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Capital Markets and Legal Development: the China Case
By Zhiwu Chen∗
Yale School of Management
September 12, 2003
Abstract Recent research establishes a significant positive correlation between law and finance (and hence economic growth), re-starting a debate on the “law matters” thesis. However, which way the causality goes is still not clear. The purpose of this paper is to use the on-going reform experience of China, especially its capital market experience, to examine the direction of causality. First, we show that China’s recent experience is largely consistent with Coffee's (2001) "crash-then-law" interpretation of this correlation. Indeed, it is the large and clearly defined constituency of investors that has been a key driving force behind much of the recent legal progress. The rights and economic interests of this constituency have fundamentally challenged the traditional emphasis of the Chinese legal culture on administrative and criminal sanctions, but not on civil litigation law. Second, we compare the different contributions to legal change made by the stock market and the consumer product markets. We argue that capital markets are perhaps the most conducive to the formation of a politically powerful constituency and hence more aggressive legal change, because of (1) the higher degree of commonality among interested parties and (2) immediately measurable and tangible damages. These two characteristics not only allow investors to identify with each other more easily, but also create an ideal basis for more debate in the media, which in turn promotes the development of a legal culture. Key words: law and finance, legal reform, shareholder rights, product liability, capital market development, economic development.
∗ Zhiwu Chen is a Professor of Finance at the Yale School of Management, 135 Prospect Street, New Haven, CT 06520, USA; [email protected]. The author would like to thank the editor for this issue, Belton Fleisher, for his patience and encouragement, Donald Clarke, Andrei Shleifer and Steve Yun for their comments and suggestions, and SHI Minglei, WANG Yonghua, XIONG Peng, Steve Yun, and ZHOU Feng for helping with the data and case collection. Any remaining errors are the author's responsibility alone.
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1. Introduction A central thesis in the law and economics literature is that law matters for economic and
market development. According to this thesis, the existence of a legal system that
protects contract and property rights is a precondition for economic development because,
without such a system, the lack of certainty about who will stand to benefit from
otherwise beneficial transactions and/or investments will simply inhibit such transactions;
Or, if they occur, the costs of doing so will be unacceptably high (North 1990).1 Thus,
absent of such a legal order, markets cannot develop and economic growth will stall.
Recently, a sequence of provocative research by La Porta, Lopez de Salines, Shleifer and
Vishny (1997, 1998) (LLSV hereafter) has shifted the focus of the "law matters" debate
to capital market development issues. Using a large database of various institutional and
economic variables for a cross section of countries, LLSV show that the degree of
protection a country's substantive law provides for outside shareholders/security-holders
has a significant bearing on the depth and liquidity of its capital markets: stronger legal
protection for minority shareholders is associated with deeper and more liquid capital
markets and with less concentrated share ownership. 2 In effect, they argue that deep
capital markets cannot be developed unless shareholder-friendly fundamental legal
reforms are adopted as a precondition.
A consensus in the literature is that law clearly matters for market development,
especially after a market reaches certain mature stage. Market-friendly law is a desirable
good. But, how does a country get to that point? How does legal change arise to prepare
for sustained growth? ---- While not questioning the correlation between capital market
depth and legal protection for shareholder rights, Coffee (2001) offers the opposite
interpretation of the above correlation: market development precedes, rather than follows,
shareholder-friendly legal reforms. His argument is based on the historical fact that
1 See Clarke (2003) for a discussion of the "property rights matter" thesis based on recent experience in China. 2 See Shleifer and Vishny (1997) for a comprehensive survey, and Ohnesorge (2003 this issue) for discussions on how this literature may benefit from the recent experience of China. The "Law matters" thesis for securities market development has prompted much new research and debate in law and economics. Responses and hypotheses from the law literature include Black (2001), Cheffins (2001), and Coffee (2001).
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"Although securities exchanges have existed since the seventeenth century, exchanges
primarily traded debt securities up until the mid-nineteenth century. Then, over a
relatively brief period and at a time when the private benefits of control were
unquestionably high, dispersed ownership arose in both the United States and the United
Kingdom - largely in the absence of strong legal protections for minority shareholders,
which came afterward." Coffee further comments that "this sequence makes obvious
political sense: Legal reforms are enacted at the behest of a motivated constituency that
will be protected (or at least perceives that it will be protected) by the proposed reforms.
Hence, the constituency (here, dispersed public shareholders) must first arise before it can
become an effective lobbying force and an instrument of legal change."
Two questions then come to mind. First, how does such a constituency arise in a market
growth process? Second, which types of market or economic activity are more conducive
to legal development? In a broad sense, since there are different markets (e.g., securities
markets, consumer product markets, labor markets) and since all these markets may be
simultaneously developing in a country, it may be true that not all of them lead to the
creation of equally powerful constituencies. If that is the case, which types of market tend
to create constituencies that are the most effective in causing legal change? Clearly, the
answer will differ from country to country, depending on a country’s own pre-existing
context. If there are general characteristics about the types of economic activity that are
the most conducive to legal change, understanding them will help shed new light on the
interactive dynamics between law and economic development.
The purpose of this paper is two-fold. First, we show that Coffee's (2001) "crash-then-
law" interpretation of both the above mentioned correlation (between law and finance)
and the capital market history in the United States and the United Kingdom is largely
consistent with the on-going reform experience in China.3 For young markets, it is
economic development that precedes legal change, rather than the other way around.
Unlike Russia and other East European countries that took a shock-therapy approach to
3 See Boycko, Shleifer and Vishny (1997) for discussions on transition and legal adaptation experience in Russia.
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economic transition, from 1978 onward China has adopted a gradual trial-and-error
approach to transform its planned economy into a market-oriented one, starting with the
agricultural sector. After its success with reforming the agricultural sector in the early
1980’s, China began to re-structure its state-owned industrial enterprises into joint-stock
corporations, and first opened the Shanghai Stock Exchange in December 1990 by letting
several former state-owned firms go public. While the Chinese stock market has helped
former state-owned enterprises raise capital from the public, its impact on legal change
has perhaps been even more significant. The experience is one of true “crash-then-law”.
Second, we compare the different contributions to legal change made by the stock market
and the consumer product markets. In economic terms, the impact of China’s stock
market on the real economy and society as a whole has been marginal, with about 10
million investors, whereas the various consumer product markets have been large in a
country with more than 1.2 billion people. That is, while the stock market may have
directly affected only a small fraction of the population and a small percentage of
Chinese businesses, the consumer product markets have affected much larger proportions
of the population. Thus, the constituency of citizens arising from stock market
development should be much smaller in number than the constituencies arising from
consumer product markets. Yet, the former has been a much stronger force for legal
change . Why is it so?
