July 30, 2019 / by Pieter Verstraete

China’s IPOs; The New Normal

Last week was a remarkable moment for China’s domestic stock market with the launch of its STAR market exchange. This index is seen as answer to the American Nasdaq-index and focused on high tech companies. The government aims to offer investment opportunities to affluent domestic investors and wants to avoid that Chinese champions like Alibaba and Tencent list in the US or Hong Kong instead.

On its first trading day it sparked a frenzy among investors as on average the share price of the 25 companies rose by 140%, with some reaching gains as much as 520%. According CNN, the first day created three new billionaires. Despite the fact that most stocks lost some of their gains during the week, most stocks are still trading much higher than their IPO price. Unlike the other boards on the Chinese stock market, the STAR index can move freely during its first trading week, after which a daily cap of 20% will be applied. The other markets permit main-board stock prices to move 44% on the first day and thereafter 10%.

It is still too early to say whether the new board will be a success. However, almost 150 companies lined up already to get listed and investors are eagerly waiting for new IPOs. Investors are willing to pay more for the growth: tech board stocks that posted profits in the past two years saw 2018 earnings grow by an average 88%. That compares with 25% growth for firms on the Shanghai Composite Index, and a 16% expansion rate for those on Shenzhen’s ChiNext.

This article particularly looks at China’s IPO market; secondary market policies and reforms are not taken into consideration. It will answer questions related to IPOs, such as ‘How does the IPO system in China work?’, ‘How common is committing fraud?’ and ‘What has the government been doing to reform?’

China’s stock exchange structure

Currently there are two stock exchanges in Mainland China: The Shanghai Stock Exchange (Main Board) and the Shenzhen Stock Exchange (Main Board, SMEs, ChiNext), which have been operating for almost 30 years, since their inauguration in December 1990. The Main Board serves for blue-chip companies, representing the stalwarts of industry and are considered safe, stable and profitable. The SME Board and ChiNext are heavyweights in industry segments and innovative high-growth companies respectively. The newly launched STAR exchange focuses on young and fast-growing tech and science companies.

Any initial public offering in China requires the approval of the Listing Committee of the CSRC. A company seeking a listing on the Stock Exchange through an IPO must meet the mandatory conditions under relevant laws and regulations with respect to the form of its corporation, its lawful operation in its history, its financial status, the independence of its business, etc. Listing requirements for the Main Board and SME Board are basically the same. ChiNext on the other hand has less strict listing conditions (e.g. in terms of profits).

Similar as in the West there are three important service providers involved to guide the process for the company that wants to go public: a securities company acting as sponsor and underwriter, an accounting firm and a law firm. Generally, the process takes at about a year and entails the following steps:

  • Restructuring: advisors conduct due diligence and start the legal restructuring
  • Training: the sponsor gives systematic training to the company’s directors, shareholders and other senior officials
  • Application and review: prepare and submit the application to the relevant authorities
  • Listing and continued monitoring: Roadshow to promote the IPO, determine issue price and offering the shares to the public. After listing, the sponsor keeps checking the company’s adherence to relevant laws and regulations

Fraud on China’s stock exchange

Despite the legal framework with all applicable laws and regulations in place, China’s stock market has been making the headlines with fraudulent cases. Below are just a few of the dozens of cases over the last decade.

Last year the Shenzhen Stock Exchange started delisting procedures for Geeya after the CSRC found that Geeya cheated to gain listing approval by posting inflated revenues and profits, fabricating contracts and falsifying payment collections, among other means, to fulfill the conditions for a public offering. The regulator found that the sponsor, auditing firm and law were all involved in fabricating the falsities.

In 2016, the CSRC opened an investigation into six Chinese companies suspected of IPO fraud. The six cases marked the start of a relatively new campaign by the CSRC at that time intended to detect and punish IPO fraud. The alleged fraudulent included false representations made in IPO prospectuses and inflation of company revenue and net income, designed to induce market speculation and artificially boost company stock prices following an IPO. Earlier in 2016, Dandong Xintai Electronics became the first Chinese company forced to delist after IPO disclosure issues, the most severe IPO fraud punishment till then.

Further back: In 2013 China’s securities watchdog punished two brokers for collaborating with fraudulent firms to list shares. It also suspended Ping’An Securities’ underwriter license for three months after it helped a fraudulent company to list shares in 2011.

Between October 2012 and the end of 2013, China’s IPO market was frozen amidst government attempts to clean up the market. More than 750 companies had to wait over a year for the IPO window to be reopened.

Market Reforms

Every time a scandal hits the market, the Chinese authorities announces to further control the market and severely punish those who do not obey the rules.

Since 2009, Beijing has tried several times to implement reforms in the IPO market, aiming to abandon its role for approving IPOs and price-setting, so market forces can valuate companies. After this policy change was introduced, underwriters and companies were given full play in setting share prices. This led to new stock being sold at unreasonably high prices amid mainland investors’ enthusiasm for IPOs. Most of the stocks, after surging for several days, saw their prices sink owing to profit-taking. From this perspective, it doesn’t come as a surprise that the market supervisors maintain a careful approach; China’s stock market, opposed to its Western peers, is mainly dominated by retail investors.

In 2015, the CSRC planned to embark on a registration-based IPO system, similar to the process used in the United States. Under that system, the regulator would require full information disclosure by the companies once they submit their listing applications.

The CSRC would be responsible only for assessing the truthfulness of the documents, rather than the applicants’ earnings potential, before granting them approvals to raise funds.

The aim was to give market forces full play in deciding IPO prices. The turbulence on China’s stock market stock mid-2015 however foiled the regulator’s attempt to push ahead with the market-based reform.

Post-2016, we see a trend towards stricter enforcement and the CSRC has repeatedly been making statements about this. In January 2018 it promptly rejected 6 out of 7 IPO applications on one day, adding ‘IPO fraud is one of the most serious legal violations in the securities market and it seriously jeopardized the foundation of the market. The IPO review will become stricter in 2018 and the requirement for the authenticity of corporate finance and the business compliance has been raised to an unprecedented level’. As a result, the approval rate dropped to below 45% opposed to over 80% in 2017 and over 90% the years before.

At the end of 2018 plans were released for the ‘Shanghai Technology Innovation Board’, which we know now as the STAR market. As mentioned before, the new board is seen as a key effort to enhance the Chinese mainland market’s attraction for tech listings in competition with the Hong Kong and American markets.

Under the new system, regulators will no longer set rigid requirements on profitability, customer concentration and other business criteria. Instead, companies’ materials will be reviewed to make sure their disclosures are real, accurate and adequate. Companies will need to meet one of five criteria set in the draft rules involving market value, profit potential, revenue, research capacity and business outlook.

The relaxed requirement on profitability will open the door for pre-profit companies like biotech startups to list on the board. The new framework further includes the adoption of a registration-based mechanism for initial public offerings (IPOs) and companies with unconventional legal and shareholding structures. The proposed rules all point to allowing the market to play the decisive role in stock issuance and pricing.

As common practice in China with new concepts, Shanghai’s new board will be the test bed for a total overhaul of China’s stock market. Experts have been responding cautiously positive to the welcome market reforms: “If it only moves (the decision-making on IPOs) from the CSRC to the Shanghai exchange, it will be not enough,” one expert said. Others are more skeptical arguing that the regulatory review only makes it easier for companies to cheat and makes the costs of cheating extremely low.

We can conclude that the government is actively pursuing market reforms, however it will take time for the market to determine whether the changes can make a real shift from China’s long standing IPO approval system, the source said.



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