Article |
Comparative Perspectives on Gatekeeper Regulation under Chinese Securities Law [Volume 10 – 2020] |
11 March 2020 |
| FILED UNDER 2020 ARTICLES |
| Moqi Zi |
| Collaborative researcher, Kyushu University Legal Research Institute, Fukuoka, Japan |
1. Introduction |
This paper focuses on the issue of gatekeepers. As to the definition of gatekeeper, generally, there is no textbook or uniform definition, but two types of definitions provided by two different scholars seem to be widely accepted.[i] The first one is “private parties who were able to prevent corporate misconduct by withholding their cooperation from wrongdoers.”[ii] This definition is first proposed by the then famous Yale law professor and now Harvard law professor Reinier Kraakman in 1980s.[iii] The second definition is proposed by one of the most prominent securities and corporate law professor John C. Coffee in 2006, which is “the professionals who provide verification or certification services.”[iv] Between these two definitions, the scope of the second one is narrower than the first one, because the first one may include key suppliers for issuer,[v] which is out of the scope of current discussion, so the second definition will be used in this paper. |
In this paper, following introduction, in Section 2, I will first explain why regulation of gatekeepers is necessary. Then starting from Section 3, I will identify similar problems in the regulation of gatekeepers. In particular, I will identify five issues that share similarities in the underlying problems among China, US and EU. From the US, there are three issues, namely (i) conflict of interest and weak supervision and enforcement, (ii) liabilities shifting game among gatekeeper and (iii) securities analyst’s liabilities. In EU, the issue is regulation of securities analyst. In Hong Kong, the issue is regulation of sponsor. In Section 4, I will delve into detailed discussions about the different solutions and their effects in the US, EU and Hong Kong then characterize them into different models. Then, based on the comparisons of the models, in Section 5, I will propose some useful lessons for China to solve its current problems. |
There are two main problems when regulating gatekeepers. The first problem is the third-party liabilities problem, which means to what extend the gatekeeper should be responsible for the loss of investors. As time goes by, for underwriters, lawyers and accountants, the law has recognized their importance in guarding the market, so the scope for bearing third parties’ liability had been gradually expanded, albeit with some restrictions. However, in US and EU, for sell side securities analyst, whether they should be held responsible for the loss of third party is unknown, since they usually make predictions about the future, so even if the future turns to the opposite to what the securities analyst predicted, it’s hard to subject them to misrepresentation liabilities. Moreover, even if we can prove that such misrepresentation is made with fraudulent intention, there is still the high cost of burden of proof issue. Therefore, for securities analyst, other methods except liability rules are necessary. |
The second problem is the distribution of liabilities and liabilities shifting problem. Apart from securities analyst, for underwriter, lawyer and accountant, their third-party liabilities are generally recognized, however, due to their different contribution to the final outcome, the key question for these three gatekeepers is how to distribute liabilities among them. In order to ascertain the portion of each of their liability, it usually involves proving intention and such burden of proof is very high. Moreover, these gatekeepers are afforded with due diligence defense to be exempt from liabilities, and because there is no single clear cut line for the exact scope of due diligence defense, so these gatekeepers will tend to be involved in liabilities shifting game and blame others for failing to do the job, thus further lifting up the burden of proof. In US, before 1990s, there was no such problem. However, due to the concern of too much legal risk on gatekeepers, there is a series of reforms of laws, which made the distribution of liabilities a problem. Previously each one of gatekeepers can be held accountable to the whole loss of the investor, no matter their fault or contribution to the loss. However, it’s believed that this regime posed too much burden on the lawyer and accountant, and therefore the US made revision to the liabilities rule in litigation, so now each of them will only be responsible for their own contribution in the loss. Moreover, previously, the lawyer and accountant will have to actively participate in the investigation of documents, especially for lawyers, who will even be required to investigate some financial documents, and if they failed to do this, then they may be subject to aiding and abetting liability in private class action. However, it’s also believed that it posed too much burden on the lawyer and accountant, so therefore this aiding and abetting liability has been prohibited in private class action by the US Supreme Court ruling and the PSLRA. Because of these changes, the liabilities shifting becomes possible. Because each party wants to minimize their own share and they can’t be held liable to aiding and abetting liability, so they only focus on their own part and never care about other signals showing signs about possible misbehaviors, and therefore ignorance becomes a bless. In Hong Kong, it faced a similar problem where the due diligence duty of sponsor is not very clear, and even worse, before 2013, sponsor was not subject to private litigation liability for misstatement in prospectus, so therefore the deterrence effect of sponsor in Hong Kong to engage in misbehaviors is lower than US. In this case, it’s necessary to come up with some solutions to alleviate this problem. |
Against the above background, in order to solve the above problems, several regulatory techniques are introduced. Generally, there are five types of regulatory techniques, including litigation, information disclosure, corporate governance, regulatory oversight and payment regulation. After the introduction of these regulatory techniques, I examined the applications of them to each of the following gatekeepers in different jurisdictions and discussed the effects of different regulatory techniques on these different gatekeepers. Generally speaking, for underwriter, accountant and lawyer, each jurisdiction to some extent chose to either make more detailed due diligence duty or increase communication and information disclosure among different gatekeepers and regulators. As for securities analyst, the US chose to use liabilities rules, information disclosure and corporate governance technique to control conflict of interest while the EU used a more radical payment regulation method to control such conflict of interest. |
In the end, based on the above discussion, I aim to identify some lessons for China regarding gatekeeper regulation. In short, I argue that for securities analysts, the lesson is to follow the EU in using payment regulation because such regulation can cut the roots of the conflict of interest problem and also can provide the market with more flexibility to better adjust to new situations. For underwriters, lawyers and accountants, in terms of liability in litigation, the key lesson is that more detailed due diligence duties, and information disclosure can help alleviate the problem of shifting liabilities, but such a method is too costly. In this case, I therefore make proposal, based on China’s latest experiment, for a sponsor-pays-first regime, which places the underwriter under strict liability and allows underwriter to sue lawyer and accountant for their shares. It is argued that such a scheme represents the best option for China, given current market conditions. |
2. Rationale of Regulation of Gatekeepers |
After introduction of definition, we would naturally wonder why we need gatekeeper and why they’re important. There are generally 2 answers for this question. The first one is based on game theory.[vi] It says the market can’t differentiate the good issuer from the bad one.[vii] The reason of this claim goes as the following. The issuer is a one-time player, and also the rewarding of entering securities market is very high, and at the same time, independently verifying issuer’s quality is almost an impossible mission for investors, so the issuer’s cost of being caught for conducting misbehaviors is low.[viii] When the rewarding is high and the cost is low, in a one-time gaming situation, the player has a high propensity to engage in a cheating strategy.[ix] However, for the underwriter whose job is to select and recommend companies for listing, they’re multiple times players, so therefore they are more likely to develop a collaboration relationship with the investors in the market to select the good apples from the bad ones.[x] During the years, they will gradually develop reputational capitals, and every time they invest some of their reputational capitals in the market to vouch for the issuer.[xi] |
The second reason why gatekeeper is of importance is that it alleviates the burden of securities regulators to detect fraudulent behaviors by issuers.[xii] The numbers of market participants far outweigh the market regulators. For example, in China, the average time for listing on the main board was 862 days in 2016,[xiii] and there were around 700 companies in total waiting to get listed.[xiv] If we don’t include the gatekeepers in the frontline for policing frauds, but instead start everything from ground zero, the listing process will be paralyzed. This means involving gatekeeper is essentially an outsourcing technique by the regulators. The regulators can’t control everything on its own, so it delegates certain monitoring powers to the gatekeepers. In the following, I will discuss four types of gatekeepers in securities market, including underwriter (sponsor in some jurisdictions), accountant, lawyer, and securities analyst. |
However, clarification of the importance of gatekeeper doesn’t directly lead us to the conclusion that we need to regulate them, because there is still one last unanswered question, which is why we should regulate the secondary wrongdoer, the gatekeeper instead of the primary wrongdoer, the issuer. There are two arguments why only regulating primary wrongdoer is not enough and we need to expand regulation to the secondary wrongdoer. The first argument is that primary liability is too costly.[xv] Firstly, primary wrongdoer has the strongest incentive to commit a crime, and the large portion of gains they can get from the securities market is beyond measurable.[xvi] For example, in the case of Enron, after the unraveling of the cover up, 80 billion market prices just vanished in the air.[xvii] Compared to this 80 billion gain, how severe should the primary punishment be to set off such a huge incentive? Secondly, the law of diminishing marginal utility applies here as well.[xviii] If the punishment is already high enough, then when we improve it to a higher level, the increase in penalty won’t have a deterrent effect in proportion to this increase. Thirdly, too high a penalty will bankrupt the company and also affect many participants who rely on this company, which is not the desired outcome.[xix] The second argument against only regulating primary wrongdoer is related to compensation. When the company became insolvent, it will render them judgment-proof, so in this case we would like to have someone compensate the losses.[xx] |
If gatekeeper is important and necessary as discussed above, we certainly don’t want them to fail, which means we don’t want them to either collude with the issuer to falsify documents or simply don’t work hard enough to fulfill their due diligence obligation. For starter, we need to understand why gatekeeper fails. One of the most important reasons behind such failure is the laisse-fair regulatory approach toward gatekeepers.[xxi] The rationale behind this approach is the belief that reputation sanction is enough for regulating gatekeeper, because they’re long term player, so it’s “unreasonable for them to collude with the issuer”.[xxii] However, history suggests otherwise. Theoretically, every economics model, not different from other scientific discipline, is constrained by several conditions and has limited scope for application, so we need to understand when reputation sanction applies. Logically speaking, reputation sanction works only if people care about reputation, so we can rephrase the question into a new one, which is under what kind of circumstances people don’t care about reputation?[xxiii] Like any other economics theories, market forces work here. If we assume there is a market for reputation, the price of reputation increases when supply is shorter than demand. If there is a monopoly for reputation, then the market dominators won’t care too much about reputation.[xxiv] Put it more simply, monopoly is one of the most common four cases for market failure.[xxv] One exemplary monopoly market is the accounting services market, where the big four accounting companies monopolize most shares of the market. Also in the investment banking industry, when choosing underwriter or sponsor for issuing securities, there aren’t too many options either. The monopoly problem is better in legal services market, since there are many firms for competition.[xxvi] |
The obvious solution to monopoly is to increase supply in market. However, simple competition won’t solve this problem, because there is the other race-to-bottom concern.[xxvii] This is precisely the other dilemma in the imperfect competition market. Although there are only 5 major accounting firms dominating 90% of market share,[xxviii] there is still a race-to-the-bottom problem among them. The reason is that the service provided by either one of the accounting firm is no different from the other four. In order to win clients, there is no reason to invest in more reputational capital due to the law of the diminishing marginal utility, so they have to compete on other basis, for example lowering the price, or providing other non-auditing services or simply lowering the standard for auditing.[xxix] This means “reputation only works when people choose to compete on the basis of reputation.”[xxx] Unless certain bottom line is drawn, or the redress system is efficient enough, too severe competition may drive the firms to go to the other end of extreme. |
Now we know that the reputation sanction may not work sometime, then we can explain the precise mechanism under which the failure occurs. After Enron scandal and the collapse of Arthur Anderson, professor Coffee had consistently published several articles in the gatekeeper area and tried to find an answer to what went wrong to contribute to the failure of gatekeeper.[xxxi] First and foremost, he made one thing clear, the Enron scandal is more attributable to the failure of the gatekeeper than the board.[xxxii] He made such conclusion by combining two pieces together. The first one is the steadily increasing quality of corporate governance and the second one is the steadily decreasing reputation provided by the accounting firm.[xxxiii] In light of these two trends, he drew the conclusion that it’s the gatekeeper to blame.[xxxiv] Finally in 2006 he published a whole book focusing exclusively on gatekeeper and in this book he gave three reasons as to why gatekeeper failed.[xxxv] |
The first one is ‘‘the decline in deterrence hypothesis’’. This is contributed mainly by the US Supreme Court Central bank[xxxvi] case in 1994 and the following PSLRA[xxxvii] reform in 1996. In the Central bank[xxxviii] case, the US Supreme Court ruled that there were no aider and abettor liability for auditors and lawyers, and they have to take primary roles in the fraudulent activity in order to be held liable under the 1934 Securities Exchange Law Rule 10(b)-5.[xxxix] Although there were many following cases[xl] trying to define what constitutes a primary role, the courts split on this issue.[xli] The only consensus reached is that if lawyer and auditor issued documents registered with the SEC and the documents were later found to be false, then under this circumstance can the lawyer and auditor be deemed to take primary roles in a fraudulent activity.[xlii] |
The Central bank case is just a prelude to the more drastic reform. In 1995 the Congress passed the PSLRA to severely restrict the litigation against any types of securities cases not limited to professional.[xliii] The US litigation system is particular in one aspect, which is the extensive evidence discovery process.[xliv] The plaintiff tried to use the court’s coercive power to force the defendant to reveal the key evidences.[xlv] PSLRA particularly targets this process. Among several changes it made, 3 of them are the most fatal. The first one is that the PSLRA requires that the defendant must “knowingly” take the fraudulent behavior.[xlvi] It means it permanently excludes any reckless or negligent behaviors, which is the major source of litigation against the gatekeepers. The second one is that it sets an extremely high standard on when can sue.[xlvii] The plaintiff must provide substantial evidences and also indicate the particular behaviors and specify a list of fraudulent activities that the defendant engages in.[xlviii] The third one is that any discovery of evidence is halted during the motion to dismiss stage.[xlix] In conclusion, now the litigation became a “Catch 22” game, the plaintiff has to know everything before they can know it. The court can’t be used as a tool for the discovery of evidence any more. |
The second reason of failure is ‘‘the increased managerial pressure hypothesis’’.[l] This is contributed mainly by the shift in agency cost. The managerial pressure or rise in agency cost is contributed by severe conflict of interest. First of all, the growing non-audit fees have increased to comprise more than 70% of revenue in the big 5 accounting firms in 2002.[li] The survival of accounting firms relies on the performance of other non-audit services, therefore it became prevalent to use auditing services as a leverage to solicit other non-auditing services.[lii] This practice called cross-selling or cross-subsidization contributes to an accompanying decrease in the standard of auditing.[liii] Secondly, there are only 5 accounting firms in the industry at that time therefore it’s an imperfectly competitive market.[liv] The large accounting firms can collude with each other and lower their standards altogether. |
The third one is ‘‘the stock market bubble hypothesis’’.[lv] During the time from late 1990s to early 2000s, there was a rising stock market bubble. This market bubble can provide enough compensation to almost every market participant so that they don’t really care too much about the reputation of the accounting firm.[lvi] |
In conclusion, we can see that gatekeeper failure is primarily caused by two things, the conflict of interest problem and the lack of deterrence problem. These problems can’t be solved by only relying on reputational sanction and market discipline, so regulatory intervention is needed. |
After the introduction of the definition of gatekeeper, the importance of gatekeeper and the necessity of regulation of gatekeeper, in the following, I will introduce the problems faced by regulating gatekeepers. |
3. Similar Problems in US, Hong Kong and EU |
In the following, I will introduce similar problems in US, Hong Kong and EU. In US, I will examine the problems faced by regulating underwriter, accountant and lawyer. In Hong Kong, I will examine the problems faced by regulating sponsor. In EU, I will examine the problems faced by regulating securities analyst. |
3.1. US |
In China, if there were problems uncovered after conducting due diligence, each gatekeeper tends to blame the others for failing to do the work. |
In US, there is the similar problem of liabilities distribution among different gatekeepers. For example, in IPO, there’ll be many parties involved, at the very least 3 parties will take part in this process, including underwriter, lawyer and accountant. However, if there is misstatement in the documents for IPO, how to ascertain different parties’ liabilities is a problem. They may each contribute to a portion in the process, however, they will point fingers to each other to try to ameliorate their liabilities. Even worse, sometimes they even turn a blind eye to the documents presented by others so that they can claim innocence during the trial. This liabilities shifting game makes investigation and enforcement action very time consuming and costly. |
