A study of private securities litigation against false corporate disclosure in the People's Republic of China

Abstract

In the early 1990s, stock markets were introduced by the Chinese government to assist in the reform of poorly performing state-owned enterprises (SOEs) by providing SOEs a channel to raise capital from private individuals and by installing market discipline on SOE managers. The development of the stock markets since then has been phenomenal, albeit in the absence of an investor-friendly legal framework. In the late 1990s, the markets were riddled with exposures of corporate disclosure frauds in which the interests of millions of minority (individual) investors were infringed upon. Investors who fell victim to these scandals responded by bringing private securities litigation (hereafter as "PSL") suits. This study examines the emergence, development, existing problems and future trends of PSL in relation to false corporate disclosure in China. The study is primarily motivated by the observed narrow scope of the several prior studies and the lack of a systematic account of recent court practices in PSL. An updated study is needed in light of the recent progress in capital market and corporate reforms. The research aims to fill the gap that to date there has been little systematic assessment of PSL in China, in particular, concerning the practice of people's courts in handling PSL suits and a detailed comparison of the PSL rules in China with those in the U.S. from which the 2003 SPC Rule has heavily borrowed. Chapter 1 of the study provides an overview of the study. Chapter 2 of the study first examines the frequency and extent of false corporate disclosure in China, and then identifies several institutional reasons for the rampant disclosure frauds. It also explores the tension between minority investor protection and the traditional political ideology that commits to safeguarding state interests and maintaining state control. This tension is the key to understanding the development of PSL in China. Through a comparison of differences in the causes and effects of PSL in the U.S. and in China, the chapter concludes that minority investors are more vulnerable and winning PSL is more difficult for them in China than in the U.S. The differences and complications in China also suggest that the development of PSL might be a long and bumpy ride. In Chapter 3 I identify two independent but logically coherent theories on a country's choice of corporate rules with a selective adaptation approach. They are Bebchuk- Roe's theory on a country's choice of corporate rules and Potter's selective adaptation of international norms. Both theories propose three mutually consistent key elements that affect the selective adaptation including political ideology. I show that both frameworks can be treated as a unified analytical framework that is capable of explaining the emergence of PSL in China. Adopting this selective adaptation framework also enables me to develop a central argument in Chapter 4 that the lack of detailed rules supporting Article 63 of the Securities Law (1998) is not the main reason for people's courts' passive and reluctant attitude towards taking on and actively adjudicating PSL suits. After reviewing all the relevant laws and regulations governing false corporate disclosure in Chapter 4, the study finds that until the recent major revision of Company Law and Securities Law in 2005, Chinese laws and regulations have primarily relied on public enforcements (administrative sanctions and criminal penalties) to combat disclosure frauds. Nevertheless, Article 63 of the Securities Law (1998) does provide a legal basis for investors who suffered a loss as a result of disclosure frauds in securities issuance to seek civil remedies. Then what explained the three-stage emergence of the PSL in China (marked by the issuance of the 2003 SPC Rule)? Using the Bebchuk-Roe and Potter's theoretical framework on a country's selective adaptation of corporate rules, I find that (a) public-regarding judgments as to which rules would be most efficient, (b) the effect of interest group politics, and (c) culture and political ideology all played a role in the emergence of PSL in China. The latter two elements on "culture & ideology" and interest group politics thus means that the emergence of PSL in China is bound to be slow and gradual, which reflects a more complicated and dynamic selective adaptation process. While Article 63 created a high market demand for PSL, it did not result in a corresponding supply of PSL court service. I argue that understanding this disparity is central to understanding the key factors behind the emergence of PSL in China. After carefully analyzing the stages of the PSL development and people's courts changes in behaviors, I conclude that people's courts' passivity and reluctance in taking on PSL suits in the early stage of the PSL development (before 2002) is likely a strategic choice and a reflection of the tension between traditional political ideology and protecting private investors. In contrast, the commonly blamed lack of detailed operational rules does not appear to be the major reason. My analysis also reveals that legal reforms clearly lagged capital market developments in China and the emergence of PSL in China is also consistent with the "crash-then-law" argument. Chapter 5 provides an up-to-date assessment of the progress of PSL against corporate false disclosure in China following the implementation of the 2003 SPC Rule by analyzing court handling of three large-scale representative cases. I conclude that PSL in practice is far from being effective in China. The somewhat disappointing progress in "law in action" provides another test of the argument that Article 63 of the Securities Law (1998) was not enforced is not due to the lack of detailed supporting rules. Indeed, during the five years following the implementation of the detailed 2003 SPC Rule, courts still frequently refuse to follow the rule in taking on and trying PSL suits. The inherent