George Michael Gerstein is an associate in the Fiduciary Responsibility group at Groom Law Group, where he advises financial institutions and plan sponsors about a broad range of issues related to Title I of the Employee Retirement Income Security Act (ERISA).
This section is concerned with some of the key aspects of fiduciary responsibility and prohibited transaction issues under ERISA, Gerstein explains, especially in connection with plan investments and related products. While much of the industry’s regulatory focus in recent years has been paid to a familiar list of issues—notably the definition and scope of the fiduciary relationship under ERISA, along with the increasing prevalence of state-run retirement programs for private sector workers—Gerstein tells PLANSPONSOR a new line of client inquiry is emerging: How can qualified retirement plans access potential growth in China?
Gerstein says the conversation is currently unfolding around a pilot program called the “Shanghai-Hong Kong Stock Connect,” which he explains as an effort to link the stock markets in Shanghai and Hong Kong and bring greater accessibility, accountability and transparency to those markets for global investors. Under the program, investors in Hong Kong and Mainland China can trade and settle shares listed on the other market through exchanges and clearing houses in their home market.
It sounds obscure, but Gerstein has received an increasing number of client calls asking about what this could potentially mean for retirement plans in the U.S., “and whether it would work under ERISA.”
“I have the sense that asset managers are intrigued but are still in the exploration phase” regarding deeper expansion into China and the Shanghai markets via the Stock Connect, Gerstein says. “As for exposure, apparently some of the major indices will start including China A shares over the next couple of years … with many passive vehicles tracking indices.” Gerstein says the signs all show the asset managers that service U.S. retirement plans “consider this very much to be in play.”
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China and Shanghai?
Probably the most important detail for U.S. retirement plan investors regarding the Shanghai-Hong Kong Stock Connect is that certain international investors are able to use the platform to purchase eligible Shanghai-listed shares through their local broker. It's an inviting prospect in the search for return, given that the Shanghai market is often cited as the fifth-largest by market capitalization.
As Gerstein explains it, “the Shanghai-Hong Kong Stock Connect links the Stock Exchange of Hong Kong and the Shanghai Stock Exchange so that U.S. investors, for example, can trade China A shares directly. It launched last year and is significant. Prior to the Stock Connect, a U.S. investor had to have a special license or simply trade in A shares through derivatives. Now, it becomes easier to trade in domestic shares of the world's second largest economy.”
Stock purchased through the exchange is “self-contained and is designed to avoid hot money chasing the Chinese market,” he adds. “There are quotas and the restrictions that apply to foreign investors remain in place. The U.S. investor would access the Mainland market via Hong Kong. In other words, the U.S. investor would not have an account to hold the A shares with the Shanghai Stock Exchange. Instead, the investor's account would be in Hong Kong.” Other important details: the relevant A shares are denominated in the renminbi currency, and “we are dealing with equity only at this point.”
“I think the Stock Connect has been considered a success so far,” Gerstein says. “It's been stable and there's definitely been demand. Capacity will likely increase over the coming years, as well as the availability of different products, though it is tough to say with any certainty. Capacity will need to increase once A shares are included in some of the major indices.”
NEXT: What U.S. investors should consider
Gerstein says there is clearly growing interest among U.S. investors in gaining access to domestic Chinese stock markets.
“I think that most of them are still in the exploration phase, though,” he says. “Asset managers are still trying to understand the model and have raised some concerns. Fortunately, though, the Stock Connect has shown a willingness to address investor concerns.”
He shares the following technical example: “At first an investor would need to ensure that each of its executing brokers had sufficient securities in the investor's account to consummate the transaction prior to execution. This would need to be done on T-1. The investor would have several hours prior to execution when its assets were not held with its custodian. This worried people and so now there is an ability to leave the securities with the custodian until settlement.”
Still, there are issues that need to be worked out before U.S. investors really start rushing in, such as a clearer understanding of who holds custody of the A shares. “There also needs to be clear records of ownership,” Gerstein adds. “Again, I would imagine these issues will be addressed in one way or another.
“ERISA fiduciaries have asked whether trading over the Stock Connects works under ERISA,” Gerstein notes. “Certainly, there are the prudence considerations. Then, we need to remember that ERISA only allows plan assets to be placed outside the reach of the U.S. courts under very limited circumstances. Congress was worried about runaway assets. So, the key is to apply the ‘indicia of ownership’ rules to A shares. As the Stock Connect continues to fill in the blanks, this analysis hopefully becomes easier and provides a level of comfort to fiduciaries.”