China Lawyer Blog

Evaluation of Investment Funds in Mainland China (II)

LI Weidong 李伟东

2.1 Development in Mainland China
2.1.1 The Role of Chinese Securities Market
2.1.1.1 Historical Development of Securities Market
As mentioned above, a securities investment fund is classified as one kind of securities covered by the Securities Law (China). Furthermore, assets of investment fund should be invested in the securities market, such as stock and bonds. Therefore, the Chinese fund industry is regarded as an integral part of the domestic securities market. This study will first give a brief of the development of the securities market in China.
China started its economic reform and open-door polices in 1978, and began to conduct experimental projects in “shareholding” vehicles in 1984. The first publicly traded stock, the Beijing Tianqiao Store(天桥百货), was introduced in July 1984. Other pioneers included the Shanghai Feile Audio Equipment Co. (飞乐音响), which was offered to the public in Shanghai in November 1984, and the Shenzhen Bao’an Joint Investment Co. (深寶安) offered at around the same time. After 1986, some state-owned enterprises, such as the Shanghai Vacuum Electronic Device Co. Ltd (真空电子), Shenyang Jinbei Motor Vehicle Co. Ltd. (沈阳金杯) and the Shenzhen Development Bank (深发展), began to shift to the shareholding system and issue shares openly in the market.
In the spring of 1992, the Deng Xiaoping made general speeches during his southern Mainland China inspection tour. In the speeches, Deng Xiaoping fully affirmed the experiments of reform to introduce the shareholding system and securities market. His speech was a powerful spur to speed up the progress of reforms. As a result, the securities market reforms and economic development helped each other into a new era of development.
In early March 1992, the State Economic Restructuring Commission and other State departments jointly issued “Proposals Concerning the Standards of Limited-liability Companies,” which played a positive role in institutionalizing and standardizing the trial reforms to establish the shareholding system. Reform of the state-owned enterprise system was accelerated to push enterprises onto the market. In April, the central government officially gave the Shenzhen and Shanghai city local governments more autonomy over issues of local shares.
One undesirable event that happened in 1992 was the outbreak of riots in Shenzhen, known as the “8.10 Incident”. In August 1992, Shenzhen announced that lottery forms were distributed on 9 August 1992. It was estimated that over 400,000 investors had lined up for over three days and nights at the local PBOC offices to obtain a form that would give them the right to subscribe to shares of an upcoming IPO. But on the day these forms were handed out, 10 August, the prescribed 5 million forms had been used up in less than four hours. That afternoon and evening Shenzhen was the scene of violent rioting as the populace vented its anger against a process that was clearly corrupted by the managing PBOC officials. The next day the government distributed an additional 500,000 forms to restore the society order. Although this riot was induced by the lottery system of Initial Public Offerings (IPOs) in Shenzhen, it is the start of the central government’s effort to control over the development of the securities industry in general and the stock exchanges in particular. Thus, in October 1992, the State Council Securities Commission (hereinafter “SCSC”) and the Mainland China Securities Regulatory Commission (hereinafter “CSRC”) were established to break the pattern of multi-departmental administration of the securities industry. The major duty of the CSRC is to supervise and administer the securities market and to protect investors.
Following the “8.10 Incident,” on 4 May 1993, the SCSC promulgated “Provisional Regulations Concerning the Issue and Trading of Shares,” representing the first step of Mainland China towards enacting a nationally applicable national law concerning securities markets.
On 25 Jan 1996, the State Council promulgated the “Provisional Regulations on Prohibiting Securities Fraud.”
In April 1998, the CSRC issued the “Implementation Guidelines on Information Disclosure for Companies Seeking Public Offering of Stock.”
On 29 December 1998, the top legislative authority in Mainland China, namely, the Standing Committee of the National People’s Congress, finally passed the long-expected National Securities Law. Given overwhelming approval by the top legislators, the law is expected to serve as a milestone to mark Mainland China’s legal establishment of its securities market.
Ever since 1992 when the CSRC was established, more than 300 laws, regulations, rules, standards, and guidelines that concerning the securities and futures market, have been promulgated by the Chinese legislative and administrative authorities.
As a result of the improved regulatory system and a market-oriented appraisal system for Initial Public Offerings as well as expanded capital supply to the market, Chinese securities market reported a record turnover of 5.23 trillion Yuan in 1999. The number of listed enterprises rose to 949 by the end of 1999. Capitalization of stock reached 2.65 trillion Yuan, up 36 percent from 1998. By the end of July 2000, there were 1,025 listed companies in Mainland China with 343 billion capitals in stock.
2.2.1.2 Opening of Chinese Securities Market
The opening up of Chinese Securities Market started in the early 1990s. In 1991, Mainland China began issuing B shares that targeted foreigners. On 9 October 1992, the first N-share issued by the Brilliance was listed on the New York Sock Exchange (NYSE). In the same year, the CSRC announced the creation of “H” shares of Chinese companies listed on the Hong Kong Exchange. On 2 July 1993, the first H-shares issued by the Tsingtao Brewery were listed in the Stock Exchange of Hong Kong (SEHK). On 7 October 1996, the United Kingdom and Chinese relevant authorities signed a “Memorandum of Understanding”, under which Chinese enterprises could offer shares and list on the London Stock Exchange. The first “L” share listed was Datang Power Company. Consequently, in Mainland China, the same shares of a given company may sell at significantly different prices in the “A”, “B”, “N”, “L” and “H” markets.
The opening up of Chinese securities market has led to the improvement of regulation system of the domestic market in China by adapting to foreign regulatory practice. For example, in April 1994, the CSRC and the SEC (the United States) signed a “Memorandum of Understanding” which established a framework for providing technical assistance to the CSRC, for sharing information with each other, and for enforcing American and the Chinese securities laws co-operatively.
On 12 December 2001, the CSRC announced several securities commitments upon WTO entry. These are (1) overseas securities institutions may directly engage in the transaction of Chinese B shares; (2) overseas securities institutions agents in Mainland China can become special members of all Chinese Stock Exchange; (3) Mainland China is to gradually permit qualified foreign-funded enterprises to issue stocks and listed in Mainland China when conditions are mature; (4) Chinese-foreign joint ventures on securities and fund management companies are allowed to establish; (5) Chinese-foreign joint securities companies can engage in the underwriting of Chinese A-shares, the underwriting and trading of B-shares, H-shares, and bonds issued by the government and companies.
Aimed at adapting to the new situation of economic globalization and internationalization of the securities market after China’s entry into the World Trade Organization (WTO), Chinese securities government launched a series of reform in order to further standardize the practice of the securities market. On 15 Jan. 2002, to protect private remedies for public investors, the Supreme People’s Court decided that the people's courts could accept the civil tort and compensation dispute cases caused by false statements in the securities market. In June 2002, in order to improve the information disclosure quality of listed companies, and to protect investors’ rights and interests, the CSRC formulated three relative documents regarding “Guideline on Contents and Format of Information Disclosure by Companies.” On 28 September 2002, in order to protect the interests of the investors and maintain the order of the securities market, the CSRC enact “Administrative Measures on Takeover of Listed Companies to Standardize its Takeover of listed companies.”

2.2.1.3 Problems of Chinese Securities Market
Although Chinese securities market has developed rapidly, there are many problems in Chinese securities market. In particular, some substantial shareholders infringed the property of the listed company; some accounting firms and accountants release false audit reports for the listed company; and some companies manipulate the stock prices of the listed company, etc. The situation was to such extent that Professor Wu Jinglian (吴敬璉) even described the securities market as a big casino.
Ellen Hertz tries to explain the reason of “the falsification of financial statements by listed companies, [of] joint trading of listed Companies with their controlling shareholders, [of] excessive speculation and insider manipulation” in Chinese market in his research. He argues that the reform work of the securities market is “managed by state officials who put their own requirements for reliable revenues, stable class relations, and continued hegemony above any perceived need for economic expansion.” The aim of everyday work in the securities market is to meet the prevailing State plan not for investor protection.
Daniel M. Anderson also illustrates that “public disclosure and state control over which companies can issue shares publicly are strange bedfellows in Chinese securities regulation.” “One consequence of their co-existence is less investor protection.” This study agrees with their arguments that a paramount problem in Chinese securities market is the lack of investor protection regulations.
The Chinese government is realizing that the securities market should play a more significant role in consolidating China’s economy. Whether this goal can be reached depends on the level of protection afforded to investors.

