Bargaining for Compensation in the Shadow of Regulatory Giving: The Case of Stock Trading Rights Reform in China BARGAINING FOR COMPENSATION IN THE SHADOW OF REGULATORY GIVING: THE CASE OF STOCK TRADING RIGHTS REFORM IN CHINA WALLACE WEN-YEU WANG* JIAN-LIN CHEN** 1. IN TR O D U CTIO N ........................................................................ 299 II. HISTORICAL BACKGROUND AND REFORM ...................... 303 A. HISTORICAL BACKGROUND ..................................................... 303 B. DEFICIENCIES IN THE SPLIT SHARE STRUCTURE ....................... 305 C. THE IMPLEMENTED REFORM .................................................... 308 III. DOCTRINAL AND LEGAL BASIS: TRADITIONAL A PPR O A C H E S ............................................................................ 312 A. CONTRACT THEORY AND OTHER PRIVATE LAW REMEDIES ..... 312 1. Share E quality .................................................................. 3 13 2. Trading Rights and Non-Tradable Shares ........................ 315 3. Analyzing the Contract .................................................... 316 4. Tort and Unjust Enrichment ............................................. 318 5. Conclusion on Private Law Remedies ............................. 319 B. PUBLIC LAW REMEDIES ..... . ..... ........................... 320 1. Scope of Judicial Review ................................................. 320 2. A pplicable L aw ................................................................ 323 3. U.S. Regulatory Takings Doctrine .................................. 324 C. LIMITATIONS OF THE PUBLIC-PRIVATE DICHOTOMY ................ 326 IV. DOCTRINAL AND LEGAL BASIS: GIVINGS DOCTRINE .. 327 A. IMPORTANCE AND RELEVANCE OF GIVINGS ............................. 327 B. IDENTIFYING AND CHARGING THE GIVINGS ............................. 331 1. R eversibility of the A ct ............................................................ 331 2. Identifiability of the Recipients ........................................ 333 Professor of law and director of the Center for Corporate and Financial Law, College of Law, National Taiwan University *" Fourth year law student, National University of Singapore. 2006] REGULATORY GIVINGS IN CHINA 299 3. Proximity of the Act to a Taking ...................................... 334 4. Refusability of the Benefits .............................................. 336 V. ECONOMIC ANALYSIS OF THE CHINESE REFORM .......... 337 A. PROPERTY RULE VS. LIABILITY RULE VS. MANDATORY T RAN SFER R ULE ...................................................................... 337 B. PRIVATIZED BARGAINING ISSUES ............................................. 341 1. Negligibility of Transaction Costs ................................... 342 2 . E qu ity ............................................................................... 34 3 3. Rationality of Economic Actors ....................................... 344 VI. REFORM RISKS AND RECOMMENDATIONS ...................... 346 A . RISKS OF THE REFORM ............................................................. 346 1. The Risk of Over-Compensation ...................................... 346 2. The Risk of Holding Out .................................................. 348 B . RECOMMENDATIONS ................................................................ 349 1. Third Party Appraisal Mechanisms .................................. 349 2. Guidelines for the Bargaining Process ............................. 351 VII. CONCLUSIONS: LESSONS ON CHARGING GIVINGS ........ 352 A. GIVINGS SUBJECT TO A CONDITION PRECEDENT ...................... 353 B. IMPLICATIONS FOR THE CHARGING OF GIVINGS ....................... 355 1. INTRODUCTION The split share structure' is a unique Chinese phenomenon that has plagued its capital markets. It arose out of classifying shares based on ownership whereby only certain types of shares were allowed to trade on the Chinese exchanges. The remaining types, constituting the majority of shares, were not allowed to trade and could only be transferred privately.2 "Split share structure" is the translation of "I]Y4, " used in the China Securities Regulatory Commission English website, http://www.csrc.gov.cn/en/homepage/index-en.jsp (last visited Dec. 26, 2006). It is also sometimes translated to "equity division" or "share divestment" by some translators. 2 China, being of civil law tradition, naturally adopts the civil law classification of companies. Unlike the common law traditions where most limited companies are limited by shares regardless of whether they are public or private companies, China only recognized two classes of companies: limited liability companies and companies limited by shares. The former is very similar to the private companies under common law while the later is akin to the public companies. The setting up and management requirements are much more onerous for the companies limited by shares. Also, only companies limited by shares can issue shares to the public and be listed on the stock exchange: See generally, . _'X, [SHI TIANTAO, COMMERCIAL LAW] 143-149 (Beijing, Law Press 2004). Hence, shares in China (and other civil law jurisdictions) have a much narrower COLUMBIA JOURNAL OF ASIAN LAW This non-trading of the bulk of shares resulted in severe market deficiencies, such