Case study of ‘important clients + shareholders’ in IPOs

To prevent interest transfer and forgery in business performance, the regulatory authorities and intermediaries are generally cautious about share purchasing of proposed public companies by clients and suppliers that are parties of interest to the companies.

Since 2018, there have been several cases where important clients were introduced to the board of directors as “important clients + shareholders” prior to when the companies went public, which was subsequently commented on as “hugely profitable” by some securities publications. In order to have a more objective understanding of this, it is necessary to review the cases mentioned in the relevant reports.

The IPO of Wuhan Bester Group Telecom (the company’s name was changed to China Bester Group Telecom in March 2019). Through careful study of the audit results of Bester Telecom as announced by the China Securities Regulatory Commission (CSRC) and the company’s prospectus published after the share release, the author found that China Mobile Innovation Industry Fund (China Mobile Fund), the shareholder associated with China Mobile and the No. 1 client of Bester Telecom, assigned its shares held in Bester Telecom during the audit of the company.

In the audit results announced by the Issuance Examination Committee (IEC), it confirmed that “China Mobile Fund transferred its shares to Li Liubing et al”. Therefore, Bester Telecom cannot be set as an example of where the regulatory authorities have approved of the model of “important clients + shareholders”.

The IPO of Hangzhou DP Technologies (DPtech). As another listed company with shares held by China Mobile Fund, DPtech has two major differences from Bester Telecom. First, the proportion of DPtech’s shares held by China Mobile Fund is less than 5%. Second, the sales revenue DPtech has made from China Mobile accounted for a small amount of its main business income, which was lower than 30% throughout the reporting period, and showed a downward trend year by year.

In addition, although DPtech listed China Mobile Fund as its related party after entering the issuance stage, it did not disclose China Mobile and China Mobile Fund as its related parties in its earlier prospectus.

Judging from the feedback from DPtech and the audit results of DPtech announced by the CSRC, the regulatory authorities have paid special attention to the model of “important clients + shareholders”.

The IPO of Jiangxi JL MAG Rare Earth (JL MAG). JL MAG is quite special in the cases of “important clients + shareholders”. Its shareholder, Xinjiang Goldwind Science & Technology (Goldwind), not only purchases directly from JL MAG, but also designates its suppliers to make purchases from JL MAG. The case is special because:

1. the affiliate transaction between JL MAG and Goldwind/its affiliated companies is not much, with the most being 6% during the reporting period;

2. although the proportion of transactions between JL MAG and the suppliers designated by Goldwind is considerable, the transactions were disclosed in comparison with affiliate transactions based on the principle of prudence;
3. Goldwind has held shares in JL MAG since its inception, not a sudden purchase of shares; and
4. the regulatory authorities have paid special attention to the de-purchase model to see if it is a customary practice within the industry, and whether JL MAG has relied heavily on Goldwind.

The IPO of Guangdong Topstrong Living Innovation & Integration (Topstrong). Quite a few affiliated distributors of Topstrong hold shares in Topstrong, totalling 14.1% of the company’s shares. But the shareholding ratio of each distributor is low, all less than 5% of the company’s shares.

During the reporting period, the amount of sales that Topstrong made from these distributors accounted for no more than 15% of its operating income, and the sales showed a downward trend. In the prospectus, the company disclosed its transaction with the participating distributors as “an important transaction disclosed as per the requirements of related transactions”, and demonstrated the non-existence of interest transfer between the company and the shareholding distributors.

A key point is that the company offers a range of custom-made products including customized drawers and doors. Unlike standardized products, these products cannot be used by other consumers. The customized production means that the distributors are not in a position to stack inventory for the company.

To sum up:

1. 1. The first three cases feature something in common, that is, the important clients who are affiliated parties, or suspected of being affiliated parties, are all “industry leader + state-controlled large enterprise + listed company”. In the first two cases, China Mobile selects suppliers via centralized procurement or bidding methods. In the third case, Goldwind and the Chinese car enterprises designated to place purchase orders with JL MAG are all public SOEs under strict internal control. It’s unlikely that they will be able to transfer benefits to the listed private enterprise;
   2. The distributors who participate in the shareholding of Topstrong do not fall within the above category, but the sales ratio of each dealer is low. Strictly speaking, they can’t be counted as “important clients”, and their shareholdings were all carried out when Topstrong was listed in the China’s New OTC Market, which is relatively open and fair;
   3. A considerable number of peer companies have listed, making the industry characteristics and market information distinct and transparent; and
   4. The profits of the listed companies are relatively huge. Even the net profits of DPtech and JL MAG, the two companies listed on the second board, have exceeded RMB100 million in the last reporting year.

Therefore, the significance of the above cases is still far from the point where it can be exalted as “hugely profitable”. Once a similar situation occurs, it will undoubtedly attract attention in the audit. Companies undergoing IPOs that plan to introduce important clients as shareholders should discuss the issue thoroughly with their intermediaries.

Dong Yiping is a partner at Grandway Law Offices

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