2.2.2 Development of Investment Fund Industry
2.2.2.1 Period between 1990 and 1997
This study divided the development of the fund industry in China into tow stages, namely, period between 1990 and 1997, and post-1997.
The period between 1990 and 1997 was the infancy of the investment fund industry in China. In this stage, there were two types investment funds, “closed-end corporate funds” and “closed-end contractual funds” in China. A “closed-end corporate fund” refers to a type of company established according to the Company Law (China), which issuing shares to the public and reinvesting the money raised in securities market. It has directors and board of directors, fund manager, bank custodian and shareholders. A “closed-end contractual fund” refers to a kind of fund that issuing shares to the public according to a specific “trust agreement”. Such an agreement is made among fund manager, custodian and investors, and it is regarded as a constitutive document of the fund. Usually, both the closed-end corporate funds and the closed-end contractual funds are referred to as “old funds,” as opposed to the securities investment funds referred to as new funds established after 1997.
The first closed-end contractual investment fund, the Wuhan Securities Investment Fund (武漢證券投資基金), was set up at Wuhan with a capital of RMB 10 million Yuan in 1990. The first closed-end corporate fund is the Shandong Zibo Investment Fund (山東淄博投資基金), which was set up on 3 November 1992 and listed subsequently on the Shanghai Securities Exchange after approval by the People’s Bank of China. . The largest fund in this period, the Tianji Investment Fund (天讋投資基金) with RMB 581 million yuan, was established at Shenzhen on 5 February 1993, comprising of investment in securities (58%), projects (22%), bank deposit (16%), property (3%) and others (1%). According to statistics provided by the Chinese publication Mainland China Funds Observe, 73 investment funds were in existence between 1993 and early 1994 in Mainland China, with an approximate total assets value of RMB 6 billion. At this stage, investment fund was a product created by the regional trading centers in the early 1990s.
Due to the "overheat" of the economy, the People Bank of China (PBC) issued an Emergency Notice on 19 May 1993, announcing that approval of launching funds and fund-management companies would be given only by the headquarters of the PBC. The aim of this regulation is to prevent depositors from drawing their money from banks to invest in the fund. The development of Chinese funds has since slowed down and no new domestic investment funds established until the end of 1997.
During this infant period, there are some problems in the investment fund industry. First, law-making is not only often lagged behind the needs of the investment fund industry, but also there is some confusion within the regulations. According to the “Notice of State Council Regarding Further Strengthening of Securities Market Marco-management”, the PBC was only responsible for the examination and approval of the investment funds. However, certain local PBC branches went beyond it by issuing regulations to control the investment funds operator in the relevant local areas. In June 1992 and 1993, Shenzhen issued the “Interim Provisions on the Administration of Investment Trust Funds”, and Shanghai issued the “Provisional Regulation on Management of Investment Funds” respectively. Furthermore, Stock Exchanges of Shanghai and Shenzhen also issued self-regulations governing funds listed on their market separately. In addition, some funds have been listed on certain regional securities trading centers throughout Mainland China, such as Shenyang, Dalia, Tianjin and Hai’an, etc. Those centers also made their own regulations concerning investment funds. Pursuant to those regulations, a financial institution that wishes to conduct investment funds business needs to seek approval first from a local PBC branch and then from the PBC headquarters in Beijing. Due to conflicts of interest between the local government and the central government, local regulations (both issued by the local exchange and by local branches of the PBC) may differ from that of the Central Government, let along terms and definitions may vary in each jurisdiction. This situation impeded the integration of the fund market in China.
Secondly, in theory, investment funds should have fund manager to manage funds, and fund custodian to take custody of fund assets. Besides, fund manager and fund custodian should be mutually independent. But in practice, fund managers or fund custodians did not have independent legal personality in the structure of the old funds; instead, they were merely a department of banks or securities institutions.
Thirdly, risk control and investor protection were inadequate. Old funds invested widely without careful research or restrictions on their investment apportionment. Some funds invested heavily in real estates that resulted in a low liquidity, and some lent fund capital at high interests.
Lastly, information disclosure was inadequate. The information about investment portfolios and fund profits disclosed by these NAV every half-year was often too simple and too vague. Thus, investors were not well-informed of the operation of funds. Consequently, investors had only limited knowledge of funds, and were unable to tell the difference between funds and stock shares.
In order to build up a healthy investment fund market, in 1997, based on the regulatory framework of Hong Kong's Code on Unit Trusts and Mutual Fund, the State Council Securities Commission issued the “Provisional Measures Governing Securities Investment Funds (Provisional Measures).” The Provisional Measures, firstly, empower the Securities Supervision Regulatory Commission (CSRC) to approve and to supervise the securities investment fund, which avoid conflicts of interest between local government and central government. Secondly, the Provisional Measures require each investment fund to have fund manager to manage funds, and fund custodian to take custody of fund assets. Fund custodians and fund managers must be mutually independent in their administration and finances, and their high-level managing staff may not assume positions within each other. Thirdly, in order to control risk, the Provisional Measures not only restrict activities of fund investment, but also enumerate a series of prohibited activities. Finally, the Provisional Measures require each fund should provide standard and adequate information disclosure in order to protect fund investors. Therefore, the Provisional Measures is critical step in right direction for the rational development of China’s fund industry.

2.2.2.2 Post-1997 Period
The post-1997 period was characterized by the publication of the “Provisional Measures Governing Securities Investment Funds.” “New funds” were often referred to as the securities investment funds in Mainland China, which emerged at the beginning of 1998.
The first two new funds in Mainland China, the Jintai Securities Investment Fund (金泰) and the Kaiyuan Securities Investment Fund (開元), were established in March 1998, which received warm welcome from the public investors. People swarmed to open a special investment funds accounts or a securities accounts for funds trading to such an extent that the two funds were oversubscribed by 40 times than the expected. It was reported that the afterwards established new funds, the Fund Xinghua (興崋), the Fund Yu’an (裕安), the Fund Anxin (安信) and the Fund Puhui (普惠) were also oversubscribed by 40.7 times, 54.8 times, 52.6 times and 85.9 times respectively. Several funds reached the highest price on their first day of listing. For example, the Fund Xinghua, having a face value of RMB 1 Yuan and an issuing price of RMB 1.01 Yuan per unit, opened at a high of RMB 2.01 Yuan when fisted listed on 8 May.
The high prices were partly triggered by the authority’s favorable policies for funds’ subscription to IPOs. Chinese investors commonly believed that the government would not allow new funds to fail. To prevent the speculation of funds, in August 1998, the CSRC prohibited an investor from holding directly or indirectly more than 3% of any fund’s units.
On 14 July 1999, Mainland China’s first two index-weighted investment funds, the Fund Xinghe and the Fund Pufeng, were established. Index-weighted funds are attractive to Chinese investors because they invest mainly in listed companies according to their weight in the composite indices of the securities.
At the beginning of 2000, “old funds” were also reconstructed into new funds by letting authorized fund management companies and fund custodians replace the previous fund managers and previous custodians respectively. For example, on 1 August 2001, three old funds, the Fund Jianye, the Fund Shengyang Gongzong and the Fund Shanjian, were reconstructed into a new fund, the Jinding Fund. The Guotai Fund Management Company and the Construction Bank acted as its fund manager and fund custodian respectively. By the end of September 2001, all 22 old funds had been reconstructed into new closed-end contractual funds.
The performance of the new funds, however, did not live up to the expectations of Chinese investors. After the first disclosure of the fund’s NAV in June 1998, the price of funds began to drop down. On 2 March 2000, the prices of all new funds were still below their NAV. Certain scholars argued that the reason of discount trading was that the existing fund governance could not gain confidence from investors. Investors have been eagerly waiting for an open-end fund coming from 2000.
In 2001, Chinese fund-management companies began to launch open-end funds. Although open-end funds have higher risks than closed-end ones, prices of the closed-end funds are easily affected by the market demand and are more amenable to speculation when a fund is listed on the secondary market. The first open-end fund, the Hua’an Innovation Investment Funds （华安创新基金）, finally entered into Chinese securities market on 3 September 2001. It is managed by the Hua’an Fund-management Company with an investment focus on high-tech in the areas of electronic technology, network, biological technology, new medicine, aviation and aeronautics technology, ocean technology, new material, new energy. In October 2001, Southern Fund-management Company launched the second open-end fund, namely, the Huaxia Stability Investment funds （华夏稳定基金）. Afterward, the Huaxia Fund-management Company launched the third open-end fund, namely, the Huaxia Growth Investment Funds, in Novermber 2001. （华夏成长基金）. By the end of May 2003, altogether 75 investment funds, including 54 closed-end contractual funds and 21 open-end funds, had been established and managed by 35 fund-management companies, which accumulated a total capital over RMB 150 billion Yuan.

2.2.3 Problems Pertinent to the Fund Industry
Although the investment fund industry has achieved remarkable results in Mainland China, there are still some problems in the industry. This part will firstly list some important events disclosed by public media in the Chinese fund industry.
1. The Case of Mr. Hong Lai
On 12 June 2000, Mr. Hong Lai, the general manager of the Jiashi Fund-management Company (嘉实基金管理公司), asked the CSRC to examine the qualification of Mr. Wang Shaohua, the director of the above Fund-management Company. Three days later, Mr. Wang, is authorized by the chief director of the Jiashi to hold a special board of directors meeting and to dismiss Mr. Hong Lai without giving any reasons.
In this case, the board of Jiashi did not inform the important event to the public and to the fund investors. Fund investors did not know why Mr. Hong Lai was dismissed.