as conflicts of interest between the non-tradable shareholders 3 and tradable shareholders, erosion of the capital market pricing mechanism and problems in corporate governance. While it is not the sole cause, the split share structure certainly has contributed significantly to the poor performance of the Chinese markets. Both the need for reform and the difficulty of the legal issues involved cannot be over-stated. At first sight, the reform of the split share structure seems to be a simple lifting of the trading restrictions on non- tradable shares. However, the tradable shareholders, who usually paid artificially inflated prices because of the split share structure, would suffer a significant loss in their share prices using the simple rule of supply and demand.4 On the other hand, the non-tradable shareholders would receive a substantial profit from being able to sell their shares at a much higher price than under the private transfer market. The failed 2001 reform attempt that simply allowed the trading of non-tradable shares without any mention of compensation underscored the complexity of the legal issues. Learning from the series of past failed attempts, the Chinese regulatory authorities have implemented the current on-going reform utilizing a privatized bargain mechanism whereby the non-tradable shareholders negotiate with the trading right from the tradable shareholders. This article is about China's reform. The policy nature of market reforms in China means legal analysis is usually relegated to the backseat. Nevertheless, we aim to provide a comprehensive and in-depth legal analysis of this reform. The central legal question is whether the Chinese regulatory authorities can simply grant the trading rights (and the huge benefits that such rights would bring about) to non-tradable shareholders. meaning than in common law jurisdictions. It is important for civil law traditions that certain shares in companies limited by shares are barred from trading on the stock exchange. 3 "Non-tradable shareholders" and "non-tradable shares" is our preferred translation for "SAI AN A" and "*AAR". The flip side will be "tradable shareholders" and "tradable shares" for " A HR " and "'Ai AN". This is one of the two types of translations that have appeared in the related documents posted on the China Securities Regulatory Commission English website, id. The other is "non-floating shareholders". Some translators also used the term "non-floatable shareholders" and "non-circulation shareholders". For informational purposes, "tradable shares," "circulation shares," "floating shares," and "floatable shares" turn up respectively 5292, 441, 492, and 29 search counts on the Yahoo China search engine, SA} ]f [Yahoo! Main Page], http://www.yahoo.com.cn/ (last visited Oct. 31, 2006). 4 An increase in the supply of shares with the non-tradable shares entering the stock market will not match a corresponding increase in demand, especially in the short term. The demand of the shares traded on the stock exchange is primarily dependent on the number of investors and amount of investment capital, which will largely remain the same in the short-term with or without the trading of non-tradable shares. 300 [20:1 REGULATORY GIVINGS IN CHINA Put another way, do the tradable shareholders have any right to compensation from either the non-tradable shareholders or the Chinese regulatory authorities when their non-tradable shares are allowed to trade? This is a legal question that not only requires the close examination of the private relationship between the non-tradable shareholders and the tradable shareholders, but it will also bring into focus the government's role in this tripartite relationship. Should the government compensate losses to private parties that arise out of its regulations and policies? Specifically, should the regulatory takings doctrine 5 be extended to our case where the tradable shareholders suffer a direct loss from a regulation which does not directly target them? Should the non-tradable shareholders be allowed to simply enjoy the huge profits from the government regulation without any charges and at the expense of the tradable shareholders? To answer these questions, Part II first traces the historical background of this reform and also explains how the reform is currently implemented. We then examine the traditional approaches towards the legal basis of the reform in Part III. Private law remedies are discussed first before we look into the public law remedies. Contract theory - which concludes that tradable shareholders should be compensated by non-tradable shareholders since the trading of non-tradable shares now breaches the contract term that the shares "temporarily not trade" - is the predominant theory among Chinese legal scholars. However, we refute the validity of contract theory's result by both critically examining the theory's premises and applying contractual principles. Arguably, the tradable shareholders' loss is caused by the regulatory authorities allowing the non-tradable shares to trade on the stock exchange. Hence we proceed to look into public law remedies. Chinese doctrine on protecting private property from government actions is still at its infancy and is too limited in scope to provide a plausible legal basis. As a comparative study, we apply the more developed U.S. takings doctrine to this reform, but even that fails to provide tradable shareholders with any basis or right to compensation. The difficulties in categorizing the legal basis of the Chinese reform under the traditional dichotomy of private law and public law demonstrates the blurring of the public-private distinction. The incorporation of a privatized bargaining mechanism in the essentially public nature of market reform underscores the limitations of a strict public-private dichotomy. ' Regulatory takings doctrine refers to the US legal doctrine that requires the government to compensate individuals when they suffer property value diminution due to government regulations. See infra Part III.B.3. 