Caixin Explains: New Rules for IPOs Let Market Forces Do the Talking
Beijing) – A recent change to the country's initial public offering system has been hailed by observers as a step toward a registration-based system that lets investors determine value, which is a crucial component of an effective capital market.
The new policy was announced by the China Securities Regulatory Commission (CSRC) on November 30. About 50 enterprises will have completed their IPOs under the new regulation by the end of January, a CSRC spokesman said.
Under the new regulation, companies still need the CSRC's approval to go public, but they no longer need to prove their ability to continue making money. This judgment now rests with the market. This is a change significant enough to make the IPO system look like one based on registration, which the CSRC said it would eventually adopt as reform deepens.
The news bodes well for many securities firms that have seen their investment banking income fall sharply since November last year, when the CSRC stopped letting companies list on the Shanghai and Shenzhen bourses. By the end of last month, more than 760 firms had filed applications with the CSRC to go public.
What is the significance of the new regulation?
The defining characteristic of the revised IPO policy is its message that the CSRC will ease out of the role of parent and become a fact checker. The regulator and the IPO review committee will only be responsible for checking whether the application material and other information conform to standards, the policy states. It will not vouch for the "sustained profitability of the issuing company and the investment value," as it had in the past. The judgment will instead be left to the market and investors.
The new regulation also beefed up measures aimed at cracking down on speculative investment in IPOs, which has been blamed for causing absurdly high prices for new stocks. It also strengthened punishment for issuing companies and underwriting intermediaries should they milk or cheat other investors.
What happens to companies that lie to or withhold important information from investors?
The regulation stipulates that in case IPO materials are found to be false, misleading or contain important omissions that significantly impact whether the issuing company meets IPO requirement, the issuing company must buy back all new shares sold in the IPO. Also, both the company and its underwriters will be punished. Some analysts view the buy-back requirement as a doorway to a delisting mechanism.
Before the new rules, did investors have any protection against IPO fraud?
Investor compensation was dealt with on a case-by-case basis when listed companies were found cheating because the Securities Act did not say how this type of situation should be handled.
For example, Wanfu Biotechnology (Hunan) Agricultural Development Co. Ltd., which went public in 2011, was recently found inflating its revenue and profits. The company's chairman and 19 other executives were fined and penalized. Ping An Securities, the company's IPO underwriter, was fined and required to set up a 300 million yuan fund to handle investor compensation. It also became the first brokerage firm to have its underwriting privilege halted by the CSRC since the IPO system was established in 2004. Wanfu is still listed on the Shenzhen bourse, though trading of its shares has been indefinitely suspended.
What was the approval-based IPO system?
The essence of the approval-based system was that the CSRC examines and approves a company's credential at every step of the IPO procedure. It takes upon itself the job of verifying the company's worthiness of investment in addition to examining whether the application materials are complete. In this system, the CSRC was held accountable to some extent for the performance of a listed company because it is seen as endorsing the company's "sustained profitability."
What is wrong with this?
There were several major drawbacks. First, the approach obstructed market forces in effectively allocating financial resources. The painfully long process to gain regulatory approval to go public cost many companies the best opportunity to list their stocks.
More importantly, the approval system bred corruption. It was well-known that companies would go to great lengths, including bribing IPO review committee members, to ensure their listing succeeded. There was also a whole network of underground businesses that thrived on blackmailing IPO hopefuls.
Because it was so difficult to list, zombie companies with virtually no operations are still often traded at high prices as investors speculate that they will be taken over by a company that balks at the regular IPO channel.
How was the IPO pricing mechanism improved?
During price inquiry, the issuing company and its underwriters are required to dismiss bidding prices in at least the top 10 percent. This is intended to reduce the likelihood that they can collude with a bidding investor to raise the stock price.
The issuing company's original shareholders are also discouraged from setting the IPO price too high because the lockup period for their holdings of the company's shares will be extended if the stock price closes below the issuing price for 20 straight days within the first six months or if it closes below the issuing price after first six months.
The original shareholders are also barred from selling shares for lower than the issuing price in the first two years after the lockup period ends. This would help solve one of the most severe problems that haunts secondary market investors. Because a company's original shareholders almost always acquired their shares for very cheap, selling them for less than the IPO price still meant making a fortune but often hurt retail investors.
How has the market reacted?
The ChiNext board for startup enterprises posted is largest single-day decline of all time on December 2. Its benchmark index fell 8.26 percent from the previous trading day to close at 1,253.93. Analysts say the fall was primarily triggered by the new regulation, which opened the door to more companies to list on the board. The expectation of fiercer competition combined with the fear that an influx of new stocks would spread investor money too thin and drag down existing stock values were the primary reasons behind the tumble, analysts say.
The impact to the main board was relatively light, partly because not as many companies have announced plans to list on the main board as on the ChiNext board. The benchmark indexes for the Shanghai and Shenzhen stock exchanges were down 0.59 and 1.94 percent, respectively, closing at 2,207.37 and 8,376.64.
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