Capital connections

China’s regulatory mindset on capital is undergoing an unprecedented metamorphosis. China has linked the two major financial centres of Shanghai and Hong Kong, providing new pathways for the mainland capital market. Market regulations are also getting a revision with the Securities Law at the fore, a signal that ideas that have been percolating in the regulatory sphere have coalesced into an increasingly clear roadmap for future development of the capital market.

The Shanghai-Hong Kong Stock Connect formally opened for service on 17 November 2014. According to a Xinhua report, following the Easter and Qingming holidays this year, a tide of mainland capital surged southbound to invest in the Hong Kong stock market. The southbound connection exhausted its daily quota for two days straight on 8 and 9 April, and Hong Kong shares rose nearly 2,000 points over a three-day period.

Activity on the New Third Board is similarly blazing. According to reports, 2,309 companies had been listed on the New Third Board as of 21 April, and its combined market capitalization has exceeded RMB 1 trillion (US$161 billion). The New Third Board had an annual turnover of RMB 814 million in 2013, and leaped to 15 times its previous turnover with RMB 13.04 billion last year. Already the turnover this year has exceeded RMB 60 billion.

Moreover, the more than one-year suspension of A-share initial public offerings was lifted in January last year. Figures from ChinaVenture reveal that 125 companies listed on the Shanghai and Shenzhen markets in 2014, raising a total of RMB 79 billion.

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Chinese companies’ enthusiastic demand for capital is not limited to domestic markets. Chinese IPOs attract considerable attention in global capital markets from the US to Hong Kong. One of the best recent examples is Alibaba, which experienced the world’s largest IPO in September 2014.

Changes in legislation and regulatory approach are an important factor leading to the excitement stimulating the market. Reform remains the theme for the China IPO market in 2015. One such reform that many are keen to observe is in the IPO registration regime. In a March government release, Premier Li Keqiang stated plainly that the regulatory regime for issuing new stock would be reformed this year.

According to reports, the Standing Committee of the National People’s Congress had its first deliberation on the draft revision of the Securities Law on 20 April. The draft included a number of significant revisions, such as systemic changes for IPOs.

The Shanghai-Hong Kong Stock Connect is only the beginning. During a January visit to Shenzhen, Premier Li declared, “A Hong Kong-Shenzhen stock connect should come next.” A new connection for the capital markets seems to be soon to form.

Shanghai-Hong Kong Stock Connect

The Shanghai-Hong Kong Stock Connect promotes a two-way channel between mainland and Hong Kong capital markets without changing the trading rules of either. It is without a doubt an important step to the further opening of Chinese capital markets.

Christopher Betts, a partner at Skadden Arps Slate Meagher & Flom in Hong Kong, says, “The principal impact is that investors now have the means of trading in these markets without necessarily having to establish accounts in them; and it also means that issuers can access these investors without necessarily having to list in Shanghai or Hong Kong.”

“The stock connect programme will create a combined market system connecting mainland China investors with international investors, via the Hong Kong Stock Exchange,” says Jeffrey Mak, a partner of DLA Piper in Hong Kong.

Tom Chau, a partner of Herbert Smith Freehills in Beijing, adds: “It is also worth noting that the stock connect will play an important role in the internationalization of RMB.”

The Shanghai-Hong Kong Stock Connect also brings with it new opportunities for investment for traders within and outside mainland China. Wang Lixin, a partner of King & Wood Mallesons based in Shenzhen and Guangzhou, comments: “Investors can engage in arbitrage on differences between the two markets such as A- and H-share prices, transaction systems and trading hours. At the same time, investors can find more variety in the other market where their own may be lacking. For example, shares in the military, pharmaceutical and liquor industries in Shanghai and shares in the gaming and entertainment industries in Hong Kong.”

“The Shanghai-Hong Kong Stock Connect also gives domestic institutional investors an excellent chance to draw lessons and learn from the investment rationale of foreign institutional investors,” remarks Shenzhen-based DeHeng Law Offices partner Liu Zhenguo.