2. China’s Legal Tradition
A distinctive feature of China's legal tradition is that the legal system is not separated
from, or independent of, the administrative system (e.g, Jones (2003) for an excellent
overview). At least since the Tang dynasty (618-906 A.D.) and until the end of Qing in
1911, the system of government in China consisted of a strong central government
headed by the Emperor, who ruled through a bureaucracy and with absolute power. The
lowest ranking officials at the county level represented the central government and in
effect exercised all of the power of the state, including tax collection, public works, and
even deciding lawsuit cases. Thus, adjudication was simply one of the many
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administrative duties. Since there was no doctrine of the separation of power among
government institutions, the county magistrate's power was virtually unchecked except
that the subjects could technically appeal to a higher level official.
Another distinctive feature is its emphasis on administrative and criminal sanctions, with
a lack of formal development in civil liability and procedural law. The traditional Chinese
view, even as of today, is that the law is an instrument used by the ruler to enforce its
power and authoritative control and to maintain social order. Consequently, as the central
part of the Qing Dynasty's legal system, for example, the Qing Code was a collection of
rules that were predominantly concerned with the official activities and functions of the
bureaucrats within the government apparatus, not with disputes and relationships between
and among private citizens. The imperial law touched upon private matters only as the
matters were thought to affect imperial policies. Thus, the code was primarily of an
administrative nature, and it tended to rely only on administrative and criminal penalties.
This is in sharp contrast with the Roman law tradition, from which western laws are
derived. At the heart of Roman law is civil law, rather than administrative law. Roman
law arose during a time when Rome was a small agricultural society. As a result, the law
developed mostly in response to the occurrence of disputes between private citizens
and/or social groups. Therefore, early on, civil matters occupied a central place in
western laws. As Jones commented, "In China, the subject matter of Roman civil law was
considered only when it affected the interests of the Emperor." (Jones, 2003, p. 13).
Today's legal system in China is not much changed from the dynastic era. The law is still
viewed as an instrument of the ruling class; The judicial system is still treated as part of
the government's administrative system and hence there is no effective judicial
independence; Politics and adjudication are often mixed together; There is still no
officially adopted doctrine of the separation of power. Today's legal system probably
differs from those in the different dynasties, mainly in that after the mid 1980's and as
part of the reform efforts, there have been many newly enacted substantive laws
(particularly in the areas of commercial and civil law) and even a Civil Procedure Law of
1991. That is, there are many more “laws on the books” today than in the various
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dynasties. However, as discussed later, the existence of these substantive and procedure
laws has not fundamentally altered or neutralized the two dominant characteristics of the
legal system mentioned above. Many judges are not trained lawyers, and even a large
number of them, especially in less developed provinces, are former military officers who
had no formal legal training prior to being a judge. Still, since 1978, a substantial legal
framework has been put in place, with institutions that together resemble a western legal
infrastructure (except there is a Communist Party political-legal committee that is super-
imposed on the legal system, controlling the assignment, promotion, demotion and
replacement of judges). It is issues and conflicts arising out of the economic reform
process that have played the critical role of pushing the legal infrastructure to work and
adapt. The economic development process has generated an increasingly larger force for
judicial independence. The on-going case of China is a vivid example of how the “crash-
then-law” process works. We next show that it is the stock market and private securities
litigation that have been central in injecting life into the "laws on the books."
3. Stock Market and Legal Development
Economic reform started in 1978, soon after the end of the disastrous Cultural Revolution.
However, until the mid 1980’s the focus of the reform efforts was on the agricultural
sector, allowing farmers to have a piece of land to grow grain crops and retain whatever
profits the farmer was able to generate. However, no one was given or allocated the
ownership of any land property, and the farmers were just given the usage right for a
short period of time (land usage right was re-shuffled among villagers every few years).
The main objective was to encourage family-based farming and individual responsibility
(rather than collective farming as practiced before the reform started). There was then a
large increase in income and living standard among farmers.
The success in agriculture then started to affect the debate on how to reform the industrial
sector where state ownership was by far dominant. The first experiment in the mid 1980’s
was to apply the individual-responsibility model of farming to industrial enterprises. That
is, an individual manager or a team of managers could assume the responsibility of a
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state-owned enterprise (SOE) for several years, with an annual revenue or profit target;
Profits above the target would be paid to management and workers as bonus. This
responsibility model did not work out, since it promoted mostly short-term behavior by
management. It was then realized that without clearly defined ownership, there would not
be an incentive structure to induce managers to take a long-term view.4 In the late 1980’s,
therefore, joint-stock limited-liability corporations became the new experiment, with
some SOEs converted into joint-share corporations.
3.1. The Stock Market
Preparation was then also under way to start an official stock exchange to trade shares of
the new joint-stock companies. But, private ownership and privatization was political
taboo. In particular, no one would want to be responsible for causing the loss of state
assets. As a political compromise, the reformers proposed to have several classes of
shares: state shares, legal-person shares (only ownable by legal-person institutions and
corporations), and floating common shares (A-shares for domestic citizens only and B-
shares for foreign investors only). In particular, the state shares and legal-person shares
would not be publicly tradable, so that no loss of state ownership would occur. However,
regardless of share type, the holder of a share is entitled to the same cashflow and voting
rights. Today, a typical public corporation has about one third of its shares in each
category of state, legal-person and floating common shares.5 Given that most legal-
persons or corporations are state-owned or state-controlled, about two thirds of most
corporations’ shares are state-controlled directly or indirectly. This ownership structure
has been a major factor behind the difficulties in private securities litigation, because
4 In some sense, state ownership represents an extreme form of diverse ownership as each citizen in the country is supposed to own an equal piece of the firm. Thus, the separation between ownership and control is also extreme. But, there has been no corporate governance structure in place to ensure the functioning of this extreme separation. Since the state controls the management of each SOE and since the government is not democratically elected, there is no institutional infrastructure to ensure that the agents at the various levels all work in the best interest of the ultimate shareholders -- the citizens. Therefore, it is not surprising that the management responsibility model did not work. 5 See Chen and Xiong (2001) for a study on the underpricing structure of legal-person shares. They show that because these shares are not tradable, they are priced at an average discount of 86% to the otherwise identical floating common A-shares. This pricing and liquidity distortion is also a source for corporate governance problems.
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granting damage awards in private litigation would amount to the loss of state assets (to
the extent that the state owns a majority of the shares outstanding), which puts the court
in a conflicted situation.
Besides the state-dominated ownership structure, another obstacle blocking private
securities litigation is ideological. The traditional communist view was that only income
through labor is rightly acceptable. Though the Shanghai Stock Exchange opened in
December 1990 (followed by the Shenzhen Stock Exchange two months later), this
official line on rightful income remained in the Communist Party charter until November
2002, when the 16th Party Congress changed the charter to officially acknowledge that
acceptable income can be earned through both labor and capital (i.e., monetary capital,
intellectual capital and managerial capital). Therefore, until late last year, Communist
Party members were officially not supposed to buy or trade stocks; Otherwise, any
income from holding stocks would not be legitimate. This ideology was of course
contrary to the notion of shareholder rights and the protection thereof, which has been
partly responsible for the slow implementation of the Securities Law and the Company
Law of the People's Republic of China (PRC). It has been an obstacle between law on the
books and law in action. The question is again: what led to the removal of this obstacle
last year? How did China eventually move the law off the books and into action, at least
to some extent?
