Why the IPO reforms don't go far enough

A CSRC senior officer has expressed that he is fond of US style prospectuses similar to that prepared by Facebook for its high-profile IPO last year, which include disclosure of all the risk factors. The new policies will help speed up the evolution of the Chinese prospectus, which has been criticised for lacking sophistication when compared with international counterparts.

Law firms beware

The CSRC's IPO review and approval process, which used to place a lot of emphasis on the profitability and sustainability of the growth of the issuer, will now be focused on information disclosure. The key to a registration-based system is stringent liability against fraudulent information and the existence of an effective legal and market mechanism to penalise the responsible parties. The Opinion states that the issuer should be the first one responsible for information disclosure. However, sponsors, accounting firms and other intermediaries (the Opinion itself does not mention lawyers, but in practice the issuer's lawyer is included) should also undertake in writing that they shall be liable to investors for losses arising from fraudulent disclosure, misleading statements and material omissions in the listing documents they prepared.

The new measures are an unambiguous warning to the intermediaries, especially sponsors and accounting firms, which have been criticised for supplying the capital markets with extremely attractive listing companies that turned ugly in only a few months. It is unclear whether it is the true intention of CSRC to require the intermediaries to be jointly responsible for the full extent of liabilities to the issuer. This has never been international practice and it is especially dangerous for law firms: most law firms lack sufficient insurance coverage and partners actually have unlimited liability. Even if CSRC wanted this to happen, it would require a change to the PRC Company Law (公司法), PRC Securities Law (证券法) and even the PRC General Principles of the Civil Law (民法通则).

Lines also need to be drawn to demarcate the liabilities among different intermediaries. For example, why should law firms be responsible for accounting errors? The new measure will undoubtedly deter wrongful acts by intermediaries; however, it will also in practice make the intermediaries insurers for the investors. My intuition tells me that the negative impact to the market may be that intermediaries have to multiply their fees for the same services or refrain from handling most of the deals that are already in their in-trays. With respect to penalties, the Opinion focuses more on administrative penalties than civil liabilities and makes no mention of class action or derivative securities litigation, which are internationally established measures to ensure responsible information disclosure and investor protection. It is expected that progress on this matter is on the horizon, however, it must be accompanied by improvement of the court system, which itself will be reformed under the new leadership.

Pricing

The Opinion also addressed reforms to the pricing mechanism for IPOs, focusing on identifying effective quotes from institutional investors and solid market participation. More institutional investors' quotes are required during the pricing determination process and qualified individual investors are allowed to participate in the offline pricing determination and placement. More flexibility is given to the issuer and underwriter in price determination; however, a specific risk factor statement must be publicised if the PE ratio for the IPO is higher than industrial average in the secondary market. The Opinion also specifies the percentages allocated to institutional placement in the total IPO and allocations within the institutional placement; priority is given to the public securities fund and state social security fund. A reallocation mechanism has also been introduced, which will be triggered when the oversubscription figure exceeds 50 times and 100 times. These measures are designed to favour small investors and avoid situations where a small group of institutions conspire to create an overly high issuing price.

For the existing shareholders of the issuer, there is good news and bad news. The good news is that they may be able to sell their old shares during the IPO on the condition that they have owned these shares for more than three years and that after the sale there shall be no change of the actual controlling shareholders. This is in compliance with the practice of major international exchanges. The bad news is that if, after the IPO, the share price of the company is lower than the issuing price, they may not be able to cash out of their shareholdings. Moreover, the prospectus must disclose the shareholding and reduction strategy in the IPO documents. These measures reflect a mixture of investor protectionism and modernisation of the capital market. Under the new measures, the pricing strategy of the controlling shareholders is expected to be more conservative. Private equity and other pre-IPO institutional investors will also benefit from the new measures: now they can exit earlier and they have a de facto share price stability guarantee from the controlling shareholders. More clarification is necessary from CSRC on the extent to which controlling shareholders and institutional investors jumping in immediately before the IPO will be allowed to cash out their investments: previously the investments could be locked for up to three years.

