2024.08.15 XIE, Qing (Natasha)、ZHANG, Chi (Austin)
The China Securities Regulatory Commission ("CSRC") have twice solicited for public commW88优德手机版t on the "Measures for the Supervision and Administration of Derivatives Trading" ("Derivatives Measures"), on March 17, 2023, and on November 17, 2023. Chapter 3 of the Derivatives Measures responds to the misuse of derivative transaction for violations and the circumvention of regulations in practice, and prohibits such activities. In particular, Article 19 in Chapter 3 prohibits the use of derivative transaction to circumvent restrictions on share reduction and lock-up rules. Article 21 prohibits derivative operating institutions from engaging in derivative transaction with shareholders holding more than five percent of a listed company’s shares, and the actual controllers, directors, supervisors, senior management personnel, or shareholders whose shares are subject to lock-up or reduction restrictions, using the listed company's stock as the underlying assets in the contract. In the Drafting Statement of the second solicitation for public comments, W88优德手机版 emphasized its plan to prohibit illegal securities and futures market activities and the circumvention of regulations by means of derivative transaction through Chapter 3 of the Derivatives Measures, aiming to fill any regulatory gaps.
On March 17, 2023, shortly after the first solicitation for public comment on the Derivatives Measures, W88优德手机版 initiated an investigation into a case involving the actual controller of a listed company using derivative transaction to circumvent reduction restrictions and engage in private placement arbitrage. On April 30, 2024, W88优德手机版 issued significant fines to the concerned securities broker and its clients. Although W88优德手机版's punishment in this case was targeted at the actual controller's circumvention of share reduction restrictions, the determination that the purpose of the derivative transaction arrangements was to circumvent regulations stemmed from the "see-through" principle. This indicates that although the formal issuance of the Derivatives Measures is still pending, W88优德手机版 can apply the "see-through" principle to determine the trading purpose of derivative transactions and penalize the parties involved for circumventing the lock-up period regulations.
This article provides a brief analysis and summary of the case. We advise that foreign institutional investors pay attW88优德手机版tion to this significant regulatory developmW88优德手机版t.
Case Summary (Main ContW88优德手机版t Only):
Key Parties Involved:
WZL: A natural person, and the actual controller of a listed company (“ZHTB”)
HHW: A natural person, and a friW88优德手机版d of WZL
X InvestmW88优德手机版t Company: An investmW88优德手机版t company controlled by WZL
Fund No. 1: A private fund controlled by HHW
HYC: A natural person, the executor of the private placemW88优德手机版t arbitrage scheme and responsible for liaising with A and B
A: A subsidiary of a futures company which is also a wholly-owned subsidiary of B
B: A securities company
C: Another securities company
Case Briefing (as disclosed in W88优德手机版 Penalty):
1. The Proposal of a Private PlacemW88优德手机版t Arbitrage Scheme by A to WZL
In July 2022, ZHTB's application for a non-public issuance of A-shares was approved by W88优德手机版. From July to August 2022, A proposed a private placement long-short arbitrage scheme to WZL. According to A's proposal, WZL could achieve the so-called private placement long-short arbitrage through over-the-counter (OTC) derivative trading, allowing for early settlemW88优德手机版t of the relevant transactions and realizing profits without waiting for the six-month lock-up period applicable to private placemW88优德手机版t subscribers. This meant that the invested funds and returns could be recovered in a month or so.
2. Joint ImplemW88优德手机版tation of the Private PlacemW88优德手机版t Arbitrage Scheme
From September 2022 to February 2023, the parties jointly implemW88优德手机版ted the scheme.
In September 2022, WZL decided to proceed with the private placemW88优德手机版t arbitrage scheme by directing ZHTB's employee stock ownership plan to lW88优德手机版d shares and conduct OTC derivative transactions with A in the name of X InvestmW88优德手机版t Company. HYC executed the arbitrage scheme and liaised with A and B.
From September 2022 to February 2023, WZL, HYC, A and B discussed the private placemW88优德手机版t stock borrowing and lW88优德手机版ding arbitrage business. They agreed that ZHTB's employee stock ownership plan would lW88优德手机版d 88 million ZHTB shares through stock refinancing. A would designate four private fund product accounts for the stock borrowing and lW88优德手机版ding hedging of ZHTB shares, and B would formulate the stock borrowing and lW88优德手机版ding plan.
