On September 24, the Supreme People's Court issued a notice: Cases involving civil compensation due to insider trading, fraudulence and market manipulation on the securities market should not be accepted for the time being.

The notice immediately evoked strong responses from investors, securities circles and the legal community. It is illegal activities on the securities market that have done the most damage to small and medium investors. The institutional defects concerning civil compensation on the securities market have aroused unprecedented concern.

Unregulated actions have often occurred on China's securities market. Companies fabricate false accounts and release phony information, and major shareholders appropriate corporate funds and jointly manipulate stock prices. Before the Supreme People's Court issued the notice, many cases had arisen in which investors sued listed or intermediary companies for illegal operations, which inflicted property losses on investors.

On April 25, the China Securities Regulatory Commission (CSRC) investigated and dealt with four companies that jointly manipulated the stock price of Guangdong Yorkpointso Ltd. From October 5, 1998, the four companies bought and sold the company's stock among themselves by using 627 individual and three institutional stock accounts. The stock price of Guangdong Yorkpointso was thus artificially pushed up from 5.6 yuan (US$0.68) in August 1998 to 126.31 yuan (US$15.28) in February 2000, the growth reaching 21.5 times at the highest. Guangdong Yorkpointso became the first stock surpassing 100 yuan (US$12.1) on the Chinese stock market. By February 5 this year, the four companies had made 449 million yuan (US$54,312,326) in profit. The CSRC confiscated the 449 million yuan in illegal income from the four companies, plus an additional 449 million yuan in fines. Many people holding the stock suffered losses of various degrees, some as high as 700,000 yuan (US$84,674).

In early August, Guangxia Industry, a listed company known for its outstanding performance, was exposed by the media for disclosing phony information. In two years, Guangxia created dazzling records in terms of both stock price and performance. In the year 2000, its stock price rose 440 percent, ranking first on both the Shanghai and Shenzhen stock exchanges. Its capitalization exceeded 10 billion yuan (US$1,209,628,644). However, everything concerning the company was false. Guangxia made up export contracts, fabricated the list of exports, boosted performance, created false annual reports and disclosed phony information. In early August, the company was suspended from trading for one month. When trading resumed, stock prices plummeted for 15 consecutive down limits from more than 30 yuan (US$3.63) to about 5 yuan (US$0.6), setting a record on the Chinese stock market. According to the mid-year report, by the end of June, Guangxia had a total of 14,245 shareholders.

Following Guangxia Industry, was picked up by the CSRC. Less than 18 months after the initial public offering (IPO), major shareholders had almost "eviscerated" the assets of the company. By May 31, major shareholders and associated companies had appropriated more than 2.5 billion yuan (US$302,407,161) of the company's funds, which accounted for 96 percent of its net assets. As a consequence, the interests of small and medium investors had been seriously infringed upon and the asset safety of the listed company was directly threatened.

According to the China Securities News report, preliminary statistics show that since 1999, the CSRC has put 220 illegal actions on file. Administrative sanctions have, so far, been imposed in 92 cases, with fines and confiscation totaling 1.49 billion yuan(US$169,348,010).

Who Should Compensate for Shareholders' Losses?

In the case of Guangdong Yorkpointso, 363 people have collectively entrusted the Zhong Lun Law Firm to carry out litigation, demanding 24.6 million yuan(US$2,975,686) in compensation. The plaintiffs took legal proceedings in Beijing and Guangzhou on September 20. Recently, more than 100 investors also brought a suit against Guangxia Industry at local courts in Shanghai and Wuxi.

Since 1998, when a Mr. Jiang in Shanghai sued Hongguang Industry for causing losses to investors by inventing false information, many other Chinese shareholders sought legal assistance to recover their losses. But, so far, none have succeeded. In Jiang's case, the court overruled his claim, saying that the disclosure of false information did not have a necessary cause-effect relationship with the losses of shareholders. Those who now sue Guangxia and Yorkpointso face the notice of the Supreme People's Court demanding that local courts temporarily suspend the acceptance of similar cases.

Why Are the Cases Not Being Accepted?

Article 108 of the Civil Procedure Law of the People's Republic of China stipulates four conditions for bringing a lawsuit. (1) The plaintiff must be a citizen, legal person or organization that has a direct interest in the case. (2) There must be a definite defendant. (3) There must be a specific claim or claims, facts, and a cause or causes for the suit. (4) The suit must be within the scope of acceptance for civil actions by the people's courts and under the jurisdiction of the people's court where the suit is entertained. In legal terms, these cases meet the conditions for taking action and the court has no reason to refuse to accept them.

Why Does the Court Refuses to Answer These Suits?

According to interpretation of the Supreme People's Court notice, the court now lacks the conditions for trying such cases.

Cao Shouye, a division director of the Supreme People's Court, said there are two reasons for not accepting such cases at the moment. One is related to legislation. The Securities Law provides very abstract stipulations on civil liabilities. As the stipulations are not specific enough, the courts have difficulties applying them. The other is related to the administration of justice. Judicial personnel have unsatisfactory quality, and relevant judicial interpretations are yet to be unveiled.

Cao said that, according to State legal provisions and from the perspective of case filing, the court should accept these cases. However, as cases involving securities disputes are complicated with wide connections and big influence, it is better not to accept such cases for the time being, out of consideration of both the legal and social effects of a trial.

Pitfalls in the System

Law experts pointed out that existing laws are strong on penalizing violators for their administrative or legal responsibilities, and weak on providing civil compensation to investors who suffered losses. To a great extent, this encouraged violators to try their luck while eroding investors' confidence in securities investment. A complete system of securities law should put equal emphasis on civil, administrative and criminal responsibilities.