2. Mr. Cheng Siwei’s Complain
Mr. Cheng Siwei (成思威), Vice Chairman of the National Standing Commission, did some investigation on activities of fund manager. On 22 June 2000, he decried in a speech at the National Committee that many illegal activities, such as “Duidao”, “Daocang”, that damages investors’ rights exist in the fund industry. His speech drew the attention of most public investors to problems in the investment fund industry, as they were dissatisfied with the activities of fund managers.

3. Mr. Zhao Yugang’s Research
Mr. Zhao Yugang (赵裕刚), a staff who worked in the Shanghai Stock Exchange, did a research on activities of fund managers in 2000 and reported his research to the leaders in the Central Government. Afterward, the Cai Jing (財經) Magazine obtained the above said research and published it on 16 October 2000.
Based on his investigation on the activities of 22 investment funds managed by 10 fund-management companies between 1999 and 2000, Mr. Zhao drew the conclusion that there were many illegal activities in the fund industry, such as insider trading and manipulation.
His research consists of two parts. The first part of his research mainly focused on the analysis of fund purchase-sell behaviors of 20 investment funds in Shanghai Stock Exchange during the period between 8 August 1999 and 3 December 1999. The second part is an extended research of fund style and evaluation. Based on his early research on fund purchase-sell behaviors, Mr. Zhao made a follow-up study of the stock exchange records in Shanghai Exchange dated before April 28, 2000 of the same 20 funds and additional 2 new funds, i.e., Fund Hanxing and Fund Jingfu. By so doing, Mr. Zhao analyzed the market behavior of the 22 investment funds.
In my view, Mr. Zhao’s research is reliable and inspirable. It is not only because he carefully studied the stock exchange records of the total 22 investment funds in China at that time, but also because his research spans from August 1999 to April 2000 and that made his research valid. The problems in the fund industry that he discovered could exactly present the problems of the Chinese fund industry.
In his research, Mr. Zhao mainly examines four categories of problems existing in the Chinese fund industry.
The first problem is funds are inclined to make fake turnover in the securities market though the behavior of the “duidao(对倒)”. “Duidao” refers to the behavior that the fund either sells or buys the same securities at certain price within its different accounts. The aim of the “duidao” is to make false turnover in the securities market so as to mislead other investors. According to Securities Law and Criminal Law, the behavior of the “duidao” has been defined as a kind of manipulation and should be prohibited in China. Unfortunately, Mr. Zhao found in his study that 9 out of the 10 fund-management companies investigated did actions of “duidao” except Jiashi Fund-management Company.
The second problem is that investment funds manipulate stock price through the behavior of “daocang (倒仓)”. “Daocang” refers to the behavior that Fund A sells a certain amount of a specific security to Fund B at a certain price which Fund A and Fund B have negotiated before. Mr. Zhao found both Dacheng Fund-management Company and Boshi Fund-management Company made a lot of behaviors of “daocang”.
Thirdly, Mr. Zhao argued that an important method to protect fund investors is to keep the fund independently. However, he found that most funds affiliated with securities companies. For example, the Fund Kaiyuan and the Fund Tianyuan bought a lot of shares of the Nanjing Gaoke Company, the Feile Gufeng Company and the Jiangsu Kongyi Company in 1999. Both the fund manager of the Fund Kaiyuan and that of Fund Tianyuan is the Southern Fund-management Company whereas the Southern Securities Company is the shareholder and director of the Southern Fund-management Company. The interesting point is that the Southern Securities Company had bought shares of the Nanjing Gaoke Company, the Feile Gufeng Company and the Jiangsu Kongyi Company before 1999. The Southern Securities Company didn’t sell out these shares until the Fund Kaiyuan and the Fund Tianyuan drove the shares to a higher price in 1999. This situation inevitably leads certain people to describe the fund-management companies as the second assets management departments of securities companies.
The forth problem is misleading information. According to the information disclosure guidelines set in the “Provisional Measures,” fund manager should complete their annual report within 90 days after each financial year of the specific fund; they should finish the interim report within 60 days after each first 6-month’s of the financial year; and should publish their portfolio quarterly within 15 days after the end of every quarter. Nonetheless, there are no regulations to forbid the market change of the specific fund within such 90 or 60 or 15 days, not to mention to publish the correspondent market change of the specific fund either. In other words, the actual fund’s stock records may change during such periods. Consequently, the published fund report according to the “Provisional Measures” may not necessarily reflect the present-time fund stock but the past. Therefore, the disclosed information of the fund could easily mislead the public. For example, Mr. Zhao indicated in his research that among the three portfolios published by the total 10 fund management companies between the period of August 1999 and April 2000, only one company gave accurate information to the public while the other 5 fund management companies committed serious misleading and the rest 4 fell in between.
Followed Mr. Zhao’s research, Mr. Hu Lifeng, a researcher from Xiameng United Trust Investment Company, did a research on interim reports of 26 funds in 2000. Mr. Hu drew the same conclusion as Mr. Zhao that most of funds disclose misleading information in their interim reports.
Mr. Zhao’s research drew great attention from the public and the Chinese authorities. Public commentators predicted that public investors would lose their confidence when such illegal activities go on in China. The social pressure pushed the CSRC to investigate activities of fund-management companies. On 27 March 2001, the CSRC released its report on investigations into potential wrongdoings of 10 fund-management companies. But, the CSRC didn’t disclose the detailed contents of the investigated report and no sanction has been imposed on funds. The published report states as follows:

The Boshi Fund-management Company was shown to have conducted an extraordinary number of abnormal transactions; Dacheng and Changsheng were found to have conducted abnormal transactions. Five fund-management companies that are suspected of such transactions turned out to be coincidences or at worst guilty of only minor infractions. Only two companies out of the 10 that being investigated were clear of wrongdoing.

4. The Case of Yin Guangxia
After the event of the “Darkness of Fund”, a media press disclosed another scandal in the fund industry. In August 2001, the CSRC launched an investigation into the Yin GuangXia (银广夏) Company after the Cai Jing (財經) magazine revealed the false numbers of the exports and foreign currency earnings in the 2000 Annual Report of the Company. Although there is no evidence that Fund Jinghong and Fund Jingfu, both managed by the Dacheng Fund-management Company, involved in the false statement, it is the Fund Jinghong (基金景宏) and the Fund Jingfu (基金景福), together with their connected persons --- the China Economic Development Trust Investment Company (CEDTIC) that pushed the share price of the Yin Guangxia up to 4.4 times that of the before in 2000. So far, the State Finance Administration has revoked the license of the Zhong Tian-qing Accountant Firm, and two CPAs were arrested because of the Yin Guangxia Case. The case is still under investigation to date.

5. Research of the Financial Research Centre of the China Social Science Academic
Due to problems in the fund industry, some scholar began to rethink the development of investment fund industry in China. On 11 October 2001, China Securities Daily（中国证券报） published the research report of the Financial Research Centre of the China Social Science Academic, entitled “Rethinking the Characteristics of the Securities Investment Funds in China.” This research analyze four negative aspects of securities investment funds in China. First, the aim of investment fund is to make profit for investors. However, funds are unique in that they are organized and operated by fund managers whose primary loyalty and interests lie outside the funds. Consequently, conflicts of interests exist in the fund structure. This conflict of interest may induce fund managers to do some abnormal activities to maximize the their own profit. Secondly, investment decision of the fund manager often depends on timely and accurate information. If the fund manager cannot keep up with accurate information and make a subsequent false investment decision, the fund investors will lose their money. Thirdly, in the past years, the Chinese government exaggerated contributions of securities investment fund. Finally, due to the lack of effective monitor system, fund managers are easily to will abuse their power to benefit themselves. This research makes a conclusion that (1) the investment funds did not help in stabilizing the securities market; (2) the investment funds did not reduce market risks; (3) the investment funds did not make profit for investors as their commercial aim; (4) the investment funds were not institutional investors in Mainland China. Consequently, the research paper denied the social economic contributions of existing investment funds in Mainland China.