Preferred shares

There are complicated policy goals behind the launch of the pilot programme on preferred shares. Capital markets in China have long been criticised for being devoted to raising funds rather than delivering returns for investors. The preferred share, which is a form of equity with features similar to debt instruments such as preference on dividend and distribution upon liquidation, will be used as a mechanism along with the newly established mandatory dividend distribution policy to promote distribution to investors.

On the other hand, CSRC has acknowledged that the preferred share will facilitate financing efforts by financial institutions (most of them SOEs) to satisfy capital adequacy ratios. It is also expected that SOEs will issue preferred shares to reduce their state shareholdings while retaining state control. It is worth mentioning that the preferred shares mechanism is only indirectly mentioned in the PRC Company Law and has absolutely no mention in the PRC Securities Law. The full implementation of the preferred shares will be conditional on amendments to these national laws.

The aim of the new policies is definitely to protect investors. Chinese capital markets hit a new low after the 2008 financial crisis. During this period – especially in the Chinese GEM market – investors saw too many fraudulent disclosures, too much fake accounting, exaggerated promotion and conspiracy in pricing new IPOs. Most of the new IPOs were followed by a sudden decline in performance and a tumbling share price. This means that most of the new policies, which clearly are constructed to avoid market fraud and penalise wrongdoers, will be welcomed by investors.

Too much administration

The new policy will also change the role of the supervisory authorities from identifying and approving good IPO candidates (which they have failed to accomplish so far) to suspending and deterring problematic market activities. This complies with the overall policy by the new Prime Minister, Li Keqiang, of reducing unnecessary government interference and creating a more market-oriented economy. However, the new policies still stick to the traditional PRC practice of relying heavily on administrative measures. Firstly, it has long been expected that if more discretion and authority is vested in the exchanges (which are not government agencies and are closer to the market) and less administrative approval authority is given to CSRC, a branch of government, it will help to create a better-managed capital market. However, nothing has been done about this in the new policies. Secondly, there are probably too many administrative measures that deal with details. Like the fixed figures shown in the Opinions, the CSRC is actually creating more administrative thresholds and approvals.

The Chinese capital markets' problems have multiple causes and cannot be cured by only one medicine, even if it is a very strong dose. The approval-based system, which focused on identifying and approving good companies but is weak on post-listing supervision and enforcement, is only one cause. Other causes include excessive funding after the Rmb4 billion governmental incentives plan, which caused too much speculation in the capital markets, and the immaturity of China's business law and legal enforcement, which still does not allow class action lawsuits and derivative securities litigation (the influence of local governments on local courts is to be blamed here – local governments always prefer to praise local companies that list). Private equity funds and various influential institutions which search for, educate and then talk up the business prospects of successfully listed companies should not escape condemnation: they are the real winners in the market boom.

In any case, the new policies still represent great progress towards a more responsible, market-directed and healthy capital market. They have incorporated several internationally established measures, including information disclosure, preferred shares and liquidity of old shares upon IPO. At the same time, there are still a lot of Chinese characteristics. I have to state that positive administrative measures, even those which are regarded as excessive, may be the only cure which has an immediate effect. There is an old Chinese saying: “when righting a wrong, you must be excessive (矫枉必须过正).” I believe this saying also underlies the thoughts of the person who designed these new policies.

The new policies will have a serious impact on the investment banking, public accounting and legal business markets. Even veteran professionals will need to reexamine their internal control and risk prevention mechanisms. Heavy competition is a norm in IPO deals, and the fees to intermediaries have been continuously reduced in the past few years. Full compliance with the new measures and reasonable risk control will cause the expense of an IPO deal for intermediaries to drastically increase. If the fees to the intermediaries are not increased accordingly, these agencies will suffer the loss of able professionals. I don't think this would be helpful to China's capital markets. Skilled professionals are vital to a healthy and dynamic capital market.

Dai Guanchun, Jingtian and Gongcheng, Beijing