INTRODUCTION

The Chinese Finger Trap is deceptively simple: A small round tube, with openings on both ends inviting the index fingers. However, fingers inserted into the trap become stuck, and no amount of pulling will release them. The inner workings of this device, including its solution, have confounded thinkers for centuries.

Like the Finger Trap, many international business transactions may appear simple at the first glance. Once one engages in them, however, it becomes apparent that there is more to them than meets the eye. Their complexity readily becomes apparent, and the rules of the transaction are elusive. The focus of this paper is one such transaction: an American bank investing in a Chinese bank[1]

In a developing country, the health of the financial institutions is crucial to the stability of the overall economy.[2] One of the ways developing countries seek to insure the health of their financial institutions is through the investment of capital and expertise from developed countries.[3] However, the relationship between financial institutions in developing and developed countries poses risks to the economic stability of both.[4]

Developing countries seeking to attract foreign investment into their financial industries want to make those industries appear as safe and profitable as possible.[5] Investors generally make investment decisions based on information about the current and the prospective financial situation of the corporation.[6]

Recent corporate scandals in the United States, most notably that of the Enron Corporation, have shed light on the corrupting pressures on management to provide financial results that drive up a corporation's share price.[7] For the same reasons, developing countries are under pressure to make their industries look attractive and profitable to foreign investors.[8] This inevitably leads to the risk that financial disclosure may be selective, overly optimistic or downright fraudulent.

In response to the major corporate scandals involving fraudulent financial reporting in the United States, the U.S. government dramatically increased its regulation over financial disclosure, in particular, and corporate governance in general, through the passage of the Sarbanes-Oxley Act of 2002. ("SOX")[9] This legislation is primarily directed towards single U.S. corporations that are registered with the Securities and Exchange Commission and publicly traded.[10]

The increasing number of multinational and multi-corporate transactions in the international economy make application of a single-state financial disclosure requirements more difficult to apply.[11] Concurrently, competition between states over the requirements of regulatory schemes may drive corporations to avoid the more stringent regulation schemes of some states.[12] This has the potential of encourage investment in those states that have lax or underdeveloped regulatory schemes, known as "accountancy havens."[13]

With a population of approximately 1.3 billion people, China's banking sector represents a huge customer base in China.[14] Recently, China has heavily reformed its legal and economic structure in order to attract foreign investors.[15] The epitome of this effort is demonstrated by China's accession into the WTO in 2001.[16] As part of their commitments in joining the WTO, China has essentially agreed to open its banking sector to foreign businesses by the end of 2006.[17]

This modernization of China's legal and economic structures has attracted significant investment from U.S. financial institutions seeking to access the Chinese banking market.[18] Assuming that China's banking sector continues to open up to foreign investment, the amount of U.S. investment in China's banking sector will continue to grow.[19]

This article explores the possibility of inaccurate financial disclosures by state-owned Chinese banks in which U.S. financial institutions own stock. More specifically, it explores what liability U.S. financial institutions have for inaccurate financial disclosure in China's state-owned banks. The current situation could lead to an international regulatory mess that like the Chinese Finger Trap, does not have an obvious solution.[20]

In Part I of this paper the possibility of a Chinese state-owned bank disclosing inaccurate financial information, with or without the help of its U.S. shareholders, is examined. This is done in Part I where the general legal and economic climate in China is examined. Against that backdrop, the numerous instances of inadequate legal and economic controls and the resulting corruptions are discussed. Part I continues by examining corrupt practices of U.S. financial institutions, most notably, their involvement in the Enron collapse. Finally, Part I will look at the current investments in Chinese state-owned banks by U.S. financial institutions. The predictive thesis is that major U.S. financial institutions showed a disregard for corporate governance with willing participation in various Enron frauds. Now that Enron has collapsed and the U.S. market is more tightly regulated, its financial institutions may be seeking regulation situations abroad. China is a perfect candidate due to its immature regulatory system and numerous instances of corporate fraud.

Part II of this paper examines the various regulations affecting U.S. financial institutions investing in Chinese banks. It begins with an overview of the basic regulations governing these institutions. In order to determine whether U.S. regulation would apply in China it is necessary to discuss the concept of control and financial disclosure. In addition, basic international regulatory and jurisdictional issues will be briefly examined.

Part III of this paper critically examines the possibility of financial disclosure violations in United States-China banking investments. The regulatory framework in the U.S. for addressing these violations is then reviewed. Finally, this paper will suggest recommendations for improving the regulatory structure.

I. U.S.-CHINA BANKING INVESTMENT[21]

A. The Modernization of China

Throughout much of its history China did not adhere to a developed rule of law.[22] This situation did not improve recently when the People's Republic of China was formed as a communist state under the leadership of Mao Zedong in 1949.[23] Under Mao Zedong the rule of law effectively ceased to exist, as Mao wielded great power and party ideology controlled.[24]

After Mao Zedong's death in 1976, China sought to modernize its economy and legal system.[25] The modern development of China's legal system began with the passage of the 1978 Constitution of the People's Republic of China, which embodied the principles of modernization and embraced the relationship between the rule of law and a healthy economy. [26] Since 1978, there has been a prolific amount of legislation passed in China in order to further the goal of economic development.[27]

One of China's main achievements of economic development was induction to membership in the World Trade Organization ("WTO").[28] China implemented major legal reform and made many commitments in order to join the WTO.[29] This began to pay off when the United States bilaterally agreed to China's WTO membership in 2000.[30] Soon thereafter, enough countries accepted China's membership and November 10, 2001, China was able to join the World Trade Organization.[31] China's accession marked an historic milestone in Chinese history, and a significant moment for the future of the international economy.[32]

China's economic modernization has resulted in significant financial success, both domestically and internationally. Domestically, China's economy is experiencing steady growth.[33] Chinese industries are reaping the benefit of being the US's fastest growing export market in the world.[34] Internationally, China has become an economic powerhouse.[35] As a result of its economic modernization, China is receiving massive amounts of foreign investment.[36] Generally, these foreign businesses see profitable returns on their investments, and it is estimated that investment in China will continue to grow.[37] In general, China appears on track to achieve its goal of becoming a developed country by 2050.[38]

B. Chinese Legal and Economic Problems

While China's economy and legal system have shown tremendous progress, problems still exist which hamper reform efforts. Two significant problems affecting China's modernization are the difficulties of implementing its legal reforms, and economic crimes such as bribery and fraud.

