a foreign public official by a Singapore citizen outside Singapore would fall within the reach of the PCA even though it does not expressly prohibit the bribery of foreign officials. The Court of Appeal has confirmed the legitimacy of this feature and justified the citizenship-based differentiation on the basis of international comity and the sovereignty of other nations.31 This notion of extra-territorial jurisdiction is not a novel one, however, and is employed similarly under both US and UK anti-corruption law. In fact, both UK and US legislation allows for an even greater extra-territorial reach by extending the scope to include companies operating outside jurisdiction. The UK Bribery Act 2010 has extra-territorial jurisdiction to prosecute bribery committed abroad by UK corporations and persons who have a “close connection” with

30  Lim Teck Chye v Public Prosecutor [2004] 2 SLR(R) 525, supra note 28. 31  Public Prosecutor v Taw Cheng Kong [1998] 2 SLR 410, at [64]–[75].

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the UK.32 Likewise, the US Foreign Corrupt Practices Act makes it illegal for any US entity to engage in foreign corrupt practices.33 This applies equally to US companies, foreign corporations trading securities in the US, US nationals, citizens, and residents acting in furtherance of a foreign corrupt practice whether or not they are physically present in the United States. As it stands, Singapore has yet to extend the scope of the PCA to companies operating outside Singapore. 3.4 The Disgorgement of Criminal Benefits Notwithstanding the retributive and deterrent based considerations hardwired into the prescribed penalties of the act, the PCA also ensures that an offender is precluded from enjoying the benefits of any monetary gratification received. Under section 13(1) of the PCA, the offender will be made to pay an additional penalty amounting to the sum of the gratification received, which penalty shall be recoverable as a fine. Section 13(2) of the PCA allows the court to increase the penalty that is to be paid by the offender where he is charged with two or more offences and the outstanding offences are taken into consideration for the purpose of sentencing. In Lai Wai Khuen,34 the accused person was a former assistant director with the Media Development Authority (“MDA”) in Singapore. In return for facilitating the approval and disbursement of MDA grants, Lai had been corruptly obtaining loans from applicants. These loans were used to finance his substantial debts which he had accumulated from his frequent gambling on board cruise ships and in casinos. The authorities were tipped off when one of the persons whom he tried to borrow money from had turned down his request for a loan of S$3000 (about US$2400) and made a complaint to MDA. The accused person pleaded guilty to six charges of corruption in his capacity as public official, for obtaining loans of between S$1500 (about US$1,200) and S$5000 (about US$4000). Lai was sentenced to 14 months’ imprisonment and ordered to pay a penalty of S$18000 (about US$14400) in respect of the total bribe money in the charges amounting to S$18800 (about US$15000). The District Judge took into account the fact that Lai had paid back S$500 (about US$400) and S$300 (about US$240) to two persons. The primary object of section 13 of the PCA is to preclude corrupt wrongdoers from benefitting from the fruits of their criminal conduct. As this 32  Section 13 of the UK Bribery Act 2010. 33  Ibid., §78dd-1(a). 34  Media and Development Authority Assistant Director Lai Wai Khuen (unreported), supra note 12.

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provision is not meant to be additional punishment on the offender, where the gratification has been surrendered or seized by the authorities, the offender is no longer accountable for it. Section 13 of the PCA is supplemented by the Corruption, Drug Trafficking and Other Serious Crimes (Confiscation of Benefits) Act, Chapter 65A which allows the court to confiscate properties from offenders who are convicted of corruption offences, if the said properties are found to be benefits of corruption offences. Furthermore, in a principalagent type scenario where the agent’s corrupt conducts resulted in monetary loss to the principal, the PCA provides the principal with redress in the form of civil debt recovery. As such, a principal may recover as a civil debt the value of any monetary gratification from either the agent or the person who gave gratification to the agent. 3.5 The Powers of Enforcement 3.5.1 The Main Body Charged with Corruption Enforcement In Singapore, the Corrupt Practices Investigation Bureau (“CPIB”) is the main government enforcement body charged with investigating corruption. The CPIB consists of three primary departments; namely the Operations Department, the Corporate Affairs Department and the Investigation Department. As one of its primary aims is to prevent and purge corruption at all levels of government, it is accountable directly and only to the Prime Minister’s office. This should be contrasted with the Singapore Police Force which is under the direction of the Ministry of Home Affairs. The Operations Department plays a significant supporting role; it maintains the Intelligence Division which gathers and collates intelligence to support the investigation needs of the Investigation Department. It also entails several branches which further support investigative efforts including the Computer Forensic Branch and the Polygraph Branch. The Corporate Affairs Department entails several key divisions that deal with the internal and administrative matters such as the review and implementation of human resource strategies, day-to-day operations, the incorporation of IT technology into operations and the handling of financial, procurement and assets matters of the CPIB. Finally, the Investigations Department executes the main investigative functions under the PCA. It comprises two separate divisions focusing respectively on public sector and private sector corruption. Despite being a government investigation body on its own, the Public Prosecutor’s consent must be obtained following all investigations of corruption before an individual can be prosecuted. The Attorney-General’s Chamber itself has a review system in place and no decision is made by a single individual, thus weeding out any possibility of bias or corruption within.

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Beyond its general duties of enforcement, the CPIB also collaborates with various government agencies and departments to increase public officials’ awareness of corruption-related issues and to conduct procedural reviews. Additionally, it also works in tandem with the Ministry of Education to educate students from tertiary institutions on the dangers of corruption and the importance of strict enforcement, reinforcing the core value that prevention is better than cure. In light of the stellar job performed by the CPIB in detecting and overcoming corruption offences in Singapore, it was recently announced that the CPIB’s manpower would be boosted by more than 20 per cent. It is said that this would assist the CPIB to better deal with increasingly complex and cross-border cases of corruption.35 3.5.2 The Powers of the CPIB The police powers provided for in the POCO are a far cry from the wide-ranging powers granted to the CPIB in the enforcement of corruption in Singapore. Under section 15 of the PCA, any investigator of the CPIB may arrest without a warrant any person who has been concerned in any offence under the PCA or against whom a reasonable complaint or suspicion has been made or credible information has been received. Sections 18, 20 and 21 allow for the inspection of bank accounts, share accounts, purchase accounts, banker’s books, properties and income tax under prescribed conditions. Section 22 grants both police officers and CPIB investigators access to any suspected area and search, seize and detain incriminating documents under a warrant issued by the CPIB’s Director. Moreover, section 22(2) states that if the said CPIB investigator or police officer has reasonable grounds to believe that any delay in obtaining a search warrant would likely frustrate the object of the search; he may exercise all the powers as though he were empowered to do so by a warrant issued. Section 24, which is said to be perhaps CPIB’s most useful asset,36 states that if “the fact that an accused person is in possession, for which he cannot satisfactorily account, of pecuniary resources or property disproportionate to his known sources of income” is evidence that he or she had obtained the said resources or property “corruptly as an inducement or reward”. In Taw Cheng Kong,37 the High Court was made to consider the admissibility of certain CPIB statements and, in doing so, provided insight on the extent of the powers granted under the PCA. The statements in question were obtained 35  straitstimes.com (2015). 36  Quah, supra note 3. 37  Public Prosecutor v Taw Cheng Kong [1998] 2 SLR 410, supra note 31.

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pursuant to section 27 of the PCA, which states that “every person required by the Director or any officer to give any information on any subject which it is the duty of the Director or that officer to inquire into under this Act and which it is in his power to give, shall be legally bound to give that information”. In drawing a distinction between the PCA and the Penal Code, the High Court held that where a suspect was being interviewed under section 27 of the PCA, the suspect would not be entitled to refuse answering incriminating questions. Where a suspect was accused of a non-corruption offence and being interviewed pursuant to the Penal Code, the suspect’s privilege against self-incrimination would remain intact. The High Court further stated that under the Penal Code, the suspect must be informed of his privilege against self-incrimination when telling him that he is legally bound to tell the truth, whereas under section 27 of the PCA the suspect simply needs to be shown a copy of section 27 and “nothing more”.38 In the circumstances, the High Court concluded that the CPIB statements were entirely admissible. The decision of the High Court is the clearest indication that the offence of corruption is deemed to be far more damning to the interests of Singapore than typical Penal Code offences and, as such, corruption enforcement in Singapore enjoys a separate legal status which grants it far more extensive and pervasive powers under the PCA than those found in the Penal Code. The sheer extent of the CPIB’s powers is visibly demonstrated in the recent high-profile corruption case of Ding Si Yang.39 The accused person, Ding, was charged with allegedly bribing soccer officials who had come down to Singapore to officiate a match at the Asian Football Confederation Cup by providing them with sexual services. Expectedly, the CPIB launched a fullblown investigation into Ding’s affairs and finances, leaving no stone unturned in the process. Despite there being no allegation of any monetary exchange in that case, the CPIB proceeded to seize several of Ding’s bank accounts, cars and even real estate to conduct a thorough investigation of his financial affairs. Ding was eventually convicted of three (3) counts of corruption and sentenced to three (3) years’ imprisonment. Upon appeal by the Prosecution, the High Court enhanced his sentence to five (5) years’ imprisonment.40 3.5.3 The Balancing Approach of the Judiciary Naturally, the twin-elements of corruption would be easier satisfied in the face of blatant contravention of rules, laws or prescribed codes of conduct. 38  Ibid., at [152]. 39  Ding Si Yang v Public Prosecutor [2014] SGDC 295, supra note 11. 40  Ding Si Yang v Public Prosecutor and another appeal [2015] SGHC 8.

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The courts have been quick to stress, however, that not every act of conflict of interest or breach of fiduciary duty permits the inference of corruption.41 Despite applying a considerably extensive ambit to the offence of corruption, the courts ought to be commended for their efforts in not simply applying a broad-brush approach and equating every contravention of rules with a corrupt intent. In Khoo Yong Hak,42 the accused person, Khoo, faced ten charges of corruptly giving gratification to one driver as inducements to bring more foreign workers to his medical centre for their pre-employment medical examination. It was not disputed that Khoo’s conduct was in breach of an ethical code of conduct issued internally by the Singapore Medical Association which may warrant disciplinary action. The High Court made it clear, however, that this did not make the arrangement corrupt per se. Then-Chief Justice Yong Pung How’s decision was heavily influenced by the fact that Khoo had not sought to persuade the driver to act contrary to the driver’s obligations to his clients; accordingly the driver had not acted improperly at any point of time. Moreover, Khoo never made an attempt to hide the payments and the driver was made to sign a voucher upon each payment. The High Court therefore found that there was no corrupt intent on Khoo’s part and the arrangement was a legitimate and mutually beneficial business transaction between Khoo and the driver. Accordingly, Khoo was acquitted of all criminal charges. The High Court has also made it clear that even where the gratification was given for an illegal purpose, this too would not make it corrupt per se. A line must be drawn between a reward for doing something merely illegal, and a reward for doing something which is not just illegal but is in itself corrupt.43 In light of Singapore’s uncompromising attitude and rigorous crackdown of corruption, the judicial system must be lauded for its continued efforts to protect a clear delineation of corruption, thereby preventing the obfuscation of offences and ensuring that suspects are not overly prejudiced by the ruthlessness of Singapore’s anti-corruption laws. 3.6 Other Legislative Provisions 3.6.1 The Penal Code Provisions In addition to section 5 and 6 of the PCA, the Penal Code (Chapter 224) also makes up the legal framework regulating corruption in Singapore. The Penal Code in particular creates specific offences related to corrupt conduct 41  Chan Wing Seng v Public Prosecutor [1997] SGHC 97, supra note 15, at [21]. 42  Public Prosecutor v Khoo Yong Hak [1995] SGHC 101, supra note 14. 43  Chan Wing Seng v Public Prosecutor [1997] SGHC 97, supra note 15, at [21].

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i­ nvolving public servants in Singapore. Under section 21 of the Penal Code, the term “public servant” is given a vast definition which includes judges, arbitrators, government officers and prison directors. Section 161 of the Penal Code makes it an offence for a public servant to take a gratification, other than legal remuneration, in respect of an official act. Section 162 of the Penal Code makes it an offence for a person to take a gratification in order, by corrupt or illegal means, to influence a public servant. Section 163 of the Penal Code makes it an offence for a person to take gratification for the exercise of personal influence with a public servant. This yet again exemplifies Singapore’s unflinching stance against corruption, and in particular, its unforgiving attitude towards corruption offences committed by public servants and officials. 3.6.2 The Criminal Law (Temporary Provisions) Act With the globalisation of soccer and the myriad of illegal betting markets in Asia, corruption has gradually developed into a devastating cross-border phenomenon which has seen match-fixing in areas as far as Eastern Europe, Africa and the Middle East. This continues to present a monumental challenge on both global and national corruption enforcement agencies and organisations and Singapore is not exempt from this. In recent years, the problem of cross-border corruption has seen Singaporean enforcement resort to the most controversial powers available to the government. Under the Criminal Law (Temporary Provisions) (Amendment) (“CLTPA”), the government is empowered to detain suspected criminals without trial for up to a year in the interests of “public safety, peace and good order”. Given their pervasive and draconian nature, these detention orders were traditionally used only as a last resort in cases where accomplices and witnessed dared not to testify against criminals in court, for fear of reprisal. In fact, the CLTPA detention orders have been typically restricted to cases involving serious crimes such as secret society activities, drug trafficking, and unlicensed money-lending. In light of the draconian nature of the detention orders and the considerable hardship it stands to cause to detainees, the legislature enacted a number of procedural safeguards which are incorporated into the Act. At the offset, any proposed case undergoes close scrutiny by senior officials from the Ministry of Home Affairs. Further, the Public Prosecutor’s consent is required before the detention order can be issued. Additionally, the cases are reviewed by independent advisory committees comprising of former Justices of the Peace, judges and senior lawyers. Detainees, also, are given the opportunity to present their case to the advisory committees and be represented by legal counsel.

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Most importantly, the Minister of Home Affairs must obtain Parliamentary approval every five years to extend the CLTPA. In doing so, the Minister is made to account to members of parliament for the CLTPA’s continuing need amid the prevailing circumstances. It should be noted that the CLTPA has been extended 13 times since it was enacted in 1955. This reluctant acceptance of the CLTPA’s necessity is summarised by Member of Parliament Sylvia Lim: I look forward to the day when this Act can be thrown away. However, I am sad to note that the day has apparently not yet come. Several crime concerns loom. We have two casinos here, still in early stages of o­ peration which can become controlled by organised criminals if not policed well. I am also not oblivious to the recent experience of our neighbours across the Causeway. There, public safety and security deteriorated this year with deadly gun violence by organised criminals which appeared to have been linked to the release of persons in preventive detention when the detention law was abolished two years ago. Last month, to restore order, the Malaysian Government has re-introduced detention of criminals without trial under amendments to its Prevention of Crimes Act. In Singapore, we should be concerned not to have spill-over events. Looking at the crime risk currently, I am unable to oppose the extension of the Act for another five years.44 In October 2013, the government, for the very first time, exercised its discretion to employ the detention orders in relation to a case of cross-border corruption. In exercising its discretion to detain several persons suspected of being involved in a global match-fixing syndicate operating in Europe and other countries, it was highlighted that where cross-border illegal activities are involved, the difficulties of securing evidence and witnesses willing to co-operate and testify against the syndicate in open court are amplified.45 Amongst the suspects detained under the CLTPA was one Dan Tan Seet Eng. Dan was alleged to be the mastermind of the syndicate and had been the focus of global speculation since February 2013, when anti-crime agency Europe released details of its long-running match-fixing probe. It claimed to have uncovered 680 suspicious football matches across the world, including World Cup and European Championship qualifiers and two Champion League games.46 44  wp.sg (2013). 45  parliament.gov.sg (2013). 46  BBC.com (2013).

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This was only recently contested in the matter involving Dan Tan where it was argued that cases involving match-fixing offences should not be within the scope of the detention powers, especially since the Act mandates that the powers must be used in the interest of public safety and ought therefore to be restricted to crimes that offend those very interests. Having been detained since October 2013, Dan Tan’s detention order has since been extended to October 2015 ahead of his scheduled release in October 2014. 4 Conclusion Notwithstanding the clandestine nature of corruption and the inherent difficulties in the detection and eventual proving of a corruption offence, Singapore has enjoyed considerable success in its strict enforcement of the offence. Naturally, the shortfalls in effective detection and enforcement are supplemented by certain attributes of human nature: recipients of gifts invariably flaunt their wealth and possessions; they indulge in taking corrupt gifts. When questioned, these individuals are often unable to explain their sudden windfall. Moreover, people are naturally envious of others, so that they are inclined to come forwards to file complaints and routine checks by the authorities on the person complained of can provide telling leads.47 At a recent conference organised by CPIB and the Civil Service College on maintaining integrity in the public sector, Prime Minister Lee Hsien Loong commended the Singaporean public’s role in uncovering corruption. To further encourage public engagement, Mr Lee announced the Government’s plans to open a “One-Stop Corruption Reporting Centre” which would allow citizens to make complaints more discreetly and in a more accessible manner.48 It is also remarked that the regionalisation of business implies that Singaporeans doing business overseas are increasingly faced with the prospect of having to conform to foreign practices in order to remain “competitive”. Notably, what may be regarded as corruption in Singapore may be a way of life or standard business practice elsewhere.49 It is reassuring to see, however, that Singapore has shown its willingness to interpret and apply the law in a pragmatic and non-restrictive manner thereby ensuring that it is able to adapt to modern business and commercial realities.

47  Fong (1995). 48  pmo.gov.sg (2015). 49  Ibid.

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Although Singapore prides itself as a society that possesses a government which is clean and incorruptible, the several recent cases of high-profile corruption reinforces the need to remain vigilant and steadfast in the crackdown of corruption and serves as a timely reminder that there is no room for complacency in this battle. References Bibliography

app.cpib.gov.sg (2012) “Speech by Prime Minister Lee Hsien Loong at CPIB’s 60th Anniversary Celebrations,” http://app.cpib.gov.sg/data/website/doc/Manage Page/247/SPEECH%20BY%20PRIME%20MINISTER%20LEE%20HSIEN%20 LOONG%20AT%20CPIB_pdf.pdf (accessed 29 April 2015). BBC.com (2013) “Can Singapore Tackle its Match-fixing Stain?,” http://www.bbc.com/ news/world-asia-24340863 (accessed 29 April 2015). Fong, Phillip (1995) “Gift Giving in Business: Legal and Evidential Issues.” 8 Asia Business Law Review 42–49. Lee, Kuan Yew (2000) From Third World to First, the Singapore Story: 1965–2000, Times Media, Singapore. Oon, Clarissa (2008) “Tough Law Enforcement Critical in Fighting Graft, Says Expert,” Straits Times, 28 March. parliament.gov.sg (2013) “Speech on Detention of Global Soccer Match-fixing Suspects by Deputy Prime Minister Teo Chee Hean, Delivered in Parliament on 21 October 2013,” http://sprs.parl.gov.sg/search/topic.jsp?currentTopicID=00005128WA¤tPubID=00005228-WA&topicKey=00005228-WA.00005128WA_1%2BhansardContent43a675dd-5000-42da-9fd5-40978d79310f%2B (accessed 29 April 2015). pmo.gv.sg (2015) “Transcript of speech by Prime Minister Lee Hsien Loong at ‘Integrity in Action’ Public Service Values Conference on 13 January 2015,” http://www.pmo .gov.sg/mediacentre/transcript-speech-prime-minister-lee-hsien-loong-integrityaction-public-service-values (accessed 29 April 2015). Quah, Jon (2013) “Curbing Corruption in Singapore: The Importance of Political Will, Expertise, Enforcement, and Context,” in J. Quah, ed., Different Paths to Curbing Corruption, Singapore: Emerald, 137–66. straitstimes.com (2015) “Singapore Steps up Efforts to stay Free of Corruption,” http:// www.straitstimes.com/news/singapore/courts-crime/story/singapore-stepsefforts-stay-free-corruption-20150114 (accessed 29 April 2015). transparency.org (2013) “Corruption Perceptions Index 2013,” http://cpi.transparency .org/cpi2013/results (accessed 29 April 2015).

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wp.sg (2013) “Speech on Criminal Law (Temporary Provisions) Act by M. P. Sylvia Lim, delivered in Parliament on 11 November 2013,” http://wp.sg/2013/11/speech-on-crim inal-law-temporary-provisions-act-mp-sylvia-lim/ (accessed 29 April 2015).

Cases

Public Prosecutor v Ng Boon Gay [2013] SGDC 132. Ding Si Yang v Public Prosecutor [2014] SGDC 295. Teo Chu Ha v Public Prosecutor [2013] SGHC 179, at 42–49. Public Prosecutor v Khoo Yong Hak [1995] SGHC 101. Chan Wing Seng v Public Prosecutor [1997] SGHC 97. Public Prosecutor v Peter Benedict Lim Sin Pang [2013] SGDC 192. Pandiyan Thanaraju Rogers v Public Prosecutor [2001] 2 SLR(R) 217. Public Prosecutor v Tey Tsun Hang [2013] SGDC 165. Tey Tsun Hang v Public Prosecutor [2014] SGHC 39. Public Prosecutor v Teo Chu Ha [2014] SGCA 45. Public Prosecutor v Leng Kah Poh [2013] SGDC 123. Public Prosecutor v Lim Teck Chye [2004] SGDC 14. Wong Teck Long v Public Prosecutor [2005] 3 SLR(R) 488. Public Prosecutor v Taw Cheng Kong [1998] 2 SLR 410. Ding Si Yang v Public Prosecutor and Another Appeal [2015] SGHC 8.

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Chapter 15

Cracking the Whip on Financial Crimes in Singapore Hamidul Haq Abstract This paper outlines the roles of the relevant authorities in dealing with financial crimes in Singapore. It should be noted that Singapore has historically had a low rate of corruption in her public sector, which stands as a strong contrast against the high levels of corruption in her neighbouring South East Asian countries. It is argued that the Singapore government makes a point of ensuring that its employees are well remunerated and, therefore, are less prone to corruption. By examining developments in the law relating to a spate of high-profile cases of corruption, fraud and money-laundering in recent times, this paper also investigates the depth of the powers made available to the relevant authorities. The circumstances under which the most invasive of measures are taken against suspects of financial crimes will also be described. Although these enforcement methods are largely still in their infancy, they have proven to act as an effective deterrent. A closer inspection, however, is absolutely necessary to mitigate the perceived stark imbalance of power that the authorities’ possess and to ensure suspected offenders are not prejudiced even before conviction.

Keywords financial crimes – Singapore – legislation – enforcement

1

Overview of the Context of Financial Crimes in Singapore

Financial crime is a significant global threat with far-reaching consequences affecting both victims and the integrity of financial markets. In 2013, Singapore

* Equity Partner, Rajah & Tann LLP of Singapore. Contact: [email protected].

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saw a 10.6% increase of commercial crimes,1 whilst the Commercial Affairs Department (“CAD”) received 22417 suspicious transaction reports, a 25% increase from the previous year. In the same year, Singapore recorded its highest ever number of money laundering prosecutions and convictions involving the seizure of more than S$115 million (about US$92 million) of suspected criminal proceeds.2 The rising trend may be attributed to two main factors. Firstly, Singapore’s position as a leading commercial and financial hub exposes it to a high level of cross-border money laundering and terrorist financing risks. Secondly, advancements in information and payment technologies create potential loopholes for perpetrators to escape detection.3 Nonetheless, Singapore has been consistently ranked amongst the least corrupt countries in the world by independent agencies, ranking the fifth of 176 countries in the Corruption Perception Index Scores in 2013, and is recognised as the least corrupt country in Asia.4 Recent developments in Singapore law have demonstrated how cases are becoming increasingly complex and sophisticated. Singapore’s extensive enforcement procedures, however, remain to be successful in tackling these crimes. 2

Overview of Financial Crimes in Singapore

2.1 Overview of Corruption Law in Singapore The Prevention of Corruption Act (“PCA”) is the primary legislation in Singapore that criminalises both the giving and receiving of corrupt gratification. It was drafted to be deliberately wide to cover the multitude of situations in which an offence of corruption may occur. Additionally, it applies equally to both public sector and private sector corruption. The PCA complements perfectly Singapore’s political will to combat corruption and helps enforce the public perception of corruption as a “high risk, low reward activity”.5 The government’s commitment to its policy of zero tolerance on corruption is also reflected in its unwavering response to recent high-profile corruption scandals. Prime Minister Lee Hsien Loong contended that the investigation of recent high-profile corruption cases reflects Singapore’s 1  spf.gov.sg (2013). 2  sbr.com.sg (2014). 3  mas.gov.sg (2014). 4  transparency.org (2013). 5  Quah (2013b), p. 137.

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determination to clamp down on corruption and wrongdoing even when it is “awkward or embarrassing for the government”.6 2.2 Overview of Anti-Money Laundering Law in Singapore Money laundering is the process by which criminals pass monies representing the proceeds of criminal activity through the financial system to disguise their criminal origin so that they appear to have originated from a legitimate source. Singapore has established a stern and robust anti-money laundering (“AML”) and counter-financing of terrorism (“CFT”) regime through legal and regulatory means. Singapore’s broad and comprehensive AML and CFT regime is contained in several key statutes and regulations, including: 1.

Corruption, Drug Trafficking and Other Serious Crimes (Confiscation of Benefits) Act (“CDSA”)); 2. Notes and Guidance issued by the Monetary Authority of Singapore (“MAS”); 3. Terrorism (Suppression of Financing) Act 2002; 4. United Nations Act (Chapter 339, 2002 Revised Edition); 5. The United Nations (Anti-terrorism Measures) Regulations; Money­ lenders (Prevention of Money Laundering and Financing of Terrorism) rules 2007; 6. Casino Control (Prevention of Money Laundering and Terrorism Financing) Regulation 2009.

Other factors that have moulded Singapore’s AML and CFT policies and regulations include the FATF’s 40 recommendations on money laundering and nine special recommendations on terrorist financing as well as the Statement of Principles proposed by the Basel Committee on Banking Supervision and Supervising Practices in December 1988. The CDSA is the primary legislation enacted to combat money laundering in Singapore. The money-laundering offences are found in sections 43 (assisting another to retain benefits of drug trafficking), 44 (assisting another to retain benefits from criminal conduct), 46 (acquiring, possessing, using and concealing or transferring benefits of drug trafficking) and 47 (acquiring, possessing, using, concealing or transferring benefits of criminal conduct) of the CDSA. Apart from sections 43–47 of the CDSA, one must also be careful not to commit the offence of tipping off another person which effect is likely to prejudice the investigation under section 48 of the CDSA. 6  app.cpib.gov.sg (2012).