Such situation is caused by its legal regime. Most interestingly, in US, although underwriter (sponsor), accountant, lawyer are all called as gatekeepers, it seems that the degree to which they should safeguard the gate diverges. Investors can sue all the groups of people who sign their names and vouch for the accuracy and completeness of the documents submitted to and registered with the SEC,[lvii] but different persons bear different liabilities. For issuer, it bears strict liabilities,[lviii] while for all other types of professionals involved in issuing stocks, they are presumed to bear liabilities unless they can prove otherwise,[lix] which is called due diligence defense.[lx] Due diligence defense can be divided into two types, the first type is for expert and the second type is for non-expert.[lxi] Experts have to prove that they conducted reasonable investigation to the expertised-portion and did believe there is no misrepresentation while non-experts have to prove that they had reasonable ground to believe and did not find there is any misrepresentation.[lxii] In short, the difference is that for expert, the due diligence defense is reasonable investigation defense, while for non-expert, it’s reasonable belief defense. Although expert and non expert differs in due diligence defense, their due diligence defense all has the word reasonableness. The following question is what is reasonableness. Reasonableness is defined as “prudent person managing his own property”.[lxiii] This is very vague, although several case laws try to define different liabilities of different gatekeepers, there is still no clear boundary. |
For underwriter in US, it’s deemed as the most important gatekeeper,[lxiv] therefore, although they’re non-expert, and they can reasonably rely on other professional’s work, this reasonableness standard is hard to be met. In order to satisfy such reasonableness standard, they have to go over all documents that could have potential issues.[lxv] It can’t argue that because it relies on other professionals’ work, so if any of them are not true, it’s not his fault. The underwriter is still responsible for verifying all documents submitted by other professionals.[lxvi] |
The second group of gatekeeper to the securities market is auditor. Auditor is deemed to be “expert” under US securities law.[lxvii] If a gatekeeper is qualified as an expert, then it only needs to bear the responsibilities for its portion of documents signed and submitted to the SEC.[lxviii] Secondly, for expert, it has to conduct reasonable investigation and made affirmative conclusions that they did believe there is no misrepresentation.[lxix] |
As for lawyer, they have dual-roles. For the legal opinion part, it’s deemed as expert,[lxx] however, for other expertised-portions such as financial statement, they’re non-expert.[lxxi] Therefore, in this case, lawyer and underwriter are all non-experts, and they have very similar responsibilities. Imposing such high duty on lawyer may be due to two reasons. The first reason is that financial information and legal information have mixed together, and sometimes it’s very hard to disentangle one from the other.[lxxii] For example, for materiality of information, accountant and lawyer has different understanding,[lxxiii] and for control of company and property, they also have different understanding.[lxxiv] However, ultimately such judgment is a legal matter so it’s the lawyer’s duty to make the final decision whether to disclose such information or not. In this case, we could see that lawyer’s role is quite similar to the role of underwriter, where the scope of liabilities is similar and both the underwriter and lawyer should be responsible to review all documents submitted.[lxxv] The second reason to impose such high duty on lawyer is that underwriter itself doesn’t possess the ability, time and resources to conduct a full investigation, therefore they have to rely on lawyers to help with due diligence.[lxxvi] Therefore, if lawyer is deemed to be an expert and only responsible for verification of legal opinion, then the underwriter’s ability to conduct due diligence will also be influenced. |
However, imposing such high duty on lawyer also draws substantial criticisms from legal community. The main reason is that lawyer shouldn’t be gatekeepers because it needs to maintain confidentiality of client’s information.[lxxvii] This means if lawyer spotted any illegality, it of course can give its legal advice to its client on how to rectify the illegality or control its impact, however, if the client refused to follow such advice, there is nothing the lawyer can do except to quietly quit the job, however, it’s impractical to expect a lawyer to quit because it will lose the client. In this case, if we prioritize confidentiality, it substantially weakens the role of lawyer as gatekeeper. Although in multiple cases, the SEC tried to pursue the liability of lawyer for aiding and abetting illegal behaviors, but they all got turned down by courts.[lxxviii] |
The above due diligence defense offered to each gatekeeper to be exempt from liability is essentially fault-based, and the vague definition in reasonableness requirement in due diligence defense makes fault proving difficult, which turns this to a blame shifting game. To make things even worse, the gatekeepers’ role is further weakened by the US Supreme Court in Central Bank Case in 1994 and its following case Stoneridge. These cases significantly restricted the application of private class action, where private class action can only be applied to primary wrongdoer but not secondary wrongdoer-gatekeepers. In order to restrain litigation boom after the recognition of implied private rights of action under 10b-5 by US Supreme Court and the recognition of third parties liabilities of gatekeepers after 1970s, in 1994 in the Central Bank v. First Interstate Bank case, the US Supreme Court in a 5-4 votes banned the aider and abettor liability of the accountant and lawyer in private litigation.[lxxix] After this case, the accountant and lawyer has to take a primary role in order to be found liable. However, the definition of primary role has not reached consensus except for one condition, which is if the accountant or lawyer drafts and submits documents, then they will be deemed as constituting primary role. In the later development in Stoneridge,[lxxx] some lawyers try to circumvent this ban and form a new concept called scheme liability,[lxxxi] where the whole fraudulent process were deemed to be a whole scheme so that lawyer and accountant’s role was not secondary but primary in this sense.[lxxxii] However, this scheme liability is not recognized by the US Supreme Court either.[lxxxiii] |
Finally, to make gatekeeper’s role even weaker, in 1995, the US Congress passed the PSLRA to forbid private class action on aiding and abetting liability, so now it became statutory law to restrict aider and abettor liability.[lxxxiv] Moreover, the law also significantly lifted the litigation standard. The PSLRA deals with 2 issues. The first one is the way of compensation.[lxxxv] The question is can we ask the auditing firm to compensate all the losses first, or only ask them to compensate losses in proportion to their fault? This is the debate between joint liability and joint and several liabilities. The US takes the approach of joint liability for a certain period of time, and this causes boom in the litigation against the accounting firms. Under this act, the accounting firm’s liability is restricted to at most 50% of the losses of the investors provided that the issuer doesn’t have the ability to pay.[lxxxvi] Only under one condition does the accounting firm bears joint liability, which is the small amount suit.[lxxxvii] For the loss less than the amount of 200,000 US dollars and also exceeding 10% of the plaintiff’s assets, then the accounting firm needs to bear joint liability provided that the issuer doesn’t have the ability to pay.[lxxxviii] Before the PSLRA reform, the accounting firm can bear the joint liability of fraud, which means even if it only contributed a small portion to fraud, they may be sued to pay the equivalent whole amount. However, the PSLRA changed joint liability to the joint and several liabilities, so that each one only needs to take responsibility in proportion to their fault. |
The second issue addressed under PSLRA is to raise litigation standard. Before the PSLRA reform, the plaintiff can bring litigation against accounting firm simply by showing that the auditing report is inaccurate and the price of the audited company falls following the release of the auditing report, and hopes to find proof of negligence during the trial.[lxxxix] Following the PSLRA reform, the standard to file suit against accounting firm rockets. Now the plaintiff has to prove beforehand the defendant acts knowingly or recklessly.[xc] Moreover, the plaintiff has to show there is causal relationship between the loss and the information in the admission stage.[xci] The PSLRA reform substantially limits the ability of the investors to bring lawsuit, it basically requires the investors to prepare detailed and precise evidences in advance before the case can be even admitted into the courtroom. |
In conclusion, the underwriter, the lawyer and accountant’s liabilities are all fault based, with due diligence defense to be excused from liabilities. However, there are several problems in this. The first one is that the degree of due diligence defense is not clear, so it’s time consuming to determine appropriate liability of each gatekeeper. Secondly, for non-expert such as lawyer and underwriter, they can claim that they are mislead by the accountant’s report or issuer’s behaviors. The third one is that US Supreme Court’s ruling and PSLRA significantly reduced gatekeeper’s liabilities by restricting application of private class action on aider and abettor liability and limiting the scope of compensation that can be born by each gatekeeper. |
In conclusion, in practice, the situation will look like this. Although underwriter is responsible to check all the documents provided, however, because the scope of underwriter’s due diligence is not so clear, and as non-expert they can reasonably rely on other persons’ work, but the definition of reasonable reliance is also not clear, so they can blame the other gatekeepers. The lawyer in theory has very similar liabilities as underwriter, however, due to confidentiality reason, they almost can’t be subject to legal liability, because even if they spot illegality, they can’t report them. The accountant as expert is only responsible for reviewing financial statement, and the liability seems clearer as opposed to the above two, so they’re the one that got sued the most in securities class action. However, after the reform of PSLRA, it’s harder to pursue the liabilities of accountant in private class action. Because firstly, only when they’re primarily liable in financial misstatement can they be sued in private class action and secondly the accountant is only responsible for compensation to at most 50% of losses, which means the previous strategy to only sue accountant in court becomes insufficient. This complicated regime makes the liabilities distribution among gatekeepers into a blaming game. The underwriter could use defense strategy to accuse the other two, while lawyer can also point fingers to accountant for providing false information. The only one who can’t blame other gatekeepers is the accountant, however, after PSLRA the account is restricted to at most 50% of compensation, thus again passing the ball to others. |
3.1.1.1. Third Parties Liabilities of Securities Analyst |
In China, securities analyst only subjects to scant conflict of interest regulations, so there are multiple cases where securities issue biased reports to engage in insider trading or market manipulation activities.[xcii] |
The last group of people, who as of today maybe called as gatekeeper, however, in terms of strong conflict of interest and weak legal intervention, doesn’t act the way a gatekeeper should have done. They are sell side securities analysts. Sell side securities analyst is subject to the least regulation, either from private litigation or public enforcement. |
Securities analyst can engage in 3 types of misbehaviors. The first one is insider trading, the second one is market manipulation and the third one is misstatement. For insider trading, in the past it’s generally permitted for securities analyst to engage in insider trading.[xciii] However, after the passage of Regulation Fair Disclosure, the securities analyst can’t engage in insider trading anymore, however this regulation doesn’t create private rights of action, so the securities analysts only subject to public enforcement by SEC.[xciv] For market manipulation and misstatement, securities analysts can be subject to private litigation, however, it’s not easy to prove, since the information contained in the research report is soft information but not hard facts, so it’s hard to categorize them into misleading information.[xcv] |
Even faced with these problems, in US, regulators still face oppositions for regulating securities analyst. There are two types of concerns which addresses the refusal for strong legal intervention. The first reason of opposition of regulation is the freedom of speech concern.[xcvi] Compared with buy side analyst-investment advisor, regulation of sell side analyst is harder and also draws many criticisms. For buy side analyst, it’s subject to fiduciary duty, so any type of undisclosed conflict of interest could be subject to enforcement action.[xcvii] In this case, there is no need to prove causation between recommendation of securities and losses of investors. However, for sell side securities analyst, because they provide report to the public, so the number of people who see this report is uncertain. Moreover, because they generally make prediction to the future performance of the company, so it would be difficult to sanction them even if the company doesn’t perform as predicted in the future. Solely sanctioning them based on this wrongful prediction will infringe the right of freedom of speech to express its opinions by the sell side analyst. The second reason of opposition of regulation is that securities market needs information provider.[xcviii] Because most of the research report is free, so it needs other businesses to subsidize this research, or no one will produce research report any more. Favorable report in exchange of solicitation of business is therefore deemed to be a necessary evil to maintain information flow in the market. However, it can’t be denied that sell side securities analyst does engage in many types of securities misbehaviors, so simply let these misbehaviors go unpunished is not acceptable, so the real issue is to find appropriate ways to regulate them. |
3.2. Hong Kong: Liabilities Shifting of Sponsor |
The reason to study Hong Kong is that in China the sponsor system was directly borrowed from Hong Kong. Therefore, the problems once happened in Hong Kong also occurred in China, so they shared similar problems. |
Sponsor in Hong Kong is required by law to verify the documents submitted to SFC.[xcix] Although underwriter in US also has very similar duty, but the wording of law is so implicit as compared to the explicit duty of due diligence of sponsor in Hong Kong. In US, due diligence is stipulated by law as a defense used to excuse underwriter from liability rather than a direct duty imposed on underwriter,[c] therefore it seems as only one of duties compared to other multiple functions taken by underwriter. Moreover, at the time of borrowing such system from Hong Kong, the professional services industry in China was relatively weak as compared to now, and there were no large domestic law firms and accounting firms in China.[ci] Furthermore, because financial industry was and still is controlled by government, so securities firms in the market are mainly SOEs,[cii] and therefore it’s very natural to favor securities firms rather than other gatekeepers. These are all the important considerations to borrow sponsor system from Hong Kong, where the due diligence was majorly carried out by securities firms acting as sponsors instead of putting such duty on accountants and lawyers. The original idea was to use sponsor to help CSRC guard the securities market as the front-line patrol. However, since sponsor system didn’t prevent the wide spread occurrences of securities misbehaviors in China in all these years after its implementation, so many people argue that there is no meaning to maintain such system,[ciii] and China should instead learn from the US model, where more due diligence duties should be put on accountants and lawyers and private securities class actions should be the main enforcement technique.[civ] However, in the following Section 5.3.1.1, I’ll explain why such proposal is incorrect because it failed to correctly understand the situations in both Hong Kong and US. |
In Hong Kong, the sponsor system had two reforms. The first one was introduced after a very significant scandal, the Euro-Asia Agriculture Scandal. Euro-Asia is an agricultural company, and its main business includes a Netherlands theme park and high-tech agriculture.[cv] However, such Netherlands theme park was mainly used to transfer money to the pockets of large shareholders through construction projects and the so called high-tech agriculture doesn’t generate profits at all.[cvi] All the financial statements and related documents used to corroborate financial statements were falsified.[cvii] However, such company nevertheless managed to get listed in Hong Kong Stock Exchange and was seen as the future of Chinese agricultural business model.[cviii] After this scandal, the first reform was introduced in 2003, in the new Listing Rule of HKSE and Code of Conduct by SFC, sponsor for the first time was explicitly subject to administrative liabilities for misstatement in prospectus.[cix] Also, it required the sponsor to be independent and obtained necessary resources and expertise to conduct due diligence.[cx] |
Although sponsor system was introduced in Hong Kong, it still had many insufficiencies, which can be illustrated by several major scandals in Hong Kong. One of the biggest scandal is the Hontex International scandal.[cxi] Hontex is a clothing manufacturer. In order to manipulate financial statement, Hontex bought multiple local small clothing stores to sell its clothes.[cxii] Due to the opaque nature of financial statement of local small stores, Hontex managed to boost its statement substantially.[cxiii] Mega Capital was the sponsor in this case.[cxiv] Mega Capital agreed to the Hontex’s proposal that Mega Capital shouldn’t directly contact its suppliers and sellers so the interview with suppliers and sellers was mainly conducted by Hontex themselves with the presence of sponsor during the interview.[cxv] This scandal was exposed due to the whistle blowing by an auditor from KPMG after the whistleblower found out that the partner responsible for due diligence was bribed by Hontex to turn a blind eye.[cxvi] |
This case exposed three of the most significant problems in sponsor regulation in Hong Kong. The first one is the lack of civil liability on sponsor for misstatement in prospectus.[cxvii] Previously, sponsor only bears administrative liability and can only be sanctioned by SFC. This was deemed as not imposing enough incentive on sponsor to conduct due diligence. The second major insufficiency is no different from that of underwriter in US, which is the unclear duty of due diligence on how to divide liabilities between sponsor and other gatekeepers, and the severe conflict of interest in sponsor when conducting due diligence,[cxviii] since sponsor is paid by issuer, so therefore they may collaborate with or at least acquiesce to the illegal behaviors of issuers. The third one is the lack of collaboration among sponsor and other gatekeepers,[cxix] which is a derivative problem of liabilities shifting. For example, in the above case, although the auditor found out problems, the sponsor had no idea that such problems existed. |
Against this background, after 2013, Hong Kong for the second time reformed its regulations of sponsor.[cxx] In the 2013 new regulations, sponsor was required to bear civil liability for the misstatement in prospectus and several methods were introduced to manage such conflict of interest,[cxxi] which will be reviewed in the following comparative studies in Section 5.1.1.1. |
3.3. EU: Third Parties Liabilities of Securities Analyst |
