Conclusions of the Workshop on the Investment Funds Law
of the People's Republic of China

Beijing, February 26 - March 2, 2001

I. General remarks

Contractual and company structured funds are contemplated in the 5th draft law. The establishment of a structure that contemplates both a strong depositary and independent directors with significant powers and oversight responsibilities is recommended. Such a structure could offer significant advantages in increasing the confidence of investors in the investment fund industry, especially at this stage of the fund industry's development. This structure could be implemented using either the company or contractual model. For the sake of simplicity it is recommended to choose one or the other model. If the contractual model were chosen, it would be necessary to provide either (1) a mechanism for the election and operation of a board of directors in the contractual fund or (2) that the independent directors constitute a special class of directors of the management company who would represent the interests of, be answerable to and removable by the shareholders of the funds under management and have defined responsibilities within the management company. The second of these solutions might be more manageable within the context of China's existing corporate law, to be implemented by issuing a special class of the management company's securities to shareholders of the funds under management and defining the role of independent directors in the portion of the management company's charter (or constitution) that creates that class of securities. The initial independent directors should at least be subject to approval (if chosen by the management company), and arguably even selection, by the regulatory agency, with subsequent independent directors generally chosen by the independent directors already in office (again, subject to regulatory agency approval) except in the rare instance in which shareholders determine to remove an existing independent director and select a new one. By contrast, the necessary mechanism for the election of directors by fund shareholders is already in place in a company structure. However, all existing funds in China utilize the contractual model, and the use of the company structure would require certain amendments to the company law in order to allow open-end funds. Therefore, a unique solution would be to choose the contractual model with independent directors.

In any case, the most important task is to define the role of the depositary and the independent directors regardless which structure has been chosen.

At least in the context of open-end funds, it is possible that the regulatory authority could conclude after sufficient experience that a contractual structure, utilizing a strong depositary without independent directors, would be sufficient to safeguard the interests of investors. Therefore, the draft law should provide for that possibility, to be implemented, if thought desirable, by the regulatory authority on a schedule that it deems appropriate after study and public comment.

In all contexts it is critical to appropriately regulate affiliated transactions. Affiliated transactions are transactions between the fund and a defined group of related parties. Such transactions would include sale of securities by affiliated parties to the fund and purchase of securities by affiliated parties from the fund, as well as transactions in which the fund and affiliated parties participate jointly. Affiliated parties would include, at a minimum, (1) the fund management company and the depositary, (2) directors and officers of the fund, the fund management company and the depositary, (3) persons or entities that could exercise significant influence over the fund, the fund management company or the depositary and (4) persons under common control with any of them. There are two basic models as to how to regulate affiliated transactions:

• In the U.S. model, this goal is accomplished by outright prohibition of most affiliated transactions and significant regulation of those that are allowed. However, it should be noted that a regime that relies upon such prohibitions would in all likelihood require the availability of an exemptive and interpretive mechanism in the regulatory authority in order to be able to authorize affiliated transactions in circumstances in which, after consideration, it is determined that such transactions do not in fact present a potential for abuse.
• In the European, Australian and Hong Kong model it is simply required that all affiliated transactions be conducted on an "arm's length" basis. This means that the transaction is on the same terms that would apply if two independent parties were transacting with each other under circumstances in which neither party was in a position to take advantage of the other.
  It is relevant that chapter I be expanded to ensure appropriate insurance to cover acts of fraud and negligence on the part of the fund manager and other entities. As an alternative, fund managers, depositaries and other service entities could be required to maintain sufficient initial and ongoing capital to ensure their financial responsibility.

Consideration should also be given to including provisions designed to make clear how the law or more particularly the regulatory authority will operate in the context of Internet trading.

