On October 14, 2023, the China Securities Regulatory Commission (“CSRC”) released a news announcement titled CSRC Amends and Optimizes Securities Borrowing and Lending Rules for Better Effect of Countercyclical Adjustments. In the announcement the CSRC amended and optimized the rules for securities borrowing and lending (“SBL”) as well as refinancing of securities held by strategic investors, and tightened policies for the same. On the same day, the Shanghai Stock Exchange (“SSE”) and the Shenzhen Stock Exchange (“SZSE”, together with SSE, the “Stock Exchanges”) released the Circular on Optimizing the Relevant Arrangements for Securities Borrowing and Lending and Securities Refinancing (the “Circulars”), which contained detailed provisions for optimizing SBL and securities refinancing transactions. The Circulars provide important rules on SBL and securities refinancing transactions, including: (1) raising margin ratios for SBL; (2) requiring that the senior management and core employees of an IPO issuer that participate in a special asset management plan (ESOP) established for a strategic placement shall not lend their allocated shares within the committed holding period, while other strategic investors are restricted from lending their allotted shares in the initial period after an IPO in terms of the method of lending and the proportion of the number of allotted shares they can lend; and (3) specifying brokers’ management responsibilities for SBL and securities refinancing businesses.
Another prominent provision of the Circulars is that, “where an investor holds restricted shares of a listed company, strategic shares of a listed company, or shares subject to transfer restrictions, such as shares acquired from major shareholders or specific shareholders of a listed company through block trades, the investor and its related parties shall not sell such shares through SBL during the relevant holding period.” This provision comes into force on October 16, 2023, and prohibits investors and their related parties from selling shares subject to selling restrictions through SBL during the relevant holding period. Below is a brief analysis of this provision:
I Restrictions under Previous Rules
There are three circumstances where an investor is subject to restrictions on selling or transferring shares: (1) it holds restricted shares in a listed company and shall not sell the shares during the relevant holding period; (2) it holds shares allotted to IPO strategic investors and has committed not to sell the shares within relevant holding period (the “Strategic Shares”); (3) it acquires shares from major shareholders or specific shareholders of a listed company through block trades and shall not transfer the shares during relevant lock-up period (the “Specific Block Trade Shares”) (collectively, the “Restricted Shares”).
The previous Stock Exchange rules already prohibited holders of Restricted Shares mentioned in the above points (1) and (2) from selling the shares through SBL during the relevant holding period, to prevent them from evading committed holding periods and selling the shares earlier by means of SBL. In accordance with the relevant provisions of the Stock Exchanges1, (a) an investor holding restricted shares of a listed company shall not sell the shares through SBL, nor shall they post the restricted shares held in their ordinary securities account as collateral; (b) an investor participating in a registration-based IPO strategic allotment of shares, as well as its related parties, shall not sell the allotted shares through SBL within its committed holding period, unless otherwise provided by the Stock Exchanges.
It is important to note the difference in the rules applicable to the above circumstances (1) and (2), that is, both the shareholder of Strategic Shares and its related parties are prohibited from selling the shares through SBL during the committed holding period; but only the shareholder holding restricted shares of a listed company is subject to short selling restrictions, not its related parties. It is also worth noting that, despite the absence of an explicit definition of “related party”, we believe that the purpose of extending the applicable scope of short selling restrictions to cover related party of a strategic investor is to prohibit the strategic investor’ short selling via an account in the name of a party in which the strategic investor may exercise control or influence. We believe that regulators may determine a “related party” following a “substance over form” principle and based on an analysis of specific circumstances, rather than on the appearance of a related party relationship.
For Specific Block Trade Shares mentioned in (3) above, although the relevant Stock Exchange rules provide that the shareholders holding these shares shall be subject to a six-month lock-up period (i.e. it is prohibited from transferring Specific Block Trade Shares within six months upon the completion of block trades)2, none of these rules clearly provide restrictions on such shareholders and their related parties from selling the shares through SBL during the lock-up period.
II “Enhanced” Restrictions under the Circulars
The Circulars reiterate the previous short selling restrictions and add the following two restrictions on investors holding restricted shares in a listed company and investors holding Specific Block Trade Shares:
Firstly, the Circulars now prohibit investors holding Specific Block Trade Shares from selling the shares through SBL within the lock-up period. In our view, although the previous Stock Exchange rules do not have clear rules that prohibit investors holding Specific Block Trade Shares from short-selling the shares within the lock-up period, given that a “lock-up period” applies to Specific Block Trade Shares, regulators may likely apply the same regulatory principles in their law enforcement to crack down on the short selling activities of investors holding Specific Block Trade Shares who evade the “lock-up period” and sell the shares earlier by means of SBL. In a draft consultation paper on OTC derivatives trading released in March 2023, the CSRC proposed to restrict OTC derivatives trading activities by investors holding shares subject to relevant lock-up periods, and stated that “it is prohibited to circumvent the shareholding reduction rules and restricted shares rules through OTC derivative trading”. Though this consultation paper has not yet been finalized, it reflects the trend of an enhanced law enforcement by regulators and indicates that regulators may “look through” to determine and punish behavior that circumvents regulations.
Secondly, compared with the previous Stock Exchange rules that subject both strategic investors and their related parties to short selling restrictions, the Circulars unify regulatory standards by stating that short selling restrictions shall also apply to the related parties of investors holding a listed company’s restricted shares and Specific Block Trade Shares. The Circulars don’t set out the definition of a “related party” either, but likewise, we believe that regulators may determine a “related party” following a “substance over form” principle and based on an analysis of specific circumstances, rather than on the appearance of a related party relationship.
III Legal Consequences for Violation of the Circulars
The Stock Exchanges may take self-disciplinary measures or impose disciplinary sanctions on investors or their related parties for breaches of any provisions under the Circulars according to the business rules of the Stock Exchanges. The announcement highlighted that the CSRC will strengthen the supervision of illegal arbitrage activities, undertake strict law-enforcement measures, and impose heavier punishments. This means that violations of the Circulars may not only lead to self-disciplinary measures and disciplinary sanctions but may also trigger administrative investigations and corresponding administrative penalties.
Our Observations
The enhanced restrictions over short selling come at a crucial time. As part of a set of measures taken by regulators to respond to investors’ recent concerns on market drop, the Circulars are a warning to short selling participants. Market participants are advised to interpret the regulatory principles and spirit embedded in the Circulars prudently, attach great importance to compliance risk at special times, and review and reassess the compliance of relevant transactions and make adjustment accordingly.
1. Articles 61 and 63 of the Detailed Implementing Rules of the Shanghai Stock Exchange on Margin Financing and Short Selling (Amended in 2023); Article 7.2 of the Detailed Implementing Rules of the Shenzhen Stock Exchange on Margin Financing and Short Selling (Amended in 2023)
2. Article 5 of the Detailed Implementing Rules of the Shanghai Stock Exchange for the Sale of Shares by Shareholders, Directors, Supervisors and Senior Management of Listed Companies; Article 5 of Detailed Implementing Rules of the Shenzhen Stock Exchange for the Sale of Shares by Shareholders, Directors, Supervisors and Senior Management of Listed Companies.