After the Enron Scandal, the EU Commission delegated the the Oviedo ECOFIN Council to study problems related to financial industry in 2001, which identified among other things, several problems related to securities analyst.[cxxii] Moreover, in 2001, the FSA in UK also formed its own independent investigation to the problems related to securities analyst.[cxxiii] This study identified long hanging problems traced back to 1986 big bang reform in UK, where at that time there was a fixed commission for broker and dealers.[cxxiv] Since broker and dealers can’t compete on price, so instead, they chose to compete on providing additional services, including investment research and seminars and so on.[cxxv] These soft services create conflict of interest for analyst and jeopardize the integrity for their reports.[cxxvi] Both reports from EU and UK identified similar problems, where there is a severe conflict of interest on the side of securities analyst to issue favorable report for issuer. Moreover, right after these reports, in 2003, the Parmalat scandal in Italy broke out.[cxxvii] In this scandal the red flags were so obvious where Parmalat held substantial cash with low interest return and also held significant debt with high interest expense.[cxxviii] Nevertheless, most institutional investors were generally blind on this fraudulent behavior. Among all the analyst reports covering Parmalat in 2002, only one team from the Merrill Lynch issued a sell rating.[cxxix] In one of the buy reports, although it expressed concerns about the company’s debts, it nevertheless issued buy rating.[cxxx] Apart from two reports expressed worries, all the other analysts remained unworried about possible violations at Parmalat so they still maintained their buy ratings.[cxxxi] |
4. Comparisons of Regulatory Models |
Different regulatory techniques have been employed to regulate different types of gatekeepers. These regulatory techniques mainly include litigation, information disclosure, corporate governance, regulatory oversight and payment regulation. In the following, I will introduce how these regulatory techniques are applied to different types of gatekeepers and their effects of applications. |
4.1.1. Underwriter |
In 1933 Securities Act Section 11(b), due diligence defense is offered to various gatekeepers. The due diligence defense has different applicability based on whether the portion in the document is expertised portion or not,[cxxxii] and whether the person reviewing such portion is expert or not.[cxxxiii] For underwriter in US, they’re deemed as non-expert.[cxxxiv] For non-expert, the due diligence defense is divided into two parts, and one is applied to expertised portion while the other is applied to non-expertised portion. For non-expertised portion in registration statement, “the non-expert must conduct reasonable investigation and had reasonable ground to believe and did believe that such expertised portion were true.”[cxxxv] While for expertised portion in the registration statement, “the non-expert must show that they had no reason to believe and did not believe that the expertised portions were false.”[cxxxvi] Generally speaking, there are 2 differences between expertised portion and non-expertised portion. The first one is in terms of conduct. For non expertised portion, the conduct is reasonable investigation, while for non-expertised portion, there is no requirement for such reasonable investigation.[cxxxvii] The second one is in terms of intentional aspect. For expertised portion, the intentional aspect is reasonable ground to believe it’s true, while for non-expertied portion, the intentional aspect is no reason to believe it’s false.[cxxxviii] In conclusion, for expertised portion, the standard is reasonable reliance and for non-expertised portion, the standard is reasonable investigation. |
After analyzing the above texts, one question naturally arises, which is what’s the standard of reasonableness. The language reasonableness appears in the above text several times, for example “reasonable investigation”, “reasonable ground to believe” and “no reason to believe”, so reasonableness is the central standard to evaluate whether an underwriter can evoke due diligence defense, because based on the language of the text it’s not important whether investigation is conducted or whether an underwriter believe the registration statement to be true or not, the key is whether such investigation is reasonable or whether such belief as to the truthfulness or falsity is reasonable. So in Section 11(c), the text defines that “the standard of reasonableness shall be that required of a prudent man in the management of his own property.”[cxxxix] However, such standard is still unclear based on the definition of this text. Such standard was made a little clearer by the Escott v. Barchris casein 1968.[cxl] |
BarChris is a company building bowling alleys, however in the registration statement for raising capital by issuing debentures, it misstated its financial statement and overstated the number of bowling alleys it sold, didn’t disclose that BarChris would lose money on some notes, misstated backlogged orders, did not disclose that money raised would not go to reconstruction but to debt financing, and that some insiders had not repaid loans.[cxli] Drexel&co. was the lead underwriter in the issuing of such debentures and the court held that due diligence defense didn’t apply to Drexel&co.[cxlii] The court gave two reasons. The first one was that Drexel&co. simply relied on the the documents issued by underwriter’s lawyer and accountant, however, the problem was that the lawyer and accountant didn’t conduct investigation as well, and they just simply relied on the statement from the management.[cxliii] Because of this, it showed no reasonable basis to believe that the statement is not false. The second one was that Drexel&co. attended many meetings with management for the preparation of issuance of debentures.[cxliv] Drexel&co. asked many crucial questions in the meeting but these questions were not answered by the management.[cxlv] This implied that Derxel&co. knew the problems but didn’t conduct reasonable investigation. The third one was that Drexel&co. was also on the board of the company.[cxlvi] Because of this, it made it unreliable to state that it had “reasonable ground to believe the statement is not false.”[cxlvii] |
There were several lessons which can be learned from this case. The first one is that underwriter should at least know whether the accountant and lawyer fulfil their duties and this process control should be an integral part of their reasonable investigation, otherwise failure of their investigation may backfire on underwriter and make due diligence defense inapplicable. The second one is that the standard of reasonableness is evaluated by whether the underwriter could have some actual knowledge to the situations that needs to be investigated. |
Although BarChris case was deemed to be the ground breaking case in terms of defining the standard of reasonableness, however, it still leaves many questions unanswered. Because in this case, BarChris actually didn’t do any investigation, and just blindly rely on the documents issued by lawyer and accountants, so we still don’t know to what degree should the underwriter conduct investigation and can rely on documents issued by experts thus unable to know the standard of reasonableness.[cxlviii] |
After BarChris, there were several cases answering this question. In In re WorldCom,[cxlix] the court ruled that there were certain “red flags” that should trigger investigation by the underwriter, and these “red flags” include |
|
Moreover, in this case, the court ruled that comfort letter issued by auditor can’t be reasonably relied upon by underwriter as expertised portion, since comfort letter is not audited financial statement.[cli] |
In In re Rectifier Securities Litigation,[clii] the court ruled that when evaluating reasonable investigation, the underwriter should be familiar with issuer’s financial status, management and operation status, and industry information；conduct personnel interview; verify statistics received from issuers from third parties；receive written confirmation of statistics from issuer and auditors.[cliii] However, in terms of expertised portion especially for audited financial statement, the duties of underwriter vary according to different case laws. According to BarChris, the underwriter should review original documents, but was not required to verify the reasonableness of the application of auditing and financial principles.[cliv] However, there was another contrasting opinion where the Seventh Circuit in Sanders v. John Nuveen & Co.[clv] took the opposite approach, criticizing the underwriters for not meeting with the auditors or reviewing any accounting work papers which might have revealed evidence of fraud between the issuer and the auditors. |
In University Hill case, the court ruled that reasonable investigation is related to the familiarity with the issuer and the size of issuer.[clvi] Standard of due diligence increases with the increase of familiarity to issuer, while such standard is higher when the size of issuer is smaller. In In re Rectifier Securities Litigation, the court stated that reasonable investigation doesn’t mean perfect investigation.[clvii] Moreover, according to Rule 176 discussed below, scope of due diligence is limited by the availability of information.[clviii] |
Finally, in 1982, the SEC codified some principles established by courts and issued Rule 176,[clix] where it stated that several factors should be taken into consideration when evaluating reasonableness, and they include: |
|
In conclusion, reasonableness is determined by the particular situations of issuer’s status and the relationship between issuer and underwriter. There are two uncertainties hanging over underwriter. The first one is that underwriter should be aware of “red flags”, and many things should be independently investigated by underwriter except for application of accounting principle. However, even for application of accounting principle, due to the constraint of “red flags”, underwriter may still need to watch out for unusual application of accounting principle, since what constitutes as “red flags” is not certain, so therefore the underwriter’s due diligence duty is also not certain. The second uncertainty is that although underwriter’s scope of due diligence duty is limited by the availability of information thus not overly expansive, however, such availability of information is also determined by the company’s size, industry and its relationship with underwriter. Since these are all principles, so the definition of availability of information is also not certain. |
4.1.1.2. Liabilities of Litigation for Sponsor and Information Disclosure Obligation by Sponsor in Hong Kong |
Before 2013, sponsor in Hong Kong (Hong Kong version of underwriter) can’t be sued by private investors for misstatement in prospectus.[clx] This is because in Hong Kong, the civil prospectus liability is defined in Hong Kong Companies Ordinance Section 40(1), however this section doesn’t clearly include sponsor for civil liability. Moreover, other relevant sources of law such as both common law and Misrepresentation Ordinance in Hong Kong had insurmountable obstacles for inventors.[clxi] Section 40(1) requires “directors, every person who has authorized himself to be named in the prospectus as a director, every person who has authorized the issue of the prospectus and every person who is a promoter of the company, to pay compensation to all persons who subscribe for any shares in the prospectus for the loss or damage they have sustained by reason of any untrue statement included therein.” In this section, sponsor is not mentioned. Someone argues that sponsor should be included under the definition of promoter, |
since Section 40 is modelled after or derived from Section 43 of the UK equivalent. Although the wording of s 43 of the UK Companies Act 1948 (like s 40 of the Companies Ordinance) does not expressly state that sponsors are liable nor does it include sponsors within the definition of ‘promoters’, the leading UK company law textbook in discussing the definition of promoters in s 43 of the UK Companies Act 1948 asserted unequivocally that sponsors ‘would clearly be liable’ but solicitors are excluded from liability. This is because the definition of ‘promoter’ in the UK Companies Act 1948 (which is identical to s 40(5)(a) of the Companies Ordinance) means someone who was a party to the preparation of the prospectus.[clxii] |
However, this is only one academic definition, but apart from this, nothing can be found in parliament’s materials, or judicial precedents or statutory guidelines to support this position.[clxiii] Therefore, sponsor before 2013 was not subject to civil liability for misstatement in prospectus. However, sponsor was subject to administrative liability for misstatement in prospectus.[clxiv] The SFC can issue private or public reprimand, suspend the practice of sponsor or revoke the license of sponsor, or impose a maximum fine equaling to 10 million Hong Kong dollars or 3 times of the gains or losses avoided, whichever is higher.[clxv] |
Apart from lack of private liability of sponsor for misstatement in prospectus, the duties of due diligence of sponsor is also not sufficient, which caused a series of major scandals. In 2012, the SFC revoked the license of Mega Capital (Asia) Company Limited and imposed 42 million HK dollars fine for the misstatement in prospectus of Hontex International Holding Companies Limited, since Mega Capital only spent less than one month on due diligence on Hontex, and it only knew the situations of Hontex to a very limited level.[clxvi] The fine imposed on Mega Capital is the largest in history.[clxvii] Also, in 2008 and 2011 there were several similar cases where sponsors failed to adequately discharge its due diligence duties. In 2011, the SFC barred two sponsors from entering into the stock market due to failure of conducting proper due diligence causing misstatements in the prospectus.[clxviii] In addition, in 2008, the SFC imposed a 2.8 million Hong Kong dollars fine on the sponsor of the issuer Tungda Innovative Lighting Holdings Limited, the Core Pacific-Yamaichi Capital Limited, for the same reason as the above mentioned case.[clxix] Against this background, the SFC proposed to reform the current regime for sponsor regulations in 2012. In May 2012, the SFC issued the “Consultation Paper on the Regulation of Sponsors”.[clxx] After this consultation, the SFC issued “Consultation Conclusions on the Regulation of Sponsors” which made several recommendations to the reforms that should be adopted by SFC in terms of regulations of sponsors.[clxxi] In receipt of these suggestions, the SFC reformed Section 17 in relation to sponsor in Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (Code of Conduct). Also, Practice Note 21 of the Exchange Listing Rule has been changed. There are several changes for sponsor’s regulations. |
Firstly, sponsor needs to bear civil liability for prospectus. The sponsor is also equipped with due diligence defense to be exempt from civil liability. In this case, the plaintiff only needs to prove misstatement in prospectus and sponsor needs to prove that they fulfill their due diligence duty to be exempt from civil liability. In order to clarify such due diligence defense, Section 17 of Code of Conduct and Practice Note 21 of the Exchange Listing Rule clarified sponsor’s obligations in details.[clxxii] Firstly, sponsor needs to receive original certificate related to transactions by issuer, conduct interviews and onsite investigations, and such interviews and investigations should remain independent and without intervention from issuers.[clxxiii] Secondly, sponsor both has the obligation and the right to closely collaborate with accountant and lawyer to independently review their works.[clxxiv] Although it’s not required for sponsor to conduct the same auditing process by the same standard of auditor or make legal judgment with the same standard of lawyer, the sponsor nevertheless should remain vigilant for the important assumptions and analysis methods applied by experts and conduct its own investigation to evaluate whether such conclusion made by expert is appropriate or not.[clxxv] Moreover, the sponsor should also make sure that the expert is independent from the issuer and also maintain sufficient resources and expertise to conduct due diligence. Thirdly, there is a minimum time required for conducting due diligence. The minimum time for due diligence is set for two months.[clxxvi] Fourthly, sponsor is required to set up a team with appropriate expertise when conducting due diligence.[clxxvii] A member of the team should be delegated as team leader and coordinator in charge of collaboration with other professionals and supervision of due diligence process.[clxxviii] |
Secondly, apart from detailed due diligence defense requirement, in order to incentivize the sponsor to conduct due diligence, the SFC also imposes information disclosure obligation on sponsor. Firstly, the “Consultation Conclusion” requires disclosure of a prefixed amount of sponsor’s fee and this fee can’t be tied to other businesses and must be listed independently.[clxxix] In this case, it can ameliorate the conflict of interest when sponsor is conducting due diligence. Due diligence must now be paid directly, which means it has become a business that can truly generate profits instead of an ancillary service that must be cross subsidized by other businesses. Secondly, it requires the mandatory noisy withdraw to the SFC when the sponsor finds out fraudulent activities but the issuer refuses to correct it,[clxxx] which means the sponsor needs not only to quit the job but also reports the reasons for quitting the job to SFC. Thirdly, if submission of documents is rejected, then the next submission will be frozen for 8 weeks.[clxxxi] This on the one hand gives enough time for sponsor to supplement materials and on the other hand provides further incentives for sponsor to conduct due diligence properly from the start. Fourthly, information of application, information of rejection and sponsor’s name will be disclosed on the SFC’s website, which serves as a reputation sanction and creates another incentive for sponsor to conduct due diligence properly. |
In conclusion, sponsor in Hong Kong now bears civil liability for misstatement in prospectus. Moreover, the due diligence duties of sponsor became more detailed. Lastly, information disclosure technique was used on sponsor to incentivize it to conduct due diligence more properly. |
4.1.2. Accountant |
The due diligence defense for accountant is relatively clearer than underwriter, since accountant is regarded as expert and can only be held liable for expertised version which is the financial statement.[clxxxii] However, in history such liability is never straight forward and the scope of accountant’s liability changed from expansion to restriction. |
In history, accountant was not subject to third parties’ liability, which means they don’t need to compensate the losses of third parties even if the financial statement audited by it was false.[clxxxiii] Also, they were only responsible for compensation of losses of the parties with whom they entered into contract, so third parties other than the contractual parties would not be compensated because they were not deemed to have privity to the contract.[clxxxiv] Only after 1970s with the recognition of pure economic loss in third parties’ liabilities, the importance of accountant was recognized and their statues as gatekeeper to the securities market was established.[clxxxv] Entering into 1980s, the accountant became one of most sued parties in securities class actions. However, because at that time parties liable for securities fraud are subject to joint liabilities,[clxxxvi] therefore even if in a case where issuer is the one mainly responsible for financial misstatement while the accountant only took a secondary role in such misstatement, the accountant can still be sued to cover all the losses suffered by investors. This spurred strong oppositions from accounting industry. Moreover, at that time both the industry and academia observed that there are just too many litigations and some of the litigations are meritless and they’re initiated simply to coerce the companies to enter into settlement before the stock price dropped any further.[clxxxvii] Therefore, against this background, several reforms were initiated to restrict private litigations on accountant. |
The first restriction was introduced by the US Supreme Court Central Bank case.[clxxxviii] In this case, the Colorado Building Authority issued bonds to finance local residential and commercial development in 1986.[clxxxix] In this issuance of bonds, the petitioner Central Bank of Denver was the trustee in this case.[cxc] The bonds used land as collateral and the Central Bank of Denver required the land to be evaluated every year and the value after evaluation must maintain at least 160% of the outstanding bond principal plus interest.[cxci] Amwest Development was supposed to do evaluation annually.[cxcii] However, in 1988 land values in the related area dropped so the Central Bank expressed concerns to Amwest that the value of collaterals might not be kept at the agreed value and moreover the most recent assessment was 16 months old.[cxciii] Amwest and the Central Bank agreed to conduct an independent audit before the end of the 1988.[cxciv] However, bonds defaulted before the audit.[cxcv] |
