China Economic Review 14 (2003) 451 – 472

Capital markets and legal development:

The China case
Zhiwu CHEN
Department of Finance, Yale School of Management, 135 Prospect Street, New Haven, CT 06520, USA
Accepted 19 September 2003

Abstract

Recent research establishes a significant positive correlation between law and finance (and hence
economic growth), restarting a debate on the ‘‘law matters’’ thesis. However, which way the
causality goes is still not clear. The purpose of this paper is to use the ongoing reform experience of
China, especially its capital market experience, to examine the direction of causality. First, we show
that China’s recent experience is largely consistent with Coffee’s [Yale Law Journal 111 (2001,
October)] ‘‘crash-then-law’’ interpretation of this correlation. Indeed, it is the large and clearly
defined constituency of investors that has been a key driving force behind much of the recent legal
progress. The rights and economic interests of this constituency have fundamentally challenged the
traditional emphasis of the Chinese legal culture on administrative and criminal sanctions, but not on
civil litigation law. Second, we compare the different contributions to legal change made by the stock
market and the consumer product markets. We argue that capital markets are perhaps the most
conducive to the formation of a politically powerful constituency and hence more aggressive legal
change, because of (1) the higher degree of commonality among interested parties and (2)
immediately measurable and tangible damages. These two characteristics not only allow investors to
identify with each other more easily, but also create an ideal basis for more debate in the media,
which in turn promotes the development of a legal culture.
D 2003 Elsevier Inc. All rights reserved.

Keywords: Law and finance; Legal reform; Shareholder rights; Product liability; Capital market development;
Economic development

1. Introduction

A central thesis in the law and economics literature is that law matters for economic and
market development. According to this thesis, the existence of a legal system that protects

E-mail address: zhiwu.chen@yale.edu (Z. Chen).

1043-951X/$ - see front matter D 2003 Elsevier Inc. All rights reserved.
doi:10.1016/j.chieco.2003.09.016
452 Z. Chen / China Economic Review 14 (2003) 451–472

contract and property rights is a precondition for economic development because, without
such a system, the lack of certainty about who will stand to benefit from otherwise
beneficial transactions and/or investments will simply inhibit such transactions. Or, if they
occur, the costs of doing so will be unacceptably high (North, 1990).1 Thus, absence of
such a legal order, markets cannot develop and economic growth will stall. Recently, a
sequence of provocative research by La Porta, Lopez de Salines, Shleifer and Vishny
(1997, 1998) (LLSV hereafter) has shifted the focus of the ‘‘law matters’’ debate to capital
market development issues. Using a large database of various institutional and economic
variables for a cross section of countries, LLSV show that the degree of protection a
country’s substantive law provides for outside shareholders/security holders has a
significant bearing on the depth and liquidity of its capital markets: stronger legal
protection for minority shareholders is associated with deeper and more liquid capital
markets and with less concentrated share ownership.2 In effect, they argue that deep capital
markets cannot be developed unless shareholder-friendly fundamental legal reforms are
adopted as a precondition.
A consensus in the literature is that law clearly matters for market development,
especially after a market reaches certain mature stage. Market-friendly law is a desirable
good. But, how does a country get to that point? How does legal change arise to prepare
for sustained growth? While not questioning the correlation between capital market depth
and legal protection for shareholder rights, Coffee (2001) offers the opposite interpretation
of the above correlation: market development precedes, rather than follows, shareholder-
friendly legal reforms. His argument is based on the historical fact that ‘‘Although
securities exchanges have existed since the seventeenth century, exchanges primarily
traded debt securities up until the mid-19th century. Then, over a relatively brief period
and at a time when the private benefits of control were unquestionably high, dispersed
ownership arose in both the United States and the United Kingdom—largely in the
absence of strong legal protections for minority shareholders, which came afterward.’’
Coffee further comments that ‘‘this sequence makes obvious political sense: Legal reforms
are enacted at the behest of a motivated constituency that will be protected (or at least
perceives that it will be protected) by the proposed reforms. Hence, the constituency (here,
dispersed public shareholders) must first arise before it can become an effective lobbying
force and an instrument of legal change.’’
Two questions then come to mind. First, how does such a constituency arise in a market
growth process? Second, which types of market or economic activity are more conducive
to legal development? In a broad sense, since there are different markets (e.g., securities
markets, consumer product markets, labor markets) and since all these markets may be
simultaneously developing in a country, it may be true that not all of them lead to the
creation of equally powerful constituencies. If that is the case, which types of market tend

1
See Clarke (2003, in press) for a discussion of the ‘‘property rights matter’’ thesis based on recent
experience in China.
2
See Shleifer and Vishny (1997) for a comprehensive survey, and Ohnesorge (2003, this issue) for
discussions on how this literature may benefit from the recent experience of China. The ‘‘Law matters’’ thesis for
securities market development has prompted much new research and debate in law and economics. Responses
and hypotheses from the law literature include Black (2001), Cheffins (2001), and Coffee (2001).
 Z. Chen / China Economic Review 14 (2003) 451–472 453

to create constituencies that are the most effective in causing legal change? Clearly, the
answer will differ from country to country, depending on a country’s own preexisting
context. If there are general characteristics about the types of economic activity that are the
most conducive to legal change, understanding them will help shed new light on the
interactive dynamics between law and economic development.
The purpose of this paper is twofold. First, we show that Coffee’s (2001) ‘‘crash-
then-law’’ interpretation of both the abovementioned correlation (between law and
finance) and the capital market history in the United States and the United Kingdom
is largely consistent with the ongoing reform experience in China.3 For young markets,
it is economic development that precedes legal change, rather than the other way around.
Unlike Russia and other East European countries that took a shock-therapy approach to
economic transition, from 1978 onward China has adopted a gradual trial-and-error
approach to transform its planned economy into a market-oriented one, starting with the
agricultural sector. After its success with reforming the agricultural sector in the early
1980s, China began to restructure its state-owned industrial enterprises into joint-stock
corporations, and first opened the Shanghai Stock Exchange in December 1990 by
letting several former state-owned firms go public. While the Chinese stock market has
helped former state-owned enterprises (SOEs) raise capital from the public, its impact on
legal change has perhaps been even more significant. The experience is one of true
‘‘crash-then-law.’’
Second, we compare the different contributions to legal change made by the stock
market and the consumer product markets. In economic terms, the impact of China’s stock
market on the real economy and society as a whole has been marginal, with about 10
million investors, whereas the various consumer product markets have been large in a
country with more than 1.2 billion people. That is, while the stock market may have
directly affected only a small fraction of the population and a small percentage of Chinese
businesses, the consumer product markets have affected much larger proportions of the
population. Thus, the constituency of citizens arising from stock market development
should be much smaller in number than the constituencies arising from consumer product
markets. Yet, the former has been a much stronger force for legal change. Why is it so?

