Abstract: The debut of the registration-based IPO system on ChiNext on April 27, 2020 marks a significant move of China's capital market reform. To support the pilot scheme, improvements need to be made in the following two aspects: the incentives for and constraints over sponsor organizations, and the management of investor suitability. To promote the new IPO system across the entire A-share market, systemic institutional reform is needed which includes putting in place strict, effective and sustained regulation, reconsidering the T+1 trading mechanism, and better protecting the rights and interests of investors.
In the late spring of 2020, China's capital market kicked off another major reform. On April 27, the Central Committee for Comprehensively Deepening Reform gave its approval to the "Overall Implementation Plan Regarding ChiNext Reform and Trial Registration System", which marks the official start of ChiNext's IPO registration reform.
As the debut of the registration-based IPO system in China's capital market since the implementation of the new securities law, ChiNext's reform this time is one that faces the entire market. If the scientific and technology innovation board (also known as the STAR market) is the "experimental field" of reform, ChiNext reform is the key to push the reform of China's capital market into the "deep water zone".
I. Why is ChiNext's IPO reform launched at this time?
There are many considerations behind the decision to launch the registration-based IPO system on ChiNext at a moment when the international capital market is experiencing high volatility and large turmoil.
First of all, no matter from the perspective of the companies seeking to be listed, investors, stock exchanges or even the regulatory authorities, China's capital market, especially the issuance system, has come to a point where there's no choice but to be reformed.
Moreover, the ChiNext was officially established on October 30, 2009, more than 10 years ago, and it has become relatively mature. The pilot registration-based IPO system on the STAR market introduced a year ago has also provided experience to the ChiNext reform. Hence, for China's capital market, the timing to further expand the pilot registration system is ripe.
At the same time, the outbreak of the Covid-19 pandemic at the beginning of this year seriously affected the global supply and industrial chains, leading to the resurgence of anti-globalization and trade protectionism. As China's core industrial components are still dependent on imports, it is urgent to enhance independent innovation and realize the domestic production of core components.
Faced with the impact of the Covid-19 pandemic, by implementing the registration-based IPO reform, the ChiNext board as one of the main channels of equity financing for small and medium-sized enterprises (SMEs) will greatly alleviate the financing difficulties of enterprises, especially technology-based SMEs, facilitate their liquidity and the overall development of the real economy. Meanwhile, improving the inclusiveness of the capital market, and cultivating a batch of high-quality, high-growth, world-leading sci-tech innovative enterprises and generating disruptive technological innovation, can also help us better cope with the economic impact of the pandemic and embrace the new international order in the post-pandemic era.
In addition, the dividend of China's capital market reform will attract foreign capital to re-evaluate the global asset allocation value of A-shares, reduce the recent doubts the international market has about the integrity of the financial reporting of Chinese listed companies, thereby restoring the confidence of global investors in Chinese companies as fast as possible.
II. What does the registration-based IPO system mean for China's capital market?
China's A-shares IPO system has roughly experienced two main stages, both of which are approval-based. It is currently transitioning to the registration-based system. No matter what stage it is in, one problem has been haunting the market, that is, the pace of IPOs is administration-led rather than market-led.
In the past, there used to be an implicit barrier for IPO application, that is, companies who apply for IPO on the main board need to have a net profit of at least 80 million yuan in the most recent year, while those who apply for IPO on the growth enterprise market are required to have a net profit of no less than 50 million yuan in the most recent year. For most of the growing and innovative SMEs, 50 million is a daunting number, which blocked their path to IPO. The ChiNext board which was established with the aim to provide more convenient financing channels for SMEs has thereby been regarded as the "startup success board".
Too much administrative control over IPO has also led to the "barrier lake" phenomenon on the A-share market. Throughout the nearly 30-year history of A-shares, regulators have halted IPOs nine times, or once every three years on average. Apart from the latest suspension in 2015, the longest one was in 2013, when no IPO was approved for nearly 14 months.
Now, by drawing on the experience of the STAR market, ChiNext has started its second decade. On the whole, ChiNext's reform plan is the same as the STAR market in aspects such as the 20% limit on price movement, registration process and margin trading; the differences lie in the relaxation of the requirement of co-investment of securities companies and the restrictions on the eligibility of investors, as well as the positioning of the board. Due to the different positioning of the two boards, the ChiNext board and the STAR market each will have their own focus and develop in an appropriately competitive and complementary manner.
Adopting a registration-based IPO system on ChiNext is mainly reflected in the change in how IPOs are vetted and supervised.
First, the implementation of the registration-based IPO system is in essence the decentralization of the administrative power over IPO approval, that is, IPO filings shall be reviewed by stock exchanges and their opinions submitted to the China Securities Regulatory Commission (CSRC) for approval of registration.
Second, the focus of examination and supervision has shifted from IPO qualifications to information disclosure. Rather than the single emphasis on sustained profitability, more diversified and inclusive listing requirements have been introduced, with more attention on companies' sustainable operating capability and information disclosure, while leaving investment decisions to the market.