To answer these, we should keep in mind that the very justification for starting a stock
market in China was to help the SOEs raise capital from the general public and solve the
money-losing SOEs’ financial problems, and that it was not to offer the general public a
way to diversify investment portfolios and hedge future consumption/income risks.6 Thus,
shareholder rights were more of an afterthought, which became a concern several years
after stock trading became widespread. One practice that was followed from 1990 to
2000 was that the government adopted a quota system on the number of IPOs for each
6 Walter and Howie (2003) argue extensively that the Chinese government’s determined interest has really been, and will continue to be, to use the equity capital markets as a tool
9
year, so that there would be a planned and orderly sequence of IPOs with no supply
shocks. This idea and practice of a planned growth path have been so much at the heart of
the Chinese modernization process over the past 150 years that it is almost impossible to
do away with (e.g., Goetzmann and Koll, 2002; Kirby, 1995). Another consideration for
the planning was to make the IPO flow low enough, so that IPO prices would be high,
creating an impression of unbeatable IPO demand and setting a perfect environment for
more SOEs to issue shares. In other words, the first task of the government agencies in
charge was to manage and maintain a positive and encouraging market.
At the beginning of each year, the national IPO quota was approximately equally divided
among the 32 provinces and province-level cities. Table 1 shows the number of IPOs for
each year to lie between 13 and 206, with an average of 100 new listed companies per
year. This implies that in a typical year each province would get a quota of about 3 IPOs.
This limited supply of IPO permits clearly made the value of each such permit very high,
and created a huge opportunity for rent-seeking and bribing. Consequently, each
provincial government set up a dedicated Securities Listing Office to both lobby the
China Securities Regulatory Commission (CSRC) for a higher quota and to assist local
firms to prepare for IPO.
For provincial and lower governments, how many local firms they can have publicly
listed has become a major metric of performance, on which future promotion of local
government officials depends. As a result, provincial and lower-level officials are all the
more willing to help local firms manipulate financial numbers or commit un-masked
fraud, all for the purpose of getting more local stocks traded nationally. Or, when local
firms are caught by the media for committing financial fraud or earnings manipulation,
local governments and sometimes even higher government agencies would cover up the
fraud.
of enterprise reform, while other by-products of the capital markets have been more of a side purpose.
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Both of the central government’s bias in helping the SOEs and the local government’s
desire for political performance have not helped to give much weight to shareholders’
interest. From the very beginning, the PRC stock market was biased against shareholders.
Even after a company successfully obtained an IPO permit (usually as a result of much
lobbying and/or bribing efforts), the process of preparing and filing for IPO could easily
take more than two years (true even as of today). The first period in the long IPO process
is the so called “ShangShi FuDao Qi” (the pre-IPO “nurturing” period). This nurturing
period is literally to strip a money-losing SOE into two pieces: the “good” piece (to be
IPOed) and the “bad” piece (to be the controlling shareholder after the IPO of the “good”
piece). This is sometimes the period of creating fake receipts and fake contracts to make
up whatever profits that are needed to meet the IPO requirements. For example, the PRC
Company Law requires a candidate IPO firm to have positive earnings in each of the
most recent three years. Additional CSRC regulations further require the firm to satisfy
conditions on return-on-equity (ROE), before an IPO approval can be granted. These
requirements have forced firms to manipulate earnings and financial results.
After an IPO, the firm again has to satisfy profitability requirements in order to issue
seasoned equity offerings (SEO). For example, over the years, the minimum condition for
an SEO as set by CSRC regulations has gone through various changes: the firm's ROE
had to be (1) positive in the most recent two years, a policy as of 1993; (2) above 10%
based on the recent three years' average, as of 1994; (3) above 10% in each of the recent
three years, as of 1996; (4) above 10% based on the recent three years' average, but at
least 6% for each of the recent three years, as of 1999; (5) above 6% based on some
weighted average for the recent three years, as of 2001. These four policy changes have
each time caused publicly traded firms to adapt their accounting manipulation schemes.
In one study, Lang and Wang (2002) find that for each year before 1994, strangely many
public firms had their ROE just slightly above 0%; Then, between 1994 and 1999, more
than half of the public firms had an ROE lying slightly above 10% but below 12%; But,
from 2000 onward (in particular since 2001), most of the firms had an ROE between 6%
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and 8%. Their study presents perhaps the strongest evidence of market-wide earnings
manipulation, implying that investors have been systematically defrauded.
Another common practice by Chinese public companies is "tunneling", as defined in a
different context by Johnson , La Porta , Lopez de Silanes and Shleifer (2000). That is,
controlling or majority shareholders engage in related-party transactions with the listed
firm, usually with the latter buying worthless assets from the former at unreasonably high
prices or with the latter lending to the former at favorable rates. As the Chinese magazine
New Fortune has reported, tunneling of shareholder assets is widespread and has led to
calls for regulation and tighter enforcement by the CSRC.7
Given these systematic problems mentioned above, the Chinese stock market still
managed to become the third largest one in Asia based on market capitalization (after
Japan and Hong Kong). As of July 2003, the Shanghai Stock Exchange and the Shenzhen
Stock Exchange together have 1259 companies listed (A and B shares included). The
combined total market capitalization of the companies is over 4 trillion yuan (about $500
billion),8 and trading is active with a monthly turnover rate of 18.2%. About 20% of the
1259 companies are private firms, without the state being the controlling shareholder.
By no means is China's stock market well developed yet. But it does show signs of life.
Table 1 shows the total amount of capital raised in each year. In Table 2, we see that the
amount of capital raised on China’s stock market is, when measured as a fraction of GDP,
lower than the U.S. market but higher than Japan’s and Germany’s, in the 1990’s. It
should be recognized that this period marked the beginning of China’s stock market
(hence one would expect some level of exuberance).
7 See Clarke (2003 this issue). Featured articles on corporate governance issues (in Chinese) can be found at New Fortune's website: http://www.newfortune.net.cn. 8 The exact market capitalization value for all listed companies combined is a mystery because the state and legal-person shares are not publicly traded and hence no reliable price information can be used to value them. The 4 trillion yuan given here is based on the official estimate published on the CSRC website, in which they simply multiply the total number of shares outstanding by the floating A-share price. From Chen and Xiong (2001), it is clear that this is an over estimate of the true value, because the legal-person and state shares are sold in private transfer and auction transactions, at an average discount of 86% relative to the floating A-shares. See also Walter and Howie (2003) for another discussion on this market capitalization issue of China's listed firms.