II. Manager of Investment Funds

It is recommended that the first sentence of art. 9 be revised to provide that the manager of investment funds must be a management company duly authorized for that purpose and subject to separate regulation. Currently the nature of that regulation is specified in the subsequent provisions of chapter II. However, in view of the desire to regulate investment managers who provide investment advice to individuals and other kinds of entities in addition to managers of public investment funds, consideration should be given to placing such requirements in a separate law. Alternatively, the remainder of chapter II should be substantially revised and expanded to provide for the regulation of all kinds of investment managers. One example of a separate law regulating investment managers generally is provided by the U.S. Investment Advisers Act of 1940, which was adopted in conjunction with the Investment Company Act of 1940 and has been coordinated with the Investment Company Act through a provision in the Investment Company Act that requires advisers to investment companies to be registered under the Advisers Act. If a separate law is adopted to regulate all investment managers, provisions that are specially applicable to managers of public investment funds could be included in either of the two laws.

With reference to art. 10 sec. (1) it is suggested that the law should specify the minimum paid up capital, subject to variation by decree of the regulatory authority. Art. 10 sec. (1) could also impose a liquidity requirement concerning the way the company capital is employed. For example, the standard could be set as 25 percent of the management company's fixed operating expenditures in the previous year. Regarding insurance see conclusion no. 3 above.

Art. 10 sec. (4) should be amended to include a requirement that each fund management company should have an internal auditing office, whose head has substantial authority and reports directly to the board of directors. The compliance officer should report directly to the managing directors.

Art. 12 should be amended to include in the manager's responsibilities, first, marketing and promoting funds and, second, pursuing legal rights on the part of the funds that it manages, subject to the supervision of the independent directors of those funds.

Art. 13 sec. (1) should be reformulated so that it refers to loss caused by misappropriation or other default rather than investment performance. Also 20 percent is in this context too high and should be no more than 1 or 2 percent. Other matters such as losses occurring through regular trading activities can be specified as an example of sec. (5). Art. 13 sec. (2) should be modified to provide that any change, not just major changes, in directors, supervisors or other senior managerial staff should be reported to the regulatory authority.

The directors, officers and controlling persons of the fund management company should be approved by the regulatory authority (art. 9 and art. 13 sec. 2).

The introductory sentence to art. 14 should be amended to provide that the manager must act solely in the best interests of the fund investors.

With regard to art. 14 sec. 2 see conclusion no. 2 above (affiliated transactions).

Art. 15 should provide that the management company may participate by proxy on behalf of its managed funds in shareholders' meetings of the funds' portfolio companies, rather than always being required actually to attend the meetings. In addition, the management company should exercise active control over voting decisions and not delegate the responsibility to any third party.

With regard to art. 16, although independent directors in the contractual model must be directors of the management company, both their initial selection and subsequent replacement should be subject to approval of the regulatory authority. In addition, the selection of subsequent independent directors should be the responsibility of the independent directors then in office, subject to approval by the unit holders of the funds managed by that management company if possible. In the company model, the independent directors would be directors of the fund companies and not of the management company - please see conclusion no. 1 above. Either the law or the regulations should contain specific standards defining what is an independent director, but the regulatory authority should have the discretion to disapprove a nominee, even if that nominee satisfies all the specified requirements.

The fund manager should not be permitted to assign its management duties without approval of the independent directors and the regulatory authority, ratified by the fund shareholders if possible. For this purpose "Assignment" should be defined to include a change of control of the management company.

It may be suggested that art. 20 should be amended to provide the fund management contract should be renewable annually after the first two years, subject to the separate approval of the independent directors. The independent directors should also have a general right to dismiss the fund manager. However, such a decision should be ratified by a shareholders' meeting, presumably in conjunction with seeking shareholder or government approval for the selection of a replacement manager (with the understanding that governmental approval of the a new manager should also be required).

With respect to art. 21 the regulatory authority should have the right impose less severe measures, such as fines or suspension of the right to engage in new business, in the case of violations of laws and regulations that would not justify revocation of the license. The word "shall" should be changed to "may" in order to provide for appropriate regulatory discretion.

