Commercial Banks to Launch Fund Management Companies

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1 Commercial Banks to Launch Fund Management Companies Christophe Han and Charles Qin Following an extended period of solicitation of opinions and a heated debate on the issues of commercial bank's incorporation of fund management companies, the People's Bank of China (PBOC), the China Banking Regulatory Commission (CBRC) and the China Securities Regulatory Commission (CSRC) jointly formulated and promulgated the Administration of pilot projects for the Establishment of Fund Management Companies by Commercial Banks Procedures (the New Procedures), to allow some pilot commercial banks to launch fund management companies. Before the promulgation of the New Procedures, commercial banks could only act as fund custodians or fund distribution agents and were not allowed to take any equity shares in fund management companies. The promulgation of the Tentative Procedures is definitely good news for those commercial banks that are looking forward to stepping into the securities investment fund business. It is reported that a number of commercial banks have already submitted initial applications to establish fund management companies and that the relevant regulators have already started to review the applications. The first fund management company with a commercial bank as its major shareholder is likely to come into existence soon. LEGISLATIVE FRAMEWORK The PRC Securities Investment Funds Law (Funds Law), effective as of June , sets out certain criteria for the establishment of fund management companies, including the criteria that the principal shareholders shall have relatively good business performance in their engagement in the securities business, securities investment consultancy, management of assets held in trust or management of other financial assets, and also that they shall have no record of violation of applicable regulations within the last three years and shall have registered capital of not less than Rmb300 million. Such criteria have been emphasized by the Administration of Securities Investment Fund Management Companies Procedures (the SIFMC Procedures) published by the CSRC (effective as of October ), which also set out qualifications for shareholders, other than principal shareholders, of fund management companies. However, the PRC Commercial Banking Law (the Commercial Banking Law) revised in 2003 prohibits commercial banks from engaging in trust investment and securities business or making investment in fixed assets of non-self use or in non-banking financial institutions and enterprises within the PRC, except for those businesses or investment otherwise permitted by the state. Although it is generally understood that a commercial bank cannot make investments in non-banking financial institution and enterprises, the provisions of the above exception clause of the Commercial Banking Law also make it possible for commercial banks to engage in fund investment businesses and to invest in fund management companies once they have been authorized by a particular statute. The New Procedures are formulated to this effect. METHODS OF INCORPORATION Prior to the promulgation of the New Procedures, there have been fund management companies in which commercial banks have held indirect equity investments through an overseas non-banking subsidiary, or in which there has been direct or indirect equity investment of financial holding

2 groups that are major shareholders of commercial banks. The New Procedures officially authorize commercial banks to directly invest in fund management companies that may launch funds to invest in bonds, securities and other investment fields permitted by relevant laws and regulation. This is a breakthrough in the existing segregated business scheme of banking, securities and insurance sectors. Although commercial banks may directly establish and control fund management companies, pursuant to the provisions of the SIFMC Procedures, one institution can directly or indirectly invest in no more than two fund management companies, between which such institution can only take controlling equity in one fund management company. Commercial banks may also take equity stakes in fund management companies by means of acquisition of existing fund management companies, which must also be conducted in accordance with the New Procedures. QUALIFICATIONS OF INVESTORS According to Article 2 of the New Procedures, state-owned commercial banks and joint-stock commercial banks that are incorporated within Chinese territory may establish fund management companies. Commercial banks are encouraged to diversify the shareholding structure of the fund management companies with their equity investments. As for the meaning of "diversify the shareholding structure", we understand that the PBOC, CSRC and CBRC intend to encourage commercial banks to jointly establish fund management companies with overseas-qualified investors and other domestic institutional investors. This may facilitate the introduction of advanced management skills and risk control technologies into the invested fund management companies. The New Procedures do not apply to foreign commercial banks. According to the SIFMC Procedures, a foreign investor of a fund management company must be a financial institution with financial assets management experience and meet other requirements as provided in those procedures. PROPORTION OF EQUITY INTEREST In making for direct investment in fund management companies, the New Procedures further stipulate that commercial banks must act as the principal shareholders. The term "principal shareholder" is not defined in the New Procedures. As per the SIFMC Procedures, a "principal shareholder" refers to a shareholder with the largest proportion of equity stake and whose capital contribution accounts for no less than 25% of the total equity of the fund management company concerned. It seems that a fund management company may have more than one principal shareholder. Article 9 of the New Procedures stipulates that apart from the rules herein, the conditions for establishment of a fund management company invested by a commercial bank and the qualifications of the shareholders of fund management companies shall also comply with relevant provisions stipulated in the SIFMC Procedures. A commercial bank, as it is required to be a principal shareholder of a fund management company set up by commercial banks, shall make the largest contribution of share capital, and this shall not be less than 25% of the total equity of the fund management company. RISK CONTROL Risk control is one of the major concerns for fund management companies incorporated by commercial banks and the entire third chapter of the New Procedures deals with this issue. Segregated Operation Principle