2. China’s legal tradition

A distinctive feature of China’s legal tradition is that the legal system is not separated
from, or independent of, the administrative system (e.g., Jones, 2003, for an excellent
overview). At least since the Tang dynasty (618 – 906 A.D.) and until the end of Qing in
1911, the system of government in China consisted of a strong central government headed
by the Emperor, who ruled through a bureaucracy and with absolute power. The lowest
ranking officials at the county level represented the central government and in effect
exercised all of the power of the state, including tax collection, public works, and even

3
See Boycko, Shleifer, and Vishny (1997) for discussions on transition and legal adaptation experience
in Russia.
454 Z. Chen / China Economic Review 14 (2003) 451–472

deciding lawsuit cases. Thus, adjudication was simply one of the many administrative
duties. Since there was no doctrine of the separation of power among government
institutions, the county magistrate’s power was virtually unchecked except that the
subjects could technically appeal to a higher level official.
Another distinctive feature is its emphasis on administrative and criminal sanctions,
with a lack of formal development in civil liability and procedural law. The traditional
Chinese view, even as of today, is that the law is an instrument used by the ruler to
enforce its power and authoritative control and to maintain social order. Consequently, as
the central part of the Qing Dynasty’s legal system, for example, the Qing Code was a
collection of rules that were predominantly concerned with the official activities and
functions of the bureaucrats within the government apparatus, not with disputes and
relationships between and among private citizens. The imperial law touched upon private
matters only as the matters were thought to affect imperial policies. Thus, the code was
primarily of an administrative nature, and it tended to rely only on administrative and
criminal penalties. This is in sharp contrast with the Roman law tradition, from which
western laws are derived. At the heart of Roman law is civil law, rather than
administrative law. Roman law arose during a time when Rome was a small agricultural
society. As a result, the law developed mostly in response to the occurrence of disputes
between private citizens and/or social groups. Therefore, early on, civil matters occupied
a central place in western laws. As Jones (2003) commented, ‘‘In China, the subject
matter of Roman civil law was considered only when it affected the interests of the
Emperor’’ (p. 13).
Today’s legal system in China is not much changed from the dynastic era. The law is
still viewed as an instrument of the ruling class; The judicial system is still treated as part
of the government’s administrative system and hence there is no effective judicial
independence; Politics and adjudication are often mixed together; There is still no
officially adopted doctrine of the separation of power. Today’s legal system probably
differs from those in the different dynasties, mainly in that after the mid-1980s and as part
of the reform efforts, there have been many newly enacted substantive laws (particularly in
the areas of commercial and civil law) and even a Civil Procedure Law of 1991. That is,
there are many more ‘‘laws on the books’’ today than in the various dynasties. However, as
discussed later, the existence of these substantive and procedure laws has not fundamen-
tally altered or neutralized the two dominant characteristics of the legal system mentioned
above. Many judges are not trained lawyers, and even a large number of them, especially
in less developed provinces, are former military officers who had no formal legal training
prior to being a judge. Still, since 1978, a substantial legal framework has been put in
place, with institutions that together resemble a western legal infrastructure (except there is
a Communist Party political –legal committee that is super-imposed on the legal system,
controlling the assignment, promotion, demotion, and replacement of judges). It is issues
and conflicts arising out of the economic reform process that have played the critical role
of pushing the legal infrastructure to work and adapt. The economic development process
has generated an increasingly larger force for judicial independence. The ongoing case of
China is a vivid example of how the ‘‘crash-then-law’’ process works. We next show that it
is the stock market and private securities litigation that have been central in injecting life
into the ‘‘laws on the books.’’
 Z. Chen / China Economic Review 14 (2003) 451–472 455

3. Stock market and legal development

Economic reform started in 1978, soon after the end of the disastrous Cultural
Revolution. However, until the mid 1980s the focus of the reform efforts was on the
agricultural sector, allowing farmers to have a piece of land to grow grain crops and retain
whatever profits the farmer was able to generate. However, no one was given or allocated
the ownership of any land property, and the farmers were just given the usage right for a
short period of time (land usage right was reshuffled among villagers every few years).
The main objective was to encourage family-based farming and individual responsibility
(rather than collective farming as practiced before the reform started). There was then a
large increase in income and living standard among farmers.
The success in agriculture then started to affect the debate on how to reform the industrial
sector where state ownership was by far dominant. The first experiment in the mid 1980s was
to apply the individual-responsibility model of farming to industrial enterprises. That is, an
individual manager or a team of managers could assume the responsibility of an SOE for
several years, with an annual revenue or profit target. Profits above the target would be paid
to management and workers as bonus. This responsibility model did not work out, since it
promoted mostly short-term behavior by management. It was then realized that without
clearly defined ownership, there would not be an incentive structure to induce managers to
take a long-term view.4 In the late 1980s, therefore, joint-stock limited-liability corporations
became the new experiment, with some SOEs converted into joint-share corporations.

3.1. The stock market

Preparation was then also under way to start an official stock exchange to trade shares
of the new joint-stock companies. But, private ownership and privatization was political
taboo. In particular, no one would want to be responsible for causing the loss of state
assets. As a political compromise, the reformers proposed to have several classes of shares:
state shares, legal-person shares (only ownable by legal-person institutions and corpo-
rations), and floating common shares (A-shares for domestic citizens only and B-shares for
foreign investors only). In particular, the state shares and legal-person shares would not be
publicly tradable, so that no loss of state ownership would occur. However, regardless of
share type, the holder of a share is entitled to the same cashflow and voting rights. Today, a
typical public corporation has about one third of its shares in each category of state, legal-
person, and floating common shares.5 Given that most legal-persons or corporations are

4
In some sense, state ownership represents an extreme form of diverse ownership as each citizen in the
country is supposed to own an equal piece of the firm. Thus, the separation between ownership and control is also
extreme. But, there has been no corporate governance structure in place to ensure the functioning of this extreme
separation. Since the state controls the management of each SOE and since the government is not democratically
elected, there is no institutional infrastructure to ensure that the agents at the various levels all work in the best
interest of the ultimate shareholders—the citizens. Therefore, it is not surprising that the management
responsibility model did not work.
5
See Chen and Xiong (2001) for a study on the underpricing structure of legal-person shares. They show that
because these shares are not tradable, they are priced at an average discount of 86% to the otherwise identical
floating common A-shares. This pricing and liquidity distortion is also a source for corporate governance problems.
456 Z. Chen / China Economic Review 14 (2003) 451–472