The relative immaturity of China's legal system poses a number of obstacles to its effectiveness.[39] One of the biggest challenges to effectiveness in China's legal system is the lack of predictability.[40] This problem is probably a direct result of the system's immaturity.[41] Chinese judges are left to interpret the sometimes legally imprecise statutory law without the guidance of precedent.[42] Another major problem affecting China's legal system is interference by politicians, which results in a lack of true independence for the judicial branch.[43] This interference lessens the predictability in the application of laws and creates a lack of transparency.[44]

Corruption of officials through bribery is also a serious problem in China.[45] There are cultural grounds for acceptance of bribery, and corruption is frequently practiced.[46] There may also be a link between this corruption and the development of the market economy.[47] Corruption has an adverse effect on foreigners doing business in China.[48] Recently, the Chinese government has initiated programs to cut down on these practices.[49]

Corporate fraud is another problem facing China's economic development. Alarming reports of shareholder deception and record falsification has begun to emerge.[50] This poses a particularly troubling problem for international securities listings. For example, the largest IPO on the New York Stock Exchange in 2003 was China-based, China Life Insurance.[51] However, soon after the IPO, the corporation was sued by U.S. investors for failure to disclose reports of accounting discrepancies.[52]

C. China's Banks

China has carried out a number of significant reforms to modernize its banking institutions.[53] Commercial banks were, until recently, governed by the state-owned central bank called the People's Bank of China.[54] However, recent reforms have established the China Banking Regulatory Commission to take over the supervisory functions of the People's Bank of China.[55] In addition, banks that are publicly listed, either domestically or abroad, are also governed by the China Security Regulatory Commission.[56]

In 1995 China enacted the Law of the People's Republic of China on Commercial Banks which lays the regulatory framework for commercial banks and is supplemented by rules and regulations made by supervisors and other authorities.[57] Some of these regulations include annual reporting requirements and director liability for the reliability of information.[58]

One significant aspect of the Chinese banking sector is state ownership of the majority of banking institutions. The Chinese government owns the majority of each of China's four largest banks, which in turn control over 50% of all total banking assets and deposits.[59] The four largest banks in China, sometimes called "The Big Four" are: Bank of China (BoC), Agricultural Bank of China (AgBoC), China Construction Bank (CCB), and Industrial and Commercial Bank of China (ICBC).[60]

Another significant aspect of Chinese banks is that they do not have any deposit insurance.[61] The majority of banks in China are state-owned, and prior to filing for bankruptcy, banks in China must have permission from the state-owned PBC.[62] PBC has never allowed a commercial bank to file for bankruptcy in China.[63]

Despite this regulatory framework, there are still significant problems in China's banking sector. The state ownership of the majority of banking assets in China has led to problems with bad loans, a lack of transparency, and significant corruption.

One of the biggest problems associated with state ownership of "The Big Four" is the high incidence of bad loans.[64] It appears that the Chinese government used bank loans to support troubled companies (regardless of the risk) in order to keep the economy going.[65] It is estimated that somewhere between 25% and 75% of these loans went bad.[66] There does appear to be progress in the paying down of bad loans, but it is estimated that it will take almost $200 billion to restore the capital base of only two of China's banks, ICBC and AgBoC.[67]

Another problem with the financial institutions is the lack of adequate transparency.[68] In one often-repeated story, a former U.S. Treasury department official visiting a $25 billion Chinese financial institution was shocked to find that there were no financial records at all.[69] Additionally, China generally lacks efficient risk management strategy and credit rating.[70] Corruption is yet another major problem in Chinese banks.[71] Reports have indicated widespread corruption in the Chinese banking industry, even at the highest levels.[72]

D. U.S. Financial Institutions

U.S. financial institutions have a long history of weak corporate governance practices.[73] Especially for banks, failures of corporate governance can lead to particularly acute problems.[74] Repeated instances of unsavory practices on the behalf of financial institution officials have led to a vast amount of regulations governing banks in the United States.[75] In fact, the largest financial collapse in its history, the Stock Market Crash of 1929, was caused in part by the unsavory practices of banks.[76]

One of the legislative reactions to U.S. banks' involvement in the Stock Market Crash of 1929 was the Glass-Steagall Act of 1933.[77] One of the purposes of this act was to severely limit banks from participating in the securities markets.[78] In 1999, the Glass Steagall Act was largely repealed by the Gramm-Leach-Bliley Act of 1999.[79] This had the effect of removing many limits on banks' engaging in securities transactions.[80]

The most recent crisis involving U.S. financial institutions is the recent rash of corporate scandals, particularly Enron. A detailed analysis of financial institutions' involvements in Enron will shed light on the regulatory framework discussed in Part II.

E. The Role of Major U.S. Financial Institutions in the Enron Collapse

Enron went from being a one of the largest and most respected companies in the United States to insolvency and national shame with shocking speed.[81] In 2001, Enron was from the seventh largest U.S. corporations, with assets of over 49 billion, yet declared bankruptcy.[82] In that year U.S. investors lost some $61 billion in Enron stock, 4,500 Enron employees lost their jobs in Houston, Texas, and employees' 401(k)'s disappeared to the tune of $1.3 billion.[83]

In brief, Enron's failure was caused by its decision to sell off its profitable assets and to massively invest in various projects, most of which turned out to be almost entirely unprofitable.[84] Enron's management, whose compensation was tied to its stock performance, was under enormous pressure to keep the price company stock up.[85] Instead of accepting the fact that Enron stock was failing, certain Enron employees engaged in practices designed to make the company's stock appear profitable.

