Chinese Supreme Court's Commitment to Strengthen Investor Protection

The Supreme Court of China (the Supreme Court) recently issued the National Civil Commercial Trial Work Meeting Minutes (the Meeting Minutes, in Chinese “九民纪要”) which immediately invites heated discussions in the financial market. The Meeting Minutes is a summary of principles that the Supreme Court would refer to when deciding on thorny issues related to commercial legislation and regulation which have been vehemently discussed but remain ambiguous. Despite being a civil law jurisdiction where courts in China are not bound by case precedents, judicial guidance issued by the Supreme Court such as this Meeting Minutes would play a critical role in the nationwide judicial system.

The Meeting Minutes comprises of altogether 12 sections and 130 articles. Among them, the fifth section “Disputes on protection of the Financial Consumer Rights” is the most relevant to the asset management industry.

Overview of the Fifth Section

The main views of the Supreme Court are summarised as follows:

Defining suitability obligations

Suitability obligations are defined as the obligation on managers or distributors of the financial products to ensure the suitability of the recommendation or solicitation they made to investors in all circumstances, taking into account investors’ investment objectives, risk tolerance, financial profile, and other information of which the managers or distributors are or should be aware through the due diligence process. More importantly, the Meeting Minutes stresses that the investors will assume relevant risks and responsibilities only if the managers or distributors have duly performed their suitability obligations.

Based on this pre-requisite, investment risks may now be borne by managers or distributors if they have committed negligence or fraud when carrying out the suitability assessment.

Joint and several liabilities

According to the Meeting Minutes, where financial investors participate in mismatched high-risk investment activities and suffer consequential losses due to the inept performance of investor suitability assessment by the manager or the distributor, they may request either the manager or the distributor to bear the corresponding liabilities and pay compensation by filing a court application.

It is worth noting that the investors are also entitled to hold both parties jointly and severally liable pursuant to Article 167 of General Rules of the Civil Law. Article 167 stipulates that “Where an agent knows or should have known that the object of the mandate is illegal but still performs it, or the principal knows or should have known that an agent's performance is illegal but fails to raise any objection, the principal and the agent shall be jointly and severally liable.”

The Meeting Minutes reflect that the court’s focus is on whether the manager (being the principal) and distributor (being the agent) have fulfilled their respective duties in selling the financial product and whether either party is negligent or reckless. In the absence of a detailed risk allocation mechanism, the possibilities for the managers to bear risks are high. In light of the possibility of vicarious liability, we suggest the managers be cautious when engaging distributors and prepare a more robust distribution agreement beforehand.

Discharge of suitability obligation

Normally, investors are required to give representation in the fund contract or state in a separate undertaking letter in handwriting to confirm that they acknowledge, understand and are willing to take all the risks involved in the investment. However, the Meeting Minutes stresses that, this kind of representation or handwriting statement alone is no longer sufficient to discharge managers from its suitability obligation.

Courts will now use a hybrid standard for the assessment. In other words, courts would now consider objective standard of a reasonable person as well as a subjective standard, i.e., the specifics of the financial product and characteristics of the investor to ascertain whether this particular investor is able to make an informed evaluation of the potential profits and risks involved.

A case has been cited by the Supreme Court when explaining this rule. In that case, a street vendor was “allured” to purchase wealth management products, who signed all the requisite forms without being adequately informed of the risks involved by the manager or distributor. When adjudicating the dispute where this street vendor claimed to rescind the contract and take back his money, the court took the view that the street vendor was not in a position to truly understand risks of the product without the aid of the manager or distributor, and therefore leaned towards the street vendor rather than the manager.

Following the adoption of hybrid standard, robust representations and warranties as well as risk disclosures from the managers or distributors would certainly facilitate the investors to make an informed decision. In addition, the managers are encouraged to customize their suitability assessments and explanations of the terms of financial products and risks for investors based on ages, educational background and investment experiences.

Burden of Proof

According to the Meeting Minutes, once the investor is able to prove its purchase of the financial product and the loss suffered, the burden of proof will then shift to the manager. The manager must prove proper performance of suitability obligation in order to exonerate itself from liability, except where the losses are attributable to investor’s own fault such as intentionally providing false information or failing to accept the manager’s advice which results in unsuitability.

The allocation of burden of proof demonstrates the Supreme Court’s inclination on investors protection and also underlines the importance for the managers to keep the whole client identification and suitability test traceable.

Key Principles to be adopted in the trial of civil and commercial cases

Aligning with the Supreme Court’s commitment to strengthen investor protection, the Meeting Minutes embodies three key principles that the Supreme Court would adopt in deciding disputes between investors and the managers and/or distributors:

“Under the premise that the seller has fulfilled its obligations, the buyer should bear the responsibility”

The principle of investment risks allocation in the Chinese financial market has evolved from “let the buyer beware and assume relevant risks on its own” to “under the premise that the seller has fulfilled its obligations, the buyer should bear the responsibility”. The evolution reflects the views of regulators and judiciary that the buyer’s assumption of investment risk is contingent upon the seller’s due performance of its obligation during the sales of financial products.

“Protecting financial consumers”

Unlike the U.S. and European markets where most securities investors are institutional investors, there are a large number of individual investors directly participating in the financial market in China. Considering their relatively disadvantaged position due to the lack of experience, information and imbalanced bargaining power, it justifies why individual investors are accorded more protection in the Chinese judicial system.

“It is meaningful to make reference to rules issued by financial regulators”

The courts are encouraged to make direct references to the rules issued by financial regulators such as China Securities Regulatory Commission (CSRC) and Asset Management Association of China (AMAC) and apply them in contractual disputes even though these rules technically would only be enforced by way of administrative enforcement and do not have the effect of law.

Considerations for negotiating the fund contract

We recommend the managers consider the following points in drafting commercial arrangements.

Delineation of responsibilities

Delineating the responsibilities of the manager and the agent and specifying that the manager will not be responsible for any acts beyond the scope of the agency in the agreement would protect the manager from being held vicariously liable for the agent’s act.

Proper exculpation and indemnification clauses

Adding exculpatory and indemnification clauses in the agreement, under which the manager would be exculpated from the agent’s acts and the agent is liable to compensate the manager for any loss suffered, provided that there is no gross negligence, wilful misconduct or fraud on the part of the manager. These clauses would serve as an extra safeguard to insulate the manager from liabilities arising from agent’s acts.

Selection of arbitration over court

Arguably the Meeting Minutes serve as a guidance for courts of local levels but not arbitrators, they signal what approach that the lower courts are likely to take when facing similar issues.

On the other hand, arbitrators would generally respect free will of contracting parties, in the absence of a clearer mandatory rule, than leaning towards the investors over the managers.

To conclude

The Meeting Minutes not only shed light on the devotion of Chinese judiciary in enhancing investor protection, but also have important implications for the financial market and the legal professional community. The main takeaway for asset management industry is to beware of its obligations and be discreet when performing the investor suitability assessments and, not the least, contracting with agents.