state-owned or state-controlled, about two thirds of most corporations’ shares are state-
controlled directly or indirectly. This ownership structure has been a major factor behind
the difficulties in private securities litigation, because granting damage awards in private
litigation would amount to the loss of state assets (to the extent that the state owns a
majority of the shares outstanding), which puts the court in a conflicted situation.
Besides the state-dominated ownership structure, another obstacle blocking private
securities litigation is ideological. The traditional communist view was that only income
through labor is rightly acceptable. Though the Shanghai Stock Exchange opened in
December 1990 (followed by the Shenzhen Stock Exchange 2 months later), this official
line on rightful income remained in the Communist Party charter until November 2002,
when the 16th Party Congress changed the charter to officially acknowledge that
acceptable income can be earned through both labor and capital (i.e., monetary capital,
intellectual capital and managerial capital). Therefore, until late last year, Communist
Party members were officially not supposed to buy or trade stocks; otherwise, any income
from holding stocks would not be legitimate. This ideology was of course contrary to the
notion of shareholder rights and the protection thereof, which has been partly responsible
for the slow implementation of the Securities Law and the Company Law of the People’s
Republic of China (PRC). It has been an obstacle between law on the books and law in
action. The question again is what led to the removal of this obstacle last year? How did
China eventually move the law off the books and into action, at least to some extent?
To answer these, we should keep in mind that the very justification for starting a stock
market in China was to help the SOEs raise capital from the general public and solve the
money-losing SOEs’ financial problems, and that it was not to offer the general public a
way to diversify investment portfolios and hedge future consumption/income risks.6 Thus,
shareholder rights were more of an afterthought, which became a concern several years
after stock trading became widespread. One practice that was followed from 1990 to 2000
was that the government adopted a quota system on the number of IPOs for each year, so
that there would be a planned and orderly sequence of IPOs with no supply shocks. This
idea and practice of a planned growth path have been so much at the heart of the Chinese
modernization process over the past 150 years that it is almost impossible to do away with
(e.g., Goetzmann & Koll, 2002; Kirby, 1995). Another consideration for the planning was
to make the IPO flow low enough, so that IPO prices would be high, creating an
impression of unbeatable IPO demand and setting a perfect environment for more SOEs to
issue shares. In other words, the first task of the government agencies in charge was to
manage and maintain a positive and encouraging market.
At the beginning of each year, the national IPO quota was approximately equally
divided among the 32 provinces and province-level cities. Table 1 shows the number of
IPOs for each year to lie between 13 and 206, with an average of 100 new listed
companies per year. This implies that in a typical year, each province would get a quota of
about three IPOs. This limited supply of IPO permits clearly made the value of each such
permit very high, and created a huge opportunity for rent-seeking and bribing. Conse-

6
Walter and Howie (2003) argue extensively that the Chinese government’s determined interest has really
been, and will continue to be, to use the equity capital markets as a tool of enterprise reform, while other by-
products of the capital markets have been more of a side purpose.
 Z. Chen / China Economic Review 14 (2003) 451–472 457

Table 1
IPO listings and capital raising on China’s stock market
Number of new Total amount raised
listings in each year through IPO and SEO
(million yuan)
1991 13 500
1992 40 9409
1993 124 31,454
1994 110 13,805
1995 24 11,886
1996 203 34,152
1997 206 93,382
1998 106 80,357
1999 98 89,739
2000 137 154,086
2001 79 118,214
2002 71 96,175
Data used in this table are graciously provided by www.SinoFin.com.cn.

quently, each provincial government set up a dedicated Securities Listing Office to both
lobby the China Securities Regulatory Commission (CSRC) for a higher quota and to
assist local firms to prepare for IPO.
For provincial and lower governments, the number of local firms they can have publicly
listed has become a major metric of performance, on which future promotion of local
government officials depends. As a result, provincial and lower level officials are all the
more willing to help local firms manipulate financial numbers or commit unmasked fraud,
all for the purpose of getting more local stocks traded nationally. Or, when local firms are
caught by the media for committing financial fraud or earnings manipulation, local
governments and sometimes even higher government agencies would cover up the fraud.
Both the central government’s bias in helping the SOEs and the local government’s
desire for political performance have not helped to give much weight to shareholders’
interest. From the very beginning, the PRC stock market was biased against shareholders.
Even after a company successfully obtained an IPO permit (usually as a result of much
lobbying and/or bribing efforts), the process of preparing and filing for IPO could easily
take more than 2 years (true even as of today). The first period in the long IPO process is
the so-called ‘‘ShangShi FuDao Qi’’ (the pre-IPO ‘‘nurturing’’ period). This nurturing
period is literally to strip a money-losing SOE into two pieces: the ‘‘good’’ piece (to be
IPOed) and the ‘‘bad’’ piece (to be the controlling shareholder after the IPO of the ‘‘good’’
piece). This is sometimes the period of creating fake receipts and fake contracts to make up
whatever profits that are needed to meet the IPO requirements. For example, the PRC
Company Law requires a candidate IPO firm to have positive earnings in each of the most
recent 3 years. Additional CSRC regulations further require the firm to satisfy conditions
on return-on-equity (ROE), before an IPO approval can be granted. These requirements
have forced firms to manipulate earnings and financial results.
After an IPO, the firm again has to satisfy profitability requirements to issue seasoned
equity offerings (SEO). For example, over the years, the minimum condition for an SEO
as set by CSRC regulations has gone through various changes: the firm’s ROE had to be
458 Z. Chen / China Economic Review 14 (2003) 451–472

(1) positive in the most recent 2 years, a policy as of 1993; (2) above 10% based on the
recent 3 years’ average, as of 1994; (3) above 10% in each of the recent 3 years, as of
1996; (4) above 10% based on the recent 3 years’ average, but at least 6% for each of the
recent 3 years, as of 1999; and (5) above 6% based on some weighted average for the
recent 3 years, as of 2001. These four policy changes have each time caused publicly
traded firms to adapt their accounting manipulation schemes. In one study, Lang and Wang
(2002) find that for each year before 1994, strangely many public firms had their ROE just
slightly above 0%; then, between 1994 and 1999, more than half of the public firms had an
ROE lying slightly above 10% but below 12%; but, from 2000 onward (in particular since
2001), most of the firms had an ROE between 6% and 8%. Their study presents perhaps
the strongest evidence of marketwide earnings manipulation, implying that investors have
been systematically defrauded.
Another common practice by Chinese public companies is ‘‘tunneling,’’ as defined in a
different context by Johnson, La Porta, Lopez de Silanes, and Shleifer (2000), that is,
controlling or majority shareholders engage in related party transactions with the listed
firm, usually with the latter buying worthless assets from the former at unreasonably high
prices or with the latter lending to the former at favorable rates. As the Chinese magazine
New Fortune has reported, tunneling of shareholder assets is widespread and has led to
calls for regulation and tighter enforcement by the CSRC.7
Given these systematic problems mentioned above, the Chinese stock market still
managed to become the third largest one in Asia based on market capitalization (after
Japan and Hong Kong). As of July 2003, the Shanghai Stock Exchange and the
Shenzhen Stock Exchange together have 1259 companies listed (A and B shares
included). The combined total market capitalization of the companies is over 4 trillion
yuan (about US$500 billion),8 and trading is active with a monthly turnover rate of
18.2%. About 20% of the 1259 companies are private firms, without the state being the
controlling shareholder.
By no means is China’s stock market well developed yet. But it does show signs of life.
Table 1 shows the total amount of capital raised in each year. In Table 2, we see that the
amount of capital raised on China’s stock market is, when measured as a fraction of GDP,
lower than the U.S. market but higher than Japan’s and Germany’s, in the 1990s. It should
be recognized that this period marked the beginning of China’s stock market (hence one
would expect some level of exuberance).
The above brief review of the development background illustrates that in the 1990s and
even today there is not enough ideological acceptance of private ownership and stock
trading, neither is there sufficient protection of property rights. Especially in the early