Enron needed to borrow massive amounts of money to keep afloat as well as conceal massive amounts of debt in order to keep the share price high.[86] Instead of simply borrowing the money that Enron needed from financial institutions or selling shares to raise capital, which might raise red flags regarding Enron's financial difficulties, Enron created a whole host of financial schemes to hide its economic position.[87]

One of the ways that Enron hid borrowing money was through manipulation of the pre-pay system.[88] Enron manipulated the pre-pay system by offering to sell to large financial institutions energy futures at a set price, and with the agreement to buy the asset back in the future at a higher price.[89] In this way, Enron would record these transactions, which were for all practical purposes loans, on their 10Q and 10K financial statements as "trades of energy futures."[90] According to the bankruptcy examiner, these pre-pay transactions became the "quarterly cash flow lifeblood of Enron."[91]

Financial institutions also aided Enron's scams through manipulation of the major financial institutions' equity analysts.[92] Traditionally, equity analysts are employed by large brokerage firms and investment banks, and provide objective analysis of a company's financial position to investors.[93] Manipulation of the analysts was accomplished by confusing them with impenetrable financial statements and blinding them with huge banking fees and profits for supporting the stock.[94]

Enron also created numerous Special Purpose Entities (SPE's) designed to conceal debt and create profit Enron employees.[95] Under the guidance of a Securities and Exchange Commission (SEC) sanctioned Financial Accounting Standards Board opinion, SPE's were allowed to be created and treated as an independent entity which did business with Enron for accounting purposes, provided that an independent investor purchased and retained at least 3% of the SPE's assets and an independent owner exercised control.[96] For example, Enron established the Joint Energy Development Investment Limited Partnership (JEDI) SPE by giving cash collateral to Barclay's Bank, who became the 3% independent investor. Enron was allowed to hold 50% of the stock and still keep the entity off their books.[97]

Another factor leading to the collapse of Enron was the lack of auditor independence. Enron's long-term auditor, Arthur Anderson, received millions of dollars in fees for auditing, in addition to millions of dollars in fees for financial consulting.[98] This close relationship with Enron resulted in a conflict of interest that may have contributed significantly to Anderson's inability to objectively analyze Enron's accounting or take steps to correct abuses.[99]

F. Consequences of Financial Institutions' Involvements in the Collapse of Enron

The most important response to Enron and other related scandals was the passage of one of the most important pieces of corporate legislations since the 1930's, the Sarbanes Oxley Act of 2002 (SOX).[100] SOX includes provisions addressing audits, financial reporting and disclosure, conflicts of interest, and corporate governance of public companies.[101] In addition to certain provisions of SOX, which will be discussed in more detail in Part II, there were several other consequences for U.S. financial institutions involved in Enron, such as Senate investigations, SEC enforcement, and private lawsuits.

The U.S. Senate's Permanent Subcommittee on Investigations in the Senate Committee of Government Affairs conducted several thorough investigations into the role of major financial institutions involved in the Enron collapse.[102] The reports generally concluded that U.S. financial institutions were involved in deceptive accounting practices, corporate abuses, and the ultimate collapse of Enron.[103] One Senate report concluded that there was a regulatory gap, because the SEC did not regulate banks and banking regulators did not regulate banks adequately.[104] The Senate report recommended that the SEC be allowed to take enforcement action against banks that are involved in Enron-type transactions, and that bank regulators be allowed to take action during examinations.[105]

In January 2003, the Subcommittee on Investigations, having investigated the role of financial institutions in the collapse of Enron, asked the Federal Reserve Bank (FRB), Office of the Comptroller of the Currency (OCC), and SEC to respond to its recommendations that the SEC provide a statement concerning the liability of a financial institution's participation in securities violations of U.S. publicly listed companies.[106] In December 2003, the agencies responded with a jointly prepared memo describing the types of securities law violations that would give rise to a cause of action under SEC rules and listing several enforcement actions that the SEC had taken against several financial institutions involved in Enron.[107]

The SEC report detailed how it had initiated several enforcement actions against financial institutions involved in Enron. In July 2003, the SEC initiated a civil action against J.P. Morgan Chase and Co. for its participation in the prepay scheme used by Enron to defraud investors.[108] J.P Morgan settled the claim and was ordered to pay $135 million in disgorgement, penalties, and interest, and was enjoined against future violations.[109] Citibank was charged for the same violation and settled for $120 million in disgorgement, penalties, and interest and was enjoined against future violations.[110] Merrill Lynch was charged with its participation in two transactions that it knew would violate securities regulations and settled for $80 million in disgorgement, penalties, and interest, and was enjoined against future violations.[111]

Probably the most harmful consequence faced by financial institutions for their involvement in Enron was a class action securities fraud suit filed against them. This lawsuit resulted in settlement payments of over $7 billion.[112] William Lerach, whose law firm represented the plaintiffs in the suit, has written about how laws passed restricting securities fraud lawsuits may have had a direct impact on the upsurge in securities fraud.[113]

G. Major U.S.-China Banking Investments

China's large population and high household savings has made the Chinese banking industry increasingly attractive to foreign investors.[114] However, China currently limits foreign investment in its banking sector to a maximum of 20% equity in a Chinese bank and the total of all foreign equity must be limited to 25% per bank.[115] This limited privatization of China's banks is seen as a way for it to retain control of its banking assets while raising capital and recruiting strategic partners.[116] In addition to limited ownership, there are very high capital requirements for investors.[117] It is believed that these conditions will improve at the end of 2006 as part of China's WTO commitments.[118] However, it is not clear whether the amount of foreign ownership will increase from what is currently allowed.[119] Nevertheless, these obstacles have not significantly deterred major U.S. financial institutions from investing in China.