6. The Case of Shenzhen Expressway
The event of “Shenzhen Expressway” further asserted the argument of the Financial Research Centre of the China Social Science Academic. In December 2001, “Shenzhen Expressway”, a company listed on the Shanghai Stock Exchange, decided to issue new A Shares and invited securities investment funds to subscribe for the new A Shares at prices ranging from RMB3.39 to 3.66 yuan per share. A total of forty-seven funds had applied for the subscription of the new shares. The total number of new shares applied by these funds for subscription was 28,865,000,000, with a total value of RMB105.6 billion yuan. However, the net asset value of these funds as of 23 November 2001 was only RMB78 billion. Apparently, most of the funds applied for subscription of new shares of a total value of few times more than the net asset value of the fund. Although there is no express regulation on the number or value of shares that a fund may apply for in an issue of new shares by a listed company, under the Provisional Measures, the total investment by a fund in the stock of one listed shall not exceed 10 % of the net value of the assets of the fund. It was reported that among the forty-seven funds, only three had applied for subscription of new shares with a total value below 10% of the net asst value of the fund.
In January 2002, Mr. Zhang Jing Hua, who was then the director of the Funds Department of the CSRC, wrote a letter to the fund managers of the relevant funds. The letter was later publicized. Many people were surprised of the emotional charge and anger expressed of by Mr. Zhang. According to Zhang, in the extreme case, if a fund is allotted all the shares that it has applied for the subscription, the fund would not have sufficient cash to subscribe for the full allotment since the total value for subscription is exceeding the fund’s net assets, and which would eventually make the fund to give up part o its allotment, and this in turn would have bring about an unprecedented disaster in the stock market. Subsequently, on 30 March 2002, the CSRC issued the “Notice on the Relevant Problems Regarding the Participation of Securities Investment Funds in the Application of Share Issue.” In this Notice, the CSRC sets out several restrictions on the applications for new issues of shares: (1) each fund may not apply for new shares of a total value exceeding the fund’s total asset value; and (2) the total number of shares that each fund applies for shall not exceed the total number of shares on offer.

As discussed above, most problems of the investment fund industry were first disclosed by the media or scholars, and then investigated by the CSRC in Mainland China. There is little literature on the problems of fund industry. The reason is rather complex and has been discussed in Chapter One. In order to explore the real situation of problems in the fund industry, this study decided to conduct a field investigation to obtain the first-hand information and to make up for the inadequate data. First, this study managed to interview nine cases through a slow and snowball process and they represented diverse backgrounds, including four fund managers, three fund-related managers (including one legal affairs officer, one asset management manager and one trading business manager) in the related securities companies, two officials in the CSRC (one in Beijing’s headquarter and one in its Shenzhen office) from July to September 2001. Secondly, this study made a supplementary questionnaire survey on fund investor’s view of the protection of fund investors in April 2003.
According to the first-hand information and library resources, this study summarizes three types of activities which may damage fund investors in practice, that is, (1) the problem of ineffective fund governance, (2) misleading information disclosure and (3) illegal related transactions.
First, due to ineffective fund governance, fund managers may abuse their powers to benefit themselves and their related parties. For example, I interviewed four fund managers from fund-manager companies and asked them some questions on fund governance. Such as what is the reason of “darkness of investment funds” in China? Can fund custodian effectively supervise activities of fund-management companies? What’s fund-management companies’ strategy toward it? One of the fund managers that I interviewed responses to those questions as following:

(1) To say the truth, the overall quality of the listed companies in the Chinese stock market is not so satisfactory. The result is not much shares could be chosen as potential investment. Besides, there are no stock index options for investors to buy in China. Chinese manipulator and fund manager can only make profit by pushing the share price up. Consequently, fund manager is inclined to use some unfair means to push up the share values in order to make profit, for example, by means of ‘duidao’ and ‘daocang.’ Actually, the “dark side of the fund” described by Mr. Zhao Yugang is an open secret in our industry except nobody would like to or dare to disclose the ‘dark’ until Mr. Zhao came up. However, he left the Shanghai Stock Exchange afterwards and I learned he is now working in a securities company located in Dalian. I don’t think his boss will appoint him assume important position either.
(2) There is the problem in the institutional design. For example, there are few mechanisms to monitor our fund manager. Although the law regulates that the fund custodian has the legal right to monitor the fund manager, but in practice, the fund custodian has a very good relationship with the fund manager. The custodian has no right to supervise the decision made by the fund manager, nor does it have the ability to understand whether or not the decision made by the fund manager has involved in the problem of related transaction, and whether or not the decision is in the interest of the fund investor. So far, there is no report on the fund custodian using his authority to fire the fund manager because of the misconduct of the latter.
(3) Fund manager also has many pressures. For example, in China, fund manager is appointed or nominated either by the chairman of the board of directors or the general manager of the fund management company while the latter two are elected or recommended by the shareholder of the company. It is then impossible for fund manager to do something that may harm the interest of the shareholder since it will in turn harm the interest of the chairman and general manager. In a word, the chairman and the general manager would not allow their fund managers to conduct things which will damage the interest of the fund management company shareholders. Furthermore, it is very likely in practice that the fund manager is also recommended by the shareholders, especially by the large shareholders of the company. So, it is no wonder that the fund manager is easily to abuse his power to please the company’s related parties, say, the related securities company.

Secondly, investment fund may publish misleading information to the public. For example, on 17 January 2000, all investment funds issued their investment portfolios up to 31 December 1999 according to regulations. Ridiculously, one day later, two of them, namely, Fund A and Fund T, issued notice of correction immediately. However, Fund A did not list the changes in a clear way, or in other words it did not declare what has been corrected in comparison with disclosure dated 17 Jan 2000. Only after a very careful comparison could investors find out that what has been corrected is the name of the top 10 stock portfolios that the Fund A has hold. Besides, there was an important omission in the disclosed document; namely, a stock named “Vacuumed Electronics” was missing in the previous coverage, not to mention the inaccurate disclosure. Moreover, the correction notice itself is also problematic. (1) By listing new stock portfolios, the notice did not clearly write out the difference and the changes comparing to the previous announcement; thus the correction message is ambiguous. (2) The omission of “vacuumed electronics” is unforgivable. It is not only because the stock actually ranked in the 6th in the corrected disclosure, but also because it cannot come up with a convincible reason of such a significant mistake. How could such an important stock have been missed in the previous disclosure? There must be something wrong with the related persons. It further perplexes the investors.
In addition, according to the survey conducted by this study, 82 percent respondents of the total 38 valid questionnaires did not satisfied with the work on information disclosure. Mr. Wei (Interview case no. 1), an officer from the CSRC in my interview also criticizes fund-management companies do not pay more attention on the duty of continuous information disclosure.
Thirdly, illegal related transaction is becoming a major scourge of the fund industry. For example, investment funds buy securities from related securities companies or related investment trust companies at an inappropriate price; investment funds buy securities underwritten by a related securities companies, where those securities are inappropriate price or do not meet the funds’ objectives; investment funds pay excessive commissions or fees to an related securities companies intermediary used for buying or selling securities or other investment of a fund, etc.
In my questionnaire survey, about 58 percent respondents of the total 38 valid questionnaires do not believe that fund managers could well perform their duties, in which about 84 percent respondents of the total 38 valid questionnaires answer the reason is conflict of interests, about 90 percent respondents of the total 38 valid questionnaires answer the reason is the loophole of regulations, about 76 percent respondents of the total 38 valid questionnaires answer the reason is lack of supervision, while about 5 percent respondents of the total 38 valid questionnaires answer the reason is lower transparency. Regarding information disclosure, only about 11 percent respondents of the total 38 valid questionnaires satisfied with the contents of continuous information disclosure of investment fund, while about 82 percent respondents of the total 38 valid questionnaires dissatisfied with the contents of continuous information disclosure. As a result, about 61 percent respondents of the total 38 valid questionnaires do not trust fund manager, while about 18 percent respondents do not give any comments. Besides, about 82 percent respondents of the total 38 valid questionnaires want to withdraw their money from the fund industry, in which about 61 percent respondents of the total 38 valid questionnaires answer the reason is lack of protection, about 10 percent respondents answer the reason is lack of knowledge on fund, about 26 percent respondents answer the reason is the market going down, and 3 percent respondents do not give any comments on the reason. The above figures indicate that law making is lagging behind the needs of investor protection. Those figures also indicate the above three type types of activities seriously damaged the fund investors in practice and also destroyed public investors’ confidences.


2.2.4 The Underpinning Reason
The reason of problems existing in the Chinese fund industry is complex, including political , legal tradition and culture. This study mainly focuses on the reason of legal aspect, namely, lack of effective regulations to protect investors in China.
The same problems in China also occurred in the United States during investment fund industry history. In 1935, the U.S. Securities Exchange Commission (SEC) studied investment funds and found many investors, particularly, smaller and unsophisticated investors, for whom products of the fund were so attractive, lost large sums of money. Because the assets of investment funds were managed by unscrupulous managers, it was inevitable that they failed to observe the principles of fiduciary duty to their investors. “The problem of the protection of the investor and the national economy is too vital to permit haphazard voluntary solutions.” As President Roosevelt stated:

There is no necessity of reviewing in detail the many unhealthy practices which this legislation is designed to eliminate. It is enough to point out that the investment trusts have themselves actively urged that an agency of the Federal Government assume immediate supervision of their activities. This attitude on the part of the investment trust industry and investment advisers is most commendable.

