China Law Insight : China Business and Intellectual Property Lawyers & Attorneys : King & Wood Law Firm : IP, Arbitration, Litigation, Securities, Foreign Investment

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.】
 

Given China's resilience to the financial crisis, it seemed a good place to meet redemptions and liquidity needs by selling positions. However, it was much easier to get money into China than to get it out.

Beijing has long been wary of foreign investors, imposing strict controls on FDI and offshore loans. Unable to resist GDP growth, renminbi appreciation and real estate expansion, investors wanted in – keen to avoid regulatory processes and wanting exit strategies. Offshore structuring appeared as a solution, but this was conceived against the bubbling real estate market – where much of the foreign money was headed.

I warned investors that 1 billion square feet of residential and commercial projects were underway in Beijing alone. But local banks and foreign funds provided cash; developers continued to build. The government tried to rein in a runaway market. The lending spigot at local banks ended, interest rates and down payment requirements increased and anti-speculation taxes were imposed. The bubble began to burst, with markets in south China suffering first. Developers, undeterred, bought more land and continued building. Their ambitions finally caught up with them last year.

China's listed real estate developers have seen their share prices fall by 80% from November 2007. Despite government efforts to revive the residential market, buyers are only responding to price cuts. Many of these developers are hemorrhaging cash, turning to non-banks and gray market lenders.

The unlisted firms have caused the most trouble. An IPO promised riches and so these developers expanded aggressively. They needed capital; foreign investors acquiesced. Investments were structured offshore and the money came onshore via preferred equities and convertible bonds issued by offshore companies with real estate holding companies in China.

Many large developers missed IPO deadlines, facing disgruntled investors. Alternative investment managers now face redemptions from investors and busted covenants and debt defaults from Chinese developers.

It seems, from the offer¬ing circulars, that few of the investors or developers knew what they were getting into. The developers gave guarantees, pledged unlisted shares, issued “no-IPO put options”. They agreed to pay punitive escalating internal rates of return, going from 30% to 70%, if the IPO was delayed by 18- 30 months.

The alternative investment managers who relied on “contractual” guarantees to protect their interests overlooked the clause in the circulars which states that offshore creditor rights are not enforceable in Chinese courts. Neither are judgments in foreign courts binding on Chinese corporations or citizens.

Many of the international law firms that developed these structures are now advising clients not to enter Chinese litigation. Yet they recognize that by the time the offshore judicial process concludes, Chinese developers would have transferred assets with any unencumbered value, or allowed onshore creditors to slap asset preservation orders on any remaining assets.
The international law firms are too pessimistic. Foreign investors can use the Chinese legal system to enforce their offshore creditor rights, seize collateral, freeze assets to keep them from disappearing, enforce guarantees and bring Chinese entrepreneurs to negotiate.

Most Chinese real estate developers sleep soundly yet foreigners remain engrossed in inconclusive meetings trying to answer their investors’ questions:
• What is the status of my investment in China and what is the condition of the Chinese partner?
• Is the original investment strategy still viable in the present climate?
• Should I continue to hold, sell or invest additional capital and if so is there a realistic business plan I can evaluate?
• If I continue to hold or invest is there a way to get closer to the company and its assets onshore to remedy some defects inherent in offshore structures?
• How do I limit my liability and is there a plan to get my capital out of China?
• Are my interests and those of the alternative investment manager still aligned?

My advice to foreign investors is: act now. Chinese business partners will inevitably satisfy local creditors first, unhesitatingly encumbering a foreign investor's secured assets. Investors must rectify the defects in their offshore structures so they can use local courts and rely on Chinese litigation to settle with local partners.

The end game is to develop a capital preservation and exit strategy, leading to an informed decision to invest, sell or stay the course.