2006] COL UMBIA JOURNAL OF ASIAN LA W This is where we turn to the givings doctrine in Part IV. Mirroring takings doctrine, which focuses on identifying which deprivation of property caused by the government must be compensated, givings doctrine seeks to determine under what circumstances must the beneficiaries of government actions be charged for a received benefit. Abraham Bell and Gideon Parchomovsky only recently developed the givings doctrine from the U.S. takings doctrine in the Yale Law Journal.6 We argue for its merits and relevance to the Chinese reform, including the inextricable relationship between takings and givings, their similar effects on relative wealth, risks of abuse and other political vices and fairness and efficiency considerations. We explain that the givings doctrine can provide a legal basis for regulatory authorities requiring non-tradable shareholders to compensate tradable shareholders before trading. From this practical application of this givings doctrine, we also highlight some of the conceptual and practical complications that have arisen and propose some refinements. Building on this givings doctrine, we utilize economic analysis to evaluate the Chinese reform in Part V. First, we look into the choice of property rule over both liability rule and mandatory transfer rule when granting tradable shareholders an entitlement to compensation. Efficiency and practical considerations affirm the Chinese approach. We next discuss the private bargaining mechanism, which is a rather unique feature in the Chinese system, where centrally-administered reform is more of the norm. Though we give due credit to the Chinese reform, we also identify its limitations in Part VI. These limitations have resulted in the risks of over-compensation and holding out that could possibly undermine and even derail the reform process. We propose some recommendations that we believe will both deal with those risks and improve the efficiency of reform implementation. These recommendations are not only relevant to this China's reform but are useful in future practical application of the givings doctrine. Indeed, the Chinese reform has proved to be a fruitful application of the givings doctrine. In the conclusion, we identify the unique nature of givings under the Chinese reform. The reliance of a property rule protection and the requirement for a private precondition not only represents novel departures from the original givings doctrine, but also further advance the efficiency and fairness merits of givings charging. Similarly, the innovative utilization of mixing entitlement protection and the extension of compensation rights to derivative takings provides invaluable practical lessons and useful pointers that are relevant to future 6 Abraham Bell & Gideon Parchomovsky, Givings, 111 YALE L.J. 547 (2001). [20:1 REGULA TORY GI VINGS IN CHINA developments and applications of the givings doctrine, both within and without China. II. HISTORICAL BACKGROUND AND REFORM We first examine the historical background of split share structure reform. We highlight the problems and deficiencies arising out of this structure, and then proceed to explain the reform measures implemented by the Chinese government. This provides the basis for our later analysis and discussion. A. Historical Background One must go back in history to understand the complexity and uniqueness of the current split share structure reform in China. Since the first Chinese joint stock limited company was created in July 1984, 7 shares have been classified by type. The Provisional Measures on the Issuance of Shares, issued in July 1984 by the Shanghai branch of the People's Bank of China, classified the shares into two categories: collective shares and individual shares. 8 The collective shares were issued to the state, collectives, village enterprises and agricultural production teams. Individual shares were issued to workers, residents, community members and their families. When the Chinese stock exchanges were first set up in Shanghai and Shenzhen in December 1990, 9 the shares were classified into state shares, legal person shares, individual shares and special shares in accordance with their ownership.' 0 ' [11 ft [PRACTICAL OPERATION OF SPLIT SHARE STRUCTURE REFORM AND POST-SPLIT SHARE STRUCTURE] 8 (fq% t1#. [He Ru ed.], 2006) [hereinafter He]. 8 tfilflffil)-,M [Provisional Measures on the Issuance of Share] (promulgated by Standing Comm. People's Cong., Shanghai Mun., Aug. 10, 1984, effective Aug. 10, 1984, repealed 1987), § 2, available at http://www.law999.net/law/doc/dOO3/1984/08/10/00049183.html (last visited Oct. 31, 2006). 