1

Capital Markets and Legal Development: the China Case

By Zhiwu Chen∗

Yale School of Management

September 12, 2003

Abstract Recent research establishes a significant positive correlation between law and finance (and hence economic growth), re-starting a debate on the “law matters” thesis. However, which way the causality goes is still not clear. The purpose of this paper is to use the on-going reform experience of China, especially its capital market experience, to examine the direction of causality. First, we show that China’s recent experience is largely consistent with Coffee's (2001) "crash-then-law" interpretation of this correlation. Indeed, it is the large and clearly defined constituency of investors that has been a key driving force behind much of the recent legal progress. The rights and economic interests of this constituency have fundamentally challenged the traditional emphasis of the Chinese legal culture on administrative and criminal sanctions, but not on civil litigation law. Second, we compare the different contributions to legal change made by the stock market and the consumer product markets. We argue that capital markets are perhaps the most conducive to the formation of a politically powerful constituency and hence more aggressive legal change, because of (1) the higher degree of commonality among interested parties and (2) immediately measurable and tangible damages. These two characteristics not only allow investors to identify with each other more easily, but also create an ideal basis for more debate in the media, which in turn promotes the development of a legal culture. Key words: law and finance, legal reform, shareholder rights, product liability, capital market development, economic development.

∗ Zhiwu Chen is a Professor of Finance at the Yale School of Management, 135 Prospect Street, New Haven, CT 06520, USA; zhiwu.chen@yale.edu. The author would like to thank the editor for this issue, Belton Fleisher, for his patience and encouragement, Donald Clarke, Andrei Shleifer and Steve Yun for their comments and suggestions, and SHI Minglei, WANG Yonghua, XIONG Peng, Steve Yun, and ZHOU Feng for helping with the data and case collection. Any remaining errors are the author's responsibility alone.

2

1. Introduction A central thesis in the law and economics literature is that law matters for economic and

market development. According to this thesis, the existence of a legal system that

protects contract and property rights is a precondition for economic development because,

without such a system, the lack of certainty about who will stand to benefit from

otherwise beneficial transactions and/or investments will simply inhibit such transactions;

Or, if they occur, the costs of doing so will be unacceptably high (North 1990).1 Thus,

absent of such a legal order, markets cannot develop and economic growth will stall.

Recently, a sequence of provocative research by La Porta, Lopez de Salines, Shleifer and

Vishny (1997, 1998) (LLSV hereafter) has shifted the focus of the "law matters" debate

to capital market development issues. Using a large database of various institutional and

economic variables for a cross section of countries, LLSV show that the degree of

protection a country's substantive law provides for outside shareholders/security-holders

has a significant bearing on the depth and liquidity of its capital markets: stronger legal

protection for minority shareholders is associated with deeper and more liquid capital

markets and with less concentrated share ownership. 2 In effect, they argue that deep

capital markets cannot be developed unless shareholder-friendly fundamental legal

reforms are adopted as a precondition.

A consensus in the literature is that law clearly matters for market development,

especially after a market reaches certain mature stage. Market-friendly law is a desirable

good. But, how does a country get to that point? How does legal change arise to prepare

for sustained growth? ---- While not questioning the correlation between capital market

depth and legal protection for shareholder rights, Coffee (2001) offers the opposite

interpretation of the above correlation: market development precedes, rather than follows,

shareholder-friendly legal reforms. His argument is based on the historical fact that

1 See Clarke (2003) for a discussion of the "property rights matter" thesis based on recent experience in China. 2 See Shleifer and Vishny (1997) for a comprehensive survey, and Ohnesorge (2003 this issue) for discussions on how this literature may benefit from the recent experience of China. The "Law matters" thesis for securities market development has prompted much new research and debate in law and economics. Responses and hypotheses from the law literature include Black (2001), Cheffins (2001), and Coffee (2001).

3

"Although securities exchanges have existed since the seventeenth century, exchanges

primarily traded debt securities up until the mid-nineteenth century. Then, over a

relatively brief period and at a time when the private benefits of control were

unquestionably high, dispersed ownership arose in both the United States and the United

Kingdom - largely in the absence of strong legal protections for minority shareholders,

which came afterward." Coffee further comments that "this sequence makes obvious

political sense: Legal reforms are enacted at the behest of a motivated constituency that

will be protected (or at least perceives that it will be protected) by the proposed reforms.

Hence, the constituency (here, dispersed public shareholders) must first arise before it can

become an effective lobbying force and an instrument of legal change."

Two questions then come to mind. First, how does such a constituency arise in a market

growth process? Second, which types of market or economic activity are more conducive

to legal development? In a broad sense, since there are different markets (e.g., securities

markets, consumer product markets, labor markets) and since all these markets may be

simultaneously developing in a country, it may be true that not all of them lead to the

creation of equally powerful constituencies. If that is the case, which types of market tend

to create constituencies that are the most effective in causing legal change? Clearly, the

answer will differ from country to country, depending on a country’s own pre-existing

context. If there are general characteristics about the types of economic activity that are

the most conducive to legal change, understanding them will help shed new light on the

interactive dynamics between law and economic development.

The purpose of this paper is two-fold. First, we show that Coffee's (2001) "crash-then-

law" interpretation of both the above mentioned correlation (between law and finance)

and the capital market history in the United States and the United Kingdom is largely

consistent with the on-going reform experience in China.3 For young markets, it is

economic development that precedes legal change, rather than the other way around.

Unlike Russia and other East European countries that took a shock-therapy approach to

3 See Boycko, Shleifer and Vishny (1997) for discussions on transition and legal adaptation experience in Russia.

4

economic transition, from 1978 onward China has adopted a gradual trial-and-error

approach to transform its planned economy into a market-oriented one, starting with the

agricultural sector. After its success with reforming the agricultural sector in the early

1980’s, China began to re-structure its state-owned industrial enterprises into joint-stock

corporations, and first opened the Shanghai Stock Exchange in December 1990 by letting

several former state-owned firms go public. While the Chinese stock market has helped

former state-owned enterprises raise capital from the public, its impact on legal change

has perhaps been even more significant. The experience is one of true “crash-then-law”.

Second, we compare the different contributions to legal change made by the stock market

and the consumer product markets. In economic terms, the impact of China’s stock

market on the real economy and society as a whole has been marginal, with about 10

million investors, whereas the various consumer product markets have been large in a

country with more than 1.2 billion people. That is, while the stock market may have

directly affected only a small fraction of the population and a small percentage of

Chinese businesses, the consumer product markets have affected much larger proportions

of the population. Thus, the constituency of citizens arising from stock market

development should be much smaller in number than the constituencies arising from

consumer product markets. Yet, the former has been a much stronger force for legal

change . Why is it so?

2. China’s Legal Tradition

A distinctive feature of China's legal tradition is that the legal system is not separated

from, or independent of, the administrative system (e.g, Jones (2003) for an excellent

overview). At least since the Tang dynasty (618-906 A.D.) and until the end of Qing in

1911, the system of government in China consisted of a strong central government

headed by the Emperor, who ruled through a bureaucracy and with absolute power. The

lowest ranking officials at the county level represented the central government and in

effect exercised all of the power of the state, including tax collection, public works, and

even deciding lawsuit cases. Thus, adjudication was simply one of the many

5

administrative duties. Since there was no doctrine of the separation of power among

government institutions, the county magistrate's power was virtually unchecked except

that the subjects could technically appeal to a higher level official.