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2.2.1 Case Studies on Anti-Money Laundering In Jeanette Ang,7 it was held that in order to make out an offence of retaining benefits from criminal conduct, the prosecution is required to demonstrate as part of the actus reus of the offence that the monies in question are indeed “benefits of criminal conduct”. The prosecution, however, only needs to adduce some evidence linking the monies in question with an act that might constitute an offence listed in the Second Schedule to the CDSA. As this is largely fact dependent, circumstances could also arise where the only logical inference to any reasonable person was that the monies involved were the benefits of criminal conduct. The individual in question must have “reasonable grounds to believe” that the monies in question were the benefits of criminal conduct. The High Court stated that having “reason to believe” essentially involved a “lesser degree of conviction than certainty but a higher one than speculation”. As such, it can be surmised that the test is both subjective and objective in nature. Singapore’s strict stance against money laundering was also demonstrated in the case as Ang’s appeals against conviction and sentence were dismissed by the High Court. It was observed that Ang had actively facilitated the retention of more than S$2 million on various occasions and this was not an inconsequential amount by any measure. The High Court also stated that money-laundering was an offence that merited a deterrent sentence and it would not have been averse to enhancing the original sentence of nine months’ imprisonment had the Prosecution appealed against it. In Public Prosecutor v Sek Leong Seng,8 the accused person, Sek, received an email from a stranger claiming to be a London barrister and acting for the Governor of Bayelsa State in Nigeria. The stranger sought Sek’s assistance in transferring US$22.5 million to an offshore account in exchange for a share of the money. Sek agreed to open an account in exchange for 50% of the said sum of money. Upon receipt of €4870 (about US$6200), his account was frozen for suspected money laundering. He pleaded guilty to assisting the retention of criminal benefits under section 44(1)(a) of the CDSA and was sentenced to four months’ imprisonment. In Goh Teck Meng,9 the accused person, Goh, made the deliberate decision to assist an accomplice in receiving illegal monies by opening a bank account. There were several notable aggravating factors present which the court made reference to; in particular, Goh was an active and knowing participant in 7  Public Prosecutor v Jeanette Ang [2010] SGDC 232. 8  Public Prosecutor v Sek Leong Seng [2010] SGDC 356. 9  Public Prosecutor v Goh Teck Meng [2009] SGDC 495.

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the scheme. His actions were premeditated and entailed the recruitment of other people to assist him in his scheme. Due to the magnitude of the offence, there were also multiple victims. In light of the numerous aggravating factors and the reality that money-laundering offences are difficult to detect and tackle, the District Judge was of the view that a deterrent sentence was necessary and sentenced Goh to 30 months’ imprisonment on each of his charges to run consecutively. This amounted to a total sentence of 60 months’ imprisonment. 2.3 Overview of the Law on Fraud Related Crimes in Singapore Although there is no specific offence of fraud under Singapore law, the Penal Code creates several fraud-related offences, such as criminal breach of trust, cheating and the falsification of accounts. Criminal breach of trust (“CBT”) applies when a person who is either entrusted with assets or manages assets, uses these assets for purposes not covered by the entrustment. Cheating applies when a person is deceived or tricked into doing something or not doing something that in both cases is likely to lead to harm. Falsification of Accounts applies when there is willful falsification of any documents or electronic records with intent to defraud. 2.3.1 Criminal Breach of Trust (“CBT”) The relevant provisions relating to this offence are set out under sections 405 to 409 of the Penal Code. Section 405 prohibits the dishonest misappropriation of property in violation of any direction of law or purpose for which he was entrusted with the property. The key element of a section 405 offence is the pre-condition that the accused was entrusted with property or with dominion over property, as this sets the offence apart from the offence of theft. The subsequent physical action done dishonestly can take several forms including the misappropriation, conversion, use or disposal of the said property. In cases of CBT offences, the bulk of convictions result in the imprisonment of the offender. In Tan Cheng Yew10 and another appeal, the accused person was convicted after trial of (amongst other offences) two charges of CBT under section 409 of the Penal Code, which involved sums of S$1.5 million (about US$1.2 million) and S$1940724.97 (about US$1.55 million) respectively. The charges related to the payment of money by clients to the accused as a practicing advocate and solicitor which he then misappropriated for his own use. On appeal, the High Court enhanced his sentence to 6 years’ imprisonment per charge, on account of the level of pre-meditation and planning that went into the offences as well as the need for general deterrence. 10  Public Prosecutor v Tan Cheng Yew [2011] SGDC 268.

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Singapore has recently witnessed its most high-profile case of CBT involving core management members of the City Harvest Church (“CHC”), one of the biggest and most prominent megachurches in Singapore. In this case, six of CHC’s most high-ranking officials, comprising of its founder Pastor Kong Hee, Kong Hee’s wife Yeow Sun Ho, former board member John Lam, finance manager Sharon Tan, ex-fund manager Chew Eng Han, deputy senior pastor Tan Ye Peng and former finance manager Serena Wee. The six accused persons are currently on trial for the alleged misuse of church funds to the tune of S$50 million (about US$39.9 million) through the execution of sham bonds. This includes S$24 million (about US$19.9 million) to allegedly fund Sun Ho’s music career and a further S$26 million to allegedly cover up the losses. These bonds were said to have been executed through a music production firm Xtron and a glass manufacturer Firna, both of which were operated by long-time supporters of the mega church. It is the Prosecution’s case that the companies Xtron and Firna amounted to nothing more than shell entities that were used to do Kong Hee and Sun Ho’s bidding. The focus of the initial investigations was the Crossover Project which was started in 2002 to use Sun Ho’s secular music to connect with people and reach out to non-Christians. It was subsequently revealed by the Commissioner of Charities that it had uncovered financial irregularities and misconduct with the purported intention to finance Sun Ho’s secular music career. During the trial, it was also suggested that key information regarding the church’s finances were kept hidden from the church members and the church had purged its books of all records relating to the bonds in Xtron. In fact, Ms Lai Baoting, a former assistant accountant at the church, said that at times she “did not know” how certain sums were derived, but simply followed directions to record entries involving millions of dollars to companies such as Xtron and Amac Capital Partners, a fund management firm owned by Chew Eng Han. The trial is currently ongoing. 2.3.2 Cheating The cheating offence under the Penal Code is the statutory embodiment of fraudulent conduct in relation to property. The full scope of cheating offences can be identified in sections 415 to 420 of the Penal Code. These offences include cheating simpliciter (section 415), aggravated cheating (section 420), cheating by personation (section 416) and cheating caused to a person whose interest the offender is bound to protect (section 418). In order for a cheating offence to be established, there must first be deception on the victim. This may take a number of different forms including fraudulently or dishonestly inducing a person to deliver any property to any

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other person. Additionally, it may involve intentionally inducing that person to do or omit to do anything which he would not do or omit if he were not so deceived; where that act or omission causes or is likely to cause damage or harm to any person in body, mind, reputation or property. In Koh Seah Wee,11 the first accused, Koh, was the deputy director of SLA’s Technology and Infrastructure (“TI”) and the second accused, Lim, was his subordinate. Koh and Lim were responsible for the procurement, tendering and approval of contracts within SLA’s TI department. Koh faced a whopping 372 charges. He pleaded guilty to 55 charges of which 46 concerned the offences of cheating or conspiracy to cheat. Lim faced a total of 309 charges. He pleaded guilty to 49 charges. Out of these, 40 charges concerned the offence of conspiracy to cheat SLA and one charge involved a conspiracy to cheat a particular finance company. The offences were in relation to Koh and Lim rigging the quotation results by arranging for their own vendors (the accomplices) to offer the lowest quotations which Lim would recommend and Koh would approve. Through this scheme, 282 of such contracts were awarded to 11 “vendors” who were merely facades operated by several accomplices. Consequently, SLA was dishonestly induced to pay these “vendors” a sum of more than S$12.1 million (about US$9.68 million). Both the accused persons had used the illegally obtained monies in similar ways by buying private properties in their wives’ names, opening bank accounts in the names of family members and buying luxury cars. Even though they were both first time offenders the High Court felt that offences involving public funds committed against public institutions warranted severe and strict punishment. Koh’s total sentence amounted to 22 years’ imprisonment while Lim received a total sentence of 15 years’ imprisonment. A recent high profile case centred on the conviction of fraud is that of Chia Teck Leng12 which is regarded as the largest case of commercial fraud in the history of Singapore. The accused person, Chia, pleaded guilty to an elaborate fraud perpetrated over a period of more than four years in his capacity as the finance manager of Asia Pacific Breweries (Singapore) Pte Ltd (“APBS”), on (among other foreign banks) Skandinaviska Enskilda Banken AB (Publ), Singapore Branch (“SEB”) and Bayerische Hypo-Und Vereinsbank Aktiengesellschaft (“HVB”). Purporting to be acting on APBS’s behalf, he requested SEB and HVB to offer various credit facilities to APBS. He then accepted the Credit Facilities in APBS’s name and provided the companies

11  Public Prosecutor v Koh Seah Wee and another [2011] SGHC 240. 12  Public Prosecutor v Chia Teck Leng [2004] SGHC 68.

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with forged resolutions of APBS’s board of directors purportedly documenting APBS’s acceptance of the Credit Facilities. Chia admitted to 6 charges of forgery and 8 charges of cheating with 32 other charges taken into consideration for the purposes of sentencing. Chia had cheated the banks a collective amount of about S$117.1 million (about US$93.6 million). Although CAD managed to secure the recovery of about S$34.8 million (about US$27.8 million), some S$62 million was squandered and lost at various casinos around the world. Taking into consideration the colossal sum of money involved, Chia’s blatant abuse of authority as financial manager of APBS and the adverse effect this case had on the reputation of Singapore as a financial hub, he was sentenced to a staggering 42 years’ imprisonment in total. In recent times, however, an alarming trend of cheating offences involving e-commerce has surfaced in Singapore. In 2013, direct financial losses from cybercrime in Singapore grew from US$944 million to US$1 billion. This means that Singapore cybercrime victims had the highest average per capita losses worldwide of US$1158. Not only was this twice the figure set in 2012, but it was also four times the global average.13 The number of cyber cheating cases has also grown exponentially in Singapore and statistics suggest that this trend is set to continue. Cyber cheating offences saw a surge of 113.9% from 238 cases in 2012 to 509 cases in 2013.14 Between January and June 2014 alone there were 504 cases of cyber cheating; this represents a whopping 425% increase in numbers in comparison to the same period in 2013.15 Given the inherent difficulties in detecting and tracing criminal proceeds over cyberspace, it is no surprise that increasingly sophisticated scams are emerging online. In particular, the Multiple Payment Online Purchase Scam (“MPOPS”) and the Paypal Email Scam (“PES”) have been identified as the most widespread and prominent. The MPOPS typically involves culprits posing as sellers of electronic gadgets such as mobile phones, tablets and laptops, who would then cheat victims by failing to make delivery of the purchased goods online. Consequently, the culprits would ask for further payments to be made on the pretext of mixed delivery orders. Victims typically accede to the request for further payment but end up not receiving the purchased goods. The payments by victims are typically made through bank transfer and once received are quickly transferred out of local bank accounts to overseas bank accounts, thus making the tracing and return of the funds significantly more difficult. 13  symantec.com (2013). 14  spf.gov.sg, supra note 1. 15  spf.gov.sg (2014).

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The PES, on the other hand, involves culprits targeting online sellers. In such cases, culprits, claiming to be from overseas, place purchase orders with victims specifying “Paypal” as mode of payment. The culprits would then send fictitious emails purportedly from “Paypal” confirming that payment had been made. In some cases even, these fictitious emails would request the victims for administrative payments such as account activation fees to be made via local bank transfers or through remittance to overseas accounts. 2.3.3 Falsification of Accounts Producing false entries in accounts is an offence under section 477A of the Penal code, punishable with up to ten years imprisonment or fine or both, regardless of whether the falsifications were used, or intended for the purposes of carrying out subsequent acts of CBT or cheating. An offence under section 477A of the Penal Code will be made out if it is proven that there was in fact an intention to defraud and the willful falsification of any documents or electronic records. Particular attention should be given to the explanatory statement in section 477A of the Penal Code which states that it shall be sufficient to allege a general intent to defraud without naming any particular person intended to be defrauded, or specifying any particular sum of money intended to be the subject of the fraud or any particular day on which the offence was committed. In Li Weiming,16 however, the High Court confirmed that where a section 477A Penal Code charge was involved, the Prosecution was required to present a specific case as to the nature of the accused’s fraudulent attention. This includes the identity of the person or body that was the object of the fraudulent intention. This ensures that the Prosecution proceeds only with cases that genuinely warrant criminal prosecution and prevents it from hiding behind the explanatory note to avoid taking a position. In Ng Teck Soon,17 the accused was alleged to have conspired with others to falsify invoices and delivery orders involving a large sum of money to push up sales of Citiraya—a public listed company on the Mainboard of the Stock Exchange of Singapore. In 2004, as Citiraya was not meeting its forecasted sales figures, the accused person, Ng, and three others decided to inflate its revenue by falsification of its sales figures by means of fictitious invoices and delivery orders to meet the sales targets. Ng was convicted after trial on 32 charges of falsification of accounts and sentences of between six to nine months’ imprisonment per charge, with a global sentence of 21 months’ imprisonment in total. 16  Li Weiming and other matters v Public Prosecutor [2013] SGHC 69. 17  Public Prosecutor v Ng Teck Soon [2008] SGDC 304.

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2.4 Overview of the Law on Market Abuse and Misconduct in Singapore 2.4.1 Insider Trading Insider trading is an offence under the Securities and Futures Act (“SFA”). The law on insider trading is described to “protect corporate confidences and to prevent insiders privy to such confidences from benefiting as an unfair advantage when they deal in the market”.18 Prime Minister Lee Hsien Loong, who at the time was the Deputy Prime Minister, highlighted in the 2001 Parliamentary Debates where the Order for the Second Reading of the Securities and Futures Bill was read: At the core, the mischief of insider trading lies in tilting the playing field unfairly against other market participants. Those who knowingly have inside information should be prohibited from trading, whether or not they are connected with the company. The intent is to address the core evil of trading while in possession of undisclosed market sensitive information, instead of having liability depend on a person’s connection with the company [as was previously the case under the SIA]. An individual is said to have committed the offence of insider trading if, while in possession of Price Sensitive Information (“PSI”) that is not generally available, he has: 1. 2. 3.

subscribed, purchased or sold securities or entered into an agreement to do so; procured another person to subscribe, purchase or sell those securities or enter into an agreement to do so; or communicated the information to another having known that the other person would likely subscribe, purchase or sell the securities or procure another person to do so.

It is therefore evident that whether an offence of insider trading is made out depends substantially on the nature of the information in question. For these purposes, the question that is asked is whether a reasonable investor would be influenced by knowledge of the said information when deciding to subscribe, purchase or sell securities. Accordingly, the PSI must also be shown to have material effect on the price or value of securities.19 Examples of inside information include an entity’s earnings or financial performance, impending 18  Public Prosecutor v Alan Ng Poh Meng [1989] CSLR XIII 1327. 19  As stated in section 216 of the SFA.

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t­ ake-over offers and share placements, proposed offering of securities and proposed investment plans. The key elements of insider trading under the SFA are listed in sections 218 and 219 of the SFA. Section 218 sets out the prohibited conduct by a connected person in possession of inside information. Under the provision, a person is deemed to be connected to a corporation if he acts in the capacity of an officer, a substantial shareholder or any other position that may reasonably be expected to give him access to PSI. Section 218(4) further creates a rebuttable presumption that the connected person had knowledge that the said information might have a material effect on the value of the securities of the corporation when traded and that it was not generally available. This is to reinforce the general perception that a greater level of discipline and accountability is expected of those in fiduciary positions.20 Crucially, the officers and agents of a company are also subject to s. 157(2) of the Companies Act (Chapter 50), which prohibits the improper use of any information acquired by virtue of their position as an officer or agent of the company to gain, directly or indirectly, an advantage for themselves or for any other person or to cause detriment to the company. Section 219 of the SFA, on the other hand, sets out prohibited conduct by other persons in possession of inside information. In order to establish that an offence of information-connected insider trading has been committed it must be shown that the person has actual knowledge that the information was PSI and was not generally available. Unlike section 218, no presumption operates under this section. In trying to balance the interests of justice and the realities of modern business practices, the SFA also sets out an essential defence to the insider trading provisions. The “Chinese Wall Exception”, which is set out in Sections 226 and 227 of the SFA, states that a corporation or partnership will not be found to have breached the insider trading provision despite the attribution of knowledge of its officer or partner respectively, if: 1. 2.

3.

the decision to enter into the transaction or agreement was taken by a person other than the officer or partner; the corporation or partnership had arrangements that could reasonably be expected to ensure that the information was not communicated to the person who made the decision, and that no advice with respect to the transaction or agreement was given to person by a person in possession of the information; and the information was not communicated and no such advice was given to the decision-maker.

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If the Chinese Wall Exception is not established on the facts, a corporation will be made liable for insider trading if it is found to have dealt in securities when one or more of its officers are found to possess inside information at the time of dealing. The mere establishment of the Chinese Wall Exception however does not absolve the corporation from liability, but it can rebut the presumption that the officer who dealt in securities on its behalf, possessed inside information. A contravention of the insider trading provisions in the SFA can result in one of three courses of action taken against the offender. Firstly, the offender may be subject to criminal prosecution which, if convicted, may result in imprisonment for a term of up to seven years, a fine of up to S$250000 (about US$200000) or both. Secondly, the offender may face a civil penalty action under section 232 of the SFA. Under this course of action, the Monetary Authority of Singapore (“MAS”) may, with the consent of the Public Prosecutor, bring an action in court against the offender to seek an order for a civil penalty. In such cases, the court may make an order for the payment of a sum in accordance with section 232(2) or 232(3) of the SFA. Finally, the offender may also face civil liability under section 234 of the SFA which involves the payment of compensation outside of court. In such circumstances, the amount of compensation is limited by the “maximum recoverable amount” as specified in section 234(2) and 234(6) of the SFA. It is noteworthy that a civil penalty action pursued outside court is separate from one pursued in court under section 232 of the SFA. The former does not exclude a further criminal prosecution whereas the latter action shall not be commenced if the person has been convicted or acquitted in criminal proceedings for the contravention of insider trading provisions. Moreover, the operation of a civil penalty under section 232 is available whether or not the contravening party has gained profit or avoided any loss whatsoever; this provides ample options for effective enforcement according to the specific facts accompanying a potential offence. A criminal penalty was given as a result of insider trading in Johnson Chong,21 a major case involving the Chief Operating Officer and Executive Director of Airocean Group Ltd. Chong faced three charges of insider trading after selling more than two million Airocean shares through his mother’s bank account for a net total of S$411804.79 (about US$330000), whilst having possession of PSI relating to the CEO of Airocean being investigated by the CPIB over specific transactions with other subsidiaries. Chong was convicted of the offences and sentenced to a total of four months’ imprisonment and five years’ disqualification from being a director. On appeal, his conduct was found not 21  Madhavan Peter v Public Prosecutor and other appeals [2012] SGHC 153. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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to be of sufficient gravity to justify a custodial sentence and the High Court replaced his imprisonment term with a fine of S$200000 (about US$160000). A civil penalty, however, was given in the matter concerning senior employees of Wilmar International Limited (“Wilmar”). Here, two senior ­employees, whilst in possession of non-public PSI concerning Wilmar’s intention to invest in Kencana Agri Limited (“Kencana”), bought 626000 and 50000 shares respectively in Kencana. After the public announcement of the PSI, Kencana’s share price closed at S$0.385 (about US$0.31), a 10% increase over the preceding day’s closing date. The employees made a profit of about S$43000 (about US$34300) and S$2000 (about US$1600) respectively. Both employees admitted civil liability for contravening Section 219(2)(a) SFA and paid MAS civil penalties of $110000 (US$88000) and $50000 (US$40000) respectively. 2.4.2 Market Rigging The offence of market rigging was created in order to protect the market for securities against activities resulting in artificial or managed manipulation and to ensure that the market reflects the forces of genuine supply and demand. Section 197(1) of the SFA states that it is an offence to do, cause anything to be done or engage in any conduct with the purpose of creating a false and misleading appearance of active trading in any securities. Accordingly, the offender must have done said prohibited act knowingly or recklessly with the purpose of creating the false or misleading appearance. In Ng Geok Eng,22 the accused person, Ng, was found to have traded 192.5 million shares using 18 accounts belonging to him and three others to illicitly manipulate the share price of Autron Corporation Limited, a publiclisted company. Ng’s motive was to prevent calls on margin loans which were made to him on the security of Autron shares already owned by him. He pleaded guilty to four charges, including one charge of market rigging under section 197(1) of the SFA and was sentenced to six months’ imprisonment by the High Court. 2.4.3 False or Misleading Statements Section 199 of the SFA criminalises the making or dissemination of false or misleading statements to induce the subscription, sale or purchase of securities or to cause the raising, lowering, maintaining or stabilising the market price of securities. It must also be shown that the person making the statement either did not care to verify the truth of the statement or that he ought reasonably to have known it was false or misleading in a material particular. The offence, 22  Ng Geok Eng v Public Prosecutor [2007] 1 SLR 913.

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however, is judged on an objective basis and, therefore, the question is simply whether a reasonable person, on receiving the statement concerned, would have been induced to sell or buy any securities. The issue of what amounted to a material particular was considered in Wang Ziyi.23 It was held that materiality is “presumably to be tested in relation to the potential impact which the statement may have in terms of inducing the sale or purchase of securities or in terms of its effect on the market price of shares”. In this case, the accused person, Wang, was convicted on appeal on a charge under section 199(b)(i) of the SFA for disseminating, on an online forum, false information that was likely to induce the sale of shares in Datacraft Asia Limited. The offence consisted of two internet postings in which he claimed that CAD had raided Datacraft’s offices the week prior. This was based on information that the accused had obtained from his friend that he made no effort to verify. 2.4.4 The Employment of Manipulative and Deceptive Devices Section 201 of the SFA acts as a “catch-all” provision that covers all forms of securities fraud that have not been otherwise dealt with in other sections of the SFA. The widely drawn provision prohibits: 1. 2. 3. 4.

the employment of any device, scheme or artifice to defraud; engaging in any act, practice or course of business which operates as a fraud or deception, or is likely to operate as a fraud or deception, upon any person; the making of any statement that the individual knows to be false in a material particular; or omitting to state a material fact necessary in order to make the statements made, in the light of circumstances under which they were made, not misleading.

In Wong Siaw Seng, Joseph Tan Kian Ming, Oh Chao Qun and Ng Sae Kiat,24 the above-named individuals were Contracts for Differences (“CFD”) hedgers employed by Philips Securities Pte Ltd (“PSPL”). They faced ten counts of engaging a practice with other CFD hedgers which operated as a fraud upon PSPL, by using nominee accounts to either purchase CFDs from PSPL below the prevailing best ask price for the underlying securities or sell CFDs to PSPL 23  Public Prosecutor v Wang Ziyi Able [2008] 2 SLR 61. 24  Public Prosecutor v Ng Sae Kiat, Tan Kian Ming Joseph, Wong Siaw Seng, Oh Chao Qun [2014] SGDC 294.

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above the prevailing best bid price. The case is significant as this is the first instance a Singapore Court had to decide on the appropriate sentence for a charge under section 201(b) of the SFA which concerned a CFD security. The Prosecution had asked for a jail term to be imposed whereas the Defence urged the court to impose a high fine instead. It was argued that the Court ought to accord due consideration to the speculative nature of losses incurred by PSPL in the absence of all the relevant hedging data. The distinct nature of the CFD security in the present case meant that the quantum of losses put forth by the Prosecution was inaccurate and further, that a CFD hedger would have hedged his position in the trade by placing a corresponding transaction for an actual security in the SGX market. The court agreed and sentenced the four individuals to a fine, ranging from S$60000 (about US$48000) to S$140000 (about US$112000). The Prosecution has appealed the decision of the District Court and the matter is due to be heard in before three Judges in the High Court later this year. 3

Enforcement in Singapore

3.1 Corrupt Practices Investigation Bureau (“CPIB”) The CPIB is an independent anti-corruption agency responsible for enforcing the offences under the Prevention of Corruption Act. It has developed a ­reputation as a formidable agency that is able to “detect any whiff of corruption” and “bring the perpetrators to justice”.25 The CPIB director reports directly to the Prime Minister’s Office, guaranteeing functional independence and enabling it to carry out investigations free from influence from any Ministry or government department. It consists of an Operations Division for investigative work and an Intelligence Division, which gathers and collates intelligence to support the investigative functions. The CPIB performs three primary functions, namely receiving and investigating complaints concerning corruption in the public and private sectors, investigating malpractices and misconduct by public officers and examining the practices and procedures in the public service to minimize opportunities for corrupt practices. The CPIB has been effective because of its reliance on expertise and the adoption of a total approach to enforcement.26 It deals with both small and big cases of corruption in both the public and private sectors. The CPIB also employs a proactive approach to its activities on corruption prevention and 25  app.cpib.gov.sg, supra note 6. 26  Quah (2013), p. 13.

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education, reviewing the procedures and practices in those government agencies where corruption has occurred. 3.2 Commercial Affairs Department (“CAD”) The CAD is Singapore’s principal white-collar crime investigation agency that investigates a wide array of commercial and financial crimes within the Singapore Police Force. The CAD’s Financial Investigation Division is tasked specifically to combat money laundering in Singapore and works closely with local financial institutions, government agencies and its foreign counterparts. The 3 branches within this division are: the Suspicious Transaction Reporting Office, the Financial Investigations Branch and the Proceeds of Crime Unit. A major reorganisation of the CAD was recently conducted in order to shape a more threat-focused and intelligence-led agency. In 2013, the CAD tripled its financial investigation resources, with dedicated branches for international cooperation and terrorist financing, investigations into proceeds from both domestic and overseas criminal activity and serious tax crimes. The Suspicious Transaction Reporting Office was also expanded to become a full-fledged division with three analytical branches and one field research branch.27 This has enabled the CAD to more effectively detect investment fraud in its early stages and allows it to provide improved support to other law enforcement agencies in AML and CFT investigations. 3.3 Investigative Powers of the Authorities Under the PCA, The CPIB is empowered to investigate suspected offences of corruption. Its wide range of arrest and special investigative powers are listed in the same statute and allows the seizure of property found under circumstances that create suspicion of the commission of any offence during its investigation. Section 18 of the PCA further empowers the Public Prosecutor to authorize the CPIB Director and his senior officers to investigate “any bank account, share account or purchase account” of any person suspected of having committed an offence under the PCA. Where crimes of a financial nature are concerned, the relevant enforcement agency is empowered to freeze whole bank accounts that may have had any connection to the offence, without any reference to the courts. Recent changes made to the Criminal Procedure Code have further enhanced police powers by giving the authorities full discretion as to the release of properties seized. This was recognized in the decision of Mustafa Ahunbay.28 Whilst this provides yet another invaluable asset to the 27  cad.gov.sg (2013). 28  Mustafa Ahunbay v Public Prosecutor [2013] SGHC 188.

