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China's Rocky IPO Reboot

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Robyn Josep weighs the positive and negative implications of China’s new share issuance reform process

China’s small and medium-sized stock investors understand frustration. After the country reopened its stock market in 1990, small investors watched on the sidelines as institutions – benefiting from fixed pricing and rules that allowed them to capture most of issuances – made fortunes off of underpriced A-share IPOs.

Several rounds of reform later, overpricing, reflected by high bidding during the book-building process, has become a problem. The chief symptom of this malady is systematically elevated price-to-earnings ratios. As for the tragic result, institutional investors have had few qualms with cashing out in the secondary market, leaving small investors holding shares with rapidly plummeting values

THE GOOD MEASURES
On 30 November, the China Securities Regulatory Commission, released a reform document that signalled the impending end of what had become a year-long IPO freeze. Among other goals, the “Opinions on Further Reforming the New Share Issuance System” (the Opinions) are intended to restore balance to IPO share pricing. They call on issuers and underwriters to reject the top 10 percent of bids during book-building. They also increase the supply of shares rationed offline, notwithstanding a stronger claw-back mechanism favouring retail investors, and restrict the number of permitted bidders in order to reduce upward pressure on issue prices.

Apart from these and other price-restraining measures, there is much to like in the Opinions. They pave the way for more efficient processing of IPO applications by  calling on the CSRC to judge applications according to their legality and fidelity to regulations as opposed to an analysis of the applicant’s expected financial and business performance. On the one hand, this may help clear the roughly 700-applicant backlog. On the other, it could allow the market to play a more “decisive” role in resource allocation – a key goal of the Communist Party’s November Third Plenum.

The Opinions offer other advantages to listing firms. For example, they double the effective period of IPO approvals, allowing issuers that receive approvals when market or industry conditions are soft more time to wait out the situation.

Finally, they may lead to more careful disclosure by requiring intermediaries that show negligence in their due-diligence activities to compensate investors for any resulting losses, and by calling for the temporary suspension of underwriters who sponsor companies that subsequently suffer significant losses. While these two measures may lead to higher costs for intermediaries, raising the quality of disclosure is a necessary condition if a registration-based IPO system is to work.

THE NOT-SO GOOD MEASURES
The implications of the Opinions are not all positive. Trading was volatile on the first day after the new reforms were announced. The ChiNext start-up board fell 8.3 percent due to the large number of small and medium enterprises in the application queue. Declines in the Shanghai Composite Index and the CSI300 were more muted – the markets closed down 0.6 percent and 0.8 percent respectively.

Chinese investors worry that, by clearing the backlog of IPO applicants, the CSRC will flood the market with new shares. Seeking to allay investors’ concerns, the CSRC stated on 30 November that clearing the backlog would take about one year. Since 760 firms were in the queue on that date, investors were hardly reassured. After all, 760 IPOs spread over one year still equals 60-plus IPOs per month.

More troubling is the potential damage to investor confidence that might arise if the Opinions are not properly implemented or if unforeseen problems occur after implementation. The reality is that investors have grown used to the CSRC’s interference. Since 1990, there have been eight temporary freezes in new share issuance, with four occurring since mid-2005 alone. In fact, the CSRC has a habit of using soft conditions in the A-share market as a basis to halt issuance and undertake reforms. Hopes are high that the prescriptions called for in the Opinions will make future freezes unnecessary.

Early indications are not promising. On 31 December, the first batch of five IPO applications since October 2012 gained CSRC approval. Three days later, six more firms won approval. But, by 10 January, China had witnessed its first voluntary IPO suspension of 2014 as Jiangsu Aosaikang Pharmaceutical, citing a P-E ratio of 67 times, abruptly postponed its offering. By 13 January, the number of voluntary suspensions had risen to six.

On the day of Aosaikang’s suspension, CSRC spokesperson Deng Ge denied that the regulator had interfered in the IPO. Likewise, the CSRC has claimed no responsibility for the suspensions of the other five IPOs.

Yet, on 12 January, the CSRC released a short set of measures that call for companies with P-E ratios that exceed the industry average in the secondary market to disclose special risk advisories. The regulator also announced the start of a “spot check” investigation of 44 institutional investors and 13 chief underwriters. Perhaps it is no coincidence that all of the chief underwriters for the 11 approved IPO applications were chosen to participate in this “spot check”.

THE ROCKY RELAUNCH  
The six voluntary IPO suspensions, combined with the CSRC’s investigation, is a dramatic setback to China’s securities and futures regulator during what should have been a moment of triumph.
In fact, the setback is two-fold. First of all, the relatively uninterrupted slides in both the Shanghai and Shenzhen composites over the first two weeks of 2014 suggest the sensitivity and concern of investors over the roll-out of the new IPO approval system. This bodes ill for the short and medium-term performance of the A-share market and for anything but a long-term recovery in confidence.

Second, the CSRC and its leadership may suffer a reputational cost within the bureaucracies of the Chinese government and the Communist Party. After all, the Opinions were one of the first concrete reform proposals to be announced following the release of the Third Plenary Decision document, which specifically mentions the need to reform the stock registration and distribution systems.

Following the plenary, many observers noted that implementation challenges would test the Chinese leadership’s ability to follow through on its reform pledges. Since IPO reform is far from the most challenging Chinese reform hurdle, critics may feel justified by the rocky IPO relaunch. In other words, by causing China’s wider reform agenda to lose face, the CSRC may have committed the gravest error of all.

Robyn joseph is a partner in Kreab Gavin Anderson Hong Kong office and specialises in regulation issues, policy monitoring, corporate responsibility and crisis communications.  

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