3 The basic principle of the "segregated operation of the banking, securities and insurance sectors" remains unchanged in the New Procedures. Strictly complying with the segregated operation principle, a commercial bank that invests in a fund management company shall build up an effective risk segregation system that shall be submitted to the CBRC for the record. Governance and Management A fund management company incorporated by a commercial bank shall establish a sound corporate governance mechanism to control risk. This is the same as that required of other fund management companies, and a fund management company invested by a commercial bank shall build up a sound mechanism of independent directors and chief compliance officer. An incorporated fund management company shall build up the system of business segregation from its shareholders, which aims to operate under a sound corporate governance mechanism and to safeguard legitimate rights and interests of fund shareholders and other parties concerned. The staff of a fund management company established by a commercial bank shall not be on the payroll of the investor bank, and cannot take concurrent positions in the two institutions. Senior managers of the incorporated fund management company shall meet relevant requirements stipulated in the Administration of Appointment of Senior Management Personnel of the Securities Investment Fund Industry Procedures. Operation and Investment of Funds Fund management companies invested by commercial banks shall raise and manage funds within the business scope stipulated by the Funds Law. According to the New Procedures, the type of funds raised and managed by those fund management companies, during the preliminary pilot period, are not limited to money market funds and bond fund; other types of funds are allowed. Here, "other types of funds", referring to stock funds and mixed funds, means the fund assets managed by commercial bank-invested fund management companies. These can be directly invested in the stock market. This indicates that commercial banks may, to some extent, do a mixed business through their subsidiaries. Notwithstanding the provisions on "other types of funds", it is anticipated that fund management companies launched by banks will first start with the development of money market funds and bond funds, the areas in which banks have rich expertise. The New Procedures provide that fund property managed by a commercial bank-invested fund management company shall not be used to purchase securities issued by or underwritten during the distribution period by its shareholders. In addition, according to the provisions of the Funds Law, fund property is also not allowed to be invested in or used for purchasing or selling securities issued by or underwritten during the distribution period by a shareholder that has a controlling shareholding relationship with, or a company that has other material interests in, the fund custodian. As for the financing contribution to the fund, the New Procedures provide that it shall comply with the relevant rules and regulations. However, so far there are few specific procedural or substantial provisions regarding financing contribution to the funds in the Funds Law or to any other laws and regulations. It is necessary for fund managers to make some financing contribution to a fund, since fund managers have to deal with fund shareholders' daily redemption and also because they bear the responsibility of using fund property to carry out investments on behalf of fund shareholders. In practice, fund managers usually make financing contributions to a fund by means of repurchasing bonds in inter-bank markets and in the stock exchanges, which may be the only method of financing contributions with justification.