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police force in its strict crackdown of financial crimes, it almost completely removes the courts’ discretion thereby leaving aggrieved individuals with little avenue for recourse. Additionally, the scope of what amounts to property for the purpose of seizure is very wide. In the recent case of Ding Si Yang,29 Ding was charged with allegedly bribing soccer officials at the Asian Football Confederation Cup by providing them with sexual services. At the end of a lengthy trial, Ding was found guilty of corruption by the District Court and was sentenced to three years’ imprisonment. This was subsequently enhanced to five years’ imprisonment by the High Court. Curiously, during the course of investigations, the CPIB launched a thorough investigation into the financial affairs of the accused and seized various bank accounts, cars and even real estate; despite there being no allegation of any monetary exchange whatsoever. This demonstrates that investigations can be as extensive as the authorities deem to be necessary and is yet another example of Singapore’s unrelenting stance towards financial crimes. 3.4 The Discretion of the Public Prosecutor The Public Prosecutor is also able to exercise prosecutorial discretion by deciding on the number of charges and types of offences that may be filed against the accused. In money-laundering cases, besides being charged with the underlying substantive or predicate offence, the offender is concurrently charged with the secondary money-laundering offence for any form of use or conversion of the proceeds whatsoever. Therefore, in a scenario where an individual unwittingly accepts into his account a sum of monies arising from criminal conduct and subsequently transfers the monies out of his account, he may be criminally charged from the dishonest receipt of stolen property as well as an accompanying money-laundering offence for the subsequent outward transfer. This twin-pronged approach was applied in Koh Seah Wee30 where the former deputy director of the Singapore Land Authority and his accomplice were charged for multiple counts of cheating and for the conversion of the stolen property. The criminal charge relating to the conversion of property arose from their use of the illegal gains to purchase various properties and expensive cars. The case remains the biggest case of public-sector fraud in almost 20 years.

29  Ding Si Yang v Public Prosecutor [2014] SGDC 295. 30  Public Prosecutor v Koh Seah Wee and another [2011] SGHC 240, supra note 11.

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3.5 The Detention Orders of the Government The most controversially extensive powers of the government in relation to financial crimes are the detention powers of the Criminal Law (Temporary Provisions) (Amendment) (“CLTPA”). Under the CLTPA, the government is empowered to detain suspected criminals without trial for up to a year in the interests of “public safety, peace and good order”. In October 2013, the government, for the very first time, exercised the detention powers to detain a number of persons suspected of being involved in a global match-fixing syndicate with operated in Europe and elsewhere. This has been most recently contested in the matter involving an individual known as Dan Tan,31 the alleged ringleader of the said match-fixing syndicate. It was argued that such match-fixing cases should not be within the domain of “detention without trial” especially in light of the fact that the Act requires detentions to be in the interests of public safety and should therefore be limited to crimes that threaten these very interests. The arbitrary nature of the detention orders is evident as, having been first detained in October 2013, his detention order was subsequently extended to October 2015. On 25 November 2015, the Court Appeal reversed the High Court decision to uphold the detention order and granted Tan’s release. In less than a week, however, the CLTPA was invoked to detain him again under amended grounds. As evidenced by Tan’s untimely extension of detention, the government possesses a hugely imbalanced and unfettered discretion over the employment of said detention orders. In fact, concerns about the potentially prejudicial and draconian effect of being detained without trial surfaced as early on as the reading of the bill which would eventually become the CLTPA. In 1955, at the Second Reading of the Bill, then Opposition Leader Lee Kuan Yew stated: If the Government feels that it is necessary to take this step, we shall not resist it, but we ask them to remember it is not democratic, that it is not fair to blunt the strike instrument, and that all these extraordinarily stringent regulations should be set aside as soon as conditions permit.32 The detention orders under the CLTPA have proven to be an invaluable asset for enforcement in Singapore. Throughout the years, the detention orders have proven to be particularly effective in the crackdown of secret societies and drug trafficking, especially where witnesses would otherwise be too afraid to testify in trials. It has also been argued that the above-mentioned situations, 31  Tan Seet Eng v Attorney General [2015] 2 SLR 453 32  Singapore Parliamentary Debates, vol. 1, cols. 767 (22 September 1955).

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in which the detention orders were previously exercised, highlight a clear risk to “public safety, peace and good order”. In comparison, the government’s act of extending these powers in the enforcement of overseas corruption has been criticized as unjustified and used simply to cover the gaps in the crackdown of cross-border crime.33 4

Legislative Developments

The long tentacles of the law relating to financial crimes are constantly growing. Significant amendments have been made to the Mutual Assistance in Criminal Matters Act (“MACMA”). Amongst other things, the amendments have altered the definition of a corresponding drug law, removing the need to prove a foreign offence via a foreign certificate. This enables Singapore to become more facilitative in providing mutual legal assistance, becoming a stronger partner for international cooperation to fight cross-border crime. On the other hand, it must also be mentioned that efforts have been made to mitigate the perceived imbalance of power that the authorities possess, thereby ensuring that suspected offenders are not prejudiced even before conviction. For instance, the Criminal Case Disclosure Conference (“CCDC”) regime that was introduced in the Criminal Procedure Code 2010 ushers in a new era of pre-trial criminal discovery, allowing the courts to move towards greater transparency in the criminal justice system.34 The CCDC regime has created a “formalised system of reciprocal disclosure that imposes obligations on both the prosecution and accused to reveal aspects of their cases and the evidence that each party intends to rely on at the pre-trial stage”.35 The objectives of the regime were articulated by the Minister for Law in 2010. He highlighted that the timely disclosure of information would help parties to prepare for trial and assess their cases more fully. In addition, he emphasized that the CCDC regime introduced greater transparency to the pre-trial process.36 5 Conclusion As illustrated in the various examples above, Singapore has succeeded in creating a robust and relevant framework to ensure a strict and effective 33  wp.sg (2013). 34  Li Weiming and other matters v Public Prosecutor [2013] SGHC 69. 35  Li Weiming and other matters v Public Prosecutor [2013] SGHC 69, ibid at [25] 36  Singapore Parliamentary Debates, vol. 87, cols. 413–14 (18 May 2010). Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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crackdown of financial crimes in its pursuit to establish itself as a globally renowned e­ conomic and financial hub. This success is in no small part due to Singapore’s commitment to stay relevant by continually broadening, updating and improving the legal framework relating to financial crimes. It is important to realise that enforcement in Singapore is not solely restricted within the job scopes and duties of the relevant enforcement agencies; rather it is a fluid and dynamic process that extends from the commencement of investigations to the time of sentencing. Moreover, it is a role which is performed collectively by all the relevant state actors. Although a number of the methods are still very much in their infancy as Singapore continues to develop and tweak its legal framework to accommodate global and technological advances according to modern financial realities, it is evident that Singapore’s unflinching attitude to enforcement will make it extremely harrowing for a criminal to pursue the fruits of his crime here. References Bibliography

app.cpib.gov.sg (2012) “Speech by Prime Minister Lee Hsien Loong at CPIB’s 60th Anniversary Celebrations,” http://app.cpib.gov.sg/data/website/doc/Manage Page/247/SPEECH%20BY%20PRIME%20MINISTER%20LEE%20HSIEN%20 LOONG%20AT%20CPIB_pdf.pdf (accessed 29 April 2015). cad.gov.sg (2013) “The Financial Police CAD Annual Report 2013,” http://www.cad .gov.sg/content/dam/cad/docs/Annual%20Reports/CAD%20AR%202013_Final_ lowres_15Jul.pdf (accessed 29 April 2015). mas.gov.sg (2014) “Combating Financial Crime: International and National Efforts— Keynote Address by Mr Ong Chong Tee, Deputy Managing Director (Financial Supervision),” http://www.mas.gov.sg/news-and-publications/speeches-and-mon etary-policy-statements/speeches/2014/combating-financial-crime-internationaland-national-efforts.aspx (accessed 29 April 2015). Quah, Jon (2003) Curbing Corruption in Asia, Singapore: Eastern Universities Press. ——— (2013a) “Introduction: Different Paths to Curbing Corruption,” in J. Quah, ed., Different Paths to Curbing Corruption, Singapore: Emerald, 1–23. ——— (2013b) “Curbing Corruption in Singapore: The Importance of Political Will, Expertise, Enforcement, and Context,” in J. Quah, ed., Different Paths to Curbing Corruption, Singapore: Emerald, 137–66. sal.org.sg (2013) “Discovering the Right to Criminal Disclosure—Lessons from Civil Procedure,” http://www.sal.org.sg/digitallibrary/Lists/SAL%20Journal/Attach ments/643/(2013)%2025%20SAcLJ%20548–579%20(D%20Wong_CrimDisclosure) .pdf (accessed 29 April 2015). Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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sbr.com.sg (2014) “Financial Criminals on a Massive Banking Spree in Singapore: Bloomberg,” http://sbr.com.sg/financial-services/news/financial-criminals-mas sive-banking-spree-in-singapore-bloomberg (accessed 29 April 2015). spf.gov.sg (2013) “Annual Crime Brief 2013,” http://www.spf.gov.sg/mic/2014/02/2014 0214_others_crime_brief.html (accessed 29 April 2015). ——— (2014) “Mid-Year Crime Brief for January–June 2014,” http://www.police.gov.sg/ mic/2014/08/20140813_others_midyear_crime_brief.html (accessed 29 April 2015). symantec.com (2013) “2013 Norton Report,” http://www.symantec.com/about/news/ resources/press_kits/detail.jsp?pkid=norton-report-2013 (accessed 29 April 2015). transparency.org (2013) “Corruption Perceptions Index 2013,” http://cpi.transparency .org/cpi2013/results (accessed 29 April 2015). wp.sg (2013) “Speech on Criminal Law (Temporary Provisions) Act by M. P. Sylvia Lim, Delivered in Parliament on 11 November 2013,” http://wp.sg/2013/11/speech-oncriminal-law-temporary-provisions-act-mp-sylvia-lim/ (accessed 29 April 2015).

Cases

Tan Seet Eng v Attorney General [2015] 2 SLR 453. Ding Si Yang v Public Prosecutor [2014] SGDC 295. Public Prosecutor v Ng Sae Kiat, Tan Kian Ming Joseph, Wong Siaw Seng, Oh Chao Qun [2014] SGDC 294. Li Weiming and Other Matters v Public Prosecutor [2013] SGHC 69. Mustafa Ahunbay v Public Prosecutor [2013] SGHC 188. Public Prosecutor v Jeanette Ang [2010] SGDC 232. Public Prosecutor v Sek Leong Seng [2010] SGDC 356. Public Prosecutor v Koh Seah Wee and another [2011] SGHC 240. Public Prosecutor v Goh Teck Meng [2009] SGDC 495. Public Prosecutor v Ng Teck Soon [2008] SGDC 304. Public Prosecutor v Wang Ziyi Able [2008] 2 SLR 61. Ng Geok Eng v Public Prosecutor [2007] 1 SLR 913. Public Prosecutor v Chia Teck Leng [2004] SGHC 68. Public Prosecutor v Alan Ng Poh Meng[1989] CSLR XIII 1327.

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Chapter 16

Role of the Criminal Law in Maintaining Hong Kong as an International Financial Centre Simon N. M. Young Abstract While criminal law is an essential part of the legal environment used to maintain Hong Kong’s status as an international financial centre (IFC), its role is limited. Criminal law and processes are reserved for serious cases that involve the protection of property rights, economic interests, or the integrity of the financial system. Deterrent and remedial civil processes are increasingly being used as a more effective way to enforce law designed to maintain Hong Kong’s IFC status.

Keywords Hong Kong international financial centre – white collar crime – financial crime – ­securities law enforcement – criminal and civil sanctions

1 Introduction The Hong Kong government is constitutionally required to “provide an appropriate economic and legal environment for the maintenance of the status of Hong Kong as an international financial centre”.1 The criminal law is an essential part of that legal environment. But what precise role does it play in maintaining an international financial centre (IFC). Too much criminal law can restrict freedom of contract, breed inefficiencies, and become a tool for the powerful to oppress the weak. Too little criminal law would allow the dishonest to wreck havoc on the marketplace and take advantage of investors and * Professor and Associate Dean (Research), Faculty of Law, The University of Hong Kong. The author thanks Antonio Da Roza for his assistance. Contact: [email protected]. 1  Basic Law, Art. 109.

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others. There needs to be a proper balance of criminal and non-criminal laws to enforce and regulate financial systems without unduly impairing economic growth and competition. This chapter discusses the role of criminal law in maintaining Hong Kong’s status as an IFC. The underlying criminal law framework can be organised into two broad categories: (i) offences that protect property rights and interests, and (ii) offences that safeguard the integrity of the financial system. The role of criminal law must be seen against a network of regulatory contexts governing financial markets, banks and other financial institutions, companies and individuals who participate in financial systems. Each regulatory regime has its own criminal and non-criminal measures to enforce the law and achieve regulatory aims. In this crowded field, criminal law plays a limited but traditional role, to censure and punish harmful or serious misconduct. It also plays an important secondary role of providing teeth to the numerous powers and duties that promote more disclosure and transparency in the market place. 2

Use of the Criminal Sanction

Every society has criminal laws to protect its most basic moral values. As societies become more developed, criminal laws are used to protect and realise important societal aims and purposes. The criminal laws used in maintaining Hong Kong’s IFC status are of two kinds. The first are those that protect individual property rights and economic interests. These offences are mainly found in the Theft Ordinance,2 which was largely migrated from the English Theft Acts of 1968 and 1978.3 Other similar offences can be found in specific legislation such as those that relate to companies and insolvency. The second kind is a broader category. These laws are concerned with maintaining the integrity of financial systems. Such integrity is measured by people’s confidence in the system. Confidence is affected by behaviour that distorts the level playing field in the marketplace, promotes the movement of illegal assets, or induces conflicts of interest. Where such conduct poses a serious risk to public confidence in financial systems, interdiction by the criminal law is required. Illustrative offences of both these types are described more fully below.

2  Theft Ordinance (Cap. 210). 3  Jackson (2003), p. 727.

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2.1 Protecting Property Rights and Economic Interests 2.1.1 General Offences The Theft Ordinance revised “the law as to theft and similar or associated offences” by abolishing common law crimes and consolidating relevant offences under a single statute.4 Two offences explicitly protect “property belonging to another”. The classic offence of “theft” is defined as the dishonest appropriation of property belonging to another with the intention to permanently deprive the other of it.5 Appropriation has a broad meaning. It includes an “assumption by a person of the rights of an owner” and also the situation where a person comes “by the property (innocently or not) without stealing it” and later assumes a right to it “by keeping or dealing with it as owner”.6 Following English case law, there is an appropriation even if property is taken with the consent of the owner; what matters is whether the appropriation was dishonest.7 Property, also defined broadly, includes “money and all other property, real and personal, including things in action and other intangible property”.8 The other offence that protects property belonging to another is “obtaining property by deception”, one of several offences designed to deal with frauds. It is committed when a person “by any deception (whether or not such deception was the sole or main inducement) dishonestly obtains property belonging to another, with the intention of permanently depriving the other of it”.9 Other offences in the Theft Ordinance protect broader proprietary or economic interests. The statutory offence of “fraud” involves intentional deceit inducing a person to act (or omit to act) that results in benefit to another person or “prejudice or a substantial risk of prejudice” to a person other than the offender.10 Prejudice is defined as “any financial or proprietary loss, whether temporary or permanent”.11 There are other offences that prohibit the use of deception to obtain “pecuniary advantages”, obtain “services”, evade liability,

4  Theft Ordinance, long title. 5  Ibid., s. 2(1) [liable to 10 years imprisonment]. 6  Ibid., s. 4(1). 7  R v Hinks [2001] 2 AC 241 (HL), applied in HKSAR v Wong Cho Sum [2001] 3 HKLRD 76, [34]–[35] (CA); HKSAR v Woo Mei Bo Mable, unreported, CACC 565/2002, 15 Aug 2003, CA, [98]. 8  Theft Ordinance, s. 5(1). For a case involving theft of a chose in action, see HKSAR v Wong Cho Sum, ibid. 9  Ibid., s. 17(1) [liable to 10 years imprisonment]. 10  Ibid., s. 16A(1) [liable to 14 years imprisonment]. 11  Ibid., s. 16A(3).

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or procure an entry in certain records.12 Two offence sections are directed towards protecting the economic interests of investors and creditors. They are the offences of false accounting and publishing false statements by company directors.13 While there are many cases of false accounting, one of the more famous cases involved the prosecution of the chairman and financial controller of the multi-billion dollar conglomerate Allied Group for misrepresenting large share placements by independent investors when in fact the shares were issued to connected companies.14 There is a provision in the Theft Ordinance that extends criminal liability to company officers where the company is proved to have committed certain offences.15 Directors, managers, secretaries or similar officers of the company will also be guilty of any corporate offences committed with that individual’s “consent or connivance”.16 In practice, provisions of this kind have little impact because of the stringent requirements for proving corporate criminal liability.17 Such liability requires that the directing mind and will of the company have the mens rea for the offence, and thus it becomes superfluous to speak of whether the directors had consented or connived in the offence. The requirement of “consent or connivance” would only add something more if the offence committed by the company was one involving strict or absolute liability.18 A common thread that runs through many of the offences discussed here is the element of dishonesty.19 As interpreted by courts, this is an important mental element ensuring that only persons with moral culpability will be convicted. Dishonesty “describes a state of mind [. . .] consisting of both objective and subjective elements”.20 Dishonesty means that, by ordinary standards of reasonable and honest people, the defendant’s conduct was dishonest, and the defendant “realised that what he was doing was by those 12  Ibid., ss. 18, 18A, 18B, 18D, respectively. 13  Ibid., ss. 19, 21, respectively. 14  Young (2006). 15  Theft Ordinance, s. 20(1), applying only to offences committed by a “body corporate under section 17, 18, 18A, 18B, 18D, 19 or 22(2)”. 16  Ibid., s. 20(1). 17   Hong Kong still applies the English identification doctrine as set down in Tesco Supermarket Ltd v Nattrass [1972] AC 153 (HL). See HKSAR v Telephone Est (HK) Company Ltd [2014] 1 HKC 197 (CFI); The Queen v Lee Tsat Pin, unreported, CACC 315/1985, 19 Dec 1985, CA, [20]. 18  See e.g. Securities and Futures Commission v C.L. Management Services Limited, unreported, ESS3067/2013, 11 June 2014, Mag Crt, [52]. 19  Common to offences in Theft Ordinance, ss. 2, 15–18, 18A–18D, 19, 22, 24. 20  Mo Yuk Ping v HKSAR (2007) 10 HKCFAR 386, [45]–[46].

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standards dishonest”.21 Thus the element does not simply ask if the defendant believed his actions were honest; the question is asked with reference to the objective standard. Fraud offences have the additional element that either deceit or deception was used.22 This element is defined broadly and includes any deceit or deception “(whether deliberate or reckless) by words or conduct (whether by any act or omission) as to fact or as to law, including a [deceit/deception] relating to the past, the present or the future and a [deceit/deception] as to the intentions of the person [using the deception or practicing the deceit] or any other person”.23 Another important offence is the common law offence of conspiracy to defraud. In 1999, at the strong urging of the Administration, legislators decided to retain this common law offence, even though all other common law conspiracies had been abolished and a new statutory offence of fraud was being enacted.24 Government lawyers argued that retaining this longestablished and broad offence was desirable in case there were gaps in the statutory offence and also to meet the double criminality requirement in extradition requests to and from places that also had the offence.25 In Mo Yuk Ping v HKSAR, the Court of Final Appeal (CFA) considered the elements of this offence and found them to be in compliance with constitutional requirements of legal certainty.26 This case involved artificial trading in a stock in order to maintain its price and avoid default on a loan. The common law offence is committed when two or more persons agree to “use dishonest means to cause economic loss to another or to put at risk another’s economic interests”.27 The test for dishonesty is the “two-stage” Ghosh test, which is the same as the one

21  R v Ghosh [1982] QB 1053, 1064 (CA), recognised as the position adopted in Hong Kong in Chan Fat Chu Raymond v HKSAR (2009) 12 HKCFAR 775, [49] and Mo Yuk Ping v HKSAR, ibid., [51]. (Emphasis added) 22  Statutory fraud in s. 16A of the Theft Ordinance has the element of deceit. Other offences in ss. 17, 18, 18A, 18B, 18D, 22 require proof of deception. 23  Ibid., s. 17(4). 24  The Law Reform Commission of Hong Kong had recommended its abolition in 1996 (see LRCHK (1996), [5.48]), but the Administration convinced legislators to retain it in 1999 (see LegCo Secretariat (1999), [27]). See also Theft Ordinance, s. 16A(4); Crimes Ordinance (Cap. 200), s. 159E(2). Conspiracy to defraud is punishable up to 14 years imprisonment (Crimes Ordinance, s. 159C(6)). 25  Legal Policy Division (1998), p. 2. 26  Mo Yuk Ping v HKSAR, supra note 20. 27  Ibid., [40] & [55].

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used in theft and other offences.28 In addition to economic loss, the offence also extends to means that induce persons to act “contrary to public duty”, thereby serving as an important tool in corruption cases.29 In upholding the need for this broad offence, Sir Anthony Mason NPJ wrote: It has been widely recognized that there is no limit to the ingenuity of fraudsters in engineering novel means of defrauding others. This ingenuity leads to the conclusion that the enactment of specific offences is not an adequate safeguard unless they are accompanied by a general offence.30 Given the increased use of the Internet to handle financial transactions, police are making greater use of a general computer-related offence known as “unlawful access to a computer”.31 The offence is committed if a person obtains access to a computer with one of four possible states of mind: (a) with intent to commit an offence; (b) with a dishonest intent to deceive; (c) with a view to dishonest gain for himself or another; or (d) with a dishonest intent to cause loss to another.32 In one case, a Merrill Lynch private wealth manager was convicted of this offence for creating loans in client accounts without the client’s knowledge or authorisation.33 2.1.2 Offences in Specific Legislation While the offences in the Theft Ordinance are general enough to cover most situations, there are also offences protecting property rights and interests in specific regulatory legislation. In the company law context, there are offences for the making of false statements,34 issuing prospectuses containing untrue statements,35 and destroying documents filed in the Company Registrar’s office “with a view to gain [. . .] or with intent to cause loss to another”.36 When companies become insolvent and are wound up, there are offences to protect 28  Ibid., [55]. 29  Ibid. 30  Ibid., [63]. 31  Crimes Ordinance, s. 161(1) [liable to 5 years imprisonment]. 32  Ibid. 33  H KSAR v Hsu Ming Mei [2013] 1 HKLRD 286 (CA). 34  Companies Ordinance (Cap. 622), ss. 895(1) [liable to 2 years imprisonment] & 915 [liable to 6 months imprisonment]. 35  Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap. 32), ss. 40A(1) & 342F(1) [liable to 3 years imprisonment]. For more, see Da Roza & Tang (2014). 36  Companies Ordinance, s. 65(1) [liable to 7 years imprisonment].

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creditors and investors.37 The more serious of these offences include knowingly being party to a business of a company carried on with intent to defraud creditors or for any fraudulent purpose,38 company officer disposing of property obtained on credit within 12 months of the winding up,39 and frauds by officers of companies which have gone into liquidation.40 2.2 Safeguarding the Integrity of Financial Systems Even before 1997, judges took into account Hong Kong’s status and reputation as an international financial centre in its decisions. In a 1993 human rights challenge to the Securities and Futures Commission’s (SFC) powers of investigation, the court noted: “Effective regulation is essential to the continuance of Hong Kong’s economic prosperity as a commercial and international financial centre.”41 Post-1997 decisions have made explicit reference to maintaining Hong Kong’s IFC status in various contexts, including decisions to admit overseas counsel on an ad hoc basis,42 sentencing decisions,43 and decisions to order re-trial.44 There are many criminal offences aimed at safeguarding the integrity of the financial system. These offences aim at maintaining the high repute of the system and ensuring public confidence in financial and legal institutions. While these offences are indirectly concerned with economic and proprietary interests, they are more directly concerned with preventing and punishing conduct that threatens to taint and impair the proper operation of financial systems and regulatory regimes. This chapter discusses three types of offences concerned respectively with the integrity of financial markets, the integrity of financial transactions, and the integrity of individuals in business and government.

37  Companies (Winding Up and Miscellaneous Provisions) Ordinance, Sch 12. 38  Ibid., s. 275(3) [liable to 5 years imprisonment]. 39  Ibid., s. 271(1)(o) [liable to 5 years imprisonment]. 40  Ibid., s. 273 [liable to 2 years imprisonment]. 41  In Re Commission Ordinance, unreported, HCMP3039/1992, 8 Jan 1993, HC, [81]. 42  Re Robin Potts QC, unreported, HCMP4108/1999, 23 Sept 1999, CFI, [11], but see more recent decision in Re Timothy Michael Lord QC, unreported, HCMP1397/2013, 16 Aug 2013, CFI, [19]. 43  H KSAR v Hill Wong, unreported, CACC 329/2006, 4 July 2007, [26]; HKSAR v Pike James Edward, unreported, CACC 486/2006, 9 Aug 2007, CA, [32]-[33]; HKSAR v Boma Amaso [2012] 2 HKLRD 33, [31] (CA). 44  H KSAR v Tarazona Edgar Henry, unreported, CACC 508/2002, 21 May 2013, CA, [76].