7
See Clarke (2003, in press). Featured articles on corporate governance issues (in Chinese) can be found at
New Fortune’s website: http://www.newfortune.net.cn.
8
The exact market capitalization value for all listed companies combined is a mystery because the state and
legal-person shares are not publicly traded and hence no reliable price information can be used to value them. The
4 trillion yuan given here is based on the official estimate published on the CSRC website, in which they simply
multiply the total number of shares outstanding by the floating A-share price. From Chen and Xiong (2001), it is
clear that this is an over estimate of the true value, because the legal-person and state shares are sold in private
transfer and auction transactions, at an average discount of 86% relative to the floating A-shares. See also Walter
and Howie (2003) for another discussion on this market capitalization issue of China’s listed firms.
 Z. Chen / China Economic Review 14 (2003) 451–472 459

Table 2
Raising capital through the stock market across countries (%)
China United States Japan Germany France
1991 0.02 0.23
1992 0.36 0.90 0.06
1993 0.91 1.64 0.16 0.11
1994 0.30 1.64 0.08 0.03 0.18
1995 0.20 1.08 0.20 0.27 0.29
1996 0.50 1.26 0.54 0.56 1.94
1997 1.25 1.72 0.27 0.29 0.08
1998 1.02 2.35 0.74 2.74 0.88
1999 1.09 1.34 0.93 1.04 0.85
2000 1.72 2.03 0.90 1.44 1.44
2001 1.20 2.33 0.49 0.29 1.56
2002 0.94 1.26 0.34 0.20 0.85
Average 0.79 1.60 0.47 0.61 0.90
S.D. 0.65 0.25 0.13 0.02 0.47
The total amount of capital raised includes both IPO and seasoned equity offerings on the stock market. The ratio
reported here is the total capital raised divided by the country’s GDP in the same year.

years, China did not have a legal infrastructure to support capital market development.
However, consistent with the ‘‘crash-then-law’’ hypothesis of Coffee (2001), China started
out without a clear idea of what institutional framework would be needed for a stock
market, but as investors increased in number, a powerful constituency was developing,
which led to a sequence of legal development.9

3.2. The years prior to the securities law of 1999

China’s stock market was started top-down, with the CSRC and other government
agencies controlling every step of the way in both the overall market development and the
process of a firm’s pre-IPO preparation as well as post-IPO operations. The stock
exchanges are state-owned and managed by government-appointed officials, while the
securities firms are state-owned (or majority-controlled) either directly or indirectly. Since
the beginning of the market, it has been a well known secret that every public company
had been ‘‘nurtured financially’’ and repackaged just for the sake of IPO, with widespread
practice of making up the numbers so as to meet the listing requirements.
Even with so much known accounting fraud and open market manipulation, private
securities litigation did not arise in significance until 2001 after a sequence of events.
Though the Shanghai Stock Exchange started in late 1990, suing management and
directors and/or other parties for damages was not much on investors’ mind until after a
sustained market downturn started in the middle of 1993. As Fig. 1 shows, over the first
year and a half, the Shanghai Stock Exchange Composite Index (hereafter SSE Compos-
ite) went straight up from 100 in 1990 to 1266 by May 21, 1992. In particular, the index

9
See Hutchens (in press) for an excellent account and analysis of the development history of private
securities litigation in China. He summarizes the various factors (positive and negative) that have each contributed
to legal development in a country whose tradition has deemphasized civil law.
460 Z. Chen / China Economic Review 14 (2003) 451–472

Fig. 1. History of Shanghai Stock Exchange composite index.

went from 617 to 1266 in a single day on May 21, 1992. It was then followed by 5 months
of decline. But, that decline did not last long enough to get a substantial number of
investors to call for private litigation against corporate manipulators. In late 1992, the
government stepped into encourage stock trading, restarting an upward movement.
In the early 1990s, even if any investor had wanted to sue for damages, the court would
not have accepted such lawsuits. The only law that shareholders would be able to rely on
up until July 1, 1994, was the PRC General Principles of Civil Law, which provides that
victims of torts are entitled to civil compensation. However, the PRC judiciary had little
experience with tort law in general and securities law in particular, which remains true
today. Legal training was all but stopped during the Cultural Revolution, and then restarted
around 1980.
Furthermore, the legal system is modeled after the Japanese civil law system, which
in turn was adapted from German law during the Meiji reform period of the 19th
century. An overwhelming theme of Chinese law is that ‘‘wei jin pizhun bu ke,’’ that is,
without a formal written rule from the law or from a legal interpretation by the Supreme
People’s Court (SPC), judges cannot on their own interpret and apply a legal principle to
decide specific cases. Given that at the time when the PRC General Principles of Civil
Law was enacted in 1986 there was not a stock market, it is not surprising that the
general PRC Civil Law did not include securities-related provisions until revisions in the
late 1990s.
In principle, before judges can accept any new type of private suit, in general the
National People’s Congress has to first pass a law for the specific area and then the SPC
has to issue one or more detailed legal interpretations. This process can last for 5 years
or longer.
Nonetheless, while there was no securities law until July 1, 1999, administrative
regulations were introduced to fill in the gap. The Provisional Rules on Stock Issuance and
Trading of 1993 issued by the CSRC proscribed various miscreant practices and provided
for civil compensation for those who were financially injured as a result (Hutchens, in
 Z. Chen / China Economic Review 14 (2003) 451–472 461

press). But, the court was not ready for private securities litigation, and hence these
administrative provisions would not amount to anything for private investors. Penalties
based on the Provisional Rules of 1993 could only be enforced either administratively by
the CSRC, or through criminal litigation by the Public Security Department. The following
are three representative cases of this nature:10

1. The first administrative case on insider trading was announced on January 28, 1994, in
which the violator, the Shanghai securities brokerage division of the XiangFan Trust
and Investment Company (a subsidiary of the Agricultural Bank of China), was fined
by the CSRC. The violator was accused of (1) insider trading and market manipulation
and (2) trading stocks using customer account capital. The brokerage division was
ordered to turn in all the trading profits of 16,711,808 yuan (about US$2 million), and
pay a fine of 2 million yuan (about US$240,000). The brokerage firm was also
suspended from trading for 2 months. But, in this case, no manager or any other
individual was personally fined or penalized in any way. Still, this case marked the first
attempt to enforce rules on the stock market.
2. The first administrative case against false disclosure and misleading statements in
connection with securities trading was decided on June 7, 1996. In this case, the named
violators were the DaMing Group (a listed company of ShengLi YouTian), and the
underwriter firm, accounting and auditing firm, and law firm that each provided service
to facilitate the IPO of the DaMing Group. The CSRC’s charge included
misrepresentation of the listed company’s outstanding share structure, omitting material
facts, and false statements in its IPO Prospectus. The administrative penalty included a
fine of 2 million yuan for the listed company and a warning to its board of directors.
The named underwriter firm, accounting firm and law firm were respectively fined
400,000, 200,000, and 100,000 yuan. Again, no individual manager or other person
was fined or named in the administrative action.
3. In December 1999, the Prosecutory Office of Chengdu City formerly filed a criminal
action against the chairman and key executives of HongGuang Enterprise (a listed
company) for accounting fraud. On November 26, 1998, the company was fined, while
its directors and executives were warned, in an administrative action by the CSRC. The
company was found to have overstated its 1996 and 1997 earnings, respectively, by 157
million and 31.52 million yuan. On December 14, 2000, the court ruled against the
defendants in the criminal case.