According to Eric Huang, head of SG & Co PRC Lawyers’ asset securitization practice in Shanghai, many investors on the Hong Kong stock market are after long-term returns on investment. They also pay greater attention to participation in corporate governance and require equitable, sustained dividend yields. “The stock connect will help optimize investor return mechanisms on A-shares,” Huang says.

The Shanghai-Hong Kong Stock Connect should also have greater room for development. ETR Law Firm’s executive partner Quan Zhaohui says, “Trading on the stock connect has not yet met expectations.” Long-term funds have yet to participate in northbound investment to Shanghai, he said, and mainland institutional investors have yet to invest southbound to Hong Kong. Moreover, while quota utilization has reached a new high on the stock connect, financial stocks remain the investment of choice by foreign capital.

However, disparity between the two markets also bring risks and challenges, as does the stock connect’s own limits.

Stephen Fletcher, a partner of Linklaters in Hong Kong, advised Hong Kong Exchanges and Clearing (HKEx) on the establishment of the Shanghai-Hong Kong Stock Connect. He says different investors experience different issues.

“Making sure all those different rules fit together and can be complied with is perhaps one of the biggest worries that some investors need to deal with.” Fletcher says, “Things that may appear straightforward might not actually be so and you can’t just assume the rules will be the same as the ones you’re familiar with.”

Firstly, investors should understand that the stock connect uses a shareholder representation model. Shares purchased by investors via the stock connect are held by Hong Kong Securities Clearing Company and China Securities Depository and Clearing Corporation, respectively, on behalf of the investors.

The companies’ names are registered in the relevant listed company’s list of shareholders – the investors themselves are not registered in the shareholder registers of HKEx or the Shanghai Stock Exchange.

“Investors buying shares through the stock connect therefore cannot directly exercise rights over the listed company,” says Sherry Ma, a senior partner of Co-effort Law Firm in Shanghai.

For investors holding shares, “there are certain restrictions on the shares percentage”, she says. “Further, southbound investors must abide by the rules of China Securities Regulatory Commission (CSRC) and fulfil the requisite disclosure and notification obligations.”

In the holder representation model, the investor’s time limit to exercise their rights is extremely short, which forms a risk on their rights and interests. “It presently is not clear what sort of resolution there would be if the shareholder experiences losses created from technical or operational failures during the holder representation process,” says Jason Xia, a partner of Wintell & Co based in Shanghai.

There are several issues worth noting, such as where settlement rules and price limits diverge in Shanghai and Hong Kong, as well as how investors are able to participate in IPOs via the Shanghai-Hong Kong Stock Connect.

“Domestic investors need to heed certain distinctions between domestic and Hong Kong transaction rules. For example, mainland stock exchanges have trading limits, while Hong Kong does not have any upper or lower limits on the stock,” says Dai Hua, a partner of Jingtian & Gongcheng based in Beijing. “Or, mainland stock exchanges adopt a trade date plus one day (T+1) settlement period, while the Hong Kong Exchange adopts a trade date plus zero days (T+0) convention.”

Llinks Law Offices’ Shanghai-based partner Wayne Chen says that the liquidity of small and medium-sized market shares on the A-share market is relatively high, while their liquidity on the H-share market is correspondingly low. “Therefore, one should also be concerned about the stock’s liquidity during the transaction, and avoid losses from heavily held stocks with weak liquidity,” he says.

Liu notes that the Hong Kong and US stock markets are quite well connected. Furthermore, he adds, the Hong Kong market has a clear-cut delisting mechanism and a high degree of marketization. “Mainland institutional investors may find it difficult to grab hold of Hong Kong stock market trends and control them, to the extent that they may even suffer setbacks.”

Zhang Shiwei, a Beijing-based partner of Zhong Lun Law Firm, cautions that domestic and offshore investors need to pay attention to risks associated with currency exchange rates during the operation. “Even where the value of RMB assets does not change, there could be losses created due to currency devaluation during the conversion process,” he says. “The RMB is currently not freely convertible, and RMB exchanges are also subject to certain restrictions by Hong Kong banks.”

In terms of short selling, “investors cannot do covered short selling [in the mainland] in the way they do it in Hong Kong, because the Shanghai exchange has restrictions that apply to both domestic Chinese investors and foreign investors,” Fletcher says.

