Legal compliance obligations under National Nine Articles

One of the hottest topics in the contemporary capital market is the promulgation of Several Opinions of the State Council on Strengthening Regulation, Preventing Risks and Promoting the High-Quality Development of the Capital Market, known otherwise as the new National Nine Articles.

This column analyses the legal enforcement of the new articles, exploring their impact on the obligations of different market participants and the potential changes they may face.

Fraudulent stock offerings. With the longstanding regulatory framework of “accountability based on application”, the new articles further expand the scope of on-site inspections for companies under review. According to various media reports, nearly all pending IPO applications are now subject to such inspections. These combined measures are expected to increase the exposure of pre-existing violations at the time of application.

Illicit share entrustment, penny stock trading and tunnelling. These violations, although not uncommon, have historically received varying levels of regulatory attention. While share entrustment has been regulated by rules concerning information disclosure, penny stock trading and tunnelling have not previously been primary focal points. The necessity for stronger regulatory oversight in these areas is evident, although identifying such violations in practice may prove challenging.

Financial fraud and fund misappropriation. There are a variety of illegal activities committed by listed companies. Information disclosure violations may stem from multiple causes, such as financial fraud, fund misappropriation and illegal guarantees. The new articles continue to prioritise the two most egregious violations: financial fraud and fund misappropriation. Financial fraud typically involves inflating profits, while fund misappropriation usually entails draining company resources through fictitious transactions.

Market manipulation and insider trading. To avoid delisting and to inflate stock prices for major shareholders selling shares, some listed companies may collude with market institutions to manipulate the market under the guise of market value management. The new articles aim to curtail such practices. Nevertheless, legitimate market value management should remain encouraged, as a well-functioning mechanism enhances the quality of listed companies and yields better returns for investors.

Circumvention of delisting. Among all the causes of delisting, it is financial distress or low market capitalisation that are the most common. Some listed companies may resort to financial fraud to avoid triggering their delisting criteria, or collude with market entities to manipulate stock prices above a face value of RMB1. By creating a higher level of scrutiny of these activities, the new articles aim to eliminate low-quality listed companies from the capital market via the delisting mechanism.

Market manipulation and malicious short selling. Following on from stock market turbulence in 2015, the National Nine Articles reiterate the importance of thoroughly investigating market manipulation and malicious short selling cases. They also emphasise the need for improving standards for monitoring abnormal trading and market manipulation, as well as promulgating regulations regarding algorithmic trading.

Compared to mature capital markets with a significant presence of high-frequency trading, the Chinese market is dominated by retail investors. Therefore, it is crucial to establish clear and scientific standards to allow legitimate high-frequency trading and stimulate market activity without enabling market manipulation.

Illegal share selling. After the 2015 market turbulence, illegal share selling was penalised under the Securities Law, with fines typically around 10% of the total amount sold. The new articles have adopted more stringent measures, expanding the types of illegal share selling, increasing the rate of fines (as seen in the Viti Electronics case, the fine reached about 30% of the amount sold) and implementing mandatory share buybacks .

Investor compensation. Aside from a few state-owned enterprises that offer investors the option of cash compensation through a voluntary delisting system, most delisted companies have left their investors with irrecoverable losses. The new articles stipulate that, in cases of delisting due to major violations, the controlling shareholders, actual controllers, directors and senior executives of delisted companies will be held liable, and must provide effective compensation to investors.

Co-ordination between administrative and criminal proceedings. The new articles focus on improving the efficiency of co-ordination between administrative and criminal proceedings. After the imposition of administrative penalties for securities violations, the China Securities Regulatory Commission will transfer cases reaching the criminal prosecution threshold to the Securities Crime Investigation Bureau under the Ministry of Public Security.

Historically, the time from the imposition of an administrative penalty to taking compulsory measures by public security authorities ranged from six to 18 months.

This is expected to be substantially shorter with the National Nine Articles in place.

Representative action. The representative action (class action) system has been in place for several years, yet its application has been limited. In practice, it is impacted by objective factors such as a defendant’s solvency, and the court’s workload and human resources. The new articles advocate broader application and the author expects a significant increase in representative action cases in future.

Blacklist of intermediaries. Intermediaries were subject to a collective punishment system, where an administrative investigation into one project could lead to the suspension of similar business activities across an entire institution. This restriction was lifted in early 2023. Under the new articles, this year several accounting firms have faced suspension from providing securities services.

In summary, the National Nine Articles portray a long-term vision for the capital market by focusing on stringent regulation, risk prevention and promotion of high-quality development. Under the “teeth and thorns” system, as well as rigorous and stringent regulation, market participants should exercise self-discipline and diligence to deliver returns for investors.

Liu Siyuan is a senior partner at Jingtian & Gongcheng. She can be contacted by phone at +86 10 5809 1385 and by email at [email protected]