The stock market reforms that China’s Securities Regulatory Commission posted last Saturday represent a near revolution for its financial markets and are the latest manifestation of Prime Minister Li Keqiang’s determination to continue the transformation to a market-based economy in which retail investors hopefully can expect rational market rules to prevail.
The reforms, in gestation for more than a year and due to go into effect on Jan. 1, mark a fresh beginning for a financial regime that since China’s first steps into the market economy has been little more than a casino plagued by insider trading. They very much are intended bring China’s markets into line with western practices, equipping the retail consumer with protections long enjoyed by overseas markets and Hong Kong from years of reform.
Given the new set of regulations, the next concern is that the markets themselves will have the necessary will and sophistication to enforce them. And the regulation is only at the front end. After the regulators have determined whether the listing applicants are qualified, Li’s philosophy of big market, small government comes into play again, leaving investors and the markets to a caveat emptor philosophy in which they must rely on their own judgment as to value and risk.
Since the 3rd Plenum, the government has been involved in a whirlwind of activity in the financial sector. The CSRC yesterday also issued a directive supporting financial reform in the nascent Shanghai Free Trade Zone, followed by Finance Ministry clarification of corporate tax rules in the free trade zone. Other announcements have included a Yunnan-Guanxi border rea financial reform program to push for greater cross-border use of yuan to enhance cooperation with Asean countries. Land reform, the streamlining and disclosure of party and government administration have also been pushed.
The rules include a transition towards a registration-based IPO system, potentially removing a stumbling block that has inflated valuations of new offerings. New IPOs in the Shanghai and Shenzhen exchanges were shut down more than a year ago for a variety of reasons including concerns over fraud and abuse and that too many dud companies were being brought to the market and that investors weren’t allowed a level playing field.
Some 50 companies are expected to take advantage of the listing rules in January alone. As many as 765 Chinese companies have been jammed up waiting for the new rules to take effect. That in turn raises the question of whether there will be market saturation as the numbers of new companies outstrips the number of investors out there to buy the shares.
The rules also are designed to equip the capital markets with preferred shares – shares that entitle their holders to fixed dividends and whose payment takes priority over those of ordinary share dividends. That can be expected to attract long-term money such as pensions and insurance asset managers to invest in banks and other highly-geared companies with stable cash flow such as utilities operators. It should also serve to satisfy the funding needs of companies without further extending their financial leverage.
Apart from that, the rules are designed to limit so-called back-door listings in which companies buy already-listed shell companies and inject their entire assets into them to escape the regulatory process. Backdoor listing has also been popular as the rules are less stringent than for full-fledged IPOs. Thus, shell companies, typically very small ones with very poor financials have been trading on speculation that new businesses would eventually find them as new homes. The CSRC has now closed the door on the regulatory arbitrage.
Beyond the headlines, the four major policy documents posted by the CSRC were packed with details. The following are highlights of some of the most interesting policies from each document.
First, the degree of emphasis given to boosting transparency of the listing process is surprisingly high. The documents also pledge to make sponsors liable for ensuring information accuracy, with the goal of leveling the field for all investors to judge the value of upcoming IPOs. The new checks and balances are designed to curb market malpractices and restore investor confidence.
The IPO prospectuses are to be posted on the CSRC website so that investors can inspect them as soon as the regulator accepts them for review. Sponsors are to be banned from underwriting IPOs for 12 months if submitted prospectuses contain incorrect or contradictory information.
In an effort to move the market along, the CSRC will deliver its official response – approval, suspension, termination or disapproval – within three months of the submission of their applications.
IPO candidates can choose to list at any time within 12 months after the CSRC gives the IPO approval. Senior management of the new listings must pledge not to sell stocks below IPO price in the two years following the lock-up period, which will automatically be extended by six months if the shares trade below the IPO price for 20 consecutive days within the first six months, or close below the price at the end of the first six months. Substantial shareholders – those holding more than 5 percent – must give public notice three trade days prior to selling shares.
Bookrunners – the main underwriters or lead managers of the issuances – are expected to avoid manipulative IPO pricing by removing the top 10 percent of the institutional book with the highest subscription prices. Prior to opening the retail tranche of the IPO book, bookrunners must disclose the institutional book including name, price and quantity.
If the tranche is oversubscribed by 50 to 100 times, the bookrunner must reallocate 20 percent of the shares offered to the retail book. If it is oversubscribed by more than 100 times, the, bookrunner must reallocate 40 percent of the shares on offer to the retail book.
Retail investors must hold a certain minimum amount of equities in their brokerage accounts in order to participate in the IPO subscription. A trading-halt mechanism based on IPO prices will be established to restrict speculation on new listings.
In a move to guarantee compliance, the CSRC has vowed to investigate sponsors which bring companies to the market whose earnings deteriorate significantly during the first year.
By launching trials for preferred stocks, Chinese banks will likely get an immediate boost as the new equity base counts towards banks’ Tier-1 capital and fulfilling their Basel requirements, a comprehensive set of accounting reforms to improve the regulation and supervision of the banking sector.
Companies are recommended to pay preferred dividends in cash. Rules for calculating preferred dividends should be clearly defined: floating or fixed rate, whether dividend shortfalls should be carried forward to the next fiscal year, and if preferred stockholders are eligible for additional profits beyond defined rates. Companies must pay overdue preferred dividends prior to buying back any preferred stock, unless the company is a commercial bank.
Preferred stock issuance must be less than 50 percent of outstanding common shares and total capital raised should be less than 50 percent of net asset value. Preferred dividends and bonuses received by corporations as a result of investing in preferred stocks are corporate income tax-free. Preferred stock investment by the National Social Security Fund and other corporate pension funds should not count toward the existing equity investment quota.
As to cash dividend guidance for listed companies, the CSRC encourages them to reward investors by having a clearly defined dividend policy. This can be implemented through cash, issuance of preferred stocks or share buybacks as the regulators described. Most importantly the policy to pushing listed companies to lift their dividend payout, especially mega state-owned enterprises, is a key financial initiative market has been waiting for.
Boards of directors should clearly define the company’s dividend policy after taking into account the opinions of small shareholders and independent directors. Dividend by cash should be the preferred option if financially equipped to do so or through stocks if company is still in growth phase. Mature companies without major capital expenditure plans are encouraged to consider a minimum 80 percent dividend payout ratio. Mature companies with major capital expenditure plans should consider a minimum 40% dividend payout ratio.
Growth companies with major capital expenditure plans should consider a minimum 20 percent dividend payout ratio,
On the issue of shell listings, companies seeking back-door listing through shells will face equal requirements as IPO candidates. Shell-listings will be banned from the Chi Next board, the country’s second board, effective immediately.
(Steve Wang is chief China economist and research director for the Hong Kong-based REORIENT Securities Ltd. He is a regular contributor to Asia Sentinel)