On July 27, 2012, the China Securities Regulatory Commission (the “CSRC”), aiming to attract more investments by qualified foreign institutional investors (“QFIIs”), published a Regulation Regarding Certain Issues in the Implementation of the Administrative Measures on Onshore Securities Investment by Qualified Foreign Institutional Investors (the “New Regulation”). This alert outlines the notable changes reflected in the New Regulation as compared to the regulation it supersedes — the Notice of the China Securities Regulatory Commission on the Implementation of the Measures for the Administration of Onshore Securities Investment by Qualified Foreign Institutional Investors (the “CSRC Notice”).
Prior to launching the New Regulation, the CSRC issued a draft version on June 20, 2012 (the “Draft Regulation”). The New Regulation reflects certain comments received by the CSRC from the public during the past several weeks. This alert also summarizes major differences between the Draft Regulation and the New Regulation.
Since its launch in November 2002, the QFII program has undergone successive expansions, the most notable of which was the enlargement of investment quotas from US$30 billion to US$80 billion announced this past April. However, some of the regulations relating to the QFII program, notably the Administrative Measures on Onshore Securities Investment by Qualified Foreign Institutional Investors and the CSRC Notice because of their high thresholds for market entry, have been viewed as not encouraging further opening up of the capital markets and attracting more offshore medium and long-term capital. The New Regulation published by the CSRC intends to address this situation by relaxing the market entry criteria and the operational constraints, expanding the scope of permitted investment, and simplifying and facilitating the administrative processes.
2. Prominent Changes
(i) QFII Eligible Institutions Expanded
In the CSRC Notice, foreign institutions eligible for the QFII program were limited to fund management institutions, insurance companies, securities companies, commercial banks and other institutional investors (such as pension funds, charitable foundations, endowments, trust companies, sovereign wealth funds, etc.). The New Regulation has expanded the scope of eligible institutions by replacing “fund management institutions” in the CSRC Notice with the term “asset management institutions”. According to reports1 on the CSRC’s website quoting a responsible CSRC official, private equity investment firms now can apply for QFII licenses under the “asset management institutions” category. As the term “asset management institution” is not a defined legal term in China, the CSRC has ample discretion to decide which institutions will be deemed “asset management institutions”.2
(ii) QFII Market Entry Criteria Lowered
Consistent with the Draft Regulation, the New Regulation substantially lowers the market entry criteria as shown in the chart below.
|Current Criteria||New Regulation|
|Asset Management Institutions||
|Other institutional investors (such as pension funds, charitable foundations, endowments, trust companies, sovereign wealth funds, etc.)||
(iii) New Products Eligible to QFIIs
According to the New Regulation, the products eligible for investment by QFIIs have been substantially expanded and now include:
The New Regulation allows QFIIs for the first time to invest in fixed income products traded in the IBBM. The types of fixed income products traded in the IBBM may include (i) bond products, such as central government and local government bonds, central bank bonds, policy-oriented and ordinary financial bonds, subordinated bonds, mixed capital bonds, and RMB-denominated bonds issued by international development agencies (such as the World Bank, Asian Development Bank etc.) and (ii) asset-backed securities (“ABS”) products.4 The New Regulation permits QFIIs to participate in the IBBM in addition to current players such as PRC commercial banks, PRC non-banking financial institutions, other Chinese institutional investors as well as approved foreign institutional investors (e.g., Chinese branches of foreign banks, foreign central banks or monetary authorities, and foreign banks participating in RMB settlement for cross-border trade). Opening the IBBM to QFIIs may not only enable QFIIs to improve their performance and attract more foreign capital by diversifying their investments, but may also indirectly stimulate the IBBM.
However, quite a few issues related to QFII investments in the IBBM remain to be further clarified by authorities other than the CSRC. For example, the People’s Bank of China or the China Banking Regulatory Commission may need to address the following questions:
Similarly, the tax authorities may need to clarify whether or how QFIIs can enjoy current preferential treatment applicable to certain fixed income products traded in the IBBM. For example, interest accrued on local government bonds issued from 2009 through 2011 is exempt from income tax, and income tax is assessed on interest accrued on the Railway Construction Bonds issued from 2011 through 2013 at half the otherwise applicable tax rate. It is therefore expected that some of the current applicable rules may require amendments, or new rules may need to be enacted to govern how QFIIs can participate in the IBBM.
The New Regulation has also expanded the “products traded on the Stock Exchanges” to “products traded and transferred on the Stock Exchanges.” This expansion aims to include privately placed small and medium enterprise bonds that are issued and transferred (rather than traded) on the Stock Exchanges.
(iv) Shareholding Ceiling Raised
Like the Draft Regulation, the New Regulation raises the ceiling for aggregate shareholdings of all foreign investors in the “A” shares of a listed Chinese company from the current 20 percent to 30 percent. The ceiling for the shareholding of a single foreign investor in the total share capital of a listed Chinese company remains at 10 percent.5
(v) Securities Accounts6
The Draft Regulation sought to remove the ambiguity surrounding ownership of assets held by a QFII for itself and its clients. The Draft Regulation expressly required a QFII to open separate segregated securities accounts for its own capital and its clients’ capital and further clarified that assets in accounts opened for QFII clients would belong to the QFII clients and would not be the property of the QFII or its custodian.