Another distinctive feature is its emphasis on administrative and criminal sanctions, with

a lack of formal development in civil liability and procedural law. The traditional Chinese

view, even as of today, is that the law is an instrument used by the ruler to enforce its

power and authoritative control and to maintain social order. Consequently, as the central

part of the Qing Dynasty's legal system, for example, the Qing Code was a collection of

rules that were predominantly concerned with the official activities and functions of the

bureaucrats within the government apparatus, not with disputes and relationships between

and among private citizens. The imperial law touched upon private matters only as the

matters were thought to affect imperial policies. Thus, the code was primarily of an

administrative nature, and it tended to rely only on administrative and criminal penalties.

This is in sharp contrast with the Roman law tradition, from which western laws are

derived. At the heart of Roman law is civil law, rather than administrative law. Roman

law arose during a time when Rome was a small agricultural society. As a result, the law

developed mostly in response to the occurrence of disputes between private citizens

and/or social groups. Therefore, early on, civil matters occupied a central place in

western laws. As Jones commented, "In China, the subject matter of Roman civil law was

considered only when it affected the interests of the Emperor." (Jones, 2003, p. 13).

Today's legal system in China is not much changed from the dynastic era. The law is still

viewed as an instrument of the ruling class; The judicial system is still treated as part of

the government's administrative system and hence there is no effective judicial

independence; Politics and adjudication are often mixed together; There is still no

officially adopted doctrine of the separation of power. Today's legal system probably

differs from those in the different dynasties, mainly in that after the mid 1980's and as

part of the reform efforts, there have been many newly enacted substantive laws

(particularly in the areas of commercial and civil law) and even a Civil Procedure Law of

1991. That is, there are many more “laws on the books” today than in the various

6

dynasties. However, as discussed later, the existence of these substantive and procedure

laws has not fundamentally altered or neutralized the two dominant characteristics of the

legal system mentioned above. Many judges are not trained lawyers, and even a large

number of them, especially in less developed provinces, are former military officers who

had no formal legal training prior to being a judge. Still, since 1978, a substantial legal

framework has been put in place, with institutions that together resemble a western legal

infrastructure (except there is a Communist Party political-legal committee that is super-

imposed on the legal system, controlling the assignment, promotion, demotion and

replacement of judges). It is issues and conflicts arising out of the economic reform

process that have played the critical role of pushing the legal infrastructure to work and

adapt. The economic development process has generated an increasingly larger force for

judicial independence. The on-going case of China is a vivid example of how the “crash-

then-law” process works. We next show that it is the stock market and private securities

litigation that have been central in injecting life into the "laws on the books."

3. Stock Market and Legal Development

Economic reform started in 1978, soon after the end of the disastrous Cultural Revolution.

However, until the mid 1980’s the focus of the reform efforts was on the agricultural

sector, allowing farmers to have a piece of land to grow grain crops and retain whatever

profits the farmer was able to generate. However, no one was given or allocated the

ownership of any land property, and the farmers were just given the usage right for a

short period of time (land usage right was re-shuffled among villagers every few years).

The main objective was to encourage family-based farming and individual responsibility

(rather than collective farming as practiced before the reform started). There was then a

large increase in income and living standard among farmers.

The success in agriculture then started to affect the debate on how to reform the industrial

sector where state ownership was by far dominant. The first experiment in the mid 1980’s

was to apply the individual-responsibility model of farming to industrial enterprises. That

is, an individual manager or a team of managers could assume the responsibility of a

7

state-owned enterprise (SOE) for several years, with an annual revenue or profit target;

Profits above the target would be paid to management and workers as bonus. This

responsibility model did not work out, since it promoted mostly short-term behavior by

management. It was then realized that without clearly defined ownership, there would not

be an incentive structure to induce managers to take a long-term view.4 In the late 1980’s,

therefore, joint-stock limited-liability corporations became the new experiment, with

some SOEs converted into joint-share corporations.

3.1. The Stock Market

Preparation was then also under way to start an official stock exchange to trade shares of

the new joint-stock companies. But, private ownership and privatization was political

taboo. In particular, no one would want to be responsible for causing the loss of state

assets. As a political compromise, the reformers proposed to have several classes of

shares: state shares, legal-person shares (only ownable by legal-person institutions and

corporations), and floating common shares (A-shares for domestic citizens only and B-

shares for foreign investors only). In particular, the state shares and legal-person shares

would not be publicly tradable, so that no loss of state ownership would occur. However,

regardless of share type, the holder of a share is entitled to the same cashflow and voting

rights. Today, a typical public corporation has about one third of its shares in each

category of state, legal-person and floating common shares.5 Given that most legal-

persons or corporations are state-owned or state-controlled, about two thirds of most

corporations’ shares are state-controlled directly or indirectly. This ownership structure

has been a major factor behind the difficulties in private securities litigation, because

4 In some sense, state ownership represents an extreme form of diverse ownership as each citizen in the country is supposed to own an equal piece of the firm. Thus, the separation between ownership and control is also extreme. But, there has been no corporate governance structure in place to ensure the functioning of this extreme separation. Since the state controls the management of each SOE and since the government is not democratically elected, there is no institutional infrastructure to ensure that the agents at the various levels all work in the best interest of the ultimate shareholders -- the citizens. Therefore, it is not surprising that the management responsibility model did not work. 5 See Chen and Xiong (2001) for a study on the underpricing structure of legal-person shares. They show that because these shares are not tradable, they are priced at an average discount of 86% to the otherwise identical floating common A-shares. This pricing and liquidity distortion is also a source for corporate governance problems.

8

granting damage awards in private litigation would amount to the loss of state assets (to

the extent that the state owns a majority of the shares outstanding), which puts the court

in a conflicted situation.

Besides the state-dominated ownership structure, another obstacle blocking private

securities litigation is ideological. The traditional communist view was that only income

through labor is rightly acceptable. Though the Shanghai Stock Exchange opened in

December 1990 (followed by the Shenzhen Stock Exchange two months later), this

official line on rightful income remained in the Communist Party charter until November

2002, when the 16th Party Congress changed the charter to officially acknowledge that

acceptable income can be earned through both labor and capital (i.e., monetary capital,

intellectual capital and managerial capital). Therefore, until late last year, Communist

Party members were officially not supposed to buy or trade stocks; Otherwise, any

income from holding stocks would not be legitimate. This ideology was of course

contrary to the notion of shareholder rights and the protection thereof, which has been

partly responsible for the slow implementation of the Securities Law and the Company

Law of the People's Republic of China (PRC). It has been an obstacle between law on the

books and law in action. The question is again: what led to the removal of this obstacle

last year? How did China eventually move the law off the books and into action, at least

to some extent?

To answer these, we should keep in mind that the very justification for starting a stock

market in China was to help the SOEs raise capital from the general public and solve the

money-losing SOEs’ financial problems, and that it was not to offer the general public a

way to diversify investment portfolios and hedge future consumption/income risks.6 Thus,

shareholder rights were more of an afterthought, which became a concern several years

after stock trading became widespread. One practice that was followed from 1990 to

2000 was that the government adopted a quota system on the number of IPOs for each

6 Walter and Howie (2003) argue extensively that the Chinese government’s determined interest has really been, and will continue to be, to use the equity capital markets as a tool

9

year, so that there would be a planned and orderly sequence of IPOs with no supply

shocks. This idea and practice of a planned growth path have been so much at the heart of

the Chinese modernization process over the past 150 years that it is almost impossible to

do away with (e.g., Goetzmann and Koll, 2002; Kirby, 1995). Another consideration for

the planning was to make the IPO flow low enough, so that IPO prices would be high,

creating an impression of unbeatable IPO demand and setting a perfect environment for

more SOEs to issue shares. In other words, the first task of the government agencies in

charge was to manage and maintain a positive and encouraging market.