Additionally, investors must consider the various taxation issues which the Shanghai-Hong Kong Stock Connect may involve. Chen points out that, in addition to the commission, transaction fees, stamp duty and other fees southbound investors to Hong Kong must pay, they also may need to continue paying security portfolio fees even where they make no transactions. Northbound investors to Shanghai, like southbound investors, must also pay handling fees, securities management fees, transfer fees, stamp duty and other charges.

Just how to safeguard a shareholder’s rights and interests and take measures against infringing behaviour can be a huge issue due to these divergences. “Presently Hong Kong and Shanghai have different standards for determining illegal transactions by listed companies such as insider trading and market manipulation. There is also a disparity in their ability to combat market manipulation realistically,” says Ian Zheng, a partner of Zhonghao Law Firm based in Chongqing.

Zhang Yun, a lawyer with Tahota Law Firm in Chengdu, says: “The laws in Hong Kong and Shanghai are by no means similar in attacking improper market activity. Moreover, Hong Kong and the mainland presently have their own independent supervisory framework for securities trading. Judicial assistance mechanisms between the two have not been constructed, nor have the two sides entered into agreements on judicial assistance.”

Jincheng Tongda & Neal senior partner Wu Guohua says that the Hong Kong Securities and Futures Commission and CSRC have entered into a memorandum of understanding on strengthening regulatory and enforcement cooperation, which sets out provisions on issues including cross-boundary enforcement of investigation alerts, investigation assistance, document delivery and cross-boundary enforcement. “However specific details on supervision and enforcement are pending further practice,” she adds.

More channels for investment

Much like the Shanghai-Hong Kong Stock Connect, the qualified foreign institutional investor (QFII) and RMB qualified foreign institutional investor (RQFII) systems were put into place to strength domestic capital markets. They also open these markets to the global market, as Chinese capital accounts have not yet been fully liberalized. According to information released by the State Administration of Foreign Exchange, in December, RQFII had a net capital outflow of around RMB 20 billion for the first time on account of institutional profit-taking and effects engendered by the Shanghai-Hong Kong Stock Connect.

Li Cheng, a partner of Global Law Office based in Shenzhen, suggests that foreign investors can choose between the Shanghai-Hong Kong Stock Connect and QFII and RQFII system based on market conditions, or use them together to maximize profits.

Investors must consider a number of factors when choosing between the two. Firstly, the QFII and RQFII threshold for investment is high, and the main participation conditions are strict. The systems are limited only to designated institutional investors, whereas the Shanghai-Hong Kong Stock Connect is open to any institutional or individual investor which meets its conditions.

“The Shanghai-Hong Kong Stock Connect adheres to the first come, first served principle, and the majority of the opportunities for investor participation are equal. QFII and RQFII are unable to compare in this regard,” says Liu.

However, Wang states, “For institutional investors in search of quality and opportune transactions, the conventional QFII and RQFII are more able to guarantee that an investor’s trading strategy can be realized promptly and successfully.”

There are no restrictions on the scope of QFII and RQFII investment in A-shares, but investment on the stock connect is limited to the Shanghai Stock Exchange A-share market and to certain HKEx markets. “The Shanghai-Hong Kong Stock Connect’s current restrictions on large- and mid-cap stocks may be unable to satisfy the need for diversified investment,” says Ma.

“Investment on the stock connect is currently more limited; moreover, one can only invest in the secondary market and conduct spot transactions, making it difficult to hedge risks,” remarks Jason Wang, a partner of Han Kun Law Offices.

While the Shanghai-Hong Kong Stock Connect may offer limited choices, it has higher investor autonomy. “With QFII and RQFII, an asset management company acts as the investment vehicle. Investment is from offshore to onshore and investors must invest via specific products. Whereas the Shanghai-Hong Kong Stock Connect’s main feature is that the stock market is the vehicle. Investment is both inbound and outbound, and investors have a certain freedom in choosing their investments,” says Li.