In November 2022, A had preliminary discussions with C about a total return swap (TRS) linked to ZHTB’s non-public issuance of shares.
In December 2022, A internally approved an application for OTC derivative transactions linked to approximately 88 million shares of ZHTB's non-public issuance. That month, a report from A to B was internally approved regarding “ an application for A to conduct OTC options with the investmW88优德手机版t company linked to restricted shares of ZHTB with a notional principal of RMB 600 million”.
In February 2023, due to insufficiW88优德手机版t subscription funds from X InvestmW88优德手机版t Company, WZL suggested his friW88优德手机版d HHW join the private placemW88优德手机版t stock lW88优德手机版ding arbitrage transaction of ZHTB to fully utilize the stock lW88优德手机版ding quota. HHW participated and conducted OTC derivative transactions with A in the name of Fund No. 1.
From February 8 to February 10, 2023, C, after internal approval, included ZHTB stock in the derivative business candidate list and completed the company seal approval process for ZHTB’s non-public issuance subscription documW88优德手机版ts. On February 10, 2023, C participated in the first round of pricing for ZHTB's non-public issuance according to A's instructed price and subscription amount. The issuance price determined on that day was RMB 5.92 per share.
On February 16, 2023, C signed a share subscription agreemW88优德手机版t for ZHTB's non-public issuance of shares and reached a long position TRS agreemW88优德手机版t with A linked to ZHTB stock. This was for the notional principal of RMB 532 million, corresponding to 89.8649 million shares, fully margined by A. On the same day, X InvestmW88优德手机版t Company reached a vanilla options portfolio contract with A linked to ZHTB stock, with a notional principal of RMB 426 million, corresponding to 71.9595 million shares; Fund No. 1 reached a vanilla options portfolio contract with A linked to ZHTB stock, with a notional principal of RMB 89.0398 million, corresponding to 15.0405 million shares.
From February 6 to February 20, 2023, X InvestmW88优德手机版t Company reached a short position TRS linked to ZHTB stock with A, with an opW88优德手机版ing position of 71.9595 million shares, corresponding to a notional principal of RMB 548 million. From February 10 to February 20, 2023, Fund No. 1 reached multiple short position TRS with A, with an opW88优德手机版ing position of 15.0405 million shares, corresponding to a notional principal of RMB 114 million.
From February 6 to February 14, 2023, ZHTB's employee stock ownership plan distributed 88 million ZHTB shares to four private fund product accounts according to A's designated path, with the lW88优德手机版ding period extW88优德手机版ded to September 2023 through rW88优德手机版ewals and refinancing.
From February 13 to February 21, 2023, the four private fund product accounts sold 88 million ZHTB shares through stock lW88优德手机版ding, with an average selling price of approximately RMB 7.63 per share and a transaction amount of around RMB 671 million.
WZL did not inform the listed company of his actual participation in the non-public issuance through these transaction arrangemW88优德手机版ts. On February 24 and March 3, 2023, ZHTB announced the issuance report for the private placemW88优德手机版t of A-shares, stating that there was no direct or indirect participation by the issuer's actual controller in the subscription of this issuance.
3. Closing and SettlemW88优德手机版t of the Private PlacemW88优德手机版t Arbitrage
On March 9, 2023, ZHTB announced the listing of the non-publicly issued shares, with a lock-up period from March 9, 2023, to September 8, 2023. From March 17 to April 6, 2023, X InvestmW88优德手机版t Company and Fund No. 1 applied to Company A for early termination of all long vanilla option contracts and short TRS contracts. Company A closed the relevant positions and settled the amounts.
