Increasing transparency

China Law & Practice's Annual Review was released at the Awards Ceremony in Beijing this month. Part of the Annual Review comprises insights from leading lawyers. In this Q&A, Gary J Gao and Y Q Richard Song discuss legislative changes, developments in China's captial markets and what investors can expect in the future.

1. What have been some of the key legislative changes affecting China's capital markets over the past year? How did these developments clarify issues with current legislation?

Firstly, there were new regulations allowing qualified foreign investors to issue renminbi-denominated bonds known as dim sum bonds, which was a step forward in the internationalisation of China's currency. The launch of the new RQFII (RMB qualified foreign institutional investor) programme towards the end of last year helped to diversify investment products available to foreign investors. This year, the regulatory developments concerning IPOs are attracting attention.

Secondly, new government initiatives in the renminbi-denominated bonds market and the new RQFII programme demonstrate its commitment to properly promoting the internationalisation of the currency and its free conversion.

Finally, regulatory changes addressing the issues in the onshore IPO market can be summarised as below.

Pricing

The price-to-earning ratio is too high and new offerings are overpriced. The first trading day is usually very active, resulting in companies often closing below the listing price at the end of the day.

A higher disclosure obligation has been introduced to justify the high pricing of the shares and allow individual investors to supervise the pricing process. For example, if a company's shares are priced 25% higher than shares of other companies in the same industry, the issuer will have to disclose the reasons justifying the price difference. Also, five to 10 individual investors will be able to participate in the pricing enquiry process where the old rules stated that only institutional investors were entitled to participate in this process.

Approval system

The main challenge here is to obtain approval from the CSRC to list onshore, often causing listed companies to be overvalued.

Listed companies may now be subject to tighter rules on suspension and delisting. This is intended to stop the problem of the so-called “never die bird” and overvalued listed companies. For example, the Shenzhen Stock Exchange, Rules on Listing of Shares on the ChiNext, which entered into force on May 1 earlier this year, now provide that poorly performing companies will be delisted if the price of their shares fall below their par value for 20 consecutive trading days or if they are warned three times for improper practices including misrepresenting their assets.

Securities fraud

Insider trading is an acknowledged fact in the Chinese stock markets and affects investor confidence.

There are new stricter regulations on insider dealing. The Chairman of the CSRC, Guo Shuqing has said that insider dealing will no longer be tolerated. For example, on June 8 2012, the Tentative Provisions on Strengthening the Regulation of Unusual Stock Transactions in the Course of Material Asset Re-organisation of Listed Companies (Draft for Comments) were released, which state that the stock exchange is to conduct an examination of any unusual transaction where a listed company decides to suspend trading to enter into restructuring involving major assets.

2. How do the Guidelines released during the May Holiday from the CSRC change the IPO market?

The Guiding Opinions on Further Intensifying the Reform of the System for Offering of New Shares issued on April 28 2012 and their complement (Measures for the Administration of the Offering and Underwriting of Securities (2nd Revision)) issued on May 18 2012 would be a positive change to the legislative framework if enforced correctly.

The provisions above specifically institute the following changes:

• Five to 10 individual investors may participate in the pricing enquiry process. They must possess at least five years of investment experience to be qualified;

• Share issuers and lead underwriters are allowed to determine the share price through negotiation between themselves.;

• Up to 50% of the offered shares may be offered through offline placement; and

• Divulging information after obtaining CSRC approval and before the publication of the preliminary prospectus is strictly prohibited.

a. Are investors happy with the increased transparency the reforms offer?

Investors are certainly happy about the changes. These regulations are bringing positive changes to the pre-existing framework as transparency has been increased, efforts are being made to diminish insider trading and the problem of overvaluation is being addressed.

b. Was there anything else you were hoping the reforms would address in relation to IPOs?

On other stock exchanges, decision power is being given to the market while the government only plays a minor role in the pricing, and investors are making investment decisions. The reforms are a step in the right direction, but legal professionals hoped they would further reduce the role of administrative examination and approvals in order to become a registration system. The government is expected to focus on supervising, rather than regulating the market. Fraud needs to be eliminated by enhancing market supervision and restoring investor confidence. new regulations can be formulated to address this issue and give the investor the right tools to defend their rights and recover losses. Third parties, including lawyers, will then be able to assist deceived investors without facing administrative barriers.

3. Last year, the Shanghai International Board was supposed to be launched, but the economic crisis caused it to be delayed. When do you expect the Board to be launched and how have you advised clients who are considering listing on the Board?

The economic crisis is not the sole, but a contributing cause in the delay in launching the Shanghai International Board. China rapidly recovered from the economic crisis and recently slowed down its development to focus on added-value industries like high tech and green technologies. No definite time table has been set and so we are not advising any clients to wait to list on the Board.

We believe the following issues need to be addressed before the Board is launched:

• Non-convertible currency: the biggest obstacle to the launch is that renminbi is not a freely convertible currency;

• Enforcement: Chinese governmental entities will not have full control over the issuers and, due to conflict of laws and jurisdictions, cross-board legal enforcement will be a problem;

• Confidence: Chinese investor confidence is at a new low meaning less money is being invested in the market; and

• Affordability: can China afford another new Board? The risk of failure is important in this environment.

An indicator that the market may not be ready yet is that whenever news on the launch of this new Board is broadcast, there is a negative effect on the stock markets.

4. Towards the end of last year MOFCOM released new security review provisions for VIE structures. How have the provisions affected VIEs in China?

