The first compulsory delisting of stocks due to fraudulent IPOs and disclosure violations on the Star Market in Shanghai raises questions on the intermediaries’ role as capital markets gatekeepers.
The China Securities Regulatory Commission (CSRC) has penalised Star Market-listed Amethystum Storage Technology and Essence Information Technology for their involvement in financial deception leading to their mandatory delisting.
While the delisting date for both issuers was slated for early July, the CSRC has affirmed its “zero tolerance” policy on fraudulent activities and continued to hold intermediaries accountable.
In the Essence Information Technology IPO, intermediaries – Dongxing Securities, Pan-China Certified Public Accountants and Kangda Law Firm – have been filed by the CSRC for allegedly failing to exercise due diligence in the IPO.
As for Amethystum Storage Technology, a CSRC decision on the underwriter China Securities, accounting firms RSM China and Grant Thornton, as well as GFE Law Office was still pending.
Emilia Shi, the Shanghai-based senior partner and head of capital markets at Dentons China, said in the aftermath of the introduction of the registration-based IPO system, every intermediary needed to reinforce its obligations as a gatekeeper.
She gave an example where in the past, brokerages and accountants had played the primary role of verifying bank flows to prevent financial fraud by listed companies.
However, intermediaries now play a more significant role in detecting such fraud, and law firms should thus conduct their own inquiries independently of accountancy firms and strengthen their inspection during the IPO stage, she said.
This includes examining the adequacy of corporate disclosures, scrutinising the causes of connected transactions, rectifying irregularities and gauging subsequent risks.
Despite this, in the Amethystum case, intermediaries mentioned during the IPO stage that they had attempted to request bank flow from the two concerned suppliers to verify financial transactions with the issuer, but both suppliers declined to provide the information, citing commercial secrecy as the reason.
“Not all disclosure violations or fraudulent offerings are the responsibility of lawyers, which is not always the case,” said Qin Zheng, a partner in the Guangzhou office at AllBright Law Firm. “Intermediaries have very limited powers to assist companies going public.”
“Intermediaries do not have a particularly strong position when they are accessing information on the companies’ counterparties, upstream and downstream clients and their bank information.”
Qin said without co-operation from relevant parties, intermediaries resolve issues through compromise, potentially indeed compromising the authenticity of due diligence.
However, Dentons’ Shi believed that law firms were inherently concerned with the chain of evidence and could detect anomalies in linked documents. The key issue at hand was whether the duty of due diligence was being properly fulfilled.
The recent “mandatory delisting” cases have garnered significant attention. Shi said that as the registration-based IPO system continued to develop, there would likely be an increase in both listings and delistings.
“China’s multi-level capital market is shifting towards a disclosure-focused, market-facilitation-oriented listing review mechanism,” she said. “If companies fail to meet the listing standards, delisting becomes a normal occurrence.”
Given the first round of mandatory delistings on the Star Market, Qin believed that the incident served as a warning to both listed firms and companies planning to list. He suggested that the regulator should clearly define the responsibilities of each intermediary. Without clear guidelines, it may be challenging to treat all parties fairly in the pursuit of liability.
China Securities, the underwriter for Amethyst Storage Technology, has collaborated with other intermediaries to create a special fund for advance compensation, which totals RMB1 billion (USD141 million). The implementation of the fund would be considered when the CSRC determines the punishment.
Advance compensation, also known as pre-judgment compensation, refers to a measure in which investors who suffer losses in the securities market because of fraudulent issuance, misrepresentation, or other material breaches of the law by the issuer, the controlling shareholder, beneficial owner, or relevant securities company, can receive initial compensation from them. The advance payer then recovers the money from the responsible entity that does not participate in the advance payment.
Although the advance compensation scheme was included in the Securities Law, which came into effect in 2020, it is not mandatory. AllBright’s Qin said while the system does facilitate investors in obtaining compensation efficiently and conveniently, it has not yet achieved its maximum effectiveness in the securities market.
“As a law, there has been only one case of practice in the three years since it was enacted, suggesting that the law may not be particularly effective in addressing the needs of society.”
He advised that the legal industry could further discuss and provide insights to support the normalisation of the system, achieving maximum protection to investors.