Moreover, Grandall Law Firm chief executive partner Lü Hongbing comments, “QFII’s exit strategy is rather difficult, while the stock connect has nearly free access, and its profit exit strategy is more relaxed.”

The Shanghai-Hong Kong Stock Connect, however, has a closed loop cross-boundary flow of capital. Capital gained from the sale of securities must return via its original route and cannot remain in the market where it was gained. On the other hand, capital from dealing in QFII and RQFII securities can remain in that market for a certain amount of time, and the remittance and exchange of cross-boundary capital can also go along varying paths.

On this, Han Kun’s Wang says, QFII and RQFII have a number of disadvantages compared to the Shanghai-Hong Kong Stock Connect. There is greater uncertainty with QFII and RQFII due to their opaque approval limits and schedule. There usually is a set lock-in period for investment capital – three months for QFII, and one year for RQFII. Investors must remit and exchange funds on their own, and they must also separately commission a custodian bank, increasing transaction costs. The tax policies for QFII and RQFII also have undergone a period of uncertainty, making it difficult for investors to calculate tax costs on exit.

Zhong Lun’s Zhang says the Shanghai-Hong Kong Stock Connect’s taxation policies are more favourable than those of QFII and RQFII for institutional investors. And yet, “insofar as the ratio of overall investment income and tax burden is concerned, QFII and RQFII are not necessarily that dissimilar to the Shanghai-Hong Kong Stock Connect due to their differing investment strategies and tax planning.”

Stock issuance reforms

After more than a year of stop and go, the transition from assessment to registration for issuing new shares is beginning to take shape. The new regime will bring major changes to Chinese capital markets.

Chau says: “The key principle of the registration regime is to make stock offering and listing process to be more market driven. It means that the success of an offering and listing shall be determined by the market.”

Lü Hongbing finds that “registration regime reform is not merely confined to the offering of new shares, and the planning and practice of its correlated institutions already far exceeds the extent of that for offering of new shares. Rather, for all aspects involved in building rule of law in capital markets,” he says, “the opportunity to promote improvement in rule of law in the capital market overall by transitioning from assessment to a registration for issuing new shares is the ultimate goal of these reforms.”

It should be noted that any new changes to the issuance regime first hinge on the amendment of the Securities Law. “Revision of the Securities Law is a prerequisite to formalizing the regime. It also an important sign that the regime is moving toward something substantial,” says Jason Xia.

At the same time, Beijing-based Jingtian & Gongcheng partner Yin Yue points out that “there are other eye-grabbing revisions to the Securities Law besides the registration regime for issuing new shares. For example, there is the expanded range of protections for small and medium investors.”

Wu Xiaoling, deputy head of the National People’s Congress Financial and Economic Affairs Committee, has stated that October will be the soonest that the third deliberation on the draft Securities Law amendment could occur.

High Mark Law Firm partner Shi Lijia notes, “The specifics of the Securities Law amendment have not been fixed. Further, after it is revised, its corresponding regulations and detailed implementation rules must also be amended before the new share registration regime can be launched in practice. Thus there is a great deal of uncertainty as to its specific execution time.”

CSRC is accelerating its preparations for the transition from requiring that new shares be approved to requiring that they be registered. Llinks’ Chen notes that IPO approval has gained in speed this year, with an evident increase from prior years. CSRC maintains the proportion of shares issued each month while also increasing the issuance of new shares in a timely and appropriate manner, both of which are harbingers of regime change.

Chen Yang, a partner in Han Kun Law Offices’ Beijing office, says, “Increased information disclosure and greater responsibilities of intermediary institutions are the direction the registration regime will go.” In the past year, CSRC has also adopted a number of approaches and introduced new measures to strengthen both.

Regulators are increasing market supervision in practice. Says Lü Hongbing: “In particular, regular supervision of securities intermediates and listed companies has become increasingly strict and normalized. No longer will we see any more campaign-style raids. At the same time, they are increasing their ability to investigate and combat securities crimes.”

CSRC stated in a January report that, since 2014, it has strengthened investigation of information disclosures that violate the law. CSRC has filed investigations against 43 listed companies and intermediate institutions, issued administrative penalties to a number of companies, intermediate institutions and related individuals, and banned 21 individuals from the market. It has also transferred the cases of 21 people suspected of criminal misbehaviour to the police.