At the beginning of each year, the national IPO quota was approximately equally divided

among the 32 provinces and province-level cities. Table 1 shows the number of IPOs for

each year to lie between 13 and 206, with an average of 100 new listed companies per

year. This implies that in a typical year each province would get a quota of about 3 IPOs.

This limited supply of IPO permits clearly made the value of each such permit very high,

and created a huge opportunity for rent-seeking and bribing. Consequently, each

provincial government set up a dedicated Securities Listing Office to both lobby the

China Securities Regulatory Commission (CSRC) for a higher quota and to assist local

firms to prepare for IPO.

For provincial and lower governments, how many local firms they can have publicly

listed has become a major metric of performance, on which future promotion of local

government officials depends. As a result, provincial and lower-level officials are all the

more willing to help local firms manipulate financial numbers or commit un-masked

fraud, all for the purpose of getting more local stocks traded nationally. Or, when local

firms are caught by the media for committing financial fraud or earnings manipulation,

local governments and sometimes even higher government agencies would cover up the

fraud.

of enterprise reform, while other by-products of the capital markets have been more of a side purpose.

10

Both of the central government’s bias in helping the SOEs and the local government’s

desire for political performance have not helped to give much weight to shareholders’

interest. From the very beginning, the PRC stock market was biased against shareholders.

Even after a company successfully obtained an IPO permit (usually as a result of much

lobbying and/or bribing efforts), the process of preparing and filing for IPO could easily

take more than two years (true even as of today). The first period in the long IPO process

is the so called “ShangShi FuDao Qi” (the pre-IPO “nurturing” period). This nurturing

period is literally to strip a money-losing SOE into two pieces: the “good” piece (to be

IPOed) and the “bad” piece (to be the controlling shareholder after the IPO of the “good”

piece). This is sometimes the period of creating fake receipts and fake contracts to make

up whatever profits that are needed to meet the IPO requirements. For example, the PRC

Company Law requires a candidate IPO firm to have positive earnings in each of the

most recent three years. Additional CSRC regulations further require the firm to satisfy

conditions on return-on-equity (ROE), before an IPO approval can be granted. These

requirements have forced firms to manipulate earnings and financial results.

After an IPO, the firm again has to satisfy profitability requirements in order to issue

seasoned equity offerings (SEO). For example, over the years, the minimum condition for

an SEO as set by CSRC regulations has gone through various changes: the firm's ROE

had to be (1) positive in the most recent two years, a policy as of 1993; (2) above 10%

based on the recent three years' average, as of 1994; (3) above 10% in each of the recent

three years, as of 1996; (4) above 10% based on the recent three years' average, but at

least 6% for each of the recent three years, as of 1999; (5) above 6% based on some

weighted average for the recent three years, as of 2001. These four policy changes have

each time caused publicly traded firms to adapt their accounting manipulation schemes.

In one study, Lang and Wang (2002) find that for each year before 1994, strangely many

public firms had their ROE just slightly above 0%; Then, between 1994 and 1999, more

than half of the public firms had an ROE lying slightly above 10% but below 12%; But,

from 2000 onward (in particular since 2001), most of the firms had an ROE between 6%

11

and 8%. Their study presents perhaps the strongest evidence of market-wide earnings

manipulation, implying that investors have been systematically defrauded.

Another common practice by Chinese public companies is "tunneling", as defined in a

different context by Johnson , La Porta , Lopez de Silanes and Shleifer (2000). That is,

controlling or majority shareholders engage in related-party transactions with the listed

firm, usually with the latter buying worthless assets from the former at unreasonably high

prices or with the latter lending to the former at favorable rates. As the Chinese magazine

New Fortune has reported, tunneling of shareholder assets is widespread and has led to

calls for regulation and tighter enforcement by the CSRC.7

Given these systematic problems mentioned above, the Chinese stock market still

managed to become the third largest one in Asia based on market capitalization (after

Japan and Hong Kong). As of July 2003, the Shanghai Stock Exchange and the Shenzhen

Stock Exchange together have 1259 companies listed (A and B shares included). The

combined total market capitalization of the companies is over 4 trillion yuan (about $500

billion),8 and trading is active with a monthly turnover rate of 18.2%. About 20% of the

1259 companies are private firms, without the state being the controlling shareholder.

By no means is China's stock market well developed yet. But it does show signs of life.

Table 1 shows the total amount of capital raised in each year. In Table 2, we see that the

amount of capital raised on China’s stock market is, when measured as a fraction of GDP,

lower than the U.S. market but higher than Japan’s and Germany’s, in the 1990’s. It

should be recognized that this period marked the beginning of China’s stock market

(hence one would expect some level of exuberance).

7 See Clarke (2003 this issue). Featured articles on corporate governance issues (in Chinese) can be found at New Fortune's website: http://www.newfortune.net.cn. 8 The exact market capitalization value for all listed companies combined is a mystery because the state and legal-person shares are not publicly traded and hence no reliable price information can be used to value them. The 4 trillion yuan given here is based on the official estimate published on the CSRC website, in which they simply multiply the total number of shares outstanding by the floating A-share price. From Chen and Xiong (2001), it is clear that this is an over estimate of the true value, because the legal-person and state shares are sold in private transfer and auction transactions, at an average discount of 86% relative to the floating A-shares. See also Walter and Howie (2003) for another discussion on this market capitalization issue of China's listed firms.

12

The above brief review of the development background illustrates that in the 1990’s and

even today there is not enough ideological acceptance of private ownership and stock

trading, neither is there sufficient protection of property rights. Especially in the early

years, China did not have a legal infrastructure to support capital market development.

However, consistent with the "crash-then-law" hypothesis of Coffee (2001), China started

out without a clear idea of what institutional framework would be needed for a stock

market, but as investors increased in number, a powerful constituency was developing,

which led to a sequence of legal development.9

3.2. The Years Prior to the Securities Law of 1999

China’s stock market was started top-down, with the CSRC and other government

agencies controlling every step of the way in both the overall market development and

the process of a firm’s pre-IPO preparation as well as post-IPO operations. The stock

exchanges are state-owned and managed by government-appointed officials, while the

securities firms are state-owned (or majority-controlled) either directly or indirectly.

Since the beginning of the market, it has been a well known secret that every public

company had been “nurtured financially” and re-packaged just for the sake of IPO, with

widespread practice of making up the numbers so as to meet the listing requirements.

Even with so much known accounting fraud and open market manipulation, private

securities litigation did not arise in significance until 2001 after a sequence of events.

Though the Shanghai Stock Exchange started in late 1990, suing management and

directors and/or other parties for damages was not much on investors’ mind until after a

sustained market downturn started in the middle of 1993. As Figure 1 shows, over the

first year and a half the Shanghai Stock Exchange Composite Index (hereafter SSE

Composite) went straight up from 100 in 1990 to 1266 by May 21, 1992. In particular,

the index went from 617 to 1266 in a single day on May 21, 1992. It was then followed

13

by five months of decline. But, that decline did not last long enough to get a substantial

number of investors to call for private litigation against corporate manipulators. In late

1992, the government stepped in to encourage stock trading, re-starting an upward

movement.