Therefore, First Interstate, who bought the largest bulk of bonds, sued the Central Bank of Denver for “aiding and abetting” Amwest.[cxcvi] The issue in this case is that “Whether private civil liability under section 10(b) of the Securities Exchange Act of 1934 extends … to those who do not engage in the manipulative or deceptive practice but who aid and abet the violation.”[cxcvii] |
Finally, in a 5-4 vote the Supreme Court ruled that the aider and abettor can’t be held liable under section 10(b),[cxcviii] because in order to meet section 10(b)’s requirement, according to precedent established by Basic v. Levinson, reliance on the misstatement or omitted to state the material facts needs to be proved.[cxcix] However, it’s not Central Bank who made the misstatement or omitted to state the material facts, because Central Bank is only an aider and abettor, and there is a difference between primary violator and aider and abettor.[cc] The court reasoned that |
Our reasoning is confirmed by the fact that respondents’ argument would impose 10b-5 aiding and abetting liability when at least one element critical for recovery under 10b-5 is absent: reliance. A plaintiff must show reliance on the defendant’s misstatement or omission to recover under 10b-5… Were we to allow the aiding and abetting action proposed in this case, the defendant could be liable without any showing that the plaintiff relied upon the aider and abettor’s statements or actions… Allowing plaintiffs to circumvent the reliance requirement would disregard the careful limits on 10b-5 recovery mandated by our earlier cases.[cci] |
Moreover, there is no explicit language in the text of section 10(b) or Congressional materials that can support the claim that aider and abettor liability is covered by section 10(b).[ccii] The court wrote that “from the fact that Congress did not attach private aiding and abetting liability to any of the express causes of action in the securities Acts, we can infer that Congress likely would not have attached aiding and abetting liability to § 10(b) had it provided a private § 10(b) cause of action.”[cciii] |
After Central Bank case restricting the application of aider and abettor liability under rule 10b-5, lawyers were trying to redefine to concept of reliance by introducing the “scheme liability”, where both the aider and abettor and the primary violator are considered as a whole to participate in a fraudulent scheme. This issue was brought up in the case Stoneridge.[cciv] In this case, Charter participated in a multitude of fraudulent practices in order for its quarterly reports to meet Wall Street expectations.[ccv] It was soon realized by Charter’s executives that even with the fraudulent efforts certain financial predictions still would not be realized by the company.[ccvi] Charter elected to change its current arrangements with its customers/suppliers, Scientific-Atlanta and Motorola, who agreed to the altered arrangements in order to help with the shortfall.[ccvii] Charter was allowed to trick its auditor into authorizing a financial statement demonstrating that the predicted revenue and operating cash flow numbers were met even though the transactions they entered into has no economic substance.[ccviii] However, alternatively, preparation or dissemination of the financial statement was not performed by the customers/suppliers, Scientific-Atlanta and Motorola in their own financial statement.[ccix] |
The investors (Stoneridge) claimed that the customers/suppliers were in reckless disregard of or aware of Charter’s intention to utilize the transactions to exaggerate its revenues and were aware that the resulting financial statements issued by Charter would be relied on by investors and research analysts.[ccx] It was also claimed by investors that they had relied upon the customers/suppliers misleading acts.[ccxi] |
The court formed the issue as “Is a third-party customer/supplier of a company considered a prime participant where investors wishing to bring the action have not relied on the third-party customer/supplier’s acts, for purposes of a private cause of action under § 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5?”[ccxii] |
The Supreme Court once again ruled that rule 10b-5 can’t be applied in this case. The reasons given by the court are almost the same as Central Bank. The court wrote that “A third-party customer/supplier of a company is not a prime participant, even though its misleading acts are part of a scheme to defraud investors, where investors wishing to bring the action have not relied on the third-party customer/supplier’s acts.”[ccxiii] However, this time the situation became more unfavorable to the plaintiffs, because in 1995 PSLRA, the act explicitly excluded aider and abettor liability from securities class action. The court wrote that “Moreover, the investors’ theory would place an unsupportable interpretation on Congress’ explicit answer to Central Bank in PSLRA § 104 by enlivening the implied cause of action against many aiders and abettors, in turn discouraging Congress’s resolve that only the SEC should pursue this class of defendants.”[ccxiv] However, there is a significant difference between this case and Central Bank. In this case, the defendant Scientific Atlanta did take an active role in deceptive practice while the help provided to Central Bank is minimal compared to Scientific Atlanta, therefore, the question would be that is it appropriate to call Scientific Atlanta a secondary offender instead of a primary one?[ccxv] This question didn’t skip the eyes of Supreme Court, as Justice John Paul Stevens, joined by Justices David Souter and Ruth Bader Ginsburg, wrote in the dissenting opinion, that it (Stoneridge) had actually undertaken plainly deceptive acts.[ccxvi] |
So after the Central Bank case and the Stoneridge case, we can see that the actual issue is not on how to define reliance but rather on how to differentiate between primary violator and aider and abettor. Without answering this question, the plaintiffs can’t know what kind of conducts they relied on, the conduct of primary violator or aider and abettor? Therefore, it brings us to the following case Janus.[ccxvii] |
Janus Capital Group, Inc. (JCG) (defendant) created the Janus Investment Fund (JIF), a family of mutual funds legally distinct from JCG.[ccxviii] Janus Capital Management LLC (JCM) (defendant) provided investment advisory services to JIF.[ccxix] All officers of JIF were officers of JCM.[ccxx] In accordance with legal requirements, JIF issued prospectuses for several of its funds.[ccxxi] These prospectuses stated that market timing was not a proper practice for the funds, and implied that JCM would seek to restrict it.[ccxxii] However, the fact shows the contrary practices of JCM and JCG against their statement. In September 2003, the New York State Attorney General filed a complaint alleging that JCG had made secret arrangements to allow market timing for several of the funds managed by JCM.[ccxxiii] First Derivative Traders (First Derivative) (plaintiff) brought suit against JCG and JCM on behalf of other owners of JCG stock.[ccxxiv] They argued that JCG and JCM unlawfully made misleading statements in prospectuses about various Janus funds, most notably that it did not permit “market timing” of the funds, however in practice they did the exact opposite.[ccxxv] |
The issue of this case is that can JCM “be held liable in a private securities fraud action for ‘helping or participating in’ another company’s misstatements?”[ccxxvi] |
The Court ruled that “Because the false statements included in the prospectuses were made by Janus Investment Fund, not by JCM, so JCM and JCG cannot be held liable in a private action under Rule 10b–5.”[ccxxvii] The court further defined the word “make”. “The maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it. Without control, a person or entity can merely suggest what to say, not “make” a statement in its own right.”[ccxxviii] The court further reasoned that an aider and abettor can provide “‘substantial assistance’ to the making of a statement but do not actually make it. Reading “make” more broadly, to include persons or entities lacking ultimate control over a statement, would substantially undermine Central Bank by rendering aiders and abettors almost nonexistent.”[ccxxix] |
Although in this case, the Supreme Court didn’t directly define the concept of primary violator and aider and abettor, but nevertheless it shed some light to the definition. It seems that the Supreme Court took a very conservative approach as to define the primary violator to the one who has ultimate control over the final statement. Persons giving advises or even “substantial assistance” to this final statement but doesn’t have ultimate control over it is not a primary violator but only aider and abettor, therefore can’t be subject to rule 10b-5. |
The second restriction of accountant’s liability was caused PSLRA,[ccxxx] where restriction of aider and abettor liability became statutory law and joint liability was changed to joint and several liability and there is a capped ceiling for compensation for each of the defendant.[ccxxxi] Moreover, the pleading standard was also raised by PSLRA where detailed evidences and particular allegations need to be presented to prove intention and causation in the admission stage.[ccxxxii] In the following, I will introduce these two restrictions in details. |
After 1994 repeal of aider and abettor liability and the following 1995 PSLRA restricting class action, there is significant increase in the numbers of restatement of financial report and significant decrease of private litigations, which was identified by empirical research as one of reasons leading to Enron Scandal.[ccxxxiii] Although in order to compensate the loss of deterrence effect in PSLRA, the Act makes it mandatory for accountant to report suspicious activities to SEC, this clause largely remains dormant, since the SEC lacks the resources to enforce such obligations.[ccxxxiv] Therefore, after the Enron Scandal, the US Congress passed SOX Act to introduce new corporate governance and regulatory oversight tools to regulate accountant.[ccxxxv] Moreover, because US introduced independent agency PCAOB to be specifically in charge of supervision of accounting industry,[ccxxxvi] so the previous dormant mandatory reporting clause became active after the SOX Act, which equals imposing a new information disclosure duty on the accountant. These regulatory techniques will be introduced in the following. |
4.1.2.2. Information Disclosure in US |
In terms of information disclosure, after passage of PSLRA, the up-the latter report obligation was imposed on accountant. When encountering a problem, the auditor should first report the problem to the auditing committee inside the company.[ccxxxvii] If the committee failed to act or if the reply was not appropriate, the auditor shall choose to either (1) resign and report the problem to the SEC or (2) not to resign and report the problem to the SEC.[ccxxxviii] Also, if the auditor chose to resign, the auditor should register such resignation with the SEC and also explains the corresponding problems to the SEC.[ccxxxix] However, empirical evidence suggests that on the one hand, before the passage of SOX Act, there was seldom reporting activities by accountant, but on the other hand, reporting did lead to investigations by SEC, which suggests that such reporting requirement if put to action is effective.[ccxl] |
4.1.2.3. Corporate Governance in US |
In terms of corporate governance, the SOX Act mainly introduced three reforms. The first one is to establish independent audit committee. The committee is composed of outsiders, and it’s the only one in the company with power to hire outside auditing firm.[ccxli] Also, it’s barred to hire the auditing firm whose former employee now serves as the executive of the hiring company.[ccxlii] Moreover, the auditing committee must contain a majority of persons outside auditing and accounting professions to avoid apathetic attitude towards auditing firm.[ccxliii] Although they’re required to have accounting knowledge.[ccxliv] Lastly, the compensation of the member of auditing committee is restricted strictly to only director fees and is not related to performance of the company so that misstatement won’t increase their income.[ccxlv] |
The second one is to require CFO and CEO to certify the documents. The CFO and CEO shall state that that “information contained in the periodic report fairly presents, in all material respects, the financial condition and results of operations of the issuer.”[ccxlvi] Certifying misleading financial statement can be subject to 5 million monetary fines and 20 years’ imprisonment.[ccxlvii] |
The third one is to establish internal control.[ccxlviii] Internal control is defined as by Committee of Sponsoring Organizations of the Treadway Commission (COSO) framework as as “a process, effected by an entity’s board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives relating to operations, reporting, and compliance”,[ccxlix] which was also explicitly mentioned in SEC’s Final Rule: Management’s Reports on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports.[ccl] Also, guidance on management’s testing of these internal controls is stipulated under SOX 404 top-down risk assessment,[ccli] and external auditor’s auditing of this internal control was stipulated under PCAOB Auditing Standard No. 5.[cclii] There are two key provisions in SOX Act under this internal control.[ccliii] The first one is Section 302.[ccliv] Essentially, Section 302 of the Sarbanes-Oxley Act stipulates that the CEO and CFO should be directly responsible for the accuracy of documents submitted to SEC, including financial reports and internal control reports. The second one is section 404.[cclv] It stipulates that annual financial report should be accompanied with an internal control report stating that management made assessment of the effectiveness of its internal control and is responsible for problems occurred under the current internal control structure. Moreover, any shortcomings in these controls must also be reported. In addition, the PCAOB made auditing standard No.5, which further requires that registered external auditors must certify the company management’s assertion that internal controls are effective.[cclvi] However, such external auditing attestation to the internal management was severely objected by issuers, because it essentially meant that there are two full scale auditing works required, one for financial statement and the other for internal control.[cclvii] Because of these oppositions, in 2007 PCAOB issued new auditing standard No.5 to supersede the previous auditing standard No.2, which loosened internal control auditing requirement for small issuers.[cclviii] Further in 2010, Dodd-Frank Act exempts internal control audit for anyone with capitalization under 75 million, and internal control report can be updated twice a year.[cclix] Then finally in the Jumpstart Our Business Startups (JOBS) Act, it further exempts anyone with capitalization under 1 billion, which effectively exempts two thirds of listing companies in US.[cclx] |
4.1.2.4. Regulatory Oversight in US |
In terms of regulatory oversight, the SOX Act established PCAOB.[cclxi] The reason to establish PCAOB is to make sure supervisory body is independent from accounting industry. In the past, the accounting industry was self-regulated by AICPA.[cclxii] For AICPA, the contribution of funds to it can be controlled by its members so the it had to represent the interests of its members instead of the public.[cclxiii] The AICPA also didn’t have resources to investigate and sanction its members. For example, the Washington Post found that in over eleven years, the AICPA only disciplines less than twenty percent of accountants, and moreover these accountants had already been punished by the SEC.[cclxiv] The PCAOB changes this situation by making contribution of fees mandatory and the amounts of contribution is based on its market shares of revenues.[cclxv] Although the Board’s budget needs to be approved by the SEC each year, it is funded by fees levied on the issuers and broker-dealers relying on the audit firms supervised by the Board.[cclxvi] Moreover, the personnel of PCAOB is also independent from the industry. The PCAOB has five Board members, including a Chairman, each of whom is appointed by the SEC, after consultation with the Chairman of the Board of Governors of the Federal Reserve System and the Secretary of the Treasury.[cclxvii] In order to have appropriate expertise on the board but also at the same time offset the influence from accounting industry, the law requires that among five members in the Board, two of them must be Certified Public Accountants.[cclxviii] However, if one of the CPA is appointed as the Chairperson of the PCAOB, then “he or she may not have been a practicing CPA for at least five years prior to being appointed to the board.”[cclxix] Each member serves full-time, for staggered five-year terms.[cclxx] |
The newly established PCAOB has 3 major powers. The first one is “inspections of registered public accounting firms.”[cclxxi] The PCAOB periodically issues inspection reports of registered public accounting firms.[cclxxii] While most part of the reports is made public (called “Part I”), “portions of the inspection reports that deal with criticisms of, or potential defects in, the audit firm’s quality control systems are not made public”, if the Board is satisfied with the improvements or corrections made by the firms within 12 months after the report issued.[cclxxiii] On the other hand, those portions are made public (called “Part II”), if (1) the Board determines that the firm does not satisfactorily address the criticisms or potential defects, or (2) the firm shows no evidence that efforts have been made to address these criticisms or defects. Although such report didn’t provide many details thus not very informative to the public but it does increase accounting quality according to empirical researches.[cclxxiv] |
The second one is to “establish auditing, quality control, ethics, independence, and other standards relating to public company audits.”[cclxxv] Previously, regulatory supervision of accounting industry was weak because the then regulatory agency of accounting industry-the AICPA was not independent. There are two aspects that can illustrate such non-independence. Firstly, the auditing standard was established by AICPA, an organization representing the interests of the industry.[cclxxvi] In two studies in 1966 and 1979 conducted by AICPA concerning independence of auditing business, it made the conclusion that consulting business didn’t affect the independence of auditing business, which was obviously not the case.[cclxxvii] Secondly, although in 1977, the POB was established as an independent organization from AICPA to supervise the accounting industry, however, such independence was not assured. Although POB is organizationally independent from AICPA, it relied on the discretionary funding from professions.[cclxxviii] Such dependence was illustrated by the case where AICPA withheld its funding from reviewing Big 5’s stock ownership status.[cclxxix] |
The third one is to “conduct inspections, investigations, and disciplinary proceedings of registered accounting firms.”[cclxxx] PBCOA can issue fines up to 750,000 dollars to natural person and 15 million dollars to any other person in the event of “intentional or knowing conduct, including reckless conduct…or repeated instances of negligent conduct.”[cclxxxi] PCAOB can “sue and be sued, complain and defend, in its corporate name and through its own counsel, with the approval of the SEC, in any Federal, State or other court.”[cclxxxii] PCAOB almost had unlimited funds because it’s self-financed with funds raised from its regulated entities based on the costs from previous financial year,[cclxxxiii] which means its costs were transferred to the regulated entities and can adjust its funding based on costs from last year. Because of this, it had a very large base of enforcement staffs of over 800 people,[cclxxxiv] and in 2018 it made a record high number of 35 enforcement actions.[cclxxxv] |
4.1.3. Lawyer |
In terms of due diligence defense, the lawyer is very different from underwriter and accountant. First of all, after the Supreme Court ruling and PSLRA, the lawyer will not be subject to private litigations for aider and abettor liability, which leaves only the public enforcement option for violation of due diligence defense. However, public enforcement action also faces the duty of confidentiality obstacle. Compared to the increased public enforcement action against accountant after 2002 SOX Act, the public enforcement intensity against lawyer still remains low. In the following, I will introduce the relevant cases and laws and regulations which makes the pursuant of legal liability of lawyers difficult. |
