China Law Insight : China Law Insight: China Commercial and Intellectual Property Lawyers and Attorneys, Full Service Law Firm: King & Wood

According to the Guiding Opinion, the CBRC continuously published Administrative Measures for Leverage Ratio of Commercial Banks (June 1), Administrative Measures for Loan Loss Provisions of Commercial Banks (July 27), then Administrative Measures on Commercial Banking Capital (Draft for comments) (August 12) and Administrative Measures on Commercial Banking Liquidity Risk (tentative) (Draft for comments) (October 12), to solicit public opinions. The four above administrative measures all provide for implementation from January 1, 2012.

The new regulatory standards are stricter than Basel III with respect to key regulatory indicators. The CBRC requires the tier 1 capital adequacy ratio to be not less than 5%, higher than Basel III's requirement of 4.5%, which is the international standard. The CBRC requires commercial banking leverage ratios to be not less than 4%, higher than the 3% that is the international standard. With respect to requirements for loan loss reserves, the CBRC requires a new indicator of the "loan provision ratio" (the ratio of loan loss reserves to outstanding loans shall not be less than 2.5%), which places a great deal of pressure on many small and medium-sized banks.

According to the International Finance News this week, among the above four new regulatory standards, the CBRC may postpone implementation of the capital adequacy ratio, loan loss reserve and liquidity indicators, while the leverage ratio will be still implemented as planned. News of the decision was welcomed by the banking industry. Although this action can not be regarded as loosening the restrictions of regulatory policy, it provides adequate preparation for regulatory authorities, commercial banks and capital markets, which helps the successful implementation and smooth transition of the new regulatory policies. As to the extent of influence on the credit supply capacity of the banking system as well as on the macro economy, only time will tell.  (Written by Su Meng)

根据《指导意见》，2011年银监会连续公布了《商业银行杠杆率管理办法》（6月1日）、《商业银行贷款损失准备管理办法》（7月27日），之后又公布了《商业银行资本管理办法（征求意见稿）》（8月12日）和《商业银行流动性风险管理办法（试行）（征求意见稿）》（10月12日），向社会公开征求意见。上述四项管理办法均规定自2012年1月1日起实施。

在关键监管指标上，新监管标准较第三版巴塞尔协议标准更为严格。银监会要求核心一级资本充足率不得低于5%，高于第三版巴塞尔协议规定的4.5%的国际标准；要求商业银行杠杆率不低于4%，高于3%的国际标准；而在贷款损失准备要求上，银监会还提出贷款拨备率（贷款损失准备与各项贷款余额之比不得低于2.5%）这一新指标，更让不少中小银行倍感压力。

据《国际金融报》本周最新消息，上述四项新监管标准中，银监会可能推迟执行资本充足率、贷款损失准备和流动性指标，而杠杆率指标仍按时执行。消息一出，银行业内人士多表示支持，虽然此举无法被视为监管政策的放松，但为监管机构、商业银行和资本市场都提供了更充分的准备时间，有利于新监管政策的顺利实施和平稳过渡。至于新监管制度将在何种程度上对银行体系的信贷供给能力以及宏观经济的运行产生影响，我们将拭目以待。（作者：苏萌）

The circular focuses on one of the two regular models of bank-trust cooperation. In the first model, commercial banks collect funds from clients through the issue of wealth management products and entrust these funds to trust companies for outside management ("Model A"). In this model the bank's customers have no direct contact with the trust company.

In cases following the second model, which is not addressed by the circular, trust companies engage banks as a distributor of their financial products ("Model B").

The circular states that "Model A" products should be classed as either finance products or investment products. Under the new regulation, the proportion of finance bank-trust product liabilities must remain below 30% of total outstanding bank-trust liabilities. The circular also states that funds obtained through sale of investment products may not be invested in unlisted companies, although some flexibility may be allowed to encourage investment in developing industries, such as new energy.

The circular will force banks to reduce the volume of credit and quasidebt investment, including classic equity investment with a counterpurchase option, to below 30%, forcing banks and trust companies to look for new ways to maximize profit through investment-class bank-trust products. It will be difficult, however, for trust companies to achieve this goal with the circular's new restrictions on private equity investments.

It is possible that trust companies may find ways around the new regulation either by creating limited partnerships to act as investment vehicles for funds obtained through the sale of investment-class trust products or by investing in equity-linked products, primarily contractual arrangements involving no actual equity ownership.

