Member Article

On 24 August 2006, the China Securities Regulatory Commission ("CSRC"), People's Bank of China ("PBOC") and the State Administration of Foreign Exchange ("SAFE") jointly issued new regulations, the "Measures for the Administration of Investment in Domestic Securities by Qualified Foreign Institutional Investors" (the "New QFII Rules") that govern the regime allowing qualifying foreign institutions approved by the CSRC as Qualified Foreign Institutional Investors ("QFIIs") to invest in China A shares and other Renminbi ("RMB")-denominated securities in the People's Republic of China ("PRC") subject to the grant of investment quotas by SAFE. The New QFII Rules supersede the original QFII rules that were in place since 2002 and took effect from 1 September 2006. The CSRC also issued a notice relating to the implementation of the New QFII Rules (the "Implementing Notice") that took effect from the same date. On 27 September 2006, the CSRC issued a set of Q&A (“CSRC Q&A”) which highlighted the objectives and emphasis of the New QFII Rules. The amendments to the QFII rules aim to attract long term capital and to enhance regulation of investments in PRC. The New QFII Rules favour foreign fund management companies and insurance companies, as a matter of policy, by lowering their qualifying criteria whilst maintaining the same criteria applicable to foreign securities companies and commercial banks as in the original QFII rules. At press time, SAFE has not issued any corresponding set of rules detailing the foreign exchange requirements with the issue of the New QFII Rules, therefore the previous set of SAFE rules which has not yet been abolished would technically still apply. However, there are some clear contradictions of the existing SAFE Rules and the New QFII Rules. It is expected that SAFE will soon issue a new set of SAFE rules that will clarify the position. Background By way of background, the PRC authorities intended the QFII regime to attract long-term investors to invest in the China domestic securities market. The original QFII rules expressly stated that priority would be given to QFII applicants which manage closed-ended China funds, pension funds, insurance funds and other professionally managed funds. This intention continues to be reflected in the New QFII Rules which expressly state that applications from qualifying institutional investors that are pension funds, insurance funds, mutual funds, charitable funds and other long term asset management institutions will be given priority with a view to encourage mid to long term investments into China. The original QFII rules contained restrictions, including a capital lock-up period of between one to three years limiting repatriation and other operating restrictions that posed difficulties to fund managers operating investment funds, in particular open-ended investment funds. Most of the first QFII applicants were securities companies and investment banks. In the CSRC Q&A, it was recognised that the original QFII rules which allowed a QFII to open only one sub-account with the PRC securities registration and settlement house ("PRC Clearing House") caused problems including that proprietary assets of a QFII were not segregated from the assets of its underlying customers which did not comply with domestic and foreign regulatory requirements, and that the structural need of QFIIs which are fund management companies in setting up several public funds was not satisfied. In addition to other less substantive changes, the New QFII Rules and the Implementing Notice introduce the following significant changes addressing some of these problems: Lowered Qualifying Criteria The qualifying criteria in terms of assets-under-management ("AUM") for QFII applicants that are fund management institutions has been reduced from US$10 billion to US$5 billion in the most recent financial year, although the requirement to have operated fund management business for over five years remains. This will enable more fund management companies to apply on their own for QFII approval and QFII quota instead of relying on third party QFII quotas for their China-focused funds or investing indirectly through structured products. The qualifying criteria for insurance companies is changed from at least US$10 billion in AUM to at least US$5 billion in securities assets held in the most recent financial year. There is no change to the qualifying criteria for securities companies and commercial banks. In addition, while the old rules did not specifically cater for other categories of institutional investors, it is now provided in the Implementing Notice that other institutional investors (pension funds, charitable funds, donation funds, trust companies, government investment companies) are subject to the qualifying criteria of having been established for at least five years and having AUM or having a securities portfolio with at least US$5 billion in the most recent financial year. Opening of sub-accounts Under the New Rules, each QFII is now allowed to hold multiple securities sub-accounts with the PRC Clearing House that correspond to respective multiple RMB special accounts. The securities sub-accounts may be opened as direct accounts or nominee accounts. It is provided in the Implementing Notice that nominee accounts should be opened for customers to whom the QFII provides asset management service. Where the QFII establishes a securities account for public funds, insurance funds, charitable funds, donation funds, government investment funds or other long-term investment funds under its management, the account may be opened in the direct name of "QFII+fund". It is further expressly provided that assets in such account belong to the relevant fund and are independent of the QFII and the custodian. These are significant developments as the original QFII rules under which a QFII was required to appoint a PRC custodian and open one RMB special account and only one securities account with the PRC Clearing House. Proprietary investments of a QFII through its QFII quota had to be commingled in the same account with assets of the QFII's customers and investors investing through its QFII quota. Such an arrangement raised issues of custody risk as the proprietary assets of the QFII were not segregated from the assets of the underlying customers, and also as between the assets of