These positive efforts have been partiality cut back by the New Regulation, which has restored certain provisions of the CSRC Notice. Under the New Regulation, (i) a QFII is legally required to open separate segregated securities accounts for its own capital and its clients’ capital, and (ii) assets in segregated accounts opened for a QFII’s long-term investment clients (such as a publicly placed fund, insurance fund, pension fund, charity foundation, endowment fund and sovereign investment fund (collectively, “Long-Term Clients”)) belong to the Long-Term Clients and are not the property of the QFII or its custodian, but (iii) the ownership of assets in segregated accounts opened for a QFII client other than a Long-Term Client remains unclear. It remains to be determined whether the lack of clarity regarding ownership of assets in accounts opened for QFII clients other than Long-Term Clients was intentional or not.
As in the Draft Regulation, the New Regulation allows Chinese fund management companies to provide ad-hoc asset management services7 for QFIIs and to open corresponding accounts to facilitate QFII operations.
(vi) Engagement of Multiple Securities Companies by QFIIs
QFIIs have been theoretically allowed to engage up to three securities companies to trade securities in each of the Stock Exchanges. In practice, however, a QFII could only engage one security company in each Stock Exchange because (1) each QFII is only allowed to open one special RMB account and (2) the CSRC Notice required a one-to-one correspondence of the securities account with the special RMB account. The New Regulation abandons this one-to-one correspondence, thereby effectively permitting QFIIs to engage multiple securities companies.
(vii) Less Onerous Application Requirements and Electronic Filing
The New Regulation reduces the burden of applying for a QFII license because (1) it no longer requires an applicant to submit its articles of association; (2) it now only requires the submission of a power of attorney issued by the applicant to its custody bank, instead of a draft custody agreement; (3) it now requires an applicant to submit audited financial statements for the most recent one-year period instead of the past three years; and (4) the explanation by the applicant regarding whether it has been subject to any severe penalty by regulatory authorities must now be made for the latest three years or, if shorter, the period since its establishment.
To further simplify and add transparency to the application and administration processes, the New Regulation expressly recognizes an electronic filing of a QFII application through the CSRC website and requires the reporting of major events to be made by electronic filing.
The New Regulation has responded to many of the suggestions and comments made by industry players and should help to further attract and facilitate investments of foreign capital through QFIIs.
In the past, the relevant regulators, CSRC and State Administration of Foreign Exchange, have worked in close coordination with respect to legislation and rules governing QFIIs. According to media reports quoting an official of CSRC,8 CSRC will actively coordinate with relevant authorities to study relevant measures to address the foreign exchange and tax implications brought about by the New Regulation.
This alert is not a legal advice but just a general overview.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:Joseph-Roger
2 Although the replacement of “fund management institutions” by “asset management institutions” had already been made in the Draft Regulation, the CSRC’s position on this issue appears to have changed during recent weeks. When the Draft Regulation was issued in June 2012, the CSRC’s official explanation of the Draft Regulation limited eligible institutions under the “asset management” category to “fund management institutions.” As noted previously, however, the CSRC position reflected on the CSRC website is that private equity firms are also included among eligible asset management institutions.
On the other hand, we believe that this change is not likely to affect whether hedge funds will be allowed to participate in the QFII program, as the CSRC website report (see endnote 1) continues to emphasize that China encourages long-term capital to participate in the QFII program and in the past hedge funds have been deemed by the Chinese authorities to be short-term capital.
3 Under the Measures for the Administration of the Capital of Commercial Banks (For Trial Implementation) issued on June 7, 2012, and to be effective as of Jan 1, 2013, “tier 1 capital” is defined as the sum (subject to certain adjustments) of the following items:
Such measures apply to banks incorporated in China. It is unclear whether Tier 1 capital of foreign commercial banks will be calculated based on the above calculation method.
4 Under the Draft Regulation, QFIIs were allowed to invest only in bond products traded in the IBBM. We presume that the expansion under the New Regulation to include ABS is primarily intended to support the recently announced third pilot program for credit ABS and another program for asset backed notes under the Guideline Regarding Asset Backed Notes of Non-financial Institutions in the National Inter-Bank Bond Market published by the National Association of Financial Market Institutional Investors on Aug. 3, 2012.
5 Neither the 30 percent ceiling nor the 10 percent ceiling applies to strategic investments made according to the Administrative Measures for Foreign Investors’ Strategic Investment in Listed Companies.
6 We note that securities regulators in the United States interpret the reach of their own jurisdiction broadly, including in connection with “broker-dealer” and “investment adviser” activities. In particular, the US Securities and Exchange Commission takes the position that it has jurisdiction over non-US securities firms when the firms solicit and effect transactions in debt and equity securities (including non-US securities and non-dollar denominated securities) with any US investors, or seek to provide investment advisory services to US investors, including institutional investors such as QFIIs. Therefore, to the extent that a QFII is a US institution, Chinese securities firms, custodial banks and fund management institutions, should consult with experts in U.S. securities regulation to ensure that accounts for QFIIs are solicited and established in a manner that complies with US regulatory requirements.
7 Subject to relevant restrictions on investment scope set forth in QFII related regulations, such services shall be conducted according to the Trial Measures for Fund Management Companies to Provide Asset Management Services for Specific Clients.
8 See endnote 1.
This article was originally published by Bingham McCutchen LLP.