Banks and trust companies may also increase sales of “Model B” trust products, which are not addressed in the new circular. The second model, however, will reduce the number of qualified investors able to take part in trust investment. This model may also force banks to reveal their profits to clients.

The circular also stipulates that bank-trust investment products launched prior to the circular's publication must be shown on bank balance sheets before the end of 2011 and that banks must maintain the capital adequacy ratio for trust products according to the same regulations as applied to loans. The circular states that balance sheet restructuring must be carried out according to a specific set of requirements but does not state the specifics of these requirements. The circular does not address bank-trust investment products released after the publication of the circular, but the regulations are unlikely to be different.

Finally, the circular requires that all trust products must have contracts of longer than one year and prohibits the creation of open-ended finance-class trust products. Before the CBRC prohibited bank-trust cooperation in July, trust products often fulfilled long term financing need through the creation of several short term financing agreements. This process has now been regulated. For example, a three year project may be split into three separate one year financing products, ensuring the timely injection of funds. The new regulated system still retains some risk, however, and if the second and third year products fail to sell, financing for the project may fail.

 I. Scope of Outsourcing by and Management Responsibilities of a Bank
A. Scope of Outsourcing

The scope of outsourcing is the first decision a bank needs to make before outsourcing its services. Currently, the China Banking Regulatory Commission ("CBRC") has not established general restrictions regarding the scope of IT outsourcing that a bank can engage in. However, a bank should not outsource its IT technology management responsibilities and must report to the CBRC or its branch offices any important outsourcing engagement (see below Section I Subsection C, Report to Supervisory Authority or Notice to Client). Therefore, relevant supervisory authorities may not permit a bank to outsource the management or maintenance of some of its highly confidential or core information systems.

B. Cross-border Outsourcing

In recent years, a number of financial institutions have engaged outsourcing service providers in India, China, and other developing countries because of the lower labor and operational costs in these countries. However, the accumulation of outsourcing service to one or a few countries may amplify the "Country Risk" of the information. Once an offshore outsourcing country faces an incomprehensible problem, the financial institutions outsourcing their business to such a country may suffer irreparable harm. Therefore, the supervisory authorities in many countries tend to take a cautious regulatory approach towards the cross-border outsourcing implemented by banks.

The CBRC's Guidelines on Risk Management of Outsourcing by Banking Institutions ("Risk Management Guidelines") require that a bank which conducts cross-border outsourcing shall prudently assess the legal and regulatory risks to ensure the security of the clients' information. The Risk Management Guidelines also establish that such a bank must make sure the regulatory authority at the place where the service provider is located have signed a memorandum of understanding or other agreements with China's banking regulatory authority. Moreover, the CBRC's Guidelines on Risk Management of Commercial Banks' Information Technology ("Technology Management Guidelines") require that the board of directors shall ensure a bank operates the core system containing client information, account information and product information independently and within the territory of China.

C. Report to the Supervisory Authority or Notice to Client

According to the Technology Management Guidelines, the banks shall exercise precautions when implementing important outsourcings (such as data centers and information technology facilities), and shall report these outsourcings to the CBRC or its branches in writing. In addition, the Guidelines require that any outsourcings involving client information be deemed an important outsourcing of the bank. As the existing PRC law is unclear about the definition of "important outsourcing," we suggest that the banks consult with the competent supervisory authority at their domicile if they are uncertain about whether the outsourcing to be performed will be regarded as an important outsourcing subject to reporting duty to CBRC.

The Administrative Rules on Electronic Banking ("E-Banking Rules") provide that banks shall report any outsourcing of electronic banking. According to the E-Banking Rules, a bank shall report to the CBRC before outsourcing the general design and development of electronic banking transaction processing system, authorization management system, data backup system, and other confidential information management and transmission systems.

In addition, the Risk Management Guidelines require the bank to submit an outsourcing appraisal report to the local branch of the CBRC regularly. However, banks will need further clarification or detailed guidance of the relevant authority on compliance.

In addition to the responsibility of reporting to the supervisory authority, in certain circumstances, the banks also need to inform the relevant clients about their outsourcing arrangement. For example, the Technology Management Guidelines require that a bank shall notify clients any outsourcing involving the client information.

D. Internal Approval

According to the relevant regulations, all IT outsourcing contracts of a bank shall be approved by the bank's department of information technology risk management, legal department, and its information technology management committee. Certain IT outsourcing contracts may require the approval of the board of directors.

E. Compliance of Offshore Regulatory Authority

When implementing outsourcing, the foreign-invested commercial banks in China shall comply with the requirements of the CBRC as well as those of the regulatory authorities in their home country. Therefore, these banks need to manage the risk arising from the regulatory difference between China and their home country.