In the early 1990’s, even if any investor had wanted to sue for damages, the court would

not have accepted such lawsuits. The only law that shareholders would be able to rely on

up until July 1, 1994 was the PRC General Principles of Civil Law, which provides that

victims of torts are entitled to civil compensation. However, the PRC judiciary had little

experience with tort law in general and securities law in particular, which remains true

today. Legal training was all but stopped during the Cultural Revolution, and then

restarted around 1980.

Furthermore, the legal system is modeled after the Japanese civil-law system, which in

turn was adapted from German law during the Meiji reform period of the 19th century. An

overwhelming theme of Chinese law is that “wei jin pizhun bu ke”, that is, without a

formal written rule from the law or from a legal interpretation by the Supreme People’s

Court (SPC), judges cannot on their own interpret and apply a legal principle to decide

specific cases. Given that at the time when the PRC General Principles of Civil Law was

enacted in 1986 there was not a stock market, it is not surprising that the general PRC

Civil Law did not include securities related provisions until revisions in the late 1990’s.

In principle, before judges can accept any new type of private suit, in general the

National People’s Congress has to first pass a law for the specific area and then the SPC

has to issue one or more detailed legal interpretations. This process can last for five years

or longer.

Nonetheless, while there was no securities law until July 1, 1999, administrative

regulations were introduced to fill in the gap. The Provisional Rules on Stock Issuance

9 See Hutchens (2003) for an excellent account and analysis of the development history of private securities litigation in China. He summarizes the various factors (positive and negative) that have each contributed to

14

and Trading of 1993 issued by the CSRC proscribed various miscreant practices and

provided for civil compensation for those who were financially injured as a result

(Hutchens, 2003). But, the court was not ready for private securities litigation, and hence

these administrative provisions would not amount to anything for private investors.

Penalties based on the Provisional Rules of 1993 could only be enforced either

administratively by the CSRC, or through criminal litigation by the Public Security

Department. The following are three representative cases of this nature:10

1. The first administrative case on insider trading was announced on January 28,

1994, in which the violator, the Shanghai securities brokerage division of the

XiangFan Trust and Investment Company (a subsidiary of the Agricultural Bank

of China), was fined by the CSRC. The violator was accused of (1) insider trading

and market manipulation and (2) trading stocks using customer account capital.

The brokerage division was ordered to turn in all the trading profits of 16,711,808

yuan (about $2 million), and pay a fine of 2 million yuan (about $240,000) . The

brokerage firm was also suspended from trading for two months. But, in this case,

no manager or any other individual was personally fined or penalized in any way.

Still, this case marked the first attempt to enforce rules on the stock market.

2. The first administrative case against false disclosure and misleading statements in

connection with securities trading was decided on June 7, 1996. In this case, the

named violators were the DaMing Group (a listed company of ShengLi YouTian),

and the underwriter firm, accounting and auditing firm, and law firm that each

provided service to facilitate the IPO of the DaMing Group. The CSRC’s charge

included misrepresentation of the listed company’s outstanding share structure,

omitting material facts, and false statements in its IPO Prospectus. The

administrative penalty included a fine of 2 million yuan for the listed company

and a warning to its board of directors. The named underwriter firm, accounting

firm and law firm were respectively fined 400,000, 200,000, and 100,000 yuan.

legal development in a country whose tradition has de-emphasized civil law. 10 For details of these and other administrative cases, visit the CSRC website: http://www.csrc.gov.cn. Under the leadership of CSRC Chairman ZHOU Xiaochuan, particular efforts were made to improve market and administrative transparency. Part of the efforts was to make the CSRC website more informative and accessible to the public.

15

Again, no individual manager or other person was fined or named in the

administrative action.

3. In December 1999, the Prosecutory Office of Chengdu City formerly filed a

criminal action against the chairman and key executives of HongGuang Enterprise

(a listed company) for accounting fraud. On November 26, 1998, the company

was fined, while its directors and executives were warned, in an administrative

action by the CSRC. The company was found to have overstated its 1996 and

1997 earnings respectively by 157 million and 31.52 million yuan. On December

14, 2000, the court ruled against the defendants in the criminal case.

These and other administrative and criminal sanctions were taking place at an accelerated

pace after 1995. It was happening against the following background. When the Shanghai

Stock Exchange opened in December 1990, there were 45,000 individual stock accounts

and most of the investors were Shanghai locals. As the stock market went unstoppably

higher in 1991 and 1992, the easy money generated much excitement and attracted more

and more individuals into the market. Hertz (1998) gives a sociological account of the

China stock trading phenomenon. Occasional encouraging and possibly misleading

editorials by the People’s Daily (the central government’s mouthpiece) and remarks by

top leaders have also played a significant role in mobilizing the public to buy stocks,

which tends to serve the government’s purpose of helping the financially distressed state-

owned enterprises well.

By the end of 1999, there were 44 million stock accounts (this number went up to over 70

million by April 2003).11 As noted above, the wave of administrative actions against

violators of securities rules started in early 1996, which coincided with the last phase of

the 3-year long bear market that began in mid 1993. During this unprecedented, long bear

11 The number of investors is vastly different from the number of stock accounts. First, the same investor has to have one account with the Shanghai Stock Exchange and one with the Shenzhen Stock Exchange, if he or she is to trade stocks listed on both exchanges. These two accounts of the same investor are counted as two, implying the70 million accounts must be divided at least by two. Second, investors often own multiple accounts to hide their identity by opening accounts using borrowed ID cards from others. This is a common practice especially among market manipulators, who have to hide their trades to evade regulators' attention. Some believe a realistic number of investors is more like 10 million or less. See Walter and Howie (2003) for more discussion.

16

market, many individual investors were stuck with losses, and these losses motivated

them to seek ways of recovery. The investors were joined by professional and academic

commentators to call for better enforcement of market rules and ultimately for a “better”

market. This wave of public pressure then forced the CSRC to take more aggressive

administrative actions in 1996 and onward. Thus, it is the first bear market, together with

the fast-growing investor constituency, that led to significant public enforcement (“crash

then administrative enforcement”).

However, from the administrative penalties, the public learned that first of all, managers

and intermediaries responsible for misleading or cheating investors were actually not

fined personally (but only given a verbal warning). It is usually the listed companies that

were fined. That is, the shareholders, not the responsible violators, ultimately were

paying the fines. Secondly, shareholders who suffered losses were not given any piece of

the administrative fines (the fines went to the Ministry of Treasury). Thirdly, as in the

later securities criminal cases, defendants may have been jailed, but that again did not

help injured investors recover any financial loss.

Unable to benefit from administrative or criminal sanctions, investors and the more

general public all learned about the limitations of the traditional emphasis on

administrative and criminal penalties by the Chinese legal system. In a major sense,

investors care more about recovering loss than about whether a violator is fined

administratively or jailed. Thus, the public debate on private securities litigation started to

gain momentum. Fortunately, in a country with a generally restricted press, the financial

media (including print, internet and TV) has enjoyed increasingly more freedom, so

investors, professionals and academics can openly discuss shareholder rights and civil

litigation issues. The common economic interest led to the informal formation of a

significant constituency, though for political reasons the government forbids any formal

shareholder organization.