9 Yuwa Wei, The Development of the Securities Market and Regulation in China, 27 LOY. L.A. INT'L & COMp. L. REV. 479, 488 (2005). 10 rv1[-m}ov, , [Provisional Measures of Shenzhen Municipality for Administration of the Issue and Trading of Shares] (promulgated by the Standing Comm. People's Cong., Shenzhen Mun., May 15, 1991, effective June 15, 1991), § 33, translated in Chinalawinfo (Lexis) PRCLEG 591. Special shares are shares issued to foreign governments, legal persons and individuals. 3032006] COLUMBIA JOURNAL OF ASIAN LAW With the exception of renaming special shares as foreign investor shares, this classification scheme was maintained until recently. 1 This categorization created different classes of shares, each having different rights. Shares were strictly forbidden from mixing with shares of other categories, 12 and their transfer methods varied in accordance with their category. Individual shares (also known as "A" shares) could only be traded in the stock exchange's A shares market; the foreign investor shares (also known as "B" shares) could only be traded in the exchange's B shares market.' 3 Cross-trading between the two markets was impossible. State shares and legal person shares, on the other hand, were prohibited from trading on stock exchanges. 14 Consistent with the sacred nature of state-owned property in the Socialist economy as enshrined in the Chinese Constitution, 15 state shares were also subject to many additional transfer restrictions.' 6 There were attempts at the initial development phase of the Chinese stock markets to allow the legal person shares to be traded on the stock exchanges. However, due to excessive demand, followed by hyperactive markets and consequent political concerns, these measures were abruptly halted and suspended indefinitely.17 All these factors resulted in entrenchment of the split share structure of China's domestic stock market: on one side, non-tradable shares consisted of legal person shares and state shares; and on the other, tradable shares consisted of A shares.18 The classification of shares based on ownership is a phenomenon unique to China and is not found in other stock markets. Nevertheless, this classification must be understood in the context of China's transition 1 t [Trial Measures on Share-formulated Enterprises] (promulgated by the former St. Council Nat'l Development and Reform Comm., May 15, 1992, effective May 15, 1992), 1992 [ *R at [ST. COUNCIL GAZ.] 549, § 4. 12 He, supra note 7, at 9. 13 William I. Friedman, One Country, Two Systems: The Inherent Conflict Between China s Communist Politics and Capitalist Securities Market, 27 BROOK. J. INT'L L. 477, 496 (2002). '4 1d. "S 3P,8 [CONSTITUTION] art. 12 (2004). 16 See, e.g., N Hi If W - If O]f 3M Vi * f 8- [Provisional Measures for State Shares Management in Limited Stock Company] (promulgated by St. Council Econ. Reform Comm., Nov. 3, 1994, effective Nov. 3, 1994), § 29, available at http:/law.chinalawinfo.com/newlaw2002/SLC/SLC.asp?Db=chl&Gid=10591 (last visited Oct. 31, 2006) [hereinafter Provisional Measures]. 17 He, supra note 7, at 10. '8 As mentioned earlier, B shares can only be purchased by foreign investors and hence are not part of China's domestic stock market. In any case, B shares only make up a small part of the total equity market, comprising less than 6% of all shares since 1993 and hovering around 2% since 2001. Id. at 16. [20:1 REGULA TORY GI VINGS IN CHINA from a socialist economy to today's capitalist economy. During the initial conceptualization and establishment of the Chinese stock market, the government had to confront a difficult ideological conflict between socialist and capitalist economies. 19 During the early years of reform, any major deviation from the system of state ownership would prove too drastic and politically unacceptable. The "privatization" of the economy was a major concern for the Chinese government. 20 Thus, state and legal shares, which accounted for the majority of shares, were prohibited from trading in the stock market. This asserted state control over the listed companies so as to maintain the Socialist state-ownership system.21 Hence, the system was designed in accordance with what was most acceptable rather than what was most reasonable. 22 B. Deficiencies in the Split Share Structure It is widely acknowledged that this classification of shares and accompanying trading prohibition on the majority of shares is a material cause of the Chinese stock market's deficiencies and corporate governance problems. This split share structure produced a separate set of supply and demand forces which led to different prices and earnings ratios for the same shares. This in turn resulted in different pricing for the 23same issue. The inability to trade the majority of shares also caused an artificial inflation of share prices because the entire market, including non-tradable shares, was factored into the exchange prices of the tradable shares.24 All else being equal, the price of the tradable shares will fall if the non-tradable shares are allowed to enter the market. 