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The above brief review of the development background illustrates that in the 1990’s and
even today there is not enough ideological acceptance of private ownership and stock
trading, neither is there sufficient protection of property rights. Especially in the early
years, China did not have a legal infrastructure to support capital market development.
However, consistent with the "crash-then-law" hypothesis of Coffee (2001), China started
out without a clear idea of what institutional framework would be needed for a stock
market, but as investors increased in number, a powerful constituency was developing,
which led to a sequence of legal development.9
3.2. The Years Prior to the Securities Law of 1999
China’s stock market was started top-down, with the CSRC and other government
agencies controlling every step of the way in both the overall market development and
the process of a firm’s pre-IPO preparation as well as post-IPO operations. The stock
exchanges are state-owned and managed by government-appointed officials, while the
securities firms are state-owned (or majority-controlled) either directly or indirectly.
Since the beginning of the market, it has been a well known secret that every public
company had been “nurtured financially” and re-packaged just for the sake of IPO, with
widespread practice of making up the numbers so as to meet the listing requirements.
Even with so much known accounting fraud and open market manipulation, private
securities litigation did not arise in significance until 2001 after a sequence of events.
Though the Shanghai Stock Exchange started in late 1990, suing management and
directors and/or other parties for damages was not much on investors’ mind until after a
sustained market downturn started in the middle of 1993. As Figure 1 shows, over the
first year and a half the Shanghai Stock Exchange Composite Index (hereafter SSE
Composite) went straight up from 100 in 1990 to 1266 by May 21, 1992. In particular,
the index went from 617 to 1266 in a single day on May 21, 1992. It was then followed
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by five months of decline. But, that decline did not last long enough to get a substantial
number of investors to call for private litigation against corporate manipulators. In late
1992, the government stepped in to encourage stock trading, re-starting an upward
movement.
In the early 1990’s, even if any investor had wanted to sue for damages, the court would
not have accepted such lawsuits. The only law that shareholders would be able to rely on
up until July 1, 1994 was the PRC General Principles of Civil Law, which provides that
victims of torts are entitled to civil compensation. However, the PRC judiciary had little
experience with tort law in general and securities law in particular, which remains true
today. Legal training was all but stopped during the Cultural Revolution, and then
restarted around 1980.
Furthermore, the legal system is modeled after the Japanese civil-law system, which in
turn was adapted from German law during the Meiji reform period of the 19th century. An
overwhelming theme of Chinese law is that “wei jin pizhun bu ke”, that is, without a
formal written rule from the law or from a legal interpretation by the Supreme People’s
Court (SPC), judges cannot on their own interpret and apply a legal principle to decide
specific cases. Given that at the time when the PRC General Principles of Civil Law was
enacted in 1986 there was not a stock market, it is not surprising that the general PRC
Civil Law did not include securities related provisions until revisions in the late 1990’s.
In principle, before judges can accept any new type of private suit, in general the
National People’s Congress has to first pass a law for the specific area and then the SPC
has to issue one or more detailed legal interpretations. This process can last for five years
or longer.
Nonetheless, while there was no securities law until July 1, 1999, administrative
regulations were introduced to fill in the gap. The Provisional Rules on Stock Issuance
9 See Hutchens (2003) for an excellent account and analysis of the development history of private securities litigation in China. He summarizes the various factors (positive and negative) that have each contributed to
14
and Trading of 1993 issued by the CSRC proscribed various miscreant practices and
provided for civil compensation for those who were financially injured as a result
(Hutchens, 2003). But, the court was not ready for private securities litigation, and hence
these administrative provisions would not amount to anything for private investors.
Penalties based on the Provisional Rules of 1993 could only be enforced either
administratively by the CSRC, or through criminal litigation by the Public Security
Department. The following are three representative cases of this nature:10
1. The first administrative case on insider trading was announced on January 28,
1994, in which the violator, the Shanghai securities brokerage division of the
XiangFan Trust and Investment Company (a subsidiary of the Agricultural Bank
of China), was fined by the CSRC. The violator was accused of (1) insider trading
and market manipulation and (2) trading stocks using customer account capital.
The brokerage division was ordered to turn in all the trading profits of 16,711,808
yuan (about $2 million), and pay a fine of 2 million yuan (about $240,000) . The
brokerage firm was also suspended from trading for two months. But, in this case,
no manager or any other individual was personally fined or penalized in any way.
Still, this case marked the first attempt to enforce rules on the stock market.
2. The first administrative case against false disclosure and misleading statements in
connection with securities trading was decided on June 7, 1996. In this case, the
named violators were the DaMing Group (a listed company of ShengLi YouTian),
and the underwriter firm, accounting and auditing firm, and law firm that each
provided service to facilitate the IPO of the DaMing Group. The CSRC’s charge
included misrepresentation of the listed company’s outstanding share structure,
omitting material facts, and false statements in its IPO Prospectus. The
administrative penalty included a fine of 2 million yuan for the listed company
and a warning to its board of directors. The named underwriter firm, accounting
firm and law firm were respectively fined 400,000, 200,000, and 100,000 yuan.
legal development in a country whose tradition has de-emphasized civil law. 10 For details of these and other administrative cases, visit the CSRC website: http://www.csrc.gov.cn. Under the leadership of CSRC Chairman ZHOU Xiaochuan, particular efforts were made to improve market and administrative transparency. Part of the efforts was to make the CSRC website more informative and accessible to the public.
15
Again, no individual manager or other person was fined or named in the
administrative action.
3. In December 1999, the Prosecutory Office of Chengdu City formerly filed a
criminal action against the chairman and key executives of HongGuang Enterprise
(a listed company) for accounting fraud. On November 26, 1998, the company
was fined, while its directors and executives were warned, in an administrative
action by the CSRC. The company was found to have overstated its 1996 and
1997 earnings respectively by 157 million and 31.52 million yuan. On December
14, 2000, the court ruled against the defendants in the criminal case.
These and other administrative and criminal sanctions were taking place at an accelerated
pace after 1995. It was happening against the following background. When the Shanghai
Stock Exchange opened in December 1990, there were 45,000 individual stock accounts
and most of the investors were Shanghai locals. As the stock market went unstoppably
higher in 1991 and 1992, the easy money generated much excitement and attracted more
and more individuals into the market. Hertz (1998) gives a sociological account of the
China stock trading phenomenon. Occasional encouraging and possibly misleading
editorials by the People’s Daily (the central government’s mouthpiece) and remarks by
top leaders have also played a significant role in mobilizing the public to buy stocks,
which tends to serve the government’s purpose of helping the financially distressed state-
owned enterprises well.