II. Summary Terms of Outsourcing Contracts

The CBRC requires that banks must enter into IT outsourcing contracts when engaging IT outsourcing services. The contracts shall be in written forms and clearly provide the rights and responsibilities of the parties. An IT outsourcing contract usually consists of the outsourcing agreement and the service level agreement.

A. Outsourcing Agreement

An outsourcing agreement shall at least contain the following terms: (1) the scope and standards of the outsourcing service; (2) the confidentiality and security of the outsourcing service; (3) the continuity of the outsourcing service; (4) the auditing of and inspection on the outsourcing service; (5) the dispute resolution arrangement of the outsourcing service; (6) the transitional arrangement upon revision or termination of the agreement; and (7) the liabilities in case of default.

The outsourcing agreement shall have both effective binding force on the parties and a certain amount of flexibility. An inadequate outsourcing agreement may lead to uncertainties during the service provider's performance of the IT outsourcing service. In practice, some outsourcing agreements do not include detailed provisions to govern the service provider's performance, quality of service, and rights and responsibilities of the parties. In this case, disputes may arise and the business that the bank outsources may be at risk if the parties are unable to timely execute supplementary agreements to address new situations, issues, and risks that arise during the performance of the outsourcing agreement. For these reasons, the banks should strive to make the outsourcing agreement as clear, specific, and meticulous as possible when drafting the agreement. However, due to the nature of IT outsourcing, a bank's need varies in different phases of business development (especially when two parties have established a long-term cooperative relationship). Therefore, the parties may need to amend the agreement as needed to make sure the performance of the agreement will not be affected. If the outsourcing agreement lacks flexibility, the time budget and financial costs that the parties will need to bear for additional negotiations may increase significantly. The continuity of the bank's business may also be compromised. Therefore, the outsourcing agreement should be flexible enough to be amended to adapt to the new situations appearing during the execution of the agreement.

B. Service Level Agreement

The service level agreement is entered into by the bank that plans to outsource its business and the outsourcing service provider regarding the assessment of business performance and service quality. The purpose of such an agreement is to evaluate, monitor, and control the operational and financial risks in relation to the IT outsourcing service. A reasonable and meticulous service level agreement is an integral part of a sophisticated IT outsourcing agreement. As an internationally accepted standard to evaluate IT outsourcing service, the service level agreement is a legal document executed by the bank and the service provider and is crucial to the bank's supervision and management of the service provider.

CBRC requires that a bank considers the following factors when drafting a service level agreement: (1) whether the agreement has established qualitative and quantitative performance indicators to evaluate the service provided to the bank and relevant clients is sufficient; (2) whether the agreement appraises the performance of the service provider through the service quality report, periodical self-evaluation, and internal or independent external auditing; and (3) whether the agreement includes any steps to help the service provider to improve the procedures and performance when the service provider is unable to meet the agreed standards or indicators.

In practice, Chinese banks and their outsourcing service providers are inexperienced in formulating service level agreement. Therefore, the established terms might not suffice in protecting the interests of the parties. For example, the agreement may not include a term to protect the bank's interests where material technical errors arise during the outsourcing service provider's performance of the agreed service. In essence, both parties should exercise due care when formulating the service level agreement to ensure that the agreement is able to provide good protection to both parties.

As IT outsourcing for financial institutions in China continues to develop, relevant supervisory regulations are being updated and improved to keep up the latest development of the IT outsourcing practice of banks. Similar to the IT outsourcing of banks, the IT outsourcing of securities companies, futures companies, fund management companies, and insurance companies also involve many important legal and regulatory issues. The financial institutions engaging in IT outsourcing services shall effectively manage their outsourcing contracts to control the risks and make sure that the performance of these contracts will not compromise their responsibilities to the clients and the supervisory authority, as well as their compliance with regulatory requirements.

Although claims of this kind are generally for small amounts, their impact on the banks concerned should not be underestimated. The dispute between the bank and the investor is often quite intense. For these reasons, Chinese financial regulators are very concerned about the potential impact of such cases on the larger financial order. Another issue is that cases involving small claims are usually tried in local courts which do not have expert knowledge of complex financial products. This means that the relevant courts take a cautious approach to the conduct of such trials and the resulting court decisions reflect this cautious attitude.