25 The artificialness of inflated share prices was evidenced by often absurdly high share prices, even of companies with negative net assets.26 Another '1Id. at 5; Mt.f, X4 ' - j, i- [Huang Man Xing, Discussion on the Non- trading Problem of State Shares], A Akfff1- [COM. RES.], No. 12, 2005 at 171, 173. 20 He, supra note 7, at 5. 21 Id. at 8. 22 , , J Ji~t fi : [Luo Peixin, Legal Analysis of Non-Tradable Shares Trading Proposals] 17 (2001), http://www.sse.org.cn/UpFiles/Attach/1691/2004/03/04/1657448125.pdf (last visited Oct. 31, 2006). 23 -- _s =i R v3 , k * M,' 2 [Guiding Opinions on the Split Share Structure Reform of Listed Companies] (promulgated by China Securities Regulatory Comm., May 31, 2005, effective May 31, 2005), 2, http://law.chinalawinfo.com/newlaw2002/SLC/SLC.asp?Db=chl&Gid=59728 (last visited Oct. 31, 2006) [hereinafter Guiding Opinions]; Friedman, supra note 13, at 497. 24 Huang, supra note 19, at 173. 25 Id. 26 id. 2006] 305 COLUMBIA JOURNAL OF ASIAN LAW practical consequence of the split share structure was the over-speculative nature of its stock market. This over-speculative nature of the market was reflected in the fluctuation of stock prices and the rate at which shares changed hands.27 For the period of 1994 to 1999, the differences of the stock market's highest and lowest points in the United States and Singapore were 200% and 110%, respectively. In contrast, the Shanghai stock exchange experienced a difference of up to 500%. Similarly, for the period of 1995 to 2004, the average annual turnover rate in the Chinese stock market was always above 200% and peaked at over 400% in 2000.28 This is much higher than the other stock markets, especially the mature markets. The split share structure and its consequences led to three deficiencies in the Chinese capital markets. 29 First, the split share structure resulted in a conflict of interests between the non-tradable shareholders and the tradable shareholders. 30 Because tradable shareholders would always be a minority and unable to control or significantly influence the company, the main form of profit from the share investment would be the increase in share price. Such an increase is normally brought about by the company's improved performance, competitiveness and profitability. 31 However, this increase in share prices could not be enjoyed by the non-tradable shareholders who were unable to sell their shares on the stock exchange. Rather, their main form of profit stemmed from utilizing the split share structure to obtain financing at a high premium (possible under the artificially inflated share prices described above) to rapidly increase the asset value of the company. 32 The asset value of the company is an important price factor when the non- tradable shares are traded in private transfer deals. Hence, it is not surprising that under the split share structure, the non-trading majority shareholders were quite impervious to the secondary market share prices and were not particularly motivated to ensure the profitability and performance of the company. 33 On the other hand, the non-tradable shareholders had huge personal incentives to induce the company to issue 27 Id. 28 He, supra note 7, at 50. 21 RHA* ET AL., _ - [WU XIAOQIU ET AL., FSI CHINA CAPITAL MARKET RESEARCH REPORT] 4 (for the tenth China Capital Market Forum organized by People's University Financial & Securities Institute, yet to be published officially) (2006) [hereinafter FSI REPORT]. 30 Guiding Opinions, supra note 23, T 2. 3' FSI REPORT, supra note 29, at 6. 32 Id. 33 id. 306 [20:1 REGULA TORY GIVINGS IN CHINA more shares on the stock exchange. This resulted in a mad rush for listing and share issuance 34 that was not always in the interest of the company and the tradable shareholders. Needless to say, such conflicts of interest among shareholders of the same company are conducive neither to company management nor to the overall development of the capital market. The second deficiency is the erosion of the capital market pricing mechanism. 35 As actual stock market share prices were only based on a minority of the total number of shares, the traded prices did not reflect the opinion of the other market players. 36 An important condition for a stock market pricing mechanism to operate effectively is the double-arbitrage mechanism of the primary and secondary markets.37 The destruction of the primary market by the split share structure shielded the non-tradable shareholders from the effects of fluctuation in the secondary market share prices. This allowed them to profit from the issuance of new shares when the secondary prices were overly inflated without the corresponding primary market arbitrage risk present in mature markets.38 In addition, the lack of market liquidity and overly speculative climate arising from the split share structure also hurt the resource allocation mechanism of the Chinese stock market.39 The third deficiency concerns corporate governance. The split share structure impeded the development of both a scientific evaluation standard and an effective incentive mechanism. 40 With stock prices in the overly speculative market inaccurately reflecting the company's market value, the only possible means of evaluating the management performance is its current profit.41 However, the fact that current profit does not necessary reflect future profitability and development means its use as an evaluative standard does not support of the company's long term development. This stands in contrast to the use of a company's market share value, which factors in considerations of both current and 34 1d. at4. " Id. at 7. 