China’s plan to allow the market a greater role in initial public offerings hinges on stamping out a raft of practices that deceive investors, from lax underwriting standards to executives who falsify earnings to obtain higher valuations.
The proposed switch to a U.S.-style IPO model comes after a 14-month moratorium on Chinese offerings and is part of a wider push by the Communist Party to lessen government control of the economy. The so-called registration system would leave questions of IPO supply and timing of deals to companies, not Chinese regulators who now must approve most facets of an offering. Hurdles abound, including creating a legal system robust enough to guard against stock-sale fraud.
“The registration system is the right direction, but it requires many other conditions to make it work,” said Zhang Yuanzhong, a Beijing-based lawyer at Wentian Law Firm specializing in securities litigation. “You need a compensation mechanism that allows investors to recover losses, and a legal definition of securities fraud needs to be established to allow investors to bring cases to court.”
Beijing’s plan to overhaul its IPO process came in a 60-point statement released Nov. 15 after leaders gathered in the third full meeting, or plenum, of the party’s 18th Central Committee. China was home to the world’s largest IPO market in 2010 with $71 billion worth of offerings. The market is frozen now as regulators draft rules to curb misconduct in first-time share sales.
Acknowledging the obstacles to the proposal, China Securities Regulatory Commission chairman Xiao Gang said Nov. 19 the shift to a looser IPO system must be gradual to avoid shocks to the market.
‘Touch One Hair’
The CSRC may need until at least 2015 to introduce the new system, as it would first have to overhaul the country’s securities law, said Leon Qi, a Hong Kong-based analyst at Daiwa Securities Group Inc. It must also clear a backlog of more than 700 companies waiting to go public under existing rules, Qi said.
Xiao warned of the enormity of the task at hand, saying that creating a registration-based system is the kind of reform where “if you touch one hair, the whole body feels the impact.”
China now relies on the CSRC to act as a gatekeeper for offerings. A seven-person listing review committee examines each application in a lengthy process, judging factors such as investment potential and profit sustainability. It even uses its power to sit on IPO applications when stock markets are weak to restrict the supply of new equity.
“Government control of the IPO tap provides a floor to the markets,” said Keith Pogson, a partner at Ernst & Young who oversees financial services in Asia.
Under the new model, the watchdog’s role would switch to ensuring only that companies’ disclosures meet certain legal and financial requirements, a model used by developed countries including the U.S.
That places the burden of ensuring the accuracy of disclosures on the listing companies and its bankers, some of whom currently lack the capability to conduct proper due diligence, according to Xiao.
“It’s going to be tough,” said Beijing lawyer Zhang. “Many companies have deep-rooted connections with local authorities, and local courts may lack independence.”
Chinese investors now lack legal channels to seek compensation for fraud losses, according to Zhang. That’s especially a problem as individual investors dominate trading on China’s stock exchange. Institutions account for just 17 percent of the free float, said former CSRC chairman Guo Shuqing.
One outcome of a registration-based system should be more realistic valuations as the number of IPOs increases, said Gary Liu, a researcher at the China Europe International Business School in Shanghai.
Rich valuations for IPOs helped drive a boom in new offerings three years ago. Price-to-earnings ratios of Chinese IPOs averaged 58 times in 2010 and 48 times in 2011, according to former CSRC chairman Guo.
“The fact that so many companies have lined up to sell shares indicates that valuations are still too high,” Liu said in an interview in July.
Chinese regulators are already in the midst of a crackdown on securities fraud. The CSRC, under pressure to avoid exacerbating a 24 percent slump in the Shanghai Composite Index in the past three years, has been drafting tougher rules to curb misconduct. Last December the CSRC ordered companies to reexamine their offering documents for spot checks, forcing more than 200 firms to withdraw their applications.
Since May, at least 21 bankers, auditors, lawyers and executives have been barred from China’s securities industry.
The CSRC fined Ping An Securities Co. 76.7 million yuan ($12.6 million) and Minsheng Securities Co. 3 million yuan in May for failed due diligence in IPOs, while Nanjing Securities Co. was censured for similar violations. Bankers at all three firms were barred from the industry for life. Ping An was arranging the IPO of Wanfu Biotechnology Hunan Agricultural Development Co., which had forged financial data, the CSRC said.
“China still has this get-rich-quick mentality and it’s deeply embedded in the current culture,” said Ernst & Young’s Pogson. “People are more willing to take short-term risk and care less about their long-term reputation.”
Proposed regulations, published in draft form in June on the CSRC’s website, call for penalties against brokerages and their employees for transgressions such as including inaccurate information in a prospectus and poor risk disclosure, or when companies post a drop of more than 50 percent in profit in the year following an IPO.
Under the rules, the regulator could temporarily ban a securities firm from equity underwriting if key data is omitted, or if misleading or falsified information is published in the prospectus.
“You can’t jump from complete state control to market-driven overnight,” Pogson said. “The transition needs to be carefully managed.”