With these two changes, the ChiNext reform has set another important milestone towards a market-based pacesetting of IPOs.
Whether it is the STAR market or the ChiNext board, the implementation of the registration system has a very positive significance:
First, since the issuance and pricing of new shares under the registration system are more market-oriented, in the long run, IPO underpricing will be reduced, staging gains will decline, we may see more shares fall on IPO, and the phenomenon that getting an IPO allotment means a definite gain will also gradually disappear on the ChiNext board.
Second, the registration system in effect leaves the decision of the listing and delisting of companies to the market, which will unclog the "barrier lake" of IPO. At the same time, a more flexible delisting system can also unblock the exit of the capital market, smoothing the flow of the asset pool and alleviating the distortions and chaos on China's capital market. More importantly, under the registration-based IPO system, opportunities to get listed will no longer be rare, shell companies will no longer be pursued by unlisted enterprises, the value of shell companies will disappear eventually, and bad companies will exit the market more quickly.
In addition, as the amount of capital in the market and the number of listed companies move towards equilibrium, risk-free staging will disappear, the price of newly issued shares will return to their real value. As a result, the difference among companies will increase, poorly performing companies will delist, scarce capital will flow to high-quality enterprises, creating an market which rests on the principle of survival of the fittest. This will incentivize listed companies to improve their operations, cultivate enterprises' risk management awareness, improve the performance of listed companies, promote the healthy and sustainable development of the capital market, and shift the focus of China's economic development from high-speed to high-quality.
III. Suggestions for the auxiliary reforms
To implement the overall reform plan, the CSRC recently issued a slew of draft measures for the solicitation of public opinions, which include Administrative Measures for the Registration of Initial Public Offering Stocks on the ChiNext (Trial), Administrative Measures for Registration of Securities Issuance of Listed Companies on the ChiNext (Trial), Ongoing Regulation Measures for ChiNext-Listed Companies (Trial), Administrative Measures for the Sponsor Business of the Issuance and Listing of Securities.
The four draft regulations released for public opinion have standardized and improved the registration system, ongoing supervision, issuance and sponsorship of the ChiNext-listed enterprises. The contents that need to be further modified and improved include:
First, the incentives for and constraints over sponsor organizations. Through the registration mechanism, power is being transferred to the market. As an important participant in the market, the power and responsibility of sponsor institutions in the process of the listing of enterprises will increase. How to motivate and constrain the behavior of these market institutions?
One of the major moves of the STAR market was about the co-investment requirement of sponsor institutions, that is, mandating the relevant subsidiaries of the securities brokers to participate in the placement so as to bind with the return and risk of the STAR projects they had underwritten. However, the forced co-investment arrangement of the STAR market is actually a double-edged sword.
For one thing, it aligns the interests of sponsor institutions and companies listed on the STAR market, so that sponsor institutions undertake due responsibilities for their underwriting activities, and set reasonable prices for the stocks of the companies going public, which will stem excessive valuation of new listings. For another, it entails risks because interest alignment may lead to misconduct by sponsor institutions, such as sponsoring unqualified companies to get listed, and the thusly formed interest group may collectively manipulate the market value of the listed company. In other words, if regulators fail to hold sponsor institutions’ investment activities in check, the registration-based reform could end up breeding irregular investments by the security dealers.
Under the current reform, however, sponsors will not have to invest in all projects they recommend, but are only requested to invest in unprofitable companies, red chip companies, companies with special voting rights, and companies listed at a high offering price. This is an improvement to the previous STAR market pilot scheme, and it is part of China’s sustained reform endeavor to improve its capital market.
Another thing worth attention in the draft guidelines for the registration-based reform of ChiNext is the requirement and management concerning the suitability of investors.
The most important implication of the reform on investors at large is the adjustment of barriers to entry. It is stipulated that new individual investors on the ChiNext market need to have no less than 100,000 yuan of daily assets on average in the first 20 trading days, and they must have experience in the transactions of A-shares for no less than 24 months. Existing investors are permitted to continue their engagements in the market as long as they sign the new risk disclosure statements.
According to the 2018 annual report by the Shanghai Stock Exchange, up until the end of 2017, more than 85% of investors in the A-share market have less than 500,000 yuan of assets. Some institutions have estimated that a threshold for the STAR market of 500,000 yuan will shut the door upon 95% of individual investors and thereby dampen market liquidity.
That threshold has been slashed to 100,000 yuan with the reform, which is reasonable because companies listed on ChiNext are more mature than those on the STAR market, and the move will allow more individual investors to participate.
But that also sparks controversy because the new barrier may be too low. The revamped ChiNext does not set a ceiling or floor for the prices of new shares in their first five trading days, after which there will be a 20% limit (10% pre-reform) for the volatilities, and that will add to risks of short-term speculations. Besides, many unprofitable companies will be allowed to get listed under the new regime, and investors will have to tell good from bad in the mix. They will also have to be more risk-tolerant because startups’ business performances and share prices tend to be more volatile. All of these entail careful considerations of how to manage the eligibility of investors in the ChiNext market.
