With the once-hyped ChiNext beset by market doubts, could the expansion of the new third board and the international board restore market confidence? Raymond Yang investigates
In 2010, 347 Chinese companies listed on Chinese stock exchanges, accounting for 45% of all global IPOs. Zero2IPO Research Center predicts that in 2011, more than 400 companies will list. However, according to statistics from Wind Info, between early 2010 and early this month, the share price of 190 of the 473 A-share companies had dropped below their issue price.
“Half fire and half sea” is a good way to describe the current situation of the Chinese capital markets. On the one hand, with a constant stream of new issues, entrepreneurs, institutional investors and brokers are salivating at the prospect of a seemingly inexhaustible gold mine. On the other hand, new issues often fall below their issue prices, leaving individual investors trembling with fear. The new third board is due for expansion, and the long-awaited international board may arrive soon. Will these two boards, together with the ever-hot ChiNext, revive the fortunes of the Chinese capital markets?
This article examines the underlying issues. In the next China Business Law Journal, with analysis from experienced capital markets lawyers, we will look at whether the capital markets and the practice of securities law is facing a shake-up in the face of increasingly strict licensing and regulatory requirements.
Are you a good boy?
On the opening of ChiNext on the Shenzhen Stock Exchange at the end of October 2009, 28 lucky companies listed. By the end of April this year, there were 209. Ma Xiumei of Jingtian & Gongcheng predicts at least 500 companies will list A-shares during 2011, with at least half of these being on ChiNext.
The rapid expansion of ChiNext can partly be attributed to the overall growth of the Chinese economy, but a more important reason is that it plays a much-needed role among the country’s capital markets. According to Tang Jinlong, a senior partner at Zhong Yin Law Firm, ChiNext’s role in “establishing a multi-layered capital market and minimizing the negative impact of global recession on the Chinese economy cannot be underestimated”. Lin Zhong, a partner at Shanghai’s Chen & Co Law Firm, explains: “[ChiNext] provides domestic enterprises, especially small and medium-sized ones, with a means of raising capital, and adds impetus to the development of new strategic industries,” Wayne Chen, a partner at LLinks Law Offices, points out that “it also leads to increased activity and development in venture capital and private equity”. This is because, as Xu Jiali, a partner at Longan Law Firm, adds, “ChiNext provides a feasible exit mechanism for private equity”.
Right from the start, ChiNext was intended to be a weather-vane for policy. According to Wang Yadong, executive partner of Run Ming Law Office, the Further Promoting ChiNext Guidance, published by the China Securities Regulatory Commission (CSRC) in March 2010, emphasizes that the main role of ChiNext is “enabling entities in the nine main sectors (such as renewable energy) to list, as well as ensuring that sponsors carefully choose their targets in eight industries such as property development and investment”. Nonetheless, some of the companies listed on ChiNext are in traditional industries, which is not entirely consistent with ChiNext’s stated purpose. Li Jing, a lawyer at Zhejiang’s L&H Law Firm, believes that “in future, the emphasis should be on differentiating between the main candidates for listing on the SME Board and ChiNext”. Partners Zhang Xuebing and Guo Kejun of Zhong Lun Law Firm also recommend that the policies and guidance of regulatory bodies “should be clarified”.
Some lawyers explain the purpose of ChiNext from the angle of “value”. Zhang Tao, a partner at Jun He Law Offices, believes that “the biggest advantage of ChiNext is to give Chinese entrepreneurs a dream, a realization that after all, the capital market is not as unattainable as they first thought”. He says this encourages the participation of small and medium-sized firms in the capital markets. “The principal value of ChiNext is not about how many millionaires it can produce, but rather about establishing the right sets of values for businesses – that businesses should rely on solid technologies and innovative business and management models to win over the market”. In the words of Xu Meng, a partner at V&T Law Firm, “a good boy will get what he deserves”.
Shenzhen Stock Exchange Chairman Chen Dongzheng refers to the companies listed on ChiNext as a group of children, and stresses that in order for the exchange to prevent these children from getting meningitis or polio, “the most important measure is to rely on preventative inoculations”.