These and other administrative and criminal sanctions were taking place at an
accelerated pace after 1995. It was happening against the following background. When
the Shanghai Stock Exchange opened in December 1990, there were 45,000 individual
stock accounts and most of the investors were Shanghai locals. As the stock market went
unstoppably higher in 1991 and 1992, the easy money generated much excitement and

10
For details of these and other administrative cases, visit the CSRC website: http://www.csrc.gov.cn. Under
the leadership of CSRC Chairman ZHOU Xiaochuan, particular efforts were made to improve market and
administrative transparency. Part of the efforts was to make the CSRC website more informative and accessible to
the public.
462 Z. Chen / China Economic Review 14 (2003) 451–472

attracted more and more individuals into the market. Hertz (1998) gives a sociological
account of the China stock-trading phenomenon. Occasional encouraging and possibly
misleading editorials by the People’s Daily (the central government’s mouthpiece) and
remarks by top leaders have also played a significant role in mobilizing the public to buy
stocks, which tends to serve the government’s purpose of helping the financially distressed
SOEs well.
By the end of 1999, there were 44 million stock accounts (this number went up to over
70 million by April 2003).11 As noted above, the wave of administrative actions against
violators of securities rules started in early 1996, which coincided with the last phase of the
3-year long bear market that began in mid-1993. During this unprecedented, long bear
market, many individual investors were stuck with losses, and these losses motivated them
to seek ways of recovery. The investors were joined by professional and academic
commentators to call for better enforcement of market rules and ultimately for a ‘‘better’’
market. This wave of public pressure then forced the CSRC to take more aggressive
administrative actions in 1996 and onward. Thus, it is the first bear market, together with
the fast-growing investor constituency, that led to significant public enforcement (‘‘crash
then administrative enforcement’’).
However, from the administrative penalties, the public learned that first of all, managers
and intermediaries responsible for misleading or cheating investors were actually not fined
personally (but only given a verbal warning). It is usually the listed companies that were
fined. That is, the shareholders, not the responsible violators, ultimately were paying the
fines. Secondly, shareholders who suffered losses were not given any piece of the
administrative fines (the fines went to the Ministry of Treasury). Thirdly, as in the later
securities criminal cases, defendants may have been jailed, but that again did not help
injured investors recover any financial loss.
Unable to benefit from administrative or criminal sanctions, investors and the more
general public all learned about the limitations of the traditional emphasis on administra-
tive and criminal penalties by the Chinese legal system. In a major sense, investors care
more about recovering loss than about whether a violator is fined administratively or
jailed. Thus, the public debate on private securities litigation started to gain momentum.
Fortunately, in a country with a generally restricted press, the financial media (including
print, Internet, and TV) has enjoyed increasingly more freedom, so investors, professio-
nals, and academics can openly discuss shareholder rights and civil litigation issues. The
common economic interest led to the informal formation of a significant constituency,
though for political reasons the government forbids any formal shareholder organization.
The Company Law of 1994 does provide ambiguous support for certain shareholder
rights, including the right to seek compensation for damages due to financial fraud,
misleading statements, market manipulation, and so on. But for the reasons mentioned

11
The number of investors is vastly different from the number of stock accounts. First, the same investor has
to have one account with the Shanghai Stock Exchange and one with the Shenzhen Stock Exchange, if he or she
is to trade stocks listed on both exchanges. These two accounts of the same investor are counted as two, implying
the70 million accounts must be divided at least by two. Second, investors often own multiple accounts to hide
their identity by opening accounts using borrowed ID cards from others. This is a common practice especially
among market manipulators, who have to hide their trades to evade regulators’ attention. Some believe a realistic
number of investors is more like 10 million or less. See Walter and Howie (2003) for more discussion.
 Z. Chen / China Economic Review 14 (2003) 451–472 463

above (e.g., the lack of operational guidance or legal interpretation from the SPC), the
court refused to accept private securities litigation until years later.
In April 1999, a shareholder in Shanghai filed a civil suit against HongGuang
Enterprise for financial damages due to the defendant’s accounting fraud (see the
description of the first criminal case discussed above). But, for many months, the Shanghai
court gave no answer as to whether the case would be accepted. Then, in early 2000, the
court decided not to take the case.

3.3. Where is the crash?

On December 29, 1998, the National People’s Congress passed the PRC Securities Law
and the Law became effective on July 1, 1999. Together with the Company Law of 1994,
this marked the completion of the ‘‘laws on the books’’ concerning corporation formation,
public offering, and securities trading in China. However, this does not mean that injured
investors could rush to court to file lawsuits for damage recovery or to force a
corporation’s board and/or management to take shareholder-interest-maximizing measures.
The PRC Securities Law became effective in the midst of a stock-market bull run that
started in January 1999 and ended in June 2001 (when the SSE Composite Index reached a
peak of 2218). During that period, accounting fraud, market manipulation, and insider
trading were rampant. The CSRC took 92 administrative actions against perpetrators
(including 104 corporate entities and 270 individuals).12 The media also reported on fraud
cases. But, the bull market made the new formal law almost unnoticed for 2 years (most
investors were probably busy counting profits).
Within the first 2 years after the PRC Securities Law became effective, investors made
few attempts (if any) to seek damage recovery through litigation, and the judiciary was not
in any hurry to prepare for the enforcement of the Securities Law. The Supreme People’s
Court was not working to draft a legal interpretation or procedural rules for the new law.
When many investors were profiting from the bull run and only some investors were
suffering losses from fraud, the pressure for fast legal change could not be too high. There
had to be a crash (or a sustained period of decline).
Then, several key events occurred. On April 23, 2001, the CSRC announced a major
administrative penalty against four fund management firms in GuangDong, fining them a
total of 400 million yuan (about US$50 million) in addition to ordering them to return the
same amount of illegal profits. The cause for action was that from October 1998 to
February 2001, the four firms engaged in manipulating the stock price of, and publishing
false statements concerning, Yorkpoint Science & Technology. The chairman of York-
point, his relatives, and key managers were all behind the manipulation scheme and held
stakes in the defendant firms.13
In the July 2001 issue, Caijing magazine’s cover story featured a detailed account of the
fraud scheme of Yorkpoint’s stock. In the immediate August issue, Caijing published an
extensive investigative report on another high-profile corporation, YinGuangXia Enter-

