The South China Morning Post is reporting that the combined quota under the qualified foreign institutional investors (QFII) scheme, through which overseas funds can buy China’s A-shares, will be doubled to US$300 billion effective immediately. The quota scheme is an alternative to the Stock Connect, which we have previously discussed.
I am here at The Harvard Club discussing what plan fiduciaries should consider when evaluating potential exposure to China A-shares. Some of the key issues I am outlining are:
1 – Indicia of ownership issues, particularly for non-US managers (ERISA plans)
2-Prudence considerations in light of foreign investor restrictions (e.g., forced sales) and language barriers when examining public disclosures (ERISA and governmental plans)
3 – Adherence to plan documents, including, but not limited to, the plan’s ESG policies (if any) (ERISA and governmental plans)
4- Fiduciaries should remember that A-shares are traded in renminbi (ERISA and governmental plans)
Wellington Management provides some interesting insights on the ascendancy of China A-Shares and how investors should be thinking about them. Fiduciaries may wish to consider my detailed ERISA analysis on the Shanghai-Hong Kong Stock Connect.
Section 404(b) of ERISA provides that a fiduciary may not maintain the indicia of ownership of plan assets outside the jurisdiction of the U.S. district courts. But, clearly, investments in non-U.S. securities may be entirely reasonable and prudent for an ERISA plan’s participants and beneficiaries. The DOL’s regulation (29 CFR 2550.404b-1) sought to both ensure the U.S. district courts’ jurisdictional arm reached plan assets while expressly recognizing and preserving the importance of international investments, particularly for diversification purposes.
Fiduciaries have three decision-making points.
- Are the proposed investments qualifying assets (e.g., securities issued by a company that is neither organized in the United States nor has its place of business in the United States) under the DOL regulation?
- What are, in fact, the indicia of ownership of the international investments?
- Which pathway is the fiduciary taking to ensure that it complies with Section 404(b) of ERISA?
It is often not a straightforward decision as to what exactly are the plan’s indicia of ownership of particular non-U.S. investments. The most classic example would be stock and bond certificates. But in other types of investments, such as privately offered securities, subscription documents and limited partnership agreements may be enough. Still in other cases, trade confirmations or account statements may be the best indicia of the plan’s ownership in the investment. There is, unfortunately, not always a simple answer to what exactly are the indicia of ownership of a particular investment.
There are essentially four pathways for the fiduciary to satisfy its duties under Section 404(b) of ERISA under the DOL regulation, each of which are subject to myriad conditions. The first and most common method is where the fiduciary that has management and control over (i.e., decision-making authority to purchase, hold or dispose of) the non-U.S. plan assets is a U.S. bank, insurance company or investment adviser. A second pathway is where the indicia of ownership are maintained in a global custodial relationship. However, one key condition is that the U.S. bank-custodian needs to be liable to the plan as if it retained physical possession over the indicia of ownership in the U.S. Yet a third pathway is where the indicia of ownership are maintained by a broker-dealer registered under the Exchange Act and in the custody of a “satisfactory control location,” as defined under U.S. securities laws. The fourth and final pathway is where a US. Bank or broker-dealer registered under the Exchange Act physically possesses the indicia of ownership.
ERISA fiduciaries should consider the requirements under Section 404(b) as they apply to international investments. From a practical standpoint, investment managers, when negotiating their investment management agreements, should be on the lookout for attempts to impose upon them the duty to ensure compliance with Section 404(b) of ERISA, rather than the plan’s custodian, which may be the more appropriate party.
As its government continues to make progress on capital-market reforms, and with fiduciaries having wider access to and confidence in the markets, few would argue that President Xi Jinping’s measures to attract foreign investment have not paid off. There are concerns, however, related to uncertainty regarding the potential fallout from a possible trade war, an economic slowdown that has been worse than expected and the pressure on companies related to their massive debt obligations. In response, Beijing has introduced moderate policy easing and chosen to soften its stance on deleveraging. This is in sharp contrast to the US Fed which has advocated monetary tightening and, in turn, a rising rate environment. Given the changing liquidity environment, along with the risk of capital controls, how can investors reevaluate and recalibrate their China exposures and strategy to take advantage of these trends? This esteemed panel of China investment vets will use their insight and experience, along with a bit of tea-leaf reading, to provide a GPS for investing in China. One that will get an investor from point A to point B directly, free of any unnecessary or hazardous detours. Issues to be explored will include:
- What are the political and macroeconomic risks that investors can expect in the near and longer term?
- What is on the horizon for debt and equity markets in China and how does this impact the rest of the global economy, both emerging and developed?
- What are the potential outcomes and where do the opportunities for institutional investors lie?
- What risks could arise and how can one anticipate/hedge against?
- What does accessibility require, how should it be approached and what is different about investing in China?
We’ve been following developments re. China A Shares, as investment managers continue to ask about the fiduciary implications of entering this market.