The first case is the 1972 SEC v. National Student Market Corp.(NSMC)[cclxxxvi] case, in this case, the SEC brought litigation in court against two lawyers and their law firms in aiding and abetting securities fraud.[cclxxxvii] This is the first case in 40 years after the passage of securities law where lawyer was sued in court for violation of anti-fraud clause of securities law.[cclxxxviii] In this case, in a merger transaction, the lawyer noticed that there was a huge financial misstatement for one party, but the lawyer didn’t do anything but kept finishing the deal thus violating anti-fraud provision of securities law.[cclxxxix] In this case, the court ruled against the SEC.[ccxc] However, such ruling was very controversial. Because on the one hand, the court admitted the culpability of lawyers, writing that “mere silence constituted “substantial” assistance of a securities violation.”[ccxci] However, on the other hand, the court nevertheless wrote that “the opinion did not play a large part in the consummation of the merger” but was “simply one of many conditions to the obligation of NSMC to complete the merger.”[ccxcii] |
In the second case Carter[ccxciii] in 1979, the SEC changed strategy, instead of initiating civil enforcement in court, the SEC used administrative power under Rule 102(e) to sanction lawyers.[ccxciv] The Rule 102(e) is the Rules of Conduct stipulating the conduct of professionals when they practice before SEC.[ccxcv] The lawyers found that the CEO bolstered the numbers in financial statement and withheld material information.[ccxcvi] Although the lawyers repeatedly required the CEO to rectify the numbers, however, each time the request was refused.[ccxcvii] Nevertheless, lawyers helped the CEO prepare the financial statement and the false statement was released.[ccxcviii] The Administrative Law Judge (ALJ) ruled in favor of SEC and found the lawyers in violation of Rule 102(e).[ccxcix] However, on appeal, the commissioners reversed the ruling because they believed the professional standards were too broad, and “professional responsibilities of lawyers had not been so firmly and unambiguously established.”[ccc] |
After these two cases, the American Bar Association (ABA) opposed very firmly to the SEC’s enforcement actions. In response, they revised their Model Rules for Professional Conduct of Lawyers several times. The first time happened after the NSMC[ccci] case, the ABA expressed that disclosure could only happen in the clearest cut cases, and only federal legislations can impose such duties on lawyers, neither court nor SEC could impose such duty.[cccii] The second time happened after the Carter[ccciii] case, they codified their “never to disclose client’s fraud” approach however they did provide an escaping route for lawyers to avoid potential liability, which is that if they terminate their representation and withdraw their previous works from the client, then they’ll be free from liability.[ccciv] From the above we can see the most contended issue is whether lawyer can be held liable for aiding and abetting a securities fraud and whether lawyer should notify regulators or third parties when they found out the fraud. |
The final blow came after the 1994 US Supreme Court ruling and 1995 PSLRA, private litigation can’t be applied to aiding and abetting liability.[cccv] In this case, it’s virtually impossible to hold lawyers liable. Since the financial statement is not ultimately controlled by lawyer, so if the lawyers noticed problems in financial statement, they didn’t need to act. Moreover, the law is in contrast to the formal ruling and practice that lawyer was not expert if they didn’t sign the documents, which means lawyer should conduct reasonable investigation into financial statement of other documents. However, this will create very odd situation that even if problems were found, then there is nothing the lawyer should do, thus making legal due diligence less effective. Moreover, more than 60% of underwriter’s due diligence are outsourced to lawyer, this will undercut the effectiveness of underwriter’s due diligence as well if they were not allowed to speak.[cccvi] |
4.1.3.2. Information Disclosure in US |
In the up-the-ladder report under SOX Act, the reporting obligation is different between lawyer and auditor. For lawyer, it must first report the problem to the CLO or CEO of the company.[cccvii] If there is no response or inappropriate response, then the lawyer must report this matter further to the auditing committee or legal compliance committee or the board of directors.[cccviii] After this stage, the reporting duty of the lawyer is relieved.[cccix] Therefore, there is no similar requirement to report problems to SEC or resignation as accountant due to the concern of breach of confidentiality duty.[cccx] |
For ABA, this time they gave some leeway to the disclosure of frauds to third parties by lawyer. Apart from the pervious ABA Model Rule 1.16 where it requires the lawyer to terminate representation and withdraw from the prior work which will contribute to the future violations of law or profession conduct of lawyer,[cccxi] the ABA Model Rule 1.6 provides many circumstances that the lawyer may disclose the information to third parties,[cccxii] and such circumstances include |
|
Although such rules are not obligations but only rights offered to lawyers, and lawyers may or may not choose to disclose these situations to third parties, however it’s an improvement to the previous total forbiddance. This model rule has been widely adopted by a majority states in the US therefore becoming hard law.[cccxiii] |
4.1.3.3. Regulatory Oversight in US |
Among all the regulatory authorities of gatekeepers in US, the weakest one is the ABA who regulates legal community. Not only is it funded by legal community thus representing the community’s interests, but also it’s overseen by each state’s supreme court, which renders it almost critics-proof, since court lacks the resources to supervise the industry therefore the ABA has no other outside constrains.[cccxiv] Statistic shows that the bar only processes 10 percent of the complaints each year and it takes as long as 10 years to get a lawyer disbarred.[cccxv] Moreover, there is a low transparency.[cccxvi] There are only four states’ bars who will disclose statistics and results of their disciplinary proceeding.[cccxvii] The biggest problem of ABA is that it only has a relative weak federal power, since it can promote model rules, but whether the rules will be adopted is at the discretion of the state authority. |
4.1.4. Securities Analyst |
Regulation of securities analysts in US goes through several stages. In the first stage, the securities analyst is free from regulation, and in the second stage they receive some restrictions on inside trading, and in the third stage the laws and regulations imposed some requirements on avoiding unbiased research. In the following, I will discuss these changes in details. |
In the first stage, securities analyst is provided with immunity to insider trading.[cccxviii] In US, inside trading is based on breach of fiduciary duty.[cccxix] However, most of the time, in order to widen coverage on the media, issuers will intentionally give information to the securities analyst.[cccxx] However, in this case, it’s not deemed to be a breach of fiduciary duty under US securities law,[cccxxi] because both securities analysts and the officers in firms providing such information are permitted by their companies to do so, therefore they do not breach fiduciary duty to their companies. |
However, such prevalent inside trading caused severe conflict of interest problems, since the analyst often use favorable research reports in exchange of such information, because of this the SEC made the Regulation Fair Disclosure (Regulation FD) to address this issue.[cccxxii] Regulation FD prohibits some aspects of the above mentioned selective disclosure issue. Under Regulation FD, directors in issuers will be prohibited from selectively disclosing inside information to the securities analyst either intentionally or unintentionally.[cccxxiii] If acting intentionally, the information should be disclosed to the public simultaneously.[cccxxiv] If acting unintentionally, the information must be disclosed to the public within 24 hours or the next trading day.[cccxxv] Moreover, there is one restriction in this regulation. This regulation only regulates communication originating from directors, not any other types of employees.[cccxxvi] Also, this regulation doesn’t create a private right of action.[cccxxvii] |
However, although prohibition on insider trading decreases the incentives to issue favorable reports to some extent, securities analyst still faces other pressures from the issuer because they’re still paid by the issuer and rely on the future business opportunities provided by the issuer, so they still can’t remain independent and can be easily influenced by issuers to make biased research, so in order to address this issue father, the US regulators made the following four efforts. The first effort is to require the Regulation Analyst Certification (Regulation AC) made by the SEC.[cccxxviii] Regulation AC requires the analyst to insert words in the research report that the statement accurately reflects the analyst opinion and no part of analyst compensation is or will be directly or indirectly related to the specific views expressed in the report.[cccxxix] If there is such compensation, its source should be disclosed.[cccxxx] The second effort is the section 505(b) in SOX, where the analyst not only needs to guarantee the report reflects its opinion, but also needs to disclose any types of conflicts that may affect its opinions.[cccxxxi] The third effort is to further prevent the conflict of interest form happening in the first place. The restrictions and bans regarding securities analyst activities are particularly addressed in FINRA Rule 2241. The rule mainly regulates the major conflict of interests that is pervasive in the securities analyst industry, which is post-recommendation trading. To solve this conflict of interest, it sets rules requiring certain black-out period where the analyst can’t comment or make public appearance.[cccxxxii] Moreover, they are banned from participating in the solicitation meeting.[cccxxxiii] The rule was previously FINRA 2271 and the new rule 2241 took effect in 2017, and it relaxed several restrictions and bans on securities analyst. Compared to the old version, it mainly shortened the number of days of the quite period where the securities analyst can’t comment on the stocks. The fourth effort is to use corporate government technique to ensure the independence of securities analyst department within the investment bank. In SOX section 501(a),[cccxxxiv] it doesn’t only require that the investment bank should separate research department and investment banking department, but also has more detailed requirements to keep securities analyst independent. It requires that the securities analyst report shouldn’t be approved by investment banking division and also the compensation of securities analyst should only be decided by other departments outside of investment banking division. Moreover, it requires that the securities analyst shouldn’t be retaliated in any way. |
Even facing with so many regulations, there are still loopholes in regulation. The first one is in the area of insider trading. Although the SEC could sanction and bring litigation against securities company, there is no private right action allowed. Secondly, and most importantly, there are huge conflicts of interest for securities analyst, and these conflicts of interest may result in biased research leading to market manipulation or misstatement. However, it’s hard to regulate these biased information, since they’re soft information about the prediction of future, but not hard facts, so even if the result is different form facts, it can be hard to qualify them as misleading information. |
Because regulating these soft information is hard, so the regulators came up with regulating the source of these soft information, the conflict of interest. However, these conflict of interest regulations are also not robust. Firstly, the conflict of interest disclosure is more like a disclaimer, and if all securities analysts add such disclaimer, it can hardly have any warning effect on the market. Secondly, although the securities analyst department is separated from investment banking division, they can still face market pressure, for example, client will reject future collaboration opportunity if unfavorable report is issued, which will lead to the third part, the market pressure regulation. The third part of the regulation is the blackout period and the ban from solicitation meeting, however the blackout period is still shorter than the time normal people can get information,[cccxxxv] so the analyst still has advantage, and for ban from solicitation meeting, the securities analyst can still participate in other types of meetings, and the future business collaboration strategies may still influence the securities analyst report. |
4.1.4.2. Payment Regulation in EU |
To regulate gatekeepers, at the center of the issue is the funding problem,[cccxxxvi] because gatekeeper is paid by the issuer, so they naturally fall into the pocket of issuer. However, we still need to rely on the gatekeeper to guard against the possible illegal behaviors of the issuers, so there is a clear conflict of interest. Here in this relationship between the issuer and the gatekeeper is the traditional principal-agent relationship, which means the agent-the gatekeeper should act in the best interest of the principal-the issuer. However, our policy goal is to use gatekeepers to protect investors, not the issuers. To solve this problem, the most fundamental way is to disconnect the principal-agent relationship between issuer and gatekeeper and establish a new one between investor and gatekeeper, which is the investor pay model. If the gatekeeper is paid by the investor rather than the issuer, then the issuer will lose control over the gatekeeper. |
The regulatory method of securities analyst in EU uses two methods. The first one is conflict of interest disclosure stipulated under MAR and Commission Delegated Regulation (EU )2016/958, which requires detailed disclosure of author, sources, valuation methodologies and assumptions, and also the disclosure of any meaningful positions held by the broker.[cccxxxvii] This method is not too different from the US one albeit with more details in disclosure. |
The second regulatory method mainly targets the payment structure, which means payment from third party can’t be used to influence the objectivity of the advice provided.[cccxxxviii] This is a distinctive EU regulation, so this section will focus on the discussion of this method. There are several features in EU payment regulation. Firstly, definition of investment research is very broad, and it doesn’t distinguish sell side from buy side investment research. According to Recital 28 of Commission Delegated Directive (EU) 2017/593, investment research in EU is defined as “research material or services concerning one or several financial instruments or other assets, or the issuers or potential issuers of financial instruments, or closely related to a specific industry or market such that it informs views on financial instruments, assets or issuers within that sector.”[cccxxxix] Moreover, “it should also explicitly or implicitly recommend or suggest an investment strategy and provide a substantiated opinion as to the present or future value or price of such instruments or assets, or otherwise contain analysis and original insights and reach conclusions based on new or existing information that could be used to inform an investment strategy and be relevant and capable of adding value to the investment firm’s decisions on behalf of clients being charged for that research.”[cccxl] In this case, we can see that the definition of investment research in EU covers all types and areas of financial instruments and must provide opinions for those financial instruments rather than only providing straight facts. |
Secondly, a ban of inducement and the unbundled research payment rule were introduced.[cccxli] It means that any fees or commissions or any monetary benefits paid by third party can’t be retained by the firm except for minor non-monetary benefits(which will be discussed later in the next paragraph). Payment to research needs to be separated from other fees.[cccxlii] It on the one hand acknowledges the necessity of subsidization of research, but on the other hand stresses that the research can’t be linked to other businesses. It essentially replaces the cross-subsidization model with the direct customer payment model. There are two ways the investment firm pays for investment research. The first one is that it can pay with its own money, and the second one is that it can pay with clients’ money.[cccxliii] However, if it chooses to use clients’ money, then it must establish independent Research Payment Account (RPA).[cccxliv] The RPA must satisfy the following four requirements. Firstly, “the RPA is funded by a specific research charge to the client, which is pre-agreed with the client and regularly assessed.”[cccxlv] Secondly, “the firm has, and applies, a clear written policy to regularly assess the quality of the research, based on robust criteria and its ability to contribute to better research decisions.”[cccxlvi] Thirdly, “the firm provides information in advance to clients on the research budget for all clients and the research charge for each client, as well as information on the annual cost each client has incurred for third party research and, on request by clients or competent authorities, amounts paid to providers from the RPA (via a clear audit trail) and how this compares to budgeted amounts (taking into account any rebated unspent sums).”[cccxlvii] Fourthly, “the research charge shall not be linked to the volume and/or value of transactions executed on behalf of the clients, shall not be influenced or conditioned by levels of payment for execution services and may not exceed the research budget.”[cccxlviii] |
Thirdly, as mentioned above, non-monetary benefit is allowed provided that it’s capable of enhancing the quality of service provided to a client, and is clearly disclosed and also does not impair the manager’s duty to act in the best interests of the client.[cccxlix] Under Art 11(2) Delegated Directive,[cccl] a fee or non-monetary benefit is considered to enhance the quality of the service to clients if: |
|
The definition of non-monetary benefits was stipulated in Article 12(3) of the Delegated Directive,[cccli] which allows (among other things) the following as acceptable minor non-monetary benefits: |
|
Such payment regulation has significant influence on the EU market. According to empirical researches, the numbers of researches circulated in the market dropped and the price of the research also dropped significantly ranging from 20% to 40%.[ccclii] This means that there is less low quality and repetitive researches in the market, and at the same time each research report becomes less expensive, which means that the overinvestment of research problem is partially controlled.[cccliii] |
In conclusion, in US and EU, although both of them acknowledge the need for subsidization of research, the difference is that the US acknowledges qui pro quo while the EU asks for more pricing transparency and requires direct payment of research service. In order the control the conflict of interest caused by qui pro quo, the US used several conflicts of management regulations however these regulations have too many loopholes and more importantly, the burden of proof of false report is too high making enforcement actions too costly. The EU model in this sense is cheaper than the US model, it adjusts the incentives of securities analyst by cutting the ties of research and any form of cross subsidization from the investment banking activity. |
5. Lessons for China |
In China, academics generally argue for two reforms. The first one is to abolish the China’s sponsor system, because sponsor liability doesn’t help alleviate the rampant securities frauds in China.[cccliv] Moreover, China learned this approach from Hong Kong, and not too many jurisdictions use this sponsor model, only Hong Kong, UK AIM board and Malaysia does,[ccclv] whereas US, the largest securities market, doesn’t use this model and they’re called underwriter. The opponents of sponsor system argued that underwriter should be mainly responsible for the task of price building and selling of securities, and they should not spend most of their time reviewing documents.[ccclvi] The second reform proposal is to lessen the sponsor liabilities in China.[ccclvii] Because in US and Hong Kong, regulations are less strict than China, so even if we need to keep sponsor system, sponsor as the secondary offender shouldn’t bear so many liabilities and we should mainly punish the primary offender, the issuer.[ccclviii] |