The Company Law of 1994 does provide ambiguous support for certain shareholder

rights, including the right to seek compensation for damages due to financial fraud,

17

misleading statements, market manipulation and so on. But, for the reasons mentioned

above (e.g., the lack of operational guidance or legal interpretation from the SPC), the

court refused to accept private securities litigation until years later.

In April 1999, a shareholder in Shanghai filed a civil suit against HongGuang Enterprise

for financial damages due to the defendant’s accounting fraud (see the description of the

first criminal case discussed above). But, for many months, the Shanghai court gave no

answer as to whether the case would be accepted. Then, in early 2000, the court decided

not to take on the case.

3.3. Where is the Crash?

On December 29, 1998, the National People’s Congress passed the PRC Securities Law

and the Law became effective on July 1, 1999. Together with the Company Law of 1994,

this marked the completion of the “laws-on-the-books” concerning corporation formation,

public offering and securities trading in China. However, this does not mean that injured

investors could rush to court to file lawsuits for damage recovery or to force a

corporation's board and/or management to take shareholder-interest-maximizing

measures.

The PRC Securities Law became effective in the midst of a stock-market bull run that

started in January 1999 and ended in June 2001 (when the SSE Composite Index reached

a peak of 2218). During that period, accounting fraud, market manipulation and insider

trading were rampant. The CSRC took 92 administrative actions against perpetrators

(including 104 corporate entities and 270 individuals).12 The media also reported on fraud

cases. But, the bull market made the new formal law almost unnoticed for two years

(most investors were probably busy counting profits).

Within the first two years after the PRC Securities Law became effective, investors made

few attempts (if any) to seek damage recovery through litigation, and the judiciary was

12 Visit the CSRC website for data on administrative actions: http://www.csrc.gov.cn.

18

not in any hurry to prepare for the enforcement of the Securities Law. The Supreme

People's Court was not working to draft a legal interpretation or procedural rules for the

new law. When many investors were profiting from the bull run and only some investors

were suffering losses from fraud, the pressure for fast legal change could not be too high.

There had to be a crash (or, a sustained period of decline).

Then, several key events occurred. On April 23, 2001, the CSRC announced a major

administrative penalty against four fund management firms in GuangDong, fining them a

total of 400 million yuan (about $50 million) in addition to ordering them to return the

same amount of illegal profits. The cause for action was that from October 1998 to

February 2001, the four firms engaged in manipulating the stock price of, and publishing

false statements concerning, Yorkpoint Science & Technology Corp. The chairman of

Yorkpoint, his relatives and key managers were all behind the manipulation scheme and

held stakes in the defendant firms.13

In the July 2001 issue, Caijing magazine's cover story featured a detailed account of the

fraud scheme of Yorkpoint’s stock. In the immediate August issue, Caijing published an

extensive investigative report on another high-profile corporation, YinGuangXia

Enterprise.14 It was found that from 1998 to 2001, YinGuangXia fabricated sales receipts

(with hundreds of millions worth of exports to Germany) and lied to the market about

various production facilities that actually never existed. The total amount of faked sales

was over 1 billion yuan (about $120 mllion), which resulted in a non-existent profit of

770 million yuan. This scandal was a shock to not only the investor community but also

the larger society in general. Many expected to see accounting fraud of a lesser nature,

but not so egregious. The YinGuangXia scandal was dubbed the "Enron of China". -----

These stories came out just as the stock market was suffering a major downturn from the

June high of 2218 for the SSE Composite Index to around 1700 by the end of September

(see Figure 1).

13 The fines are yet to be collected. Judicial decisions in civil cases and administrative fines are often hard to enforce, another reality in China that is waiting for reform.

19

These events provided the needed crash for legal change. Disappointed investors started

to demonstrate in front of the CSRC building. Key officials from the CSRC initiated

meetings with the Supreme People's Court, urging the court to assume a more significant

role in regulating securities markets through adjudicating cases. However, a typical

Chinese official (whether in a bureaucratic position or in a judicial position) always

thinks in terms of administrative territories. In this case, matters related to stock trading

were considered to be the sole responsibility of the CSRC, not that of the judicial system.

Thus, even after the CSRC's efforts to convince the court of its role, the judiciary showed

much reluctance to join in.15

On September 20, 2001, investors filed suits against the company and management of

Yorkpoint Science & Technology, simultaneously in the No. 1 Intermediate Court of

Beijing, the Intermediate Court of Guangzhou, and the Intermediate Court of Shanghai.

Some investors in Jiangsu province were preparing to do so as well. Lawyers were also

filing paperwork in different courts to sue the management and directors of YinGuangXia

Enterprise and other responsible parties.

In the mean time, newspapers and TV were full of stories of angry investors, with articles

detailing legal rules and remedies concerning securities litigation. A wave of lawsuits

was in formation, which challenged the Supreme People's Court and the entire PRC

judicial system. To the Communist Party, this appeared to be too dangerous politically.

3.4. The Temporary Ban on Private Securities Litigation

On September 21, 2001, the Supreme People's Court issued a notice directing all lower

courts temporarily NOT to accept private securities lawsuits. Just as a private litigation

storm was about to begin, such an announcement was a shock to everyone with a stake in

the market or concerned about capital markets and legal development in China. It

14 See Caijing's website for current and past articles: www.caijing.com.cn. 15 Private conversations with participants in these discussions between the CSRC and the Supreme People’s Court suggest that senior officials from the Court were blaming the CSRC for all the securities trading

20

prompted an immediate outcry from various professions and interest groups. It fueled

much further heated debate on not just market development, but also the rule of law in

general and judicial roles in particular. That notice put the Supreme People's Court on the

spotlight. In retrospect, private securities litigation had provided China's court system

with the best chance to gain political standing and respect in the larger Chinese society.

But, the highest court squandered the chance.

From several interviews given by the then Vice President of the Supreme People's Court,

Mr. LI Guoguang, it became clear that the Court had the following concerns. First, as

suits were filed against the same defendants and for the same cause but by different

plaintiffs and in different lower courts, it became possible that there would be different

rulings, the occurrence of which would jeopardize the reputation and credibility of the

legal system. In the history of the PRC, there had never been such an instance in which

numerous plaintiffs would simultaneously file separate lawsuits in different provinces but

against the same defendants and for the exact same cause. How should the court system

respond to this possible crisis? Could there be chaos, both legal and political? Second, if

financially injured investors would each file an individual suit, the entire court system

would be more than overwhelmed with securities litigation. Are there efficient ways to

handle such mass litigation? Third, given the lack of prior experience in this area, the

lower court judges had no uniform standards yet with regard to who has a standing to sue,

what type of evidence is required, how damages are calculated, and so on. Finally, if

there would be numerous lawsuits against all these listed firms and if the private plaintiffs

would be awarded rightfully deserved relieves, it would lead to major losses of state

assets (since the listed companies are mostly state-controlled). In such civil litigation, the

defendant’s interest is in fact the state’s interest. This is precisely where plaintiff’s rights

and state interest collide. Is there a compromise between the two? How can there be

judicial independence? ----- These questions and reasons were sufficient to cause the

Court to pause.

related troubles and that the judiciary did not want to get involved. Protection of shareholder rights was not exactly the first thing on the Court’s priority list.