In art. 21 sec. (2) the term "revoked according to the law" should be replaced by "extinguished according to law" in order to avoid ambiguity.

With regard to art. 22 and art. 23 it should be clarified that in case of the dismissal of a fund management company, the independent directors are charged with the lead role in selecting a new management company.

III. Depositary

The depositary should be a commercial bank or other financial institution that operates under the supervision of the bank regulatory authorities.

Art. 25 should make it clear whether it is intended that any institution qualifying as a depositary should also be licensed by the funds regulatory authority (CSRC). If it is intended that depositaries will be regulated by both the funds and the bank regulatory authorities, it may be desirable to establish a coordinating mechanism to deal with possible regulatory conflicts.

With regard to art. 25 sec. (3) consideration should be given as to whether some reference to appropriate insurance would be desirable. In art. 25 sec. (4) the requirement should be that the depositary either has or participates in a safe settlement system subject to oversight by the regulatory authority.

With regard to art. 26 it should be made clear that the fund manager and depositary may not belong to the same group of companies unless an additional set of requirements is applied.

The obligations described in art. 27 sec. (4) could be assigned to the fund management company, rather than the depositary.

In the case of a depositary structure, art. 28 should make it clear the depositary will have the right both to initiate and participate in legal proceedings on behalf of the fund. With regard to art. 28 sec. (2) the principles for the calculation of net asset value should be set uniformly for all funds and not be subject to variation by contract.

With regard to art. 28 sec. (4) it will be recommended in chapter 4 that the auditors be appointed by the independent directors. However, the auditors should report both to the depositary and the independent directors, except in cases of issues arising with regard to the performance of the depositary, rather than reporting to the independent directors only.

The duties of supervision that are provided in Articles 28 sec. (3) and (5) should include a duty to take reasonable care to ensure that the specified functions are carried out in accordance with the provisions of the fund constitution and with the requirements of the investment fund law and regulations under it. In performing these supervisory duties the depositary must act solely in the interests of fund shareholders. The depositary's duty to report violations by the fund manager to the regulatory authority as provided in Article 28 sec. (5) should also apply in respect to the matters referred to in Article 28 sec. (3).

Article 28 should also be expanded to make specific provision for the depositary's supervisory role in relation to daily transactions in property of the fund and compliance with investment and borrowing powers. It is recognized that the depositary must not be burdened with impractical duties, but the depositary should be under some obligation to monitor the transactions carried out by the manager since this is not a task, which can be accomplished by the independent directors.

In relation to fund transactions, the manager should be able to give instructions as to the purchase or sale of securities for the fund without having to obtain the authority of the depositary. However, the depositary must on a daily and continuing basis be satisfied that the manager's transactions are in conformity with the investment fund law and regulations, including any specifically applicable contractual restrictions. Article 28 should provide that if the depositary is of the opinion that a particular transaction exceeds the powers or rights of the manager or is, for example, in contravention of the investment orientation of the fund, the depositary should require the manager to cancel the transaction or make a corresponding purchase or sale of the securities to restore the fund to its previous position (at the manager's expense).

The resulting structure should provide an additional layer of safeguards in the interests of investors. If, for example, the manager undertakes transactions that contravene the law or regulations made by the regulatory authority, it should be possible for the investors who may have been prejudiced by that action to look to both the manager and the depositary for compensation - with the depositary being responsible if he has failed to exercise due care to monitor the manager's transactions and, having become aware of contraventions, failed to take steps to cause improper transactions to be cancelled or rectified.

Under art. 29 the independent directors should also approve the appointment of the depositary and have the right to bring actions against it.

In the introductory sentence to art. 29 the word "shall" should be changed to "may".

In art. 30 the regulatory authority should be empowered to adopt interim measures, such as fines or the suspension of the right to engage in new business, in the case of violations of laws and regulations that would not justify revocation of the license. The word "shall" should be changed to "may" in order to provide for appropriate regulatory discretion.

IV. Establishment of an Investment Fund...