The thing about ChiNext is…
Dialectical materialism tells us that there are two sides to every story, and that there is often a discrepancy between the ideal and reality. The year 2010 saw ChiNext expose a number of “bad boys” and their frightening scandals, giving pause to the capital and legal markets alike.
Lawyers argue that the problem of companies giving false and misleading information during the listing process is not caused by any shortcomings of ChiNext’s rules themselves. It is more about the profit-oriented mentality of capital markets and speculation by entrepreneurs, local governments and middlemen (sponsors, accountants and lawyers). Liu Su, a partner at Haiwen & Partners, advises prospective listing companies that while an eagerness to raise much-needed capital is understandable, the saying “more haste, less speed” should be remembered. Tang of Zhong Yin Law Firm also points out that lawyers acting for companies seeking to list on ChiNext should “raise their professional awareness” to prevent problems from arising. Strict regulatory policies and legal liability in the US have led to the overnight collapse of international giants like Enron and Arthur Andersen as a result of false accounting. However, in the Chinese market, the cost of breaking the rules is much lower. Zhang Tao of Jun He Law Offices is of the opinion that “the solution to the problem is to enforce the law, to increase the cost of breaking it”.
ChiNext’s problem of “the three highs” (high issue price, high P/E ratio and high oversubscription rate) has been a main complaint. The granting of shares at a low price immediately before an IPO and even corruption involving private equity funds pre-listing are considered as by-products of this problem. Some lawyers say bluntly that the ones to blame for “the three highs” are private equity investors and venture capitalists.
The authorities have introduced measures to tackle the three highs problem. Partner Qu Kai at Kaiwen Law Firm gives an example: in the Sale and Issue of Securities Administrative Measures, amended in October 2010, “the ambit for price enquiries have been widened, whilst at the same time the possibility for random pricing is reduced”.
Bao Huifang, a partner at Kangda Law Firm, says that the regulatory authorities have a pricing guideline for share issues on ChiNext: “if the P/E ratio is less than 30, the amount of capital to be raised must not be more than twice the net assets”. This has been reflected in practice: in November 2010, the average P/E ratio of ChiNext companies reached a high of over 90; the figure has consistently come down since then. Early this month, the P/E ratios of three new ChiNext issues were around 31 to 32.
However, the biggest headache for ChiNext companies may be how to manage and use surplus cash generated by over-subscription. According to Dai Guanchun, a partner at Jingtian & Gongcheng, specifically to address the issue of using surplus subscription monies, the Shenzhen Stock Exchange issued the ChiNext Business Information Disclosure Memorandum No. 1, which requires monies from oversubscription to be used in the company’s main business activities, and not in high-risk activities such as equity investments, trust management, derivatives or business start-ups, or providing financial assistance to third parties.
Unfortunately, as Bao says, small and medium-sized enterprises listed on ChiNext may lack professional managers, so “the businesses do not know how to manage and utilize their surplus capital”. For instance, Memorandum No. 1 states that if surplus cash is to be used to replenish working capital and to repay bank loans, the amount used cannot exceed more than 20% of the cash obtained from oversubscription during any 12-month period. Some ChiNext companies have taken this literally, so that after setting aside 20% of surplus capital for replenishing working capital and repaying the bank, they are at a loss as to what to do with the rest, and simply put the money into a bank account. According to the figures from Moneyweek, up to 18 August 2010, ChiNext companies possessed RMB45.9 billion (US$7 billion) of oversubscription monies, of which almost 75% is lying idle in savings accounts.
Qu of Kaiwen predicts that the market will ultimately revert to a reasonable level, and the bubble created by ChiNext will burst. His concern is that when the problem of oversubscription monies is solved, a new problem will arise – how ChiNext companies might raise more capital. “Business opportunities come and go quickly. What determines whether a company succeeds or fails is whether it can raise the capital it needs in the shortest period of time”. Qu hopes that “the regulatory bodies will quickly look into and publish guidelines for authorizing small-scale fast-track share issues in order that this problem can be solved.”
In a study of the latest quarterly reports by ChiNext listed companies, First Financial Daily found that nearly 30% of the companies showed a fall in profit in the first quarter of 2011. Although the Administration of Initial Public Offerings and Listing of Shares on ChiNext Interim Measures, which took effect in May 2009, mention delisting procedures, the procedures have, to this day, still not been published. As yet, there is no mechanism to allow poorly performing companies to delist.