36 He, supra note 7, at 30. 37 See, e.g., id. at 31. 31 Id. at 32. 39 Id. at 32-33. Due to transfer and trading restrictions between the different categories of shares, capital could not always move from low-yield investments to high-yield investments. Similarly, the over-speculative nature of the market meant that the share prices might not necessarily reflect the true value of shares. 40 FS1 REPORT, supra note 29, at 9; See also Guiding Opinions, supra note 23, 2. 41 FSI REPORT, supra note 29, at 9. 2006] 307 COLUMBIA JOURNAL OF ASIAN LA W future profitability, as an evaluative standard in mature stock markets.42 The split share structure also limits available management incentives.43 The average income of a high level manager in China consists of 85% basic salary, 15% short-term incentives (shares dividends) and practically zero long-term incentives (stock options). This is in sharp contrast with that of the U.S., where 32% is basic salary and 51% long-term incentive, or even Hong Kong, where 52% is basic salary and 27% long-term incentive. 44 Another corporate governance problem that arises out of the split share structure is the elimination of the risk of hostile takeovers via the stock market. The threat of management change following a hostile takeover pressures company management to work hard and ensures good corporate governance. This is because hostile takeovers are more likely to take place when share prices are low, which is usually attributed to bad governance.45 However, the lack of liquidity of the majority of shares means hostile takeovers do not occur under split share structure conditions. As a result, the pressure on Chinese listed companies' management is less, while the chance of management slack is greater. C. The Implemented Reform These deficiencies underlie the clear need for reform. The "Provisional Measures on Raising the Social Security Funds through Sales of the State-owned Shares" 46 were introduced in 2001. The aim was to reduce state shareholding through permitting the trade of state shares on the stock exchange. Section 5 of these measures stated that companies with state shares should include those shares as 10% of the financing capital when they issue or reissue shares to public investors. This regulation, implicitly based on the principle that tradable shares and non-tradable shares enjoy equal trading rights, was silent on any compensation to the tradable shareholders. The stock market reacted violently to its introduction, crashing from over 2200 points at the time the measures were adopted to around 1300 points when they were 42 Id. 43 He, supra note 7, at 40. 44Id. at 41. 45 Huang, supra note 19, at 172; Wei, supra note 9, at 485. 46 7 [Interim Measures of the State Council on the Management of Reducing Held State Shares and Raising Social Security Funds] (promulgated by the St. Council, June 12, 2001, effective June 12, 2001), translated in Chinlawinfo (Lexis) PRCLEG 1847. 308 [20:1 REGULATORY GIVINGS IN CHINA abruptly suspended by the relevant authorities after only four months.47 The failure of this reform is attributed to three reasons.48 First, it was suspected that state shares were obtaining financing at a premium since, as mentioned above, share prices in the stock exchange were usually much higher than their listed value. Second, the reissue of shares usually came at a discount. This resulted in the cost of introducing new capital actually being lower than the cost of holding existing capital, which led to heavy selling. Third, the reduction of state shares in the portion of 10% of the financing capital was too insignificant to either alter the stranglehold of majority shareholders on a company or materially improve its corporate governance. After the failed reform attempt in 2001, there was a temporary lull in reform activities. However, the Chinese stock market continued to perform poorly. For example, in sharp contrast with the high gross domestic product growth rate, which has steadily increased since recovering from the 2001 economic recession, financing from stock exchanges actually continuously and significantly declined from RMB 1169.77 billion to RMB 497.6 billion over the same period.49 Similarly, the asset return rate has steadily declined since 1995 and only slightly rebounded over the past two years of economic overheating.50 The failure of other policies as solutions inevitably forced the split share structure back to the center stage of reform.5' Reform was again attempted in May 2005. Four companies were selected to undergo trial split share structure reform,52 followed in June by a second trial round, which included 42 companies.53 The relatively 47 See ZJIii",K & E*N, $iJ fJg1 T ,8*5V* 3RJA tfi [Liu Dahong & Li Huazhen, Research of Institutional Innovation in China's Stock Market in the Double Domains of Law and Economics] (2005), http://article.chinalawinfo.com/article/user/article-display.asp?ArticlelD=29525 (last visited Oct. 31, 2006); See also FSI REPORT, supra note 29, at 57. 48 He, supra note 7, at 12. 49 Id. at 26. 50 Id. at 32. " Id. at 13. 