21

The extensive debate and analyses by legal experts in the mass media following the

notice served as one of the best legal education opportunities for the public. It was during

this period that even individuals with no legal training learned about what "class action"

litigation means, why class action may be the best mechanism for securities litigation,16

why there should be more emphasis on civil liability than administrative or criminal

liability, who should bear the burden of proof in securities litigation, why the court

should accept private action suits, and so on. As a result, a large number of investors and

readers can now comment on “class action” and the “burden of proof”. Observing these

developments from a “crash-then-law” perspective, one can see how a legal culture is

developed in such a process.

3.5. Partially Lifting the Ban

On January 15, 2002, the Supreme People's Court issued a second notice dictating that

lower courts may accept private securities litigation based on false disclosure and

material misrepresentation, subject to the condition that administrative penalty has been

imposed on the alleged fraud. However, the ban remains in place for private litigation

based on other types of claim, such as insider trading and market manipulation.

While the second notice did open the door for private securities litigation in a limited way,

the required pre-condition of an existing enabling government action was troubling and

led to a new round of debate (hence a new opportunity to develop the legal culture). The

requirement was against the principle of judicial independence, which the PRC

Constitution guarantees, and it substantially compromised shareholder rights. It was also

a fundamental re-write of the PRC Securities Law. The Supreme People’s Court’s

justification was that the lower courts have no prior evidence-discovery experience

related to securities litigation and that the pre-condition is a transitional convenience.

16 Chen (2002) provides a detailed argument for class action litigation in China, and a review of the U.S. experience in securities class action litigation.

22

Nonetheless, within a week and on January 24, three investors went ahead to file separate

suits in Harbin against DaQing LianYi, a listed company, and its management for false

disclosure and accounting fraud. Soon afterwards, 767 other investors sued the same

defendants for the same claim. Since class action litigation is forbidden by the second

notice, these separate cases had to be resolved individually.17 The Intermediate Court of

Harbin conducted individual case hearings for two months from August to October 2002,

but managed to go through only 94 out of the 770 suits.

In 2002, nine other listed companies and their respective management members, directors

and other responsible parties were sued in nine different courts. Among them,

YinGuangXia was named as a defendant in 1100 individual suits, again all for the same

cause of accounting fraud.

After the lower courts accepted this wave of lawsuits and in some cases held court

hearings in 2002, none of the cases has yet been resolved by a judicial decision even to

the date of this writing (several have been settled outside of court). The reason this time

was again that more detailed procedural and substantive rules are needed concerning who

has the standing to sue, how damages are to be determined (e.g., adjusting for systematic

risk or not?), and so on.

This led to the issuance of the PRC Private Securities Litigation Rules (hereafter, PSL

Rules) by the Supreme People’s Court on January 9, 2003. The PSL Rules is the most

detailed legal interpretation yet of the PRC Securities Law (with 37 articles), and it is a

result of extensive consultation with legal and finance experts and scholars. This new

interpretation still limits private securities litigation to false disclosure causes (no private

action is accepted on insider trading or market manipulation grounds), and it still

17 The lawyer, Mr. GUO Feng, representing 696 shareholders against DaQing LianYi was insisting on group litigation for his clients, not individual litigation. His negotiation with the Intermediate Court of Harbin lasted for almost the entire year 2002, with the stand that he would not give in unless the court accepted group litigation. His insistence and continuing efforts between the Harbin Intermediate Court and the Supreme People's Court played a crucial role in moving private securities litigation forward. As Hutchens (2003) observes, entrepreneural lawyers have made a significant contribution in Chinese legal reform. While Mr. GUO insisted on group litigation, lawyers representing the other 94 plaintiffs agreed to individual litigation, which is why the Harbin court held hearings from August to October 2002.

23

requires enabling government action as a pre-condition for the court to accept a private

suit, except that now the condition can be met by either an administrative penalty or a

criminal court ruling. New restrictions are added as well. Among other things, Article 9

states that all PSL lawsuits must be filed with the intermediate court of the jurisdiction in

which the listed firm is headquartered. The official justification for this rule is judicial

convenience (e.g., easier for evidence investigation). This restriction is inconsistent with

the PRC Civil Litigation Procedure Law, which gives the plaintiff a choice of jurisdiction

between the plaintiff's local court and the defendant's. As noted earlier, local

governments have a strong incentive to protect listed companies from their jurisdiction,

implying lower courts will be biased to favor local defendants . Thus, this restriction

comes at the expense of shareholder rights and in favor of fraudulent listed firms. It also

exposes another characteristic of the PRC legal system: judicial convenience takes

precedence over plaintiff rights.

Overall, the new rules provide lower courts with specific operational instructions for

handling false disclosure claims.18 The PSL Rules generated new excitement early this

year, and made disappointed investors more hopeful of a loss recovery. But, so far no

court ruling has been decided on any of the 2000 or so pending cases, an indication

perhaps of the lower courts waiting for further clarification and instructions from the

Supreme People's Court on certain unclear rules.

It has been more than four years since the PRC Securities Law became effective. While

much progress has been made, China’s judicial system is still struggling with the

implementation details. The distance between the “law on the books” and the law in

practice is thus not short.19 This is particularly true in countries that follow the

continental civil-law tradition of top-down law-making. The PRC experience further

proves the advantage of common-law systems in which judges at all levels are given

substantial law-making power.

18 See Hutchens (2003) for an in-depth overview and analysis of the PSL Rules and its impact on securities litigation and legal institutions in China.

24

4. Private Product Liability Litigation

In contrast, private litigation in the area of consumer product liability has not been at the

forefront of legal change in recent years. Several laws and judicial interpretation form

the formal basis for civil litigation on product liability:

1. The PRC General Principles of Civil Law of 1986 provides for civil compensation

for damages due to product defects (Articles 122, 130, 131, 132 and 136).

2. The judicial interpretation notice issued by the Supreme People’s Court on

January 26, 1988 outlines operational details for lower courts to adjudicate private

product-liability suits.

3. The PRC Civil Litigation Procedure Law of 1991 gives further procedural details

(Article 72).

4. The PRC Product Quality Law of 1993 and the PRC Consumer Rights Protection

Law of 1993 are the principal area laws concerning product liability.

The two area laws passed in 1993 were largely in response to rampant selling of defective,

fake and counterfeiting consumer products in the late 1980’s and early 1990’s. However,

that legislative response fell into the “rule by law” category, as they have become more of

a rule book for administrative and criminal sanctions. The private litigation experience

based on the product liability laws has been quite limited. Compared to private securities

litigation which has made much progress in the last two years, private litigation on

product liability still lacks momentum.

The PRC government has a quality inspection and control department or center for each

type of consumer product, such as Computer Quality Inspection Center, and

Pharmaceutical Product Quality and Regulatory Agency. These administrative

departments and agencies have served as the primary public enforcer of the PRC Product

Quality Law. They often run political-movement-like campaigns to crack down on

19 Based on a sample of transitional economies, Pistor (2000) argues that transplanting laws from another country usually does not succeed. A country's pre-existing institutional infrastructure may need to change

25

defective, poor-quality and counterfeiting products, by confiscating and burning them.

The first such campaign was launched by the State Council in 1992. Over the next ten

years, the total amount of confiscated products was worth over 30 billion yuan.