The largest investment by a single U.S. financial institution into a Chinese bank occurred in 2005 when Bank of America (BofA) purchased 9% of China Construction Bank (CCB) for approximately $3 billion.[120] BofA agreed to buy $2.5 billion worth of CCB from its government run majority owner China SAFE Investments with the option to buy an additional $500 million worth of stock when the bank is listed on the Stock Exchange of Hong Kong (SEHK).[121] BofA also has the option of purchasing additional shares of up to 19.9% of CCB.[122] BofA will also be sending fifty employees to China to assist CCB with technical matters and will take a seat on the CCB's board of directors.[123]

Prior to listing on the SEHK, CCB had SEHK waive its requirement that all listed companies have a minimum 25% float.[124] When CCB listed on October 28, 2005, it became the first of "The Big Four," the largest state-owned banks in China, to sell shares to the public.[125] This transaction was very profitable for BofA. The IPO of CCB was the largest ever on the Hong Kong stock exchange. The share value of CCB's stock has risen nearly 30% and BofA has made an estimated $5 billion.[126]

Additional large U.S.-China banking investments include a 10% stake in Industrial and Commercial Bank of China purchased by Goldman Sachs, American Express, and German insurer Allianz in August 2005.[127] In the same month, the Royal Bank of Scotland, Merrill Lynch, and Hong Kong tycoon Li Ka-shing purchased a 10% stake in Bank of China.[128] In total, three of "The Big Four" banks have now sold significant shares to foreign investors.

II. THE U.S. Regulation of U.S.-CHINA BANKING INVESTMENT

Part I examined major instances of corruption in both the U.S. and Chinese financial sectors and noted the major U.S. investment in Chinese banks. In response to this situation, it is necessary to examine the legal framework in the United States governing these investments. After the basic regulatory framework is discussed, particular attention will be given to the concepts of control, financial disclosure, and international regulation.

A. The Governing of Internationally Active U.S. Financial Institutions

Investment in foreign corporations can occur through many complex variations that would necessarily involve different regulatory nuances. Due to the limited scope of this paper, the regulatory framework of only a limited type of transaction will be discussed. This section deals with some of the regulations governing a large U.S. bank investing in a Chinese bank, similar to the transaction between BofA and CCB discussed above in Part I(G). This type of transaction ("U.S.-China bank investment"), involves a SEC regulated financial institution, with a national bank at its center, investing in a Chinese hybrid state-owned/publicly listed bank. Even with this limited scope, it would not be possible to detail all relevant regulations governing this type of transaction. Therefore, only a few basics of the regulatory framework will be discussed.

U.S. commercial banks are regulated by several federal agencies.[129] The primary agency controlling national banks is the Office of the Comptroller.[130] The Comptroller's Office is part of the Treasury Department, and as such it is part of the Executive Branch.[131] It is also the main agency in charge of on-site examination of U.S. banks.[132]

All national banks and some state banks are members of the Federal Reserve System. The Federal Reserve System was created by Congress and acts essentially as a central bank, regulating money supply and interest rates.[133] This system is governed by the Federal Reserve Board (FRB).[134]

Additionally, the Federal Deposit Insurance Corporation (FDIC) sets regulations for United States banks.[135] The FDIC insures the deposits of almost all commercial banks up to $100,000 per depositor and as such can to impose positive regulations on banks.[136] In general, deposit protection and insurance schemes are designed to protect depositors and mitigate risks to market stability.[137]

Banks that have securities registered with the SEC or that must file periodic reports with the SEC are also subject to any rules and regulations that the SEC adopts.[138] In general, banks began to significantly participate in the securities market after the passage of the Gramm-Leach-Bliley Act in 1999 (GLB).[139] Additionally, this has led to increased regulation under SOX.[140]

The Gramm-Leach-Bliley Act repealed two provisions of the Bank Holding Company Act of 1954 (BHCA) making it easier for Bank Holding Companies (BHC) to engage in securities dealing and insurance.[141] A BHC is a company with control over any bank and is allowed by statute to engage in activities in addition to banking.[142] The FRB is the lead regulator of BHC's.[143]

In addition, a bank holding company may elect to become a Financial Holding Company (FHC).[144] This allows the company to engage in an even greater number of activities.[145] In order to become an FHC, all of the banks under the BHC must be well managed and well capitalized.[146] This means that the banks must receive a satisfactory rating when examined and otherwise exhibit "the existence and use of managerial resources which the Board determines are satisfactory."[147]

B. U.S. Banks Engaging in International Banking

U.S. banking laws permit the investment by a U.S. bank in ownership of a foreign bank.[148] U.S. banks must have a capital and surplus of one million dollars and file an application in order to invest in foreign banks.[149] Banks which are allowed to hold equity in a foreign bank are known as Agreement Corporations.[150] The investment is subject to regulations prescribed by the FRB, which has issued Regulation K concerning international banking operations.[151]

Regulation K generally allows banks to invest abroad if they "act in accordance with high standards of banking and financial prudence, having due regard for diversification of risks, suitable liquidity, and adequacy of capital."[152] The FRB can rescind this general consent if the bank fails in its requirements under Regulation K or if the bank otherwise raises concerns about the safety and soundness of the investment.[153]

C. Federal Court Jurisdiction for Foreign Banking

Under the federal Foreign Banking Law, all civil suits at common law involving foreign banking are under the original jurisdiction of the federal courts.[154] In addition, courts may also apply supplemental jurisdiction where the claim arises out of the case or controversy. [155] There are two requirements for original jurisdiction: (1) one of the parties must be a corporation formed under U.S. law, and (2) the transaction giving rise to the suit must involve international or foreign banking or other financial operations.[156]

D. The SEC and Extraterritorial Antifraud Jurisdiction

The antifraud provisions of the Securities Act of 1934 are applicable even when the transaction is not in an organized U.S. securities market.[157] Under the Securities Exchange Act of 1934, suits based on foreign transactions are neither specifically included nor excluded.[158] Courts have found subject matter jurisdiction for extraterritorial transaction involving securities fraud based on whether there is an adverse effect on American investors ("effects test") or whether there are acts committed in the U.S. in furtherance of the violation ("conduct test").[159]