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2.2.1 Insider Dealing and Other Market Misconduct The Securities and Futures Ordinance (SFO), enacted in 2002, was the product of a major law reform exercise that consolidated 10 different ordinances and introduced new changes.45 When the law was proposed, its stated aim was “to enshrine a user-friendly regulatory regime for the development of a fair, orderly and transparent market that is competitive internationally as well as attractive to investors, issuers and intermediaries.”46 It was said to be a “modern legal framework” that “(a) promotes market confidence; (b) secures appropriate investor protection; (c) reduces market malpractice and financial crimes; and (d) facilitates innovation and competition”.47 Prior to the SFO, insider dealing was not treated as a criminal offence; there was only an offence of market misconduct.48 The SFO widened the scope of wrongdoing by introducing six types of market misconduct including insider dealing.49 Each type of market misconduct can be the subject of either criminal or civil proceedings, but no single set of facts can give rise to both.50 When the SFC proceeds by civil proceedings the case is brought before a Market Misconduct Tribunal, which holds oral hearings and has a wide range of powers to address any misconduct found.51 Pursuant to a 2007 agreement between the SFC and Prosecutions Division of the Department of Justice (DOJ), the SFC refers all potential market misconduct prosecutions to the DOJ, who decides whether the case should be prosecuted by the SFC in the magistrates’ court or by the DOJ in the District Court or High Court.52 It is exceptional for the DOJ to delegate its prosecution authority in this way but it was done as an acknowledgement of the regulatory agency’s expertise and commitment to enforcement. As explained below, the delegation has not been without difficulties. Insider dealing has a technical definition under the SFO but is generally committed when a person connected with a listed corporation, knowing inside information about that corporation, deals in that corporation’s listed securities or derivatives (or that of a related corporation).53 Counselling 45  Securities and Futures Ordinance (Cap. 571), originally Ord. 5 of 2002, in force on 1 Apr 2003, L.N. 12 of 2003. See also Financial Services Bureau (2000), [5]. 46  Financial Services Bureau, ibid., [6]. 47  Ibid. 48  SFC (2000), p. 4. 49  Securities and Futures Ordinance, s. 245(1). 50  Ibid., s. 252A(1), (3) & (4). 51  Ibid., Part XIII, Division 2. 52  SFC (2013b). 53  Securities and Futures Ordinance, s. 291(1)(a).

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or procuring another person to deal in the corporation’s listed securities or derivatives would also be insider dealing.54 Inside information is “specific information” about the corporation that is not generally known but would, if generally known to persons likely to deal in the security, materially affect the price of the security.55 Hong Kong courts take the offence of insider dealing quite seriously. In identifying the harm of insider dealing, the CFA referred to the threat it posed to the integrity of financial markets: Insider dealing is an “insidious mischief” which threatens the integrity of financial markets and public and investor confidence in the markets. The object of [the Securities (Insider Dealing) Ordinance] was to eliminate insider dealing and to reinforce the transparency of the markets, thereby enhancing and preserving Hong Kong’s position as an international financial centre.56 In one particularly serious case, HKSAR v Du Jun, the offender was sentenced to six years imprisonment and fined $1688000.57 Du Jun, a managing director of the fixed income department of Morgan Stanley, profited HK$23.3 million after trading HK$87.1 million worth of a stock over several months on inside information. In addressing the proper approach to sentencing in these matters, the Court of Appeal stated, “[i]t is not a mere soundbite to talk of the importance of the integrity of this particular market. It is a self-evident importance not devalued by the fact that the point is so often made.”58 In addition to insider dealing, market misconduct proceedings can also be brought for false trading,59 price rigging,60 disclosure of information about prohibited transactions,61 disclosure of false or misleading information inducing transactions,62 and stock market manipulation.63

54  Ibid., s. 291(1)(b). 55  Ibid., s. 285(2). 56  Koon Wing Yee v Insider Dealing Tribunal (2008) 11 HKCFAR 170, [45]. 57  H KSAR v Du Jun [2012] 6 HKC 119 (CA). 58  Ibid., [158]. 59  Securities and Futures Ordinance, s. 295. For more, see Mak (2015), ch 12. 60  Ibid., s. 296. 61  Ibid., s. 297. 62  Ibid., s. 298. 63  Ibid., s. 299.

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2.2.2 Anti-money Laundering and Anti-terrorist Financing Regime It is well known how money laundering activities can pose risks to financial institutions and markets and attract criticisms from the Financial Action Task Force. Hong Kong takes these risks seriously and has had anti-money laundering laws, in respect of drug trafficking proceeds, as early ago as 1989.64 In 1994, a new law was enacted to address the proceeds of all indictable offences,65 and in 1995, both laws were modernized to their current form.66 The post-September 11th terrorist financing legislation was enacted in 2002.67 In 2011, a new regulatory system was enacted to deal more broadly with money laundering and terrorist financing risks to financial institutions.68 There are two general money laundering offences. The less serious one requires everyone who suspects certain property to be the proceeds or instruments of an indictable offence to report their suspicion to the police.69 The more serious money laundering offence involves dealing with property, while knowing or having reasonable grounds to believe the property is the proceeds of an indictable offence.70 Making a report to the police of suspected property (or intending to make such a report) can be a defence to the more serious charge under certain circumstances.71 Courts have noted the risk posed by money laundering to the integrity of financial systems. In a leading sentencing decision on this offence, the Court of Appeal made reference to Hong Kong’s IFC status in questioning whether the maximum sentence of 14 years imprisonment was sufficient for the offence of money laundering:

64  Drug Trafficking (Recovery of Proceeds) Ordinance (Cap. 405), originally Ord. 35 of 1989 (hereinafter “DTROPO”). 65  Organized and Serious Crimes Ordinance (Cap. 455), originally Ord. 82 of 1994 (hereinafter “OSCO”). 66  See Drug Trafficking (Recovery of Proceeds) (Amendment) Ordinance 1995, Ord. 89 of 1995; Organized and Serious Crimes (Amendment) Ordinance 1995, Ord. 90 of 1995. 67  United Nations (Anti-Terrorism Measures) Ordinance (Cap. 575), originally Ord. 27 of 2002. See also subsidiary legislation to the United Nations Sanctions Ordinance (Cap. 537), which implement the many United Nations Security Council resolutions binding on Hong Kong. 68   Anti-Money Laundering and Counter-Terrorist Financing (Financial Institutions) Ordinance (Cap. 615), originally Ord. 15 of 2011. 69  DTROPO, s. 25A; OSCO, s. 25A [both liable to 3 months imprisonment]. 70  DTROPO, s. 25; OSCO, s. 25 [both liable to 14 years imprisonment]. 71  DTROPO, ss. 25(2), 25A(2); OSCO, ss. 25(s), 25A(2).

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Given the number of cases that have come before the courts, given the huge sums involved in quite a few of them, given that laundering the proceeds of offences—often very serious offences indeed—is designed by its very nature to enable criminals to avoid detection, and given the signal importance of preserving Hong Kong’s reputation as an international financial centre of integrity, and given the further vital importance of international cooperation in the fight against money laundering, and therefore against crime which is thereby encouraged, the question whether the maximum sentence available to the courts of this jurisdiction is one that is adequate is a matter upon which we have not deliberated but it may merit some debate and consideration by policymakers.72 2.2.3 Corruption and Bribery Laws Since 1974, Hong Kong’s Independent Commission Against Corruption has made great progress in lowering the level of corruption in both the public and private sectors. However, the circumstances of the Kwong Hing and Semtech International Holdings cases in the early 2000s, both of which involved payments to equity research analysts to write favourable reports on companies, reminded us of the vulnerability of financial markets to corruption and bribery.73 Hong Kong’s Prevention of Bribery Ordinance, enacted in 1970, contains a comprehensive set of offences to address both public and private bribery. The offence commonly used in private bribery cases is known as “corrupt transactions with agents”.74 It requires proof that an agent solicited or accepted an “advantage” as an inducement to or reward for “or otherwise on account of his” doing or having done any act in relation to his principal’s affairs or business.75 It is also a crime for anyone to offer an advantage to an agent in a similar way.76 The principal’s permission, lawful authority and reasonable excuse are available defences.77 Advantage is defined broadly to include any gift, loan, fee, reward, commission, office, contract, payment, service, favour, exercise of any right and more, but excludes “entertainment”, which is defined as “the provision of food or drink, for consumption on the occasion when it is 72  H KSAR v Boma Amaso, supra note 43, [31]. 73  H KSAR v Li Man Tak, unreported, CACC 303/2005, 13 Sept 2006, CA; HKSAR v Leung Chi Wah Earnest, unreported, CACC 275/2007, 23 Oct 2008, CA. 74  Prevention of Bribery Ordinance (Cap. 201), s. 9 [liable to 7 years imprisonment]. 75  Ibid., s. 9(1)(a). Forbearing to do an act is also captured. 76  Ibid., s. 9(2). 77  Ibid., s. 9(1), (2) & (4).

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provided, and of any other entertainment connected with, or provided at the same time as, such provisions”.78 3

Role of the Criminal Sanction

The traditional role of the criminal sanction is to censure and punish blameworthy conduct that harms or threatens harm to a particular community.79 The punishment can serve different purposes, depending on the circumstances of the case. Those purposes include protecting the public, denouncing the offence, deterring others, and compensating victims. In the IFC context, the criminal sanction continues to play its traditional role but in a more limited fashion. Its role is limited by a number of factors. First, constitutional human rights law requires criminal proceedings to have certain safeguards and protections that make resort to criminal process more restrictive and risky than civil processes. Civil processes too punitive will be deemed to be criminal. Second, the human rights implications of criminal law and process have led to the development of various non-criminal enforcement measures that help to further the purposes of deterrence, compliance, compensation and public protection without need to rely upon the criminal sanction. Third, the Prosecutions Division of the Department of Justice decides the cases to be prosecuted in the higher criminal courts, and have generally been measured in their approach. Fourth, courts have generally interpreted criminal law offences narrowly and insisted upon clear moral culpability requirements, thereby keeping the net of criminal liability constrained. For all these reasons, the criminal sanction in the context of Hong Kong’s IFC has primarily played only its traditional role of punishing and deterring serious cases. The criminal sanction has an important secondary role in the IFC context. This is to back up coercive measures that promote disclosure and investigation. This secondary role highlights the importance of transparency and access to information in ensuring the integrity of an IFC. 3.1 Primary Role: To Punish and Censure Serious Wrongdoing From July 2013 to July 2014, only about 17 per cent of all persons subject to enforcement measures under the SFO were prosecuted.80 Non-criminal measures, such as civil proceedings, disciplinary proceedings, or Market 78  Ibid., s. 2(1). 79  von Hirsch (1993). 80  SFC (2014).

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Misconduct Tribunal proceedings, accounted for the other enforcement cases. As of 31 December 2014, there was a drop of 67.3 per cent in criminal charges laid (year-on-year), while persons subject to ongoing civil proceedings increased by 31.9 per cent.81 In its statement of “enforcement philosophy”, the SFC mentions its use of a range of enforcement measures to achieve three aims: punishment (“Justly punish wrongdoers for their misconduct”), deterrence (“Deter wrongdoers from repeating the misconduct and warn other market participants against mimicking similar misconduct”) and remediation (“Ensure that the consequences of wrongdoing are remedied by wrongdoers and their accomplices”).82 In practice, criminal prosecution serves mainly the punishment aim and to a limited extent the deterrence aim. There are a number of reasons for why the criminal sanction has not played a more expansive role in the IFC context, notwithstanding the wishes of the SFC. Human rights law provisions, which operate on the constitutional level, have had considerable impact on the scope and application of the criminal sanction since 1991. Articles 10 and 11 of the Hong Kong Bill of Rights set out a set of minimum fair trial standards, which all criminal proceedings must guarantee. The more important fair trial rights include the presumption of innocence, the right to examine witnesses, and the right to silence (also known as the right against compelled self-incrimination). While these guarantees are important for protecting criminal defendants, they also make prosecutions more restrictive and challenging. Human rights law also penetrates punitive legal processes disguised as a civil process. The Insider Dealing Tribunal (IDT) under the previous securities legislation was intended to be a strong civil process with powers to order penalties but without the trappings of the criminal process. In a 2008 decision of the CFA, Koon Wing Yee v Insider Dealing Tribunal, it was held that the IDT proceedings were criminal in nature because of the severity of the penalty power.83 If the tribunal was to keep its sanctions power, it had to adhere to criminal process standards including the prohibition on the use of compelled self-incriminatory evidence. Rather than declaring all IDT proceedings involving the use of compelled self-incriminatory evidence as being unconstitutionally unfair, the Court struck down the penalty provision to restore the original intent behind the IDT of being a civil process. The Court’s remedial compromise in Koon Wing Yee reflected the policy decisions implemented in the 2002 legislation. Those who drafted the SFO 81  SFC (2015b), p. 9. 82  SFC (2013a). 83  Koon Wing Yee v Insider Dealing Tribunal, supra note 56.

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were aware of the human rights problem of the IDT and thus created a MMT that did not have the same severe penalty provision. In the words of Lord Hoffmann NPJ, “in recognition of the fact that criminal prosecutions for market misconduct are often dilatory, expensive and unpredictable, the Ordinance created the alternative of proceedings before the MMT”.84 It was also recognised that a comprehensive range of criminal and non-criminal measures was needed to achieve the legislative aims. Criminal law and process could not be expected to be the normal vehicle to serve the multiple purposes of enforcement. In a 2010 speech, the SFC’s Director of Enforcement stated that the “traditional enforcement approach [. . .] to identify and prosecute the wrongdoer” was not sufficient and the SFC was “deeply engaged in not only sending deterrent messages [. . .] but also in remedying the consequences of securities market fraud and misconduct”.85 He explained that the SFC’s approach was “to employ the full spectrum of remedies, both criminal and civil, not only to send deterrent messages but also to bring the law to bear on resolving the consequences of misconduct”.86 The MMT is an administrative tribunal that adjudicates upon misconduct proceedings instituted by the SFC. The tribunal, presided over by a judge and two other members, has wide powers to receive and consider evidence. Individuals are to be given a reasonable opportunity of being heard but the standard of proof of balance of probabilities is applicable. The Secretary for Justice must consent to all proceedings before they can be instituted before the MMT. The MMT can make a wide range of orders to promote the aims of deterrence, public protection and compensation. By order of the MMT, persons can be prohibited from being a director, liquidator, receiver or manager of a listed corporation, from acquiring or otherwise dealing in any securities, futures or leveraged foreign exchange contract for up to five years and from repeating conduct constituting market misconduct. Persons can also be ordered to pay the Government any profit gained or loss avoided, to pay costs and expenses reasonably incurred by the Government, SFC or Financial Reporting Council (as and where applicable), and to be recommended for disciplinary action by any applicable body. Failure to comply with prohibitive orders is an offence punishable up to HK$1 million and 2 years imprisonment. Courts have rejected constitutional challenges to the MMT, reaffirming its non-criminal character. Its powers have been described as “protective rather than punitive 84  Securities and Futures Commission v Tiger Asia Management LLC (2013) 16 HKCFAR 324, [21]. 85  Steward (2010), pp. 1–2. 86  Ibid., p. 2.

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in character”.87 It has been said that the MMT decides neither criminal nor civil liability. Justice Andrew Cheung described its unique character in these terms: It does not oust the jurisdiction of the criminal courts in Hong Kong, nor does it usurp their function. It is established to perform a regulatory and protective role in Hong Kong’s financial markets. It is there to ensure that those engaged in market misconduct do not profit from their wrongs. In a fairly general sense, it performs a function that protects and benefits the interests of the society as a whole. But it does not determine criminal guilt nor impose penal sanction. Certainly it wields extensive powers and indeed it must act judicially. But one thing it does not do is to exercise the judicial power of the HKSAR. Hong Kong has a long history of using administrative bodies and tribunals for similar functions.88 Part IX of the SFO provides for various disciplinary actions to be brought by the SFC against regulated persons, including registered institutions. Where a person is “guilty of misconduct” or regarded as “not a fit and proper person”, the SFC may revoke or suspend the person’s licence or approval, publicly or privately reprimand the person, prohibit applications or approvals from being made for a period of time and order a pecuniary penalty not exceeding the greater of HK$10 million or three times the amount of any profit gained or loss avoided. The SFO also provides for civil proceedings to be brought in relation to various kinds of misconduct to enable victims to more easily obtain compensation for losses. The use of section 213 as a civil enforcement tool by the SFC has given rise to litigation and commentary.89 Section 213 allows the SFC to apply for various orders where a person has contravened any relevant provision of the SFO. The orders can be far reaching including injunctive orders to restrain or prohibit continued breaches, orders to freeze property, orders to appoint administers of property, orders to declare contracts void, orders to secure compliance with other orders, and any necessary ancillary orders. In Securities and Futures Commission v Tiger Asia Management LLC, the CFA held that section 213 orders could be sought and made for market misconduct whether or not civil or

87  Luk Ka Cheung v The Market Misconduct Tribunal [2009] 1 HKLRD 114, [53] (CA). See also Chau Chin Hung v Market Misconduct Tribunal, unreported, HCAL123/2007, 22 Sept 2008, CFI, [84] & [102]. 88  Luk Ka Cheung, ibid., [68]. 89  See Low, Datwani & Datwani (2012).

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criminal proceedings for such conduct had been or would be brought.90 It is a stand-alone enforcement provision that serves purposes different from those served by criminal and MMT proceedings. Lord Hoffmann NPJ wrote, In these proceedings the SFC acts not as a prosecutor in the general public interest but as protector of the collective interests of the persons dealing in the market who have been injured by market misconduct. Proceedings under s. 213 are the public law analogue of actions for damages by individuals under s. 305 rather than a substitute for a criminal prosecution or proceedings before the MMT. They are plainly civil proceedings and therefore do not attract the protection accorded to criminal defendants.91 In late February 2015, the SFC obtained its first ever court order (pursuant to section 212 of the SFO) to wind up a Hong Kong-listed company, known as China Metal Recycling (Holdings) Limited, in the public interest.92 With the availability of court orders under sections 213 and 212, MMT proceedings, disciplinary proceedings, and other civil proceedings, criminal prosecution is far from the enforcement option of choice and can be reserved for serious cases. This appears to be the sentiment expressed in this excerpt of a speech by the SFC’s Director of Enforcement: The greatest antidote to fraud is uprooting it once discovered and remedying the consequences. Of course I am not ignoring the wrongdoer. But I am arguing that concentrating on the wrongdoing alone is not enough to maintain confidence, orderliness and fairness in our markets if it means the wrongdoing and the harm and damage it has caused remains unchecked and unremedied. [. . .] This analysis means the prescription must include broad civil and criminal remedies to chase down assets and proceeds wherever they may be; to apply for remedial sanctions for the benefit of victims; to ensure those who assist in fraud and misconduct, including those who help to hide it from detection, are made to pay for the costs of rectification and finally the prosecution of perpetrators.93

90  Securities and Futures Commission v Tiger Asia Management LLC, supra note 84. 91  Ibid., [16]. 92  SFC (2015a). 93  Steward, supra note 85, pp. 2–3.

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As hinted in the Director’s speech, the SFC would like to see more criminal prosecutions of market misconduct. However, the SFC and the DOJ have not seen eye to eye on the issue of criminal prosecution. This difference of views became apparent in August 2013, on the eve of a change in leadership in the office of the Director of Public Prosecutions (DPP).94 The SFC expressed concerns with too few market misconduct cases being prosecuted in the higher courts and the slow response from the DOJ on referred cases, which the SFC attributed to insufficient resources designated to SFC cases.95 The then DPP maintained that decisions not to prosecute in the higher courts were properly made and that his concerns with the SFC handling both investigative and prosecutorial roles were such as to call for the withdrawal of the prosecutorial role from the SFC.96 Based on enforcement statistics for the first half of 2014, there does not appear to be any relative increase in the number persons prosecuted for market misconduct, and taking into account the statistics in the second half, the trend is downwards.97 A final reason for the limited role of criminal prosecutions is the tendency of the CFA to interpret criminal offences strictly thereby keeping the net of criminal liability constrained. In practice this means cases must be evidentially strong before they will be brought to court, and sufficiently serious if they are to be brought before a higher court. Two recent cases on the money laundering offence from the CFA illustrate this tendency. In the first case, the CFA held that the meaning of “proceeds of an indictable offence” did not include legitimate money used in the commission of an indictable offence.98 In the second case, the CFA held that the mens rea element of “having reasonable grounds to believe” had to be applied from the standpoint of the defendant taking into account his beliefs, perceptions and evaluations and could only be satisfied if anyone looking at the circumstances from the defendant’s standpoint “would so believe” the property was proceeds of an indictable offence.99 Both decisions took a narrower approach to the offence than that taken in lower courts since at least 1999. Another illustration of the Court’s strict approach to the criminal law was its application of the offence of false trading to a case of “matched trades” of

94  Buddle (2013a). 95  SFC (2013b). 96  Zervos (2013), p. 10; Buddle (2013b). 97  SFC (2014); SFC (2015b). 98  H KSAR v Li Kwok Cheung George (2014) 17 HKCFAR 319. 99  H KSAR v Pang Hung Fai [2014] 6 HKC 487, [52] (CFA).

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derivative warrants.100 The two appellants were day traders who generated profits “simply by buying and selling warrants to one another”.101 Profit resulted because “the total amount of rebates [offered by the issuer] paid to the appellants was greater than the transaction costs they incurred”.102 The offence required proof of conduct done with the intention or recklessness of creating a false or misleading appearance of active trading in warrants.103 However, there was a defence if the defendants could prove on balance of probabilities that they did not have the purpose of creating a false or misleading appearance of active trading.104 Though the Court rejected the reverse onus challenge to this defence, it found that the defendants did satisfy the persuasive burden required for the defence.105 The Court disagreed with the trial court’s factual findings on the issue of “purpose”, describing them as “unconvincing”.106 3.2 Secondary Role: Promoting Disclosure and Transparency The criminal sanction is also called upon to play a secondary role of supplying the teeth behind investigative powers or disclosure obligations that further transparency aims and promote the integrity of the financial system. In the securities and anti-corruption contexts, the enforcement agencies are given exceptional investigative powers to gather evidence and compel individuals to provide information. These compulsory powers are backed up with criminal sanctions. The legislative wisdom to include immunity provisions that prohibit the use in criminal proceedings of information gathered from these compulsory powers has saved them from constitutional challenge. Courts have been supportive of these powers and have not imposed restrictions on the derivative use of compelled information or on use of the compelled information for non-hearsay impeachment purposes.107 The two money laundering offences, mentioned earlier, also work together to promote disclosures of suspicious transactions so as to provide more intelligence to the police for further investigation.

100  Fu Kor Kuen Patrick v HKSAR (2012) 15 HKCFAR 524, [6]. 101  Ibid., [42]. 102  Ibid. 103  Securities and Futures Ordinance, s. 295(1). 104  Ibid., s. 295(7). 105  Fu Kor Kuen Patrick, supra note 100, [96] & [101]. 106  Ibid., [99]. 107  H KSAR v Lee Ming Tee (2001) 4 HKCFAR 133; A v The Commissioner of the Independent Commission Against Corruption (2012) 15 HKCFAR 362.

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In the companies and securities contexts, there are many provisions aimed at promoting disclosure of accurate information to the regulators and/or the public. Disclosing or releasing false or misleading information is punished by the criminal law sanction. These offences are essential to preserving the integrity and transparency of the financial system.108 4 Conclusion Although the criminal law is an essential aspect of the legal environment sustaining Hong Kong’s IFC status, it plays only a limited enforcement role given the availability of a variety of non-criminal enforcement measures. It plays its traditional role of censuring and punishing serious blameworthy conduct that threatens property rights, economic interests or the integrity of financial systems. It is also well suited to play a secondary role in backing up investigative powers or disclosure duties to ensure a high rate of compliance. But going much beyond these roles, as the Hong Kong experience suggests, would not be wise. This is what appears to have happened with the prosecutor’s use of the money laundering offence. The CFA has now reigned in the net of criminal liability for money laundering. The time is now ripe, following the example of the SFO, for a policy response that explores greater use of non-criminal measures to address money laundering risk outside the confines of financial institutions. References Bibliography

Buddle, Cliff (2013a) “Top Prosecutor Kevin Zervos Calls for Curb on Legal Power of SFC,” South China Morning Post, 17 August. ——— (2013b) “Regulator Accused Justice Department of Failing to Prosecute ‘Serious’ Cases,” South China Morning Post, 31 August. Da Roza, Antonio & Kevin Tang (2014) Companies (Winding-Up and Miscellaneous Provisions) Ordinance: Commentary and Annotations, Hong Kong: Sweet & Maxwell. Financial Services Bureau (2000) “Legislative Council Brief—Regulatory Reform for the Securities and Futures Market—The Securities and Futures Bill,” 10 November 2000, http://www.sfc.hk/web/doc/EN/legislation/securities/others/fsb-legco-be .pdf (accessed 29 April 2015). 108  For an illustration of one of such case, see To Shu Fai v Securities and Futures Commission (2009) 12 HKCFAR 758.