In my finding, these two arguments are not true. For the first argument that sponsor is not necessary, the first counterargument is that as explained in Section 5.2, gatekeeper can alleviate the burdens of supervision by regulators.[ccclix] The second counterargument is that such failure of sponsor is mainly due to the weak enforcement of sponsor in China. In an empirical study, from 2001 to 2010, there were only 30 published cases where sponsor was sanctioned.[ccclx] Moreover, these sanctions usually didn’t implicate institution, but only individuals.[ccclxi] Lastly, methods of these sanctions usually only include private warning, public censure, or cool treatment, and only a small number of them involved suspension of business or revocation of license, but not a single case involved monetary penalty.[ccclxii] |
For the second argument that because US and Hong Kong have less strict liabilities for sponsor, so liabilities of sponsor in China should also be relaxed, there are three counterarguments. The first counterargument is that even if China should learn from US as proposed, the outcome will be that China has noting to learn. The reason is that the sponsor’s liabilities’ clause is very similar to the underwriter’s liabilities under US Securities Law, where the underwriter also bears a presumed liability unless it can prove it’s not it’s fault.[ccclxiii] The only difference is that underwriter in US is not explicitly required to check if application of auditing standards is appropriate.[ccclxiv] However, because there is the other “red flag” restriction,[ccclxv] which means if such application is too wild, then underwriter may still be responsible, so the uncertainty of underwriter liability pushes underwriter’s due diligence to cover more areas. Moreover, although underwriter has a due diligence defense, it can’t simply argue that they rely on other gatekeepers’ documents so that they can be excused from liabilities, so it has to conduct its own independent investigation,[ccclxvi] which is very similar to the Chinese regulations. |
The second counterargument is that, even for sponsor system in Hong Kong, as explained in Section 5.4.1, compared to US, apart from the difference in name, the only difference is in their different liabilities bearing mechanism. In Hong Kong, before 2013, the sponsor doesn’t bear civil liability to the prospectus, where private litigation can’t be brought against sponsor.[ccclxvii] Normally, the SFC will use two other tools.[ccclxviii] The first one is its large sanction power, and the second one is to ask the court to issue restitution order to return the situation to its original state without addressing specifically the details of how to compensate.[ccclxix] However, after 2013 reform, the sponsor also needs to bear civil liabilities to the prospectus, so now there is not many differences between Hong Kong and US in terms of sponsor or underwriter liabilities.[ccclxx] Moreover, in Hong Kong, after 2013 reform, the sponsor’s due diligence is further made more detailed. It explicitly requires sponsor’s close collaboration with lawyer and accountant, and explicitly requires the sponsor to verify the documents provided by lawyer and accountant and also verify the important assumptions behind expert opinion, and moreover, it requires the sponsor’s team to have appropriate expertise to verify such documents, which blurs the line between expert and non-expert role.[ccclxxi] In this case, sponsor’s liability regime in Hong Kong is not different from China. |
The third counterargument is that in order to avoid liabilities shifting game happening in US and Hong Kong, detailed due diligence duties are necessary in China. In US, there are no detailed rules for due diligence duties.[ccclxxii] In case laws, there are several principles.[ccclxxiii] The first one is that underwriter should conduct its own independent investigation and can’t simply rely on others.[ccclxxiv] The second one is that underwriter should at all times remain skeptical and watch out for red flags.[ccclxxv] The third one is the degree of investigation made by underwriter is determined by all the surrounding circumstances including but not limited to the nature of issuer, relationship with issuer and availability of information.[ccclxxvi] While in Hong Kong, sponsor’s due diligence duties have been becoming more and more detailed through time. Although the guiding principle is not different from US, but the implementation is more detailed including how to conduct independent investigation and how to collaborate with other gatekeepers, what constitutes as red flags and the scope and extent of investigation.[ccclxxvii] Moreover, it makes explicitly clear that onsite investigation is necessary and review of works is also necessary,[ccclxxviii] which is not the case in US regulations.[ccclxxix] These basic standards save time and resources in litigation. Although in the following, I will argue that strict liability is suitable for sponsor in China, it doesn’t mean that such detailed due diligence duties are meaningless since in the end the sponsor should be allowed to sue other gatekeepers for their shares of contributions to the misbehaviors. |
5.1.2. Strict Liability Is Suitable for Sponsor Regulation in China |
The second lesson that China can learn is to establish a strict liability regime for sponsor. The reason is that it can significantly solve the liabilities shifting problems caused by unclear due diligence defense. Some people propose other solutions such as mandatory collaboration meeting and mandatory disclosure of fraudulent activities to regulators to address this liabilities shifting issue,[ccclxxx] but they still don’t solve the problems from the root. Moreover, some people argue that it will increase the burden of sponsor too much,[ccclxxxi] but it’s still not the case. The reason is that sponsor already bears a quasi strict liability. In China’s case laws, there is almost no case where sponsor successfully exempts itself from liability by using due diligence defense.[ccclxxxii] This situation is not peculiar if we compare such situations to US and Hong Kong. In US, underwriter is required to conduct its own independent investigation and watch out for red flags,[ccclxxxiii] so it’s not too easy for underwriter to successfully exempt itself from liability. In Hong Kong, after the 2013 reform, it puts more detailed obligations than US on the sponsor,[ccclxxxiv] so its liability is actually closer to strict liability than US. In this case, it’s doubtful that transforming from quasi strict liability to real strict liability will increase too much burden on sponsor. |
However, if we were to choose strict liability, there are two questions remained. The first one is that where we should put this strict liability? Should we put it on one gatekeeper or on all the gatekeepers. In my opinion, it should be put on one gatekeeper, not all the gatekeepers. The reason is that if we put strict liabilities on all the gatekeepers, then all the gatekeepers will equally divide their liabilities, which is not a good incentive for gatekeeping. However, if we impose strict liability on one gatekeeper, and also allows the one who bears strict liability to sue the other gatekeepers and issuers, then it will save the time for investors and also keep the liabilities fair for the one who bears such strict liability. |
The second question is if we were to put strict liability on only one gatekeeper, who should this gatekeeper be? How can we justify to put this strict liability on sponsor in China instead of on lawyer and accountant? The first reason is that only sponsor has the financial power to bear strict liability. According to empirical research, sponsor earns 90% of all the fees incurred in listing, which is 10 times more than accountant and lawyer.[ccclxxxv] Secondly, only sponsor has the expertise to monitor the other two gatekeepers. Sponsor in China is the only institution who has both accounting expertise and legal expertise. For accounting expertise, it’s pretty obvious, because it’s how it can make financial models, while for legal expertise, when doing due diligence, normally it will hire outside law firms to do the job. The situation is even better in China, because China’s investment bank has less information and expertise asymmetry than US. In China, the sponsor not the lawyer is in charge of writing prospectus,[ccclxxxvi] and there are many pre-securities lawyers jumping to the side of investment bank since the payment is better. In practice, 2 pre-lawyers will be assigned to due diligence group to conduct due diligence.[ccclxxxvii] |
China recently adopted a similar approach to strict liability, which is called the sponsor-pays-first mechanism, and it requires the sponsor to first pay investors then use litigation to pursue its fair share to others.[ccclxxxviii] Firstly, it avoids liabilities shifting game, and secondly underwriter is allowed to pursue its fair share to others, therefore it won’t distort the market. However, this mechanism under Chinese Securities Law is not entirely legal. Firstly, as stated above, sponsor takes joint liability with all the other gatekeepers in securities law,[ccclxxxix] therefore only imposing this strict liability on sponsor is not entirely legal under the current Chinese law. Someone counter argues that the sponsor could waive its right and by signing contract to take such strict liability.[cccxc] However, using contract will again cause many liabilities troubles.[cccxci] Firstly, if using contract, corporate managers have an incentive to permit the gatekeeper to escape significant liability, because the less threatened the gatekeeper is, the more that gatekeeper will be willing to acquiesce in managerial misconduct.[cccxcii] Secondly, if in contract, a gatekeeper is strictly liable for a percentage of the securities fraud damages that the issuer pays, then under such a system, gatekeeper might still escape liability.[cccxciii] The reason is that the issuer might escape liability because the plaintiff cannot prove that it acted with intention, then under such circumstance gatekeeper won’t be liable, which is short of the meaning of a true strict liability.[cccxciv] Therefore, this thesis argues for the revision of law and builds this strict liability of sponsor into law, and also allows sponsor to sue other responsible gatekeepers. |
5.1.3. Sponsor and Accountant Should Have the Obligation of Noisy Withdraw, Lawyer Should Have the Obligation to Warn Accountant and Sponsor and Quite Withdraw in China |
Apart from the above “sponsor-pays-first” technique, other regulatory techniques should also be introduced in China. Noisy withdraw[cccxcv] should be imposed on sponsor and accountant but not on lawyer, and lawyer should be required to withdraw quietly[cccxcvi]. Moreover, duty to warn third parties should be imposed on lawyer, but such warning should only be made to sponsor and accountant, but not to any other third parities or regulators. These regulatory techniques would help prevent the liabilities shifting and misbehaviors from happening in the first place. |
The reason to impose noisy withdraw on sponsor and accountant instead of lawyer is that they don’t face the confidentiality issue. In SOX Act Art.307,[cccxcvii] the Congress instructed the SEC to make minimum standard of conduct for lawyers appearing and practicing before SEC, so the SEC proposed corresponding rule, however due to the concern of the breach of lawyer and client confidentiality, it wasn’t adopted in the end.[cccxcviii] To solve this dilemma, in the US, the current proposal given by many scholars is trying to argue that there should be two types of lawyers. The first one is the legal advocacy, which is also the most traditional type focusing on litigation, and there is the other more modern type, which is called securities lawyer or corporate lawyer focusing on transaction engineering, risk prevention and compliance check.[cccxcix] The difference between these two is that confidentiality is important for litigation lawyer, since it only intervenes after things happened, therefore confidentiality is a must otherwise anything the client revealed to the lawyer can be used in court against him.[cd] However, for securities lawyer or corporate lawyer, it intervenes from the beginning, so it can tutor its client to do or not to do something, in this case confidentiality is unnecessary and could even have an adverse effect encouraging the lawyer to help its client bury evidence.[cdi] |
However, such distinction is too complicated and not necessary. The better solution is to impose quite withdraw and duty to warn sponsor and accountant on lawyer and at the same time impose noisy withdraw on sponsor and accountant, and it will achieve the same result for imposing noisy withdraw on lawyer but holding the advantage of not breaching confidentiality duty. The reason is that such requirement doesn’t impose any new liability on all these gatekeepers. Firstly, such close collaboration is already a requirement, and accountant and sponsor will rely on lawyer’s judgment on legal matter, so they nevertheless need to communicate on such issues. Moreover, even in US’s ABA Code of Conduct, it has already required the lawyer to withdraw from prior work, and also allow lawyer to warn third party if substantial injuries or financial losses could be caused to third party,[cdii] however, this warning should only be given to third party, but not the regulator to avoid the confidentiality issue. Also, in China’s A share’s listing, sponsor usually doesn’t hire lawyer so legal matters are reviewed by sponsor’s in house counsel, and lawyer is hired by issuer.[cdiii] In this case, requiring issuer’s lawyer to report illegal behaviors to sponsor is necessary, since they have different interests. Finally, if sponsor or accountant knew such situation, then under the current proposal, it must act to correct this, and if correction is not possible, then sponsor or accountant must notify this to the regulator, which achieves the same result with imposing such duty on lawyer but without forcing lawyer breaching client confidentiality. Also, this proposal is no different from regulations of sponsor and accountant in Hong Kong, where it also put noisy withdraw obligation on sponsor and accountant.[cdiv] |
5.1.4. Large Scale and Comprehensive Corporate Governance Reform Is Too Expensive and Not Necessary in China |
As can be seen from above, the background of US reform is the concern of frivolous litigations and the costs on gatekeeper, and therefore the Congress introduced the other three techniques including corporate governance.[cdv] However, such large scale and comprehensive corporate governance reform shouldn’t be copied to China for the following reasons. |
Firstly, corporate governance reform didn’t reduce the costs of businesses in US, but in fact may increase them. For corporate governance reform, the center of the contestation is the SOX 404 Section, because this clause is too costly.[cdvi] In an empirical research, in US, the cost for listed companies for compliance of SOX rose 40% compared to the past.[cdvii] The average cost was 4.3 million US dollars.[cdviii] Although such cost will decrease overtime, each year listed companies need to spend an average of 700,000 US dollars for compliance of SOX.[cdix] Moreover, such costs are certain every year and is imposed only on the issuer’s side, while the costs of litigation against accountant is not certain, and such costs are also shared among all the gatekeepers and issuers. Therefore, even in US throughout the years, the scope of application of such section has been cut down.[cdx] Now it’s not required to obtain attestation of internal control by outside accountant in US.[cdxi] |
Secondly, in China, it’s very hard for CEO and CFO using “not knowing” as excuses to shed themselves from liabilities. In Art. 68 of Securities Law, it requires the board of directors and senior management to sign periodic report and also “guarantee the authenticity, accuracy and integrity of the information as disclosed by the listed company.”[cdxii] Also in Administrative Measures for the Disclosure of Information of Listed Companies, the Art.58[cdxiii] stipulates that |
The directors, supervisors and senior managers of a listed company shall be liable for the genuineness, accuracy, completeness, timeliness and fairness of the information disclosure of the company, unless adequate evidence shows they have fulfilled the obligation to be diligent and duteous. |
The directors, managers, and the secretary of the board of directors of a listed company shall be mainly liable for the genuineness, accuracy, completeness, timeliness and fairness of the information disclosure in the form of temporary reports of the company. |
The directors, managers and financial person-in-charge of a listed company shall be mainly liable for the genuineness, accuracy, completeness, timeliness and fairness of financial reports of the company. |
Moreover, in the Administrative Liability Determination Rule for Violation of Information Disclosure Obligation Art.22,[cdxiv] the following can’t be used as due diligence defense of board of directors and senior management to be exempt from administrative liabilities: |
|
Also, multiple case laws reflected the spirit of the laws and regulations, including the Harbin Electric Corporation Jiamusi Electric Machine case,[cdxv] Chengdu Huaze Cobalt&nickel Material case,[cdxvi] and Wuhan National Pharmaceutical Technology case,[cdxvii] where the CSRC didn’t accept the board of directors and senior management’s due diligence defense reasons and issued administrative penalties against them. |
This reflects the difference between US and China. In US, corporate governance traditionally is not a federal matter but rather a state one, and therefore such certification is intended to uniform different application of corporate governance in each state, which is in the US’s academia called as federalization of corporate governance.[cdxviii] Such move has received many criticisms in US’s academics for intruding state’s independence,[cdxix] and such criticism also reflects the real intention behind such clause, which is unification of state’s law. |
Lastly and most importantly, there is no such frivolous litigation environment in China as US, so there will be no need to introduce such large scale and comprehensive corporate governance technique to partially replace the private litigation technique. |
5.1.5. Regulatory Oversight Is Powerful Enough in China |
There are several backgrounds for US to enhance regulatory oversight for lawyer and accountant. The first one is that there is severe conflict of interest for industry self-regulation. The AICPA and ABA protect its members’ interests and therefore seldom initiate enforcement actions.[cdxx] The second one is that SEC doesn’t gain entire jurisdiction for regulating lawyer and accountant. Although it can discipline any expert representing issuer before it based on Rule 102(e),[cdxxi] the standard for such discipline is not clear therefore receiving many oppositions from SROs especially from ABA for not having firm regulatory basis.[cdxxii] Moreover, accountant regulatory jurisdiction is also separated in different hands of different organizations. Before SOX Act, accounting standard is regulated by (Financial Accounting Standards Board) FASB, which is supervised by SEC, but auditing standard is regulated by AICPA.[cdxxiii] Moreover, registration of accountant is separately regulated by each state.[cdxxiv] In this case, the SEC only had limited jurisdictions for regulating accountant. Therefore, after SOX Act, the PCAOB was established which gains jurisdiction for making accounting standard and is responsible for registration of accounting firm conducting auditing services for listed companies, and suspension of such registration will deprive accounting firms’ privileges for conducting auditing works for listed companies.[cdxxv] The PCAOB is further supervised by SEC,[cdxxvi] which means only after the SOX Act did SEC gain full jurisdiction for accounting firms doing business with listed companies. |
However, it doesn’t mean that China should also strengthen its regulatory oversight following US’s footsteps, because fortunately, China doesn’t face such problems as US did. CSRC from the first day of its establishment enjoys full jurisdiction over accountant and lawyer. In Art.7 of Securities Law of China, it stipulated that “the securities regulatory authority under the State Council shall carry out centralized and unified supervision and administration of the national securities market.”[cdxxvii] In Art. 227, it stipulated that “the persons directly in charge and the other persons directly responsible shall be subjected to administrative sanctions in accordance with the law.”[cdxxviii] In Art.233, it stipulated that “if laws, administrative regulations or relevant provisions of the State Council’s securities regulatory authority are violated and the circumstances are serious, the State Council’s securities regulatory authority may take the measure of banning the relevant persons responsible from the securities market.”[cdxxix] Also, periodic inspections of law firms and accounting firms are already in place. In 2017, the CSRC issued Notice on Printing and Distributing the Work Plan for the Certified Public Accountants and Asset Appraisal Organizations for Securities and Futures Related Businesses.[cdxxx] At the same year, CSRC initiated Special Inspection of Law Firms Engaging in IPO, and such inspection will become periodic in the future.[cdxxxi] In 2017, it sanctioned 8 law firms and 10 lawyers, and 2 accounting firms.[cdxxxii] In 2018, it sanctioned 11 accounting firms.[cdxxxiii] |