The main concern when these provisions came out on September 1 2011 was whether these structures would negatively affect companies listed overseas (e.g. Sina. com) or whether the Chinese government's tolerance of such structures would be affected. These new provisions provide that structures giving foreign investors indirect control of domestic enterprises may not be used to avoid the standard M&A security review necessary to complete a transaction. Article 9 states: “A foreign investor may not attempt to circumvent the Security Review by any means, including but not limited to holding on behalf of another, a trust, multi-level reinvestment, lease, loan, control by agreement, offshore transaction or other such means.” The review is intended to block transactions which may affect national security, the stable operation of the national economy, basic societal order and people's living conditions and R&D capacity for key technologies related to national security. We believe that the government will continue to tolerate this structure, but there are still potential risks attached to its use.

5. Since the China Banking Regulatory Commission (CBRC) issued the Guidelines on the Participation in Stock Index Futures Trading by Trust Companies in September 2011, how have trust players found participating in the Index?

The Guidelines issued on June 27 2011 by the China Banking Regulatory Commission (CBRC) set up new rules for trust companies wishing to directly or indirectly participate in stock index futures trading on approval from the CBRC as well as the qualification to engage in stock index futures trading.

For trust companies, the Guidelines enlarge the scope of activities they are entitled to engage in. The Guidelines differentiate between structural collective trust schemes or a trust managed by a trust company with two or more settlers, for which trading is permitted for hedging and arbitrage purposes, and single trust businesses with one settler, which can engage in trading for hedging, arbitrage and speculative trading. It also forbids the existing business of a trust company from participating in stock index futures trading. In cases where the bank is the settlor, some additional restrictions may apply. Although these regulations open the door to a new market for trust players, CBRC, concerned about regulating market risks, decided to impose restrictions on the trust companies for trading these products. For example, Article 15 of these rules provides that: “If a single trust of a trust company participates in stock index futures trading, the risk exposure of the stock index futures held at the end of any trading day may not exceed 80% of the net value of the trust assets […]”. This means reactions may differ depending on the trust company.

6. What are some of your experiences and strategies for IPOs you are working on?

Our initial strategy for offshore listings is to focus on emerging markets including Korea and Malaysia. The depreciation of Chinese companies in the US and Hong Kong following last year's scandal and the financial crisis did not establish an ideal environment for listings on these markets. Emerging markets usually have a good image of Chinese companies, PE is usually in line with the industry and higher than in the US or Hong Kong, and shares can easily be sold on the market.

For onshore and offshore listings, we usually advise Chinese companies to make sure they have an adequate filing system to maintain clean records of all historical documents. We also advise them on the importance of effective corporate governance policies.

We also educate domestic enterprises on the benefits of maintaining a good corporate image and the necessity of engaging the right third parties to support them whether for public relations or preparing for an IPO. In addition, we emphasise the importance of maintaining good corporate governance even after the company has been listed and the need to comply with all continuous listing obligations.

7. What are some of the most common problems or issues that generally arise during IPOs?

The problems on the domestic market are obtaining CSRC approval. There are over 600 companies queuing to obtain such approval. Other problems include previous shareholders are usually not cooperative when documents need to be gathered to prove previous company restructuring, the transparency of financial statements and the due diligence process requires the existence of any associated trading or related transactions to be verified. It is difficult to complete this part of the process due to the limited documentation and the similarity of Chinese names; and assembling the necessary documentation to prove the growth of a company and the projected growth to satisfy CSRC requirements is also hard.

The problems on the overseas market are: ensuring that the CFO and members of the management team understand both markets and are able to communicate with overseas investors; increasing the transparency of management and financial affairs.

8. What are the major issues or concerns issuers might have with both onshore and offshore listings? How do you address these issues?

For the onshore market, the issue remains obtaining the approval of the CSRC. For the offshore market and in the pre-listing phase, Decree No 10 issued by MOFCOM and Decree No 75 issued by SAFE, are still a major obstacle for domestic companies wishing to list legally overseas.

In the post-listing phase, following the Muddy Waters report scandal last year, restoring foreign investor confidence in Chinese companies is still a problem. Time may erase the negative impact, but we also advise our clients to ensure compliance of their continuous operations and corporate image.

9. What is your outlook for the market over the next twelve months? What are some of the major trends you see emerging?

As the financial crisis and European debt crisis ease, the market will recover and activity levels in M&A, IPOs and market trading will increase accordingly. Cooperation between global governments will help in this regard.

With regard to onshore trends, we expect: the Chinese government to reduce the number of required approvals; more market regulations reforms; the government to adopt a zero-tolerance attitude towards financial fraud and insider trading; and market participants to be able to receive higher profits since the government is pushing listed companies to distribute more dividends.

Offshore, we expect Chinese companies will slowly recover from the Muddy Waters scandal and the strongest companies with real business will maintain their good status. Chinese companies still have a lot to offer offshore markets.

提高透明度

段和段律师事务所的高俊律师和宋永泉律师对当前中国资本市场的发展提供了指引，当中涉及对透明度提高的要求，以及从“浑水丑闻”中恢复过来的前景。

1. 在过去几年中，影响中国资本市场的重要法规变化有哪一些？这些新法规如何阐明现行法规所出现的问题？

首先，允许外国投资者发行人民币计价债券 (点心债券) 这一新规定的出现成为中国货币走向国际化的一个重大进步。其次，在临近去年年底之时，新RQFII (人民币的合格境外机构投资者) 计划的发布为外国投资者可投资产品提供了多样化发展。今年，引起关注的是有关国内市场首次公开募股 (IPO) 的最新立法。