12
Visit the CSRC website for data on administrative actions: http://www.csrc.gov.cn.
13
The fines are yet to be collected. Judicial decisions in civil cases and administrative fines are often hard to
enforce, another reality in China that is waiting for reform.
464 Z. Chen / China Economic Review 14 (2003) 451–472

prise.14 It was found that from 1998 to 2001, YinGuangXia fabricated sales receipts (with
hundreds of millions worth of exports to Germany) and lied to the market about various
production facilities that actually never existed. The total amount of faked sales was over 1
billion yuan (about US$120 million), which resulted in a nonexistent profit of 770 million
yuan. This scandal was a shock not only to the investor community but also the larger
society in general. Many expected to see accounting fraud of a lesser nature, but not so
egregious. The YinGuangXia scandal was dubbed the ‘‘Enron of China.’’ These stories
came out just as the stock market was suffering a major downturn from the June high of
2218 for the SSE Composite Index to around 1700 by the end of September (see Fig. 1).
These events provided the needed crash for legal change. Disappointed investors started
to demonstrate in front of the CSRC building. Key officials from the CSRC initiated
meetings with the Supreme People’s Court, urging the court to assume a more significant
role in regulating securities markets through adjudicating cases. However, a typical
Chinese official (whether in a bureaucratic position or in a judicial position) always
thinks in terms of administrative territories. In this case, matters related to stock trading
were considered to be the sole responsibility of the CSRC, not that of the judicial system.
Thus, even after the CSRC’s efforts to convince the court of its role, the judiciary showed
much reluctance to join in.15
On September 20, 2001, investors filed suits against the company and management of
Yorkpoint Science & Technology, simultaneously in the No. 1 Intermediate Court of
Beijing, the Intermediate Court of Guangzhou, and the Intermediate Court of Shanghai.
Some investors in Jiangsu province were preparing to do so as well. Lawyers were also
filing paperwork in different courts to sue the management, and directors of YinGuangXia
Enterprise, and other responsible parties.
In the mean time, newspapers and TV were full of stories of angry investors, with
articles detailing legal rules and remedies concerning securities litigation. A wave of
lawsuits was in formation, which challenged the Supreme People’s Court and the entire
PRC judicial system. To the Communist Party, this appeared to be too dangerous politically.

3.4. The temporary ban on private securities litigation

On September 21, 2001, the Supreme People’s Court issued a notice directing all lower
courts temporarily NOT to accept private securities lawsuits. Just as a private litigation
storm was about to begin, such an announcement was a shock to everyone with a stake in
the market or concerned about capital markets and legal development in China. It
prompted an immediate outcry from various professions and interest groups. It fueled
much further heated debate not just on market development, but also the rule of law in
general and judicial roles in particular. That notice put the Supreme People’s Court on the
spotlight. In retrospect, private securities litigation had provided China’s court system with

14
See Caijing’s website for current and past articles: www.caijing.com.cn.
15
Private conversations with participants in these discussions between the CSRC and the Supreme People’s
Court suggest that senior officials from the Court were blaming the CSRC for all the securities trading related
troubles and that the judiciary did not want to get involved. Protection of shareholder rights was not exactly the
first thing on the Court’s priority list.
 Z. Chen / China Economic Review 14 (2003) 451–472 465

the best chance to gain political standing and respect in the larger Chinese society. But the
highest court squandered the chance.
From several interviews given by the then Vice President of the Supreme People’s
Court, Mr. LI Guoguang, it became clear that the Court had the following concerns. First,
as suits were filed against the same defendants and for the same cause but by different
plaintiffs and in different lower courts, it became possible that there would be different
rulings, the occurrence of which would jeopardize the reputation and credibility of the
legal system. In the history of the PRC, there had never been such an instance in which
numerous plaintiffs would simultaneously file separate lawsuits in different provinces but
against the same defendants and for the exact same cause. How should the court system
respond to this possible crisis? Could there be chaos, both legal and political? Second, if
financially injured investors would each file an individual suit, the entire court system
would be more than overwhelmed with securities litigation. Are there efficient ways to
handle such mass litigation? Third, given the lack of prior experience in this area, the
lower court judges had no uniform standards yet with regard to who has a standing to sue,
what type of evidence is required, how damages are calculated, and so on. Finally, if there
would be numerous lawsuits against all these listed firms and if the private plaintiffs would
be awarded rightfully deserved relieves, it would lead to major losses of state assets (since
the listed companies are mostly state-controlled). In such civil litigation, the defendant’s
interest is in fact the state’s interest. This is precisely where plaintiff’s rights and state
interest collide. Is there a compromise between the two? How can there be judicial
independence? These questions and reasons were sufficient to cause the Court to pause.
The extensive debate and analyses by legal experts in the mass media following the
notice served as one of the best legal education opportunities for the public. It was during
this period that even individuals with no legal training learned about what ‘‘class action’’
litigation means, why class action may be the best mechanism for securities litigation,16
why there should be more emphasis on civil liability than administrative or criminal
liability, who should bear the burden of proof in securities litigation, why the court should
accept private action suits, and so on. As a result, a large number of investors and readers
can now comment on ‘‘class action’’ and the ‘‘burden of proof.’’ Observing these
developments from a ‘‘crash-then-law’’ perspective, one can see how a legal culture is
developed in such a process.

3.5. Partially lifting the ban

On January 15, 2002, the Supreme People’s Court issued a second notice dictating that
lower courts may accept private securities litigation based on false disclosure and material
misrepresentation, subject to the condition that administrative penalty has been imposed
on the alleged fraud. However, the ban remains in place for private litigation based on
other types of claim, such as insider trading and market manipulation.
While the second notice did open the door for private securities litigation in a limited
way, the required precondition of an existing enabling government action was troubling

16
Chen (2002) provides a detailed argument for class action litigation in China, and a review of the U.S.
experience in securities class action litigation.
466 Z. Chen / China Economic Review 14 (2003) 451–472

and led to a new round of debate (hence, a new opportunity to develop the legal culture).
The requirement was against the principle of judicial independence, which the PRC
Constitution guarantees, and it substantially compromised shareholder rights. It was also a
fundamental rewrite of the PRC Securities Law. The Supreme People’s Court’s justifica-
tion was that the lower courts have no prior evidence-discovery experience related to
securities litigation and that the precondition is a transitional convenience.
Nonetheless, within a week and on January 24, three investors went ahead to file
separate suits in Harbin against DaQing LianYi, a listed company, and its management for
false disclosure and accounting fraud. Soon afterwards, 767 other investors sued the same
defendants for the same claim. Since class action litigation is forbidden by the second
notice, these separate cases had to be resolved individually.17 The Intermediate Court of
Harbin conducted individual case hearings for 2 months from August to October 2002, but
managed to go through only 94 out of the 770 suits.
In 2002, nine other listed companies and their respective management members,
directors, and other responsible parties were sued in nine different courts. Among them,
YinGuangXia was named as a defendant in 1100 individual suits, again all for the same
cause of accounting fraud.
After the lower courts accepted this wave of lawsuits and in some cases held court
hearings in 2002, none of the cases has yet been resolved by a judicial decision even to the
date of this writing (several have been settled outside of court). The reason this time was
again that more detailed procedural and substantive rules are needed concerning who has
the standing to sue, how damages are to be determined (e.g., adjusting for systematic risk
or not), and so on.
This led to the issuance of the PRC Private Securities Litigation Rules (hereafter, PSL
Rules) by the Supreme People’s Court on January 9, 2003. The PSL Rules is the most
detailed legal interpretation yet of the PRC Securities Law (with 37 articles), and it is a
result of extensive consultation with legal and finance experts and scholars. This new
interpretation still limits private securities litigation to false disclosure causes (no private
action is accepted on insider trading or market manipulation grounds), and it still requires
enabling government action as a precondition for the court to accept a private suit, except
that now the condition can be met by either an administrative penalty or a criminal court
ruling. New restrictions are added as well. Among other things, Article 9 states that all PSL
lawsuits must be filed with the intermediate court of the jurisdiction in which the listed firm
is headquartered. The official justification for this rule is judicial convenience (e.g., easier
for evidence investigation). This restriction is inconsistent with the PRC Civil Litigation
Procedure Law, which gives the plaintiff a choice of jurisdiction between the plaintiff’s
local court and the defendant’s. As noted earlier, local governments have a strong incentive