Conduct in the U.S. that would be merely preparatory for the violation would not have jurisdiction under the conduct test, however, if there were a sufficient injury to the U.S. investor, there would be jurisdiction based on the effects test.[160] The direct effect can be satisfied when a U.S. citizen loses payment even if all of the plaintiffs are foreign and there are no other connections with the U.S. [161] Courts deciding whether or not they have jurisdiction also look at whether Congress would have wanted to increase strain on U.S. courts for foreign violations as well as the effects on international relations in light of the purpose of the securities laws to protecting investors and domestic markets.[162]

E. Jurisdiction and the Foreign Sovereign Immunities Act

Under the Foreign Sovereign Immunities Act, a foreign government typically cannot be sued in U.S. courts.[163] This immunity includes entities in which a majority of ownership interest is owned by a foreign state or political subdivision thereof.[164] However, a foreign country does not have immunity from suit in the U.S. if the cause of action is based on commercial activity that causes a direct effect in the United States, even if the activity was carried out in a foreign jurisdiction.[165]

In addition there is the "act of state doctrine," which says that courts of one sovereign will not examine the validity of public acts committed by another recognized sovereign, or person whose authority derives from the sovereign, within its territory.[166] For example, one court found that a Mexican bank was not immune under FSIA when the securities contract could not be performed. However, since the breach was due to state decree, the "act of state" doctrine prohibited jurisdiction.[167] When a foreign government's participation in the market is not as a regulator but as a mere participant, however, the "act of state" doctrine does not apply.[168] In general, the effect of sovereign immunity is to shield the person of the foreign sovereign and, by extension, his agents from jurisdiction; the doctrine shields the foreign sovereign's internal laws from intrusive scrutiny.[169]

F. The Concept of Corporate Control

Since U.S. financial institutions are investing in Chinese banks, it is important to consider whether or not they have any liability for the conduct of those banks in which they invest. In particular, this paper seeks to determine whether or not U.S. financial corporations are liable for the accuracy of financial disclosure in the Chinese banking corporations in which they invest.

In the United States, the corporate doctrines of separate personality and limited liability are fundamental to the modern corporation.[170] Separate personality allows a subsidiary to be a distinct entity for the purposes of liability, even when it is partially owned by another corporation.[171] This approach is referred to as the entity approach.[172]

This limited liability is often seen as one of the greatest benefits of the corporate form.[173] One reason for the benefit is the reduction in information cost. Since a shareholder is not liable for the activities of the corporation there is no need for close monitoring.[174] The other significant benefit of limited liability is risk aversion. Without liability for the actions of the corporation, investors are more likely to invest.[175] This, in turn, allows corporations to engage in more risky activities.[176]

This framework of separate personality and limited liability developed in relation to the liability for the activities of single corporations and the relation of shareholders to that liability.[177] Increasingly, corporations own shares of other corporations, forming corporate groups.[178] Under this framework, the traditional limited liability doctrine becomes harder to apply because the two corporations formed are completely separate and essentially remain separate.[179] Indeed, a great number of cases have dealt with liability issues in multi-corporate networks.[180] In this context, the doctrine of corporate control has begun to emerge.[181]

The control doctrine is used to selectively enforce liability between a parent and subsidiary company when it is determined that there is sufficient control. Control occurs when a company has the power to direct, command the direction of management, or policies of another company.[182] The greater the control a company exerts over another, the greater the potential for liability.[183] When one company is in significant control of another, they are treated as a single enterprise and the controlling company becomes liable for the controlled company.[184] This is known as the enterprise rule as opposed to the entity rule.[185]

G. The SEC and the Concept of Control

The application of the concept of control found in SEC statutes varies from statute to statute.[186] In general the SEC has defined control as "the possession, indirect or direct, of the power to direct or cause the direction of the management and policies of a person whether through the ownership of voting securities, by contract, or otherwise."[187]

The SEC has established liability for violations of the Securities Acts' for controlling persons. The law states, "Every person who, directly or indirectly, controls any person liable under any provision of this chapter or of any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person . . . is liable, unless the controlling person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action."[188] While the SEC has not specifically defined what control means in this context, courts have held that it is not sufficient that a person has the ability to persuade a violator, they must have the practical ability to control.[189] In terms of control through shareholder ownership, the SEC has seemingly approved the position that 20% is adequate to establish control.[190]

H. The Concept of Control and the BHCA

The concept of control is found to a limited extent in the BHCA. In order to become a BHC, a company must have control over a bank.[191] This occurs when a company owns more than 25% of the voting securities, controls in any manner the election of a majority of the directors, or the FRB determines the company "exercises a controlling influence over the management or policies of the bank."[192] This phrase defines the "ability to control standard" and is usually meant to apply to the ability to continuously influence.[193]

The BHCA does say that a shareholder that owns less than five percent of a bank is presumed not to have control.[194] However the BHCA does leave it open as to whether ownership between five percent and twenty five percent of voting securities can be found to exercise control.

However, in this context the BHCA is only describing whether a company qualifies to become a BHC due to its control over another bank or other company controlling a bank. Furthermore, the BHCA expressly states that control of a bank operating outside of the U.S. does not qualify as a bank. [195] Therefore, this language does not apply to how much control over a foreign bank is necessary to bring it into the BHC.

I. Financial Disclosure

Financial disclosure is the dissemination of accurate financial information to regulators, shareholders, and the general public. The theory is that accurate financial reporting is necessary in the marketplace because it allows participants to make their best-informed decisions and allows regulators to detect inaccurate information.[196]

The requirements for financial reporting are different for typical corporations and for banks.[197] For example, corporations are allowed to keep their own records and have other outside accounting firms certify that the records are accurate.[198] Banks also keep their own records; however, instead of allowing independent auditors to certify the records, the Office of the Comptroller of the Currency sends examiners to the bank to certify the records there.[199] These agents use sophisticated computer programs to ensure that the bank's records are accurate and that the bank is in good health.[200]

One of the reasons for the higher standard facing banks has to do with the FDIC, which insures the deposits in a bank. Since the taxpayers are ultimately paying for this insurance, there is a high level of concern that the banks stay healthy.[201] In essence, if a publicly traded bank fails, it is not only the stockholders who lose out but the American taxpayer as well.[202]

