(By Yu Zhiyuan and Bai Lituan) In the capital market, agency institutions’ participation greatly reduces the degree of information asymmetry of market subjects, and plays a significant role in the capital market; thus, the agency institutions and their professionals are named by the industry as the “gatekeepers” of the capital market. Ever since the Enron Corporation scandal became public and the Sarbanes-Oxley Act (SOA) was published, in order to better protect the interests of public investors, all countries are attempting to apply new approaches to security supervision. Thus far, enhancing the gatekeepers’ obligations is one of the ways to realize investor protection. Recently, fraudulent securities issuances and severe distortions of information disclosure are occurring frequently in China’s capital market, and this has a direct causal relationship with the gatekeepers’ mechanism failure.
“Gifts Blinding the Eyes” may Present Conflicts of Interest
Not long ago, the China Securities Regulatory Commission (the “CSRC”) issued two cases of attempted counterfeit. The Nanjing Securities and Minsheng Securities, respectively, failed to perform their working process of due diligence and even furnished a system of sponsorship for listings with false records and verification reports in the Initial Public Offering (the “IPO”) program of China Xintiandi Co., Ltd and Tianneng Technology Co., Ltd. Therefore, the CSRC punished the above securities companies, and prohibited four related sponsor representatives from entry into the securities market. In fact, cases of serious losses suffered by investors from the agency institutions’ failure to fulfill its duties in the period of subsequent supervision after the affirmation of the Issuance Examination Committee of the CSRC are common in China. When the first quarterly financial report of the Longi Silicon Materials Corporation, listed on April 11, 2012, showed a 90.59% drop of net profit from a year-on-year, the issuers and the Guoxin Securities, in its role as a sponsor, did not illustrate these information in Report of Significant Documents, as requested, after affirmation by the Issuance Examination Committee.
The frequencies of false statements in the security market made by agency institutions, which are represented by securities traders, reflect their roles in the confusion and fuzzy market positioning.
The current Administrative Measures for the Sponsorship Business of the Issuance and Listing of Securities has adopted the securities issuance system from Hong Kong and Britain, i.e., the issuer’s application for listing shall engage a securities company with the qualification of a sponsor to recommend a listing. In addition, a sponsor shall conduct a prudent check of the application documents and assume joint and several liabilities in its role as sponsor. Thus, it can be seen that China established a model of “strict sponsors” responsibilities. Although the responsibilities of agency institutions, especially securities traders, couldn’t be any worse, the actual mechanism in place has still forced a lot of securities fraudulent acts. The securities company shall accept the engagement of issuers and recommend the offering and listing of issuer’ securities in accordance with the sponsorship system, while the issuer pays the sponsorship fees. Therefore, the relation between the securities companies and the issuers resembles the feature of a principal-agent of relationship. Such a relationship not only makes the existence of possible conflicts of interests but also explains the incentives of the mechanism of securities company’s fraudulent behavior. When the interests of the principal are conflicted with that of the public, it is difficult for us to expect a degree of self-consciousness and self-discipline of the agency institutions that play as an agent of a listed company or an issuer.
However, when accounting firms, rating agencies, evaluation agencies, law firms and other agency institutions obtain authorization and payments from the issuers for similar reasons, similar problems would also exist.
The Ambiguous Duties of the “Gatekeeper”
Under the model of “strict sponsors” responsibilities, sometimes the division and obligations of work between the securities and other agency institutions, as well as between other agencies institutions, are not always clear. Taking the scope of work as an example, because the scope of due diligence has no clear-cut distinction between securities companies and lawyers, the content of legal opinions may be repeated or similar to that of the prospectus.
Within the current responsibility model, where securities traders believe that the professional competence of any other securities institutions engaged by an issuer for the offering and listing of securities is explicitly defective, the securities trader may recommend the issuer to replace it. If it has any doubt over a professional opinion issued by securities institutions, the securities trader may request any other securities institutions to make an explanation or produce the relevant basis for the opinion. These provisions made through the leadership of securities companies obviously impacts the degree of independence of other agency institutions, and obscures the scope of securities companies’ duties.
