China Securities Fraud Litigation in the Post-Prepositive Procedure Era

In January 2022, the Supreme People’s Court (SPC) promulgated the Several Provisions of the Supreme People’s Court on the Trial of Civil Cases for Damages for the Tort of Misrepresentation in the Securities Market (the “2022 Interpretation”), which put an end to the prepositive procedure in securities fraud cases. By delving into China securities fraud cases in 2022, this article summarises major changes in China securities fraud litigation in the post-prepositive procedure era.

In 2003, when the SPC promulgated the first judicial interpretation on securities fraud cases, courts accepted such cases only if a plaintiff submitted evidence showing a defendant had received an administrative penalty or criminal judgment. Therefore, securities fraud litigation was preceded by a prepositive procedure in which the defendant was subject to administrative penalty or criminal judgment.

In the next 20 years, the prepositive procedure, though contentious when the SPC implemented the case filing registration system, was consistently reinforced by the SPC in its judicial supervision procedure. From around 2020, however, the SPC began to show an inclination to end the prepositive procedure, which was officially ended in the 2022 Interpretation.

Major changes in China securities fraud litigation procedure are outlined below.

Actions in dispute include:

The rapidly expanding scope of disputable actions significantly increases litigation risk and poses challenges to listed companies and other defendants.

Judicial opinions have diverged on the rapidly expanding range of disputed actions. Most courts, abiding by the civil principle that “the burden of proof lies with the party who asserts”, dismiss the claim if the plaintiff fails to provide robust evidence proving the misrepresentation, such as administrative penalties, disciplinary measures or acknowledgement by listed companies. Nevertheless, some courts have taken a more proactive role. For example, the Beijing Financial Court, in its first case concerning bonds issued by Dalian Machine Tool Group Corp. Ltd (the “Dalian Case”), granted plaintiff’s motion for forensic appraisal of alleged financial fraud based on prima facie, rather than solid and ascertained, evidence. By evaluating the bond issuer’s financial condition and other factors, the Beijing Financial Court finally held that the bond issuer committed misrepresentation by implementing financial fraud. Although the appraisal institution was applied by the plaintiff and subsequently granted by the Court, the Court, to a certain degree, inevitably exercised its investigative function, which was generally exercised by the securities regulatory authorities. This further increases the litigation risk for listed companies and other defendants.

Plaintiffs now are more inclined to name all intermediaries, directors, supervisors and senior executives as defendants, resulting in a spike in litigations against intermediaries. Due to the end of the prepositive procedure and the shifted burden of proof (it is incumbent on intermediaries to prove their due diligence), intermediaries now have to submit their working papers in almost every case to fulfil this burden, even though they have not been subject to an administrative penalty or disciplinary measures. Compiling masses of working papers in each case is an onerous responsibility, the growing number of cases has further exacerbated the situation while generating soaring litigation costs for intermediaries. Further, the absence of administrative penalties or disciplinary measures does not assure intermediaries of their freedom from civil liabilities. For example, in the ZhongAn’Xiao case and the Dalian Case, even though the intermediaries were subject to no administrative penalties or disciplinary measure, the court still held that they had failed to fulfil due diligence after evaluating working papers they submitted, and should should be jointly and severally liable up to a certain percentage. After being found liable, intermediaries are more likely to take recourse action against other defendants in the case. The end of the prepositive procedure also promotes the development of indirect recourse action.

Given the rapidly expanding range of disputed actions and heightened investor awareness of rights protection, listed companies, intermediaries as well as directors, supervisors and senior executives should follow the following recommendations.

Securities fraud cases are of stare decisis effect. If the first case is not properly handled and an unfavourable judgment is rendered, it is likely to become a precedent and the courts generally diverge from existing precedent only grudgingly. Such an unfavourable judgment will stimulate more securities litigation, promptly resulting in higher litigation risk to defendants.

Due to considerations such as litigation cost control, listed companies and other defendants sometimes engage counsel who provide general legal advice to these companies, to represent them in securities fraud cases. Securities fraud cases belong, however, to a niche domain, and defendants should seek expert advice regarding issues including (i) the dates when the misrepresentation was committed or disclosed, (ii) the base date and mean trading price, (iii) systemic and idiosyncratic risks, (iv) the calculation methodology and (v) the due diligence analysis. It is recommended to prudently weigh the extra cost of specialist counsel against the risks involved in losing such a lawsuit.

Some disputed actions do not constitute misrepresentation at all. Regulatory authorities and listed companies should pay more attention to investor education and delineate the boundaries of misrepresentation in order to avert soaring litigation costs caused by vexatious action.

Listed companies, directors, supervisors, senior executives, intermediaries and other defendants should strengthen compliance to mitigate legal risk. Listed companies should establish, update and actually implement information disclosure by-laws, and reinforce daily management of information disclosure. Directors, supervisors and senior executives should devote more attention to listed companies, thoroughly verify issues to be deliberated and keep meticulous records. They may also seek advice from outside counsel, accounting firms and other professionals as appropriate. Intermediaries should strictly abide by the rules and best practice, properly compiling and retaining working papers, in case they are obliged to produce evidence in legal proceedings to prove their due diligence.