one customer and other customers of a QFII. One aspect of the risk was that the assets of QFII's customers may be less protected, in the event of the default of the QFII from claims of the QFII's general creditors. Moreover, the QFII may use the A shares or other permissible securities held for the account of one customer to settle trades entered into by the QFII's other customers. In this regard, the New Rules go some way to reducing the custody risks and address the issue of segregation of assets between a QFII and its customers and among the sub-accounts for different funds and customers. In the CSRC Q&A, it is mentioned that these amendments aim to satisfy both domestic and overseas regulatory requirements. It should be noted that a QFII is required to file reports on the underlying investors for whom it maintains the nominee accounts and on the investment activities of such investors through such accounts. The New QFII Rules also recognise the interests of underlying investors investing through QFIIs in providing that QFIIs may appoint the actual beneficial investors to exercise shareholder rights with respect to underlying investments, and that as nominee for beneficial investors, a QFII may use its votes in part and may cast its votes in different ways according to the interests of the underlying beneficial investors. Remittance and Repatriation The New QFII Rules do not set out the specific requirements with respect to remittance and repatriation, but instead provide that remittance, repatriation and any lock-up period shall be as adjusted by SAFE based on the economic and financial situation of the PRC, foreign exchange balance of payments and according to arrangements set by the PBOC. Notably, the previous rules on lock-up periods and repatriation limits in the original QFII rules issued by the CSRC are abolished. Hence there are at present no longer any rules in place that impose those lock-up periods and repatriation limits. The policies and rules that SAFE may adopt with respect to remittance and repatriation going forward will be critical, as the original QFII rules contained rather stringent requirements and restrictions with respect to the inward remittance of QFII investment amount, lock-up period and outgoing repatriation, much of which caused difficulty for the liquidity needs of fund managers in operating investment funds, particularly open-ended funds. As noted above, SAFE has yet to issue any supplemental regulations or notice with respect to the New QFII Rules that specify the remittance and repatriation requirements. However, based on previous proposals and amidst industry lobbying on the issue, we expect that SAFE is likely to adopt a pragmatic approach particularly with respect to the remittance and repatriation arrangement for open-ended investment funds and other similar investment bodies. For instance, the lock-up period may be reduced to three months for open-ended investment funds and similar investment bodies, and in recognition of the nature of open-ended funds, the three months lock-up period may start to run from the time a certain minimum amount of the QFII quota has been remitted (rather than the full QFII quota) and thereafter, remittance and repatriation may generally be made freely according to net subscription and redemption requirements of such funds. In the CSRC Q&A, it is stated that the principal lock-up period for pension funds, insurance funds and mutual funds (being “long term capital”) would be lowered to 3 months, and for other types of capital, the lock-up period would remain at 1 year. Investment restrictions Previously: (a) each QFII may not hold more than 10% of the total outstanding shares in one listed company; (b) total shares held by all QFIIs in one listed company should not exceed 20% of the total outstanding shares of the listed company. The original rules also required that QFIIs disclose their interests in listed companies in accordance with relevant rules and in this connection to take into account domestic (ie. A shares or B shares) and overseas shares (ie. H shares) of the same company as well as interests in convertible bonds and depository certificates. The restrictions are revised as follows under the New QFII Rules: (a) each underlying offshore investor investing through QFII may not hold more than 10% of the total outstanding shares in one listed company (but excluding strategic investment by such offshore investor in accordance with the "Regulations on Strategic Investment in Listed Companies by Offshore Investors"); (b) all offshore investors may not hold more than 20% of the total outstanding shares in one listed company. The restriction in paragraph (a) now looks at the interest of the underlying offshore investor instead of the QFII itself. This would apply to investments held through one QFII or all QFIIs through which the relevant investor invests in the spirit of disclosure of interests in listed companies under relevant rules. There is no substantial change in the permitted investments under the New QFII Rules, except that it is now expressly provided that investments may be made in securities investment funds and warrants. Permitted investments include domestic listed securities, listed bonds, securities investment funds, listed warrants and other RMB-denominated securities that the CSRC may approve. QFIIs may also participate in initial offerings of shares or convertible bonds and to subscribe for share placements. Reprise The New QFII Rules contain significant improvements from the original rules, particularly for funds and fund management companies wishing to invest in the PRC domestic securities market through the QFII regime. The lead up to the issue of the New QFII Rules had already attracted much interest and applications from fund managers for QFII quotas, and it is expected that there will be more activities in this sector. The positive changes under the New QFII Rules open the way to the development of more China investment fund products. The recognition of the interests of underlying investors investing through QFII schemes in listed companies better reflects the spirit of the disclosure of interests requirements and hopefully increases the ability for underlying investors to exercise shareholder rights meaningfully which may assist in enhancing the corporate governance of PRC listed companies. © October 2006