17
The lawyer, Mr. GUO Feng, representing 696 shareholders against DaQing LianYi was insisting on group
litigation for his clients, not individual litigation. His negotiation with the Intermediate Court of Harbin lasted for
almost the entire year 2002, with the stand that he would not give in unless the court accepted group litigation. His
insistence and continuing efforts between the Harbin Intermediate Court and the Supreme People’s Court played a
crucial role in moving private securities litigation forward. As Hutchens (in press) observes, entrepreneural
lawyers have made a significant contribution in Chinese legal reform. While Mr. GUO insisted on group
litigation, lawyers representing the other 94 plaintiffs agreed to individual litigation, which is why the Harbin
court held hearings from August to October 2002.
 Z. Chen / China Economic Review 14 (2003) 451–472 467

to protect listed companies from their jurisdiction, implying lower courts will be biased to
favor local defendants. Thus, this restriction comes at the expense of shareholder rights and
in favor of fraudulent listed firms. It also exposes another characteristic of the PRC legal
system: judicial convenience takes precedence over plaintiff rights.
Overall, the new rules provide lower courts with specific operational instructions for
handling false disclosure claims.18 The PSL Rules generated new excitement early this
year, and made disappointed investors more hopeful of a loss recovery. But, so far, no
court ruling has been decided on any of the 2000 or so pending cases, an indication
perhaps of the lower courts waiting for further clarification and instructions from the
Supreme People’s Court on certain unclear rules.
It has been more than 4 years since the PRC Securities Law became effective. While
much progress has been made, China’s judicial system is still struggling with the
implementation details. The distance between the ‘‘law on the books’’ and the law in
practice is thus not short.19 This is particularly true in countries that follow the continental
civil-law tradition of top-down law making. The PRC experience further proves the
advantage of common-law systems in which judges at all levels are given substantial law-
making power.

4. Private product liability litigation

In contrast, private litigation in the area of consumer product liability has not been at
the forefront of legal change in recent years. Several laws and judicial interpretation form
the formal basis for civil litigation on product liability:

1. The PRC General Principles of Civil Law of 1986 provides for civil compensation for
damages due to product defects (Articles 122, 130, 131, 132, and 136).
2. The judicial interpretation notice issued by the Supreme People’s Court on January 26,
1988, outlines operational details for lower courts to adjudicate private product-
liability suits.
3. The PRC Civil Litigation Procedure Law of 1991 gives further procedural details
(Article 72).
4. The PRC Product Quality Law of 1993 and the PRC Consumer Rights Protection Law
of 1993 are the principal area laws concerning product liability.

The two area laws passed in 1993 were largely in response to rampant selling of
defective, fake and counterfeiting consumer products in the late 1980s and early 1990s.
However, that legislative response fell into the ‘‘rule by law’’ category, as they have
become more of a rule book for administrative and criminal sanctions. The private

18
See Hutchens (in press) for an in-depth overview and analysis of the PSL Rules and its impact on
securities litigation and legal institutions in China.
19
Pistor (2000) argues, based on a sample of transitional economies, that transplanting laws from another
country usually does not succeed. A country’s preexisting institutional infrastructure may need to change
substantially for a transplanted substantive law to work.
468 Z. Chen / China Economic Review 14 (2003) 451–472

litigation experience based on the product liability laws has been quite limited. Compared
to private securities litigation, which has made much progress in the last 2 years, private
litigation on product liability still lacks momentum.
The PRC government has a quality inspection and control department or center for each
type of consumer product, such as Computer Quality Inspection Center, and Pharmaceu-
tical Product Quality and Regulatory Agency. These administrative departments and
agencies have served as the primary public enforcer of the PRC Product Quality Law.
They often run political-movement-like campaigns to crack down on defective, poor-
quality, and counterfeiting products, by confiscating and burning them. The first of such a
campaign was launched by the State Council in 1992. Over the next 10 years, the total
amount of confiscated products was worth over 30 billion yuan.
From www.Lawyee.com, one of the largest legal case databases in China, the earliest
private product-liability case that we can find took place in 1989, in which a community
department store (GongXiao She) in Baotou City of Inner Mongolia sued a refrigerator
supplier in the same city. The cause for action was that when an employee at the
plainstiff’s store opened a refrigerator sold by the defendant in 1988, the employee was
electrified through the refrigerator handle and killed. The refrigerator was then inspected
and found to be defective by the City’s Product Standards Bureau. The local court then
found the defendant to be liable and ordered the latter to (i) refund the 7900 yuan purchase
price, (ii) pay a total of 13,987 yuan (about US$1500) for the surviving dependents of the
killed employee, and (iii) pay for other losses and expenses of 5400 yuan.
There have been other sporadic private litigation cases based on product defects, but
most of them have not attracted much attention. From www.Lawyee.com, we were able to
collect 80 private product-liability cases (43 of them were consumer-product cases, 7 cases
involved a product that caused death, and 32 cases involved bodily damage to product
users). Out of this sample, 59 cases ended with the plaintiff winning. The largest damage
award granted by the judge was 1.08 million yuan (about US$130,000), and the average
damage award was 127,395 yuan (US$15,000). The damage awards typically included
three components: compensation for direct damage, punitive damage, and litigation
expenses incurred to the plaintiff. These damage awards are clearly nowhere comparable
to those typically awarded for product liability in U.S. courts.
Among the few cases that have received much media attention are the multiple lawsuits
against Toshiba, a Japanese multinational firm. In October 1999, Toshiba accepted a
US$2.1 billion settlement in a class action filed against Toshiba (U.S.A.) in a Texas district
court.20 The complaint was that even after NEC announced and advertised a defect in its
floppy disk microcontroller back in 1989, Toshiba knowingly continued to use it in its
laptop product line. The defective disk drive caused data loss for two users. The plaintiff
class included half a million impacted users. After this settlement in the United States,
Toshiba never informed any of its customers of this defect in China and it continued to sell
computers with this defect there.
On May 8, 2000, someone in China accidentally learned about the 7-month-old Toshiba
settlement on the Internet and published a story in Chinese, which prompted an angry
reaction from numerous consumers. Internet message boards and print media were full of

