Private Banking in China - When the Honeymoon Is Over

Private Banking in China - When the Honeymoon Is Over

Private banking in China only received its baptism in September 2005 with the promulgation of the Interim Administrative Rules on Private Wealth Management Business of Commercial Bank. Some commentators have argued that the monetary threshold for the private wealth management regime is so low that its regulatory ambit covers territory more properly classified as retail banking than true private banking. By Jane Jiang, counsel, Corporate Practice, Allen Overy Shanghai

There is no doubt, that September 2005's Interim Administrative Rules on Private Wealth Management Business of Commercial Bank together with the Interim Administrative Rules on Derivative Transactions of Financial Institutions promulgated earlier in 2004, have provided China's private wealth management regime with its first distribution platform for structured products for private individuals.

In its initial stages, the products offered under the private wealth management regime predominantly took the form of structured deposits. In April 2006, the central bank of China launched the Qualified Domestic Institutional Investors (QDII) scheme, allowing various financial institutions in China to raise onshore funds and invest in offshore financial products. Four days later, armed with its experience overseeing the private wealth management regime, the banking regulator unveiled the commercial bank QDII regime, more than a year ahead of the securities regulator and the insurance regulator. The commercial bank QDII regime can be seen as an extension of the private wealth management regime under which the funds are used for offshore investment.

The initial QDII scheme was limited to fixed income products and not surprisingly met with a lukewarm reception from investors. In response, in May 2007 the banking regulator expanded the scheme's investment scope to include listed shares and public funds in qualified jurisdictions. Further, the initial single offshore product investment model gradually evolved into a multi-product model more closely resembling a fund. Capital protected products slowly gave way to more volatile products.

To individual Chinese investors who have been, through decades of foreign exchange restrictions, prohibited from investing in offshore financial products, the QDII regime is almost irresistible. After October 2007, following the downturn in the domestic equity market, news reports of over-subscription of QDII products were an almost daily occurrence. Thus commenced a happy marriage between demand for and supply of new offshore exposure. The honeymoon did not last long though. By the end of 2007, it was already evident that the credit crunch might eventually precipitate a global financial market downturn. New QDII products dried up, with a rumour circulating that the regulator had called a "soft" stop to QDII products. In truth, objective market conditions would likely have resulted in the same outcome even without any regulatory interference. Investors have now turned their anxious gaze to the sliding NAV figures of the outstanding QDII products, which are coming under increasing scrutiny from the regulator, the QDII bank and investors alike. Hitherto theoretical legal issues have now become real.

Typical legal issues arising from a market downturn Legal relationship, commercial risks and regulatory requirements The collapse of Lehman Brothers demonstrated that an offshore product provider may go bust despite a decades-long history and a strong reputation on Wall Street. When this occurs, the question arises as to who is responsible to the individual investors and to what extent?

These issues cannot be answered without first looking into the legal relationship between the parties. Though far from universal and subject to specific contractual language, the prevailing view is that dealings between individual investors and a QDII bank on the one hand and between a QDII bank and an offshore product provider on the other hand are conducted on a "principal to principal" basis. The QDII bank "repackages" the offshore product into one of its own QDII products and offers the product to their individual clients. This means that the QDII bank is contractually liable to its own clients, whilst the offshore product provider, in the absence of conduct or contractual provisions to the contrary, is only contractually liable to the QDII bank. An individual investor will not have any recourse against the offshore product provider unless it can find a non-contractual ground for its legal claim.