ABSTRACT
For a collective asset management scheme established by an employee stock ownership plan (ESOP) for the participants of the ESOP and outside unitholders, if evidence shows that the price risk of the relevant stock is ultimately borne by the ESOP participants who have prior knowledge of a misrepresentation that would affect the stock price, and the other unitholders have invested in the scheme in reliance of credit enhancement measures rather than the misrepresented information, then no transaction causation should be seen to exist between the scheme’s investment decisions and the misrepresentation.
FACTS
In April 2015, Zhong X A Co., Ltd. (“ZXA Company”), a publicly listed company, established an ESOP with a fundraising cap of RMB 50 million. After creating it, the company entrusted plaintiff Guo X Securities Co., Ltd. (“GX Securities”) to set up and manage a collective asset management scheme, whose primary investment scope was to purchase and hold ZXA Company shares. The ESOP had 15 participants, all of whom were officers or principals of ZXA Company’s subsidiary and affiliates thereof. Among them, Zhou X and Wu XX were respectively the legal representative and chief financial officer of Zhong X B Technology Co., Ltd. (“ZXB Company”). Zhou X, Wu XX, and Fu X were members of the ESOP management committee and exercised shareholder rights on behalf of all participants. Zhou X and Wu XX were also the major capital contributors to the ESOP. The ESOP stipulated that ZXA Company shares would be purchased within six months after the company’s shareholders’ meeting approved the plan.
In May 2015, the Guo X No. 1 Collective Asset Management Scheme (“Scheme”) was established with a size of RMB 300 million. The Scheme was a structured product administered by plaintiff Guo X Securities. The initial allotment ratio of Class A, Class B, and Class C Units of the Scheme was approximately 9:1:2. Class A and Class B Units were entitled to fixed income, while Class C Units, held exclusively by the ESOP, were entitled to all residual assets and returns after deducting the principal and expected returns of Class A and Class B Units as well as expenses such as the management fees and custody fees. Class C Units and Shenzhen Zhong X Investment Co., Ltd. (“SZZX Investment”) assumed compensatory obligation for the fixed income of Class A and Class B Units. The administrator was solely responsible for managing and operating the Scheme pursuant to the methods, conditions, requirements, and restrictions agreed in both the Scheme and the ESOP.
After its establishment, the Scheme purchased ZXA Company shares within the timeframe specified in the ESOP. Subsequently, the Scheme triggered the warning or stop-loss threshold on multiple occasions, prompting SZZX Investment to make five additional capital contributions to the Scheme between April 2016 and May 2017.
In May 2017 when the Scheme again crossed the stop-loss level and the fifth recapitalization was not made in full, the plaintiff sent a notice of default to both the ESOP and SZZX Investment on behalf of the Scheme, then liquidated all the ZXA Company shares it held.
In 2017, the plaintiff filed a lawsuit with the Sichuan High People’s Court against SZZX Investment to claim the unpaid principal and expected returns of the Scheme’s Class A and Class B Units, which was supported by an effective judgment.
Prior to the trial of this case, effective judgments rendered in a series of securities misrepresentation cases against ZXA Company and other defendants had made the following determination: ZXA Company had received administrative penalties from the China Securities Regulatory Commission (CSRC) for misrepresentation and should be ordered to pay restitution to investors. ZXB Company, as the subject company of a major asset restructuring deal, met the definition for “other parties with disclosure obligations,” and should therefore be jointly and severally liable for compensating investors. SZZX Investment, as the controlling shareholder of ZXB Company, should have full knowledge of the latter’s operations, and should therefore also be jointly and severally liable for the civil liabilities incurred by ZXA Company’s misrepresentation. Zhou X and Wu XX, then serving respectively as ZXB Company’s legal representative and chief financial officer, received administrative penalties from the CSRC for misrepresentation but were not ordered to pay compensation.
