Teething issues for the Stock Connect are long and varied but top of the list has been the one around beneficial ownership, which has hampered participation in the trading link’s northbound pathway by foreign funds in China’s A-share market.
“Under the Stock Connect’s trading mechanism, the Shanghai-listed shares are held in a separate account controlled by the Hong Kong Securities Clearing Co (HKSCC) on behalf of investors,” said Qiumei Yang, CEO of ICI Global Asia Pacific, a trade body for the fund management industry.
“This raises concerns about the ambiguity of share ownership since the securities were neither HKSCC’s assets nor owned by the investors. In other words, foreign investors are concerned about whether they have any proprietary rights to or beneficial ownership of the China shares under the Chinese law.”
This lack of certainty was particularly worrying for European Union-domiciled Ucits funds because they are required to have proprietary ownership over the underlying asset.
But the latest FAQ by the China Securities Regulatory Commission makes it clear that investors are now legally entitled to the rights and benefits of their shares in Shanghai, with the rules giving them the ability to exercise their rights over those shares through the HKSCC as the nominee holder.
“If we use a rough analogy of buying a house, the HKSCC is akin to the party that holds the title to the house, even though it is not the beneficial owner,” said Vivian Lam, a partner in law firm Paul Hastings' corporate department in Hong Kong.
“In the case of the Stock Connect, the one who holds the title to the house is HKSCC on behalf of the beneficial owner. With the FAQ, the rights of the beneficial owner and the distinction between him and the nominee is abundantly clear.”
Legal precedent
The FAQ, said Lam, resolves two issues that have been the main bugbear for institutions wanting to jump on the northbound pathway of the Through Train: proprietary interest and the right to enforce.
The CSRC will now recognise an investor’s rights as a beneficial owner provided HKSCC can show proof that he indeed owns shares, and with that the investor can take legal action in his own name in a Mainland court.
However, because there is no legal precedent for enforcing the rights of an offshore investor this way in the Chinese legal system, those who try to do so may discover later that there are unforeseen hurdles in the system that could make this a long-drawn out process, say lawyers.
China does not have a common law system like Hong Kong, which means the difference between beneficial and registered ownership is not expressly recognised by Chinese law, said Lam.
“The Hong Kong Exchange has been on the ball with trying to clear up the fogginess around the regulatory framework by proactively issuing FAQs, but it has its work cut out for it,” she added. “While the laws are clear on the Hong Kong side, they are less so on the Mainland.”
The Stock Connect has come a long way from its early days, when the southbound track — meant for mainland investors to put money into Hong Kong shares — was dubbed the “Ghost Train” for its meagre trading volumes.
Today that has been turned completely on its head. At the end of March the trading link saw record southbound trading, as purchases of H-shares reached HK$5.6bn ($720m) after the CSRC gave local mutual funds the green light to buy shares through the Stock Connect.
And with share prices hitting feverish levels in Hong Kong, a frenzy of block trades ensued, and market participants now believe this elevated interest is a new normal. That exuberance has propelled investors into some of the city’s biggest IPOs this year, including GF Securities and now HTSC.
But the regulators shouldn’t stop here as more detailed procedural guidelines are still needed on practical matters such as taxes on dividends and in corporate exercises like tender offers and rights issues, said Jeffrey Mak, a Hong Kong partner at law firm DLA Piper.
Hong Kong Investment Funds Association CEO Sally Wong also points out that with the China Securities Law going through national-level amendments, the concept of nominee and beneficial ownership will likely be incorporated at a high level, which would give even greater clarity to international investors.
Southbound in focus
Industry executives now expect the regulators to move on to the next stage of the game — the Shenzhen link. Chinese media have speculated that the technical systems could be ready in June before it launches in September.
When the Shenzhen connect is up and running small caps on both sides will be in focus, but more so in Hong Kong as a tide of mainland money is waiting to come in, said an equity strategist who looks at Hong Kong shares.
“There is a huge gap between Hong Kong small caps, which are trading at 35x-40x P/E, versus 110x P/E for the ChiNext,” he said. “Foreigners may think Hong Kong small caps are expensive, but Chinese retail investors don’t care because they have so much money sitting around.”
This means trading on the southbound channel of the Shenzhen link, once it comes to fruition, is likely to trump whatever happens northbound.
“The creation of these trading links is supposed to push local liquidity offshore, because the domestic bubble is difficult to contain,” the strategist said.