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Jackson, Michael (2003) Criminal Law in Hong Kong, Hong Kong: Hong Kong University Press. Law Reform Commission of Hong Kong (LRCHK) (1996) Report on Creation of a Substantive Offence of Fraud, Hong Kong: LRCHK. Legal Policy Division, Department of Justice, (1998) “Information Paper—Creation of a Substantive Offence of Fraud—Theft (Amendment) Bill 1998,” LC Paper No. CB(2) 633/98–99(03), November 1998. Legislative Council (LegCo) Secretariat (1999) “Report of the Bills Committee on Theft (Amendment) Bill 1998,” LC Paper No. CB(2)2392/98–99, 28 June 1999. Low, Chee Keong, Mohan Datwani & Samantha Datwani (2012) “Pouncing Dragon, Hidden Tiger—A Case of Regulatory Overreach?” 42 Hong Kong Law Journal 701–16. Mak, Bernard (2015) Securities Law in Hong Kong, Hong Kong: LexisNexis. Securities and Futures Commission (SFC) (2000) “The Securities and Futures Bill,” http://www.sfc.hk/web/doc/EN/speeches/public/s&fbill-broc.pdf (accessed 29 April 2015). SFC (2013a) “Enforcement Philosophy,” 5 March 2013, http://www.sfc.hk/web/EN/ regulatory-functions/enforcement/enforcement-philosophy.html (accessed 29 April 2015). ——— (2013b) “SFC statement on prosecutorial responsibility,” 30 August 2013, http:// www.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/ corporate-news/doc?refNo=13PR86 (accessed 29 April 2015). ——— (2014) “Persons Subject to Ongoing or Concluded Enforcement Proceedings— Quarterly Figures for Periods Ended 30 June 2014, 31 March 2014, 31 Dec 2013 and 30 Sept 2013,” http://www.sfc.hk/web/EN/regulatory-functions/enforcement/ enforcement-statistics/people-subject-to-ongoing-or-concluded-enforcement-pro ceedings.html (accessed 29 April 2015). ——— (2015a) “SFC Obtains Court Order to Wind up China Metal Recycling (Holdings) Limited,” 26 February 2015, http://www.sfc.hk/edistributionWeb/gateway/EN/ news-and-announcements/news/enforcement-news/doc?refNo=15PR18 (accessed 29 April 2015). ——— (2015b) “Quarterly Report: October—December 2014,” February 2015, http:// www.sfc.hk/web/EN/files/ER/Reports/QR/201410-12/Eng/00_final.pdf (accessed 29 April 2015). Steward, Mark (2010) “SFC Enforcement and Fraud—Speech at Conference on Fraud Risk Management,” 24 May 2010, http://www.sfc.hk/web/doc/EN/speeches/ speeches/10/Mark_20100524.pdf (accessed 29 April 2015). von Hirsch, Andrew (1993) Censure and Sanctions, Oxford: Clarendon Press. Young, Simon N. M. (2006) “Defending White Collar Crime in Hong Kong: A Case Study of the Lee Ming Tee Case.” 36 Hong Kong Law Journal 35–60. Zervos, Kevin (2013) “Director’s Overview,” in Department of Justice, ed., Yearly Review of the Prosecutions Division 2012, Hong Kong: Department of Justice, 6–12. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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Cases

A v The Commissioner of the Independent Commission Against Corruption (2012) 15 HKCFAR 362. Chan Fat Chu Raymond v HKSAR (2009) 12 HKCFAR 775. Chau Chin Hung v Market Misconduct Tribunal, unreported, HCAL123/2007, 22 Sept 2008, CFI. Fu Kor Kuen Patrick v HKSAR (2012) 15 HKCFAR 524. HKSAR v Boma Amaso [2012] 2 HKLRD 33 (CA). HKSAR v Du Jun [2012] 6 HKC 119 (CA). HKSAR v Hill Wong, unreported, CACC 329/2006, 4 July 2007, CA. HKSAR v Hsu Ming Mei [2013] 1 HKLRD 286 (CA). HKSAR v Leung Chi Wah Earnest, unreported, CACC 275/2007, 23 Oct 2008, CA. HKSAR v Lee Ming Tee (2001) 4 HKCFAR 133. HKSAR v Li Kwok Cheung George (2014) 17 HKCFAR 319. HKSAR v Li Man Tak, unreported, CACC 303/2005, 13 Sept 2006, CA. HKSAR v Pang Hung Fai [2014] 6 HKC 487 (CFA). HKSAR v Pike James Edward, unreported, CACC 486/2006, 9 August 2007, CA. HKSAR v Tarazona Edgar Henry, unreported, CACC 508/2002, 21 May 2013, CA. HKSAR v Telephone Est (HK) Company Ltd [2014] 1 HKC 197 (CFI). HKSAR v Wong Cho Sum [2001] 3 HKLRD 76 (CA). HKSAR v Woo Mei Bo Mable, unreported, CACC 565/2002, 15 Aug 2003, CA. In Re Commission Ordinance, unreported, HCMP3039/1992, 8 Jan 1993, HC. Koon Wing Yee v Insider Dealing Tribunal (2008) 11 HKCFAR 170. Luk Ka Cheung v The Market Misconduct Tribunal [2009] 1 HKLRD 114 (CA). Mo Yuk Ping v HKSAR (2007) 10 HKCFAR 386. The Queen v Lee Tsat Pin, unreported, CACC 315/1985, 19 Dec 1985, CA. R v Ghosh [1982] QB 1053 at 1064 (CA). R v Hinks [2001] 2 AC 241 (HL). Re Robin Potts QC, unreported, HCMP4108/1999, 23 Sept 1999, CFI. Re Timothy Michael Lord QC, unreported, HCMP1397/2013, 16 Aug 2013, CFI. Securities and Futures Commission v C.L. Management Services Limited, unreported, ESS3067/2013, 11 June 2014, Mag Crt. Securities and Futures Commission v Tiger Asia Management LLC (2013) 16 HKCFAR 324. Tesco Supermarket Ltd v Nattrass [1972] AC 153 (HL). To Shu Fai v Securities and Futures Commission (2009) 12 HKCFAR 758.

Legislation

Anti-Money Laundering and Counter-Terrorist Financing (Financial Institutions) Ordinance (Cap. 615). Basic Law of the Hong Kong Special Administrative Region of the People’s Republic of China, adopted by the 7th National People’s Congress at its 3rd Session on 4 April 1990. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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Companies Ordinance (Cap. 622). Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap. 32). Crimes Ordinance (Cap. 200). Drug Trafficking (Recovery of Proceeds) (Amendment) Ordinance 1995, Ord. 89 of 1995. Drug Trafficking (Recovery of Proceeds) Ordinance (Cap. 405). Organized and Serious Crimes (Amendment) Ordinance 1995, Ord. 90 of 1995. Organized and Serious Crimes Ordinance (Cap. 455). Prevention of Bribery Ordinance (Cap. 201). Securities and Futures Ordinance (Cap. 571). Theft Ordinance (Cap. 201). United Nations (Anti-Terrorism Measures) Ordinance (Cap. 575). United Nations Sanctions Ordinance (Cap. 537).

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Chapter 17

Anti-Corruption Law and Enforcement in Hong Kong Keeping It Clean Michael I. Jackson With the community, the ICAC is committed to fighting corruption through effective law enforcement, education and prevention to help keep Hong Kong fair, just, stable and prosperous. ICAC Mission Statement1

∵ Abstract This paper will examine Hong Kong’s anti-corruption laws and their enforcement by the ICAC, Hong Kong’s dedicated anti-corruption law enforcement agency. The key offences and investigative powers which have enabled the ICAC to successfully prosecute and prevent public and private sector corruption in Hong Kong for 40 years will be outlined and critically assessed. Various lessons learned over the course of the ICAC’s forty years of operation will be reviewed, and some of the challenges confronting the ICAC as it enters its fifth decade of operations will be explored, including legitimacy issues and public trust issues.

Keywords Hong Kong – anti-corruption law – Independent Commission Against Corruption (ICAC) – bribery – corruption offences – law enforcement

* Associate Professor, Faculty of Law, The University of Hong Kong. Contact: [email protected]. 1  I CAC (2015a).

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1 Introduction In 2014, Hong Kong’s dedicated anti-corruption agency, the Independent Commission Against Corruption (ICAC), celebrated its 40th birthday. Over the course of these four decades, the ICAC has unquestionably been highly successful in fighting corruption in Hong Kong, leveraging its resources through its three-pronged approach of law enforcement, education and prevention to further its mission of keeping Hong Kong “fair, just, stable and prosperous”. According to Transparency International’s 2014 Corruptions Perception Index of public sector corruption,2 Hong Kong ranked 17th equal (out of 175 countries surveyed), second in Asia behind Singapore (7th), and substantially ahead of its sovereign power, China, ranked 100th. This commendable ranking is principally attributable to the existence in Hong Kong of a body of broadly defined, presumptively established corruption offences, and to its dedicated, independent anti-corruption agency, the ICAC. Historically, the ICAC’s success in its fight against corruption in Hong Kong has been reinforced by the community’s strong support for its anti-corruption activities, and further fostered by Hong Kong’s legal system with its independent judiciary and high regard for the rule of law. The ICAC’s historical success was highlighted in 2010 by its then Commissioner, Timothy Tong: Every year we receive and handle around 3,500 corruption reports. Over 70% of the reports are traceable, meaning non-anonymous, and that, in our view, signifies the public’s confidence in us. We investigate every report that is pursuable. We handle over 200 court cases each year, with a registered conviction rate of 83% that reflects prudence when a decision is taken to prosecute and demonstrates effectiveness of process.3 Contemporaneously, the ADB/OECD, in its comprehensive review of the criminalization of bribery in 28 jurisdictions within the Asia Pacific Region, gave Hong Kong’s anti-corruption regime a mostly clean bill of health.4 Noting Hong Kong’s “impressive arsenal of investigative tools in bribery cases”, and recording that its legal regime mostly accords with international standards, the Report identified only three aspects of the law that needed consideration, namely: increasing the use of forfeiture in practice, increasing the maximum 2  Tranparency International (2014). Hong Kong’s score and ranking fell from 8.2/10 and 12th in 2009, to 77/100 and 17th in 2014. 3  Tong (2010). 4  A DB/OECD (2010). Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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level of fines, and developing more mutual legal assistance (MLA) relationships with overseas jurisdictions with a view to enhancing the investigation of corruption.5 Another deficit in Hong Kong’s anti-corruption regime, the criminalization of foreign corrupt practices, also came into focus following the coming into effect in 2011 of the UK Bribery Act 2010. Given its historical success, the ICAC’s 40th birthday was understandably an occasion for self-congratulation and celebration, with publicity materials and media lauding the ICAC’s past successes.6 It also marked the launch of an extensive publicity campaign involving “rebirth”, which promoted the need for continuing vigilance and reinforced the ICAC’s paramount role in keeping Hong Kong corruption free for future generations. But this publicity campaign had a second objective, that of rebuilding trust and confidence in the ICAC. For the ICAC’s reputation has been tarnished recently by highly publicized revelations of egregious misconduct by its officers, by gross delay in resolving complaints involving high profile figures, and by claims about the politicization of the ICAC and its processes. All heightened by queries about the integrity of its most recent Commissioner, Timothy Tong, in relation to expenditure and entertainment practices at the ICAC.7 The effect of such incidents on public trust and confidence in the ICAC was recorded by the ICAC’s own Annual Survey of public perceptions.8 Public support remains high,9 but between 2009 and 2014, the public’s perceived perception of corruption as “Very common/quite common” increased, while “Not quite common/very uncommon” correspondingly fell.10 Similarly, public perception of the “Effectiveness of ICAC’s anti-corruption work” fell, and “Not quite effective/very ineffective” increased.11 Asked to identify aspects of the ICAC’s work in need of strengthening, nearly half of the respondents (46.7%) mentioned “publicity and education work for anti-corruption” while 20.9% mentioned “law enforcement work”. Tellingly, the percentage of overall respondents declaring willingness to report corruption fell between the 2013 and 2014 surveys,12 while the percentage of respondents who, having come 5  Ibid., p. 209. 6  Lam (2014). 7  Ng (2013); Cheung (2013). 8  ICAC (2013), ICAC (2014). 9  Ibid., [1.33]. Figures for respondents declaring the ICAC “deserves” support were 95.3% (2013) and 96.9% (2014), down from 98.7% in 2012. 10  Ibid., Table A-c. Figures for those declaring corruption was “very common/quite common” increased from 20.9% in 2009 to 29.1% in 2013 and fell slightly to 27.6% in 2014. 11  Ibid., Table C. Figures for “very effective/quite effective” were 79.9% in 2013 and 80.6% in 2014, compared to 87.4% and higher between 2009 and 2012. 12  Ibid., Table A-a. From 80.6% in 2013 to 76.7% in 2014. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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across corruption in the past 12 months (admittedly, only 1.5% of respondents in 2014), reported it to the ICAC, fell substantially,13 something which the media headlined.14 This paper will outline Hong Kong’s anti-corruption legal regime, and survey those features which have historically enabled the ICAC to combat corruption so successfully. Part II will briefly outline the background and key components of the existing legal regime. Part III will then elaborate Hong Kong’s current anti-corruption offences. Part IV will describe the key features of the ICAC’s investigation and enforcement powers, and Part V will return to recent concerns about public confidence in the ICAC. 2 Background Corruption in Hong Kong was first regulated by the common law offences of bribery by public officers and misconduct in public office, as received into Hong Kong law pursuant to the general reception of English law in 1843.15 In 1898, the first statutory offences were enacted,16 but, like the common law offences, only corruption in the public sector was criminalized. This remained the law until 1948, when, following earlier English legislation,17 the Hong Kong legislature enacted the Prevention of Corruption Ordinance. This both amended the existing law relating to corruption in public office,18 and also, for the first time, criminalized corruption involving agents, i.e. “private sector” corruption. Various procedural and evidential rules and measures, including a presumption of corruption in certain situations, were also introduced, but the end result was a legislative framework which retained the relatively “rudimentary nature” of its predecessors.19 Enforcement was the responsibility of a specialized police unit, designated the Anti-Corruption Branch (ACB), initially located within the CID, but formally separated from it in 1952. By the late 1960s, the need for a new, more comprehensive legal framework had become urgent, driven by public perception of endemic corruption 13  Ibid., Table D-a. From 22.6% in 2013 to 11.7% in 2014. 14  Zhao (2015). 15  Subsequently provided for by s. 3, Application of English Law Ordinance (Cap. 88). 16  Misdemeanors Punishment Ordinance (No. 1 of 1898), ss. 3,4. 17  Three statutes existed: Public Bodies Corrupt Practices Act 1889, Prevention of Corruption Act 1906, and Prevention of Corruption Act 1916. 18  Prevention of Corruption Ordinance, s. 3. 19  McWalters (2010), p. 18.

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in the police force itself.20 After an extensive review, with close attention to contemporaneous developments in Singapore and Ceylon, the current legislation, the Prevention of Bribery Ordinance (“PBO”),21 was enacted. Enforcement of the PBO remained a problem, given the still close connection between the ACB and the police force. In 1973 this came to a head when Peter Godber, a Chief Superintendent in the Royal Hong Kong Police Force, managed to flee Hong Kong while under investigation for corruption. The ensuing public outcry led to the establishment of a Commission of Inquiry which inter alia recommended the creation of a fully independent anti-corruption agency. In 1974, this was implemented with the enactment of the Independent Commission Against Corruption Ordinance (“ICACO”)22 and the creation and empowerment of the ICAC. The PBO and ICACO were amended in 2007 to incorporate certain specific requirements of the United Nations Convention Against Corruption (“UNCAC”), following the latter’s ratification by the Central People’s Government and application to Hong Kong in early 2006.23 However, other requirements have not been statutorily adopted, reflecting the stated view of the Hong Kong Government that “most of the requirements of the Convention can be fulfilled by existing legislation and administration measures”.24 One significant omission is the enactment of statutory provisions criminalizing the bribery of foreign officials. Instead, compliance has been notionally achieved by judicial interpretation of one of the pre-existing corruption offences—section 9, dealing with corrupt transactions with “agents”—as potentially applying to bribes offered to foreign agents, including foreign public officials, at least where the offer of an advantage is made or agreed to be made in Hong Kong.25 One commentator has described this compliance as achieved by “legal sleight of hand in order to apply best international practice” and noted that it does not address the question of how, if at all, the jurisdiction of the ICAC may be exercised in such cases.26 20  See McWalters (2009); Kuan (1981); Lethbridge (1985), ch. 4. 21  Cap. 201. 22  Cap. 204. 23  McWalters (2009). The PRC signed UNCAC on 10 December 2003 and ratified it on 13 January 2006. It came into force for China and HK on 12 February 2006. Hong Kong is not a party to the earlier OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions (1997). 24  HKSAR (2007). See also Wong (2006); Tong (2008). 25  Infra note 108. 26  Michael (2013), pp. 7–11.

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Anti-corruption Framework: Corruption Offences

Hong Kong’s principal corruption offences are contained in Part II of the PBO, save for election-related corruption offences, which are provided for by the Elections (Corrupt and Illegal Conduct) Ordinance.27 Investigation and enforcement related offences, such as resisting or obstructing an ICAC officer in execution of duty,28 making false reports of corruption,29 and revealing the identity of a person under investigation,30 are mostly found in the PBO, although some such offences also exist under the ICAC Ordinance.31 Prosecutions for the corruption offences in Part II of the PBO may only be instituted with the consent of the Secretary of Justice.32 3.1 Statutory Offences 3.1.1 Prevention of Bribery Ordinance The PBO offence regime comprises seven sections expressly concerning “public sector” corruption (ss. 3, 4, 5, 6, 7, 8, 10), and one concerning “agents” (s. 9), which is principally used to prosecute what the ICAC characterizes as “private sector” corruption. In recent years, most prosecutions have involved “private sector” corruption, rather than public sector corruption and ancillary offences, as shown in Table 17.1 annexed below. All the PBO corruption offences, save for section 10, PBO, are founded on the “offer,” “solicitation” or “acceptance” of an “advantage”. “Advantage” is broadly defined, and includes (a) any gift, loan, fee, reward or commission consisting of money or of any valuable security or of other property or interest in property of any description, (b) any office, employment or contract, (c) any payment, release, discharge or liquidation of any loan, obligation or other liability, (d) any other service or favour (other than entertainment), (e) the exercise or forbearance from exercising of any right, power or duty, and (f) any offer, undertaking or promise of any such advantage.33 Similarly, “offer,” “solicit,” and “accept” are defined expansively.34 27  Cap. 554. 28  E.g. PBO, s. 17(3). 29  E.g. PBO, s. 29. 30  PBO, s. 30. 31  E.g. resisting or obstructing ICAC officer, ICACO, s. 13A; making false report, ICACO, s. 13B. 32  PBO, s. 31. 33  PBO, s. 2(1). Election donations are excluded, s. 2(1), being dealt with instead under the Elections (Corrupt and Illegal Conduct) Ordinance (Cap. 554). 34  Ibid., s. 2(2).

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3.1.1.1 Public Sector Corruption The public sector anti-corruption regime comprises one generally-worded section relating to the bribery of public servants,35 several more specific sections criminalizing bribery relating to public contracts,36 public tenders,37 and public auctions,38 and a further generally worded section involving the bribery of public servants by persons having “dealings” “of any kind” with the government or any other public body.39 Save for the latter, each section consists of a pair of offences, one criminalizing the conduct of the person offering an advantage, the other criminalizing the conduct of the public servant (or prescribed officer or other party) in soliciting or accepting an advantage. “Prescribed officers” are the subject of two further offences, outlined below. “Public servant” encompasses both “prescribed officers” and also various employees and other members of certain public bodies.40 “Prescribed officer” means government employees,41 but also includes various principal officials and senior government appointed officials, members of the ICAC, and “judicial officers”.42 Both “public servant” and “public body” are confined by their definitions to Hong Kong public bodies and Hong Kong public servants.43 Section 4, “the work horse” of the PBO in relation to public sector bribery,44 criminalizes both offering an advantage to a public servant,45 and also its solicitation or acceptance by a public servant.46 By way of illustration, section 4(2) reads: Any public servant who, whether in Hong Kong or elsewhere, without lawful authority or reasonable excuse, solicits or accepts any advantage as an inducement to or reward for or otherwise on account of his—

35  Ibid., s. 4. 36  Ibid., s. 5. 37  Ibid., s. 6. 38  Ibid., s. 7. 39  Ibid., s. 8. 40  Ibid., s. 2(1), Schedule 2. 41  Ibid., s. 2(1); more specifically, “any person holding an office of emolument, whether permanent or temporary, under the Government”. 42  Ibid., s. 2(1). 43  B v Commissioner of the ICAC (2010) 13 HKCFAR 1, [5] (CFA). 44  McWalters (2010), 341. 45  PBO, s. 4(1) [liable to 7 years imprisonment, and a fine of $500,000; s. 12(1)]. 46  Ibid., s. 4(2)[liable to 7 years imprisonment, and a fine of $500,000; s. 12(1)].

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(a) performing or abstaining from performing, or having performed or abstained from performing, any act in his capacity as a public servant; (b) expediting, delaying, hindering or preventing, or having expedited, delayed, hindered or prevented, the performance of an act, whether by himself or by any other public servant in his or that other public servant’s capacity as a public servant; or (c) assisting, favouring, hindering or delaying, or having assisted, favoured, hindered or delayed, any person in the transaction of any business with a public body, shall be guilty of an offence.47 Liability arises whether the relevant conduct—the offer, solicitation or acceptance—occurs “in Hong Kong or elsewhere”. However, this extraterritorial element is circumscribed by the need for the offeree or intended recipient to be a public servant, which means in Hong Kong. Where reliance is placed on paras. (a) or (b), then the acts to be performed or abstained from, expedited, delayed, etc., must be performed by the public servant “in his capacity as a public servant.” This is interpreted broadly, and not restricted to conduct which, if performed, would be legitimately performed within the public servant’s duty.48 It is determined by asking the following question, originally formulated by Leonard Jin Kong Kam-Piu v R:49 “Would the advantage have been given or could it have been effectively solicited if the person who solicited or accepted it had not been the kind of public servant which he in fact was?” If the answer is “certainly not,” then it follows that the act in question was in that person’s capacity as a public servant.50 Where paragraph (c) is relied on, then the purpose of the bribe must be broadly identified so that the nature of the assistance, favour, etc., alleged to have been shown or intended can be proved.51 There is no express requirement that the transaction be “corrupt”. Instead, the corrupt nature of the offer, solicitation or acceptance essentially arises 47  Subs. 4(2A)(2B) contain similar offences relating to the Chief Executive of the HKSAR, also liable to 7 years imprisonment. 48  Attorney-General v Ip Chiu [1980] HKLR 11 (PC). 49  [1973] HKLR 120, 129 (SC). Affirmed in So Sun-leung v R Cr App 261/73 (Full Court); AttorneyGeneral v Chung Fat-ming [1978] HKLR 480 (CA); Attorney-General v Ip Chiu, supra note 48; and Chan Wai-kei v HKSAR, unreported, FAMC 71/2005, 6 October 2005, CFA. 50  Chan Wai-kei v HKSAR, supra note 49, [5]. 51  H KSAR v Hui Russel [2009] 6 HKC 213, [71] (CA).

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upon proof the advantage was offered, solicited or accepted “as an inducement to or reward for or otherwise on account of ” the acts or facilitation to be performed by the public servant. The meaning of this phrase, and consequential breadth of the relevant PBO offences, was clarified in 1978 by the Court of Appeal in the leading case of Attorney-General v Chung Fat-ming.52 McMullin J, following his earlier decision in Chan Wing-yuen v R,53 stated that he “regarded the three expressions [. . .] as a formula designed to cover cases where the evidence was sufficient to show specific payments for specific acts or abstentions (these being covered by the first two expressions) and also cases where a general goodwill payment had been made without specific intention in relation to specific acts or abstentions [. . .] [which is] covered by the third expression ‘otherwise on account of’,” adding that “it is evident that the overall intention was to cast the net very widely”.54 “Inducement,” he explained, is to be regarded as prospective, “looking forward to the performance, or non-performance, of some identified and agreed act or abstention, or series of acts or abstentions, in the future;” whereas “reward” is retrospective, “looking back to some already accomplished act or abstention, or series of acts or abstentions”. “[O]therwise on account of,” in contrast, captures “the many acts and abstentions described in paras. (a), (b) and (c) [. . .] regarded as [. . .] having no express purpose but which would be susceptible of proof by the showing of the mere solicitation [or offer or acceptance] itself coupled with proof of the relative positions of the parties.”55 “Or otherwise on account of,” he further explained: provide[s] most exactly for the ‘keeping sweet’ situation in its most tenuous and insidious form. Whereas ‘inducement’ and ‘reward’ are terms apt to cover situations where positive breach of duty can be proved, directly or by necessary inference, there will be cases in which nothing more can be shown than an unexplained, and prima facie inexplicable, gratification linked with the incumbency of a particular office although no malfeasance or non-feasance can be proved.56 Instead of any specific act or abstention, the quid pro quo for the advantage in the latter case may be constituted by nothing more, explained McMullin J than

52  Supra note 49. 53  [1977] HKLR 186 (HC). 54  Attorney-General v Chung Fat-ming, supra note 49, 485–86. 55  Ibid., 486. 56  Ibid., 486.

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“a warm glow in the mind of the giver, or solicitee, occasioned by the feeling justified or not, that he has won a friend in office”.57 Leonard J elaborated the quid pro quo slightly differently, suggesting that although paras. (a) and (b) require an “act,” “the ‘act’ need not be particularized [but] must be discernible as within his public capacity as distinct from his private capacity”.58 This, he added, could, be satisfied, by proof of “favourable disposition”; thus in a case of solicitation by a public servant of another, “I would regard being or remaining favourably disposed to the person solicited as sufficient to amount to an ‘act’ within the meaning of the section and it is for that reason that I say the act does not have to be particularized”.59 Nor is there any express requirement that the parties acted with a “corrupt intention” or motive. In Chung Fat-ming, McMullin J notionally suggested this is to be implied, but went on to conclude “that proof of such intent is prima facie afforded by circumstances which would oblige a negative answer to the [Leonard test] question”.60 Leonard J himself, having rejected any implied need for proof of a corrupt intention, concluded, in relation to the solicitation offence under consideration in Chung, that “the mens rea required by the statute is no more than knowledge that the solicitation is an abuse of office or, to put it another way, knowledge that the solicitation passes the [Leonard test]”.61 Accordingly, Chung, a government postman, who had been acquitted at trial of soliciting a gift at Chinese New Year from residents who habitually left pre-stamped letters on top of the post boxes for Chung to pick up and post, should have been convicted. As Leonard J explained: “Clearly [this act] was not an act within the ordinary course of his duty. It was a favour he accorded to those residents of the flats who or whose servants were too lazy to post their own mail. [. . .] The only question remaining here is ‘was [this act] an act “in his capacity as a public servant” ’.”62 It was, he concluded: “Such letters were left to be posted not by any member of the public but the postman. [. . .] They were the only acts which he could reasonably be expected to perform vis-à-vis the person from whom the advantage was solicited.”63 In combination, the absence of any express or implied need to prove the transaction was corrupt or done with a corrupt intention, along with the broad 57  Ibid., 488. 58  Ibid., 497. 59  Ibid., 497. 60  Ibid., 488. 61  Ibid., 496. 62  Ibid., 493. 63  Ibid., 493.