By the end of 1999, there were 44 million stock accounts (this number went up to over 70
million by April 2003).11 As noted above, the wave of administrative actions against
violators of securities rules started in early 1996, which coincided with the last phase of
the 3-year long bear market that began in mid 1993. During this unprecedented, long bear
11 The number of investors is vastly different from the number of stock accounts. First, the same investor has to have one account with the Shanghai Stock Exchange and one with the Shenzhen Stock Exchange, if he or she is to trade stocks listed on both exchanges. These two accounts of the same investor are counted as two, implying the70 million accounts must be divided at least by two. Second, investors often own multiple accounts to hide their identity by opening accounts using borrowed ID cards from others. This is a common practice especially among market manipulators, who have to hide their trades to evade regulators' attention. Some believe a realistic number of investors is more like 10 million or less. See Walter and Howie (2003) for more discussion.
16
market, many individual investors were stuck with losses, and these losses motivated
them to seek ways of recovery. The investors were joined by professional and academic
commentators to call for better enforcement of market rules and ultimately for a “better”
market. This wave of public pressure then forced the CSRC to take more aggressive
administrative actions in 1996 and onward. Thus, it is the first bear market, together with
the fast-growing investor constituency, that led to significant public enforcement (“crash
then administrative enforcement”).
However, from the administrative penalties, the public learned that first of all, managers
and intermediaries responsible for misleading or cheating investors were actually not
fined personally (but only given a verbal warning). It is usually the listed companies that
were fined. That is, the shareholders, not the responsible violators, ultimately were
paying the fines. Secondly, shareholders who suffered losses were not given any piece of
the administrative fines (the fines went to the Ministry of Treasury). Thirdly, as in the
later securities criminal cases, defendants may have been jailed, but that again did not
help injured investors recover any financial loss.
Unable to benefit from administrative or criminal sanctions, investors and the more
general public all learned about the limitations of the traditional emphasis on
administrative and criminal penalties by the Chinese legal system. In a major sense,
investors care more about recovering loss than about whether a violator is fined
administratively or jailed. Thus, the public debate on private securities litigation started to
gain momentum. Fortunately, in a country with a generally restricted press, the financial
media (including print, internet and TV) has enjoyed increasingly more freedom, so
investors, professionals and academics can openly discuss shareholder rights and civil
litigation issues. The common economic interest led to the informal formation of a
significant constituency, though for political reasons the government forbids any formal
shareholder organization.
The Company Law of 1994 does provide ambiguous support for certain shareholder
rights, including the right to seek compensation for damages due to financial fraud,
17
misleading statements, market manipulation and so on. But, for the reasons mentioned
above (e.g., the lack of operational guidance or legal interpretation from the SPC), the
court refused to accept private securities litigation until years later.
In April 1999, a shareholder in Shanghai filed a civil suit against HongGuang Enterprise
for financial damages due to the defendant’s accounting fraud (see the description of the
first criminal case discussed above). But, for many months, the Shanghai court gave no
answer as to whether the case would be accepted. Then, in early 2000, the court decided
not to take on the case.
3.3. Where is the Crash?
On December 29, 1998, the National People’s Congress passed the PRC Securities Law
and the Law became effective on July 1, 1999. Together with the Company Law of 1994,
this marked the completion of the “laws-on-the-books” concerning corporation formation,
public offering and securities trading in China. However, this does not mean that injured
investors could rush to court to file lawsuits for damage recovery or to force a
corporation's board and/or management to take shareholder-interest-maximizing
measures.
The PRC Securities Law became effective in the midst of a stock-market bull run that
started in January 1999 and ended in June 2001 (when the SSE Composite Index reached
a peak of 2218). During that period, accounting fraud, market manipulation and insider
trading were rampant. The CSRC took 92 administrative actions against perpetrators
(including 104 corporate entities and 270 individuals).12 The media also reported on fraud
cases. But, the bull market made the new formal law almost unnoticed for two years
(most investors were probably busy counting profits).
Within the first two years after the PRC Securities Law became effective, investors made
few attempts (if any) to seek damage recovery through litigation, and the judiciary was
12 Visit the CSRC website for data on administrative actions: http://www.csrc.gov.cn.
18
not in any hurry to prepare for the enforcement of the Securities Law. The Supreme
People's Court was not working to draft a legal interpretation or procedural rules for the
new law. When many investors were profiting from the bull run and only some investors
were suffering losses from fraud, the pressure for fast legal change could not be too high.
There had to be a crash (or, a sustained period of decline).
Then, several key events occurred. On April 23, 2001, the CSRC announced a major
administrative penalty against four fund management firms in GuangDong, fining them a
total of 400 million yuan (about $50 million) in addition to ordering them to return the
same amount of illegal profits. The cause for action was that from October 1998 to
February 2001, the four firms engaged in manipulating the stock price of, and publishing
false statements concerning, Yorkpoint Science & Technology Corp. The chairman of
Yorkpoint, his relatives and key managers were all behind the manipulation scheme and
held stakes in the defendant firms.13
In the July 2001 issue, Caijing magazine's cover story featured a detailed account of the
fraud scheme of Yorkpoint’s stock. In the immediate August issue, Caijing published an
extensive investigative report on another high-profile corporation, YinGuangXia
Enterprise.14 It was found that from 1998 to 2001, YinGuangXia fabricated sales receipts
(with hundreds of millions worth of exports to Germany) and lied to the market about
various production facilities that actually never existed. The total amount of faked sales
was over 1 billion yuan (about $120 mllion), which resulted in a non-existent profit of
770 million yuan. This scandal was a shock to not only the investor community but also
the larger society in general. Many expected to see accounting fraud of a lesser nature,
but not so egregious. The YinGuangXia scandal was dubbed the "Enron of China". -----
These stories came out just as the stock market was suffering a major downturn from the
June high of 2218 for the SSE Composite Index to around 1700 by the end of September
(see Figure 1).
13 The fines are yet to be collected. Judicial decisions in civil cases and administrative fines are often hard to enforce, another reality in China that is waiting for reform.
19
These events provided the needed crash for legal change. Disappointed investors started
to demonstrate in front of the CSRC building. Key officials from the CSRC initiated
meetings with the Supreme People's Court, urging the court to assume a more significant
role in regulating securities markets through adjudicating cases. However, a typical
Chinese official (whether in a bureaucratic position or in a judicial position) always
thinks in terms of administrative territories. In this case, matters related to stock trading
were considered to be the sole responsibility of the CSRC, not that of the judicial system.
Thus, even after the CSRC's efforts to convince the court of its role, the judiciary showed
much reluctance to join in.15
On September 20, 2001, investors filed suits against the company and management of
Yorkpoint Science & Technology, simultaneously in the No. 1 Intermediate Court of
Beijing, the Intermediate Court of Guangzhou, and the Intermediate Court of Shanghai.
Some investors in Jiangsu province were preparing to do so as well. Lawyers were also
filing paperwork in different courts to sue the management and directors of YinGuangXia
Enterprise and other responsible parties.