In this sense, between 1938 and 1940, the SEC submitted to the Congress an exhaustive report on the investment fund industry. These studies indicated that activities of investment companies are subject to a pervasive pattern of substantive regulations that goes far beyond the disclosure and anti-fraud provision characteristics of other federal securities laws, such as, the Securities Act of 1933 (hereinafter the 1933 Act) and the Securities Exchange Act of 1934 (hereinafter the 1934 Act). It is necessary to spell out numerous restrictions and requirements designed to protect investors in the fund industry. Later, the Investment Company Act of 1940 (hereinafter the 1940 Act) was enacted in 1940. Investment companies, as a research report has observed, are “media for the investment in the national economy of a substantial part of the national savings and may have a vital effect upon the flow of such savings into the capital markets.” Considering the unique character of investment companies and their role on channeling savings into the national economy, the 1940 Act reflects a congressional recognition that substantive protection beyond the disclosure requirements of the Securities Act of 1933 and that of Securities Exchange Act of 1934 were needed. The role of the 1940 Act is to protect investors who entrust their savings to others for expert management and diversification of investments that would not have been available to them as individuals .
In addition, mutual funds in the United States must comply with the Investment Adviser Act of 1940 and the Internal Revenue Code of 1986, as well as laws of the state in which they are sold. In this sense, regulations in the United States are so complex that it is almost impossible to think about launching a new fund without consulting lawyer on how to ensure compliance with the relevant regulations.
By contrast, in Mainland China, prior to 1993, the main focus in debates about investment funds was whether or not the investment fund should be developed or not. With the development of the investment funds, their advantages and significance were gradually realized and the focus turned to how to standardize them.
On 22 April 1993, the China State Council promulgated the “Provisional Regulations on the Administration of the Issuing and Trading of Stocks” to indirectly acknowledge the investment funds in Mainland China. There are also two indirectly applicable regulations of investment funds, that is, the “Regulations Governing Financial Institutions of 1994” and the “Administrative Measures for Overseas Investment Funds of 1995.” The former regulates the establishment, management and termination of financial institutions, i.e., fund management companies. The latter applies to the investment funds that are though registered and raise capital outside Mainland China, but mainly invest in industrial projects within Mainland China. On 19 May 1993, the PBC issued an “Emergency Notice,” announcing that approval to launch funds and fund-management companies would be given only by the headquarters of the PBC. Moreover, corporate investment funds are also subject to the Company Law that promulgated in 1994.
In the absence of directly national legislation, local regulations were formulated to cover investment funds. The first and most important local regulation, the “Shenzhen Interim Provisions for the Administration of Investment Trust Funds,” was promulgated in Shenzhen in June 1992. Shanghai also promulgated local regulation the “Shanghai Provisional Measures for the Administration of Renminbi Securities Investment Trust Funds” in 1993 as well. Additionally, the Shanghai and Shenzhen Securities Exchanges also issued rules regarding investment funds. However, these local regulations are not unified and are far from adequate.
Along with the inflow of the foreign capital and technology, the Chinese legal system also gradually opened its door to the world and has been learning from the experience of foreign jurisdictions in relation to commercial law. In 1997, State Council Securities Commission (SCSC) issued the “Provisional Measures Governing Securities Investment Funds “(hereafter the Provisional Measure) based on the regulatory framework of Hong Kong's Code on Unit Trusts and Mutual Fund. As mentioned in the Section 2.2.2.1, the provisional Measures are critical step in the right direction for the rational development of China’s fledgling fund industry. The most contents of the Provisional Measures are similar to the Hong Kong’s Code on Unit Trusts and Mutual Fund.
Hong Kong’s law system belongs to common law system. The regulatory framework of the investment fund industry is mostly constructed on statutes, in that activities are general regulated by ordinance rather than by common law. Hong Kong has three principal ordinances governing the investment fund industry. The first is the Securities Ordinance (Cap. 333) (consolidated in the Securities and Futures Bill), which regulates the operation of stock markets, the licensing of intermediaries and proscribes improper trading or selling practices. The second is the Companies Ordinance (Cap. 32), which deals with the formation, operation and termination of companies in Hong Kong. The Companies Ordinance (Cap.32) is relevant to the fund industry when the corporate mutual fund organized under the Companies Ordinance (Cap.32) distributes its shares to the public. Under the provisions of the Companies Ordinance, a company, which sells its shares or debentures to the public in Hong Kong, must register a prospectus with the Registrar of Companies and comply with the provisions of the Companies Ordinance (Cap.32). The third is the Protection of Investors Ordinance, which “proscribes fraudulent or reckless inducements to invest in securities or other property, advertisements inducing investment or offers of investment advice.”
In Hong Kong, besides ordinances, in order to provide the fund industry with adequate guideline and criteria for authorizing funds, the HKSFC enacted two major “Codes” to regulate activities of investment fund in Hong Kong. One is the Code on Unit Trusts and Mutual Funds, the other is the Fund Manager Code of Conduct. In these two regulations, the HKSFC applies the same core principles as are found in other developed investment fund markets around the world, in line with IOSCO’s Principles for the Regulation of Collective Investment Schemes. Neither the Code on Unit Trusts and Mutual Funds nor the Fund Manager Code of Conduct has any force of law. However, a breach of the Code on Unit Trusts and Mutual Funds may, as an ultimate sanction, result in the de-authorization of the authorized fund by the HKSFC. A breach of the Fund Manager Code of Conduct will reflect adversely on the fitness and properness of the fund manager, which may result in disciplinary action, including the suspension or revocation of the fund manager’s registration with the HKSFC. As these codes are not law and their infringement is not a breach of law, certain scholar argued that, since a breach is not actionable, a person injured has no legal claim to compensation, and available sanctions are ineffective. Therefore, “such a system is fundamentally flawed and requires root-and-branch reform” in Hong Kong.
But, this study argues that the mechanical copy of Hong Kong's Code on Unit Trusts and Mutual Funds into China neglect the Chinese cultural and practical condition. (Detail discussed in the Section 3.3.6).
In China, under the framework of the Provisional Measures, the CSRC promulgated several rules to regulate activities of investment funds since 1997. In 1997, the CSRC issued (1) the “Contents and Format of Fund Agreement of Securities Investment Funds” (Rule No. 1); (2) the “Contents and Format of Custody Agreement of Securities Investment Funds” (Rule No. 2); (3) the “Contents and Format of the Prospectus of Securities Investment Funds” (Rule No. 3)); and (4) the “Guidelines on Essential Clauses for Articles of Association of Fund Management Companies” (Rule No. 4). In 1998, the CSRC issued the “Guideline on Information Disclosure of Securities Investment Funds (Rule No. 5)”. In October 1999, the CSRC issued the “Provisional Rules on Fund Manager Qualification (Rule No. 6).” The Provisional Measures and Six Rules establish the basic legal framework of closed-end investment funds in China.
On 8 October 2000, the CSRC issued “the Trial Measures for Open-End Securities Investment Funds (Trial Measures)” which came into force on the same day. The Trial Measures introduce for the first time a regulatory framework for the operation of open-end funds in Mainland China. According to the Trial Measure, open-end funds are established by fund managers. The CSRC is authorized to examine and to approve applications of establishing open-end funds. Open-end funds must have a clear, lawful and rational investment direction. An open-end fund may be established only if the following two conditions are met: (1) the net sales of the proposed fund during the establishment and offering period exceeds RMB 200 million yuan, and (2) the number of subscribers during the establishment and offering period reaches at least 100. An open-end fund may put restrictions on the proportion of fund units held by individual accounts. The amounts paid when subscribing for or redeeming open-end fund units are based on the Net Asset Value of the fund.
On 26 February 2001, in order to further strengthen the supervision and management on the funds, to standardize the operation of funds, and to protect the legal rights and interests of fund investors, the CSRC promulgated the “Notice on Standardizing Acts of Securities Transaction in the Operation of Securities Investment Funds.” It requires that “all fund management companies and employees of the funds shall improve their understanding, change their conception, absolutely know their own legal nature, serve the fund investors wholeheartedly, and fulfill the same obligations as other public investors in the activities of securities investment and transactions.”
In August 2001, the CSRC realized that some rules did not suit the development of investment funds, and decided to rectify some rules step by step. “The Guideline to the Essential Clause in Articles of Association of the Fund Management Company (the Rule No. 4)”, the first ratified rules, was replaced by the “Notice on Issuing Guiding Opinion No. 1 on Standardizing Operation of Securities Investment Fund --- Guiding Opinion on Establishing Articles of Association of Fund Management Company.”
On 11 October 2001, in order to improve the professional ethics and self-discipline consciousness of professionals in the fund industry, the CSRC issued the “Practice Rules for the Professionals in the Trade of Securities Investment Fund Industry.” This rule requires that professionals in the fund industry, such as fund manager, should “insist on the principle of fairness, equity, and openness, treat the fund and fund investors equally, and protect rights and interests of fund investors.”
On 26 November 2001, the CSRC released draft for soliciting opinions about “Notice on Issues Concerning Review and Approval of Important Matter Changes of Fund Management Companies” to normalize important changes of fund management companies. According to the opinions, the CSRC expects fund-management companies to disclose all important changes of their companies to the public and to the CSRC in time.
On 11 November 2001, China signed the “Protocol on the Accession of the People’s Republic of China” and entered the WTO. Within nine days thereafter, on 20 December 2001, the CSRC issued draft regulations on its website for public comments on foreign institutions investing in the establishment of fund management companies. On 1 June 2002, the CSRC issued the “Rules on Establishment of Fund-management Companies with Foreign Capital Equity Participation”, which went into effect on 1 July 2002. On 12 July 2002, the CSRC published a list of questions and answers (“Q&A”) on issues concerning the establishment of Sino-foreign joint venture fund management companies. Although the Q&A is not law, it clarifies a number of important issues arising from the Rules. According to the Rule, “the aggregate foreign ownership (both direct and indirect) in a joint venture fund management companies will be limited to 33%, but may rise to 49% within three years of China accession to the WTO.”
As discussed above, compare to regulations concerning investment fund in the United States and Hong Kong, although the CSRC promulgated several administrative regulations to governing the activities of investment fund in China, there is no specific law adopted by the National People’s Congress and its Standing Committee to governing activities of investment funds. In addition, it is not clear whether some law principles of the current Chinese laws would apply to Chinese investment funds.
(1) The Securities Law
The Securities Law was approved by the Sixth Session of the Ninth National People's Congress on 29 December 1998, and became effective on 1 July 1999. The draft of the Securities Law “has had a bumpy ride into law, taking six and a half years, and it also establishes the first precedent of expert legislation.”
The Securities Law defines the share of an investment fund as “a kind of security issued by the fund promoters to unspecified investors.” “The securities shall indicate that the holders shall have asset ownership, right to distribute returns of the fund and other related rights, as well as corresponding obligations.” That implies that the Securities Law is applicable to the issue and trading of investment funds. Therefore, “When issuing and dealing in securities, all parties must abide by the principles of openness and fairness,” “must abide by laws and administrative rules and regulations.” “The activities of all participants involved in the securities market should be voluntary, reimbursable, honest, and trustworthy.” The law “prohibits insider-trading, manipulation of stock markets, making and spreading false information and any other fraudulent conduct against investors.”
But, Chinese Securities law did not formulate its regulations according to characters of investment fund for protecting investors. From the experience in the United States, due to activities of mutual funds “are subject to a pervasive pattern of substantive regulations that goes far beyond the disclosure and anti-fraud provision characteristics of other federal securities law,” the U.S Congress enact the Investment Company of Act 1940.
In addition, the Chinese securities law fails to give the definition of the investment fund and to specify whether the legal form of investment funds in China is the contractual fund or the corporate fund. It also does not spell out numerous restrictions and requirements designed to protect investors in the fund industry. Thus, this study argues that the Chinese Securities Law is not enough for protection investors in the fund industry.
(2) The Company Law
The Company Law in Mainland China plays a fundamental role in the economic reform policy of the Chinese Government. The Company Law formally adopted by the National People’s Congress on 29 December 1993, and took effective on 1 July 1994. The objective of the Company Law is to protect “the lawful rights of creditors, safe-guarding social economic order and promoting the development of socialist market economy.” It applies to limited liability companies and companies limited by shares within the boundaries of Mainland China. However, the Company Law of 1994 did not take investment fund into consideration when it was drafted, though fund-management companies are governed by the Company Law.
(3) The Trust Law, Civil Law and Contract Law
The meaning of “civil law” in Mainland China is twofold. First, it is used as a generic term encompassing everything that is commercial, economic, proprietary and personal in nature. Secondly, it refers to the Code of Civil Law. The present Chinese Code of Civil Law, known as the General Principles of Civil Law (GPCL), broadly regulates the proprietary and personal relationships between legal persons, nature persons or legal and natural persons of equal status.
According to the GPCL, an obligation is a special relationship of rights and duties between specific parties, arising from terms of a contract or from a provision of law. A contract is defined as an agreement whereby parties establish, modify, or terminate civil relationship. The new Contract Law of Mainland China took effect on 1 October 1999.
According to the GPCL and the Contract Law, where one party to a contract fails to perform its obligations or its performance fails to satisfy the terms of the contract, that party shall bear liability for breach of contract such as continuing to perform its obligations, taking remedial measure, or compensating for losses. But, neither GPCL nor Contract Law mentioned that contract principles would apply to China's investment funds or to govern the legal relationships of funds.
As far as the Trust Law, effective on 1 October 2001, applies to the conduct of civil, business or public interest trust activities in Mainland China by settlors, trustees and beneficiaries.
A trust has a contract feature, combined with open-ended "catch-all" fiduciary duties to fill the gaps in the contract. According to the Trust Law, “a trustee shall manage the trust property for the beneficiary's best interest and shall fulfill the duties of honesty, trust, prudence and effectiveness.” “The trustee is strictly prohibited from commingling trust property with his own property” , “and is strictly prohibited from self-dealing” . “In order to make sure the fiduciary fulfills his duties, the trustee is required to make periodic accountings and the settlor has a right to information.” More importantly, “a settlor or beneficiary reserves the right to alter the provisions of the trust and the power to revoke the trust in limited circumstances, and thus the ultimate control over the trust estate.” The Trust Law provides “settlors and beneficiaries the long deserved right to bring fiduciary lawsuits in cases whereby trustees have breached their fiduciaries duties.”
However, many concepts of the Trust Law, such as the fiduciary duties, are a foreign concept. Chinese judges are not experts by training to deal with such open-ended notions as "fiduciary duties." Their loyalty goes to statutory legislations and they lack the law-making capacities enjoyed by their Anglo-American counterparts. Politically dependent judiciaries and historically weak legal enforcement measures may compound the difficulties in implementation of the Trust Law. Therefore the China Supreme People’s Court and scholars are still attempting to interpret the Trust Law in the common Chinese legal language and eventually to integrate it into the civil law system in Mainland China.
Investment funds have three parties, fund managers, fund custodians and fund investors. Fund managers operate and manage assets of investment funds, fund custodian keep assets of funds. Fund managers should h