4 Related Transactions As per Article 28 of the Funds Law, a fund custodian and a fund manager shall not be the same party and shall not make capital contributions to, or hold shares in, each other. Accordingly, in a case where a fund management company is established by a commercial bank and the latter makes capital contributions to and holds shares in the former, a commercial bank cannot act as the custodian for the funds managed by the invested fund management company. These same provisions are also stipulated in the New Procedures. However, these provisions are somewhat controversial. A commercial bank, serving as a fund custodian, can earn large profits, including not only custodian fees but also stable derivative profits, such as the fund deposit from settlement reserve of the fund assets in custody. A fund management company has to entrust fund property to the custody of a commercial bank other than its investor bank; with the fund management company's development of more and more fund products, more and more custodian based client sources and derivative business may flow to other commercial banks acting as fund custodians. To avoid such loss, commercial banks are likely to make "cross-custodian" arrangements on a reciprocal basis. These arrangements, although possibly conveying benefits, are not definitely prohibited in any existing laws or regulations. But they are quite unfair to those fund management companies that have not been established by banks. Although a commercial bank is not permitted to serve as the custodian of the fund products issued by a fund management company with its equity investment, it is allowed to distribute fund products, on a commission basis, according to the New Procedures. To avoid unfair related transactions, the New Procedures also stipulate that, with regard to arrangement of the distribution period, standard for service fees, participation in development of fund products, etc., a commercial bank shall not provide terms more favourable than those provided in the same kind of transactions with unrelated third parties. It shall not take discriminatory measures against other fund products it distributes, and shall not get involved in any unfair sales or unfair competition. However, in practice, it is usually quite difficult to recognize so-called unfair sales and unfair competition, since the current PRC anti-unfair competition framework is not very sophisticated. Another clause regulating unfair related transactions under the New Procedures is that a commercial bank and its established fund management company shall not conduct transactions with each other in more favourable terms than those provided in the same kind of transactions with unrelated third parties in the inter-bank bond market. In addition, the New Procedures entitle the CBRC and CSRC to jointly formulate implementing rules regarding related transactions between a commercial bank and its developed fund management company. APPROVAL AND SUPERVISION Based on China's segregated supervisory framework, commercial banks are subject to the supervision of the CBRC, while the Funds Law confers approval and supervision prerogatives in securities investment fund activities on the CSRC, including approval of fund management companies. According to the New Procedures, the CBRC and the CSRC, together with the PBOC, are empowered to coordinate the pilot incorporation of fund management companies by commercial banks. In the process of a commercial bank's development of a fund management company, the CBRC shall, in light of the overall risk control of the commercial bank, first examine the commercial bank's qualifications for making investment in a fund management company, and issue a supervisory opinion on whether to approve or disapprove the commercial bank's application for establishment of a fund

5 management company. Then, after obtaining the CBRC's approval, the commercial bank concerned shall submit application documents to the CSRC in accordance with the SIFMC Procedures and other relevant rules and regulations and CSRC will make a decision on approval or disapproval of the application in compliance with relevant laws and regulations. At the pilot stage, all documents submitted to CBRC and CSRC must all be copied to the PBOC. Fund management companies established by commercial banks shall be subject to the joint regulation of all three bodies (the CBRC, the CSRC and the PBOC). The New Procedures entitle the CSRC to examine and approve the types of fund raised, supervise fund management companies and regulate fund products raised and managed by fund management companies, in order to ensure the legitimate operations of fund assets and protect fund investors' legitimate rights and interests. The CBRC is responsible for defining the calculation criteria for relevant risk control indicators, and conducting consolidated balance sheet supervision and regulation for commercial banks. The PBOC is in charge of registering and monitoring transactions of fund management companies incorporated by commercial banks in the inter-bank bond market. LOOKING AHEAD Since the equity capital market is relatively underdeveloped and direct finance is still not freely or easily done in China, allowing commercial banks to launch fund management companies will have a salutary effect on the banking industry. Many banks have already expressed an interest in launching their own fund management companies, which will enable them to diversify their business line, broaden profit sources, and disperse the risks of indirect finance in the inter-bank market. However, from the perspective of the existing fund management companies, the promulgation of the New Procedures, allowing the development of fund management companies by commercial banks, may not be a piece of good news to them and it appears that they have to figure out how to survive in a more severe and competitive environment. With a more solid client base and stronger capital sources, commercial banks usually hold larger proportions in selling fund products. With the emergence of fund management companies established and invested by commercial banks, a large proportion of profits obtained in the funds industry, mainly from management fees, subscription fees, purchase fees, redemption fees and custodian fees, will most likely flow to the banking industry. (China Law & Practice, April 2005)