Gavin Song, a lawyer at Martin Hu & Partners, notes that Shenzhen Stock Exchange has recently issued its Public Criticism of ChiNext Listed Companies Standards. He believes that, in the light of these Standards, the regulatory bodies will soon compile and publish their delisting policies for ChiNext.
“The difference with the main board”, says partner Shi Zhenkai of Tian Yuan Law Firm, “is that delistings on ChiNext must be a direct delisting, with reorganizations and back-door listings being prohibited, so as to prevent illicit profiteering”. Lawyer Charles Li of Han Kun Law Office also notes that last year, Shenzhen Stock Exchange chairman Chen Dongzheng formally proposed a ChiNext direct delisting mechanism and the introduction of a fast-track delisting procedure, enabling a ChiNext listed company to delist directly, instead of transferring into the nominee share transfer system (commonly referred to as the “old third board”). Sun Peixian of the legal department of the Shenzhen Stock Exchange recently said that there will be three situations in which a ChiNext listed company is expected to delist: where net assets are negative; where the notes in its audit report are negative in nature or no notes are given; and where the cumulative transactional volume is less than one million shares within any period of 120 trading days.
Is direct delisting a drug which would cause side effects? Jun He Law Offices lawyer Zhang Tao worries that after direct delisting, shareholders who have suffered losses may instigate group legal actions, thus leading to more uncertainty. Xu Ying of Jiayuan Law Firm suggests adopting practices used abroad (such as on the New York Stock Exchange), to allow companies that may face delisting to submit a re-listing plan, thus giving them a chance to remedy the situation.
On 13 June 2010, the CSRC withdrew permission for the IPO of shares by Suzhou Goldengreen Technologies, on the basis that the company’s prospectus and application papers contained statements about its five patents and two pending patents which were legally and factually incorrect. The five patents had been terminated by the State Intellectual Property Office for failure to pay annual fees. This incident became known as Patentgate. Goldengreen became the first company to gain approval to be listed on ChiNext, then to have the approval revoked.
A report published by the Shenzhen Stock Exchange shows that out of 209 ChiNext companies, 168 have been granted the status of “advanced new-technology enterprise”. Companies with awards of this type must pay close attention to the protection and management of their core intellectual property rights. The managing partner of Grandfield Law Offices, Zhang Liguo, exclaims: “How can a mistake like having one’s patent terminated by omitting to pay the annual patent registration fee happen!?” Zhang believes that from now on, regulators will strengthen the auditing process in relation to the intellectual property rights of companies proposing to list on ChiNext.
And the strengthening of processes will not be limited only to IP. “Approval requirements for initial offerings on ChiNext will become stricter”, says Longan Law Firm lawyer Xu Jiali, “especially regarding the company’s capital base, shareholding structure, whether there is any nominee shareholding, and company finances”. Next, the pricing mechanism for new issues will be improved, says lawyer Chen Youxi of Capital Equity Legal Group, “as well as improving information disclosure systems to ensure that companies disclose risks to investors in a truthful, accurate, complete and timely manner”. Lastly, the managing partner of Jiangsu’s JC Master Law Offices, Justin Ma, explains that “the emphasis of future regulatory policies will be on the continuing ability of ChiNext listed companies to generate profit. Connected transactions and independence will also be looked at”.
New third board becomes a butterfly
The CSRC’s top priority for 2011 is to expand the scope of the pilot scheme on the new third board in Zhongguancun in Beijing, and set up a nationwide over-the-counter (OTC) market under a unified regulatory framework.
Data released by the Securities Association of China early this month show that 82 companies are currently listed and traded on the new third board, with a total share capital of around RMB2.7 billion. More than 5,000 enterprises are expected to seek a listing on the OTC market in the next five years, with market capitalization and transaction volume each expected to reach RMB500 billion. With such high expectations, intermediaries such as brokerage firms and lawyers are keen to see the expansion of the new third board in 2011.