In addition, the current CSRC occasionally advocates and encourages qualified law offices to issue the prospectus, an attitude closer to that of the Unit States’ securities issuance system. Although the United States has not adopted the sponsorship system in its securities listings, the independence of lawyers in the United States is without question (however, there also are problems arising from incentive systems of payment by the issuers). Therefore, the above practice shall first solve the problem of whether this would execrate the ambiguous duties of agency institutions.
With regard to the division of duties and obligations, there are unclear provisions as to whether the same standard of due diligence is applied by and between all kinds of agency institutions. However, as for the standard of bearing legal liability, all kinds of agency institutions have taken a significant difference in terms of standards. Article 27 of the Several Provisions of the Supreme People’s Court on the Trial of Cases of Civil Compensation Arising from the False Statement in Securities Market (the “Several Provisions“) stipulates “In case the securities underwriters, those recommending the listing of securities, or professional intermediary service agencies know or should know that the statement made by the issuer or listed company is false, but fails to correct it or to give the qualified opinion, a contributory infringement has been constituted by them, and they shall assume joint and several liabilities for the losses caused to the investors.” That is to say, agency institutions shall bear joint and several liabilities only for failure to correct false information, not necessarily for their subjective intention of participating in counterfeits and fraudulent activity. In the Several Provisions, however, the accounting firms’ liabilities are limited under several specific conditions. From this, we can see that the rules of the agency institutions’ liabilities s are far from the ideal standard of clarity, fairness and independency.
One of the consequences arising from the unclear division of duties or unbalanced duties is that, the agency institutions cannot fulfill their due diligence in a fair environment and their independent judgments would be unduly influenced, so as to damage the quality of their professional work.
Agency Fees are Altered to be Paid by the Investors
With the development of the sponsorship system up to now, some agency institutions have not fulfilled their duties in playing the role of the “gatekeeper”, but even have acted as business consultants for the issuers. The major problems arising from the “gatekeeper” mechanism failure are the conflicts of interests created as a result of the principal-agent relationship, and the unclear division of their duties between different kinds of gatekeepers. Then, how to solve the problems of “gatekeeper” mechanism failure?
Change the principal-agent relationship of the “gatekeeper”. In order to completely solve the conflicts of interest, the most obvious way is the alteration of the principal-agent relationship that currently exists between the issuers and sponsor institutions. If the sponsorship fees are not paid by the issuers but altered to be paid by the investors, the agency institutions may take an entire different stance on information auditing of the issuers. The assumption of engaging an agency institution by securities exchange may be a promising method. That is to say, if a listed company, or a company that is seeking an IPO, pays the relevant sponsorship fees in advance, the securities exchange may select and appoint all kinds of agency institutions in accordance with principles of openness, fairness and impartiality.
Definitude the principle of identification of liability and the scope of work of agency institutions. The liabilities between the securities companies acting as sponsors and other agency institutions, especially the application of joint and several liabilities and fault liability, should be determined more specifically, and the scope of application of supplementary liability shall be increased.
Grant lawyers more rights to work independently. In actual IPO practice, when offering legal opinions, lawyers always face the rather unclear standards attributable to “major violations”, less cooperation of due diligence from Customs, Taxation Administrations, and Administrations for Industry and Commerce, and inexhaustible research involved in material litigation, as well as myriad other problems. After the aforementioned issues are solved, more independent rights shall be endowed to lawyers. The CSRC’s actions that encourage lawyers to issue prospectus can be accepted as a beneficial attempt. The logic behind the mechanism shall be that, in reforming the sponsorship system and altering the sponsors’ responsibility in regard to securities companies, lawyers will be granted more independence and space to work effectively.
Grant investors greater protection of their rights. To revise and improve relevant securities regulations related to civil compensation, to endow the operability of class action and to grant investors more rights of recourse for civil compensation have become an urgent task. However, for there are more restrictions related to civil securities’ tort actions by current rules due to a variety of reasons, judicial systems need to provide more institutional supplies and resources, including a further openness upon acceptance of litigation into the court, and encouraging the stipulation of specific judicial interpretations regarding the standards of fraudulence, and properly enhancing the deterrent effect through the improvement of compensation standard.