On April 6, 2022, the People’s Bank of China (“PBOC”), together with the National Development and Reform Commission, the Ministry of Justice, the Ministry of Finance, the China Banking and Insurance Regulatory Commission, the China Securities Regulatory Commission and the State Administration of Foreign Exchange, issued the Financial Stability Law (Draft for Comment) (the “Financial Stability Law” or “Draft Act”). This will be the first law in China to specifically govern the prevention, resolution and treatment of financial risks and another important financial law in tandem with other laws such as the Law of the People’s Bank of China, the Commercial Bank Law, the Securities Law, and the Insurance Law. The Financial Stability Law is intended to provide a legal basis for the prevention and resolution of major financial risks. It proposes to improve financial risk prevention, resolution and treatment mechanisms, enumerate financial risk treatment measures and secure treatment resources by specifying the responsibilities of each party involved, and improve the division and coordination of duties among different departments and those between the central and local governments. According to the Draft Statement released by the PBOC, the Draft Act has followed the examples of financial stability-related legislation commonly adopted by other major developed economies with respect to the sources and the order of the application of treatment funds, and the various treatment measures.
I. Application Scope
The Financial Stability Law applies to banking, securities, futures, trust and insurance institutions, as well as financial holding companies that engage in financial business activities in accordance with financial laws. It also applies to other institutions that have been established with the approval of or recognized by the financial regulatory department of the State Council. In other words, it applies to the major existing types of licensed financial institutions. Although the Draft Act is silent on the definition of “financial business”, it does stipulate for the first time in a financial law that without a proper license, no entity or individual may establish a financial institution, nor engage in any financial business directly or in a disguised form, and provides the higher-level statutory basis that a financial business must be conducted with a license.
II. Financial Stability Working Mechanism
The Financial Stability Law specifies that the National Financial Stability and Development Overall Coordination Mechanism (i.e., the Financial Committee of the State Council) is a mechanism under which the State Council coordinates all the major issues concerning financial stability, reform and development. It specifies that each of the financial regulatory departments, the development and reform departments, the finance departments and the other departments of the State Council act as a member unit, and that this mechanism is not intended to replace the responsibilities and work procedures of each of the above-mentioned specific departments. The Financial Stability Law has established the following financial stability working mechanisms: (i) the Financial Committee of the State Council shall coordinate and direct the prevention, resolution and treatment of major financial risks; (ii) the relevant departments of the State Council and local governments shall, in accordance with the requirements of the Financial Committee of the State Council and their respective division of responsibilities, coordinate and cooperate to perform the duties to prevent, resolve and treat financial risks; and (3) the deposit insurance fund management institutions and industry security fund management institutions shall perform their duties in accordance with the law, and be market-oriented and rule-based platforms for the treatment of financial risks.
III. Division of Responsibilities and Duties
3.1 The responsibilities of each party involved. In terms of the division of responsibilities and duties regarding financial risk treatment, the financial institution under treatment, its major shareholders and the de facto controller shall bear the main responsibility. In previous risk treatment cases, the failure in corporate governance of some small and medium-sized financial institutions, and the abuse of control rights by shareholders and the de facto controller was in practice found to be an important cause of financial risk; thus, apart from strengthening the requirements for access and the continuous supervision of the major shareholders and the de facto controller of financial institutions, the Draft Act also highlights local governments’ responsibilities to resolve regional financial risks and maintain regional financial stability. This means that current risk management practices that have proven to be effective are incorporated in the new law.
3.2 Early measures to be taken by regulatory authorities. The Financial Stability Law provides a legal basis for early corrective and regulatory measures that the regulatory authorities can take. In the event of a financial institution experiencing risks such as abnormal fluctuations in regulatory indicators, the financial regulatory department of the State Council may issue a risk warning. They may also have regulatory talks with the directors, supervisors, senior management personnel, major shareholders and the de facto controller, and order corrections within a certain time frame. If no correction is made within the time limit, or the regulatory indicators deteriorate, thereby endangering the stable operation of the financial institution itself or the financial market, the financial regulatory department of the State Council may take further measures to restrict or suspend its business, restrict its distribution of dividends to shareholders, and limit the remuneration of the directors, supervisors and senior management personnel. It may order it to write down loss-absorbing instruments (such as capital) or convert it into shares and restrict the rights of the shareholders. The Financial Stability Law also stipulates that a financial institution shall itself undertake measures to resolve risks in the event of abnormal fluctuations in regulatory indicators. These measures include reducing the scale of assets and liabilities, suspending relevant businesses, liquidating assets, replenishing capital, suspending dividend distribution, or restrict the remuneration of the directors, supervisors and senior management personnel. Article 14 provides that financial institutions and non-financial enterprises participating in financial market financing shall not damage, directly or indirectly, the legitimate rights and interests of the creditors and the other stakeholders by distributing dividends. However, it remains to be seen how these requirements can be implemented in practice.