The new third board is a common term for “the stock price quotation and transfer system for unlisted joint stock limited companies in the Zhongguancun Science Park”. It is also known as the OTC market. According to the Securities Firms Acting as Agents in relation to the Stock Transfer System for Stock Price Quotation and Transfer for Non-listed Joint Stock Limited Companies in Zhongguancun Science Park Pilot Measures, published by the Securities Association of China in January 2006, securities firms can act as agents providing stock price quotation and transfer services for the companies in the science park. These measures marked the creation of the new third board. Companies on the new third board are all unlisted high-tech companies, with their project resources currently concentrated in the Zhongguancun Science Park. At present, only institutional investors are eligible to participate in the trading.
According to a CSRC spokesperson, the new third board will be expanded in two stages: firstly, qualified unlisted stock companies in national new and high-tech industrial development zones will be allowed to access the OTC market for public transfer of stocks. “In addition to the Zhongguancun Science Park, high-tech parks in Shanghai, Wuhan and Suzhou will be included in the pilot scheme,” according to Lin Zhong from Chen & Co Law Firm. Then, when the mechanism is operating steadily, the OTC market will be expanded to include qualified companies on a nationwide basis. The expanded new third board will be a nationwide OTC market regulated by the CSRC.
According to Gavin Song from Martin Hu & Partners, the new third board needs to be revamped and expanded because “the board, currently in the initial phase of the pilot scheme, fails to meet the financing needs of unlisted companies, and there is no mechanism for these companies to switch to another board”. He believes that individual investors should be allowed to participate in trading, and that market makers should be permitted. This would allow brokerage firms to act as licensed dealers to quote investors the trading prices of listed securities, accept trading requests from investors based on those prices and trade with investors with their own funds or stocks. This may go some way towards solving the financing problems of small and medium-sized enterprises, Song says.
“The expansion of the new third board will provide capital support for more high-tech enterprises at their incubation stage,” says Xu Meng of V&T Law Firm. In order to achieve this goal, he says, “companies should be allowed to use the new third board as a platform for the public offering of shares”. However, Xu is concerned about whether there will be an improved mechanism for companies to switch from the new third board to another board. He said V&T’s client Jiuqi Software is the first company successfully to have switched from the new third board to a main board for listing. However, the so-called switch of board is currently more akin to two separate and unrelated processes of first “exiting from the new third board” and then “listing on the main board”. He advocates the establishment of a green channel between the new third board and the main board or other boards, which could allow a qualified company to jump the queue for a listing on the main board.
International board about to kick off
The launch of the international board has been widely anticipated, yet its timing remains unpredictable. Previous predictions that the policies related to the international board would be introduced in 2010 were confounded. “The launch of the international board will be a long process during which initial polices will be drafted and public consultation conducted,” says Lin Zhong. “It’s unlikely that the international board will be launched this year.”
But preparations continue, and international companies including the banks HSBC and Standard Chartered, are preparing to list once the international board is up and running.
Some lawyers say that allowing international companies to list in China will raise the bar and increase standards across all the capital markets in China. According to Qu of Kaiwen: “Unless a market has international companies listed, it cannot claim to be outstanding.” But others stress that the international board may reduce valuations in the A-share market, as comparisons with the valuations attracted by international companies will become easier and more transparent.
There is a policy challenge, too. To meet the needs of listed companies on the international board, “the standards of
regulation and service in the Chinese stock markets need to be further improved,” says Ma of JC Master Law Offices. “It will also be necessary to have a sound foreign exchange market to facilitate the movement of capital across borders.”
And there is also the big question of whether companies on the international board will be subject to Chinese laws, as are foreign investment, mergers and acquisitions by foreign investors.
According to article 14 of the PRC Application of Laws in Foreign-related Civil Relations Law, if a company is listed on the international board but incorporated overseas, its rights and actions, organizational structure, shareholders’ rights and obligations and other matters will be governed by the laws of the place of incorporation, and not by the PRC Company Law. However, as the company will be listed in China, any actions connected with the issuance and listing of securities should be subject to the PRC Securities Law and yet-to-be-published issuance measures, trading rules, listing rules and settlement rules of the international board.