In the mean time, newspapers and TV were full of stories of angry investors, with articles
detailing legal rules and remedies concerning securities litigation. A wave of lawsuits
was in formation, which challenged the Supreme People's Court and the entire PRC
judicial system. To the Communist Party, this appeared to be too dangerous politically.
3.4. The Temporary Ban on Private Securities Litigation
On September 21, 2001, the Supreme People's Court issued a notice directing all lower
courts temporarily NOT to accept private securities lawsuits. Just as a private litigation
storm was about to begin, such an announcement was a shock to everyone with a stake in
the market or concerned about capital markets and legal development in China. It
14 See Caijing's website for current and past articles: www.caijing.com.cn. 15 Private conversations with participants in these discussions between the CSRC and the Supreme People’s Court suggest that senior officials from the Court were blaming the CSRC for all the securities trading
20
prompted an immediate outcry from various professions and interest groups. It fueled
much further heated debate on not just market development, but also the rule of law in
general and judicial roles in particular. That notice put the Supreme People's Court on the
spotlight. In retrospect, private securities litigation had provided China's court system
with the best chance to gain political standing and respect in the larger Chinese society.
But, the highest court squandered the chance.
From several interviews given by the then Vice President of the Supreme People's Court,
Mr. LI Guoguang, it became clear that the Court had the following concerns. First, as
suits were filed against the same defendants and for the same cause but by different
plaintiffs and in different lower courts, it became possible that there would be different
rulings, the occurrence of which would jeopardize the reputation and credibility of the
legal system. In the history of the PRC, there had never been such an instance in which
numerous plaintiffs would simultaneously file separate lawsuits in different provinces but
against the same defendants and for the exact same cause. How should the court system
respond to this possible crisis? Could there be chaos, both legal and political? Second, if
financially injured investors would each file an individual suit, the entire court system
would be more than overwhelmed with securities litigation. Are there efficient ways to
handle such mass litigation? Third, given the lack of prior experience in this area, the
lower court judges had no uniform standards yet with regard to who has a standing to sue,
what type of evidence is required, how damages are calculated, and so on. Finally, if
there would be numerous lawsuits against all these listed firms and if the private plaintiffs
would be awarded rightfully deserved relieves, it would lead to major losses of state
assets (since the listed companies are mostly state-controlled). In such civil litigation, the
defendant’s interest is in fact the state’s interest. This is precisely where plaintiff’s rights
and state interest collide. Is there a compromise between the two? How can there be
judicial independence? ----- These questions and reasons were sufficient to cause the
Court to pause.
related troubles and that the judiciary did not want to get involved. Protection of shareholder rights was not exactly the first thing on the Court’s priority list.
21
The extensive debate and analyses by legal experts in the mass media following the
notice served as one of the best legal education opportunities for the public. It was during
this period that even individuals with no legal training learned about what "class action"
litigation means, why class action may be the best mechanism for securities litigation,16
why there should be more emphasis on civil liability than administrative or criminal
liability, who should bear the burden of proof in securities litigation, why the court
should accept private action suits, and so on. As a result, a large number of investors and
readers can now comment on “class action” and the “burden of proof”. Observing these
developments from a “crash-then-law” perspective, one can see how a legal culture is
developed in such a process.
3.5. Partially Lifting the Ban
On January 15, 2002, the Supreme People's Court issued a second notice dictating that
lower courts may accept private securities litigation based on false disclosure and
material misrepresentation, subject to the condition that administrative penalty has been
imposed on the alleged fraud. However, the ban remains in place for private litigation
based on other types of claim, such as insider trading and market manipulation.
While the second notice did open the door for private securities litigation in a limited way,
the required pre-condition of an existing enabling government action was troubling and
led to a new round of debate (hence a new opportunity to develop the legal culture). The
requirement was against the principle of judicial independence, which the PRC
Constitution guarantees, and it substantially compromised shareholder rights. It was also
a fundamental re-write of the PRC Securities Law. The Supreme People’s Court’s
justification was that the lower courts have no prior evidence-discovery experience
related to securities litigation and that the pre-condition is a transitional convenience.
16 Chen (2002) provides a detailed argument for class action litigation in China, and a review of the U.S. experience in securities class action litigation.
22
Nonetheless, within a week and on January 24, three investors went ahead to file separate
suits in Harbin against DaQing LianYi, a listed company, and its management for false
disclosure and accounting fraud. Soon afterwards, 767 other investors sued the same
defendants for the same claim. Since class action litigation is forbidden by the second
notice, these separate cases had to be resolved individually.17 The Intermediate Court of
Harbin conducted individual case hearings for two months from August to October 2002,
but managed to go through only 94 out of the 770 suits.
In 2002, nine other listed companies and their respective management members, directors
and other responsible parties were sued in nine different courts. Among them,
YinGuangXia was named as a defendant in 1100 individual suits, again all for the same
cause of accounting fraud.
After the lower courts accepted this wave of lawsuits and in some cases held court
hearings in 2002, none of the cases has yet been resolved by a judicial decision even to
the date of this writing (several have been settled outside of court). The reason this time
was again that more detailed procedural and substantive rules are needed concerning who
has the standing to sue, how damages are to be determined (e.g., adjusting for systematic
risk or not?), and so on.
This led to the issuance of the PRC Private Securities Litigation Rules (hereafter, PSL
Rules) by the Supreme People’s Court on January 9, 2003. The PSL Rules is the most
detailed legal interpretation yet of the PRC Securities Law (with 37 articles), and it is a
result of extensive consultation with legal and finance experts and scholars. This new
interpretation still limits private securities litigation to false disclosure causes (no private
action is accepted on insider trading or market manipulation grounds), and it still
17 The lawyer, Mr. GUO Feng, representing 696 shareholders against DaQing LianYi was insisting on group litigation for his clients, not individual litigation. His negotiation with the Intermediate Court of Harbin lasted for almost the entire year 2002, with the stand that he would not give in unless the court accepted group litigation. His insistence and continuing efforts between the Harbin Intermediate Court and the Supreme People's Court played a crucial role in moving private securities litigation forward. As Hutchens (2003) observes, entrepreneural lawyers have made a significant contribution in Chinese legal reform. While Mr. GUO insisted on group litigation, lawyers representing the other 94 plaintiffs agreed to individual litigation, which is why the Harbin court held hearings from August to October 2002.
23
requires enabling government action as a pre-condition for the court to accept a private
suit, except that now the condition can be met by either an administrative penalty or a
criminal court ruling. New restrictions are added as well. Among other things, Article 9
states that all PSL lawsuits must be filed with the intermediate court of the jurisdiction in
which the listed firm is headquartered. The official justification for this rule is judicial
convenience (e.g., easier for evidence investigation). This restriction is inconsistent with
the PRC Civil Litigation Procedure Law, which gives the plaintiff a choice of jurisdiction
between the plaintiff's local court and the defendant's. As noted earlier, local
governments have a strong incentive to protect listed companies from their jurisdiction,
implying lower courts will be biased to favor local defendants . Thus, this restriction
comes at the expense of shareholder rights and in favor of fraudulent listed firms. It also
exposes another characteristic of the PRC legal system: judicial convenience takes
precedence over plaintiff rights.