Law experts also pointed out that, in terms of substantial law, it is commonly recognized that China's Company Law and Securities Law are weak on civil liability. They have no definite principles or methods regarding the assumption of civil liability. Nor do they have stipulations on the criteria to be used to judge the cause and effect between shareholders' losses and insider trading, fraudulence and market manipulation. Therefore, civil liabilities as stipulated in Company Law and Securities Law are futile in deterring violators.

Second, in terms of the right of action, China has yet to establish a shareholders' representative litigation system. Article 111 of Company Law said, "When the decisions made at a shareholders' meeting or by the board of directors violate laws, administrative regulations and the lawful rights and interests of shareholders, the shareholders have the right to file a lawsuit at the people's court asking it to stop those acts of infringement." But the same stipulations did not grant shareholders the right to seek compensation from the board of directors, concerned directors or infringers. Nor do they stipulate that compensation should be made to those shareholders. When major shareholders harm a listed company, the company's board of directors would not investigate its own responsibilities, but small shareholders do not have the right or the incentive to file a lawsuit on the company's behalf.

Third, in terms of litigation, there is no class action in China. Although Article 55 of the Civil Procedure Law stipulates the majority litigation system, it is difficult to put it into practice. The cost of a lawsuit is too high for small shareholders and therefore, even if they win, the compensation they received would not cover legal costs. In practice, there have been no successful cases of this type.

Fourth, a court's decision on a civil case in China does not have a "spillover" effect. The obligees of the same case cannot benefit from the court's decision if they did not register for the lawsuit, even if they sustained losses. In the case of the Yorkpointso lawsuit, only a certain number of representatives filed it. If the court's decision is in their favor, only those 363 shareholders who filed the lawsuit can benefit from the court's decision. Other shareholders, if they also want compensation, must file another lawsuit.

Basically, it is because there are no appropriate existing laws that the court has to turn down the request for a trial.

Protection of Small and Medium Investors

There are tens of millions of shareholders in China, and it is a pity that the legal system hardly provides any real protection for such a large number of medium and small shareholders.

The attorney of the plaintiff of the Yorkpointso case said bluntly that the current regulatory system couldn't provide enough protection to investors. It is only satisfied with providing information to investors, and educating them about the risks of the stock market.

Experts believe a civil compensation mechanism must be introduced into China's stock market. It must be operative, and not merely explain policies to shareholders. "We must also make new breakthroughs in legislation and the administration of justice," they suggest. "For instance, to make provisions on civil liability in the stock market, we need to revise the Securities Law, formulate rules of its implementation and work out related judicial interpretation. Besides, we must consider establishing a system of shareholders' representative litigation and class action." Some experts maintained that misconduct on the market could be treated as a special act of infringement, and its civil liability should be defined so that it is convenient to be tried.

Regarding the burden of proof, some experts maintained that since it is always difficult, and often impossible, for small shareholders to submit evidence, the court could reverse the process, asking the accused to provide evidence that they are not guilty.

To ensure civil compensation, some experts suggested that a securities damage compensation fund be created, coming from the unlawful earnings of violators and kept by financial institutions designated by the securities regulatory department or the court. The fund is to be used for making payments to investors who suffered losses. When such investors claim their rights in a class action, the custodian will pay compensation to the victims in accordance with the decision of the court.

A center for the protection of the rights and interests of medium and small investors is being created. Progress is being made in such technicalities as the form of organization and the qualifications of subject of procedure. As a non-profit organization, it will buy stock on the market and become shareholders of all listed companies. Once an infringement occurs, this organization will assume the position of a litigation representative, and bring a lawsuit against the infringing party, claiming civil compensation. The final court decision is effective to all small shareholders that suffered losses.

How Long Shall We Wait?

Zhou Xiaochuan, Chairman of the CSRC, recently reiterated that the CSRC encourages investors to use legal means to protect their rights and interests. Meanwhile, there are more and more calls for the improvement of the civil compensation system on the stock market. With such public opinions, how long will the case remain unacceptable to the court?

Wu Xiaoqiu, Director of the Finance and Securities Research Institute of the Renmin University of China, said that such lawsuits are reasonable, understandable and legal, that there is no reason whatsoever to refuse them. Although the court's refusal to accept the case for the time being is understandable, it won't be indefinite. He said, "Now that people have realized that there are legal pitfalls in the securities civil compensation system, we must make the best use of our time to improve the legal system. We should not stall for time, or it would be unfair to investors, and would hamper the development of China's capital market, as well as construction of the legal system."

Wu also said, "I think investors should keep their evidence. The court will sooner or later accept their cases, and I believe that day wouldn't be far away."

Cao said the Supreme People's Court has recently begun to study and draft documents giving judicial interpretations to the Securities Law. This would pave the way for shareholders to sue for civil compensation. In his optimistic estimation, the documents will be finalized next year.

According to China's existing laws and regulations, the plaintiff will face the problem of prescription of action, which is normally two years. Will this announcement of the Supreme People's Court postpone investors' accusations against the listed company? This is an issue of common concern at present.

Cao said this is a possible problem. But if the judicial interpretation comes out, and the lawsuit has passed the prescription of action according to the general rules of the civil law, the case would be dealt with as an exception. The issuing of this announcement by the Supreme People's Court would not hamper protection of the lawful rights and interests of shareholders and investors.

(Beijing Review November 29, 2001)