3.3 Legal obligations and responsibilities of shareholders and the de facto controller. The Financial Stability Law provides for violations and illegal acts by shareholders and the de facto controller in the process of the formation and treatment of financial risks and corresponding penalties. It specifies that violations and illegal acts shall include (i) false capital contributions, (ii) covering up the de facto control right, (iii) illegally occupying the funds of financial institutions or clients, (iv) concealing financial data or providing false financial accounting reports, (v) illegally transferring the equity and assets of financial institutions, and (vi) other circumstances in which the rights or control rights of shareholders are abused, resulting in the formation, expansion, or spread of financial risks. It does not define what constitutes an abuse of shareholders’ rights or control rights, which leaves it up to the financial regulatory authorities to exercise their own discretion. Administrative liability for committing the foregoing acts includes the confiscation of illegal gains and fines, as well as warning and fining the persons directly responsible. The directors, supervisors, senior management personnel and other staff of a financial institution shall also be investigated for legal liability for cooperating with the major shareholders or the de facto controller of the financial institution in carrying out the foregoing acts or abusing the right of operation and management or damaging the lawful rights and interests of the financial institution and its shareholders, creditors and other stakeholders. In addition, the major shareholders and the de facto controller of a financial institution shall strictly implement the measures stipulated in the emergency response plan for major financial risks of the Financial Committee of the State Council.
IV. Source and Order of Application of Treatment Funds
Since 2008, international organizations and major economies have pointed out that financial institutions shall first rescue themselves from financial risks and then seek external assistance, to reduce the dependence on public funds in financial risk treatment. The Financial Stability Law adopts the same principle. Under the Financial Stability Law, the financial institutions under treatment are required to actively save themselves from financial risks. The major shareholders and the de facto controller of a concerned financial institution shall replenish capital in accordance with the recovery and treatment plans or regulatory commitments, and the shareholders or the de facto controller who is responsible for financial risks shall fulfill their obligations to rescue the financial institution in accordance with the law. In the meantime, market-oriented funds should be mobilized to participate in the merger, acquisition, and reorganization of the financial institution; deposit insurance funds and industry security funds shall play the role of market-based and rule-based platforms for financial risk treatment. If it remains difficult to resolve the risk after exhausting the market-oriented means and implementing the recovery of assets and losses strictly and fully, only then may the provincial people’s government utilize local public resources for risk treatment in accordance with the law. The Financial Stability Security Fund shall be only used when major financial risks endanger financial stability, while moral hazards associated therewith should also be prevented.
The Financial Stability Law explicitly grants the establishment of a Financial Stability Security Fund. Following international practice, the Financial Stability Security Fund shall consist of funds raised from financial institutions, financial infrastructures and other entities, as well as other funds specified by the State Council, which is under the overall management of the Financial Committee of the State Council for dealing with major financial risks with systematic impact. When necessary, public funds such as PBOC re-lending can be used to provide liquidity support for the Financial Stability Security Fund.
V. Treatment Measures
Subject to the risk treatment needs and with reference to international common practice, the Financial Stability Law adds treatment measures such as (i) the overall transfer of assets and liabilities, (ii) establishing bridge banks and special purpose vehicles, and (iii) suspending the close-out nettings for qualified financial transactions. Write-down of equity and creditor’s rights and debt-to-equity swaps can be made to financial institutions under treatment in a market-based and rule-based manner, to share the treatment costs. It further clarifies the order of write-downs of equity and creditor’s rights and highlights that the proceeds from risk treatment received by the creditors and the relevant stakeholders shall not be less than what they could get from the bankruptcy and liquidation proceedings of the financial institutions. Bridge banks and special purpose vehicles established to undertake the business, assets, and liabilities of the financial institution concerned shall comply with prudential supervision requirements such as market access and risk management, and the financial regulatory department of the State Council may exempt or change some of the regulatory requirements subject to the risk treatment needs.