5.1.6. Payment Regulation Is Suitable for Securities Analyst in China |
For the last group, securities analyst, currently China used a conflict of interest disclosure approach similar to US, however, such approach has problems as explained above.[cdxxxiv] As explained before, there are two models for regulating securities analyst, the US model and the EU model. The US model is a liabilities based model, however, proving misstatement in analyst report is even harder than proving misstatement in other disclosure documents by issuer, since analyst report has many subjective opinions and many of them are prediction of the future.[cdxxxv] In order to address this problem, professor Jill Fisch and Hillary Sale proposed to subject the securities analyst to duty of reliability.[cdxxxvi] This duty requires any recommendation to have solid foundation, otherwise the analyst will be held liable, so in this case the burden of proof is automatically shifted to the securities analyst. Although there are mainly 2 arguments against this approach, but neither of them stands. The first one is that it will hurt information provision, and the second one is lack of fiduciary duty to the public.[cdxxxvii] For the lack of provision of information to the public, evidences suggest that there is an overinvestment on information research,[cdxxxviii] and secondly the research report provided usually drives the prices up to deviate from its actual value.[cdxxxix] In this sense, there should not be so many information research activities and many of them don’t have high quality, therefore it indicates some regulations are needed. For the second reason lack of fiduciary duty, the vast number of people is not an issue. Because under Investment Advisor Act (IAA) in US, if a journalist wrote an article and recommended a stock but failed to disclose his conflict of interest in the stock, it would be subject to SEC sanction, although the journalist also faces an indefinite number of possible readers.[cdxl] In this case, it could hardly see any difference between this journalist and the sell side securities analyst, therefore there is no reason not to also regulate securities analyst. However, even if we’re able to answer the theoretical question of why analyst report should be subject to reliability liability, there is another more important problem which is the high cost of litigation. Therefore, I will in the following introduce the EU model which uses another regulatory technique which is the payment regulation to regulate conflict of interest. |
In the EU model, it has two very clear principles. Firstly, research reports should be purchased independently, so therefore securities analyst don’t need to rely too much on the client.[cdxli] Secondly, simple disclosure of conflict of interests could only be used as a last resort to address the conflict of interest problem.[cdxlii] Even when there are no other choices as to implement this conflict of interest rule, there needs to be a meaningful explanation of conflict of interest rather than a very generic statement.[cdxliii] |
Although such payment regulation successfully drove down the price of research report and cut down the numbers of low quality repetitive research reports in the market, many people criticize that it may lower the coverage and exposure of small issuers. The reason is that because buy side has to pay for the research report, so the buy side doesn’t want to retain as many sell side securities analysts as before thus leading to a shortage of supply of securities reports in the market. However, this trend may reverse in the future. The market for now already saw the trend of merger of small securities research firms by big firms,[cdxliv] so therefore such consolidation may in the future creates larger securities research firms and they can have the abilities to cover more companies. Also, when this income from selling securities report becomes the standard of practice in the market, there must be firms specifically covering services of small companies, which will increase their coverage in the future.[cdxlv] |
6. Conclusion |
In this paper, I first discussed the necessity of gatekeeper regulation (Section 2). The paper identified 3 reasons. The first one is the conflict of interest problem for gatekeepers. On the one hand they need to supervise issuers and protect investors, but on the other hand they’re paid by the issuers so they nevertheless fall to the issuer’s pocket. Secondly, traditional reputational sanction and market discipline didn’t work today due to large financial incentives and monopolized market structure of gatekeepers. Thirdly gatekeeper regulation can help alleviate the judgment-proof problem of the issuer, because the issuer may become bankrupt and gatekeeper becomes the deep pocket. |
I then introduced several regulatory techniques in different jurisdictions to regulate gatekeepers and their effects of application (Section 5.4). These solutions were selected as the underlying problems seemed to be similar to China today. The technique used to regulate underwriter in US and sponsor in Hong Kong is the quasi-strict legal liability with a non-exclusive affirmative due diligence defense (Section 5.4.1). However, due to the unclear boundaries caused by unclear requirements in due diligence defense, this approach has caused liabilities shifting problems in different jurisdictions. Although these jurisdictions chose to make more detailed requirements of due diligence defense and enhanced information disclosure of fraudulent behaviors to address these problems, they didn’t address the problems from the root. |
For accountants and lawyers (Section 5.4.2 and 5.4.3), in US, due to the concern of frivolous litigations, aider and abettor liability was banned under private right of action and joint liability was transformed to joint and several liability after PSLRA reform. This reform decreased the deterrence effect of misbehaviors of accountant and lawyer. In order to compensate such loss of deterrence effect, in US it chose to enhance regulatory oversight, information disclosure of misbehaviors and involve accountant and lawyer in corporate governance of issuers. In comparison, accountant is more deeply involved in corporate governance than lawyer, and regulatory oversight of accountant and information disclosure obligation of accountant are also more intrusive than lawyer. However, there are two problems after these two reforms. The first one is that such reform exacerbated the liabilities shifting problem in due diligence defense. Shielding lawyer from aider and abettor liability and at the same time limiting compensation level by accountant made liabilities shifting problem severer. The second one is that such reform was too expensive. Attestation of corporate governance was even more expensive compared to private litigation. |
For securities analyst (Section 5.4.4), in US, the techniques used are mainly conflict of interest disclosure and corporate governance separating departments with conflict of interests. In EU, the technique used to address the conflict of interest issue is the payment regulation. In US, such conflict of interest regulation left many loopholes and also didn’t address the high cost of burden of proof in litigation. In EU, such payment regulation is more likely to solve the conflict of interest problem from the root, while in the short term, it may cause some turbulence in the market, but in the long run, market has sufficient capabilities to adjust to such changes. |
Based on the above analysis, I offered some lessons for China (Section 5.5). In terms of liabilities shifting problems among sponsor, accountant and lawyer, the lesson is that the above discussed methods are not enough, we need to solve the problem from the root, which is to impose strict liability on sponsor. Therefore, the current China’s experiment is on the right path, which is sponsor-pays-first regime. Secondly, for accountant and lawyer, corporate governance is too expensive so therefore it shouldn’t be introduced to China. Moreover, regulatory oversight has already been in existence, so therefore it was not necessary to introduce such regulatory technique either. At last, mandatory whistle blow and noisy withdraw should be imposed on sponsor and accountant instead of lawyer and lawyer should be required to withdraw quietly and disclose misbehaviors to accountant and sponsor, since it can avoid breach of confidentiality duty by lawyer but at the same time achieve the same result of enhancing supervision of misbehaviors. Thirdly, in terms of securities analyst regulation, the payment regulation from EU should be introduced to China. |
[i] This is by no means an inclusive data. The data is derived from the Heinonline law all periodical and review database. Confining the research to title “gatekeeper” and further confines the topic to “securities” (since it will exclude other areas where gatekeeper might be mentioned e.g. immigration law, drug or food safety law), there are overall 33 returned results. Among them all the papers cited by more than 10 articles are downloaded, which is overall 15 papers. In these 15 papers, all the trying definition refers to either Reinier Kraakman or John C. Coffee Jr.’s definition. These two kinds of definitions are also cited by The Oxford Handbook of Financial Regulation. |
[ii] Reinier H. Kraakman, Gatekeepers: The Anatomy of a Third-Party Enforcement Strategy, 2 J.L. Econ. & Org. 53, 54 (1986); see also Reinier H. Kraakman, Corporate Liability Strategies and the Costs of Legal Controls, 93 Yale L.J. 857, 888-96 (1984) (evaluating gatekeeper liability). |
[iv] John C. Coffee Jr., Gatekeepers: The Professions and Corporate Governance, 2(2006). |
[v] Jennifer Payne, The Role of Gatekeeper, in Niamh Moloney, Eilís Ferran, and Jennifer Payne (eds.), The Oxford Handbook of Financial Regulation, 257 (2015). |
[vi] Assaf Hamdani, Gatekeeper Liability, 77 S. Cal. L.Rev. 53, 122 (2003); Jennifer Payne, The Role of Gatekeeper, in Niamh Moloney, Eilís Ferran, and Jennifer Payne (eds.), Oxford Handbook of Financial Regulation, 254 (2015). |
[xii] Gordon YM Chan, Reforming the Sponsor Regulatory Regime- A Case of Hong Kong’s Response to the Impact of Chinese Listings, 43 Hong Kong L.J. 973, 1002 (2013); Joseph K. Leahy, What Due Diligence Dilemma -Re-Envisioning Underwriters’ Continuous Due Diligence after Worldcom, 30 Cardozo L. Rev. 2001 (2009); Eric Seitz, Underwriter Due Diligence: It’s [Not] A Whole New Ballgame, 61 S.M.U. L. Rev. 1633 (2008). |
[xiii] Yi Su & Qing Zhou, IPO Cong Shen Bao Dao Shang Shi Yao Duo Jiu: Qu Nian Ping Jun 862 Tian Zui Chang 56 Ge Yue (How Long Does It Take for an IPO to Go from Filing to Listing: An Average of 862 Days Last Year, Up to 56 Months), |
https://finance.ifeng.com/a/20170304/15224578_0.shtml, last visited on 30 March 2019. |
[xiv] Dong Liang & Liu Fengru, Xin Gu Fa Xing Qiao Ran Ti Su (IPO Is Quietly Speeding Up), |
http://money.people.com.cn/n1/2019/0117/c42877-30560150.html, last visited on 30 March 2019. |
[xv] Reinier H. Kraakman, Gatekeepers: The Anatomy of a Third-Party Enforcement Strategy, 2 J. L. Econ. & Org.53 (1986); Ke Steven Wan, Gatekeeper Liability versus Regulation of Wrongdoers, 34 Ohio N.U. L. Rev. 483, 522 (2008); John C. Jr. Coffee, Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms, 84 B.U. L.Rev. 301 (2004). |
[xxi] Merritt B. Fox, Gatekeeper Failures: Why Important, What to Do, 106 Mich. L. Rev. 1089 (2008); Lawrence A. Cunningham, Book Review of Gatekeepers: The Professions and Corporate Governance by John C. Coffee, Jr., 40 Brit. Acct. Rev. 87 (2008); John C, Jr. Coffee, Understanding Enron: “It’s about the gatekeepers, stupid”, 57 The Business Lawyer 1403 (2002); Coffee, supra 943. |
[xxii] Assaf Hamdani, Gatekeeper Liability, 77 S. Cal. L. Rev. 53, 122 (2003). |
[xxx] John C. Coffee Jr., Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms, 84 B.U. L. Rev. 301 (2004). |
[xxxi] See John C. Coffee Jr., It’s About the Gatekeeper, Stupid! 57 The Business Lawyer 1403 (2008); John C. Coffee Jr., Attorney as Gatekeeper: An Agenda for the SEC,103 Colum. L. Rev. 1293 (2003); Supra xxx. |
[xxxv] John. C. Coffee Jr., Gatekeepers: The Professions and Corporate Governance (2006). |
[xxxix] Thomas Lee Hazen, Securities Regulation in a Nutshell (2008). |
| [xliii] Summary: H.R.1058 — 104th Congress (1995-1996), Private Securities Litigation Reform Act of 1995, https://www.congress.gov/bill/104th-congress/house-bill/1058, last visited on 22 March 2019. |
[xliv] Craig P. Wagnild, Civil Law Discovery in Japan: A Comparison of Japanese and U.S. Methods of Evidence Collection in Civil Litigation, 3 APLPJ 1 (2002); Elizabeth Fahey & Zhirong Tao, The Pretrial Discovery Process in Civil Cases: A Comparison of Evidence Discovery between China and the United States, 37 B. C. Int’l & Comp. L. Rev. 281 (2014). |
[xlv] Wendy Gerwick Couture, The PSLRA Discovery Stay Meets Complex Litigation: Five Questions Answered, 42 Securities Regulation Law Journal 243 (2014). |
[xlvi] Practical Law, Private Securities Litigation Reform Act of 1995 (PSLRA), |
https://uk.practicallaw.thomsonreuters.com/w-000-3647?transitionType=Default&contextData=(sc.Default)&firstPage=true&comp=pluk&bhcp=1,last visited on 22 March 2019. |
[l] Book Reviews: John C. Coffee, Jr., Gatekeepers: The Professions And Corporate Governance, 83 The Accounting Review 251 (2008). |
[li] John C. Coffee Jr., What Caused Enron – A Capsule Social and Economic History of the 1990s, 89 Cornell L. Rev. 269 (2004). |
[lx] John C. Coffee Jr., Hillary A. Sale, and M. Todd Henderson, Securities Regulation, Cases and Material, 939 (2015). |
[lxiv] Chris-Craft Industries, Inc. v. Piper Aircraft 480 F.2d at 370. |
[lxv] Feit v. Leasco Data Processing Equip. Corp., 332 F. Supp. 554, 582(E.D.NY.1971); In re WorldCom, Inc. Sec. Litig., 308 F. Supp. 2d 338, 343 (S.D.N.Y. 2004). |
[lxvii] Escott v. BarChris Construction Corporation, 283 F.Supp. 643 (S.D.N.Y. 1968). |
[lxxii] Steven L. Schwarcz, Financial Information Failure and Lawyer Responsibility, 31 Journal of Corporation Law 1098 (2006). |
[lxxv] 283 F. Supp. 643 (S.D.N.Y. 1976); Robert W. Doty, Application of the Antifraud Provisions of the Federal Securities Laws to Exempt offerings: Duties of Underwriters and Counsel, 16 B.C.L. Rev. 393 (1975). |
[lxxvi] James A. Bedotto, If It Ain’t Broke, Don’t Fix It: The Frequent Use of “Underwriters’ Counsel” in Shelf-Registered Offerings Scraps the Need for Underwriter Due Diligence Reform, 42 Securities Law Regulation 293 (2014). |
[lxxvii] John C. Jr. Coffee, Attorney as Gatekeeper: An Agenda for the SEC, 103 Colum. L. Rev. 1293 (2003); Lisa H. Nicholson, A Hobson’s Choice for Securities Lawyers in the Post-Enron Environment: Striking a Balance between the Obligation of Client Loyalty and Market Gatekeeper, 16 Geo. J. Legal Ethics 91 (2002). |
[lxxix] Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994). |
[lxxx] Stoneridge Investment Partners v. Scientific-Atlanta, 552 U.S. 148 (2008). |
[lxxxiv] 15 U.S.C § 78u–4(f)(2); GAO, Securities Fraud Liability of Secondary Actors, GAO-11-664, |
https://www.gao.gov/new.items/d11664.pdf, last visited on 22 March 2019. |
[lxxxv] 15 U.S.C § 78u–4(f)(4); Judson Lobdell & Nicholas Napoli, Apportionment of Liability Under the PSLRA, 9 Securities Litigation Report 23 (2012). |
[lxxxix] Wendy Gerwick Couture, The PSLRA Discovery Stay Meets Complex Litigation: Five Questions Answered, 42Securities Regulation Law Journal 243 (2014); Elliott J. Weiss and Janet E. Moser, Enter Yossarian: How to Resolve the Procedural Catch-22 That the Private Securities Litigation Reform Act Creates, 76 Wash. U. L. Q. 457 (1998). |
[xcii] Shen Zhao Hui & Liu Jiang Wei, Zheng Bi Quan Jiao Fen Yan Xi Jiu Shi Li Yi Chong Tu Fang Fan Ji Zhi Bi Jiao Yan Jiu (Comparative Study on The Prevention Mechanism of Interest Conflicts), 23 Securities Law Review 49 (2017). |
[xciii] James C. Spindler, Conflict or Credibility: Research Analyst Conflicts of Interest and the Market for Underwriting Business, 35 J. Legal Stud. 303, 326 (2006). |
[xcv] Jill I. Gross, Securities Analysts’ Undisclosed Conflicts of Interest: Unfair Dealing or Securities Fraud?, 2002 Colum. Bus. L. Rev. 631 (2002). |
[xcvii] SEC, General Information on the Regulation of Investment Advisers, |
https://www.sec.gov/divisions/investment/iaregulation/memoia.htm, last visited on 22 March 2019; Polina Demina, NOTE: Broker-Dealers and Investment Advisers: A Behavioral-Economics Analysis of Competing Suggestions for Reform, 113 Mich. L. Rev. 429 (2014); William Alan Nelson, Broker-Dealer: A Fiduciary by Any Other Name?, 20 Fordham Journal of Corporate and Financial Law 637 (2015). |
[c] 15 U.S.C. § 77k; Section 11 and Underwriter Liability: A Case of Statutory Misconstruction, 7 Rutgers-Cam L.J. 741 (1976). |
[ci] Guo Li, Zheng Quan Lu Shi De Zhi Ze Gui Fan Yu Ye Wu Tuo Zhan (Expansion of Securities Lawyers’Business and Its Associated Regulations), 4 Securities Law Herald 14 (2011); Guo Li, Wo Guo Zheng Quan Lu Shi Ye De Fa Zhan Chu Lu He Gui Fan Jian Yi (Futhure of Securities Lawyers Industry and Regulatory Proposal). |
[cii] Shen Chaohui, Jian Guan De Shi Chang Fen Quan Li Lun Yu Yan Hua Zhong Di Xing Zheng Zhi Li－Cong Zhong Guo Zheng Jian Hui Yu Bao Jian Ren De Fa Lu Guan Xi Qie Ru (Market-based Regulatory Approach and Evolutionary Administrative Supervision-An Analysis from the Relationship between CSRC and Sponsor), 23 Peking University Law Journal 849 (2011). |
[ciii] Li Youxing, Gu Piao Shou Fa Zhong Cheng Xiao Shang Yu Bao Jian Ren Fen Li De Zhi Du Tan Tao, 5 Securities Law Review205 (2011); Jiang Daxin, Shen Hui, Cong Si Ren Xuan Ze Zou Xiang Gong Gong Xuan Ze Cui Hui Bao Jian He Mou De Li Yi Qiang (From Private Choice to Public Choice, Destroying Collusion between Sponsor and Issuer), 5 Securities Law Review 222 (2011). |
[cxi] Su Long Fei, Yang Zhi Quan, Hong Liang Guo Ji Zui Yu Fa IPO Da Jia De Xiang Gang Mo Shi (Hontex’s Crime and Punishment,The Hong Kong Model of Enforcement Action against Fraudulent Activities in IPO), http://www.xcf.cn/tt2/201207/t20120720_330925.htm, last visited on 24 March 2019. |
[cxxii] European Commission, Note for the Informal ECOFIN Council Oviedo, 12 and 13 April. A First Response to Enron-related Policy Issues (2004). |
[cxxiii] Sandler & Schrader, MiFID II Inducement Rule, supra 352. |
[cxxvii] Ron Rimkus, CFA, Parmalat, https://www.econcrises.org/2016/11/29/parmalat/, last visited on 24 March 2019. |
[cxxxii] Expertised portions of the registration statement are portions prepared or certified by an expert. This can be audited financial information or legal opinions. Non-Expertised portions of the registration statement not prepared by an expert. These are unreasearched statements. See 15 U.S.C§ 77k(b)(3). |
[cxlviii] Expanding Liability of Securities Underwriters, supra 258. |
[cl] Covington & Burling Securities Client Advisory, supra 266. |
[clii] In re International Rectifier Securities Litigation 1997 WL 529600 (C.D. Cal. March 31, 1997); FindLaw, Underwriter Due Diligence, supra 261. |
[clv] Sanders v. John Nuveen & Co., 619 F.2d 1222, 1227-28 (7th Cir. 1980), cert. denied, 101 S. Ct. 1719 (1981); FindLaw, Underwriter Due Diligence, supra 261. |
[clvi] University Hill Foundation v. Goldman, Sachs & Co., 422 F. Supp; FindLaw, Underwriter Due Diligence, supra 261. |
[clx] Ernest Lim, Sponsors’ Prospectus Liability in Initial Public Offerings in Hong Kong, 8 Capital Markets Law Journal 177 (2013). |
[clxi] Generally common law allows sponsor to insert waiver clause to exempt them from liabilities and reliance of prospectus and losses due to such reliance must be proved by the investors. In Misrepresentation Ordinance 3(1), it only recognizes company as a party of transaction involving misrepresentation, but not to other persons. |
[clxii] See R Tomasic, ELG Tyler and V Stott, Annotated Ordinance of HK Companies Ordinance (Lexis Nexis 2012) at 110 states that s 40 “may be compared with s 43 of the Companies Act 1948 (UK)”; See also LCB Gower, The Principles of Modern Company Law (3rd edn, Stevens 1969) fn 13, at 332. |
[clxiv] “Sponsors are subject to the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (which sets out overall principles and requirements applicable to the conduct of all licensed and registered persons to which they must adhere in ensuring that they are fit and proper to remain licensed and registered), the Corporate Finance Adviser Code of Conduct (which provides specific conduct guidance to corporate finance advisers) and Chapter 3A and Practice Note 21 of the Listing Rules of the Hong Kong Stock Exchange (which contains detailed guidance on sponsors’ due diligence obligations).” |
