In China, the Supreme People’s Court recently passed amendments permitting investor class actions. This follows increased crackdowns by the China Securities Regulatory Commission’s (CSRC) on unethical capital market behavior including price manipulation, insider trading, and fraudulent accounting and reporting.

Before the amendments, most Chinese investors were unwilling to pursue fraud suits due to a lack of legal support, which often resulted in zero compensation. Class actions enable investors to pool their claims against a corporate defendant, reducing time and money while improving their chances of a successful outcome.

Given recent high profile scandals at Chinese companies like those profiled below, curbing investor perception of misconduct is critical to restoring confidence in China’s $9.4 trillion stock market.  That market relies on continued investment by the world’s largest group of small and medium domestic investors that make up 95% of its value.  Perceived market integrity is also important to encourage investment by larger institutions, in and outside of China.  However, it remains to be seen whether these and other state changes actually result in more compensation for damaged shareholders.

The Class Action Amendments

China’s official composition of the class-action regulations comprises 42 articles divided into four parts.  The composition states, “if the representative requests that the defendant who loses the lawsuit pay reasonable announcement fees, notice fees, attorney fees, etc., the people’s court shall support it; in the special representative litigation, investors who have not declared to withdraw shall be deemed to have agreed to participate in the litigation; Special representative litigation cases do not pay the case acceptance fee in advance; when the investor protection agency acts as a representative to apply for property preservation in the litigation, the people’s court may not require guarantees, etc.”

The changes sound promising.  However, China is a heavily regulated, one-party state ambivalent about capitalism and open markets.  Unlike the US, there is no separation or independence among the branches of government.  The executive, legislative, and judicial functions all fall under the Central Party and this inherently lessens the potential impact of class actions on investor recoveries.

The government seems to be envisioning a system similar to that in Taiwan, where a quasi-state entity prosecutes class action for investors.  Combined with a court system controlled by the party, this permits the state to control prosecutions and potentially limit politically sensitive situations.  That can be particularly problematic when many Chinese companies are partially state-owned and/or heavily regulated to the point of effective control.

In other areas, we’ve seen similar promises to expand legal rights fail to deliver as much as hoped, particularly for the rights of non-US entities.  For example, China recently liberalized its laws on protecting intellectual property.  While foreign patent holders have received some limited protections from domestic infringers, the enforcement system is still a long way from anything meaningful in terms of protecting rights and does not have any process for compensating victims for harm.  China remains an overall unfriendly jurisdiction for foreign patent holders with all facets of the system controlled by the Central Party and favoring local companies over foreign competitors.

In short, while the new class action regulations and press surrounding it sound good, investors should remain skeptical as to whether this will result in meaningful recoveries for them, particularly those outside of China.  Even with more permissive rules, collection of judgments from companies embroiled in scandal, like those discussed below, will continue to present significant obstacles for investor compensation.

The Amendments Follow Recent Fraud Scandals

What we have seen in China is a recent spate of highly publicized fraud cases, most notably involving Xiamen-based beverage chain, Luckin Coffee, and renowned jeweler, Kingold.

Luckin Coffee

Luckin Coffee is known as the Starbucks of the East. Industry watchdogs discovered that the company falsified last year’s earnings by over 300 million USD, an estimated half of the value over the previous three quarters of 2019. An independent investment firm discovered the fraud by deploying 1,500 people to count transactions in 600 of Luckin Coffee’s stores.

The Chinese government responded by imposing heavy trade penalties on Lucking Coffee, its domestic entities, and third-party companies.  The case fueled ongoing debates between Chinese and American stock market exchanges, with American politicians calling out China’s oversight on market security issues.

Kingold

The Wuhan-based jeweler secured loans totaling $2.8 billion through 83 tons of gilded copper bars. Kingold’s fake gold went undetected despite stringent state inspection by accredited refiners such as state-controlled PICC Property and Casualty, which partially insured the loans. The company accrued the loan from Chinese institutions, including Hengfeng Bank and Dongguan Trust, across five years. Dongguan Trust discovered the fake gold in February when the company decided to liquidate Kingold’s collaterals for defaulted payment on several trust products.

Kingold’s case was addressed by China Banking and Insurance Regulatory Commission, promptly leading to its removal from NASDAQ’s listing. The fraudulent act exacerbates Wall Street’s rocky relations, where American politicians continue to expel Chinese companies with the passage of a recent bill sponsored by Sen. John Kennedy. The act carries the disclosure requirements that companies listing on the American stock market should not be owned or controlled by a foreign government.

The Outlook for Investors

The CSRC has stepped-up government prosecutions.  During the past year, it investigated at least 22 listed companies and in June 2020, issued a record high penalty of 3.6 billion yuan ($504M) on Shanghai entrepreneur Wang Yaoyuan and his daughter Wang Chengcheng for insider trading.  We expect crackdowns to continue and applaud the Party Central Committee and State Council’s Financial Commission’s stated “zero tolerance” policy for financial fraud in capital markets.  However, regulatory and criminal sanctions don’t put money in the pockets of harmed investors.  Whether and to what extent the new class action amendments result in more compensation for victims, particularly those outside China, remains to be seen.

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