“It is amazing not how big China has become but how little it is understood.” The aphorism that greets visitors on a billboard as they pass through Hong Kong International Airport captures the confusion around the concept of beneficial ownership in A shares held through Shanghai-Hong Kong Stock Connect.
Since the launch in November of the Shanghai-Hong Kong Stock Connect programme, various concerns have been expressed in relation to investments made by certain collective schemes, in particular EU-regulated Undertakings for Collective Investment in Transferable Securities or UCITS. Some investors claim that Chinese law does not explicitly recognise the concept of beneficial ownership whilst others have remarked that the concept can be found in Chinese regulations dating back to 2006 but the real issue may be enforcement.
In a survey of asset managers by the Hong Kong Investment Fund Association in November/December 2014, 85% of respondents identified beneficial ownership issues on the Chinese mainland as their top concern.
This article seeks to explain how these concerns can be addressed. In addition, it compares Stock Connect with investment via Qualified Foreign Institutional Investor and Renminbi Qualified Foreign Institutional Investor channels and concludes that an investment through Stock Connect is not only as robust as QFII/RQFII from a legal perspective but also benefits from additional enhancements.
How are the shares held in Stock Connect?
Let’s first look at how the shares of the investors are held in Stock Connect before turning to the question of beneficial ownership.
As soon as a Hong Kong broker executes a purchase order through Stock Connect, the trade is cleared because of the link between Hong Kong Securities and Clearing Company Limited (“HKSCC”) and China Securities Depository and Clearing Co. Ltd (“ChinaClear”). This means that HKSCC becomes the seller to the Hong Kong broker and buyer to ChinaClear, whilst ChinaClear becomes seller to HKSCC and buyer to the China broker.
Clearing is important since the investor and his/her Hong Kong broker will only face HKSCC as the clearing house and will not face ChinaClear or the China broker directly. HKSCC as clearing house guarantees the performance of the trade to the investor, who in turn does not take on the credit risk of the China broker.
As soon as the trade is cleared and settled through the clearing link, the shares will be held through the Central Securities Depository (CSD) link between HKSCC and ChinaClear. This means that the shares will be delivered to an omnibus account with HKSCC as the nominee holder for Hong Kong and overseas investors, as depicted in diagram 1 below.
It is of paramount importance to note that the holding of the shares by HKSCC as a CSD (in an omnibus account as nominee holder) is a fundamental cornerstone of Stock Connect and specifically mandated in its regulations. There is no other way for an investor to hold shares in Stock Connect other than through HKSCC. As a result, HKSCC is not a third-party custodian or safe-keeping agent for the investor/Hong Kong custodian and is not part of the depository/custodian network of the investment fund.
So the holding of shares by HKSCC as CSD will not be subject to certain depository regulations including segregation (as discussed below).
A key issue for investors using Stock Connect is whether investors have any proprietary rights or beneficial ownership in the shares (tracing through the chain of ownership in diagram 1).
Under Hong Kong law it is well established (following the CA Pacific case) that HKSCC holds the shares on trust for investors and investors would undoubtedly have beneficial ownership.
The remaining question then is whether investors have any proprietary rights or beneficial ownership under Chinese law. It is true that China has a civil law system that, unlike the common law system, has traditionally not contained equitable ownership and trust concepts.
But some of these concepts have been included in recent years. As from 2006, the CSRC Securities Registration Measures[i] specifically provide for the concepts of “nominee holder” and “beneficial owner” in that a nominee holder can hold shares for others who are the beneficial owners. This provision forms the basis upon which QFII/RQFII asset managers hold A shares (as the nominee holder) for their investors (the beneficial owners).
In addition, Stock Connect regulations specifically provide that HKSCC is “the nominee holder” and that investors would “enjoy rights and interest in the shares according to law.”[ii] In the circumstances, it is therefore fairly clear that, as HKSCC is the merely the nominee holder, investors would be the beneficial owners.
The Stock Connect regulations go on to state that beneficial owners (investors) are to exercise their rights through the nominee holder (HKSCC) and that the nominee holder shall consult the beneficial owners before exercising such rights.[iii] As provided in the rules of HKSCC, such rights would include, among others, the right to call shareholders’ meetings, to exercise voting rights, to subscribe for allocated rights and entitlements, and to receive dividends and distributions, which are all substantive rights normally enjoyed by beneficial owners of shares.