Another reason that tougher reporting requirements are made of banks than of corporations is that it is possible for a bank failure to cause systemic problems. This possibility is known as systemic risk.[203] The federal government has issued special regulations for Large Complex Banking Organizations aimed at preventing systemic risk.[204]

J. Financial Disclosure and the BHCA

Under the Federal Foreign Banking Law, U.S. banks are required to turn over reports about the condition of foreign banks that they hold capital stock in to the FRB upon demand; and the FRB may conduct special examinations of the foreign banks whenever it deems.[205] International investments by domestic banks are reported to the FRB via forms FR Y-10 and FR Y-6.[206] However, FR Y-10 does not require a bank to report investments that make up less than 25% of the investment's ownership.[207] These investments are reported in the annual FR Y-6 report.[208] In addition, banks must maintain records of their foreign investments, including: (1) equity, (2) amount, (3) percentage ownership, (4) activities conducted by the company, and, (5) consent to make the investment.[209] Notably absent from the information required is any kind of assessment by the preparer of the report regarding the financial condition of the foreign bank.

K. Financial Disclosure and the SEC

The Securities Exchange Act of 1934 requires all issuers who have securities registered with the SEC to file periodic financial reports to the SEC as the SEC shall prescribe by its rules and regulations.[210] The SEC has adopted rules requiring issuers to file annual and quarterly reports with the SEC.[211] These reports are required to true and correct.[212] The reports must contain all information necessary to ensure that they are not misleading.[213] It is not necessary to intend to cause these reports to be misleading in order to liable for a violation.[214]

In addition to reporting requirements, there are also record-keeping and internal control requirements under the Exchange Act. The Exchange Act requires that issuers make and keep records in reasonable detail to accurately and fairly reflect the issuer's transactions.[215] The Exchange Act also requires that an issuer refrain from knowingly circumventing a system of internal accounting controls.[216] These requirements are intended to prevent an issuer who attempts to conceal fraud by cooking the books or bypassing accounting controls.[217]

In general SOX applies to BHC's which are registered with the SEC.[218] One of the major provisions of SOX requires certifications by public companies' principal executive officer and principal financial officer in the companies' annual and quarterly reports regarding the accuracy of the reports and internal disclosure controls within the company.[219] These certifications include: (1) that the certifier has reviewed the SEC reports, (2) that they are accurate, and, (3) that the review of internal disclosure controls is found to be effective.[220]

L. Disclosure Regulations for Unconsolidated Entities

One of the ways that Enron defrauded investors was through transactions with unconsolidated special purpose entities that were not required to be included in its financial reports.[221] This was made possible through the Financial Accounting Standards Board's endorsement of the 3% rule for determining that a SPE qualified as a separate entity, even though Enron owned 50% of the entity.[222] In considering the collapse of Enron, it became apparent that there are difficulties with applying a single state's accounting standards to a large corporation with unconsolidated entities.[223]

This prompted the International Accounting Standards Board (IASB) to reconsider its position with regard to unconsolidated entities.[224] The IASB realized that allowing transactions with an unconsolidated entity to remain off the balance sheets even though the corporation owned a substantial amount of it would lead to accountancy havens and subsequent abuses.[225] To deal with these problems the IASB adopted the concept of control to determine when an unconsolidated entity should be included in financial disclosure.[226]

The IASB's goal is that by applying the doctrine of control, international accounting standards will develop more flexibility, allowing them to deal with otherwise incompatible national rules based accounting requirements.[227] Basing the consolidation of financial disclosure on the concept of control is seen as a move toward principles-based accounting as opposed to the traditional rules-based accounting traditionally adopted in the U.S. that contributed to the ability of Enron to misstate its earnings through participation in SPE's.[228]

The SEC worked in the development of these IASB standards and endorses a shift to a more principle-based accounting standard in light of Enron.[229] Further prompting this shift is the fact that SOX recognized the need to cover off-balance sheet transactions regardless of consolidation, and required the SEC to develop rules covering disclosure of these transactions.[230]

In response, the SEC implemented rules requiring issuers to discuss in a separately captioned section of Management Discussion and Analysis (MD&A) certain off-balance sheet transactions for unconsolidated entities.[231] The threshold for including such transactions "that have or are reasonably likely to have a current or future effect on the registrant's financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors."[232]

During the time that the proposed rule was open for public comment, several commentators expressed concern over whether it would be feasible for them to be expected to obtain information on unconsolidated entities.[233] In response, the SEC explained that such information was not required; the disclosure only included information about what the issuers transferred to the non-consolidated entity, not about the nature and amount of assets of that entity.[234] The SEC noted that the primary aim of the rule was to make information available to the investor about the structure and risk of the off-balance sheet transactions that might otherwise not be ascertainable from reading the financial report.[235]

M. Additional International Regulators

The promotion of internationally consistent transactional regulations by international organizations such as IASB is not a new development. In fact, many organizations promote internationally consistent regulations. There are three principle international organizations effecting international banking supervision: (1) the International Monetary Fund, (2) the World Bank, and, (3) the Committee on Bank Regulation, the later being established in 1974 by ten major commercial states in Basel, Switzerland. [236]

The Basel Committee proposed recommendations for international banking primarily concern; increasing transparency and consistent accounting standards.[237] The main purpose of these recommendations is to prevent market instabilities due to the cross-border nature of modern financial practices.[238] Although states may agree in principle to adopt these principles, these recommendations are referred to as "soft law," because they do not have any binding effect upon any party.[239]

Additionally, these international organizations face difficulties in implementing binding rules because sovereign countries have the authority to regulate conduct within their borders and change their already established regulatory procedures.[240]

N. The SEC and Memorandum of Understandings

The SEC recognizes that international cooperation is vital to the SEC's ability to regulate international securities transactions.[241] In order to provide cooperation to foreign regulators, the SEC proposed legislation amending the Exchange Act by allowing the SEC to provide assistance to foreign regulators, which Congress enacted.[242] The Act requires the SEC, when deciding whether or not to give assistance, to consider whether reciprocal authority has been obtained from the foreign party.[243] Memorandum of Understanding (MOU) between the SEC and its counterparts in foreign countries is crucial to the SEC's ability to conduct investigations overseas.[244] Over the last 15 years, the SEC has entered into MOU's with 30 countries.[245]