From www.Lawyee.com, one of the largest legal case databases in China, the earliest

private product-liability case that we can find took place in 1989, in which a community

department store (GongXiao She) in Baotou City of Inner Mongolia sued a refrigerator

supplier in the same city. The cause for action was that when an employee at the

plainstiff’s store opened a refrigerator sold by the defendant in 1988, the employee was

electrified through the refrigerator handle and killed. The refrigerator was then inspected

and found to be defective by the City’s Product Standards Bureau. The local court then

found the defendant to be liable and ordered the latter to (i) refund the 7900 yuan

purchase price, (ii) pay a total of 13987 yuan (about $1500) for the surviving dependents

of the killed employee, and (iii) pay for other losses and expenses of 5400 yuan.

There have been other sporadic private litigation cases based on product defects, but most

of them have not attracted much attention. From www.Lawyee.com, we were able to

collect 80 private product-liability cases (43 of them were consumer-product cases, 7

cases involved a product that caused death, and 32 cases involved bodily damage to

product users). Out of this sample, 59 cases ended with the plaintiff winning. The largest

damage award granted by the judge was 1.08 million yuan (about $130,000), and the

average damage award was 127,395 yuan ($15,000). The damage awards typically

included three components: compensation for direct damage, punitive damage, and

litigation expenses incurred to the plaintiff. These damage awards are clearly nowhere

comparable to those typically awarded for product liability in U.S. courts.

Among the few cases that have received much media attention are the multiple lawsuits

against Toshiba, a Japanese multinational firm. In October 1999, Toshiba accepted a $2.1

billion settlement in a class action filed against Toshiba (U.S.A.) in a Texas district

substantially for a transplanted substantive law to work.

26

court.20 The complaint was that even after NEC announced and advertised a defect in its

floppy disk micro-controller back in 1989, Toshiba knowingly continued to use it in its

laptop product line. The defective disk drive caused data loss for two users. The plaintiff

class included half a million impacted users. After this settlement in the U.S., Toshiba

never informed any of its customers of this defect in China and it continued to sell

computers with this defect there.

On May 8, 2000, someone in China accidentally learned about the 7-month-old Toshiba

settlement on the internet and published a story in Chinese, which prompted an angry

reaction from numerous consumers. Internet message boards and print media were full of

nationalistic and emotional comments. A stage was set for active debate among legal and

law experts. On May 25, the first joint action against Toshiba was filed in Beijing by 9

Toshiba users.21 On August 15, three individuals filed another suit against Toshiba in

Shanghai. ----- No news about the outcome of these suits is known even today, perhaps

because that debate had too much nationalistic flavor and the government had to keep the

court ruling quiet.

To show how little progress has been made on consumer rights in China, note a famous

1999 libel case, Hengsheng Computer v. Wang Hong et al. In August1997, Mr. WANG

Hong bought a laptop computer made by Hengsheng Computer, and later found the

laptop to keep shutting off on a regular basis. Within the warranty period and on June 1,

1998, Mr. Wang took the laptop back to the computer store where he made the purchase.

But, he was denied any service. After several failed attempts and in late June, Mr. Wang

decided to post an angry comment on an internet bulletin board, and filed a complaint

with the government-sponsored Consumer Rights Association of Beijing. No progress

was made in obtaining repair service after almost two months. Next, Mr. Wang posted

20 See Robertson (1999) for a report on this settlement. 21 Note that in consumer product-liability litigation, plaintiffs could use the joint-action litigation device in May 2000, whereas even today the Supreme People’s Court does not allow for this device in private securities litigation. In product-liability litigation, the likelihood of a major domestic political crisis is considered low. In contrast, the PRC government has been much more concerned about the political-risk prospects of allowing class action suits in securities litigation. See Lawrence (2002).

27

more comments on the internet. Two newspapers, Microcomputer World Weekly and Life

Time, reported on this story respectively on August 10 and July 27.

In April 1999, Hengsheng Computer filed a lawsuit against Mr. WANG Hong and the

two newspapers for libel damage. The lower court ruled that the defendants were liable

for injuring the plaintiff’s reputation, and ordered Mr. Wang to pay damages of 0.5

million yuan ($52,000, 25 times Mr. Wang’s annual income) and each of the two

newspapers to pay 0.25 million yuan to the plaintiff. Upon appeal, in December 2000, the

Beijing No. 2 Intermediate Court reduced the damage award against Mr. Wang to 90,000

yuan (about 4.5 times his annual income).

The court’s decisions in that libel case illustrate just how far the legal culture for

consumer rights has to go. Mr. Wang was trying to get a promised warranty service. His

internet postings were an effort to call upon other consumers to boycott the

manufacturer’s products. Yet, for doing that, he is still paying for the libel judgment.

5. Comparing Product-Liability and Securities Litigation

An intriguing research question is: why has private securities litigation led to much legal

development whereas product-liability issues have not? What characteristics distinguish

the two areas? In real impact terms, the stock market affects a relatively small fraction of

the population (10 million in a 1.2 billion population), while consumer products touch

upon the daily lives of the entire society. Thus, consumer rights should be relatively more

important to both the economy and society. But, as hypothesized in this paper, the stock

market has been more powerful when it comes to the ability to drive legal change.

We can speculate to offer the following points. First, commonality is what characterizes

the investor constituency. In securities fraud, all affected shareholders are injured by the

common fraudulent act, at the same time and in the same location. Damage causality is

easy to establish, especially since there is typically no role played by the shareholders in

causing the damages. In contrast, there are diverse types of consumer products. Even with

28

respect to the same product type, say, Toshiba computers, damages to users may occur at

different times and in different locations. This fact alone creates a weaker sense of

commonality among injured consumers. While it is sometimes technically possible to

trace all the damages back to the same defect, a defense often used by producers and

distributors is that the consumer did not use the product properly and that it was the

consumer’s fault. Product-liability cases require plaintiff-specific proof of causality.

Second, damages are easily and immediately measurable in securities trading. To

measure stock investment losses, you do not require additional information beyond price

declines. Furthermore, financial loss is the only type of damage to be concerned with in

securities cases. In contrast, damages to consumers due to product defects are often hard

to measure and intangible. Such damages can be as grave as death, and they can also be

quite subjective and difficult to measure financially. This measurement difficulty and the

intangibility of damages make the formation of constituency much harder to achieve.

Finally, these two characteristics - commonality and immediate measurability of loss –

also render securities litigation and shareholder rights an ideal topic for the media to

report and debate on. The daily realization of stock trading gains and losses is a feature

that is largely responsible for making the stock market a persistently popular topic at

social occasions and other places. In contrast, not many consumer products (if any) are

perpetually popular topics. Thus, the media’s attention on stock market trading is also a

major factor in the easier formation of a politically powerful investor constituency.

6. Conclusions

The debate on whether law matters for economic and market development has been going

on for decades, especially since the work by Max Weber and Friedrich von Hayek. In

recent years, commentators have pointed to China's recent growth experience, especially

in comparison with India which has a far better institutional infrastructure, to suggest that

29

law does not matter for growth and market development.22 These comments are

implicitly based on the "law-then-growth" thesis. However, a closer look at the PRC

experience shows that for young markets, it is probably more like "crash-then-law" or

"growth-then-law", a thesis argued by Coffee (2001). The initial phase of development

(in both the economy and markets) is necessary both for a constituency to be formed and

to set the stage for “crashes” or problems. Legal change will then follow. Legal reform is

necessary in the second phase to prepare a country for further, more mature economic

growth. Thus, a legal order may not be a pre-condition for initial market development,

but a pre-condition for more mature development.