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definition of “or otherwise on account of,” and the inclusion of “favourable disposition” as a potential “act” to be performed, ensure the offences created by section 4 have a very broad scope. The presumed criminality of an offer, solicitation or acceptance may be negated if it was done with “lawful authority or reasonable excuse”. This exclusion applies not only to section 4 offences, but to all the PBO corruption offences. The burden of proving lawful authority or reasonable excuse purportedly lies upon the accused;64 the standard of proof being upon the balance of probabilities.65 However, the Court of Final Appeal has concluded that this statutory burden, applied to an ancillary offence, is unconstitutional, and should be read down to an evidential burden only.66 The CFA left open the question whether the same outcome will follow in the case of true PBO corruption offences, and subsequent cases have generally taken the view it may be justified.67 The ambit of “lawful authority or reasonable excuse” remains unclear. At common law it would include the informed consent of the accused’s employer (or principal, in the case of agents),68 but a statutory defence of informed consent is already expressly provided for in the PBO, in the guise of “permission.” Specifically, public servants (other than prescribed officers) may establish they solicited or accepted an advantage “with the permission” of the public body they are employed by69 (or, in the case of an agent, “with the permission of his principal”70). For permission to be valid, the public body, before giving it, must “have [had] regard to the circumstances in which it is sought,” permission must be in writing and, as far as reasonably possible, given in advance of the offer, solicitation or acceptance71(and likewise in the case of agents72). In HKSAR v Yan Pak-cheung,73 concerning agents, Wright J ruled, following McWalters74 on this point, that the PBO creates a “specific defence to conduct which otherwise would be criminal in nature”, adding that although it may be an instance of 64  PBO, s. 24. 65  H KSAR v. Chung Chun-keung [2000] 3 HKC 49 (CFI). 66  H KSAR v Ng Po-on (2008) 11 HKCFAR 91 (CFA). 67  See HKSAR v Danny Chan Tat Chung [2010] 2 HKC 268 (CFI), in relation to s. 9, PBO; cf. HKSAR v Chan Chi Wan Stephen, unreported, CACC 355/2011, 21 November 2012, CA. 68  R v Ngan Lun-yan [1975] HKLR 369 (FC). 69  PBO, s. 4(3). 70  Ibid., s. 9(4). 71  Ibid., s. 4(4). 72  Ibid., s. 9(5). 73  [2009] 2 HKLRD 82 (CFI). 74  McWalters (2010), 284.

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lawful authority, the relevant subsection “does not qualify the defence of lawful authority or reasonable excuse”.75 What might constitute a “reasonable excuse” for these purposes awaits further clarification.76 Further defences are expressly limited. Thus, neither a public servant, nor an accused charged with offering an advantage to a public servant, may argue that the public servant actually lacked power to do or forbear from doing that to which the advantage purportedly relates.77 Nor, in the case of a recipient, can it be argued that he did not actually do or forbear from doing anything, or that he accepted the advantage without any intention of ever doing or forbearing from doing anything.78 Nor is it a defence to show that any advantage that was accepted, solicited or offered may be “customary” in any profession, trade, vocation or calling.79 The remaining public sector offences—sections 5, 6, 7, 8 and 10—are rarely prosecuted.80 Section 5 captures public servants corruptly giving assistance or using influence in relation to contracts and subcontracts with public bodies. Both the offer81 and solicitation or acceptance82 of an advantage in connection with such assistance or influence are criminalized. Similar offences were added in 2008 in relation to the Chief Executive. Sections 6 and 7 respectively criminalize the use of bribery to procure the withdrawal or non-participation of others in tenders for contracts with public bodies,83 and to procure others not to bid at auctions conducted by public bodies.84 The intended recipient of the bribe may be “any person”. Section 8 makes it an offence for a person, without lawful authority or reasonable excuse, while “having dealings of any kind” with the Government through “any department, office or establishment of the Government”, to offer an advantage to any prescribed officer employed in that department, etc.,85

75  Supra note 73, [26]. 76  As to how to approach it, see HKSAR v Adams Secuforce (International) Ltd [2008] 1 HKLRD 207 (CFI). 77  PBO, s. 11(1)(a)(2). 78  Ibid., s. 11(1)(b)(c). 79  Ibid., s. 19. 80  See Table 17.1, infra. 81  PBO, s. 5(1) [liable to 10 years imprisonment and a fine of $500,000; s. 12(1)(a)(ii)]. 82  Ibid., s. 5(2) [liable to 10 years imprisonment and a fine of $500,000; s. 12(1)(a)(ii)]. 83  Ibid., s. 6 [liable to 10 years imprisonment and a fine of $500,000; s. 12(1)(a)(ii)]. 84  Ibid., s. 7 [liable to 7 years imprisonment and a fine of $500,000; s. 12(1)(a)(iii)]. 85  Ibid., s. 8(1) [liable to 7 years imprisonment and a fine of $500,000; s. 12(1)(a)(iii)].

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or, while having dealings of any kind with any other public body, to offer an advantage to a public servant employed by that public body.86 Prescribed officers87 are the subject of two further offences. The first, in section 3, imposes liability upon prescribed officers for soliciting or accepting “any advantage” “without the general or special permission of the Chief Executive”.88 Liability is “strict” in the sense that it does not require any corrupt connection between the advantage and anything done by the prescribed officer; instead, as written, prescribed officers commit an offence simply by soliciting or accepting any of the normal loans, discounts, passages, gifts, entertainment, etc., that are part of daily life (so long as they qualify as an “advantage”), save to the extent permission has been given. Fortunately, general and special permission has been given by the Chief Executive to the solicitation or acceptance of a wide range of such advantages, set out in the Acceptance of Advantages (Chief Executive’s Permission) Notice 2010.89 This Notice, for example, gives a prescribed officer general permission in relation to advantages other than gifts, discounts, loans of money or passages, and, in relation to the latter categories, special permission to accept (and in some cases solicit) such advantages if they are from “relations”, tradesmen, close personal friends, and certain others (e.g. a wedding gift from a work colleague), subject to various restrictions on value, amount, duration etc. Special permission may also be sought from a designated approving authority.90 The second such offence is found in section 10, PBO. This offence focuses on the trappings of corruption, rather than corrupt conduct itself,91 and has often been described as “draconian” due to the burden of proof it places on the accused.92 Specifically, section 10(1) makes it an offence for a person who is or has been a prescribed officer or, since 2008, the Chief Executive, either (a) to maintain a standard of living “above that which is commensurate with his present or past official emoluments”, or (b) to be “in control of pecuniary resources or property disproportionate to his present or past official emoluments”, “unless he gives a satisfactory explanation to the court as to how he was able to maintain such a standard of living or how such pecuniary 86  Ibid., s. 8(2) [liable to 7 years imprisonment and a fine of $500,000; s. 12(1)(a)(iii)]. 87  Supra notes 41, 42. 88  PBO, s. 3 [liable to 1 years imprisonment and a fine of $100,000; s. 12(2)]. 89  HKSAR Gazette (2010). 90  Ibid., ss. 8, 9. 91  PBO, s. 10. 92  See eg. Mok Chuen v R [1977] HKLR 605, 606 (CA); R v Mok Wei-tak [1990] 2 AC 333, 342, per Lord Roskill (PC).

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resources or property came under his control”. Proving (b) is facilitated by an evidential presumption of “control” by the accused where there is “reason to believe”, due to the closeness of his relationship with another, or other circumstances, that pecuniary resources or property held by that other are held “in trust for or otherwise on behalf of the accused”, or where that other received them as a gift from the accused.93 In 1974, shortly after enactment of the PBO, it was held that “giving a satisfactory explanation” places the burden of proving a non-corrupt explanation on the accused, on the balance of probabilities: [. . .] ‘satisfactory explanation’ [. . .] means an explanation which shows, upon a balance of probabilities, that the difference between an accused person’s standard of living over the period charged and that which would have been commensurate with his present or past official emoluments has, if the standard of living actually maintained has been the higher of the two standards, been paid for with money the ultimate source of which was untainted by any corruption on the part of the accused.94 This has remained the law, despite constitutional challenges to this clear derogation from the presumption of innocence. As Bokhary JA explained, giving judgment for the Court of Appeal in Attorney-General v Hui Kin-hong95 in 1995: [Section 10] has proved its effectiveness in the fight against corruption. [. . .] But it comes at a price. The onus on the accused to provide an explanation deviates from [the presumption of innocence].96 [. . .] Where corruption is concerned, once can readily see the need—within reason of course—for special powers of investigation and provisions such as [s. 10] requiring an accused to give an explanation. Specific corrupt acts are difficult to detect let alone prove in the normal way. The true victim, society as a whole, is generally unaware of the specific occasions on which it is

93  PBO, s. 10(2). For the operation of this presumption, see Attorney-General v Yau Ka-ping [1977] HKLR 76 (CA); Attorney-General v Hui Kin-hong [1995] 1 HKCLR 227 (CA). Once there is “evidence to the contrary”, the prosecution must prove the accused’s control beyond reasonable doubt. 94  R v Hunt [1974] HKLR 31, 52 (FC). 95  [1995] 1 HKCLR 227 (CA). 96  Ibid., 230.

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victimized. [. . .] There is nothing unreasonable in what is required of an accused here.97 However, examination of the ICAC’s Annual Reports reveals no record of a prosecution under section 10 since 1994, and not even mention since the 1995 report. Upon conviction of any of the public sector offences, a court may, in addition to imprisonment and fines, order payment of the amount or value of “any” advantage received or part of it.98 The potential scope of all the PBO corruption offences is broadened by their inclusion as relevant offences for the purposes of the common law offence of incitement, and the statutory offences of conspiracy and attempt.99 3.1.1.2 Private Sector Corruption Private sector corruption is covered by only one section, section 9, headed “corrupt transactions with agents.” Adopting the format of the public sector offences, paired offences impose criminal liability on both an agent “who, without lawful authority or reasonable excuse, solicits or accepts any advantage”,100 and also on the offeror “who, without lawful authority or reasonable excuse, offers any advantage to any agent”.101 Similarly, both offences require the advantage to be offered, solicited or accepted “as an inducement to or reward for or otherwise on account of” an agent (a) doing or forbearing to do, or having done or forborne to do, any act in relation to his principal’s affairs or business; or (b) showing or forbearing to show, or having shown or forborne to show, favour or disfavour to any person in relation to his principal’s affairs or business. Section 9 includes a further offence which criminalizes an agent who “with intent to deceive his principal, uses any receipt, account or other document” which the principal is interested in, which contains any statement which is false or erroneous or defective in any material particular, and which “to his knowledge is intended to mislead the principal”.102 On conviction, in addition to imprisonment, a court may order the recipient of an advantage to 97  Ibid., 235. 98  PBO, s. 12(1). In relation to s. 3, a court may order payment of “the” advantage or any part of it; s. 12(2). See also s. 12(3) re conviction under s. 10(1)(b). 99  See s. 159A (conspiracy) and s. 159G (attempt), Crimes Ordinance (Cap. 200); incitement remains a common law offence. 100  P BO, s. 9(1) [liable to 7 years imprisonment and a fine of $500,000; s. 12(1)(a)(iii)]. 101  Ibid., s. 9(2) [liable to 7 years imprisonment and a fine of $500,000; s. 12(1)(a)(iii)]. 102  Ibid., s. 9(3) [liable to 7 years imprisonment and a fine of $500,000; s. 12(1)(a)(iii)].

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pay the amount or value of the advantage, or part of it, to such person or public body and in such manner as the court may specify.103 “Agent” and “principal” are partially defined in the PBO,104 but neither definition is exhaustive. “Agent” “includes public servants and any person employed by or acting for another”, whereas “principal” inter alia includes employers, including in the case of an employee of a public body, the public body. Strictly speaking, the offences in section 9 are not limited to the private sector, but, as McWalters notes, since section 4 covers the same terrain, “in practice s. 9(1) and (2) are not used in respect of [Hong Kong] public servants”.105 The nature of this agent-principal relationship was considered in R v Chong Chui Ha.106 According to Keith J., “agent” and “principal” should be interpreted broadly, and not limited to the common law formulation of an agent-principal relationship in the law of contract, according to which an agent is someone who is able to affect his principal’s legal position. Instead, he ruled, such a relationship could arise from a fiduciary relationship between two persons, according to which one person expressly or impliedly consents to the other acting on his behalf, even if in so acting the other cannot actually affect his principal’s legal position. He had in mind, for example, a real estate agent, who simply arranges introductions between other parties, without otherwise affecting either party’s legal position. This broad view of “agent” and “principal” has been affirmed, although any suggestion that a fiduciary relationship must be proved has been rejected.107 Significantly, whereas “public servant” and “public body” are expressly confined by their definitions to Hong Kong public bodies and Hong Kong public servants, “agent” is not. In B v Commissioner of the ICAC,108 the Court of Final Appeal held that it could therefore include foreign agents. More specifically, the Court ruled that “on an ordinary reading,” the expressions “any person employed by or acting for another” and “in relation to his principal’s affairs” may apply to a public official of a place outside Hong Kong and to his public duties. Accordingly, when an advantage was offered in Hong Kong by the chairman of a Hong Kong company to a visiting Mainland government official as a reward or inducement for assisting the company’s business ventures in the Mainland, which assistance would be an act or forbearance relating to the 103  Ibid., s. 12(1). 104  Ibid., s. 2(1). 105  McWalters (2010), 354, note 20. But s. 9(3), he also notes, has no public sector equivalent. 106  [1997] 4 HKC 518 (CFI). 107  HKSAR v Fung Hok Cheung [2008] 5 HKLRD 846 (CA). 108  (2010) 13 HKCFAR 1 (CFA).

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Mainland official’s public duties outside Hong Kong, section 9(2) could apply, even if the advantage would only be given outside Hong Kong. Rejecting a submission that this would give extra-territorial effect to the PBO, Bokhary PJ stated: [P]rosecuting and criminalizing the bribery here of foreign officials is [not] a course that the legislature has set its face against. Such a course makes a positive and important contribution to the worldwide struggle against corruption, an endeavor inherently and highly dependent on cross-border cooperation. [. . .] [C]riminalising and prosecuting the bribery here of foreign officials deters corruption here and helps to avoid the growth here of a culture of corruption. [. . .] In any event, the presumption [against extra-territorial effect] does not preclude the creation of an offence having an extra-territorial effect being legislated for in plain terms. And the legislation concerned is plain enough.109 Furthermore, an agreement made in Hong Kong—with the Mainland government official during his visit to Hong Kong—to offer an advantage in Hong Kong may constitute a conspiracy110 to commit bribery contrary to section 9, and likewise be triable in Hong Kong. Significantly, a third question before the court regarding the jurisdiction of the court to make ancillary orders111 for the purposes of an investigation was left unanswered. And the Court gave no guidance on the jurisdiction of the ICAC to investigate such bribery outside Hong Kong. The offer must, however, be made or agreed to be made in Hong Kong. In HKSAR v Kreiger,112 the Court of Appeal quashed convictions of conspiracy to bribe an agent, since the agreement, though made in Hong Kong, was to offer a foreign agent a bribe outside of Hong Kong; in this case, to a senior government official in Macau. Since the object of the agreement, offering a bribe, was neither to take place in Hong Kong, nor to have any significant effect in Hong Kong, the conduct was not triable in Hong Kong. For jurisdiction to exist, the prosecution has to show that “a substantial measure of the activities constituting a crime” took place in Hong Kong. But in Kreiger, all the prosecution could show, apart from the initial discussions and formulation of a proposed agreement in Hong Kong, was the dispatch of the draft agreement by email to Macau for delivery 109  Ibid., [21]. 110  Contrary to s. 159A, Crimes Ordinance (Cap. 200). 111  In particular, pursuant to s. 14(1)(d), PBO; infra note 179. 112  [2014] 3 HKLRD 404 (CA).

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to the agent in question, and some money flows in Hong Kong bank accounts. Such acts, suggested Stock JA, for the court, were not activities constituting the crime agreed, merely acts relating to the conspiracy or crime contemplated by it.113 Such acts, or the favour shown, etc., must be done, shown or forborne by the agent “in relation to his principal’s affairs or business.” The precise scope and meaning of this phrase remains unclear. It was considered in Commissioner of the ICAC v Ch’ng Poh,114 arising out of an ICAC allegation that A, a partner in a firm of solicitors, facilitated payment of a bribe to a convicted person in return for the latter swearing a false affidavit in support of Ch’ng Poh, a criminal appellant for whom A’s firm acted. The ICAC, acting on the basis of an alleged contravention of section 9, obtained a search warrant and seized documents from A’s firm. Ch’ng Poh judicially reviewed the lawfulness of the search warrant (and sought the return of the seized documents) on the basis A’s conduct was not as an agent “in relation to” the business or affairs of A’s firm. Lord Lloyd, dismissing the ICAC’s appeal against Ch’ng Poh’s successful judicial review, observed that the words “in relation to” serve much the same purpose as “in his capacity as a public servant” in relation to the public sector offences, and are “clearly intended to be restrictive”. The offences in section 9, he elaborated, require corrupt transactions “with an agent”, not merely conduct “by a dishonest agent”: It is not enough that the recipient of the bribe should be an agent in fact. Otherwise any partner in a firm of solicitors, accepting an advantage without authority or reasonable excuse, would be caught by the section. [. . .] [These words] mean that, for the section to apply, the person offering the bribe, must have intended the act or forbearance of the agent to influence or affect the principal’s affairs. [. . .] [It] is an essential ingredient of the offence under s. 9 that the action or forbearance of the agent should be aimed at the principal.115 Since there was no evidence A’s conduct was “aimed at” or “influenced or affected” A’s firm, the judge hearing the judicial review had, therefore, correctly held that A’s conduct was not “in relation to” his principal’s business or affairs, did not amount to an offence under section 9, and that the ICAC consequently lacked jurisdiction to obtain and execute a search warrant against A’s firm. 113  Ibid., [128]. 114  [1997] HKLRD 652 (PC). 115  Ibid., 657.

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Section 9 offences do not require proof of a corrupt intent or motive. According to R v Looi Kim-lee, the only mental element required is “an intention to do the acts forbidden by the section with the intention of the recipient [. . .] ‘showing or forbearing to show’ etc. [. . .]”.116 As with public sector offences, the agent and offeror may show the advantage was solicited or accepted with the permission of the agent’s principal,117 provided permission was obtained in advance or at least as soon as reasonably possible after the offer or acceptance was made.118 But it is no defence to argue that the agent lacked the power to do or forbear from doing that to which the advantage purportedly relates,119 or that an advantage was customary.120 3.1.2 Election-related Corruption Offences Corrupt and other forms of illegal conduct relating to public elections are specifically provided for by the Elections (Corrupt and Illegal Conduct) Ordinance.121 Some nine categories of election are covered, including those relating to the Chief Executive, the Legislative Council and District Council.122 The ordinance applies whether the conduct in question takes place within Hong Kong or elsewhere,123 and whether it was engaged in before, during or after the relevant election period.124 Part 2 deals with “corrupt conduct”, and criminalizes “engaging in corrupt conduct at an election”.125 “Corrupt conduct” is not defined; instead, a range of activities, including bribery, are declared to constitute “corrupt conduct”.126 Specifically, a person “engages in corrupt conduct at an election if the person corruptly” engages in various forms of bribery, including offering, soliciting or accepting an advantage as an inducement, or reward for, inter alia standing or not standing as a candidate, or for getting or trying to get a third party to stand or not

116  [1985] 2 HKC 410, 417C, per McMullin VP (CA). 117  P BO, s. 9(4). 118  Ibid., s. 9(5). 119  Ibid., s. 11(1)(2). 120  Ibid., s. 19. 121  Cap. 554. 122  Others include Election Committee Subsector, Heung Yee Kuk Members, Chairman, Vice-Chairman and Members of Executive Committees of Rural Committees, and Village Representatives. 123  Elections (Corrupt and Illegal Conduct) Ordinance, s. 5. 124  Ibid., s. 6(2). 125  Ibid., s. 6(1) [liable to 7 years imprisonment and a fine of $500,000; s. 6(1)(b)]. 126  Ibid., ss. 7 to 21.

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stand.127 “Conduct” includes conduct which affects another person only indirectly,128 and “advantage” has an extended meaning, broadly similar to that in the PBO.129 “Corruptly” is not defined, and has not presently received judicial interpretation. “Corrupt conduct” may also occur if a person, “without reasonable excuse”, offers, solicits or accepts an advantage to others as an inducement or reward inter alia for voting or not voting for a particular candidate or candidates, or for getting or trying to get a third party to do so,130 with the onus of proving “reasonable excuse” on the accused;131 or provides refreshments and entertainment at an election.132 3.2 Common Law—Misconduct in Public Office133 Over the past 30 years or so, the common law offence of misconduct in public office has become a powerful additional means of prosecuting corruption in Hong Kong. An integrity offence, it enables persons holding public office to be prosecuted for abuses of the powers, duties or responsibilities entrusted to or vested in them either at common law or by statute, and exercisable in the public interest. Broadly based, the offence requires proof of five elements: (i) a public official; (ii) in the course of or in relation to his public office; (iii) wilfully misconducts himself; (iv) by act or omission, for example, by wilfully neglecting or failing to perform his duty; (v) without reasonable excuse or justification. The misconduct must be serious, not trivial, having regard to the responsibilities of the office and the officeholder, the importance of the public objects which they serve and the nature and extent of the departure from those responsibilities.134 Although limited to misconduct by persons holding public office,135 use of the offence has been extended by charging conspiracy to commit misconduct in public office. In the recent Rafael Hui case, for example, discussed further

127  Ibid., s. 7 [emphasis added]. 128  Ibid., s. 2(1). 129  Ibid., s. 2(1). 130  Ibid., s. 11(1)(2). See further Secretary for Justice v Tam Heung Man [2012] 4 HKC 381 (CFI). 131  Ibid., s. 11(8). 132  Ibid., s. 12. 133  The common law offence of bribery also exists, but it is not prosecuted. 134  Sin Kam-wah v HKSAR (2005) 8 HKCFAR 192, 210–211 (CFA). 135  In HKSAR v Wong Lin Kay (2012) 15 HKCFAR 185 (CFA), the CFA rejected an attempt by the prosecution to extend the offence to mere employees of the government, adopting a narrower definition of “public office” than that claimed by the prosecution; see also Jackson (2012).

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below,136 Hui was alleged to have received multi-million dollar payments from property developers prior to and in anticipation of his becoming the Chief Secretary of the HKSAR, allegedly as “general sweetener” payments, i.e. in return for Hui “being favourably disposed” towards the developers once he was in post. Since Hui was not a public servant when the payments were made, he was charged with conspiracy to commit misconduct in public office, and the prosecution advanced its case on the basis it did not have to prove any actual misconduct by Hui once in post. The court accepted that having a “favourable disposition” sufficed as “misconduct,” and an agreement to make payments to secure such a disposition could therefore constitute a conspiracy.137 4

Anti-Corruption Framework: Investigation and Enforcement

The investigation of corruption in Hong Kong falls to the ICAC, headed by a Commissioner with a broad mandate to investigate not only the specific PBO offences outlined above and related offences, but also to investigate and deal with “corrupt practices” more generally.138 Since its establishment, the Commissioner of the ICAC and, via him, all ICAC officers, have been invested with all the necessary powers and investigative tools required by a modern anti-corruption agency, and these have been added to as and when necessary. 4.1 Investigative Jurisdiction and Powers The jurisdiction of the ICAC is nonetheless limited. It extends firstly to investigating alleged or suspected offences against the PBO, ICAC Ordinance, or Elections (Corrupt and Illegal Conduct) Ordinance,139 alleged or suspected blackmail by a prescribed officer involving misuse of his office,140 and alleged or suspected conspiracy to commit any of these offences.141 In addition, ICAC officers may investigate both the conduct of prescribed officers which, in the opinion of the Commissioner, is “connected with or conducive” to “corrupt practices”,142 and also, more generally, any “complaints” of alleged “corrupt 136  Infra. 137  See further HKSAR v Hui Rafael Junior & Ors, unreported, CACC 444/2014, 16 February 2016, CA. 138  I CACO, s. 12. 139  Ibid., s. 12(b)(i)(ii)(iii). 140  Ibid., s. 12(b)(iv). 141  Ibid., s. 12(b)(v)(vi)(vii). 142  Ibid., s. 12(c).

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practices” received by the Commissioner to the extent he considers it practicable.143 “Corrupt practices” for this purpose is not statutorily defined, but has been said judicially to include “conduct which can fairly be regarded as a corrupt practice (giving those words their ordinary meaning) whether or not the conduct amounts to an offence”.144 Once an investigation has commenced, ICAC officers are empowered to arrest without warrant in two circumstances. The first is where a person is reasonably suspected of committing an offence against the PBO, ICACO, Elections (Corrupt and Illegal Conduct) Ordinance, or blackmail by a prescribed officer.145 The second arises where, during an investigation of a suspected offence under the PBO or Elections (Corrupt and Illegal Conduct) Ordinance, but not the ICACO, a non-corruption offence is disclosed. If any such offence comes to light and it is either reasonably suspected of being “related to or facilitated directly or indirectly by” an offence against the PBO or Election (Corrupt and Illegal Conduct) Ordinance,146 or it is a “specified offence”,147 then an ICAC officer may arrest without warrant any person who is reasonably suspected of being guilty of that non-corruption offence.148 The list of specified offences includes theft and deception offences,149 perverting the course of justice,150 and conspiracy or attempt151 to commit any such offence.152 ICAC officers may also search any person suspected of any such corruption or non-corruption offence (hereafter “section 10 offence”) without warrant.153 An ICAC officer may use reasonable force to make an arrest, and may also enter and search any premises or place where a suspect is reasonably believed to be in order to make an arrest.154 Once a suspect is arrested, the officers may then search without warrant the premises or property in which the suspect was arrested or evaded arrest, to locate evidence of any section 10 offence.155 143  Ibid., s. 12(a). 144  Hall v Commissioner of the ICAC [1987] HKLR 210, 218, per Fuad JA (CA). 145  I CACO, s. 10(1). 146  Ibid., s. 10(2)(a). 147  Ibid., s. 10(5). 148  Ibid., s. 10(2). 149  Contrary to Theft Ordinance (Cap. 210). 150  Contrary to the common law; see HKSAR v Egan (2010) 13 HKCFAR 314 (CFA); HKSAR v Wong Chi Wai (2013) 16 HKCFAR 539 (CFA). 151  Supra note 99. 152  For full list, see ICACO, s. 10(5). 153  I CACO, s. 10(1)(a). 154  Ibid., s. 12(3). 155  Ibid., s. 10C(1)(b).