Li says that CSRC has accelerated the rate of approval to absorb existing stock. At the same time, it is enriching the stock exchange talent pool in response to upcoming reforms.

CSRC is also preparing a number of systems to spur the registration regime roll-out. It has cancelled the sustained profitability conditions for issuing shares, and it has considered drafting regulations for regional equity markets as well as for equity-based pooling of funds.

“Our feeling is that the stock market environment is increasingly falling into the shape of a virtuous circle,” says Quan. He adds, “Of course, we still require follow-up observation on the specific circumstances and how they will be implemented.”

As more corresponding reforms are put forward, the issuance of new shares will gradually transition to an information disclosure-centric regulatory approach. Market participants will be the judge of an issuer’s asset quality and investment value. Beijing-based Jingtian & Gongcheng partner Ma Xiumei notes, “This will put a higher demand on investors’ ability to judge risks.”

The timeframe for registration reform has yet to be set, but it is still impacting the Hong Kong market. “If it is implemented then I think it has the potential to have a negative impact on Hong Kong as a listing venue, because, as many market participants are aware, one of the principal reasons often cited by Chinese business owners for listing in Hong Kong is the opaque nature of the listing process in Shanghai and Shenzhen,” Betts says.

However, Chau is still confident on the competitiveness of the Hong Kong market. “The rule of law in Hong Kong is unparalleled and free currency exchange system is also attractive for mainland companies,” he says.

Mak agrees. “Hong Kong can play a more proactive role in catering to post-listing capital markets activities as well as debt, futures and derivatives markets activities in the future development of China’s capital markets.”

New Third Board

The turnover, valuation, number of shares issued and financing ability of the New Third Board have improved immensely over the past year. The New Third Board is also attracting an increasing number of individual investors.

Zheng comments: “It is known that, presently, investors pool funds to be able to use New Third Board investment accounts, or lease an account that has already been opened for investment. And many public and private fund products that already focus on the New Third Bird have begun to be sold on the market.”

CSRC has also stated that it is looking into drafting professional guidelines on the raising of public funds to invest in shares listed on the New Third Board. King & Wood Mallesons’ Wang says, “Adding public funds will bring new and more abundant funding sources to companies listed on the New Third Board. It is anticipated that this will continue the New Third Board’s upsurge.”

Longan Law Firm senior partner Jiang Yingchun, based in Beijing, sets out new features emerging on the New Third Board in the previous 12 months. First, she says, the number of listed companies has steadily increased, with optimistic estimates expecting the number to break 4,500 by the year’s end. Second, levels have formed on the New Third Board; the market-making system has increased share liquidity, and market-making businesses have increased in kind.

Third, she says, trading volume in some shares on the New Third Board have undergone a rather large rate of increase, sometimes by more than 10 times, though there have also been some irregular transactions. Fourth, listed companies are beginning to make more frequent placements, and for some the size of their deals on the New Third Board have surpassed those on the main boards. Fifth, mergers have been active. Sixth, the quality of listed companies has gradually improved.

As for trends, the New Third Board is not limited to the financial sector but covers an array of industries. An increasing number of large-cap stocks are choosing to list on the New Third Board, as evidenced by the recent listing of Qilu Bank. “This shows that the companies listed on the New Third Board are also becoming more adept at using the marketplace to expand their financing channels,” comments Wayne Chen.

Jiang Yingchun says, “It is expected that tiered management, bidding on deals and board transfers will be gradually introduced over the next 12 months. These bonus institutions will continue to raise the heat on the New Third Board.”

“As the market has grown, listed companies have become more diverse. A single market level is no longer able to meet the New Third Board’s need for further expansion; tiered management of listed companies has become a necessity,” says Sun Yan, a Shanghai-based partner of Grandall Law Firm.

Sui Qiang, deputy manager of the board’s shares transfer system, has reportedly stated that the National Equities Exchange and Quotations (NEEQ), which oversees the New Third Board, is actively researching and drafting a concrete plan for stratifying the listed company market. NEEQ is expected to make the plan public and seek comments in the third quarter.