tension between investor protection and socialist political ideology and local protectionism seem to play an important role. It also highlights the importance of supporting institutions and infrastructures to the enforcement of PSL rules. The 2003 SPC Rule was heavily influenced by the PSL in the U.S., for example, in terms of the adoption of the fraud-on-the-market theory. To help better understand and evaluate the 2003 SPC Rule, Chapter 6 provides an up-to-date review of PSL in the U.S. including the major governing statutory federal laws and their relevant antifraud provisions. My analysis of the PSL in the U.S. also highlights its problems and helps clear up some misconceptions that people tend to have about PSL in the U.S. The implication for China is that even in the U.S. that has comprehensive investor protection, defendant-friendly legal changes can still open the door for a new wave of securities frauds and PSL rules must be stringent. This chapter provides a benchmark for comparison in discussing the 2003 SPC Rule in Chapter 7 to help us understand how drafters of the PSL rule in China have selectively adapted the borrowed PSL rules to suit local cultural and ideological needs. Chapter 7 introduces and evaluates in detail the 2003 SPC Rule - the prevailing judicial regulation that governs the handling of PSL relating to false corporate disclosure. The rationale, pros and cons of each key article are analyzed by reference to people's courts' practice in trying PSL cases and the practice in the U.S. where appropriate. The 2003 SPC Rule's similarities to, and differences from, the U.S. PSL rules and judicial practice are analyzed using the powerful Bebchuk-Roe and Potter's selective adaptation frameworks. I find that the 2003 SPC Rule is laudable in many aspects of liberal borrowing of the U.S. practice, in particular, it has made a bold move in adopting the fraud-on-the-market theory despite the controversy about the market efficiency in China. The PSL rule drafters also have carefully adapted some U.S. rules to suit local circumstances. On the one hand, two aspects of the 2003 PSL Rule are more stringent than those in the U.S. (i.e., the strict liability of fraudulent company and its controlling shareholders in secondary market cases, and the liability of securities service professionals that act as aiders and abettors in secondary market cases). On the other hand, local regulatory culture of state control and political ideology of safeguarding state interests have found their way to modify PSL by introducing three "smart" ways that constitute major barriers for bringing PSL suits. These three barriers - the prerequisites to bringing a suit, jurisdictional requirements conducive to local protectionism, and the lack of an efficient form of litigation - ensure that PSL will not endanger the socialist ideology. How far PSL in China can move depends on the government's leeway in adapting its regulatory philosophy on state control and to what extent it is willing to balance state interests and private interests. My analysis also identifies some inconsistencies in articles regarding loss causation and the calculation of losses in relation to market systemic risk, which are not reported in prior studies. Finally, some preliminary suggestions are offered to solve the identified problems. China is well-known for its big difference between law on the books and law in action, as revealed by my case studies in Chapter 5. The implication is that law in action depends on supporting institutions and infrastructures. Indeed, rules can be transplanted, but supporting institutions and infrastructures are hard and must be home-grown. Chapter 8 focuses on judiciary that enforces law and infrastructures that help secure financial means for rendering relief to aggrieved investors. Both issues are important and crucially affect the enforcement of PSL rules. I analyze the weak judiciary in China that lacks independence, authority, and competence. The analysis also identifies the regional variations in local protectionism and competence of courts, suggesting that the behaviors of the local government and court and possibly the effect of judicial reform may vary according to the development level of the local economy. Two tentative measures are proposed to mitigate the adverse effect of courts' lack of independence and competence in adjudication before the full-blown judicial and political reforms are completed. One measure is to change the jurisdictional requirement in the 2003 SPC Rule and the other is to introduce the case precedent system by the SPC. Finally, the chapter, by reference to the latest developments and trend in the U.S., examines another supporting infrastructure of PSL - how financial means to provide sufficient compensation to defrauded investors can be secured via various insurance mechanisms, returning corporate and personal fines for shareholder remedies, and setting up a market-wide investor compensation fund. This study concludes in Chapter 9. The recent emergence and development of PSL in China and the issuance of the 2003 SPC Rule have been remarkable and of significance. The gradual emergence of PSL in China fits nicely Bebchuk-Roe and Potter's selective adaptation frameworks. Though the 2003 SPC Rule resembles the key features of the American PSL practice, it aims for different goals and will produce different results. While the government intends to provide a way for defrauded investors to seek economic relief, it maintains state interests through some procedural safeguards. Since the legal infrastructures (e.g., judiciary and mechanism securing financial means for providing compensation for investors) in China are still weak and will remain so in the foreseeable future, PSL in action is expected to exhibit some persistence with the old practice - i.e., law in action will be different from the law on the books. The ride of PSL in China is bound to be a long and bumpy one. I wrap up the thesis by discussing the limitations of PSL and the implications for investors.