In 1994, the U.S. and China initiated a bilateral MOU.[246] In the MOU the SEC and the CSRC agreed to provide each other with assistance in information sharing.[247] However, the MOU is a statement of intent and does not create any binding international obligations.[248] The MOU was signed at a time when the CSRC was in its infancy so the MOU does not provide any detail about procedures or methods of obtaining information on Chinese signatories.[249]

In 1995, the SEC initiated a separate MOU with the Hong Kong Securities and Futures Commission.[250] This MOU contains much more detailed information concerning the assistance that will be given by either party with regards to enforcement of securities laws. However, there is an interesting problem concerning whether or not the MOU has any legal effect considering it was adopted while Hong Kong was still under the authority of the United Kingdom.

In 2002, the first multilateral MOU was created by the International Organization of Securities Commissions.[251] Since its creation, 27 countries' securities regulators, including the SEC and Hong Kong's securities commission, have been admitted to the Multilateral Memorandum of Understanding (MMOU).[252] Pursuant to the MMOU, signatories agree to provide critical information to each other regarding the enforcement of their respective securities regulations. This MMOU has significantly increased the SEC's enforcement abilities worldwide.[253] In 2005 alone, the SEC received 368 requests for assistance and requested assistance from foreign countries 461 times.[254]

III. PEERING OVER THE GREAT WALL

A. Assessment of the Need to "Peer Over the Great Wall"

There is significant need to "peer over the Great Wall" and determine the accuracy of financial disclosure concerning U.S. investment in Chinese banks. As discussed in Part I the Chinese legal system in general and securities regulations in particular are in their infancy. In recent years, China has begun making an effort to increase its adherence to the rule of law and to improve the corporate governance of its financial institutions. These efforts are partially directed toward improving the desirability of substantial foreign investment in China's banks. This provides a strong motive for selective disclosure of information concerning these institutions. In addition, there remain other significant obstacles to effective corporate governance in China.

Corporate governance in China is hampered by a high degree of corruption and a low degree of transparency. Problems such as bribery and fraud appear widespread. In addition, state involvement, including ownership, of financial institutions in China has created unique problems concerning transparency and accountability.

Achieving transparency of state-owned banks in China presents unique challenges. There is an inherent conflict of interest regarding transparency in China's state-owned banks because the regulator is the same entity as the regulated. There is little incentive for the Chinese government to release unfavorable information concerning the banks it owns. In fact, in order to attract foreign investment, there is strong incentive not to release unfavorable information.

There is also the potential for a serious lack of accountability in Chinese state-owned banks. Bank officials that line their own pockets with banking assets have been and will likely continue to be punished. However, the motive to punish these officials largely disappears when they are contributing to the assets of the bank through accounting manipulation or other means.

Of course, U.S. financial institutions probably care little about these problems when they stand to profit from them. The participation of U.S. financial institutions in the Enron scandal shows how these institutions are willing to disregard sound corporate governance in order to make profits. In fact, their participation in Enron bears several similarities to their participation in Chinese banks.

These similarities include: (1) conflicts of interest in accounting, (2) lack of transparency, and, (3) exploitation of regulatory gaps. In the Enron case, there were significant conflicts of interest in its auditing procedures. There was lack of transparency in Enron's financial disclosure. Finally, there were regulatory gaps involved that allowed banks to profit through their participation in off-balance sheet transactions and there may be similar gaps in U.S. regulations that may allow for similar off-balance sheet profits.

In the United States, there were major repercussions for financial institutions involved in this type of fraud. The U.S. institutions were investigated by the government and enforcement action was taken through the SEC. There were also major financial consequences when financial institutions were sued by private securities litigators. Finally, there was increased regulation imposed through the Sarbanes-Oxley Act of 2002.

These measures may be causing U.S. financial institutions to increase investment in markets with more relaxed regulatory measures and less probability of investigation and litigation. China is such a market, and it is eager to attract foreign investment. There is the potential for profit inflation and securities violations occurring in the United States because of these investments. Therefore, it is necessary to address the effectiveness of the U.S. regulatory framework in addressing these issues.

B. Control and Financial Disclosure in U.S.-China Banking Investments

The best way to gauge the accuracy of a corporation's financial condition is through their financial disclosure. Recent corporate governance reforms seem premised on the theory that legal liability for the accuracy of a corporation's financial disclosure is the best method of ensuring its accuracy. Particularly, under SOX, liability for financial disclosure has been significantly increased. This method appears straightforward for a single corporation's financial disclosure. However, the application of this method becomes exceedingly complex when corporations invest in other corporations.

When one corporation invests in another corporation, they generally do so in order to make a profit. This profit is either consolidated within the financial reports of the investing corporation or else it is unconsolidated and considered a separate off-balance sheet transaction. The key issue is whether the investing corporation has any liability for the accuracy of the financial disclosure of the corporation in which it is investing.

In order to determine liability for the accuracy of these reports, progress has been made towards adopting the concept of control to determine liability. When one corporation has control over another corporation, it is generally liable for securities violations occurring on behalf of the controlled corporation. This would seem to include reporting violations under the SEC. However, the concept of control as defined by the SEC is generally unclear.

Even when the transaction is unconsolidated, a corporation must disclose information when it has the potential to have a direct effect on the capital of the investing corporation. However, this disclosure is merely intended to provide disclosure concerning the nature of the transaction. It is not intended to provide insight into the financial condition of the corporation being invested in. Similarly, while BHC's must disclose some information concerning foreign investments with less then 25% control, this information is limited and not intended to provide insight into the financial condition of the corporation in which they are invested. This leaves a gap where corporations that own less than 25% of another corporation are not liable for reporting the financial condition of the corporation in which they are invested.