The acid test for beneficial ownership is whether, in the insolvency of HKSCC, the shares would be bankruptcy assets of HKSCC available to its general creditors or whether they would belong to investors. As mentioned previously, it is well established in Hong Kong that the shares are not part of the bankruptcy assets of HKSCC but remain the assets of investors. In China, meanwhile, HKSCC is merely the nominee holder and not the beneficial owner and, on that basis, the shares would not be the general assets of HKSCC but remain those of investors.
In addition, in the insolvency of HKSCC, the courts in China would also recognise the Hong Kong liquidator of HKSCC (Chinese bankruptcy law does not apply to entities incorporated outside China, so any liquidation would take place in Hong Kong). So it follows that the Chinese court will give effect to the Hong Kong liquidation and the shares would remain the assets of the investors.
Therefore, it appears that investors do have beneficial ownership under both Hong Kong and China law.
Another challenge is determining whether the investors as beneficial owners have any direct enforcement rights against the underlying listed companies before the courts in China.
Chinese law does not prohibit a beneficial owner of shares from suing the underlying share company, nor does it expressly provide for the beneficial owner to do so. Notwithstanding this, a number of Chinese counsel believe that it is entirely possible and indeed likely that a beneficial owner would be entitled to take such legal action. The reasoning is that if Chinese law affords rights (in this case, beneficial ownership rights) to a party then, as a general rule, the court would empower a party to seek to enforce those rights and thus beneficial owners would be able to sue.
References have been made to a number of cases involving nominee holders and beneficial owners, where the rights of beneficial owners were expressly recognised and given effect to.[iv] Admittedly, these were cases outside the context of Stock Connect and the Chinese courts do not, unlike common law jurisdictions, have a system of binding precedent.
However given the mandatory nature of the holding arrangement in Stock Connect, there are even stronger grounds for the courts in China (given their nature as administrative courts) to recognise the beneficial ownership of investors and give effect to official government policies. Importantly, Article 119 of the China Civil Procedure Law only requires that a claimant have a “direct interest” in the matter. Accordingly, if an investor can demonstrate that it is a beneficial owner of the shares held through Stock Connect and that it has a direct interest in the matter, the investor would, in principle, have standing before the Chinese court.
HKSCC has made it clear that it is prepared to facilitate an investor taking legal action in China by certifying the investors as beneficial owners. To this end, ChinaClear rules expressly state that the nominee holder (HKSCC) can certify beneficial ownership in its records.[v] The fact ChinaClear’s rules were approved by the China Securities Regulatory Commission (“CSRC”) prior to being issued underlines that any such certification made under ChinaClear rules would provide solid evidence of beneficial ownership to the CSRC and courts in China.
As the shareholder of record (and nominee holder), HKSCC ostensibly has the right to sue a listed company. According to its pre-existing rules, though, HKSCC is not obligated to enforce such rights in court. This position is perfectly understandable since it is not the ordinary business of HKSCC as a clearing system and CSD to take enforcement action against the underlying companies. For precisely the same reason, clearing systems and CSDs (including Euroclear and Clearstream in Europe and the Depository Trust & Clearing Corporation in the U.S.) do not, as a general rule, enforce rights for investors by taking the underlying issuers to court. There is clearly a difference between exercising rights for investors (such as receiving dividends and arranging voting) and enforcing rights by taking action in courts.
Notwithstanding this, HKSCC has made it clear in its supplementary FAQ of January 2015 that it is prepared to assist investors in bringing legal action (and to act as nominal plaintiff) in China, subject to reasonable conditions and after consideration of its statutory duties. It is also understood that HKSCC’s rules will be amended very soon so that an express obligation will be imposed on HKSCC to assist investors in bringing legal action in such a manner.
To sum up, despite not having any direct precedent, it is entirely possible and (many believe) likely that investors in Stock Connect are entitled to take direct legal action in China against a company. But in any event this is probably a moot point now, given the HKSCC’s assurances (and the expected, imminent amendments to its rules) that it will assist investors in bringing legal action in China, where necessary.