Overall, the new rules provide lower courts with specific operational instructions for
handling false disclosure claims.18 The PSL Rules generated new excitement early this
year, and made disappointed investors more hopeful of a loss recovery. But, so far no
court ruling has been decided on any of the 2000 or so pending cases, an indication
perhaps of the lower courts waiting for further clarification and instructions from the
Supreme People's Court on certain unclear rules.
It has been more than four years since the PRC Securities Law became effective. While
much progress has been made, China’s judicial system is still struggling with the
implementation details. The distance between the “law on the books” and the law in
practice is thus not short.19 This is particularly true in countries that follow the
continental civil-law tradition of top-down law-making. The PRC experience further
proves the advantage of common-law systems in which judges at all levels are given
substantial law-making power.
18 See Hutchens (2003) for an in-depth overview and analysis of the PSL Rules and its impact on securities litigation and legal institutions in China.
24
4. Private Product Liability Litigation
In contrast, private litigation in the area of consumer product liability has not been at the
forefront of legal change in recent years. Several laws and judicial interpretation form
the formal basis for civil litigation on product liability:
1. The PRC General Principles of Civil Law of 1986 provides for civil compensation
for damages due to product defects (Articles 122, 130, 131, 132 and 136).
2. The judicial interpretation notice issued by the Supreme People’s Court on
January 26, 1988 outlines operational details for lower courts to adjudicate private
product-liability suits.
3. The PRC Civil Litigation Procedure Law of 1991 gives further procedural details
(Article 72).
4. The PRC Product Quality Law of 1993 and the PRC Consumer Rights Protection
Law of 1993 are the principal area laws concerning product liability.
The two area laws passed in 1993 were largely in response to rampant selling of defective,
fake and counterfeiting consumer products in the late 1980’s and early 1990’s. However,
that legislative response fell into the “rule by law” category, as they have become more of
a rule book for administrative and criminal sanctions. The private litigation experience
based on the product liability laws has been quite limited. Compared to private securities
litigation which has made much progress in the last two years, private litigation on
product liability still lacks momentum.
The PRC government has a quality inspection and control department or center for each
type of consumer product, such as Computer Quality Inspection Center, and
Pharmaceutical Product Quality and Regulatory Agency. These administrative
departments and agencies have served as the primary public enforcer of the PRC Product
Quality Law. They often run political-movement-like campaigns to crack down on
19 Based on a sample of transitional economies, Pistor (2000) argues that transplanting laws from another country usually does not succeed. A country's pre-existing institutional infrastructure may need to change
25
defective, poor-quality and counterfeiting products, by confiscating and burning them.
The first such campaign was launched by the State Council in 1992. Over the next ten
years, the total amount of confiscated products was worth over 30 billion yuan.
From www.Lawyee.com, one of the largest legal case databases in China, the earliest
private product-liability case that we can find took place in 1989, in which a community
department store (GongXiao She) in Baotou City of Inner Mongolia sued a refrigerator
supplier in the same city. The cause for action was that when an employee at the
plainstiff’s store opened a refrigerator sold by the defendant in 1988, the employee was
electrified through the refrigerator handle and killed. The refrigerator was then inspected
and found to be defective by the City’s Product Standards Bureau. The local court then
found the defendant to be liable and ordered the latter to (i) refund the 7900 yuan
purchase price, (ii) pay a total of 13987 yuan (about $1500) for the surviving dependents
of the killed employee, and (iii) pay for other losses and expenses of 5400 yuan.
There have been other sporadic private litigation cases based on product defects, but most
of them have not attracted much attention. From www.Lawyee.com, we were able to
collect 80 private product-liability cases (43 of them were consumer-product cases, 7
cases involved a product that caused death, and 32 cases involved bodily damage to
product users). Out of this sample, 59 cases ended with the plaintiff winning. The largest
damage award granted by the judge was 1.08 million yuan (about $130,000), and the
average damage award was 127,395 yuan ($15,000). The damage awards typically
included three components: compensation for direct damage, punitive damage, and
litigation expenses incurred to the plaintiff. These damage awards are clearly nowhere
comparable to those typically awarded for product liability in U.S. courts.
Among the few cases that have received much media attention are the multiple lawsuits
against Toshiba, a Japanese multinational firm. In October 1999, Toshiba accepted a $2.1
billion settlement in a class action filed against Toshiba (U.S.A.) in a Texas district
substantially for a transplanted substantive law to work.
26
court.20 The complaint was that even after NEC announced and advertised a defect in its
floppy disk micro-controller back in 1989, Toshiba knowingly continued to use it in its
laptop product line. The defective disk drive caused data loss for two users. The plaintiff
class included half a million impacted users. After this settlement in the U.S., Toshiba
never informed any of its customers of this defect in China and it continued to sell
computers with this defect there.
On May 8, 2000, someone in China accidentally learned about the 7-month-old Toshiba
settlement on the internet and published a story in Chinese, which prompted an angry
reaction from numerous consumers. Internet message boards and print media were full of
nationalistic and emotional comments. A stage was set for active debate among legal and
law experts. On May 25, the first joint action against Toshiba was filed in Beijing by 9
Toshiba users.21 On August 15, three individuals filed another suit against Toshiba in
Shanghai. ----- No news about the outcome of these suits is known even today, perhaps
because that debate had too much nationalistic flavor and the government had to keep the
court ruling quiet.
To show how little progress has been made on consumer rights in China, note a famous
1999 libel case, Hengsheng Computer v. Wang Hong et al. In August1997, Mr. WANG
Hong bought a laptop computer made by Hengsheng Computer, and later found the
laptop to keep shutting off on a regular basis. Within the warranty period and on June 1,
1998, Mr. Wang took the laptop back to the computer store where he made the purchase.
But, he was denied any service. After several failed attempts and in late June, Mr. Wang
decided to post an angry comment on an internet bulletin board, and filed a complaint
with the government-sponsored Consumer Rights Association of Beijing. No progress
was made in obtaining repair service after almost two months. Next, Mr. Wang posted
20 See Robertson (1999) for a report on this settlement. 21 Note that in consumer product-liability litigation, plaintiffs could use the joint-action litigation device in May 2000, whereas even today the Supreme People’s Court does not allow for this device in private securities litigation. In product-liability litigation, the likelihood of a major domestic political crisis is considered low. In contrast, the PRC government has been much more concerned about the political-risk prospects of allowing class action suits in securities litigation. See Lawrence (2002).