The treatment measures granted to the financial regulatory department of the State Council by the Draft Act will have a significant impact on the interests of the creditors and the relevant stakeholders. Therefore, the detailed rules of implementation and application of these treatment measures still need to be further refined and improved. Regarding one of the treatment measures, i.e., suspending the close-out nettings for qualified financial transactions, we think the phrase “qualified financial transactions” (which first appeared at the statute level) should be clearly defined. Apart from the futures transactions and derivative transactions for which the close-netting mechanism will be used as explicitly provided in the Futures and Derivatives Law (the Second Draft), it should further clarify whether it applies to other specific financial transactions for which the close-netting mechanism is also used. Based on the characteristics of the specific financial transactions and by referring to international practices, further clarification is also needed as to whether the counterparty of qualified financial transactions shall not exercise the termination right during the period of suspension of the close-out nettings and how long the suspension period lasts.
When implementing treatment measures such as the overall transfer of assets and liabilities and suspending the close-out nettings for qualified financial transactions, if the financial relationship or financial contract concerned bears foreign elements and the applicable law is not Chinese law, the legislators and regulators need to further consider and improve the corresponding regulations, in particular how to ensure that the aforementioned treatment measures can take expected legal effect, especially in offshore jurisdictions.
VI. Judicial Linkage
Article 36 of the Draft Act provides that “The treatment department may apply to the people’s court for centralized jurisdiction over civil litigation cases involving the financial institution under treatment and apply to the relevant department for the removal of preservation measures such as seal-up, seizure, and freezing of the property and equity of the financial institution in civil procedures, enforcement procedures and commercial arbitration procedures”. As this is similar to those in the Enterprise Bankruptcy Law on the exclusive jurisdiction over bankruptcy cases and the removal of preservation measures on the debtor’s property, we believe that the intention of Article 36 should be aligning the trial progress of the cases involving financial institutions under treatment and realizing the fair treatment of all creditors and relevant stakeholders. However, the Draft Act currently only allows the treatment department to apply for centralized jurisdiction and the removal of preservation measures, whether such an application can be granted is still subject to the relevant laws and regulations and the discretion of the court and the relevant departments. It remains to be seen how the linkage between the risk treatment and the judicial procedures works in practice.
According to Article 37 of the Draft Act, the treatment department may apply to the relevant department to suspend (i) the civil procedure (ii) the enforcement procedure with the financial institution concerned as the defendant, the third party, or the person subject to enforcement, and (iii) the commercial arbitration proceedings in which the financial institution is the respondent. This is similar to Article 134 of the Enterprise Bankruptcy Law, which provides that the financial regulatory authority of the State Council may apply to the court to suspend the civil procedure or enforcement procedure with the financial institution as the defendant or the person subject to enforcement when it takes over or maintains the trusteeship of a financial institution that encounters major operational risks. It is on this basis that the Draft Act further extends to where the financial institution under treatment is the third party in the civil procedure or the respondent in the commercial arbitration proceedings.
VII. Information Dissemination and Legal Responsibilities
It should be noted that Article 9 of the Draft Act provides that financial institutions and other market participants shall disclose financial risk information in accordance with the laws, regulations and regulatory provisions. No entity or individual may fabricate or spread misleading or false information about financial risks. Article 44 of the Draft Act further provides for legal responsibilities for violation of Article 9; that is, the competent departments shall order corrections, give a warning, confiscate the illegal gains, and impose a fine of not less than one time but not more than ten times the illegal gains; if there are no illegal gains or the illegal gains are less than 100,000 yuan, a fine of not more than 1 million yuan shall be imposed; if serious consequences are caused, a fine of not less than 1 million yuan but not more than 10 million yuan shall be imposed. Thus, financial institutions and financial information service providers are advised to pay attention to these articles and to disclose financial risk information prudently to avoid any violations.
For further information, please contact:
XIE, Qing (Natasha), Partner, JunHe