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Authorized156 ICAC officers may seize and detain anything which an officer has reason to believe is or contains evidence of an offence.157 This freestanding statutory power is the only seizure power granted to ICAC officers. Documents qualify as “evidence” for this purpose if they “might assist in determining” (a) whether a section 10 offence has been committed, and (b) by whom such an offence may have been committed.158 For the purposes of conducting any such investigation, the Commissioner and his officers are inter alia empowered by the ICAC Ordinance to conduct inquiries or examinations,159 enter Government premises and require prescribed officers to answer questions concerning the duties of any prescribed officer or public servant and produce relevant standing orders, directions, office manuals or instructions,160 access any records, books and other relevant documents in the possession or under the control of a prescribed officer161 or of a public body if reasonably thought they will reveal the practices and procedures of that public body,162 and photograph or copy any such documents etc.163 Once arrested, a person will normally be taken to ICAC offices for questioning, where his fingerprints, photographs, and weight and height may be taken as identifying particulars.164 Additionally non-intimate samples may be taken for forensic analysis, with or without consent of the arrestee, if authorized by a senior ICAC officer, who may only give such authorization upon reasonable grounds both for suspecting that the arrestee has committed a “serious arrestable offence” (i.e. liable for not less than 7 years imprisonment) and also for believing that the sample “will tend to confirm or disprove the commission of the offence” by the arrestee.165 The arrestee will then be either released on bail, or detained if a senior ICAC officer considers it necessary for the ­purpose

156  “Authorized” means authorized by the Commissioner under s. 10C(1), ICACO. This includes all ICAC officers by the terms of their warrant of appointment; see Apple Daily Ltd v Commissioner of the ICAC (No. 2) [2000]1 HKLRD 647, 653 (CA). 157  I CACO, s. 10C(1)(c). 158  Apple Daily Ltd v Commissioner of the ICAC (No. 2), supra note 160, 670, per Keith JA. 159  I CACO, s. 13(1)(a). 160  Ibid., s. 13(1)(b). 161  Ibid., s. 13(2)(a). 162  Ibid., s. 13(2)(b). 163  Ibid., s. 13(2)(b)(c). 164  Ibid., s. 10D. 165  Ibid., s. 10E(1)(2).

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of further inquiries,166 for up to 48 hours, whereupon he must either be charged and brought before a Magistrate, or released from custody.167 In addition to the above powers of search and seizure without warrant, ICAC officers may obtain and execute search warrants under section 17, PBO, or section 10B, ICACO. The first of these entitles an ICAC officer to apply ex parte for, and a magistrate or a judge of the Court of First Instance to issue, a search warrant for the purposes of an investigation into, or proceedings relating to, a suspected PBO offence, based on reasonable cause to believe the premises or place may contain “anything which is or contains evidence of” any such offence (“PBO search”).168 Exceptionally, entry and search may take place without application if there is reasonable cause to believe that making such an application would seriously impede the investigation or proceedings.169 Entry and search of the chambers of counsel or a solicitor’s office pursuant to this section is expressly prohibited, save where the investigation relates to a PBO offence alleged or suspected to have been committed by that counsel or solicitor, or by his clerk or employees.170 The second, section 10B, ICACO, confers a broader search power on the ICAC, enabling it to obtain a search warrant for the purposes not only of suspected PBO offences,171 but also for the purpose of investigating the additional offences related to or facilitated by corruption offences, and the specified noncorruption offences (“ICACO search”). In each case, seizure takes place pursuant to section 10C(1)(c), ICACO, although the seizure power is independent of and does not fall within the compass of a search warrant issued under the PBO. If entry, search or seizure relates to journalistic material, then such actions are prohibited172 unless certain additional conditions, including applying to the Court of First Instance or District Court for a production or access order,173 are satisfied.174 A court may only make such an order if it is satisfied there are reasonable grounds for believing that the material is likely to be of substantial 166  Ibid., s. 10A(2). 167  Ibid., s. 10A(6). 168  P BO, s. 17(1)(1A). 169  Ibid., s. 17(1B). 170  Ibid., s. 17(2). 171  I CACO, s. 10(2). 172  Interpretation and General Clauses Ordinance (Cap. 1), s. 83. 173  Ibid., ss. 84–85; the application must be made inter partes, i.e. on notice to the intended party to be searched. 174  See also Apple Daily Ltd v Commissioner of the ICAC (No. 2), supra note 156.

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value to the investigation of an arrestable offence, or to be relevant evidence in proceedings for an arrestable offence. Having lawfully entered pursuant to a warrant and conducted a search, ICAC officers may seize and detain anything which they have reason to believe is or contains evidence of a section 10 offence.175 Additional, more intrusive powers are conferred on ICAC officers by the PBO for the purpose of investigating (and also for “proceedings relating to”) any PBO offence (but not the wider categories of related and non-corruption offences). An officer may, for example, if he has reasonable cause to believe a PBO offence may have been committed, and that any financial records, bank account or “other account of whatsoever kind or description”, or any banker’s books, company books, documents or other article of or relating to any person named or otherwise identified in writing are likely to be relevant for the purposes of an investigation of such offence, (i) investigate and inspect such accounts, books, documents etc., and (ii) require any person to produce such accounts, books, documents, etc., and take copies of such accounts, books or documents or of any relevant entry therein and photographs of any other article.176 This includes anyone who is alleged or suspected to have committed a PBO offence, but in such cases requires leave to be obtained from the Court of First Instance,177 and only if the Court is likewise satisfied of certain statutory matters.178 Secondly, ICAC officers may apply to the Court of First Instance in chambers to make an order authorizing the Commissioner by a notice in writing to require the subject of the notice, who may be either the suspect or some other person (being either the owner of property or a person who has or may reasonably have information), to provide information by way of written statement enumerating various matters regarding assets, expenditure and liabilities.179 Although this constitutes a clear intrusion into a suspect’s right of silence and potentially a breach of privacy, its constitutionality has been upheld.180 Other similar powers relate specifically to obtaining tax records,181 obtaining property restraining orders (which may be served on both suspects and third 175  I CACO, s. 10(1)(c). 176  P BO, s. 13(1). 177  Ibid., s. 13(1A)(1B); the application for leave is made ex parte in chambers, i.e. without notice to the intended recipient. 178  Ibid., s. 13(1). 179  Ibid., s. 14. 180  X v Commissioner of the ICAC [2004] 1 HKC 228, [31] (CFA). 181  P BO, s. 13A.

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parties),182 obtaining the assistance of any public servant,183 and the surrender of travel documents.184 These additional powers equally apply to the investigation of conspiracies to commit a PBO offence.185 Legal professional privilege is protected under both the ICACO and the PBO. The ICACO expressly provides that “Nothing in this Ordinance shall prejudice any claim to privilege which any person may have at common law in relation to any communication, document or other thing made or given to a solicitor or counsel”.186 The PBO likewise declares that “nothing in this Ordinance shall require the disclosure by a legal adviser of any privileged information, communication, book, document or other article”.187 However, the latter ordinance goes on expressly to provide that a legal advisor may be required, pursuant to a section 14 notice, firstly to state certain matters, including whether he acted on behalf of any named or identified person during a specified period in connection with the transfer of moneys out of Hong Kong or their investment by such a person either within or outside Hong Kong;188 and secondly to furnish information in his possession relating to the date or amount of such transfers or investments, the bank, name and account number to which money was transferred, and the nature of any investment, “notwithstanding that the effect of compliance with such a requirement would be to disclose any privileged information or communication”.189 4.2 Enforcement Compliance with the various investigative obligations outlined above is enforced by criminalizing non-compliance. Thus, it is an offence to fail to disclose information, etc., lawfully required under the PBO,190 or to fail to furnish information in writing etc., when required by notice.191 In each case, the prosecution must prove the failure or neglect to comply occurred without reasonable excuse.192 Other offences include obstructing or resisting an 182  Ibid., s. 14C. 183  Ibid., s. 16. 184  Ibid., ss. 17A–17C. 185  Ibid., s. 12A(2). 186  I CACO, s. 18. 187  P BO, s. 15(1). 188  Ibid., s. 15(2)(a). 189  Ibid., s. 15(2)(b). 190  P BO, s. 13(3) [liable to 1 years imprisonment and a fine of $20,000]. 191  Ibid., s. 14(4)[liable to 1 years imprisonment and a fine of $20,000]. 192  H KSAR v Ng Po-on (2008) 11 HKCFAR 91 (CFA).

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ICAC officer in the execution of various PBO powers,193 neglecting or failing without reasonable excuse to render assistance as a public servant,194 wilfully making a false s­ tatement in answer to a PBO notice,195 and knowingly making a false report of the commission of a PBO offence or misleading an ICAC officer.196 Publishing or broadcasting information about the subject of a PBO order is also an offence.197 The effectiveness and secrecy of an investigation is additionally enforced by two further statutory means. One involves criminalizing disclosure.198 Two such disclosure offences exist, both of which require proof an alleged offender knew or suspected that an investigation of an alleged or suspected PBO corruption offence was taking place. Where this is so, it is an offence to disclose without lawful authority or reasonable excuse to a suspect that he is under investigation or any details of such investigation;199 secondly, it is an offence to disclose the identity of a suspect or details of the investigation to the public or any other person.200 Various exemptions exist, including where a warrant has been issued for the arrest of the subject person,201 where the subject person has been arrested,202 and where a PBO search of the suspect’s residence has taken place.203 Furthermore, a person may have a “reasonable excuse” if disclosure reveals (a) any unlawful activity, abuse of power, serious neglect of duty, or other serious misconduct by the Commissioner or his officers, or (b) a serious threat to public order or to the security of Hong Kong or to the health or safety of the public.204 The second mechanism involves the protection of informers.205 Informers have long been regarded as an integral feature of corruption prosecutions, along with immunity witnesses, and the PBO provides that neither the name nor address of any informer in relation to a PBO offence, nor of any other person who has assisted the Commissioner in any way with respect to such an offence, 193  P BO, s. 13(1) [liable ]; s. 17(3) [liable to 1 years imprisonment and a fine of $20,000]. 194  Ibid., s. 16(2) [liable to 1 years imprisonment and a fine of $20,000]. 195  Ibid., s. 14(5) [liable to 1 years imprisonment and a fine of $20,000]. 196  Ibid., s. 29 [liable to 1 years imprisonment and a fine of $20,000]. 197  Ibid., s. 13C(8) [liable to 6 months imprisonment and a fine of $10,000]. 198  Ibid., s. 30. 199  Ibid., s. 30(1)(a) [liable to 1 years imprisonment and a fine of $20,000]. 200  Ibid., s. 30(1)(b) [liable to 1 years imprisonment and a fine of $20,000]. 201  Ibid., s. 30(2)(a). 202  Ibid., s. 30(2)(b). 203  Ibid., s. 30(2)(e). 204  Ibid., s. 30(3). 205  Ibid., s. 30A.

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may be disclosed.206 This protection will not apply if a court is satisfied that an informer wilfully made a material statement in proceedings before the court which he knew or believed to be false or did not believe to be true, or if in any other proceeding it is of opinion that justice cannot be fully done between the parties thereto without disclosure of the name of an informer or other person who gave assistance.207 5

Loss of Trust and Confidence

By any measure, Hong Kong has an extensive array of offences, covering most forms of public and private sector corruption (save only for express offences dealing with corruption by foreign officials), and a well-resourced, amply empowered anti-corruption agency. Given these two features, and the undoubted historical success of the ICAC in combatting corruption in Hong Kong, why has there been a perceived loss of trust and confidence in the ICAC, resulting in its 40th Anniversary being as much a vow of renewal as a celebration? Key reasons for this build up in negative perception by early 2012 were catalogued by Young,208 including the use of illegitimate means by ICAC officers to achieve ends (such as invasions of privacy, violations of legal professional privilege, witness coaching, and material non-disclosure), several high-profile failed prosecutions, and a perceived weakening in operations, including officer misconduct. Young attributed much of this negativity to evolving public sentiments and expectations, reflecting an enhanced human rights regime in Hong Kong, and concomitant calls for greater accountability and transparency on the part of the government and its agencies. More being expected, in other words, the greater the sense of dissatisfaction when things seemingly go astray. Between 2012 and the ICAC’s 40th Anniversary in 2014, public trust and confidence in the ICAC was battered further. Three significant contributing causes stand out: the seeming deluge of corruption allegations and integrity queries against top HKSAR officials beginning from early 2012, the on-going public laundering of egregious misconduct by senior ICAC officers, and allegations that the ICAC complaint and investigation processes have become politicized.

206  Ibid., s. 30A(1). 207  Ibid., s. 30A(2). 208  Young (2013).

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Two examples of the corruption deluge between 2012 and 2014 have already been mentioned. The first involved Hong Kong’s former Chief Secretary, Rafael Hui, who was arrested in March 2012 and subsequently prosecuted for alleged corruption in relation to his dealings with several members of Hong Kong’s property tycoon class. Happily for the ICAC, this prosecution came to a successful conclusion, just as the ICAC closed its 40th Anniversary year, with the conviction, after a lengthy trial, of both Hui and several of his co-conspirators, including Thomas Kwok, co-chairman and a principal shareholder of one of Hong Kong’s largest property developers, for an alleged agreement to pay “general sweeteners” to Hui in return for Hui retaining a favourable disposition towards his paymasters when he returned to government service as Chief Secretary in late June 2005. Hui’s prosecution, and the doubts it engendered in the public’s imagination about the ICAC, occupied public attention for over two years. His conviction and imprisonment for seven and a half years, along with several of his alleged co-conspirators, was a welcome victory and naturally led to headlines such as “Hong Kong anti-corruption agency finally gets its tigers”,209 but for others it left “nagging questions” about the efficacy of the ICAC and its ability and willingness to investigate overly close relationships between the business community and government officials in Hong Kong.210 The second case concerned the former ICAC Commissioner, Timothy Tong, whose extravagant spending on food and alcohol at official ICAC functions came to public light in May 2013, a year after Hui’s arrest. Tong’s case likewise generated much negative publicity for the ICAC, evidenced by headlines such as “ICAC scandal undermines Hong Kong’s core values”,211 “ICAC reputation pays price for Timothy Tong’s spending”,212 and, at a later stage “Timothy Tong scandal deals ‘distressing’ blow to anti-graft agency”.213 But the rising concerns about integrity at the top did not end there. In early 2012 another ICAC investigation began, this one into the integrity and possibly corrupt conduct of Donald Tsang, Hong Kong’s Chief Executive between 2005 and 2012, as allegations emerged of a low-rent deal for a luxury Shenzhen flat with a businessman who owned a Hong Kong radio station, and complimentary or cheap rides on private yachts or jets for travel to Macau and

209  Lo (2014). 210  Bowring (2014); Wordie (2015). 211  Ng, Mandy (2013). 212  Ng, Kang-chung (2013). 213  Cheung (2014).

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elsewhere. Three years on, and Hong Kong still awaited a decision on whether or not Tsang was to be prosecuted.214 The ongoing public exposure of egregious misconduct primarily concerned three ICAC officers—Cho, Chan and Au—two of whom were senior investigators. Their misconduct had come to light during the course of a trial involving fraudulent warrant trading, resulting from an ICAC investigation.215 One of the principal prosecution witnesses, Cheung, handled by Cho, Chan and Au, had been given immunity to testify but then refused to do so. Having lost his immunity, Cheung was prosecuted in the District Court in 2011 for his involvement in the fraudulent trading, but he applied at the outset of his trial to the District Court Judge for a stay of prosecution on the basis of alleged misconduct by his ICAC handlers. Cheung’s testimony, partly supported by audio recordings he had made, evidenced various improper activities by his handlers, including being told what to say in the trial and to memorize his witness statements, being shown witness statements of other immunity witnesses, being taught how to lie about his evidence, and being led to believe he could read his own witness statements even after he had commenced giving evidence. Cheung’s application failed,216 but his three ICAC handlers were then prosecuted for doing acts tending to pervert the course of justice and misconduct in public office, with Cheung being the principal prosecution witness at their trial. When convicted in 2012, the trial judge, sentencing them to terms of imprisonment ranging from 18 to 30 months, commented: The ICAC is perhaps the most potent weapon Hong Kong possesses against corruption. That is why great and sometimes even draconian powers are conferred upon this institution and its officers. The exercise of those powers must be done with the utmost of integrity and any abuse of that power must be punished. It is of paramount importance that public confidence in this cornerstone institution be maintained in order for Hong Kong to continue to remain a relatively corruption free society. [. . .] What the defendants did is inexcusable.217 214  Lau (2015a); Lau (2015b). In October 2015, Tsang was eventually charged with two counts of misconduct in public office. 215  See HKSAR v Ng Chun To Raymond & Ors, unreported, DCCC 405 & 895/2009, Reasons for Sentence, 28 April 2010, DC. 216  Cheung thereupon pleaded guilty and was sentenced to 25 months imprisonment; see HKSAR v Cheung Ching-ho, unreported, DCCC 1443/2009, Reasons for Sentence, 31 May 2011, DC. 217  H KSAR v Cho Wing-nan &Ors, unreported, DCCC 360/2011, Reasons for Sentence, 30 April 2012, [31], [32], DC. Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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Immediate headlines to the contrary,218 this was not the end of the public’s exposure to this misconduct, for it has since been revisited twice. First, when the officers unsuccessfully appealed their convictions to the Hong Kong Court of Appeal in February 2014.219 Secondly, and more significantly, earlier in 2013, when those originally convicted in 2010 of fraudulent warrant trading successfully appealed their convictions and sentences, based on doubts created by the misconduct. Quashing their convictions, Stock JA for the Court of Appeal, addressing the question whether a fresh trial would offend the court’s sense of justice and propriety, expressed his concern that the misconduct of Cho, Chan and Au might not be an isolated transgression: Given the nature and gravity of the misconduct in this case, the outragedriven temptation to stay the proceedings is considerable, not least when the facts of this case as well as the facts revealed by a number of previous cases lead to a concern whether the attitude of these officers, that the end justifies the means is, in this particular agency, limited to this handful of officers or is more widespread.220 In the event, the Court of Appeal ordered Ng (D1)’s retrial on four of the charges laid against him.221 The claim of politicization is one which has increasingly featured in Hong Kong media since C. Y. Leung began his current term as Chief Executive in 2012, reflecting in part Hong Kong’s hostile political environment. The public has been exposed to sensationalist images and reports of high profile individuals arriving at ICAC offices to lay complaints against other high profile figures, based on both allegations of corruption and also conflicts of interest. Inevitably, officials have bristled at these perceived publicity stunts and their potential undermining of the impartiality of the ICAC, giving rise, for example, in February 2013, to headlines such as “ICAC used to ‘taint’ political reputations, says former No. 2”222 and “Stop politicizing ICAC, top officer says”.223 The Chief Executive himself joined the fray by suggesting apologies were due 218  Lee (2012). 219  H KSAR v Cho Wing Nin 7 Ors, unreported, CACC 178/2012, 28 February 2014, CA. 220  H KSAR v Ng Chun To Raymond &Anr, unreported, CACC 178/2010, 19 November 2013, [107], CA. 221  Ng was retried and convicted in January 2015, and sentenced to four and a half years imprisonment; see HKSAR v Ng Chun To Raymond, unreported, DCCC 405/2009, Reasons for Sentence, 30 January 2015, DC. For the ICAC’s rather muted reaction, see ICAC (2015b). 222  Cheung (2013a). 223  S CMP Staff Reporters (2013). Jiaxing Hu, Matthias Vanhullebusch and Andrew Harding - 978-90-04-31581-5 Downloaded from Brill.com06/09/2020 11:26:10PM via NALSAR University of Law

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to some of those against whom such complaints were made after inquiries were subsequently dropped, inducing a former deputy commissioner of the ICAC to criticize C. Y. Leung for “unnecessarily and inappropriately politicizing” the ICAC,224 prompting another former official to respond under a headline “The ICAC has been politicized—but not by Leung”225 When these additional events are taken into account, it is hardly surprising that public confidence in the ICAC, already exposed to other negative factors playing on their perceptions in 2012, should have fallen in the past few years. 6 Conclusion Hong Kong’s anti-corruption legal framework is mostly fit for purpose. During the forty years since its establishment, the ICAC has generally been highly successful. Confidence in its ability to fulfil its remit remains high, but there has been some loss of trust and confidence in recent years. One thread running through some of the recent travails afflicting the ICAC is the failure of individuals to maintain personal integrity, whether in carrying out senior positions of governance or in implementing Hong Kong’s anti-corruption regime. Ultimately, no matter how good the legal framework may be, no matter how well-resourced and well-endowed anti-corruption agencies like the ICAC may be, effective anti-corruption depends on the individuals given the mandate to fight corruption doing so impartially, with integrity and in accordance with the rule of law. The immediate challenge for the ICAC is to restore public confidence in the personal integrity of its officers and leadership. If it can do so, then it will have taken an important step towards regaining lost public trust, and enable it to return to its avowed mission, that of keeping Hong Kong clean. References ADB/OECD (2010) “Hong Kong, China,” In The Criminalisation of Bribery in Asia and the Pacific: Thematic Review—Final Report, 191–211, http://www.oecd.org/site/adbo ecdanti-corruptioninitiative/46485272.pdf (accessed 11 July 2015). Bowring, Philip (2014) “Rafael Hui Leaves Nagging Questions,” South China Morning Post, 28 December.

224  Chan (2013). 225  Rowse (2013).

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Chan, Jay (2013) “C. Y. Leung Slammed for ‘Politicising’ ICAC”, South China Morning Post, 24 August. Cheung, Simpson (2013b) “Timothy Tong’s Liquor Spending Gives ICAC a Hangover,” South China Morning Post, 5 June. Cheung, Simpson, & Niall Fraser (2013a) “ICAC ‘Used’ to Taint Political Reputations, Says Former No. 2,” South China Morning Post, 3 February. Cheung, Tony (2014) “Timothy Tong Scandal Deals ‘Distressing’ Blow to Anti-graft Agency,” South China Morning Post, 19 February. HKSAR (2007) “United Nations Convention Against Corruption to be implemented in HK,” Press Release 23 May 2007, http://www.info.gov.hk/gia/general/200705/23/ P200705230301.htm (accessed 11 July 2015). HKSAR Gazette (2010) Acceptance of Advantages (Chief Executive’s Permission) Notice 2010, G.N. 1967, No. 14 Vol. 14, 9 April 2010. ICAC (1994) Annual Report, http://www.icac.org.hk/filemanager/en/Content_1238/1994 .pdf (accessed 11 July 2015). ——— (1995) Annual Report, http://www.icac.org.hk/filemanager/en/Content_1238/ 1995.pdf (accessed 11 July 2015). ——— (2013) “Executive Summary,” In Annual Survey 2013, http://www.icac.org.hk/ filemanager/en/Content_1283/2013surveysummary.pdf (accessed 11 July 2015). ——— (2014) “Executive Summary,” In Annual Survey 2014, http://www.icac.org.hk/ filemanager/en/Content_1283/survey2014.pdf (accessed 11 July 2015). ——— (2015a) “Mission Statement,” http://www.icac.org.hk/en/about_icac/mp/ index.html (accessed 11 July 2015). ——— (2015b), “Man Jailed for $150m Fraud over Trading of Warrants After Re-trial,” Press Release, 30 January 2015. Jackson, Michael I. (2012) “A Functional Approach to Misconduct in Public Office,” Journal of Commonwealth Criminal Law 342–52. Kuan, Hsin-chi (1981) “Anti-corruption Legislation in Hong Kong—A History,” in R. P. L. Lee, ed., Corruption and its Control in Hong Kong—Situations up to the Late Seventies, Hong Kong: Chinese University Press, 15–43. Lam, Lana (2014) “Forty Years Since its Creation, How the ICAC Cleaned up Corruption in Hong Kong,” South China Morning Post, 15 February. Lau, Stuart (2015a) “Hong Kong Justice chief Rimsky Yuen Says Outcome of Donald Tsang Corruption Probe Will soon be Known,” South China Morning Post, 11 March. ——— (2015b) “Ex-Hong Kong Chief Executive Donald Tsang to Know in 3 Months if He Will Face Corruption Charges,” South China Morning Post, 24 June. Lee, Diana & Cheung, Simpson (2012) “Conviction Ends ICAC Officers’ Stellar Run,” South China Morning Post, 1 May. Lethbridge, H. J. (1985) Hard Graft in Hong Kong—Scandal, Corruption and the ICAC, Hong Kong: Oxford University Press.

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512

Jackson

Lo, Alex (2014) “Hong Kong Anti-Corruption Agency Finally Gets its Tigers,” South China Morning Post, 24 December. McWalters, Ian (2009), “Prevention of Bribery in Hong Kong—Law and Enforcement” (Speech at Opening Ceremony of Centre of Anti-Corruption Studies), http://www .cacs.icac.hk/en/events/files/CACS_Eng_P113-126.pdf (accessed 17 June 2015). ——— (2010) Bribery and Corruption Law in Hong Kong (2nd ed.), Hong Kong: LexisNexis Butterworths. Michael, Bryane (2013) “Can the Hong Kong ICAC Help Reduce Corruption on the Mainland?,” Centre for Comparative and Public Law Occasional Paper No. 23, Faculty of Law, The University of Hong Kong, http://www.law.hku.hk/ccpl/pub/ CCPL-OP-No23-Bryane%20Michael-Feb2013.pdf (accessed 11 July 2015). Ng, Kang-chung (2013) “ICAC Reputation Pays Price for Timothy Tong’s Spending,” South China Morning Post, 10 May. Ng, Mandy (2013) “ICAC Scandal Undermines Hong Kong’s Core Values,” South China Morning Post, 8 May. Rowse, Mike (2013) “The ICAC Has Been Politicized—But not by Leung,” South China Morning Post, 2 September. SCMP Staff Reporters (2013) “Stop Politicizing ICAC, Top Officer Says,” South China Morning Post, 19 February. Tong, Timothy (2008) “Criminalisation and Law Enforcement: A Hong Kong Experience,” Speech by Commissioner of the ICAC, 6 October 2008, http://www .icac.org.hk/en/acr/sa/3iaaca/index.html (accessed 11 July 2015). ——— (2010) “Welcome Address by Commissioner, ICAC, HKSAR at the Conference on ‘Collaborative Governance and Integrity Management’,” 16 September 2010, http://www.cacs.icac.hk/en/events/files/ICAC_Commissioner_CACSConf2010_ Opening_Address.pdf (accessed 11 July 2015). Transparency International (2014) “Results,” In Transparency International Corruption Perceptions Index 2014, http://www.transparency.org/cpi2014/results (accessed 28 February 2015). Wong, Raymond H. C. (2006) “Fighting Corruption Through Effective Law Enforcement and International Co-operation: The Hong Kong ICAC Experience,” Speech by Commissioner of the ICAC 23 October 2006, http://www.icac.org.hk/en/acr/sa/ fcteleic/index.html (accessed 11 July 2015). Wordie, Jason (2015) “Rafael Hui Trial Showed How Corruption Thrives in Hong Kong,” South China Morning Post, 14 February. Young, Simon (2013) “Prosecuting Bribery in Hong Kong’s Human Rights Environment,” in J. Horder & P. Alldridge, eds., Modern Bribery Law: Comparative Perspectives, Cambridge University Press, 267–92. Zhao, Shirley (2015) “Willingness to Expose Corruption at 4-year Low, Hong Kong Graft-buster Finds,” South China Morning Post, 11 April.