Stock connect compared with QFII/RQFII
UCITS and other investment funds have long invested in A shares in China through QFII and RQFII (open ended fund) schemes. To this end, it may be helpful to draw some comparisons (see diagram 2 below).
One difference is that the name of the investment fund is noted in the segregated account of QFII/RQFII at ChinaClear whereas investments through Stock Connect are held in the omnibus account of HKSCC at ChinaClear. Such designations achieve individual segregation in that all investment in the account is allocated to the relevant investment fund and segregated from the assets of the QFII/RQFII and from other clients of the QFII/RQFII. By comparison, HKSCC does not provide individual segregation because it is a CSD as mandated by the Stock Connect regulation and not a safe-keeping agent appointed by the custodian of the investment fund, and so does not form part of the custodian/safe-keeping agent network.
Even so, segregation in this case does not give the investment fund investing under QFII/RQFII any more ownership rights than an investment through Stock Connect – after all, the beneficial ownership of the investment through QFII/RQFII is derived from the same regulation (namely the CSRC Securities Registration Measures) as Stock Connect. On the contrary, the beneficial ownership of an investor through Stock Connect is arguably clearer given the express provisions in Stock Connect regulations.
In addition, such individual designations do not give an investment fund investing through QFII/RQFII any more direct enforcement rights since QFII/RQFII is still the holder of record in the same way as HKSCC for Stock Connect. As mentioned previously, the policy consideration for the Chinese court is also stronger in the case of Stock Connect given its mandatory nature and government backing.
Therefore, it would appear that from a legal perspective the beneficial ownership and direct enforcement possibilities for Stock Connect are at least as robust as they are for QFII/RQFII.
In terms of pre-trade checking and settlement methods, again it would appear that investment in Stock Connect is no less favourable (see diagram 2). With the enhanced pre-trade checking due to be launched in the first quarter of 2015 and the various delivery versus payment (DvP) models offered by brokers and custodians in Hong Kong, it would seem that Stock Connect may yet come out ahead.
Leaving aside the legal and structural issues, there are a number of additional factors potentially making Stock Connect more attractive for A-share investment. From a credit and risk perspective, investment funds may be more comfortable leaving their assets with HKSCC (which is a CSD subject to more stringent supervision and regulatory framework)[vi] rather than some of the less creditworthy QFII/RQFIIs.
There is also more liquidity and flexibility for shares held through Stock Connect since offshore security can be freely taken and dealt with in Hong Kong as opposed to the more stringent onshore security regime for QFII/RQFIIs in China.
Last but not least, there have been numerous reported switches from investment through QFII/RQFII to Stock Connect simply to free up QFII/RQFII quota and capitalise on the lower cost base of investing through Stock Connect.
As that Hong Kong airport billboard yells out, China is huge and developing and the complexities of manoeuvring around within it are daunting. However, by working together, we can all help to inform (and be informed by) China and this can only augur well as China integrates further into the international capital markets.
[i] Article 18 of CSRC Securities Registration Measures (re-issued and effective as of 20 November 2009)
[ii] Article 7 and Article 13 of CSRC Stock Connect Pilot Rules (issued and effective as of 13 June 2014)
[iii] Article 118 of Shanghai Stock Exchange Shanghai-Hong Kong Stock Connect Pilot Programme Provisions (issued and effective as of 26 September 2014)
[iv] See “Legal Issues on Nominee Holding in Equity Investment – Case Study” by Qiu Yonghong at China Capital Law [http://www.chinacapitallaw.com/article/default.asp?id=12364]
[v] Article 5 of ChinaClear Securities Registration Rules (issued and effective as of 25 July 2006)
[vi] HKSCC is a “recognized clearing house” licensed by the Securities and Futures Commission (SFC) under the Securities and Futures Ordinance, a CSD and Securities Settlement System (SSS) with rules approved by the SFC as well as a “financial market infrastructure” (which observes and complies with CPMI-IOSCO’s Principles For Financial Market Infrastructures (April 2012)) recognised by the SFC, International Monetary Fund and other international bodies.
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