As China struggles to impose a registration-based IPO system, regulators tighten scrutiny of overly enthusiastic businesses and scare off the unqualified.
Photo from CFP
By WANG Xin
Companies have slammed the brakes on IPOs in China, as regulators demonstrate that there might be more to a “registration-based” system than meets the eye. Since January, 73 IPO applications have been suspended: four rejected by regulators and 59 withdrawn by the companies themselves, supposedly of their own accord. Close to 800 companies are still waiting in line for review and approval, but the obstruction in the pipeline may take more than a year to flush out.
Behind the blockage is China’s push for registration-based IPOs that began on Shanghai’s STAR board and Shenzhen’s ChiNext last year. There has been much talk about extending the system market-wide to replace the current approval-based regime, redefining the responsibilities of issuers, underwriters, and regulators, but more experimenting and readjustments are undoubtedly needed.
Compared to the old system with strict screening before approval, the registration-based system allows companies to go public as long as they meet information disclosure requirements. After that, their worth is decided exclusively by the market. The role of the regulator is to ensure that price-sensitive information is disclosed accurately and on time.
More relaxed profit requirements, a shorter review period and potentially higher valuations — IPO prices are set by the companies as they wish, without being subject to any price-to-earnings ratio cap —led to a flood of applications last year. There are 200 STAR IPOs and 400 ChiNext in the pipeline, causing a logjam that may not be cleared by year-end, even at the faster pace of review under the new system. The Shenzhen exchange is reported to be very stressed and severely short-handed.
The China Securities Regulatory Commission has said that it will take “some time” for all parties to adapt to the new regime. Companies and underwriters alike need to adjust their expectations. Previously it could take up to three years to get the green light.
For starry-eyed IPO seekers and commission-hungry underwriters, however, the opportunity is too good to miss. Some underwriters are dangling incentives in front of potential clients, promising an easy IPO.
Another investment bank manager pointed out that regulators don’t really know how to define and delineate responsibilities among companies, underwriters, and themselves. In theory, the CSRC and the stock exchange’s role is mainly to oversee information disclosure, entrusting the vetting of companies to underwriters and investors. But in reality, regulators are uncomfortable with relinquishing control and letting in dubious companies. He also warned that the lack of clarity will likely cause IPO booms and busts and that regulators should not cool down an IPO frenzy simply by threatening stricter screening.
“Registration-based IPO depends on high-quality information disclosure, and trust in the market’s ability to adjust for risks,” he said. “The question is, are regulators ok with letting risky companies go public as long as they disclose all their risks? If not, we can’t have a real registration-based system.”
Given enough time, the market will correct itself. Investors are eager to buy into new IPOs, but when the current risks unfold and rationality returns, there will be less hot money washing around to support the unreasonable valuations that drew in investors in the first place.
Regulators, however, can’t just sit back and wait for the IPO market to cool itself down. During the past ten years, the CSRC has often resorted to strict screenings when IPO applications pile up. In 2013, for example, a five-month iron-fisted auditing campaign cut the list of applications from 900 to 700, many withdrawn voluntarily by issuers or underwriters.
Similar methods are being tried. On January 29, the CSRC updated its procedures for onsite due diligence inspections, widening auditors’ access to operational information and financial records. Two days later, when twenty companies were randomly selected for onsite inspections, sixteen suspended their IPO.
Issuers almost always withdraw their IPO applications if selected for onsite inspections, which often entail a two-week audit of everything, including personal transactions of executives and their families.
“There is no upside in sitting through an inspection,” a bank manager explained. “If there is a problem, it is much more difficult for the issuer to go public later.”
Onsite inspections have also been increasingly used against on underwriters. All the underwriters selected for inspection this year withdrew the associated IPO application or terminated their contracts with the issuers in question. This doesn’t necessarily indicate fraud, or suspicion of fraud.
Some issuers are not confident in their eligibility; some fear that their hastily compiled application will not stand up to an onsite inspection. This round of suspension is nevertheless a reminder for underwriters to do more to assess and disclose risks.
For underwriters who see their commissions evaporating, it’s a costly lesson to learn.
“They probably get a small service fee at most, if the issuers are nice,” an industry insider said.
Small and medium sized underwriters are likely to be hit harder than investment banks, which have more high-quality clients and diverse revenue sources.
Trials and tribulations
A rethink and readjustment of the plan is in the offing. Since last year, the State Council and CSRC have both sent out encouraging signals, prompting speculation that market-wide adoption would take place as early as the current quarter. The market, obviously, is not ready and the CSRC appears to be backpedaling a little on its promotion of the registration-based system. A spokesperson recently said that the system is still “in its trial period,” and that the commission will continue to assess the system’s viability. A document published a week later did not include any mention of market-wide adoption this year.
Many expect stricter standards for issuers before the registration system expands, and probably not this year, but things evidently cannot precede as they are.