Although the PRC Company Law is not applicable, foreign companies will need to be prepared to cope with some aspects of Chinese law. According to Zhang Tao of Jun He Law Offices, it is not yet clear whether foreign companies, like domestic Chinese enterprises, will be required to submit documentary evidence on matters such as environmental protection, taxation, social security and equity structure.
International board, international lawyers
The international board presents both opportunities and challenges to securities lawyers in China.
According to Bao of Kangda Law Firm, the CSRC may want Chinese lawyers to take a leading role in the drafting of prospectuses. Guo Kejun of Zhong Lun Law Firm says that Chinese lawyers will provide foreign enterprises with legal services in connection with listings on the international board, just as US attorneys are engaged by Chinese companies for their listings in the US.
Xu Jianjun, a partner at Deheng Law Offices, says most Chinese lawyers are still not fully aware of two potential risks associated with legal services for the international board – “a language barrier and disclosure obligations”. The language barrier cannot be overcome with simple written or oral translation. He believes that the lawyers who provide legal services must have a real understanding of both the Chinese and foreign legal systems and cultural backgrounds.
He further explains: “The disclosure obligation of a listed company is an international obligation. Suppose a US company is listed on China’s international board, and the particulars of its disclosure on the international board were inconsistent with those of the disclosure in the United States or other markets, it may be subject to class action suit and claims for punitive damages.” Chinese companies listed in the US (such as China Life) have already had painful experiences and lessons in this regard. From the first half of the year to the present, 22 Chinese enterprises faced class action suits in the US.
Xu says that even an international law firm experienced in capital markets work will encounter challenges in understanding the law in China. The same applies in reverse to Chinese firms. “Now it’s the turn of Chinese lawyers to familiarize themselves with foreign legal systems,” he continues. “It’s beyond imagination that any Chinese law firm can single-handedly perform the legal services for the listing of an international business on the international board.”
Equity incentives: what’s not to like?
On 28 May, the Fifth Summit on Market Value Management of Chinese Listed Companies will be held in Beijing. The chairman of the forum, Shi Guangyao, explained to China Business Law Journal the considerations which led to choosing equity incentives as the main theme of the event.
“If listed companies want to achieve sustainable development, they need to reconcile three sets of interest relationships – between large and small shareholders, between the company and the management team, and between the company and society. The reform of non-tradable shares, which started in 2005, has solved the clashes of interest between large and small shareholders, but to straighten out the relationship between the company and the management team we need to rely on equity incentives to complete the reform.”
Private and high-tech the majority
Among listed companies which have already announced equity incentive programmes, the majority are small- and medium-sized enterprises on the SME board and on ChiNext. These are mostly privately established and high-tech enterprises. The experience of Taiwan illustrates how incentive programmes play a key role when such enterprises reach a certain stage of development. “In Taiwanese companies, the first generation of entrepreneurs more or less retired after completing the mission of founding their companies so there was the need to introduce management teams composed of professional managers to assist the second generation,” says Zhang Liguo of Grandfield Law Offices. “At this point, good equity incentives can unite the interests of the management team and the company, so that the management team focuses on the long-term and sustainable development of the company.”
The core competitiveness of innovative and high-tech enterprises lies in their technical personnel. Unlike the traditional beneficiaries of equity incentives, who were mainly directors and senior management, the beneficiaries of equity incentives in these enterprises show a new trend. For example, in August 2010 Beijing Ultrapower came out with an equity incentive scheme specifically aimed at middle-level managers, the core technical and managerial staff and other personnel identified by the board of directors.
Lawyers have diverging views on the purpose of equity incentives. “Business owners should not attempt to retain staff through equity incentives,” says Zhang Tao of Jun He Law Offices. “Equity incentives are a reward for the past performance of the targets, rather than something looking to the future. For enterprises to be truly able to retain talent, they must rely on their cohesiveness rather than on money.” However Zhang Liguo argues that equity incentive plans are not just a reward for historical performance and that one also needs to consider the long-term incentive effect.
Before and after the listing
There are two types of equity incentives, according to the stage at which they are granted: before and after listing. Prelisting equity incentive plans encourage beneficiaries to take a direct stake; post-listing equity incentive plans offer stock options.