The Topic of Protecting Fund Investors in China
Weidong Li

1. Research Problem
1.1. Emerging Problems: An Introduction
Investment fund as a financial vehicle emerged in China in 1990, and the fund industry has made rapid progress since 1998 as a result of Chinese regulatory authorities sustained effort to accelerate their healthy growth potential. Investment funds play an active role in China's securities market and will be a matter of national public interest. It is reported that the total value of investment funds has reached RMB 450 billion Yuan by the end of 2005.
Although the investment fund industry has achieved remarkable results in China, there are serious problems therein. (1) Abuse of power by fund managers and their related parties as a result of the loophole in the fund governance. An expert with the Shanghai Stock Exchange conducted a research on activities of securities investment funds between August 1998 and April 2000 and found that most of the fund managers and their related parties conducted abnormal transactions to benefit themselves at the cost of the fund investors. The misconduct was to such an extent that Professor Wu Jinglian (吴敬琏), a famous and active economist in China, also criticized that fund managers abused their powers to make illegal profits and consequently damaged the rights of public investors. (2) The investment fund not only fails to comply with disclosure requirement in practice, but also sends misleading information to the public in some cases. In practice, a large number of fund managers treat the duty of continuous disclosure as an “one-off” compliance matter. Illegal related transactions have become a major scourge of the fund industry. For example, investment funds buy securities from related parties at an inappropriate price; investment funds buy securities underwritten by a related party whereas those securities are at an inappropriate price or do not meet the funds’ objectives; investment funds pay excessive commissions or fees to a related party intermediary used for buying or selling securities or other investment of a fund. In August 2001, the China Securities Regulatory Commission (hereinafter “CSRC”) launched an investigation into Guangxia (Yinchuan) Industry (银广夏) after the Cai Jing (财经) Magazine revealed that the 2000 Annual Report of the Company had provided false information about its exports and foreign currency earnings to the public. But at that time the share price of the Yin Guangxia had been pushed up to 4.4 times that of the before. It was later reported that the Dacheng Fund-Management Company (大成基金管理公司) who both managing the Fund Jinghong (基金景宏) and the Fund Jingfu (基金景福), and their related parties --- the China Economic Development Trust Investment Company (CEDTIC), the major shareholder of the Dacheng, had involved in the Yin Guangxia case by making related transaction to control the price of the above-mentioned listed company. Nonetheless, a large number of investors, including fund investors, lost a large amount of money due to the false statement and price manipulation.