Case Background
On February 18, 2008, at the recommendation of a wealth manager at the Oriental Plaza sub-branch of ABN AMRO (China) Co., Ltd (“ABN AMRO”) a Chinese investor decided to invest in a structured deposit (Phase III) product linked to the ABN AMRO/AIG “Chinese Agricultural Products Gross Return Index” (the “structured-deposit-based financial product”) . The principal invested in this particular product was guaranteed if the investor maintained its investment until maturity. On February 19, 2008 the investor deposited AUD 50,000 into an account which he had opened with ABN AMRO. Then, on February 21, 2008, the investor went to ABN AMRO to complete the formalities for purchasing the structured-deposit-based financial product. The product did not perform well during the developing global financial crisis. Therefore, on September 24, 2008 the investor filed an application for redemption of his investment and accordingly, ABN AMRO commenced the procedures for redemption. On October 16, 2008 ABN AMRO converted and settled the investor's redeemed funds in Chinese yuan renminbi at the investor's request.

By then the investor had lost RMB 142,621 which included a loss of RMB 40,565.64 due to his early redemption decision and RMB102,040 due to the conversion of Australian dollars into Renminbi.
On November 10, 2008, the disappointed investor filed a lawsuit with the Dongcheng District Peoples' Court in Beijing, claiming compensation from ABN AMRO for the loss which he had suffered on the basis of alleged fraud, concealment of important facts and breach of contract by ABN AMRO. In 2009, the Dongcheng District People's Court dismissed the investor's claim emphasizing that there are risks associated with wealth management products and setting out the duties and obligations that banks should observe when performing contracts for fiduciary wealth management. This case has served as an important reference for similar cases which have subsequently arisen.

Case Analysis

Was ABN AMRO’s structured-deposit-based financial product valid under PRC law?

Article 46 of the Interim Procedures for Administration of Personal Wealth Management Business of Commercial Banks (the “Procedures”) promulgated by the China Banking Regulatory Commission in September 2005 states that:

“commercial banks shall receive approval from the China Banking Regulatory Commission before they carry out the following wealth management services for individuals: 1) earning-guaranteed financial products; 2) new investment products designed on an earning-guaranteed basis for personal wealth management business; and 3) other personal wealth management services subject to approval from China Banking Regulatory Commission”.

Article 51 of the Procedures states that “commercial banks do not need to obtain approval for other personal wealth management services but they must report the same to the China Banking Regulatory Commission or its local agency in a timely manner pursuant to the applicable regulations”.

In the case mentioned above, ABN AMRO's structured-deposit-based financial product did not fall within the meaning of “investment products designed on an earning-guaranteed basis” as defined in the Procedures. However, in his complaint, the investor challenged the legality of ABN even issuing the product in China on the basis of an allegation that ABN AMRO had only filed the product with the banking regulatory agencies in Shanghai and Beijing and had not received approval for the product. He further alleged that the banking regulatory agencies did not provide any acknowledgement or receipt after they had received the product filing from ABN AMRO.

In answer, ABN AMRO submitted a bound volume to the court, which contained all of the recorded documents filed with the two banking regulatory agencies in Shanghai and Beijing, with the date of filing and the signatures of the handling clerks at the two banking regulatory agencies evident on the face of the documents. The court admitted this evidence after verifying it with the two agencies concerned and, as a consequence, accepted that the structured-deposit-based financial product issued by ABN AMRO was valid and legal, observing that the procedures for reporting to the China Banking Regulatory Commission's local agencies had been timely completed.

Did the bank give clear notice about the possible risks associated with the structured-deposit-based financial product when promoting it to the investor?

Because of the complex structure of wealth management products, most courts in China suspect that banks’ wealth managers overstate the potential earnings capacity and conceal the risks associated with their products while misleading clients into purchasing high-risk products. As a result, courts tend to sympathize with individual investors and this approach reflects the most common approach taken in legislative and judicial practice in China generally. For instance, when interpreting the insurer’s obligation under the PRC Insurance Law to “make clear explanation” of the “disclaimer” in an insurance policy, the Supreme People’s Court has decided that the disclaimer may not be deemed valid unless the insurer has clearly and expressly explained to the policy holder or its agent, either orally or in writing, the definitions, content and legal consequences of or relating to the disclaimer in addition to including notices to the same effect in the insurance policy.