HOLDING
On June 16, 2023, the Shanghai Financial Court issued civil judgment (2022) Hu 74 Min Chu No. 2613 which denied all claims of plaintiff Guo X Securities. Guo X Securities then appealed to the Shanghai High People’s Court, which upheld the original judgment in (2023) Hu Min Zhong No. 591 on March 18, 2024.
REASONING
The Shanghai Financial Court (“Court”) noted that the key issue in this case was whether transaction causation existed between the Scheme’s investment decision and misrepresentation by the relevant companies and individuals. Article 12 of the Rules of the Supreme People’s Court on Trial of Civil Compensation Cases Arising from Misrepresentation in the Securities Market (“Provisions”) provides that if a defendant produces evidence showing an investor’s decision was not induced by the alleged misrepresentation, then transaction causation is deemed non-existent. In this case, the defendants’ evidence and the circumstances of the case were sufficient to reach this conclusion.
First, the creation of the Scheme and its purchase of ZXA Company shares were both stipulated in the ESOP. The Scheme was created to implement the ESOP. Its purchase of ZXA Company shares was executed pursuant to predetermined arrangements under the ESOP and the subsequent Asset Management Agreement between the parties, rather than as a return-driven investment in the securities market in reliance of the listed company’s disclosures.
Second, the ESOP participants should have known about the securities misrepresentation. The 15 Class C Unit holders were officers and principals of ZXB Company (the subject company of a major asset restructuring deal) and its affiliates including ZXA Company. Both ZXA Company and ZXB Company received administrative penalties for misrepresentation; Zhou X (then legal representative) and Wu XX (then chief financial officer) of ZXB Company were likewise penalized for their direct involvement in the act. Notably, Zhou and Wu were the major funders of the ESOP and held two of the three seats of its management committee which exercised shareholder rights on behalf of the ESOP participants.
Third, Class A and B Unit holders invested in the Scheme in reliance of Class C Unit holders’ and SZZX Investment’s joint and several guarantee of returns. What the Class A and B Unit holders sought was fixed income, which would remain unaffected by misrepresentation-induced stock price movements had the Class C Unit holders and SZZX Investment fulfilled their joint and several compensatory obligations as agreed. Furnished evidence showed that when the misrepresentation was exposed on December 24, 2016, the plaintiff did not terminate the Scheme even as the investment lock-up period had expired, only to immediately send the default notice and an announcement of terminating the Scheme (whose term of existence had then expired) in May 2017, when Class C Unit holders and SZZX Investment failed to recapitalize the Scheme in full and on time as agreed. The fact that Class A and B Unit holders cited the unfulfillment of this joint and several compensatory obligation as the reason for terminating the Scheme, also proved that they had participated in the Scheme in reliance of such guarantee.
In conclusion, the Scheme was created, and traded ZXA Company shares, in accordance with the terms of the ESOP. During its creation and trading, Zhou X and Wu XX, both Class C Unit holders, had been administratively penalized for misrepresentation, and the other 13 Class C Unit holders were also officers or principals of ZXB Company, which made the misrepresentation, and its affiliates. Therefore, all Class C Unit holders should have prior knowledge of the misrepresentation. Furthermore, Class A and B Unit holders invested in the Scheme in reliance of the joint and several compensatory obligations of Class C Unit holders and SZZX Investment. Thus, stock trades made by the Scheme fell under Article 12(5) of the Provisions, defeating the transaction causation in this case.
SIGNIFICANCE
As China’s first securities misrepresentation case involving an ESOP-based collective asset management scheme, this case addressed how to determine the existence of transaction causation between an institutional investor’s investment decision and a relevant securities misrepresentation. The judgment clarified that presumed reliance applies equally to institutional and individual investors in determining transaction causation in securities misrepresentation cases. But this presumption is also rebuttable: where evidence shows that institutional investors have based their decisions primarily on factors other than the misrepresented information, transaction causation should be seen as no longer existent. This judgment will facilitate the trial of similar cases in the future.
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