https://www.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=18EC60, last visited on 24 March 2019. |
[clxviii] SFC Enforcement News, Licensees Disciplined for Forgery and Sponsor Failures (11 October 2011), |
http://www.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/enforcement-news/doc?refNo¼11PR1244, last visited on 24 March 2019. |
[clxix] SFC Enforcement News, SFC Resolves Compliance Issues with Core Pacific-Yamaichi Capital Limited, Core Pacific-Yamaichi International (H.K.) Limited and Core Pacific-Yamaichi Securities (H.K.) Limited (17 April 2008), |
http://www.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/enforcement-news/doc?refNo¼08PR584, last visited on 24 March 2019. |
[clxx] SFC, Consultation Paper on the Regulation of Sponsors (2012), |
http://www.sfc.hk/edistributionWeb/gateway/EN/consultation/openFile?refNo¼12CP14, last visited on 24 March 2019. |
[clxxix] Id; Guo Li, Xiang Gang Bao Jian Zhi Du Xin Gui Ping Jian (Review of Hong Kong’s New Sponsor’s Regulations), 2 Securities Market Herald 4 (2014) |
[clxxxii] 100 U.S. 195 (1879); (1842) 10 M&W 109; supra Feinman, 269. |
[clxxxv] 217 N.Y. 382, 111 N.E. 1050 (1916); 174 N.E. 441 (1932); (1958) 49 Cal.2d 647; supra Feinman, 269. |
[clxxxvi] Marc I. Steinberg & Christopher D. Olive, Contribution and Proportionate Liability under the Federal Securities Laws in Multidefendant Securities Litigation after the Private Securities Litigation Reform Act of 1995, 50 SMU L. Rev. 337 (1997). |
[clxxxvii] Marilyn F. Johnson, Karen K. Nelson, A. C. Pritchard, Do the Merits Matter More? The Impact of the Private Securities Litigation Reform Act, 23 JLEO 627 (2006); Joel Seligman, The Merits Do Matter: A Comment on Professor Grundfest’s Disimplying Private Rights of Action under the Federal Securities Laws: The Commission’s Authority, 108 Harv. L. Rev 438 (1994); Amanda M. Rose, Reforming Securities Litigation Reform: Restructuring the Relationship between Public and Private Enforcement of Rule 10B-5, 108 Colum. L. Rev. 1301 (2008). |
[ccxii] Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc, Oyez, https://www.oyez.org/cases/2007/06-43, last visited on 30 March 2019.. |
| [ccxiii] Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc, Casebriefs, https://www.casebriefs.com/blog/law/securities-regulation/securities-regulation-keyed-to-coffee/general-civil-liberty-provisions/stoneridge-investment-partners-llc-v-scientific-atlanta-inc/, last visited on 30 March 2019. |
[ccxvi] Stoneridge Investment Partners, LLC v. Scientific-Atlanta, 552 U.S. 148 (2008) (Stevens, C.J., dissenting). |
[ccxvii] Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011). |
[ccxxvi] Janus Capital Group, Inc. v. First Derivative Traders, Oyez, https://www.oyez.org/cases/2010/09-525, last visited on 30 March 2019. |
[ccxxxiii] Coffee, What Caused Enron, supra note 295; Coffee, Gatekeeper Failure and Reform, supra note 943; GAO-03-138, supra note 294. |
[ccxxxiv] 15 U.S. Code § 78j–1; ABA, Section 10A and the Internal Investigations at Financial Institutions, |
http://apps.americanbar.org/buslaw/committees/CL130000pub/newsletter/200604/vartanian.pdf, |
last visited on 26 March 2019; Thomas L. Riesenberg, Trying to Hear the Whistle Blowing: The Widely Misunderstood “Illegal Act” Reporting Requirements of Exchange Act Section 10A, 56 Bus. Law. 1417 (2001). |
[ccxxxvii] 15 U.S.C § 78j–1; ABA and Riesensburg, supra note 1162. |
[ccxlix]Annette Schandl & Philip L. Foster, COSO Internal Control – Integrated Framework: An Implementation Guide for the Healthcare Provider Industry, |
https://www.coso.org/Documents/COSO-CROWE-COSO-Internal-Control-Integrated-Framework.pdf, last visited on 29 March 2019. |
[ccl] SEC, Commission Guidance Regarding Management’s Report on Internal Control Over Financial Reporting Under Section 13(a) or 15(d) of the Securities Exchange Act of 1934, https://www.sec.gov/rules/interp/2007/33-8810.pdf, last visited on 26 March 2019. |
[cclii] AS No. 5: An Audit of Internal Control Over Financial Reporting That Is Integrated with an Audit of Financial Statements. |
[ccliii] Tim J. Leech, FCA·CIA, CCSA, CFE, Sarbanes-Oxley Sections 302 & 404 A White Paper Proposing Practical, Cost Effective Compliance Strategies, April 2003, |
https://www.sec.gov/rules/proposed/s74002/card941503.pdf, last visited on 26 March 2019. |
[cclvii] Coffee, Political Economy of Dodd-Frank, supra note 54. |
[cclix] Id; See Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), Pub. L. No. 111-203, § 989G, 124 Stat. 1383, 1948 (2010) (codified at 15 U.S.C.§ 7262 (Supp. IV 2010)) (adding new Section 404(c) to the Sarbanes-Oxley Act of 2002); See Internal Control Over Financial Reporting in Exchange Act Periodic Reports of Non-Accelerated Filers, Securities Act Release No. 9142, Exchange Act Release No. 62,914, 75 Fed. Reg. 57,385, (Sept. 21, 2010) (adopting new rules in response to Section 989G of Dodd-Frank Act); See 17 C.F.R. § 229.308 (2011). This provision permits new public companies to delay filing its management assessment of internal controls over financial reporting (and accompany auditor attestation) until the company’s second annual report. |
[cclx] Id; See President’s Council On Jobs And Competitiveness, Taking Action, Building Confidence: Five Common-Sense Initiatives To Boost Jobs And Competitiveness 19 (2011); See David Milstead, A Desperate Obama Kicks Investor Protection to the Curb, Globe And Mail, Oct. 18, 2011, at B19; See Editorial, Not Their Job, N.Y. Times, Oct. 20, 2011, at A24. |
[cclxiv] Id; David S. Hilzenrath, Auditors Face Scant Discipline, Wash. Post, Dec. 6,2001, at Al. |
[cclxxi] PCAOB, PCAOB Highlights, https://pcaobus.org/News/Speech/Pages/06092014_GWSCPA.aspx, last visited on 26 March 2019. |
[cclxxiv] John L. Abernathy, Michael Barnes, and Chad Stefaniak, A Summary of 10 Years of PCAOB Research: What Have We Learned?, 32 Journal of Accounting Literature 30 (2013); Id, Rule 4009. |
[cclxxviii] Dennis Caplan, Diane Janvin and James Kurteinbach, Internal Audit Outsourcing, An Analysis of Self-Regulation of Accounting Profession, Gary Previts, Tom Robinson(eds.), in Research in Accounting Regulation, Volume 19, 29 (2007). |
[cclxxxv] Cornerstone Research, New Report Highlights Regulatory Actions Involving Accountants The SEC resolved fewer enforcement actions in 2017, while final PCAOB actions reached a record level, https://www.cornerstone.com/Publications/Press-Releases/New-Report-Highlights-Regulatory-Actions-Involving, last visited on 26 March 2019. |
[ccxciii] In re Carter, Exchange Act Release No. 17597, [1981 Transfer Binder] Fed. Sec. L. Rep. (CCH) 82,847, at 84,149 & n.13 (Feb. 28, 1981). |
[ccxcvi] In re Carter, Exchange Act Release No. 17597, [1981 Transfer Binder] Fed. Sec. L. Rep. (CCH) 82,847, at 84,149 & n.13 (Feb. 28, 1981). |
[cccii] See Model Code Of Prof’l Responsibility DR 7-102(B)(1) (1969); Canons of Prof’l Etthics Canon 41 (1968); Canons of Prof’l Ethics Canon 37 (1968); Model Code Of Prof’l Responsibility DR 4-101(C)(3) (1969) With respect to withdrawal, see id. DR 2-110(B)(2), (C)(1)(b), C. |
[ccciii] In re Carter, Exchange Act Release No. 17597, [1981 Transfer Binder] Fed. Sec. L. Rep. (CCH) 82,847, at 84,149 & n.13 (Feb. 28, 1981). |
[cccvii] 15 U.S. Code § 7245; Karl A. Groskaufmanist, Climbing up the Ladder: Corporate Counsel and the SEC’s Reporting Requirement for Lawyers, 89 Cornell L. Rev. 511, 521 (2004). |
[cccxi] ABA Comm. On Ethics and Professional Responsibility, Formal Op. 366 (1992). |
[cccxiii] ABA, Rule 1.6: Confidentiality of Information, supra 314. |
[cccxiv] Deborah L. Rhode & Alice Woolley, Comparative Perspectives on Lawyer Regulation: An Agenda for Reform in the United States and Canada, 80 Fordham L. Rev. 2761, 2790 (2012). |
[cccxix] Marco Ventoruzzo, Comparing Insider Trading in the United States and in the European Union: History and Recent Developments, 11 ECFR 554 (2014). |
[cccxxi] Jill E. Fisch & Hillary A. Sale, The Securities Analyst as Agent: Rethinking the Regulation of Analysts, 88 Iowa L. Rev. 1035, 1098 (2003). |
[cccxxxvi] Jennifer Payne, The Role of Gatekeeper, supra 931. |
[cccxxxvii] Regulation (EU) No 596/2014 of The European Parliament and of The Council of 16 April 2014 on market abuse (market abuse regulation) and repealing Directive 2003/6/EC of the European Parliament and of the Council and Commission Directives 2003/124/EC, 2003/125/EC and 2004/72/EC, O.J.L 173/1, 12.6.2014, Art.20 (1); Commission Delegated Regulation (EU) 2016/958 of 9 March 2016 supplementing Regulation (EU) No 596/2014 of the European Parliament and of the Council with regard to regulatory technical standards for the technical arrangements for objective presentation of investment recommendations or other information recommending or suggesting an investment strategy and for disclosure of particular interests or indications of conflicts of interest, O.J.L 160/15, 17.6.2016. Niamh Molone, 685-698. |
[cccxxxviii] Directive 2014/65/EU of The European Parliament and of The Council, Recital 74 and 75, Art.24(7); Niamh Molone, 685-698. |
[cccxxxix] Commission Delegated Directive (EU) 2017/593 of 7 April 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to safeguarding of financial instruments and funds belonging to clients, product governance obligations and the rules applicable to the provision or reception of fees, commissions or any monetary or non-monetary benefits, O.J.L 87/500, 31.3.2017, Recital 28. |
[cccxl] Commission Delegated Directive (EU) 2017/593, Recital 28. |
[cccxli] Directive 2014/65/EU of The European Parliament and of The Council, Recital 74 and 75, Art.24(7); Sandler & Schrader, supra 372. |
[cccxliii] Commission Delegated Directive (EU) 2017/593, Art.13. |
[cccxliv] Commission Delegated Directive (EU) 2017/593, Art.13(1)(b). |
[cccxlv] Commission Delegated Directive (EU) 2017/593, Art.13(1)(b). |
[cccxlvi] Commission Delegated Directive (EU) 2017/593, Art.13(1)(b). |
[cccxlvii] Commission Delegated Directive (EU) 2017/593, Art.13(1)(b). |
[cccxlviii] Commission Delegated Directive (EU) 2017/593, Art.13(2)(b). |
[cccxlix] Directive 2014/65/EU of The European Parliament and of The Council, Art.24(8); Sandler & Schrader, supra 372. |
[cccl] Commission Delegated Directive (EU) 2017/593, Art.11(2). |
[cccli] Commission Delegated Directive (EU) 2017/593, Art.12(3). |
[ccclii] Lizzie Meager, Best Practice, MiFID II Research Unbundling, |
https://iflrinsight.com/articles/230/best-practice-mifid-ii-research-unbundling, last visited on 27 March 2019. |
[cccliii] Overinvestment theory means that too much money was invested into research which surpasses its generated value. However, on the other hand there is a shortage of information in the market. This dilemma can be explained by repetitive research on the same groups of company. See Luca Enriques and Sergio Gilotta, Disclosure and Financial Market Regulation in in Niamh Moloney, Eilís Ferran, and Jennifer Payne (eds.), Oxford Handbook of Financial Regulation, 512 (2015). |
[ccclvii] Quanshangcn, Guo Sheng Zheng Quan: Ke Chuang Ban Shi Dui Tou Hang De Xin Tiao Zhan, Qi Dai Tou Hang Chun Tian De Zhen Zheng Dao Lai (Science and Technology Innovation Board Is a New Challenge for Investment Bank, but We Hope the Spring Will Come Soon), |
https://new.qq.com/omn/20181213/20181213A0T4H9.html, last visited on 29 March 2019. |
[ccclviii] Lun Wo Guo Xu Jia Chen Shu Min Shi Ze Ren Zhu Ti De Kun Jing Yu Chuang Xin (The Dilemma and Innovation of Subject of Liability of False Statements in China), 7 Securities Market Herald 70 (2017). |
[ccclxviii] Zhao Xiaojun, Zheng Quan Tou Zi Zhe Bao Hu Min Shi Ze Ren Fa Lu Zhi Du De Wan Shan-Yi Xiang Gang Shi Chang Jing Yan Wei Jie (Strengthen Securities Investors Protection Through Through Litigation-From Experiences of Hong Kong), in Guo Feng, Song Xiaoyan (eds.) Securities Law Review 550 (2017). |
[ccclxxi] SFC, Consultation Conclusions on the Regulation of Sponsors, supra 360. |
[ccclxxvi] 17 C.F.R § 230.176; 1997 WL 529600 (C.D. Cal. March 31, 1997). |
[ccclxxvii] Code of Conduct and Practice Note 21, supra 362. |
[ccclxxx] Andrew F. Tuch, The Limits of Gatekeeper Liability, 73 Wash. & Lee L. Rev. Online 619 (2016-2017); Stavros Gadinis & Colby Mangels, Collaborative Gatekeepers, 73 Wash. & Lee L. Rev. 797 (2016). |
[ccclxxxi] Ma Yue, Qian Tan Bao Jian Zhi Du Cun Zai De Bi Duan Ji Qi Si Kao —— Ping An Zheng Quan Ling Shi Shang Zui Yan Fa Dan De Jing Shi (Talking about the Disadvantages of the Sponsor System and Its Reflection——The Warning of the Most Strict Penalty in the History of Ping An Securities), 2 Legal System and Society 41 (2014). |
[ccclxxxiii] 283 F. Supp. 643 (S.D.N.Y.1968); 46 F. Supp. 2d 628 (2004). |
[ccclxxxiv] Code of Conduct and Practice Note 21, supra 362. |
[ccclxxxv] Chinese Venture Capitalist Federation, Shang Shi, Jiu Jing Yao Hua Duo Shao Qian? (How Much Does it Cost to Get Listed?), http://www.sohu.com/a/131898819_476004, last visited on 28 March 2019. |
[ccclxxxvi] Guo Li, Zheng Quan Lu Shi De Zhi Ze Gui Fan Yu Ye Wu Tuo Zhan (Securities Lawyers’ Duties and Expansion of Business Models), Securities Market Herald 14 (April, 2011). |
[ccclxxxvii] Luo Yunxiang, Sponsor Representatives, IPO Zhong Lü Shi, Quan Shang He Kuai Ji De Jin Zhi Diao Cha Nei Rong You Shen Me Bu Tong Ma? Wei He San Fang Dou Yao Zuo Yi Bian Jin Zhi Diao Cha? (Is there any difference in the due diligence content of lawyers, brokers, and accountants in IPO? Why do all three parties have to do their due diligence?)https://www.zhihu.com/question/22993675, last visited on 28 March 2019. |
[ccclxxxviii] Announcement No. 32 [2015] of the China Securities Regulatory Commission―― Prospectus (2015 Revision); Chen Jie, Zheng Quan Shi Chang Xian Qi Pei Fu Zhi Du De Yin Ru Ji Shi Yong, 8 Journal of Law Application 25 (2015); Yao Yifan, Bao Jian Ren Xian Xing Pei Fu Zhi Du De Jie Du Yu Fan Si, 96 Financial Law Forum 62 (2018); Yang Chen, Lun Wo Guo Xu Jia Chen Shu Min Shi Ze Ren Zhu Ti De Kun Jing Yu Chuang Xin (On the Conundrum and Innovation of the Subjects Bearing Civil Liabilities of Misrepresentation), Securities Market Herald 70 (July 2017); Liu Yuhui Shen Liangjun, Jing Wai Ji Tou Zi Zhe Bu Chang Ji Zhi Yan Jiu (Comparative Studies of Investor Compensation Mechanisms of Foreign Jurisdictions), 8 Securities Market Herald 13 (2017). |
[cccxc] Yao Yifan, Bao Jian Ren Xian Xing Pei Fu Zhi Du De Jie Du Yu Fan Si (Rethink Sponsor-Pays-First Mechanism), 96 Financial Law Forum 62 (2018). |
[cccxci] John C. Coffee Jr., Partnoy’s Complaint: A Response, 84 B.U. L. Rev. 377 (2004). |
[cccxcv] Noisy withdraw means that it would require an attorney to withdraw from his or her representation of an issuer and also report directly to the SEC. |
[cccxcvi] Quite withdraw doesn’t require reporting to the SEC. |
[cccxcviii] John C. Coffee Jr., Attorney as Gatekeeper: An Agenda for the SEC, 103 Colum. L. Rev. 1293, 1297 (2003). |
[cdiii] Dong Yuzhou, Ning Sitian, 2018 Nian Zhong Zi Suo A Gu He Gang Gu Cheng Ji Dan (Chinese Law Firms’ Numbers of A Share Listing and H Share Listing in 2018), https://www.zhihedongfang.com/58071.html, last visited on June 19, 2019. |
[cdiv] Guo Li, supra 359; Code of Conduct and Practice Note 21, supra 362; SFC, Consultation Conclusion (2012), supra 360. |
[cdvi] John Abernathy, Michael Barnes and Chad Stefaniak, supra 299; Suraj Srinivasan and John C. Coates IV, SOX after Ten Years: A Multidisciplinary Review, Harvard Law and Economics Discussion Paper No. 758, Accounting Horizons (forthcoming), |
http://nrs.harvard.edu/urn3:HUL.InstRepos:12175242, last visited July 2, 2018 |
[cdvii] Bai Jie, “Zhong Guo Ban Sa Ban Si” Zao Yu Zhi Xing Nan (“Chinese Version of Sarbanes” Encountered Difficulties in Implementation), 12 Information Security and Communications Policy 9 (2009). |
[cdix] John Abernathy, Michael Barnes and Chad Stefaniak, supra 299. |
[cdxiii] Art.58 of Administrative Measures for the Disclosure of Information of Listed Companies (2007). |
[cdxiv] Art.22 of Administrative Liability Determination Rule for Violation of Information Disclosure Obligation (2011). |
[cdxv] Shanghai Stock Exchange Investor Education, Shang Jiao Suo Tou Jiao: Shang Shi Gong Si Cai Wu Zao Jia Gao Guan “Shuai Guo ”Shou Yan Cheng (Shanghai Stock Exchange Investor Education: Financial Misstatement of Listed Companies: Board of Managers Can’t Escape Liabilities by the Excuse of “Not Knowing”), http://finance.jrj.com.cn/2018/04/09175524363436.shtml, last visited on 28 March 2019. |
[cdxvi] CSRC, Zhong Guo Zheng Jian Hui Xing Zheng Chu Fa Jue Ding Shu Cheng Du Hua Ze Gu Nie Cai Liao Gu Fen You Xian Gong Si, Wang Tao, Wang Ying Hu Deng 18 Ming Ze Ren Ren Yuan (China Securities Regulatory Commission Administrative Penalty Decision (Chengdu Huaze Cobalt Nickel Material Co., Ltd., Wang Tao, Wang Yinghu and Other 18 Responsible Personnel)), http://www.csrc.gov.cn/pub/zjhpublic/G00306212/201801/t20180130_333361.htm, last visited on 31 March 2019. |
[cdxvii] CSRC, Zhong Guo Zheng Jian Hui Xing Zheng Chu Fa Jue Ding Shu Hu Bei Yang Fan Kong Gu Gu Fen You Xian Gong Si, Qian Han Xin,Teng Zu Chang Deng 18 Ming Ze Ren Ren Yuan (China Securities Regulatory Commission Administrative Punishment Decision (Wuhan National Pharmaceutical Technology Co., Ltd., Qian Hanxin and Teng Zuchang and Other 18 Responsible Personnel)),http://www.csrc.gov.cn/pub/zjhpublic/G00306212/201812/t20181213_348096.htm?keywords=，last visited on 31 March 2019. |
[cdxviii] Marc I. Steinberg, The Federalization of Corporate Governance, 191-224 (2018). |
[cdxix] Roberta Romano, The Sarbanes-Oxley Act and the Making of Quack Corporate Governance, 114 Yale L.J. 1521 (2005). |
[cdxx] David S. Hilzenrath, supra 1192; Deborah L. Rhode & Alice Woolley, supra 1242. |
| [cdxxiii] Raj Gnanarajah, Accounting and Auditing Regulatory Structure: U.S. and International, https://fas.org/sgp/crs/misc/R44894.pdf, last visited on 28 March 2019. |
[cdxxx] Guan Yu Yin Fa <2017 Nian Du Cong Shi Zheng Quan Qi Huo Xiang Guan Ye Wu Kuai Ji Shi Shi Wu Suo, Zi Chan Ping Gu Ji Gou Jian Cha Gong Zuo Fang An> De Tong Zhi, Zheng Jian Ban Fa〔2017〕34 Hao (No.34 of CSRC’s Notice on Printing and Distributing the Work Plan for the Certified Public Accountants and Asset Appraisal Organizations for Securities and Futures Related Businesses (2017)). |
[cdxxxi] CSRC, Zheng Jian Hui Zu Zhi Kai Zhan Lü Shi Shi Wu Suo Cong Shi IPO Zheng Quan Fa Lü Ye Wu Zhuan Xiang Jian Cha (Special Inspection of Law Firms Engaging in IPO), |
http://www.gov.cn/xinwen/2017-04/14/content_5185851.htm, last visited on 31 March 2019. |
[cdxxxii] Zheng Jian Hui “ Shuang Xian ” Yan Guan Lü Suo Zheng Quan Ye Wu Lü Suo “ Ren Tong Ge Ai ” Bu He Ge Da Xiang Mu (The Securities And Futures Commission’s “Two-Line” Strict Management Law Firm’s Securities Business Law Firm “Reluctantly Cut Love” Unqualified Big Project), |
https://www.yicai.com/news/5355919.html, last visited on 29 March 2019; “ Xian Chang Jian Cha + Qiang Hua Xin Pi ”, Zheng Jian Hui Tui Chu Liang Ju Cuo Shi Ya “ Shou Men Ren ” (“On-Site Inspection + Enhanced Information Disclosure”, The CSRC Launched Two Measures To Suppress “Gatekeepers”), |
https://www.yicai.com/news/5417387.html, last visited on 29 March 2019. |
[cdxxxiv] Li Dongfang & Liu Muhan, Wo Guo Zheng Quan Fen Xi Shi Fa Lv Gui Zhi Yan Jiu (Studies of Regulations of Securities Analysts’ Conflict of interest), 00 Tribune of Economics Law 294 (2009); Wang Kaiyuan, Mei Guo Fa Shi Jiao Xia De Zheng Quan Fen Xi Shi Li Yi Chong Tu Gui Zhi (Securities Analysts Conflict of interest Regulation under US Law), 84 Financial Law Forum 227 (2012); Shen Chaohui & Liu Weijiang, Zheng Quan Fen Xi Shi Li Yi Chong Tu Fang Fan Ji Zhi Bi Jiao Yan Jiu (Comparative Law Studies of Regulations of Securities Analysts Conflict of interest), 4 Securities Law Review 49 (2017). |
[cdxxxv] Jill I. Gross, supra 331; Ann Moralez Olazabal, Analyst and Broker-Dealer Liability under 10b for Biased Stock Recommendations, 1 New York University Journal of Law and Business 1 (2004). |
[cdxxxvii] Jill E. Fisch & Hillary A. Sale, The Securities Analyst as Agent: Rethinking the Regulation of Analysts, 88 Iowa L. Rev. 1035, 1098 (2003). |
[cdxxxviii] Luca Enriques and Sergio Gilotta, Disclosure and Financial Market Regulation in in Niamh Moloney, Eilís Ferran, and Jennifer Payne (eds.), Oxford Handbook of Financial Regulation, 512 (2015). |
[cdxlii] Directive 2014/65/EU of The European Parliament and of The Council, Article 23; ESMA, Final Report, ESMA’s Technical Advice to the Commission on MiFID II and MiFIR, [ESMA/2014/1569], 19 December 2014, |
last visited on 29 March 2019. |
[cdxliii] Cummingslaw, MIFID II – Conduct of Business Rules, |
https://www.cummingslaw.com/publications/CL_An-introduction-to-MiFID-II-part2-0215.pdf, |
last visited on 28 March 2019. |
| [cdxlv] PwC, The Future of Research: Impact of MiFID II on Research for Investment Firm, September 2016, https://www.pwc.com/gx/en/advisory-services/publications/assets/the-future-of-research-mifid-ii.pdf, last visited on 31 March 2019. |
|