20
See Robertson (1999) for a report on this settlement.
 Z. Chen / China Economic Review 14 (2003) 451–472 469

nationalistic and emotional comments. A stage was set for active debate among legal and
law experts. On May 25, the first joint action against Toshiba was filed in Beijing by nine
Toshiba users.21 On August 15, three individuals filed another suit against Toshiba in
Shanghai. No news about the outcome of these suits is known even today, perhaps because
that debate had too much nationalistic flavor and the government had to keep the court
ruling quiet.
To show how little progress has been made on consumer rights in China, note a famous
1999 libel case, Hengsheng Computer v. Wang Hong et al. In August 1997, Mr. WANG
Hong bought a laptop computer made by Hengsheng Computer, and later found the laptop
to keep shutting off on a regular basis. Within the warranty period and on June 1, 1998,
Mr. Wang took the laptop back to the computer store where he made the purchase. But, he
was denied any service. After several failed attempts and in late June, Mr. Wang decided to
post an angry comment on an Internet bulletin board, and filed a complaint with the
government-sponsored Consumer Rights Association of Beijing. No progress was made in
obtaining repair service after almost 2 months. Next, Mr. Wang posted more comments on
the Internet. Two newspapers, Microcomputer World Weekly and Life Time, reported on
this story, respectively, on August 10 and July 27.
In April 1999, Hengsheng Computer filed a lawsuit against Mr. WANG Hong and the
two newspapers for libel damage. The lower court ruled that the defendants were liable for
injuring the plaintiff’s reputation, and ordered Mr. Wang to pay damages of 0.5 million
yuan (US$52,000, 25 times Mr. Wang’s annual income) and each of the two newspapers to
pay 0.25 million yuan to the plaintiff. Upon appeal, in December 2000, the Beijing No. 2
Intermediate Court reduced the damage award against Mr. Wang to 90,000 yuan (about 4.5
times his annual income).
The court’s decisions in that libel case illustrate just how far the legal culture for
consumer rights has to go. Mr. Wang was trying to get a promised warranty service. His
Internet postings were an effort to call upon other consumers to boycott the manufacturer’s
products. Yet, for doing that, he is still paying for the libel judgment.

5. Comparing product-liability and securities litigation

An intriguing research question is: Why has private securities litigation led to much
legal development whereas product-liability issues have not? What characteristics distin-
guish the two areas? In real impact terms, the stock market affects a relatively small
fraction of the population (10 million in a 1.2 billion population), while consumer products
touch upon the daily lives of the entire society. Thus, consumer rights should be relatively
more important to both the economy and society. But, as hypothesized in this paper, the
stock market has been more powerful when it comes to the ability to drive legal change.

21
Note that in consumer product-liability litigation, plaintiffs could use the joint-action litigation device in
May 2000, whereas even today the Supreme People’s Court does not allow for this device in private securities
litigation. In product-liability litigation, the likelihood of a major domestic political crisis is considered low. In
contrast, the PRC government has been much more concerned about the political risk prospects of allowing class
action suits in securities litigation. See Lawrence (2002).
470 Z. Chen / China Economic Review 14 (2003) 451–472

We can speculate to offer the following points. First, commonality is what characterizes
the investor constituency. In securities fraud, all affected shareholders are injured by the
common fraudulent act, at the same time and in the same location. Damage causality is
easy to establish, especially since there is typically no role played by the shareholders in
causing the damages. In contrast, there are diverse types of consumer products. Even with
respect to the same product type, say, Toshiba computers, damages to users may occur at
different times and in different locations. This fact alone creates a weaker sense of
commonality among injured consumers. While it is sometimes technically possible to trace
all the damages back to the same defect, a defense often used by producers and distributors
is that the consumer did not use the product properly and that it was the consumer’s fault.
Product-liability cases require plaintiff-specific proof of causality.
Second, damages are easily and immediately measurable in securities trading. To
measure stock investment losses, you do not require additional information beyond price
declines. Furthermore, financial loss is the only type of damage to be concerned within
securities cases. In contrast, damages to consumers due to product defects are often hard to
measure and intangible. Such damages can be as grave as death, and they can also be quite
subjective and difficult to measure financially. This measurement difficulty and the
intangibility of damages make the formation of constituency much harder to achieve.
Finally, these two characteristics—commonality and immediate measurability of loss—
also render securities litigation and shareholder rights an ideal topic for the media to report
and debate on. The daily realization of stock trading gains and losses is a feature that is
largely responsible for making the stock market a persistently popular topic at social
occasions and other places. In contrast, not many consumer products (if any) are
perpetually popular topics. Thus, the media’s attention on stock market trading is also a
major factor in the easier formation of a politically powerful investor constituency.

6. Conclusions

The debate on whether law matters for economic and market development has been
going on for decades, especially since the work by Max Weber and Friedrich von Hayek.
In recent years, commentators have pointed to China’s recent growth experience,
especially in comparison with India, which has a far better institutional infrastructure, to
suggest that law does not matter for growth and market development.22 These comments
are implicitly based on the ‘‘law-then-growth’’ thesis. However, a closer look at the PRC
experience shows that for young markets, it is probably more like ‘‘crash-then-law’’ or
‘‘growth-then-law,’’ a thesis argued by Coffee (2001). The initial phase of development (in
both the economy and markets) is necessary both for a constituency to be formed and to
set the stage for ‘‘crashes’’ or problems. Legal change will then follow. Legal reform is
necessary in the second phase to prepare a country for further, more mature economic
growth. Thus, a legal order may not be a precondition for initial market development, but a
precondition for more mature development.

22
See Thakur (2003) for a growth comparison between India and China, and Kristof (2003) for a comparison
between Russia, Ukraine, and China.
 Z. Chen / China Economic Review 14 (2003) 451–472 471

Bear markets are often necessary for legal change, as happened in the United States in
the early 1930s. Each of the two major downturns of China’s stock market (1993 to 1996
and 2001 to the present, as shown in Fig. 1) led to a significant change. The first downturn
generated pressure for the CSRC to take more aggressive administrative actions against
violators, while the second set the stage to push for private securities litigation.
Another lesson from the PRC experience is that different types of economic activity
present different pressure levels for legal change. Capital markets are perhaps the most
conducive to the formation of a politically powerful constituency and hence dramatic legal
change, because of (1) the higher degree of commonality among interested parties and (2)
immediately measurable and tangible damages. These two characteristics of capital
markets not only allow investors to identify with each other more easily, but also create
an ideal basis for more debate in the public media and other places, which in turn promotes
the development of a legal culture. Anecdotal evidence indicates that there is probably
more media coverage of legal issues in China today than in other countries. Private
securities litigation has challenged the traditional Chinese view that law is a tool used by
the ruling class to rule. It has also challenged the traditional focus on substantive law rather
than procedural law.

Acknowledgements

The Author would like to thank the editor for this issue, Belton Fleisher, for his
patience and encouragement, Donald Clarke, Andrei Schleifer, and Steve Yun for their
comments and suggestions, and SHI Minglei, WANG Yonghua, XIONG Peng, Steve Yun,
and ZHOU Feng for helping with the date and case collection. Any remaining errors are
the author’s responsibility alone.

References

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