1.2 Investor Protection: Key to Market Development
The above discussed three categories of fund problems further draws my attention to the subject of investor protection in the securities market if fraud continue to emerge.
Lynn Stout noticed that there are two model of investor behavior in the legal literature. One model, in Stout’s term, is the “rational expectations investor” that implicit in most academic discussions of securities policy in the “law and economics” school of analysis. The other model is the “trusting investor” developed by Stout.
According to the “rational expectations investor” model, investors behave like members of the species homo economicus: they are cool, calculating and purely self-interested actors. The rational expectation investors not only behave rationally and selfishly themselves, but also expect others to behave rationally and selfishly. This implies that rational expectations investors presume that corporate insiders and securities professionals will not hesitate to lie or cheat or steal whenever they can get away with it. Rational expectations investors recognize when they are exposed to the risk of fraud and can protect themselves by refusing to invest.
Rely on the model of rational expectation investor, some theorists, such as, George Akerlof, Frank Easterbrook, Daniel Fischel, Stephen Choi, and Andrew Guzman argue that inadequate legal protection for investors does not primarily hurt investors. Stephen Choi and Andrew Guzman argue that regulation of investor protection is costly for issuers and financial intermediaries. Therefore, the implication of the rational expectations investor model is that rational expectations investors do not need mandatory antifraud rules to protect them from losing their investments. Professor Romano (1998) further offered a proposal to change federal securities law to allow corporations that sell stocks and bonds to investors in the United States to elect regulations not be regulated by U.S. securities law, but instead by the laws of other nations or states – including nations and states that do not provide antifraud protection.
However, after the Enron case and the WorldCom case, many scholars addressed that investors’ trust in the securities markets is very important. Professor Stout develops the trusting investor model. A trusting investor is willing to believe that at least some people might be trustworthy. They, unlike rational expectations investors, are willing to make themselves vulnerable to persons that have behaved cooperatively in the past, because they view past behavior as prima facie evidence those persons or institutions will continue to behave cooperatively in the future. As a result, trusting investors can be betrayed and defrauded at least once. Thus, professor Stout makes a conclusion that “investors may not need to trust people before they are willing to give up their hard-earned dollars. But they must at least trust system.” In the securities market, she argues that

“Investors invest not because they trust managers, brokers and investment advisor, but because they rely on the legal system to discourage managers, brokers and investment advisors from behaving like the scoundrels that they are.”

Trusting investors can learn to avoid putting their money into securities markets regulated by legal regimes that do a poor job of deterring fraud and so offer relatively low or even negative return. In sum, Professor Stout concluded, “investor confidence –meaning investor—is important to the market.”
Tamar Frankel agrees with Professor Stout’s opinion on investors’ trust in the securities markets. She further criticizes the opinion that the regulation is costly for issuers and financial intermediaries is a puzzle. Instead, she argues that investor protection regulations help to restrain the “bad apples” that may ruin confidence in the industry. As she points out, regulations on investor protection provide the industry with the stamp of “good housekeeping”, which implies that the government guards investors’ interests and at the same time reduces the high costs that investors would otherwise bear in monitoring the issuers and the institutions. So, Tamar Frankel makes a conclusion that investors would withdraw their savings from the market unless the government develop a culture of honesty and persuade investors that their mistrust is unjustified.
In Chinese securities market, I choose four points in Chinese securities market during the period between February 2001 and January 2002. The first point is February 2001, when the CSRC confirms Mr. Zhao Yugang’s research after investigating all fund-management companies in Mainland China. From February 2001 to March 2001, the Shanghai Stock Indices dropped more than 10 per cent during one month accordingly. The second point is July 2001 when the CSRC launched the investigation of illegal activities in securities market. Before the CSRC launched the investigation, the Shanghai Stock Indices is 2099. After the investigation, the Shanghai Stock Indices was dropped to 1940 at the end of July 2001. The third point is August 2, 2001 when the media disclosed Yin Guangxia Company had lied about its exports and foreign currency earnings in its 2000 Annual Report. After the disclosure, the Shanghai Stock Index was dropped from 1953 to 1820 on August 24, 2001. The fourth point is August 24, 2001 when the media disclosed that the Sanjiu Enterprise Group, controlling shareholder of the Sanjiu Medical listed on the Shanghai Stock Exchange, misappropriated 25 billion Yuan fund from the Sanjiu Medical between November 1999 and May 2001. Afterwards, the Shanghai Stock Index was dropped to below 1500 by end of January 2002. Consequently, the Shanghai Stock Indices dropped more than 30 per cent in 2001 to rank among the world’s worst performers. Although there are many reasons accounting for the drop-down, this study argues that one reason is the securities scandals emerged in Chinese securities market.
Matthew Fink, president of the U.S. Investment Company Institute, stated that

“… the lack of panic exhibited by fund investors [after the case of Enron and the case of WorldCom, the stock market crash] is direct result of their confidence in the industry’s commitment to investor protection through regulation and selfpolicing.”

In 2002, U. S. President George W. Bush said that the aim of regulation is to protect investors and strengthen public confidence in American corporations. In Hong Kong, The Hong Kong Stock Exchange did an investor survey in 1992. The survey showed that 48 percent of existing shareholders indicated that they would very likely or would certainly increase their investment in securities if the regulatory regime were improved.

As discussed above, I’d like to make an assumption that legal protection is crucial to the development of securities market.
In 1999, Rafael Porta, Florencio Lopez-de-Silanes, Andrei Shlerfer and Robert Vishny presented a model of the effects of legal protection of minority shareholders and of cash flow ownership by a controlling shareholder on the valuation of firms. They tested their model with a total sample of 371 large firms from 27 developed economies. They found evidence of higher valuation of firms in counties with better protection of shareholders, and weaker evidence of the benefits of higher cash flow ownership by controlling shareholders for corporate valuation. Their finding provides support to the core objective of securities regulations in investor protection. Where laws are protective of investors and well enforced, investors are willing to finance firm, and financial markets are both broader and more valuable.

“[Investors] pay more because they recognize that, with better protection, more of the firm’s profits would come back to them as interest or dividends as opposed to being expropriate by the entrepreneur who controls the firm. By limiting expropriation, the law raises the price that securities fetch in the marketplace. In turn, this enable more entrepreneurs to fiancé their investment externally, leading to the expansion of financial market.”

In contrast, where laws are less protective of investors, fund investors could easily lose their confidence and withdraw their money from the market, the development of financial market is stunted, which in turn led the securities market to crash. For evidence, La Porta, Lopez-de-Silanes and other scholars did a research in 1997 and which led them to make a conclusion that “in countries with low investor protection, capital markets are smaller and narrower.” In this regard, Page and Ferguson also argue: “people would not entrust their money to financial institutions if they were afraid that their money would then be stolen, or gambled away, or not invested in accordance with their wishes.”
Therefore, I’d like to make the conclusion that only if fund investors are well protected do they gain confidence in the capital market, and which will in turn bring about a healthy-developed Chinese securities market. Otherwise, the capital markets will crash subsequently. Not surprisingly, it is the exact reason why the CSRC requires “all fund management companies should take ‘winning the confidence of the market and the public investors’ as their tenet, regulate and standardize the current investment decision-making system according to the principle of honesty and good faith.”

2Legal Proposal for Protection of Fund Investors in China

An effective legal framework to protect fund investors in Mainland China is imminent. The crucial question is how to make a suitable legal framework for the protection of fund investors in China?
In this regard, the first step is that it critically examines the distinctive feature of investment funds, namely, the funds are operated by a fund manager and do not have their own employees. The interests of the fund manager and that of the investors are not necessarily aligned with each other. Consequently, there are inherent conflict of interests between investors and fund managers. Therefore, the objective of the present study is to develop a legal framework of fund investor protection to monitor and alleviate the conflicts inherent in the fund structure.
In my view, the effective legal framework to protect fund investors would consist of three elements, that is, (1) effective fund governance; (2) a system for ensuring adequate disclosure of information; and (3) control transactions by related parties.

Legal Education in China VI

John Mo and Weidong Li

IV. Curriculum of Legal Education

Chinese law has developed rapidly since 1978 when the present open-door policy was adopted. Thousands of laws, regulations, rules and measures have been made by the NPC, its Standing Committee, the State Council and its departments, and local governments at various level. In a certain sense, the National Supreme Court of China has also made “law” and rules by exercising its power to interpret laws and regulations Chinese law has grown into a body of comprehensive rules, which bear the influence of both Continental Law and Common Law tradition. Even though the present Chinese legal system was influenced heavily by the Japanese law and Taiwanese law in later 1970s and early 1980s, when the nation began to rebuild the social order by adopting rule of law, it has managed to learn rather successfully from both Continental Law tradition and Common Law tradition the past 20 years. This essential feature of the present Chinese legal system determines the curriculum of legal education today.

The law department of Beijing University officially remains a “law Department” in 2001, even though many other law departments in comprehensive universities have upgraded to either “law schools” or “law faculties”. Nevertheless it is still one of the leading institutions for legal education in China. According to the teaching plan for undergraduate students as approved in June 1996 by the Law Department, a Bachelor of law degree in the Beijing University takes four years to complete. Students are required to take 98 credits for compulsory subjects, 29 credits for designated electives (which means that students may only choose from a number of specified electives) and 13 credits for other electives. The compulsory subjects decided by the law department. As of January 2001, the professional subjects included: Jurisprudenc; Chinese History of legal thoughts; Chinese legal history; western history of legal thoughts; litigation law; civil law, contract law, criminal law, international law, private international law, civil procedure law, criminal procedure law, intellectual property law, marriage law, enterprise law, forensic science, criminology, legislative studies, and penology. The designated elective included: higher mathematic, introduction to logic, Chinese history of economic legislation, forensic medicine, forensic psychiatry, foreign constitutional law, foreign marriage and family law, criminology in practice, judicial system of china, foreign civil and commercial law, law of instruments, law and youths, science of criminal investigation, basic law of Hong Kong , roman law , law of public servants, state compensation law, arbitration, foreign administrative law, study of foreign criminal procedure, professional English, science of law, and introduction to metal hygiene. The law department does not prescribe the common compulsory subjects, which are in fact decided by the university and the general elective which can e chosen by students freely from any subjects offered within the university. The curriculum of undergraduate studies in the law department of Beijing University is one of the typical examples of the curriculum of law taught in China today.