Bear markets are often necessary for legal change, as happened in the U.S. of the early

1930’s. Each of the two major downturns of China's stock market (1993-1996 and 2001

to the present, as shown in Figure 1) led to a significant change. The first downturn

generated pressure for the CSRC to take more aggressive administrative actions against

violators, while the second set the stage to push for private securities litigation.

Another lesson from the PRC experience is that different types of economic activity

present different pressure levels for legal change. Capital markets are perhaps the most

conducive to the formation of a politically powerful constituency and hence dramatic

legal change, because of (1) the higher degree of commonality among interested parties

and (2) immediately measurable and tangible damages. These two characteristics of

capital markets not only allow investors to identify with each other more easily, but also

create an ideal basis for more debate in the public media and other places, which in turn

promotes the development of a legal culture. Anecdotal evidence indicates that there is

probably more media coverage of legal issues in China today than in other countries.

Private securities litigation has challenged the traditional Chinese view that law is a tool

used by the ruling class to rule. It has also challenged the traditional focus on substantive

law rather than procedural law.

22 See Thakur (2003) for a growth comparison between India and China, and Kristof (2003) for a comparison between Russia, Ukraine and China.

30

References Black, Bernard S., 2001, "The Legal and Institutional Preconditions for Strong Securities Markets," UCLA Law Review 48, April 2001. Boycko, Maxim, Andrei Shleifer and Robert Vishny, 1997, Privatizing Russia, MIT Press. Cheffins , Brian R., 2001, "Does Law Matter? The Separation of Ownership and Control in the United Kingdom," The Journal of Legal Studies 30, June 2001. Chen, Zhiwu, 2002, “The Use of Securities Class Action Litigation in the United States” (Zhengquan jituan susong zai Meiguo de yingyong), SECURITIES LAW REVIEW (ZHENGQUAN FALU PINGLUN) 2, PP. 260-294. Chen, Zhiwu and Peng Xiong, 2001, “Discounts for Illiquid Stocks: Evidence from China,” Yale School of Management. Clarke, Donald C., 2003 (this issue), "Corporate Governance in China: an Overview," China Economic Review, this issue. Clarke, Donald C., 2003. "Economic Development and the Rights Hypothesis: the China Problem," forthcoming in the American Journal of Comparative Law. Coffee, John C., Jr., 2001, "The Rise of Dispersed Ownership: The Roles of Law and the State in the Separation of Ownership and Control," Yale Law Journal 111, October 2001. Goetzmann, William and Elisabeth Koll, 2002, “The History of Corporate Ownership in China.” Working paper, Yale School of Management and Case Western University. Hertz, Ellen, 1998, The Trading Crowd : An Ethnography of the Shanghai Stock Market, Cambridge University Press. Hutchens, Walter, 2003, "Private Securities Litigation in China: Materials Disclosure about China's Legal System," forthcoming in the Pennsylvania Journal of International Economic Law. Johnson , Simon, Rafael La Porta , Florencio Lopez de Silanes and Andrei Shleifer, 2000, "Tunneling," American Economic Review Papers & Proceedings 90 , May 2000. Jones, William C., 2003, "Trying to understand the current Chinese legal system," in C. Stephen Hsu, ed., Understanding China's Legal System: Essays in Honor of Jerome A. Cohen, 2003, New York University Press.

31

Kirby, William, 1995, "China Unincoprorated: Company law and business enterprise in twentieth century China," Journal of Asian Studies 54, 43-63. KRISTOF, NICHOLAS D., 2003, "Freedom's in 2nd Place?" The New York Times, Aug. 29, 2003. La Porta, Rafael, Florence Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny, 1997, "Legal Determinants of External Finance," Journal of Finance 52, July 1997, pp. 1131-1150. La Porta, Rafael, Florence Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny, 1998, "Law and Finance," Journal of Political Economy 106, December 1998, pp. 1113-1155. Lang, Larry and WANG Jiangwei, 2002, "Optimal Earnings Manipulation (XunZao ZuiShiDan ZaoJia LiRunLi)", New Fortune (Xin CaiFu, Chinese magazine), October issue of 2002. Lawrence, Susan V., 2002, “Shareholder Lawsuits: Ally of the People: A lawyer campaigns for minority-shareholder lawsuits against Chinese listed companies and wins a partial victory, but political sensitivities mean class-action suits are still barred,” Far Eastern Economic Review, May 9, 2002. North, Douglas, 1990, Institutions, Institutional Change and Economic Performance, Cambridge University Press. Ohnesorge, John K.M., 2003 (this issue), "China' Economic Transition and the New Legal Origins Literature," China Economic Review, this issue. Pistor, Katharina, 2000, “Patterns of Legal Change: Shareholder and Creditor Rights in Transition Economies,” European Business Organization and Law Review 59. Robertson, Jack, 1999, “Toshiba's $2 billion settlement confounds the industry,” Silicon Strategies, November 08, 1999. (http://www.siliconstrategies.com/story/OEG19991108S0007) Shleifer, Andrei and Robert W. Vishny, 1997, "A Survey of Corporate Governance ,"

The Journal of Finance 52, June 1997, pp. 737-783.

Thakur, Ramesh, 2003, " China is outperforming India", International Herald Tribune, Jan. 7, 2003. Walter, Carl E., and Fraser J.T. Howie, Privatizing China : The Stock Markets and their Role in Corporate Reform, John Wiley & Sons.

32

Table 1: IPO Listings and Capital Raising on China’s Stock Market Data used in this table are graciously provided by www.SinoFin.com.cn.

33

Table 2: Raising Capital through the Stock Market Across Countries

Note: The total amount of capital raised includes both IPO and seasoned equity offerings on the stock market. The ratio reported below is the total capital raised divided by the country’s GDP in the same year.

China US Japan Germany France

1991 0.02% 0.23% 1992 0.36% 0.90% 0.06% 1993 0.91% 1.64% 0.16% 0.11% 1994 0.30% 1.64% 0.08% 0.03% 0.18% 1995 0.20% 1.08% 0.20% 0.27% 0.29% 1996 0.50% 1.26% 0.54% 0.56% 1.94% 1997 1.25% 1.72% 0.27% 0.29% 0.08% 1998 1.02% 2.35% 0.74% 2.74% 0.88% 1999 1.09% 1.34% 0.93% 1.04% 0.85% 2000 1.72% 2.03% 0.90% 1.44% 1.44% 2001 1.20% 2.33% 0.49% 0.29% 1.56% 2002 0.94% 1.26% 0.34% 0.20% 0.85%

Average 0.79% 1.60% 0.47% 0.61% 0.90%

Std Deviation 0.65% 0.25% 0.13% 0.02% 0.47%

34

Figure 1: History of Shanghai Stock Exchange Composite Index

Each major turn marked a government policy intervention

0

500

1000

1500

2000

2500

1990

-12

1991

-07

1992

-02

1992

-09

1993

-04

1993

-11

1994

-06

1995

-01

1995

-08

1996

-03

1996

-10

1997

-05

1997

-12

1998

-07

1999

-02

1999

-09

2000

-04

2000

-11

2001

-06

2002

-01

2002

-08

2003

-03

Data source: www.SinoFin.com.cn