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513

Cases

Apple Daily Ltd v Commissioner of the ICAC (No. 2) [2000]1 HKLRD 647, CA. Attorney-General v Chung Fat-ming [1978] HKLR 480, CA. Attorney-General v Hui Kin-hong [1995] 1 HKCLR 227, CA. Attorney-General v Ip Chiu [1980] HKLR 11, PC. Attorney-General v Yau Ka-ping [1977] HKLR 76, CA. B v Commissioner of the ICAC (2010) 13 HKCFAR 1, CFA. Chan Wai-kei v HKSAR, unreported, FAMC 71/2005, 6 October 2005, CFA. Chan Wing-yuen v R [1977] HKLR 186, HC. Commissioner of the ICAC v Ch’ng Poh [1997] HKLRD 652, PC. Hall v Commissioner of the ICAC [1987] HKLR 210, CA. HKSAR v Adams Secuforce (International) Ltd [2008] 1 HKLRD 207, CFI. HKSAR v Chan Chi Wan Stephen, unreported, CACC 355/2011, 21 November 2012, CA. HKSAR v Cheung Ching-ho, unreported, DCCC 1443/2009, Reasons for Sentence, 31 May 2011, DC. HKSAR v Cho Wing-nan & Ors, unreported, DCCC 360/2011, Reasons for Sentence, 30 April 2012, DC. HKSAR v Cho Wing Nin 7 Ors, unreported, CACC 178/2012, 28 February 2014, CA. HKSAR v Chung Chun-keung [2000] 3 HKC 496, CFI. HKSAR v Danny Chan Tat Chung [2010] 2 HKC 268, CFI. HKSAR v Egan (2010) 13 HKCFAR 314, CFA. HKSAR v Fung Hok Cheung [2008] 5 HKLRD 846, CA. HKSAR v Hui Rafael Junior & Ors, unreported, CACC 444/2014, 16 February 2016. HKSAR v Hui Russel [2009] 6 HKC 213, CA. HKSAR v Kreiger [2014] 3 HKLRD 404, CA. HKSAR v Ng Chun To Raymond & Ors, unreported, DCCC 405 & 895/2009, Reasons for Sentence, 28 April 2010, DC. HKSAR v Ng Chun To Raymond & Anr, unreported, CACC 178/2010, 19 November 2013, CA. HKSAR v Ng Chun To Raymond, unreported, DCCC 405/2009, Reasons for Sentence, 30 January 2015, DC. HKSAR v Ng Po-on (2008) 11 HKCFAR 91, CFA. HKSAR v Wong Chi Wai (2013) 16 HKCFAR 539, CFA. HKSAR v Wong Lin Kay (2012) 15 HKCFAR 185, CFA. HKSAR v Yan Pak-cheung [2009] 2 HKLRD 82, CFI. Kong Kam-Piu v R [1973] HKLR 120, SC. Mok Chuen v R [1977] HKLR 605, CA. R v Chong Chui Ha & Anr [1997] 4 HKC 518, CFI. R v Hunt [1974] HKLR 31, FC. R v Looi Kim-lee [1985] 2 HKC 410, CA. R v Mok Wei-tak [1990] 2 AC 333, PC.

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514

Jackson

R v Ngan Lun-yan[1975] HKLR 369, FC. Secretary for Justice v Tam Heung Man [2012] 4 HKC 381, CFI. Sin Kam-wah v HKSAR (2005) 8 HKCFAR 192, CFA. So Sun-leung v R (1973) Cr App 261/73, FC. X v Commissioner of the ICAC [2004] 1 HKC 228, CFA.

Legislation Hong Kong

Crimes Ordinance (Cap. 200). Elections (Corrupt and Illegal Conduct) Ordinance (Cap. 554). Independent Commission Against Corruption Ordinance (Cap. 204). Interpretation and General Clauses Ordinance (Cap. 1). Misdemeanors Punishment Ordinance (No.1 of 1898). Prevention of Bribery Ordinance (Cap. 201). Prevention of Corruption Ordinance (1948) (Cap. 215). Theft Ordinance (Cap. 210).



United Kingdom

Bribery Act 2010. Prevention of Corruption Act 1906. Prevention of Corruption Act 1916. Public Bodies Corrupt Practices Act 1889.

Other

OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions (1997). United Nations Convention Against Corruption, General Assembly resolution 58/4 of 31 October 2003.

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515

Anti-Corruption Law and Enforcement in Hong Kong

Table 17.1 From the ICAC’s Annual Report for 2013 (Appendix 9: Number of persons prosecuted for corruption and related offences in 2013 (Classified by types of offences)) Types of offences Government Private individuals Public Private Total (PBO except where departments (concerning government bodies sector otherwise stated) departments / public bodies)

Soliciting/Accepting s. 3 1 s. 4(2) 1 s. 9(1) 0

0 0 1

0 0 0

0 0 24

1 1 25

Offering s. 4(1) s. 9(2)

1 0

0 0

1 28

1 28

2

20

28

0 0

Agent using document to deceive principal s. 9(3) 3 3

Failure to comply with the terms of or making a false statement in answer to a notice served under s. 14(1), PBO s. 14(4) or s. 14(5) 1 0 0 1 2 False reports to officers s. 13B, ICAC Ord 0

0

Offences connected with or facilitated by corruption s. 10(2)(a), ICAC 2 5 Ord s. 10(5), ICAC Ord 7 14 Election Offences 0 Total 15

0 24

0

2

2

0

26

33

2

71

94

0 4

5 177

5 220

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Index Acceptance of Application 368 Administrative Administrative Approval 84, 137, 147, 149, 157, 304 Administrative Regime 140 Adopted Blueprint 82 Alipay 111, 134, 325, 327, 330, 332 Anti-corruption Law 425, 479 Anti-money Laundering 32–33, 242, 438–439, 466, 477 Anti-terrorist Financing 33, 466 Assessment 33, 35, 37–38, 64, 72, 75, 81, 151, 189, 200–202, 207, 271, 309, 343, 378, 381, 383, 413, 418–420, 425 Asset Portfolio 345 Attitude of MAS 35 Audit Committee 262–263, 271–272, 275–276, 280, 285 Automated Trading 222, 250, 252, 257, 259 Bank Bank of Credit and Commerce International  BCCI 14–15, 36–38, 45–46, 48, 55 Banking Network Security 180 Banking Operation 000 Banking Stability 67–68, 74 Barings Bank 36, 38–39 Basic Law 57–59, 72–73, 179, 457, 477 Boards’ Responsibilities 267 Bond Issue 122, 205, 426 n. 32, 467 n. 74 Bribery 36, 417, 425–426, 467, 478–485, 490, 495, 497–498, 510, 512, 514 British Colony 21, 34, 50, 57, 264 Bureaucrats’ Intervention 82 Business Environment 4–5, 13, 19–21, 143, 240 Capital Capital Account Liberalization 107, 112, 133–134, 163 Capital Buffers 330, 343–346, 349–350, 353 Capital Markets 16–17, 24–25, 30, 74, 106, 107, 109–110, 116, 126, 129, 131, 174, 197,

217, 237, 256, 355–356, 358–363, 376–377, 379, 382–383, 386–388, 390, 394, 397, 399–400, 403–404 Caveat Emptor 202–204, 207, 343 China Chinese Socialist Market 140 Chinese Wall Exception 446–447 China Securities Regulatory Commission  CSRC 62, 315, 329, 332, 347, 349, 356–358, 360–390, 397, 399, 400, 402–407 Circulars 33, 35, 96 Class Exemption 220, 222, 255 Climate Change 172, 175, 193 Code Provisions CPs 261, 264–268, 270, 281–282, 430 Commercial Commercial Affairs 199, 437, 451 Commercial Ethics 175 Commercial Transactions 107 Common Law 28, 34–35, 51, 56–57, 60, 62, 279, 459, 461, 482, 489, 493–494, 498, 500, 504 Companies Ordinance 51, 55, 60, 62–63, 220, 251, 255, 278–279, 281–282, 284, 462, 478 Comply or Explain 264, 281 Conceptual Shift 139, 145 Confidence 8, 29, 39, 43, 53–54, 61, 91, 93, 97, 101, 113, 186–187, 262, 424, 458, 463–465, 472, 480–482, 506, 508, 510 Conspiracy 442, 461, 493, 495–496, 498–500 Consultation Paper 55, 66, 71, 133, 219, 239, 245, 262, 265–266, 272, 283–284 Consumer Protections 45 n. 108, 324, 341, 351 Convertibility 107, 109, 112, 116–117, 119, 125, 127, 129, 143, 161, 163–165 Corporate  Corporate Governance Code 261–263, 265–266, 283–285 Corporate Social Responsibility 173, 175–176, 191, 194 Corporate Finance Committee CFC 198–199, 218

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518

Index

Corrupt  Corrupt Conduct 430, 491, 497–498, 507 Corrupt Intention 421, 488 Corruption 4–5, 13, 21, 76, 79, 84, 100–101, 124, 135, 142, 183, 340, 372, 374, 380, 384, 389, 409, 411–418, 420–434, 436–438, 450–452, 454–456, 462, 467, 474, 477, 479–485, 489, 491, 492–493, 495, 497–500, 502–503, 505–512, 514–515 Corruption Offences 411, 413, 424, 427–428, 431, 479–480, 482–484, 489, 493, 497, 502–503 Counter-financing of Terrorism  CFT 438, 451 Credit Event 203–205 Criminal Breach of Trust CBT 440–441, 444 Criminal Sanction 251, 458, 468–469, 474 Cross-border  Cross-border Trade 112 Crowdfunding 220–225, 229, 232–259, 287, 290–293, 295, 302, 307, 313–318 Cyber Cheating 443 Debt Financing 226, 229, 232 Deception 441, 449, 459, 461, 500 Deregulation 17, 93, 107–108, 116, 125–126, 128–130, 144, 163, 192, 199, 345 Detention without Trial 453 Directions 25, 32, 341, 402, 441, 501 Directors’ Duty of Care 261, 263, 278–279, 282 Disclosure-based 30, 198–200, 202, 204, 217–218, 355, 360–361, 388, 391, 397, 399, 401–402 Dishonesty 460–461 Dispute Settlement Body 80 n. 21, 138, 152 Economic  Economic Analysis 165, 324 Economic Disparities 170 Economic Growth Model 169, 183, 319 Economic Interests 457–461, 475 Economic Structure 82, 102 Election-related 484, 497 Emerging Market 51 Enforcement 13–14, 47, 66, 73, 84, 94, 128, 173, 199, 368, 388, 390, 394, 399–401, 409, 411–413, 415, 417, 427–429, 431,

433–434, 436–437, 447, 450–451, 453–455, 457, 464, 468–476, 479–484, 499, 504, 512 Environmental Concerns 175 Equator Principles 168, 172, 191 Equity Financing 220, 225–226, 232–233 Evolvement of the PORC 366 Ex-ante Disclosure 365 n. 22, 370–371, 381 Exchange Rate-oriented 119 Facilitate Financing 232 Falsification of Accounts 440, 444 Financial Financial Center 5, 17, 121, 221 n. 1, 359, 402 Financial Crime 436, 455, 457 Financial Crisis 14, 24, 36, 43, 48–49, 54–55, 58, 64–65, 68, 70–72, 80, 91, 113, 117–118, 120, 122, 128, 131, 133, 135, 167, 173, 179, 181, 186, 189–190, 192, 203, 257, 262–264, 275–276, 284, 299, 324, 340, 347 Financial Framework 220 Financial Governance 46, 168 Financial Innovation 30, 168–169, 319, 333 n. 33, 351, 353 Financial Regulation 28, 49–50, 64, 68–71, 74, 189, 240, 286, 324, 332, 336, 341, 344 Financial Repression 110, 112, 118, 124, 129, 133, 136, 298, 299, 301, 305 Financial Secretary 54, 57–60, 62, 69, 71–72 Financial Services 5–9, 18–19, 22–23, 28, 31, 40, 43, 45, 48, 57 n. 33, 58–60, 62–64, 66–67, 71–73, 90, 143, 160–161, 175, 177, 179–180, 182, 197, 216–217, 224, 239, 244, 256, 258, 301, 306, 314, 319, 324, 326 n. 9, 336, 340, 342–343, 351, 394, 464, 475 Financial Systems 57, 64, 68, 72, 117, 234, 342 n. 54, 458, 463, 466, 475 Financial Transformation­ 000 Financial Viability 172 Floating NAV 346–349, 352 Foreign Investments 77, 78, 140 n. 6, 143 n. 22, 159 n. 81, 95 n. 111 Fraud Fraud Offences 461

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519

Index Full Convertibility 107, 109, 119, 125, 129 Functional limitations 179 Fund-raising 197–199, 202, 207, 214, 217, 295, 299, 301–303, 307–308, 313–315, 355, 384, 387, 389–390 Futures Ordinance 55, 62, 65–66, 222, 250, 270, 464–465, 474, 478 General Offence 462 Global Global Economy 118, 138, 191–192 Global Financial Crisis 36, 43, 48–49, 58, 64–65, 68, 70, 72, 128, 131, 133, 167, 173, 189–190, 203, 257, 262, 324 Global Financial Market 106, 332 n. 29 Government Procurement 81, 84–85, 104 Grant Financing 226, 231 Guidelines and Codes 33 HKEx’s Code 263, 267, 382 n. 63 Hong Kong 3–4, 6, 9–10, 12, 14–15, 17–19, 44, 49–76, 90, 97, 100, 102–103, 108, 114–115, 127–128, 131, 135, 139, 141, 163–164, 171, 179, 182, 186, 190–193, 197, 203–204, 213, 220–227, 229–233, 240, 246, 248–258, 260–265, 268, 270, 271, 278–279, 281–285, 357, 359, 361, 382, 384, 391, 394–398, 405–406, 412, 457–458, 460–461, 463, 465–469, 471–472, 475–477, 479–486, 494, 495–499, 504–512, 514 Hong Kong’s evolution 49 Hong Kong Trade and Development Council HKTDC 224–225, 227, 257 Human Rights 84, 154, 168, 171–172, 176–178, 181, 187–189, 191–193, 463, 468–470, 506, 512 Ideological Struggles 99 iMMFs 324–337, 341, 343–352 Independent Independent Commission Against Corruption Anti-Corruption ICAC 479–485, 493–496, 499–515 Independent Commission Against Corruption Ordinance ICACO 483–484, 499–504, 514 Indigenous Innovation 81, 104 Individual Bankers 171, 177–178, 181, 187 Inequality Gap 184

Information  Information Disclosure 65, 295, 308–309, 324, 331, 342–343, 352, 360, 362, 364–365, 378, 390–392, 397, 399– 400, 403 Information Technology 160, 180, 189, 223–224, 271, 305, 418 Informed Assessment 200–202 Information and Communications Sector  ICT 4, 223 Initial Public Offerings IPO 34, 112, 224, 230, 232–235, 355–356, 359–362, 364–368, 370–407 Innovative Rules 137–138, 140 Inquiry and Checking 369 Insider Insider Dealing 55, 464–465, 469, 477 Insider Trading 75, 445–447 Insider Dealing Tribunal IDT 465, 469, 477 Institutional Framework 56, 364 Institutional reform 76, 82, 87 Integrated Approach 336–339 Integrity Integrity of Financial Systems 458, 463, 466, 475 Interdependency of Markets 262 Interest  Interest Rate 23, 110, 119, 123–125, 127, 130, 135, 227, 288–289, 299, 310, 328–331, 342, 346, 351 Internal Internal Audit 265–268, 270–271 Internal Control 261, 265–272, 276, 277, 281, 283, 284, 376 International  International Debt 24 International hub 217 Internationalization 73, 106–107, 109–113, 115, 121–122, 129–132, 134–135, 140, 161–164, 167, 170 International Financial Centre IFC 3–7, 9, 11, 15–16, 28, 49–50, 57–59, 62, 64, 67, 73–75, 162, 172, 177, 179–180, 182, 191, 193, 197, 220–221, 249, 262, 264, 457–458, 463, 466–469, 475 International Monetary Fund  IMF 64–65, 67, 70–73, 75, 118–119, 132–134, 153

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520

Index

Internet Internet Companies 325, 398 Internet Freedoms 177 Internet Money Market Funds  IMmfs 324, 346 n. 61, 347 n. 68 Investigative Investigative jurisdiction 499 Investigative Powers 53, 411, 451, 474–475, 479 Investment Reform 139, 155 IPO Reform 355, 360–361, 378 n. 51, 383 n. 67, 387, 390–391, 399, 405, 406 Isolated Enclaves 147, 388 n. 81 Issuer Eligibility 375 Issuer’s Organization 261 Judiciary Accountability 87 Laissez-faire 10, 56, 222, 334, 379 Law  Law Enforcement 128, 413, 434, 451, 457, 479–481, 512 Law Amendments 000 Level Playing Field 76–77, 79, 81, 85, 90, 94–95, 99, 342, 458 Liberalization 7–9, 12, 16, 48, 107, 112, 115–121, 125–127, 129–130, 132–135, 148, 153, 156, 160, 163, 165, 170, 181, 184, 185, 188, 329–330, 340, 345–346, 351, 359–361 Liquidity Management 130 List  Listed Entities 261, 264–265, 267, 272, 281–282 Listing Qualifications 375, 382–383, 387, 392 Negative List 83, 85, 90, 126, 138, 140, 156, 157, 159–160, 167, 307, 320 Local Protectionism 83 Loss of Trust 506, 510 Management Strategy 331, 345 Mandatory Disclosure 55, 269, 317 Mandatory Provident Fund Schemes Authority  MPFA 59, 64

Market Market Abuse 445 Market Access 8, 73, 79, 83, 85, 91, 137, 138–142, 144–145, 149, 155–161, 166, 168, 179 Market Capitalization 224, 355–359, 363 Market Competition 79, 83, 86–87, 94, 110 Market Conducts 324, 351 Market Downturn 89 Market-driven 120, 141, 232 Market Fairness 000 Market Misconduct 388, 399, 464–465, 468, 470–473, 477 Market Monopoly 83 Market Rigging 448 Medium of Exchange 107 Merits-based 198, 202 Misconduct 62, 234, 338, 388, 399, 441, 445, 450, 458, 464–465, 469–473, 477, 481–482, 498–499, 505–506, 508–509, 511 Misleading Statements 205, 448 Mixed Ownership 83, 86, 90, 105 Model of Development 81 Monetary Authority 5–6, 9, 12–13, 16–17, 25, 28, 59–60, 69, 71–72, 74, 120, 123, 133, 198, 202, 218, 222, 239, 258, 438, 447 Monetary Authority of Singapore MAS 5–6, 9, 12–14, 16–17, 25–33, 35–45, 47, 59–60, 69, 70–72, 74, 120–123, 133, 198–199, 202, 205–207, 214, 218–219, 222, 239, 243, 245, 258, 437–438, 447–448, 455–456 Money-laundering 436, 438–440, 452 Multilateral Trade 138, 146, 152–153, 165 Mutual Benefit 183, 185–186 Mutual Legal Assistance MLA 454, 481 National Equities Exchange and Quotations  NEEQ 357–358, 386–387 NEEQ Experiment 386 Non-internationalization 121–122, 129, 134, 164 Non-public Economy 78, 83, 86, 96, 149 n. 44

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Index Offer to the Public 207–209 Office of the Commissioner of Insurance OCI 59, 62–63 Online Platforms 236, 287 Opening-up 170, 181, 184–185, 187 Penal Code 411, 429–431, 440–441, 444 Policy Policy-making 18, 36, 40–41 Policy Statements 33 Political Stability 20, 168, 170–171, 183, 187–188 PORC review 367, 371–375, 385 Post-crisis Evolution 69 Power Deregulation 000 Practice Notes 33, 270 Preferential Policies 115, 137–139, 148, 165 Preliminary Meeting 369 Prescribed Officers 485, 489, 491, 499, 501 Prevention of Bribery Ordinance  PBO 467, 478, 483–485, 487, 489–495, 497–500, 502–505, 514–515 Price Sensitive Information PSI 66–67, 445–448 Private  Private Sector 77–80, 83, 90–91, 94, 96, 100, 103–104, 118, 172, 187, 198, 285, 414–415, 423–425, 427, 437, 479, 482, 484, 493–494, 506, 515 Privatization 76, 95, 124, 127, 189 Property Rights 79, 83–84, 87, 138, 186, 457–459, 462, 475 Prospectus Prospectus Requirement 197, 210–211, 213, 220, 222, 242, 244, 250–251, 255 Prudential Supervision 71, 121, 336, 338–342 Public  Public Office 482, 493 n. 135, 498–499, 508, 511 Public Ownership 78, 93–94 Public Prosecutor 415, 417–425, 427–431, 435, 439, 440, 442, 444–445, 447–449, 451–452, 454, 456 Public Sector 411, 415, 418, 423–424, 427, 433, 436–437, 480, 482, 484–485, 490, 493, 494, 496–497 Public Servant 431, 485–487, 488, 490–491, 494, 496, 499, 501, 504–505

521 Public Offering Review Committee  PORC 231 n. 40, 315 n. 63, 365–368, 371–375, 377, 379–380, 382 n. 64, 385, 389, 400, 404, 407 Qualified Domestic Institutional Investors  QDII 109, 132 Qualified Foreign Institutional Investors QFII 109, 126 Quota System 356, 362–364, 377, 380, 387–388 Reasonable  Reasonable Excuse 467, 485, 489, 490, 493, 496, 498, 504–505 Reasonable Investor Test 199–201 Recommended Best Practices  RBPs 261, 264–267, 270, 281 Reform  Reform Decision 77, 82–84, 88, 93, 96–97, 99 Reform Proposals 103, 327, 349, 352, 355 Regional  Regional Disparity 147, 165 Regional Trade 152, 157 Registration System 89, 304, 355–356, 360–361, 386–387, 389–394, 396, 397, 399–405, 406 Regulation  Regulation of Issuers 241, 244 Regulatory Dilemma 334 Regulatory Framework 13, 28, 35, 50, 52–56, 58, 62, 65, 79, 118, 178–179, 207–208, 214–215, 220–232, 235–236, 240–241, 248–249, 252, 264, 327, 331, 334, 349, 362–363 Regulatory Reforms 49, 70, 73, 155, 368 Re-regulation 107, 116 Remedial Civil Processes 457 Residual Merits 200 Resource Allocation 82, 89 Review  Review and Approval 355–356, 360, 362, 364–365, 368, 377–379, 382–383, 388–391, 394–395, 397, 399–400, 406–407 Review Process 172, 206, 367–370, 377, 383–384, 391, 395

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522

Index

Risk  Risk Anatomy 330 Risk Management 25, 33, 55, 62, 253, 261–263, 265–278, 280–285, 306, 312, 345, 476 RMB RMB business 12, 26 RMB currency 140, 143, 161–164 RMB internationalization 73, 106–107, 109–113, 121, 129 Securities and Futures Commission SFC 54–55, 59, 61–63, 65–66, 67, 69, 71–72, 75, 222–233, 249–250, 252–255, 257, 259, 395–396, 398, 463–464, 468–473, 475–477 Securities and Futures Ordinance SFO 55, 61–62, 65–67, 71, 222, 250–253, 270, 464–465, 468–469, 471–472, 474–475, 478 Security  Safe Harbours 207, 210 Securities Hawking 215 Securities Law 75, 197, 236, 243, 245, 313, 315–316, 355, 360, 364, 381, 386–387, 390, 399–400, 402, 404, 406–407, 457, 476 Securities Law Enforcement 457 Securities Ordinance 52, 55 Securities Regulation 73–75, 197, 199, 219, 317, 360, 387, 390, 392, 404 Sequencing of Reforms 117 Shanghai Free Trade Pilot Zone  SFTPZ 85, 107, 110, 112, 114–115, 129, 137–140, 143–145, 154–157, 159–164, 166–167, 170, 178–179, 183, 186 Shanghai Stock Exchange  SSE 62, 356–358, 382, 395–396, 406–407 Shenzhen Stock Exchange  SZSE 356–357, 358, 371, 381 Singapore Singapore Financial Centre 18–19, 23, 35 Singapore Exchange  SGX 6, 24, 48, 199, 268–269, 270, 284, 450 Singapore International Monetary Exchange  SIMEX 24, 38–40 Small and Medium Enterprises Small and Medium-sized Enterprise Board 222, 311

SME Board 356, 358 SMEs 220, 222, 224–225, 227–228, 319 SME Finance 223 Smooth Transition 107 Social Socialism Regime 78 Socialist Market 56, 76–77, 79, 81–82, 93–94, 103–104, 140, 147, 406 Socio-economic Justice 168, 181–182, 187–188 Special Economic Zone SEZ 137, 139–141, 143, 146–148, 162 n. 88 Sponsor System 378, 384, 388 Start-ups 221, 223–225, 227–228, 230–233, 236, 240–241, 243, 245–250, 254, 257, 259–290, 295 State-controlled 124–125, 127 State-owned Enterprises  SOEs 77–78, 80–81, 86, 88, 92, 95–97, 101, 103, 106, 124, 134, 142, 149, 186, 362, 375, 387 Stock Exchange 14, 23, 40, 49–55, 62, 65, 67, 126, 134, 198–199, 221, 224, 233, 235, 254, 260, 356–357, 371, 381, 386–87, 393, 395, 405–407, 444 Stock Exchange of Hong Kong Limited SEHK 53, 65–67, 224 n. 14, 252 Stock Exchange of Singapore SES 23–24, 40, 198–199, 444 Subsidiary Legislation 30–32, 35, 65, 466 Systemic Risk 61, 71, 311, 327, 331, 336, 342, 343–344, 347, 351 Tax Break 141 Theft Ordinance 458–459, 460–462, 478, 500, 514 Trade Trade liberalization 148 Trade Settlement 107 Transparency 62, 87, 92, 137, 153, 155, 158, 179, 192, 238, 249, 251, 253, 265, 342, 367, 373, 377, 379, 388, 391, 412, 434, 437, 454, 456, 458, 465, 468, 474–475, 480, 506, 512 Twin Peaks Model 324, 339 n. 47, 340, 351 Uniform Rules 137, 140 Unifying Risk Controls 324, 351

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Index United Nations Convention on Corruption UNCAC 483 Unit of Account 107 Venture Capital 220–221, 230–231, 235, 245, 247, 255, 257 Voluntary Codes 34, 173, 176, 188

523 World Trade Organization  WTO 12, 77, 80–81, 104, 137–138, 145–146, 148, 150–154, 156, 158–161, 166–167, 178, 180, 184–185, 191, 193 White Collar Crime­ 457

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