20 March, 2018
CSRC Announcement of 9 March 2018
Foreign Investors To Get Majority Control and Gradually, Full Ownership.
Introduction
On 9 March 2018, the China Securities Regulatory Commission (“CSRC”) issued the long-awaited consultation draft rules (“Draft Rules”) on the establishment of foreign invested securities companies (“Securities JVs”), with a consultation period of one month.
The Draft Rules set out the proposed changes to the regime on the establishment of Securities JVs which will involve, amongst other things, increase in the maximum foreign ownership percentage from 49 per cent. to 51 per cent. and the removal of restrictions on foreign ownership in 3 years following the effective date of the increase to 51 per cent., as committed by the PRC government in November 2017 (see our earlier article here).
In this alert, we discuss how the PRC government plans to implement its commitments to liberalise the securities sector, what restrictions on foreign ownership are expected to remain, and the proposed rule changes.
Ownership requirements
Incorporation of enlarged ownership cap
The Draft Rules do not expressly mention the increase in maximum foreign ownership percentage in Securities JVs from 49 per cent. to 51 per cent. As confirmed by CSRC, the increase is, however, built into the Draft Rules, which refers to the external commitments made for the PRC securities industry (i.e. “the foreign shareholding cap in a Securities JV will be increased to 51 per cent. and there will be no cap on foreign shareholding three years after the 51 per cent. cap is implemented”). CSRC explained that this cap and the associated further liberalisation, being the agreement reached at the meeting of the Chinese and US heads of state in November 2017, will be honoured.
Accordingly, once the new rules become final and effective, a foreign investor will be able to obtain up to 51 per cent. of a Securities JV (as a combined percentage of direct ownership and indirect controlling interests) and up to 100 per cent. of a Securities JV in three years following the effectiveness of the new rules, subject to CSRC approval.
Listed securities companies: The overall cap on foreign investment for listed securities companies is the same as for unlisted Securities JVs. However, there is an additional cap of 30 per cent. (up from 20 per cent. under the current regime) for each foreign investor, including those acting in concert with such foreign investor, which means that a general offer from a foreign investor to acquire a PRC listed securities company is not permitted.
H shares: In the case of Hong Kong-listed PRC securities companies, the Draft Rules fail to clarify whether the H shares of such companies are considered as foreign holdings for the purpose of determining whether the overall 51 per cent. cap on foreign investment will be met. The Draft Rules do not specify the consequence of an inadvertent breach of this cap, although, due to the onerous qualification requirements (see next section below) it is unlikely that a number of unrelated foreign investors will jointly hold 51 per cent. of a listed securities company.
Minimum foreign holding: The Draft Rules also propose that all Securities JVs must, in principle, have a minimum direct ownership and indirect control by foreign investor(s) of 25 per cent. of their equity interests in aggregate. This minimum holding does not, however, apply to a Securities JV formed from the conversion of an existing PRC securities company.
Qualifications for foreign investors
In parallel with the relaxation of the foreign ownership limit in Securities JVs, the Draft Rules aim, through tightening qualification requirements, to give CSRC additional control in vetting applications by foreign investors to invest in Securities JVs.
The enhanced requirements apply equally to new Securities JV investments and acquisition of stakes in existing Securities JVs.
Financial institution: Each foreign shareholder must be a financial institution that complies with the financial regulatory indicators of its home jurisdiction and regulators in the previous 3 years. This imposes a higher bar than the current regime, under which at least one foreign shareholder (presumably the leading foreign shareholder) needs to be a qualified financial institution, and limits the ability to form a consortium of foreign investors to control a Securities JV (as all of which must now be qualified financial institutions).
Enhanced qualification requirements for foreign investors
The existing requirements have been broadened and clarified such that each foreign investor in an unlisted Securities JV, and each foreign investor holding a stake of more than 5 per cent. in a listed PRC securities company, will be required to substantiate the following:
- it has good international reputation;
- it has continuously carried on securities business for at least five years;
- its business scale, revenue and profits have been at the forefront of the international market during the past three years;
- its long-term credit rating has been maintained at a high level during the past three years;
- it has not incurred material sanctions of a national or regional regulatory or administrative body or court in the previous three years; and
- it is not currently under investigation for alleged material breach of laws and regulations.
Compliance with the foreign investor criteria must be substantiated by relevant supporting documents, which may not be straightforward (for example, a letter from the investor’s regulator certifying its compliance with the financial regulatory indicators imposed by its home jurisdiction and regulators during the past three years and the quality of its internal control system, and certifying that it is not involved in any official investigation for alleged material breach of laws and regulations).