27
more comments on the internet. Two newspapers, Microcomputer World Weekly and Life
Time, reported on this story respectively on August 10 and July 27.
In April 1999, Hengsheng Computer filed a lawsuit against Mr. WANG Hong and the
two newspapers for libel damage. The lower court ruled that the defendants were liable
for injuring the plaintiff’s reputation, and ordered Mr. Wang to pay damages of 0.5
million yuan ($52,000, 25 times Mr. Wang’s annual income) and each of the two
newspapers to pay 0.25 million yuan to the plaintiff. Upon appeal, in December 2000, the
Beijing No. 2 Intermediate Court reduced the damage award against Mr. Wang to 90,000
yuan (about 4.5 times his annual income).
The court’s decisions in that libel case illustrate just how far the legal culture for
consumer rights has to go. Mr. Wang was trying to get a promised warranty service. His
internet postings were an effort to call upon other consumers to boycott the
manufacturer’s products. Yet, for doing that, he is still paying for the libel judgment.
5. Comparing Product-Liability and Securities Litigation
An intriguing research question is: why has private securities litigation led to much legal
development whereas product-liability issues have not? What characteristics distinguish
the two areas? In real impact terms, the stock market affects a relatively small fraction of
the population (10 million in a 1.2 billion population), while consumer products touch
upon the daily lives of the entire society. Thus, consumer rights should be relatively more
important to both the economy and society. But, as hypothesized in this paper, the stock
market has been more powerful when it comes to the ability to drive legal change.
We can speculate to offer the following points. First, commonality is what characterizes
the investor constituency. In securities fraud, all affected shareholders are injured by the
common fraudulent act, at the same time and in the same location. Damage causality is
easy to establish, especially since there is typically no role played by the shareholders in
causing the damages. In contrast, there are diverse types of consumer products. Even with
28
respect to the same product type, say, Toshiba computers, damages to users may occur at
different times and in different locations. This fact alone creates a weaker sense of
commonality among injured consumers. While it is sometimes technically possible to
trace all the damages back to the same defect, a defense often used by producers and
distributors is that the consumer did not use the product properly and that it was the
consumer’s fault. Product-liability cases require plaintiff-specific proof of causality.
Second, damages are easily and immediately measurable in securities trading. To
measure stock investment losses, you do not require additional information beyond price
declines. Furthermore, financial loss is the only type of damage to be concerned with in
securities cases. In contrast, damages to consumers due to product defects are often hard
to measure and intangible. Such damages can be as grave as death, and they can also be
quite subjective and difficult to measure financially. This measurement difficulty and the
intangibility of damages make the formation of constituency much harder to achieve.
Finally, these two characteristics - commonality and immediate measurability of loss –
also render securities litigation and shareholder rights an ideal topic for the media to
report and debate on. The daily realization of stock trading gains and losses is a feature
that is largely responsible for making the stock market a persistently popular topic at
social occasions and other places. In contrast, not many consumer products (if any) are
perpetually popular topics. Thus, the media’s attention on stock market trading is also a
major factor in the easier formation of a politically powerful investor constituency.
6. Conclusions
The debate on whether law matters for economic and market development has been going
on for decades, especially since the work by Max Weber and Friedrich von Hayek. In
recent years, commentators have pointed to China's recent growth experience, especially
in comparison with India which has a far better institutional infrastructure, to suggest that
29
law does not matter for growth and market development.22 These comments are
implicitly based on the "law-then-growth" thesis. However, a closer look at the PRC
experience shows that for young markets, it is probably more like "crash-then-law" or
"growth-then-law", a thesis argued by Coffee (2001). The initial phase of development
(in both the economy and markets) is necessary both for a constituency to be formed and
to set the stage for “crashes” or problems. Legal change will then follow. Legal reform is
necessary in the second phase to prepare a country for further, more mature economic
growth. Thus, a legal order may not be a pre-condition for initial market development,
but a pre-condition for more mature development.
Bear markets are often necessary for legal change, as happened in the U.S. of the early
1930’s. Each of the two major downturns of China's stock market (1993-1996 and 2001
to the present, as shown in Figure 1) led to a significant change. The first downturn
generated pressure for the CSRC to take more aggressive administrative actions against
violators, while the second set the stage to push for private securities litigation.
Another lesson from the PRC experience is that different types of economic activity
present different pressure levels for legal change. Capital markets are perhaps the most
conducive to the formation of a politically powerful constituency and hence dramatic
legal change, because of (1) the higher degree of commonality among interested parties
and (2) immediately measurable and tangible damages. These two characteristics of
capital markets not only allow investors to identify with each other more easily, but also
create an ideal basis for more debate in the public media and other places, which in turn
promotes the development of a legal culture. Anecdotal evidence indicates that there is
probably more media coverage of legal issues in China today than in other countries.
Private securities litigation has challenged the traditional Chinese view that law is a tool
used by the ruling class to rule. It has also challenged the traditional focus on substantive
law rather than procedural law.
22 See Thakur (2003) for a growth comparison between India and China, and Kristof (2003) for a comparison between Russia, Ukraine and China.
30
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Table 1: IPO Listings and Capital Raising on China’s Stock Market Data used in this table are graciously provided by www.SinoFin.com.cn.
33
Table 2: Raising Capital through the Stock Market Across Countries
Note: The total amount of capital raised includes both IPO and seasoned equity offerings on the stock market. The ratio reported below is the total capital raised divided by the country’s GDP in the same year.
China US Japan Germany France
1991 0.02% 0.23% 1992 0.36% 0.90% 0.06% 1993 0.91% 1.64% 0.16% 0.11% 1994 0.30% 1.64% 0.08% 0.03% 0.18% 1995 0.20% 1.08% 0.20% 0.27% 0.29% 1996 0.50% 1.26% 0.54% 0.56% 1.94% 1997 1.25% 1.72% 0.27% 0.29% 0.08% 1998 1.02% 2.35% 0.74% 2.74% 0.88% 1999 1.09% 1.34% 0.93% 1.04% 0.85% 2000 1.72% 2.03% 0.90% 1.44% 1.44% 2001 1.20% 2.33% 0.49% 0.29% 1.56% 2002 0.94% 1.26% 0.34% 0.20% 0.85%
Average 0.79% 1.60% 0.47% 0.61% 0.90%
Std Deviation 0.65% 0.25% 0.13% 0.02% 0.47%
34
Figure 1: History of Shanghai Stock Exchange Composite Index
Each major turn marked a government policy intervention
0
500
1000
1500
2000
2500
1990
-12
1991
-07
1992
-02
1992
-09
1993
-04
1993
-11
1994
-06
1995
-01
1995
-08
1996
-03
1996
-10
1997
-05
1997
-12
1998
-07
1999
-02
1999
-09
2000
-04
2000
-11
2001
-06
2002
-01
2002
-08
2003
-03
Data source: www.SinoFin.com.cn