Regulators rule as judge and jury

Five years after China joined the WTO, promises made to open up its financial sector to foreign-invested businesses are approaching fulfilment. The final elements – mainly relating to the banking sector – are likely to be in place by the end of this year and the leading foreign firms have great plans for expansion. What, then, are the next five years likely to bring? I suggest that one feature is likely to be an intensification of the regulatory risks faced by foreign companies.

It’s important to note that the Chinese financial services regulatory environment is becoming notably more stringent. Important new legislation has come into force this year, and the authorities are acquiring significant administrative powers and putting more resources into monitoring and enforcement.

Risky business

Generally speaking, this is good for the Chinese economy. However, such changes, at a time of rapid foreign market entry, are likely to present special risks for foreign businesses. The reasons for this are cumulative, but four points may be highlighted.

First, for the foreseeable future, there will still be certain restrictions on foreign companies’ activities in China; this carries a risk that local managers may be tempted to put profit above compliance.

Second, as usual in the PRC regulatory context, there are numerous ambiguities in the definitions of what may and may not be done. Third, such ambiguities will largely be resolved by the application of administrative discretion, not through a transparent judicial process – attempts to fill the void by relying upon relationships are understandable (indeed, practically essential) but a poor substitute for the rule of law.

Fourth, there is a strong likelihood of a backlash by local players under pressure from foreign competitors. As has been the case elsewhere, locals will lobby regulatory authorities to take action against particular foreign competitors for alleged infringements, genuine or otherwise. Putting all these points together, the potential for problems should be clear.
This is not mere theory: it is already starting to bite in the insurance sector, as a number of foreign companies who have been on the wrong side of the regulator can testify; and it is probably no coincidence that this is the sector in which foreign entrants have made most headway. I predict that the same phenomenon is likely to be seen in other financial services sectors as overseas players gain a foothold.

After all, this is a regulatory system that can easily be misconstrued. In reading the latest legislation, for example, it is striking how familiar many of the phrases and concepts are from common-law regulatory regimes. However, this superficial similarity may mislead because the words are not yet underpinned by a robust court system able to balance the powers of the regulator with the rights of the regulated.

The system of case-by-case testing that has shaped the regulatory environments of financial centers such as New York, London and Hong Kong has its costs, but it tends to result in robust compromises. A classic example earlier this year was a Hong Kong case in which the lower courts held that the basic human right of procedural fairness invariably required parties to be permitted legal representation at stock exchange disciplinary hearings.

The Court of Final Appeal has recently reversed that decision, to the relief of many, whilst making clear that legal representation may be appropriate in certain cases such as those where complex legal issues arise.

But China has no real history of similar judicial control and legal instruments typically discourage it. Take, for instance, the China Securities Regulatory Commission (CSRC) regulations on the freezing of assets and sealing up of evidence that came into force earlier this year.

The circumstances in which the CSRC may exercise its powers are defined in very broad terms, including a catch-all provision empowering it to act in any "other circumstances in which there is a necessity for freezing or sealing up". The regulations lack any clear limits on the exercise of these powers and, crucially, the only review provided for is an application for reconsideration by the CSRC itself, without any guarantee of an independent, segregated process.

Right to interpret

Finally, the regulations drive home the point as to who’s in charge by emphasizing that the power to "interpret" the regulations (a critical power with an instrument as vague as this) lies with the CSRC itself.

It would, of course, be a mistake (in China as elsewhere) to make the regulatory system over-legalistic, but there is an important balance to be struck between official power and the independent supervision of the exercise of that power.

The more or less complete merger of the roles of legislator, prosecutor, tribunal and appellate body suggests that China has not yet found that balance.

It will be interesting to see if the ongoing review of the Chinese court system prompts any changes. For the time being, though, foreign financial services companies in China would do well to ensure they understand the nuances of the current system and adapt their risk management approach accordingly.