It is also likely that the CSRC will be given more discretion to interpret the criteria based on the documents submitted – for example, in determining whether an entity incorporated in a regional hub, such as the Hong Kong hub of a New York investment bank, can qualify by using the business performance records of the parent group to show that its business scale, revenue and profits are “at the forefront of the international market”.
Monitoring recommended: Due to the onerous qualification requirements, foreign investors (including institutional and non-institutional investors) may need to monitor and prevent any proposed acquisition of 5 per cent. or more of the shares of a listed securities company, or control of an entity which holds 5 per cent. or more of the shares of a listed securities company, either in the A share market and/or in the H share market.
In this regard, one noteworthy change is that foreign investors will, when making an investment involving PRC securities companies, be required to take extra care to ensure that they comply with the foreign investor qualifications and that the foreign ownership thresholds are not exceeded, as the Draft Rules require a regularisation and restructuring (which could potentially include ensuring compliance with the qualifications and thresholds and failing which, potential divestment or unwinding of the investment) to be conducted within 3 months of a breach of such qualifications or threshold requirement occurring. The 3-month period may, in the case of a listed securities company, be extended if trading of the company’s shares is suspended, or if the company’s shares are subject to lock-up restrictions.
The above monitoring may also need to extend to a foreign investor acquiring control of a PRC entity which holds 30 per cent. of the shares of a listed securities company, in order to prevent a breach of the 30 per cent. individual single foreign investor cap (even if that foreign investor can satisfy the relevant qualification requirements).
Financial business qualification requirement to be removed: The reference in the current rules to the foreign financial institution’s “qualification for conduct of financial business” is proposed to be removed. This suggests a simplification of the items that the institution is required to submit to the CSRC, making the application process more workable in practice.
Changes relating to structuring of Securities JVs
By proposing to remove key requirements of the current rules relating to the establishment of Securities JVs and the conversion of existing PRC securities companies into Securities JVs, the Draft Rules, when finalised, are expected to facilitate the structuring of such transactions.
Requirements to be phased out
The following provisions are proposed to be removed from the current rules, which broadly follows the position under the Mainland-Hong Kong Closer Economic Partnership Arrangement (“CEPA”) (see our earlier article here):
- the requirement for a foreign investor to partner with a PRC securities company in order to set up a Securities JV, thus paving the way for foreign financial institutions to partner with PRC shareholders from any industry sector to set up a Securities JV; and
- the requirement for a Securities JV to have at least one PRC shareholder with a minimum shareholding of 49 per cent.
In addition, while the prohibition against the foreign investor transferring its equity interests in a Securities JV within three years from the date of the investment is also proposed to be removed from the current rules, it is not clear whether the CSRC will, in practice, still require such lock-up undertakings from foreign investors.
Business scope
The business scope provisions have been further simplified, such that a newly established Securities JV is no longer limited to including only underwriting, B-share brokerage, treasury and corporate bond business in its initial business scope.
While not expressly specified under the Draft Rules, the CSRC has indicated that a new Securities JV may include any four types of securities business upon establishment (which could potentially include activities such as brokerage and asset management), with the only condition being that the included businesses much match with the controlling shareholder’s securities business experience (which is intended to include the experience of a controlling foreign shareholder of the Securities JV).
The Draft Rules do not further specify the criteria that an existing Securities JV must meet in order to expand its business scope after attaining 51 per cent. foreign ownership. The base position is likely to be that the criteria in the existing rules for securities subsidiaries (including compliance with laws and risk indicators and market share above industry median) will continue to apply.
Overall assessment
The publication of the Draft Rules is indeed a positive market development that follows the outcome of the 2017 Sino-US economic dialogue, and the relaxation of certain restrictions under the CEPA regime; however, it must be noted that the effective date of the final rules, and hence the timing of actual implementation of the enlarged maximum foreign ownership percentage is still uncertain (although expected to be within 2018).
In the Draft Rules, the qualification requirements have been tightened up on a number of fronts to reflect the PRC government’s position that only high calibre foreign investors with solid financial business experience will be acceptable. Foreign investors will, accordingly, need to carefully consider their ability to meet the revised requirements and avoid inadvertent breach.
The removal of the restrictions on PRC partner selection and business scope will provide more flexibility to foreign investors when setting up the new Securities JVs. Strategic acquisitions of existing PRC securities companies may also provide foreign investors with relatively quicker access to the market in a more flexible manner.
Reference
Notice to Publicly Seek Comments on the Draft Foreign Invested Securities Companies Administrative Regulations (关于就《外商投资证券公司管理办法（征求意见稿）》公开征求意见的通知), CSRC, 9 March 2018
For further information, please contact:
John Xu, Partner, Linklaters
john.xu@linklaters.com