5- [Notice of the China Securities Regulatory Commission on Piloting the Share-trading Reform of Listed Companies] (promulgated by China Securities Regulatory Comm., Apr. 29, 2005, effective Apr. 29, 2005, repealed Sep. 4, 2005), http://law.chinalawinfo.com/newlaw2002/SLC/SLC.asp?Db=chl&Gid=58138 (last visited Apr. 18, 2006). 5 3 ) 0 _.-RV * A T P)tM, A0 [Notice of the China Securities Regulatory Commission on the Ensuring the Successful Second Trial of Split Share Structure Reform of Listed Companies] (promulgated by China Securities Regulatory Comm., May 31, 2005, effective May 31, 2005, repealed Sep. 4, 2005), available at 2006] 309 COLUMBIA JOURNAL OF ASIAN LA W smooth and successful completion of these trials led to the "Guidance Opinions on the Split Share Structure Reform of Listed Companies" '54 and "Administrative Measures on the Split Share Structure Reform of Listed Companies" ' 55 in September 2005, which officially began the full-scale implementation of the reform. The guiding principle behind this reform is "respect of the market order, promoting of the market's stability and development; and safeguards of the investors' legal rights, especially that of the public investors." 5 6 Reform must be market-oriented with an emphasis on creating a market mechanism conducive to proactive resolution of the split share structure problem.57 Under the implemented reform, the process for trading these non- tradable shares is essentially contractual in nature. The non-tradable shareholders of listed companies shall seek the opinions of the relevant tradable shareholders in the 'A' stock exchange when drawing up the trading proposal58 most suitable to the company's actual circumstances. The reform proposal shall be approved by the relevant 'A stock' shareholders by class voting in accordance with shareholder meeting procedures.59 This is essentially an agreement made between the different classes of shareholders. There is no fixed formula for trading consideration - any price is sufficient as long as the shareholders come to an agreement. Nevertheless, the use of consideration to balance the interests of shareholders is officially encouraged. 60 The main form of consideration is through the giving of shares by non-tradable shareholders to tradable shareholders. 61 The remaining forms include cash and share http://law.chinalawinfo.com/newlaw2002/SLC/SLC.asp?Db=chl&Gid=58608 (last visited Oct. 31, 2006). 54 Guiding Opinion, supra note 23. 5 ± ~~_ 3 ,V 8 [Circular of China Securities Regulatory Commission on Distributing the Measures for the Administration of the Share-trading Reform of Listed Companies] (promulgated by China Securities Regulatory Comm., Sep. 4, 2005, effective Sep. 4, 2005), available at http://law.chinalawinfo.com/newlaw2002/SLC/SLC.asp?Db=chl&Gid=59870 (last visited Oct. 31, 2006) [hereinafter Administrative Measures]. 56 Guiding Opinions, supra note 23, 6. 57 Id. 10. 58 "Reform proposal" is the more literal translation of the statute. "Reform proposal" is the short- form of "split share structure reform of listed companies," as stated in the Administrative Measures, supra note 55, § 5. However, most Chinese scholars use the term "trading proposal" since it is more precise in meaning compared to the many different types of "reform proposals." We use "trading proposal" in place of "reform proposal" when translating the relevant statues. 59 Guiding Opinions, supra note 23, 8. 60Id. 4. 61 A common ratio is two to three non-tradable shares for ten tradable shares, but in some cases may vary from greater than ten to less than one per ten tradable shares. 310 [20:1 REGULA TORY GIVINGS IN CHINA options. The non-tradable shareholders may also further agree to not trade their shares for a time period above and beyond the legal limit of twelve months. 62 The trading proposal must be initiated by at least two-thirds of the non-tradable shareholders, though preferably all the non-tradable shareholders should agree. 63 If there is no unanimity among the non- tradable shareholders, those initiating the proposal shall make the necessary arrangements. 64 For example, the initiating non-tradable shareholders would pay the required consideration for the opposing non- tradable shareholders first. In turn, the opposing non-tradable shareholders can only trade their shares if they repay that amount to the initiating non-tradable shareholders.65 The compensation package is subject to the approval of the State-Owned Assets Supervision and Administration Authority. 66 A two-thirds majority approval of both the total A shareholders and that of the tradable shareholders is required at the A shareholders meeting as well.67 It is difficult not to notice the overshadowing of economic methods and terms over legal analysis in the whole reform process.68 The "Guidance Opinions on the Split Share Structure Reform of Listed Companies" defines the split share structure as "a special problem in the transition of the nation's economic system," 69 and its reform is to "institutionally arrange for the non-tradable shares to trade in the stock exchange. 7 ° Section 2 of the "Administrative Measures on the Split Share Structure Reform of Listed Companies" also emphasizes that the split share structure reform is to "remove the institutional difference in share transfer in the A share market." The predominance of these economic expressions exposes a lack of legal analysis right from the initiation of the reform. 