The curriculum for postgraduate studies is determined by each law department, law school, law faculty or institution concerned. Generally speaking, a postgraduate student is expected to take a number of special subjects relating to his or her area of research, whilst he or she is also expected to take a number of common subjects required by the Ministry of Education, such as the first foreign language, the second foreign language, political education, etc. A law department or law school may also prescribe a number of common legal subjects for all its postgraduate students to take. For example, besides the common core subjects, a postgraduate student specializing in Chinese Criminal Law is expected to take General Principles of Chinese Criminal Law, Specific Rules of Chinese Criminal Law, Western Criminal Law, and Internal Criminal Law. Further, he or she may also be required to take some credits in the areas of Criminology, Criminal Psychology, Regulation of Criminal Matters, Policy on Criminal Matters, and Sociology, etc. In addition, all postgraduate students in law must complete a minor thesis at least 30,000 words in length to fulfill the requirements of the Master of Law or PhD in Law. Oral defence is also required before a candidate can be awarded a postgraduate degree in law.

The curriculum for adult education designed for the Bachelor of Law degree can be illustrated by the curriculum offered by the School of Adult Education in the Southwest University of Politics and Law. As of January 2001, a student intending to take national examinations for a Bachelor of Law degree was expected to study a number of core subjects, including Study of Mao Zedong Thoughts, English, Political Education, Special Topics of Civil and Commercial Law, Legal Theories, Legal Logic, Chinese Constitution, Chinese Civil Law and Contract Law, Chinese Civil Procedure Law, Study of Chinese Economics, Marriage Law and Inheritance Law, Chinese Administrative Litigation Law, Public International Law and Judicial Documentation. The duration of the course is three years. It must be explained here that the School of Adult Education does not have power to grant Bachelor of Law degrees to students. Instead, it offers facilities, venues and teaching materials and teaching assistance to students who have to pass annual national examinations each year to receive the necessary credits for a Bachelor of Law degree of self-study mode granted by the special authority of the government. This is why the School of Adult Education offers three or two years training courses to adults who wish to get a second chance to study for a law degree recognized to be equivalent to a university degree by the Ministry of Education of China.

Legal Education in China (III)

John Mo and Weidong Lee

II.History of Legal Education
4. Legal Education Between 1911 and 1949

The Qing Dynasty was overthrown in 1911 in a revolution headed by Sun Yat-sen, who created the Nationlist Party (Guomingdang), which later controlled the Taidenese Government (the Government of Republic of China) between 1949 and May 2000. In 1912, the Republic of China (ROC) was established by the Nationalist Party. However, the ROC did not have any effective control of China until 1927, when he authority of ROC headed by the Nationalist Party was accepted by the remaining local warlords who still occupied considerable parts of China. During the period of 1911 and 1949, China was troubled constantly by both the internal wars between various warlords, or between the Communist Party and the Nationalist Party, and the external war with Japan. Such social instability inevitable affected the development, and also the features, of legal education in China.

Following the modern legal reform commenced in the Qing Dynasty, Chinese law evolved after 1912 into a system largely similar to Continental Law model. Professor Macdonald describes the legal development in China after 1912 in the following words:

“The process of law reform begun at the start of the century was accelerated by the fall of the Ching Dynasty and the proclamation of the Republic in 1912. The Law Codification Commission of 1904 continued its work, a provisional criminal code was enacted in1912, and a provisional constitution was promulgated in the same year. However, most of the government’s energies were absorbed in the suppression of bandits and war-lords and the creation of conditions for a central administration, finally established in Nanking in1927. Prior to 1927 (the war-lord period) the law of China was in substance the law of the Ching Dynasty.
Between 1927 and 1935, a period ‘that may well be called Justinian’, the law was greatly changed. The government enacted Six Code: the Organic Law, the Commercial Law, the Civil Code, the Criminal Code, the Civil Code on Procedure, the Criminal Code on Procedure; and other laws, on companies, insurance, bankruptcy, banking, negotiable instruments, and maritime law, soon followed. Generally speaking, these codes were of the continental type.”

From 1912 to 1949, legal education was offered as part of the formal university education in China. Along with the establishment of the Republic of China in 1912, many public schools and universities were established. It was estimated that in 1912, there were about 64 schools, colleges and universities offering legal education in China. The number of institutions offering legal education fluctuated considerably between 1912 and 1925 because of constant regional wars involving various warlords. As a result of the social and political instability, there were only 33 institutions offering legal education 1924. From 1912 to 1925, the curricula of legal education consisted largely of constitution, civil law, criminal law, procedure law, foreign law, political history, administrative law, public international law, social policy, industry policy, economics, economic history economic geography and foreign languages.

The legal system in China developed substantially after 1927 when the Nationalist Government unified China through winning a number of regional wars against warlords. In 1928, the ROC Government promulgated the Criminal Law of ROC, and the Code of Criminal Procedures. In 1930, the ROC Government completed the codification of the Civil of Law. 1932, the Organic Law of Court was promulgated. In 1935, the ROC Government promulgated the Code of Civil Procedures. In 1936, the ROC Government promulgated the draft of the Constitution of ROC, which was finalized in 1946. The legal system developed by the ROC continued the Continental Law tradition introduced into China in the Qing Dynasty. Eventually, the ROC Government developed a system of law based on the so-called Six Codes, i.e., the Constitutional Law, the Code of Civil Law, the Code of Criminal Law, the Code of Commercial Law, the Code of Procedure Law, and the Code of Administrative Law and Organic Law. The meaning of “Six Codes” had changed gradually after the ROC Government retreated to Taiwan from Mainland China in 1949. Presently, the Legal system of ROC in Taiwan is still based on the notion of codification, but the strict categorization of the Six Codes appears to have not been followed, or to have been relaxed to meet needs to the reality.

The educational system became relatively stable after 1927 when the ROC Government strengthened its control over China. Legal education in China developed gradually abreast with the development of education system, whilst both were affected badly by the Anti-japanese War taking place in China between 1937 and 1945. according to the statistics available, law schools were established within 29 universities in China in 1931 and the number went up to 35 in 1935. however, the number was reduced to 27 in 1940, probably due to the no-going war between Japan and China. In addition, legal education was also offered in many colleges, which usually took a shorter time to complete than the university level, even though there was no special law school in these colleges. It was estimated that legal education was available in 35 colleges in 1931, in 24 colleges in 1937 and in 53 colleges in 1949. these statistics suggest that legal education was available in China during 1927 and 1949 at both the university level and the college level. It was also estimated that the total of the law students was 14,523 in 1931, was 31,188 in 1937 and 116,504 in 1949. the largest student enrolment appeared in 1947, when a total of 155,039 students enrolled for legal studies in China. The curriculum of legal education in each university and college was largely determined by the relevant university and college. The ROC Government attempted to bring the uniform curriculum to the system of legal education, but only succeeded partially in 1944 when a number of core subjects were agreed upon by the Ministry of Education and the relevant universities and colleges. A typical example of the curriculum of law is seen in Professor Macdonald’s article, which describes the curriculum of the Law Department of Beijing University in the following words:

“First year: Principles of Economics; Constitutional Law; Principles of Civil Law; General History of China; Western History in the Last Hundred Years; Introduction to the Study of Philosophy. Second year: Liabilities; Rights; Company Law; Principles of Criminal Law; Law of Judicial Organisation; Civil Procedure; Principles of Administrative Law; Sociology; Specific Provisions; First Year German. Third Year: Detailed Study of Liabilities; Law of Relatives; Law of Bills; Criminal Procedure; Bankruptcy; Administrative Law; Public International Law; English Law; Chinese Legal History; Military Training. Fourth Year: Law of Inheritance; Commercial Law and maritime Law; Law of Civil Execution; Civil Court Practice; Conflict of Law; Land Law; Labour Legislation: Regulation of Prisons; Political Science; Military Training; Thesis.”

The aforesaid evidence suggests that legal education in China grew slowly from 1927 to 1949, when the Chinese law was gradually merging into the family of Continental Law. However, it must be noted that due to the wartime conditions existing continuously during this period of time, the ROC Government hardly had time to implement the Six Codes and other relevant laws throughout the county. It was nevertheless remarkable that, “in such turbulent times – fifth years of almost continual civil and international strife – the university law departments were able to embark on the demanding enterprise of establishing a scientific legal pedagogy suitable to the needs of the country as a whole.”

新年好
Happy Chinese New Year