IV. Is the A-share market ready for registration-based IPO across the board?
Since it was first proposed in 2015, the registration-based regime has been tested out twice, in 2019 with the STAR board, and today with ChiNext. Looking forward, is the A-share market ready to embrace the new regime across the board?
Promotion of the registration-based regime across the A-share market not only means upgrading of the issuance system; instead, it will reshape the entire market and regulatory climate. If we look at the mature capital market in the United States, it's clear that a complete registration system features strong legislative supports, sound investor protections, fair market access, effective information disclosure, and strict exit mechanisms.
Therefore, to promote the registration-based regime across the A-share market, systematic institutional reforms are required in the following aspects:
First, there must be strict, effective and sustained regulatory supervision. Compared with the previous approval-based system, the focus of regulation under the new regime has shifted from pre-issuance approval to post-listing supervision. Then how to sustain effective regulation over companies after they go public? This is the make-or-break factor in the current reform. To address this issue, China must roll out supporting policies to enhance regulation, hold violators accountable, and impose due punishment. Regulators must crack down on all irregularities including financial frauds and insider trading.
China has already beefed up its combat against these behaviors among listed companies, but some of the due punishments have been poorly implemented, which has rendered related laws and regulations less of a deterrent. The ceiling of penalties on financial frauds has been lifted from 600,000 yuan to 1,000,000 yuan under the revised securities law, but that amount is only a proportion of the huge potential gains from fraudulent activities, so it may not be a tremendous price to pay for the violators. In the future, the new securities law must be strictly implemented, but meanwhile, the criminal law of China must be revised as well to hold violators responsible, extend the term of penalty, and substantially increase the cost of violations.
Second, the T+1 trading mechanism can be problematic. There are institutional distortions in the A-share market at present in terms of new share issuance, information disclosure, and share trading mechanism—namely the T+1 mechanism, which still prevails even in the STAR board piloting the registration-based system reform. Experiences of other countries indicate that the absence of a ceiling or floor for share price fluctuations, which could magnify both returns and risks in the market, entails a T+0 trading mechanism that gives investors an opportunity to cut their losses in time once they have made wrong decisions. Under the T+1 mechanism, with investors racing to place bets on newly-listed shares, they will not be able to stop losses in a timely manner when the prices surge or swoon. Although the regulators have their reasons to continue with the T+1 mechanism, T+0 remains a considerable choice.
Third, investors need better protection. Many of the investors cannot safeguard their legitimate rights and interests because the class action system in China is not fully-established yet. Forms and sizes of compensation should be improved, but more importantly, China needs to provide effective institutional protections for investors and upgrade its class action system to safeguard the interests of smaller investors.
V. Deepen reforms to encourage business innovation
The core functions of the capital market are value discovery and resource allocation. A well-functioning market will channel funds to startups with huge growth potential in need of capital even if they are running at a loss for now, and that is especially important in the ChiNext market, because showing support for these enterprises to go public will inspire more innovations and entrepreneurship.
For the capital market to play a better role, China needs to make sustained efforts in the following aspects, and press ahead with its reform endeavor despite all the risks and challenges ahead:
First, improving the short-selling mechanism. Despite improvements in the margin trading systems, short sales in the Chinese capital market remain relatively small in scale and not sufficiently marketized. At present, there are more margin lending activities than short selling activities, inducing an imbalance between long and short positions in the stock market. In fact, buying or selling shares are both normal transaction activities reflecting different judgements of the investors with regard to business valuations and future stock price movements, and there is no good or bad about them. Allowing and encouraging short-selling will force listed companies to improve their governance under market scrutiny, and that will facilitate the sound development of the capital market in the long run. Looking ahead, China should reinforce its short-selling mechanisms drawing on the balanced margin trading systems of developed markets and their experiences on managing stock index future transactions, hedge funds, etc.
Second, encouraging engagements by institutional investors including social security funds, pension funds, enterprise annuity funds and other long-term funds in the capital market, and raising the cap on their investments. Due to the long-term nature of technological innovation, investors should pay more attention to the growth prospects of technology startups in the long run. Institutional investors tend to do better in this regard, given their higher tolerance for risks and failures which can more effectively incentivize startups to step up their R&D efforts. In mature capital markets such as the US market, more than 80% of the investors are institutional investors, while in China it's the opposite—individual investors prevail in the market. An important aspect in the management of investor eligibility is to let professional institutions handle professional things. As China presses ahead with the market-oriented reforms, the proportion of institutional investors will inevitably go up. In this sense, enhancing management of investor eligibility will not restrict any investor from participating in the financial market, because individual investors can engage themselves through mutual funds, asset management plans and other programs; instead, it protects the interests of investors, and improves the efficiency of the market.
The registration-based reform of ChiNext has kicked off, with many challenges ahead. Despite the uncertainties, one thing is for sure: only the market has the final say in who survives, and China must make sure that the market plays the decisive role in resource allocation.