71 An economic scholar who was the head of the 62 Administrative Measures, supra note 55, § 27. 6 3 1d. § 5. 64Id. § 25. 65 E.g., TNJA , T i35iT'( ) [CHINA MERCHANT BANK CO., SPLIT SHARE STRUCTURE REFORM EXPLANATION PROPOSAL (EDITED DRAFT)] 3 (Dec. 29, 2005), available at http://www.cninfo.com.cn/finalpage/2005-12-30/16336561 .PDF. 66 Administrative Measures, supra note 55, § 15. 67 Id. § 16. 61 See, e.g., i, R' [Tan Xiao, Legal Discussion of Split Share Structure Reform] (2005), http://article.chinalawinfo.com/article/user/article-display.asp?ArticlelD=30922 (last visited Oct. 31, 2006). 69 Guiding Opinions, supra note 23, 2. 70 Id. 4. 71 Tan, supra note 68. 2006] COLUMBIA JOURNAL OF ASIAN LA W Chinese Securities Law amendment drafting team even went so far as to state that "the split share structure is a Chinese legacy policy problem and not a legal problem. ' 72 It must be acknowledged that with the majority of the listed companies having already undergone this reforn, it is highly unlikely that at this time there would be any drastic changes or policy reversals. Nevertheless, the importance of the legal analysis and critique of this reform is not diminished. Any legal lessons learned from this reform, be they positive or negative, will serve China and other transitional economies as they develop their legal systems and economies. III. DOCTRINAL AND LEGAL BASIS: TRADITIONAL APPROACHES In this part, we aim to explore the possible legal justifications behind the reform, which essentially requires the non-tradable shareholders to compensate the tradable shareholders for the right to trade non-tradable shares. We begin our legal analysis by looking at possible private law remedies. Contract theory, being the prevailing view among the Chinese legal scholars, will be discussed extensively. We conclude that non-tradable shareholders are not legally obliged under private law remedies to compensate the tradable shareholders. However, the tradable shareholders will clearly suffer considerable losses if the non-tradable shares can trade without any payment of compensation - an option entirely within the power of the Chinese regulatory authorities as evidenced by the 2001 reform attempt.74 Thus, we proceed to discuss whether any public law remedies are available to the tradable shareholders to seek compensation from the relevant regulatory authorities. A. Contract Theory and Other Private Law Remedies Contract theory is the prevailing view among Chinese legal scholars as to the legal basis of the reform.75 There was some initial 721Id. n. 4. 73 As of Apr. 24, 2006, 868 listed companies comprising of 78% of the total stock exchange value have undergone or are undergoing reform, ?A [M *, 'Ell Vj: JR 1 A I MJ, " 8" [Gao Guohua, Innovation: the Key Weapon in Share Reform], MIIR [FIN. TIMES], Apr. 28, 2006, at 7, available at http://www.financialnews.com.cn/zq/200604280192.htm. 74 See supra Part II.C. 75Tan, supra note 68, n.16; see also )fA, R 'L,- 7 Fi,1: Q -I,,i--fH, [Fang Li, Civil Law Equity Principle: Of Course the Non-Tradable Shareholders Should Compensate], M - ft 1 H 49 [No. 1 FIN. DAILY], Aug. 11, 2005, at B5, available at [20:1 REGULATORY GIVINGS IN CHINA support of the use of tort theory, although it has not gained continued acceptance 76 and will be discussed only briefly. The central tenet of the contract theory argument is that since "temporarily not trade" was a term of the non-tradable shareholders in the share issue prospectus, it is a valid and binding contractual term. Hence, in accordance with section 77 of the P.R.C. Contract Law,77 trading the non-tradable shares is a contract alteration that requires the agreement of all the contractual parties, and compensation is thus necessary to induce the tradable shareholders to agree to this alteration of the contract. 78 This theory is based on two related premises concerning the trading right of non-tradable shares. First, contrary to the provisions of the P.R.C. Company Law, the tradable shares and non-tradable shares are not equal; the fact that tradable shares can trade does not necessary imply that non-tradable shares can trade. Second, the non-tradable shares did not have the right to trade and thus compensation must be paid for loss arising from this new ability to trade. It is our view that this contract theory cannot provide a valid basis for the current reform. We refute the claim by first examining the two premises, arguing that only the first is valid. We then proceed by using ordinary contractual principles to unveil the flaws of the theory. 1. Share Equality Before the latest amendment to the Company Law last year, section 130 stipulated that "shares shall be issued on the basis of the principle of public, fair and impartial. Shares of the same class must have the same rights and benefits. For share certificates issued at the same time should be equal in price and each share should have the same issue terms., 79 Both tradable and non-tradable shares were created during the stock issuance at the formation of listed companies, and it was only http://dycj.ynet.com/article.jsp?oid=6077791; A*fitj: Ii1M' ftJ a