Jurisdiction Update: China – Winds of Change
“We Cannot Direct the Wind, But We Can Adjust the Sails”
– Cora L. V. Hatch (1859)
In December 2021, the first securities “class action” in the People’s Republic of China (PRC) against Kangmei Pharmaceutical Co., Ltd. (Kangmei) and its executives produced a $385M recovery for investors. While the media has extolled this result, non-Chinese investors should temper their expectations.
Certainly, the winds of change appear to be blowing in the right direction. The PRC government has been stressing market reforms. But what the government gives it can take away, and investors should be ready to trim their sails accordingly.
Chinese law permits two types of representative suits
- Ordinary Representative Litigation (ORL) whereby shareholders can opt-in to a group effort and elect their representative plaintiffs, and
- Special Representative Litigation (SRL), whereby one of two government approved investor protection organizations (IPOs) represent investors on an opt-out
Opt-In Class Actions Face Strong Headwinds
The number of effective opt-in ORLs has and will likely remain limited. More than 90% of Chinese investors are small. PRC law does not permit contingency fees, and there are no developed litigation funding markets. So these investor groups must finance their own prosecutions and, given the small losses suffered by most Chinese investors, many cases will prove too economically challenging to pursue.
Even if filed, these private suits face further challenges. The Securities Law 2019 Revisions (the New Securities Laws) authorized representative suits for claims involving disclosure violations, insider trading, and market manipulation. However, at least for now, the Supreme People’s Court (SPC) has limited these suits to those alleging disclosure violations.
Before the New Securities Laws, courts often refused to process investor cases. While the New Securities Law endorsed representative suits, it remains to be seen if the first instance (trial) courts change their negative attitudes towards them.
Once processed, courts must approve their proceeding. Like US courts granting class certification and ordering class member notice, for suits to proceed on a collective basis, courts in China must “announce” them by publishing notice. Before doing so, judges must make certain findings based on the plaintiffs’ submissions. Most difficult, the proposed representatives must proffer “prima facie evidence” of the defendants’ wrongdoing. This can include administrative punishment decisions, criminal judgments, admissions by defendants, or disciplinary punishments by stock exchanges or other national securities trading places approved by the state counsel.
In practice, this means the defendants must have admitted their wrongdoing, which rarely happens, or there must be written decisions by securities regulators or stock exchanges controlled by the government.
Non-Chinese investors wanting to join opt-in ORLs face extra hurdles. Registrations get verified against company registries. If investors’ shares are held in street names, before registering, beneficial owners must first get the shares put in their own names. Registration periods may be as short as 30 days, leaving little time to do it. Also, for non-Chinese investors, supporting documents must be authenticated, notarized, and apostilled if they come from a source outside the country, which exacerbates the timing challenge.
Tailwinds Accelerate Opt-Out Class Actions
The New Securities Laws and SPC Rules implementing them added the second type of representative suit: opt-out SRLs. When cases are strong on the merits and the defendants are collectible – as in Kangmei – IPOs can displace representatives, converting opt-in ORLs to opt-out SRL suits. In other words, entities controlled by the government take over the best cases, leaving to private suits the weaker ones with less solvent defendants.
Opt-out SRLs hold the most hope for future recoveries. When they happen, opt-out SRLs produce relatively quick results compared to investor suits in other countries. In Kangmei, for example, the time from initial filing to payment of compensation was less than 1 year.
Eleven shareholders filed an opt-in ORL in December 2020. The CSISC took over the case in April 2021, converting it to an opt-out SRL.  The case met the IPOs criteria for involvement: there was administrative penalty, the matter had negative social impact, and the wrongdoers were able to pay. After a public hearing in July 2021, the court ordered payment of CNY 2.46B (about US$385M) to 55,326 investors on November 12, 2021. It ordered the executives and others – not the company, which was insolvent – to pay this amount.
Unlike the US, in China, there are no claims administration processes with proof of claim forms. Shareholders do not need to take any action to receive compensation. If successful, as in Kangmei, courts determine the losses for each shareholder of record and distribute compensation directly to them. If shares are held in street name, funds get distributed to the entities holding then shares, who credit the accounts of their beneficial owners.
The Future of Chinese Class Actions
Time will tell whether we’ll see more recoveries like Kangmei. The PRC government knows rampant market abuses must be curtailed to attract more company listings and investment capital from abroad. And there’s certainly no shortage of bad actors. The China Securities Regulatory Commission (CSRC) has at least 35 investigations underway, including against Luckin Coffee and Kingold Jewelry, which imploded in scandal around the same time and gave further impetus for the New Securities Laws.
While private opt-in ORLs will continue to get filed, we expect headwinds to persist and that they will rarely offer meaningful opportunities for investors outside of China. At the same time, the tailwinds propelling opt-out SRLs should continue to yield more recoveries like the one Kangmei, benefiting investors in and outside of the country. But recoveries will only happen if the government continues to want them, given its pervasive control over the representative action process. Savvy investors should always be ready for shifting winds and be ready to trim their sails in response.
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