(This article was first published on China Law & Practice 2020 Annual Review, authorised reprint)

The Judicial Interpretation of Representative Litigations separates representative litigation into ordinary representative litigation and special representative litigation. Ordinary representative litigation covers litigation directly filed by investors or those that are triggered by investor registration organized by courts, which are respectively stipulated in the first and second paragraphs of Article 95 of the revised Securities Law.

The first paragraph of Article 95 provides that “when an investor files a securities civil compensation lawsuit pertaining to misrepresentation etc., if the litigation subject matter is the same type and there are multiple persons in one party, a representative may be appointed for the lawsuit pursuant to the law.” Moreover, according to the rules issued by the SPC, a court should apply procedures for ordinary representative litigation when: (1) the number of claimants is more than 10; (2) two to five proposed representatives are identified in the complaint; (3) and the claimants submit prima facie evidence proving facts of the securities infringement. With the development of the investor protection legal services industry, one investor protection lawyer may represent hundreds of investors. Therefore, investor protection lawyers usually take the initiative to begin ordinary representative litigation.

The second paragraph of Article 95 stipulates that “in a lawsuit filed pursuant to the provisions of the preceding paragraph, where there may be many other investors who have the same litigation request, the people’s court may make an announcement, state the information of the case of the said litigation request, and notify the investors to register with the people’s court within a certain period. The judgment or ruling of the people’s court is binding on the investors who participate in the registration.”

Generally, in registration announcements issued by courts, the following information may be included: (1) the punishment made by regulatory authorities against listed companies on misrepresentations; (2) the scope of rights holders who satisfy all requirements of registration, and such requirements may include the restriction on the date of buying shares, and the restriction on selling or continuing to hold the shares after a certain date; and (3) the method and period of investor registration, including registration address, website, information, mailing address, and contact number, etc.

The third paragraph of Article 95 of the revised Securities Law provides for the rules of special representative litigation, and states “an investor protection organization entrusted by more than 50 investors may participate in the lawsuit as a representative, and register with a people’s court pursuant to the provisions of the preceding paragraph for rights holders who are confirmed by a  securities registration and settlement organization, except where the investors clearly state that they are unwilling to participate in the lawsuit.”

According to this rule, two investor protection funds set up by China Securities Regulatory Commission (CSRC) can recruit 50 investors and then obtain information of all investors who meet the requirements of the claim from the China Securities Depository and Clearing Co., Ltd. The number of qualified investors may reach tens of thousands or even hundreds of thousands. The court will then issue an announcement of all qualified investors’ information. Investor protection organizations can file lawsuits on investors’ behalf by default even without the investors’ express consent or authorization, unless the investors explicitly opt out of litigation. That is to say, the principle is that “an investor waives his/her rights only if he/she clearly states so, otherwise his/her silence will be regarded as a consent to participate in a lawsuit".

Securities fraud litigation is categorized as a type of professional litigation. Investors often entrust professional investor protection lawyers to participate in litigation on their behalf and pay corresponding attorney fees.

If courts apply procedures for ordinary representative litigation and issue registration announcements, investors only need to participate in the registration as required. Investors may get a free ride from the representative and the representative’s lawyer without appointing their own lawyers in follow-up procedures, and enjoy the fruits of litigation. Also, the courts may decide on the amount of compensation in accordance with a legally effective judgment, even though the investor did not directly participate in the registration.

According to the special representative litigations rules, besides the 50 recruited investors, other investors are not required to expressly authorize investor protection organizations to represent them and all they need to do is wait to receive compensation from listed companies. Therefore, investors not only save on attorney fees, but they can also avoid litigation costs caused by lengthy judicial proceedings.

The enactment of special representative litigation is a burdensome topic for listed companies. In the case of special representative litigation filed by investor protection organizations, the number of claimants may increase exponentially. Up to December 2020, the highest amount claimed in ordinary securities fraud litigations of a listed company was between Rmb400 to 600 million. Under the special representative litigation rules, the total amount of claims may increase by 5-12 times, resulting in a claim scale of more than one billion or even in the billions.

Although the CSRC Investor Protection Bureau and two investor protection organizations set up by it established the principle that case selection should consider various factors such as solvency, social influence, and malice, there is still a dilemma in practice when cases are selected. Generally, cases with severe malice and great social influence will be cases that have serious financial fraud issues. Therefore, listed companies are likely to start delisting procedures and bankruptcy proceedings after they are subjected to punishment, which may result in listed companies not being able to pay compensation to investors. Even if listed companies are able to take on compensation responsibilities, the compensation paid in securities/fraud litigation will significantly reduce the companies’ net assets, which will affect the interests of existing shareholders (including small and medium investors), existing creditors, and all of its employees.

In addition to listed companies, there are also difficulties in claims against other potentially responsible entities: (1) when such claim is made against a relevant responsible natural person, investors generally face difficulties when enforcing judgments; and (2) when such a claim is made against a responsible intermediary, a problem that arises is although a securities company has a good economic capability, most intermediaries, such as auditing agencies and evaluation agencies, have limited debt-paying ability (generally no more than the amount of insurance compensation).

Article 32 of Judicial Interpretation of Representative Litigations provides that “where the people’s court has issued an announcement of registration of rights, the investor protection agency may participate in litigation as a representative under the special authorization of more than 50 rights holders during the period of announcement.” Based on this rule, in such a progressive mode, only if courts issue registration announcements can investor protection organizations initiate special representative litigation. The issuance of registration announcements by local courts has become fundamental for investor protection organizations to decide whether to initiate special representative litigations. The activation of China's first Securities Class Action case also indicated the establishment of cooperation mechanism between the CSRC and judicial system in Securities Class Action cases.

The cause for investors’ losses is complex. In addition to information disclosure violations, the cause may also include risks associated with the capital market as a whole, and other operational risks of the specific listed company. The qualification of the influence of each factor has always been an extremely difficult issue both academically and in practice. Recently, the Shanghai Financial Court jointly cooperated with Shanghai Jiao Tong University to accurately measure the specific loss of each investor influenced by listed companies’ information disclosure violations by using financial analysis methods (a multi-factor model and event-study analysis). However, such methods have not been popularized in other districts due to the complexities and difficulties in understanding how they are applied.

With the application of the special representative litigations rules, the number of claims will increase exponentially and put listed companies and other entities under huge pressure for compensation claims, which may affect their production and operations. Therefore, courts need to find a balance between the interests and protection of both investors and listed companies. This requires the courts to determine the loss amount more accurately and scientifically. Otherwise, there may be a situation where investors will receive a judgment in their favor, but the listed companies are already insolvent.

The special representative litigation mechanism has just been published, and there has not yet to be a case initiating the special representative litigation. The rules are still in their developmental stage and their future application will no doubt encounter countless obstacles and bumps. It is hoped that after continuous trials and revisions, the interests of both investors and listed companies can be equally protected, and the long-term stable development of China’s capital market can be maintained.