With this approach in mind, banks responding to similar lawsuits in China need to be able to adduce evidence sufficient to prove that they have given express notice about the specific risks associated with the particular wealth management products which they have promoted to each client on each occasion. In the case above, ABN AMRO had in fact elaborated on the clauses contained in the contract for the structured-deposit-based financial product and had also expressly drawn the investor’s attention to notices in related documents which illustrated the risks associated with that particular product in language understandable to persons who are not financial professionals (in this case in particular, concerning risks to the principal investment and foreign exchange rate risks in the context of an early redemption by the investor). At the same time, ABN AMRO had also presented evidence to the court that the investor had delivered responses to an “Evaluation Questionnaire for Investments by the Client” and a “Suitability Questionnaire” provided by the bank. In this way ABN AMRO was able to prove that it did give detailed notice about the risks associated with the particular structured-deposit-based financial product in question when promoting the product to the investor in that particular case. As a result, the Dongcheng District People’s Court concluded in its final judgment that the investor had purchased the product voluntarily on the basis of a full understanding of the risks associated with the product.

Did the bank induce the investor into early redemption?

In performing its fiduciary wealth management service, ABN AMRO had sent the investor monthly statements and reports through express courier delivery service and had properly maintained records of each statement and report. These documents showed that even though the product was not performing well, ABN AMRO had, on a monthly basis, truthfully informed the investor about the performance and net value of the product as well the risks associated with an early redemption .

By contrast, the investor had alleged in his complaint that he chose early redemption as a result of demands and inducements received from ABN AMRO's staff. In answer to these allegations, ABN AMRO presented a notarized record of telephone calls between the investor and ABN AMRO's wealth manager, which showed that the investor had chosen early redemption on the basis of his own judgment of the condition of the international financial market at the time, despite knowing that his principal investment was not guaranteed unless he held the product until maturity. In addition, notarized evidence showing the variations in the Australian dollar's exchange rate and in the product's value after the investor redeemed his investment proved that it was the early redemption decision by the investor which had caused the investor's loss. As a result, the court ultimately dismissed the investor's claim.

Given that the financial derivative market in China is not yet mature, banks should give careful thought about how wealth management products that are promoted in China can be designed and advertised well, and how their fiduciary obligations to customers in China can be performed well. Banks may be exposed to legal risks and held liable for the risks inherent in the products which they promote if they have not paid careful attention to these matters and have not strictly adhered to applicable regulations in some aspects of their services. After all, customers entrust their assets to banks because they look at banks as trustworthy financial experts. It is true that investments do come hand in hand with risks, but banks always have an obligation to keep risks within a reasonable limit.
 

【Wang Fengli is a partner and Wang Jian’gang is a lawyer from the litigation and arbitration team in the head office of King & Wood PRC Lawyers in Beijing.】
 

The move is no doubt part of a broader effort by the government to boost domestic consumption as an engine of delivering growth as outlined by the State Council in its policy “to maintain growth, adjust structure, promote reform and benefit livelihood".

The CBRC issued the Pilot Management Measures for a Consumer Finance Company (“Pilot Measures”) on July 22, 2009. The hope is that the establishment of consumer credit companies will promote domestic consumer demand and support sustainable economic development.

The PRC has (possibly luckily) missed out on the easy credit boom seen in much of the West (and also parts of Asia). The “consumer financial companies” outlined in the Pilot Measures refer to non-bank financial institutions established within the PRC and subject to CBRC approval. Crucially such companies are prohibited from taking deposits from the public. Such consumer credit companies are to provide small-amount loans according to the Article 2 of Pilot Measures. The consumer credit companies will offer personal loans for the purposes of travel, education and durables (i.e. electrical home appliances and IT products).

According to the Pilot Measures, the main shareholder in a consumer financial company must be a financial institution (can be domestic or overseas). Shareholders will also need to obtain CBRC approval and are subject to meeting certain conditions (i.e. overseas financial institutions must have had a representative office in China for more than two years or established a branch and have a sufficient analysis and research capability within China; the financial monitoring authority in their home country must have a good cooperative relationship in place with the CBRC in respect of administration and supervision). We understand that at present no foreign financial institution or foreign investor has been approved by the CBRC but the regulations do clearly allow for such possibility.

It is interesting to note that Bailian, one of China's largest retail conglomerates, is a shareholder in one of the recently established consumer credit companies.
 

Summary

Time will tell whether the growth of consumer credit in China will lead to a mountain of consumer debt as is the case of US and Korea or whether Chinese consumers will continue to pay off their bills on time much to the chagrin of their financiers. In any event the new developments are a further indication of China seeking to use domestic demand as an engine of growth rather than relying solely on exports. Foreign retailers and financial institutions are likely to closely monitor the opportunities that arise for them as credit becomes a more common part of consumer life.