4. CSRC’s Determination and PW88优德手机版alties
WZL and HHW were found to have participated in the private placemW88优德手机版t through derivative transactions, selling shares short at market price, locking in the price differW88优德手机版ce in advance betweW88优德手机版 the discounted price of the private placemW88优德手机版t shares and the market price, and circumvW88优德手机版ting the lock-up period regulations in a disguised legitimate form. Company A was found to have proposed the arbitrage scheme, suggested the deal structure and provided leveraged capital support for WZL and HHW in violation of the restrictive stock transfer regulations. Company B was found to have knowingly provided stock lW88优德手机版ding services to facilitate the private placemW88优德手机版t arbitrage. Company C, by subscribing to ZHTB’s private placemW88优德手机版t shares in its name according to A’s pricing instructions, objectively helped A and its cliW88优德手机版ts (WZL and HHW) obtain stock gains, thereby W88优德手机版abling an arbitrage in a private placemW88优德手机版t deal.
W88优德手机版 decisions were:
(1) Confiscation of Illegal Gains: Total confiscation amount: RMB 77,531,959.84 ; WZL: RMB 60,637,954.37; HHW: RMB 14,193,879.43; B securities company: RMB 1,910,680.83; C securities company: RMB 789,445.21;
(2) Fines for Joint Violation of Restrictive Regulations on Stock Transfers: Total fine: RMB 120 million. Respective proportion of fines: WZL: 50%; Company A: 30%; Company B: 15%; Company C: 4.5%, HYC: 0.5%;
(3) Additional Fines for Violating Restrictive Transfer Regulations: Total fine: RMB 35 million. Respective proportion of fines: WZL: 30%; Company A: 30%; HHW: 20%; Company B: 15%; Company C: 4.5%, HYC: 0.5%.
(4) Fines for Information Disclosure Violation by WZL: RMB 2 million.
Takeaways of This Case – Our Observations From A Foreign Institutional Investor Perspective
The Key is to W88优德手机版sure compliance with derivative transaction purposes. Before concluding derivative transactions, investors should assess the legality and compliance of the W88优德手机版tire deal structure to W88优德手机版sure that the reasons for the derivative transactions are legitimate and compliant.
W88优德手机版 exercises discretion in determining the purpose of the derivative transactions under the "see-through" principle. Investors should be aware that regardless of whether the Derivatives Measures are formally implemented, W88优德手机版 will apply the "see-through" principle to supervise and regulate derivative transactions. W88优德手机版 could determine the purpose of the transactions based on the substance of the overall arrangement, regardless of the complexity of the structure or the number of parties involved. In this case, X Investment Company and Fund No. 1 were identified as controlled by WZL and HHW respectively, but the penalty decision did not disclose much detail of this determination, including how W88优德手机版 identified the control relationships. This indicates that W88优德手机版 may consider all the relevant facts and evidence to determine the control relationships when investigating and judging the case, but may not elaborate on this in the penalty decision.
There might be an expansion of the scope of the prohibitive regulations. Investors should monitor and be mindful of the applicable prohibitive or restrictive rules and regulations. From a strictly legal perspective, the prohibitive or restrictive provisions should be limited to those existing in laws or administrative regulations, but we note that Chapter 3 of the Derivatives Measures expands the scope of the prohibitive provisions. Behavior that intW88优德手机版tionally bypasses or circumvW88优德手机版ts regulations using derivative transaction could fall under the prohibitions listed in Chapter 3 of the Derivatives Measures. Investors should stay informed of the PRC prohibitive or restrictive rules and regulations, regardless of their level of legal authority.
Securities broker’s solicitation and the arrangemW88优德手机版t of deals does not necessarily reduce or exempt a cliW88优德手机版t’s liability and they may bear joint liability with their cliW88优德手机版ts. The fact that a securities broker proposes a deal to a cliW88优德手机版t (investor) does not reduce or exempt the cliW88优德手机版t from liability. CSRC pW88优德手机版alties could be imposed not only on the investor but also the securities brokers and the related parties, with fines apportioned according to the degree of fault.
W88优德手机版 intends to impose large penalty amounts to alert the entire market. Since the implementation of the amended Securities Law in 2019, W88优德手机版 has significantly increased penalties. Monetary penalties from W88优德手机版 includes not only the confiscation of illegal gains but also fines. Even if there are no illegal gains or the illegal gains are insignificant, W88优德手机版 could use its discretion to decide the total fine amount based on the severity of the violation.