Post-listing equity incentive arrangements have a clear legal and policy basis, including the Listed Companies Stock Incentives Administrative Measures (Trial Implementation), and the Equity Incentive Related Matters Memoranda 1, 2 and 3 issued by the China Securities Regulatory Commission (CSRC). Among other things, listed companies in which the state has a controlling stake must follow the special provisions of the Listed Companies (Domestic) in which the State has a Controlling Stake Implementing Stock Incentives Experimental Measures. However, the CSRC should also set out clear provisions for equity incentive arrangements made before companies list, says Zhang Xuebing of Zhong Lun Law Firm. “At the present stage, lawyers and businesses are both ‘crossing the river by feeling the stones’.”
Lawyers concede that the CSRC is highly supportive of the equity incentive plans of companies which have already listed. However, many propose that companies should implement equity incentive plans prior to listing. “This allows the entrepreneurial team to share in the company’s growth and improves the atmosphere within the company,” says Xu Meng. “And externally it is good for the company’s image and boosts the confidence of shareholders to invest in the company.”
Zhang Liguo analyses things from a financial point of view: “Under the provisions of the existing enterprise accounting system, the difference between the locked-in price and the exercise price of stock options should be accrued costs, so it has a negative impact on the company’s profits and stock prices … If businesses do not have good profit growth, they are reluctant to institute options incentive plans,” he says.
Refusing to eat for fear of choking?
Equity incentives are not looked on with favour by all. “Some people prefer to exclude equity incentive plans,” says Xu Meng, who explains the reason as being that the formulation and implementation of such plans may “increase the amount of work, extend the time for listing applications and dilute the equity of listed companies, thus reducing the returns of private equity or venture investors”.
Even more importantly, “if the design of an equity incentive plan is not, good it could have the opposite of the intended effect and accelerate the flight of talent,” says Xu Ying of Jiayuan Law Firm. Chen Wei of Llinks Law Offices agrees: “Many companies implemented management stock ownership plans before they listed. However, some senior executives holding shares resigned soon after listing in order to profit from an early sell-off of stock. This had a significant negative impact on the continued profits of the companies concerned.” In practice, the conditions for the exercise of the equity incentive plans set by some listed companies were too low, intensifying the wave of resignations by senior executives.
Companies cannot shun equity incentives because they fear choking from eating. However, neither can they go to the other extreme and apply overly strict restrictions on the exit of beneficiaries (such as that they may not leave their jobs while they hold stock options, or their service period must run continuously for a certain number of years). Otherwise, Bao Huifang of Kangda Law Firm reminds companies: “These restrictive provisions may be in conflict with article 38 of the PRC Labour Contract Law.”
So, is there a good solution? Xu Meng proposes that to the extent permitted by law a relatively long lock-up period (e.g. three years) be imposed on the stock held by the major shareholders of companies planning to list. This would be done to exclude those who wanted to engage in short-term speculation. Xu Ying suggests: “One could adopt a system of indirect shareholding, whereby the beneficiaries of the incentives set up their own companies to hold shares indirectly in companies planning to list.”
Article 12 of the Listed Companies Stock Incentives Administrative Measures (Trial Implementation) provides that the total number of effective underlying shares involved in the equity incentive plan of a listed company may not exceed 10% of the total equity of the company. Qu Kai of Kaiwen Law Firm points out that companies can take advantage of this provision to draw up equity incentive follow-up plans as appropriate, i.e. issuing a certain small percentage of stock each time (for example, in the case of China Vanke, 1% each quarter) and expanding the scope of those offered equity incentives, thus achieving sustainable incentive results.
Equity incentives may encounter other issues in the course of implementation. The programme may be aborted half way through or may even result in business losses (such as occurred with Yili Group.) However, Shi stresses: “This is not a deficiency of the equity incentive system itself, but is due to the design of the programmes being deficient.”
So, how to design a good equity incentive scheme? He gives some suggestions. First, clarify the aim of the equity incentives, as they are not an end in themselves; second, the equity incentive programme (including the target of the incentive, the different ways of incentivizing and the conditions for the exercise of options) should be subordinated to the aims of the equity incentives; third, select the appropriate point in time to implement equity incentive programmes, based on a full understanding of the impact of equity incentives on the enterprise’s financial costs.