The limitations on the application of the concept of control have important applications relating to U.S.-China banking investments. In particular, because China currently limits foreign ownership by a single foreign corporation to 20% of a Chinese state-owned bank, there cannot be control in these institutions under the current U.S. concept of control. The lack of actual control is solidified by the fact that the Chinese government generally has almost total control over these institutions.

Therefore, under the current restrictions, there is no way that a U.S. financial institution will ever gain enough control over a Chinese state-owned bank to be liable for the accuracy of its financial disclosure. This has the effect of raising a wall between the U.S. regulatory agencies and U.S. financial institutions investing in China. Additional limitations on U.S. securities investigations and enforcement in China's banks help in make this wall a "Great Wall."

C. Jurisdiction and Enforcement for Misconduct Relating to Securities Activities

U.S. federal regulatory agencies face important limitations in their investigation and enforcement against securities violations occurring in Chinese state-owned banks, regardless of whether a U.S. institution is involved. Assuming that there is misconduct, such as accounting fraud, in which U.S. financial institutions investing in China are implicated, there are five basic scenarios that it could be manifested:

A. Misconduct occurs on behalf of the Chinese banks resulting in inaccurately high share value.

B. Misconduct occurs on behalf of the Chinese banks resulting in loss of share value.

C. Misconduct occurs on behalf of the U.S. financial institutions resulting in inaccurately high share value.

D. Misconduct occurs on behalf of the U.S. financial institutions resulting in loss of share value.

E. Any combination of the above. For example, misconduct participated in by both U.S. and Chinese financial institutions that result in inaccurately high share value.

Scenarios A and B require addressing the issues of enforcement (investigation) and legislative (application of law) jurisdiction related to China's ownership of the banks and its status as a sovereign nation. In Scenario A, the SEC would likely be the agency seeking enforcement because it would be counter to the interest of the U.S. financial institution to seek a remedy for increased profits. The SEC would likely have legislative jurisdiction in federal court due to its broad jurisdictional grant and the fact that increased share value for the U.S. financial institution would satisfy the direct effects test. China would not have immunity under the FSIA because the activity is commercial in nature.

The SEC would seek to investigate the matter through enforcement jurisdiction. The primary method of obtaining this type of jurisdiction is through international cooperation. This presents a problem because the United States and China have not updated their MOU since its very basic beginnings in 1994. If the Chinese banking securities are traded on the Hong Kong Stock Exchange, then the SEC may have the ability to investigate because both the SEC and the Hong Kong Securities and Futures Commission are members of the International Organization of Securities Commissions (IOSCO) multilateral MOU establishing investigative cooperation. It is presently unclear, however, whether the Hong Kong Commission has the authority to investigate internal matters of Chinese state-owned banks.

In scenario B, either the SEC or the financial institution involved would seek to address the violation. The analysis stays the same for the SEC's jurisdiction. The U.S. financial institution would find jurisdiction in the federal courts through its legislative grant of jurisdiction under the Foreign Banking Act. However, there does not appear to be any authority for a U.S. financial institution to investigate the banks in China. Therefore, the U.S. financial institution would not be able to effectively pursue a claim against the Chinese bank.

In Scenario C the U.S. institution's misconduct would likely fall under a fraud or reporting violation of the SEC and the SEC would have jurisdiction due to the fact that the financial institution is registered with the SEC, is located in the United States, and the activities constituting the violation occur in the United States. The same analysis essentially applies for Scenario D.[255]

In sum, limitations on U.S. regulatory agencies' investigative and enforcement abilities in China, coupled with the lack of liability for financial disclosure involving these transactions, has created a "Great Wall" between U.S. financial institution investments in China and appropriate regulation.

D. Possible Ways to "Peer Over the Great Wall" (Besides Standing on a Ladder)

Several improvements could be made to the current U.S. regulatory framework that would increase the possibility of obtaining accurate financial disclosure in U.S.-China banking investments. First, the threshold for requiring financial reporting could be based on the ability to obtain such financial reporting, as opposed to the concept of control. For example, regardless of the exact percentage of ownership control, a U.S. corporation with a seat on the corporate board of the Chinese bank should have the ability to obtain accurate financial reports concerning that bank. Since the U.S. regulatory agencies can only regulate within their borders and have statutory authority to restrict the activities of BHC's, they could make this a precondition to investing in Chinese banks.

Second, considering the fragile relationship between banks in developed countries and those in developing countries, this reporting requirement, based on an institutions' ability to obtain financial reporting, could be mandatory whenever a U.S. bank invests in the banks of a developing country. Making this requirement universal not only makes sense, but applying these rules to all or most of the banks in developing countries will be better for U.S.-China relations, because China would not be singled out for particular regulation.

The third improvement would be to incorporate the certification requirement of SOX into this reporting requirement in order to motivate U.S. corporate officers to make a best faith effort to obtain accurate financial reports.

Fourth, because the U.S. would not have the right to force any corrective action on foreign soil, it would be necessary to require that a substantial failure to comply with these guidelines will result in enforcement action taken by the FRB that could include a mandatory safe withdraw of the investment and a suspension of international banking investment activities in developing markets.

Finally, there needs to be fresh bilateral MOU's, concerning cooperation in international securities regulations, with both China and Hong Kong. In particular, these MOU's should discuss the framework for investigating securities violations when U.S. financial corporations invest in China's state-owned banks.

The intended effect of these guidelines would be to increase the accuracy of reports and to decrease securities fraud in internationally active banks. U.S. financial institutions investing in developing countries' banks would be hesitant to invest in risky banking ventures due to the greater exposure to liability.[256] In order to attract and retain foreign investment, this would have the effect of increasing developing country's efforts to raise their standards with regard to combating fraud and producing accurate financial records.

CONCLUSION

This paper has demonstrated that there is evidence of unsound business practices by major financial institutions in both U.S. and China. In doing so, it has emphasized the need to have greater transparency and accountability in U.S.-China banking investments. By analyzing a limited portion of regulations governing these transactions, this paper illuminated the some of the major deficiencies of the current regulatory framework and provided suggestions for its improvement.