A bidding mechanism is expected to follow. “Drawing from the experience of the American over-the-counter market, after the New Third Board introduces tiers, companies that have fully disclosed their information will be able to bid. Liquidity will be significantly enhanced compared to the previous agreement and market-making trades,” states Liu.

However, Quan notes, currently there are more than 2,000 companies listed on the New Third Board, yet less than 10% actually gain market-making shares. For a New Third Board company, market-making and decentralization may be the conditions needed to successfully transfer on the New Third Board.

Wang of King & Wood Mallesons says: “As it now stands, [the New Third Board] remains faced with poor mobility, low valuations, small-scale financing, high barriers of entry for investors and other issues, and it is trending toward transfers.” He adds that registration reform that puts information disclosure at its core, rather than assessment, is soon to come to light. It is expected that the new registration regime will accelerate the introduction of a transfer system.

Xia finds that, as per the open information rules, regulators are focused on managing risks. It is possible, Xia surmises, that it could delay bidding or the lowering of investment thresholds, or increase corporate responsibility to disclose information, with the hope that doing so can curb and reduce speculation on the New Third Board.

Lü Hongbing also raises that market-making is hot on the New Third Board and market volumes have increased, but transactions occur only between a small number of shares, and more than half of the companies have had few transactions post-listing. Moreover, he says, market valuations continue to rise on the New Third Board. Stock prices of mediocrely performing individual stocks soared under the operation of market-makers, and investors blindly followed suit in speculation. This, notes Lü, could be dangerous.

Jingtian & Gongcheng’s Ma points out that this is due to listed companies primarily being in emerging industries, and notes that their anti-risk capabilities are weak in terms of scale, capital and management. There is uncertainty, she says, as to whether they will continue to be profitable, and their insufficient information disclosure may increase investment risks.

CSRC and NEEQ have indicated that there will be a crackdown on illegal activity on the New Third Board. Recently they took measures to restrict account transactions of Zhongshan Guang’anju and other accounts exhibiting illicit activity. Jiang Yingchun says that instances where a few investors who did not meet prequisites jumped the gate to participate in New Third Board transactions illustrates that there needs to be stronger, and more universal, education for investors about market risks.

Shi says, “Investors should remain cautious, focus on developments in the listed companies and their actual operating conditions; they also should refrain from investing blind. Listed companies and companies intending to list should focus on being legally compliant and having orderly operations so as to fundamentally raise the company’s value. They should also strengthen share liquidity and broaden their financing channels.”

There is also a trend on the New Third Board for normalized feedback. King & Wood Mallesons’ Wang comments, “feedback assesses various aspects of a company which require refining. It gives written specifications on intermediary institutions’ work and explicitly raises professional quality requirements while also setting out higher standards for entry for companies intending to list.”

More hot spots for investment

China is currently adjusting its national strategic landscape to redistribute its integrated investment strategies such as large exports of capital to developing countries, the Belt and Road Initiative and the Asian Investment Bank. Zheng says, “The year 2015 should be an important year for renminbi export.”

“The Chinese stock market may continue at its current state, and enthusiasm for investing in Hong Kong shares may also continue to increase. So there are significant investment opportunities for valuation and correction in Hong Kong shares influenced by this,” says Zheng.

Additionally, notes Han Kun’s Wang, red chips have become a hot topic since a number of red chip companies landed on the A-share market. “Whether companies which once had formed VIEs should consider returning to the A-share market is an issue they need to fully consider. Their expected market valuation has to be taken into account, along with other issues such as the capital costs of restructuring its legal framework and financial performance continuity,” Wang says.

Li adds that 2015 will be the year for implementing reforms in the Chinese capital market. In addition to the issues above, policies related to the Shenzhen-Hong Kong Stock Connect project may come within the year. Top-level design plans and initiatives supporting reforms in state-owned enterprise ownership diversification may also be issued. Finally, regulatory norms for the online financial services industry could be introduced as well. Investors should remain linked up to follow the many blazing developments expected in the capital market this year.

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