Walter Hutchens’ Blog

The CSRC issued this Notice recently concerning IPOs. The Notice goes into effect on Oct. 1, 2003 and will apply to all IPO applications not approved before that date by the Stock Issuance and Examination Committee, a group of PRC staff and outsiders that evaluates IPO applications.

This Notice provides a number of new hurdles for companies wishing to conduct IPOs on the mainland PRC markets. The Notice asserts that these new requirements are intended to increases the quality of listed firms and promote the structural adjustment (jiegou tiaozheng) of PRC securities markets. I am skeptical that it will do either.

The hurdles imposed by the Notice include:

1. An entity applying for an IPO must have been created as a joint stock company at least three years before its IPO application. Currently, the Company Law requires that companies have at least three years of continuous profitability to conduct an IPO, but this can be calculated on a pro forma basis, so that the portion of an SOE’s business being listed is treated as a stand-alone entity to meet the 3-year total. Now under this Notice the entity must have been a joint stock company (aka company limited by shares–gu fen you xian gongsi) for at least three years prior to the IPO application. However, the Notice provides exceptions for SOEs “thoroughly transformed into joint stock companies (guo you qiye zhengti gaizhi sheli de gu fen you xian gongsi)”, LLCs (limited liability companies, you xian zeren gongsi, the other kind of entity allowed by the 1994 Company Law that is not allowed to conduct an IPO) or other exceptions approved by the State Council. It seems the CSRC is trying to make it harder for an SOE to isolate only a portion of its business as a listing vehicle and imaging it to have been a stand-alone entity to meet the requirement of three years of profits.

2. Listing applicants are not to have had major shifts in their “actual control person” (shiji kongzhi ren) or management within the three most recent years.

3. Listing applicants are to have been in the same line of business for the most recent three years. If a merger or other reorganization causes a change in the applicant’s business, they can apply to list after three years.

4. Within the most recent year and “period” (which isn’t defined–when they mean quarter or half year they know how to say that, so I have no idea what “yi qi” means), no more than 30% of the applicant’s business or acquisition of materials can be from deals with it controlling shareholder or “actual control person”

5. Within the most recent year and period, the applicant may not have entrusted its controlling shareholder or control person to handle more than 30% of its sales or materials acquisition.

6. No more than 30% of its income can be from contracting with, entrusted management from, leasing or other similar arrangements with its controlling shareholder.

7. Other than being directors of the board of the controlling shareholder, the applicant’s senior officials and board members may not have any administrative role with or get compensation from that controlling shareholder.

8. The applicant may not be in same-industry competition with its controlling shareholder

9. Per other regs, 1/3 of an applicant’s board must be comprised of independent directors, including at least one accounting expert.

10. The applicant may not through the IPO raise more than 2 times its net assets per the previous year’s audit.

Is all this a good idea? Nobody disagrees that the quality of PRC listed companies should be improved. Also, everybody knows there have been problems with SOEs treating a publicly traded company as an ATM–with SOEs or other government subdivisions going to the public markets to caputre IPO proceeds (and then for proceeds from secondary offerings of shares or bonds once the company is listed) but afterwards not treating the listed company as a stand-alone legal entity. Issuers sometimes lie to get the IPO approval (fabricating profit records) then milk the listed vehicle for cash to fund the parent’s other operations after the IPO.

Because public shareholders are minority shareholders, with only 1/3 of the stock of most PRC listed firms being publicly traded, the other 2/3 typically remaining in government hands or at least being illiquid shares, these outrages do not result in the board of the listed company being changed and the management being fired.

So the CSRC in these rules is trying to get at these problems by imposing more quality controls before an IPO.

Will it work? Marginally at best, I think. The CSRCs Notice and good intentions do not address the fundamental issue of their being accountability to public shareholders.

If merit-based listing requirements would do the trick, then PRC listed firms should already be of high quality since the Company Law requires all firms to have profitability to list.

I think the answer is not more CSRC quality control but 1) giving investors real choice so they could buy shares in more companies that are not reformed SOEs, 2) letting companies list most of their shares, so that the public markets become markets for corporate control and 3) improving the legal system so that listed companies and those associated with them are liable for their miscreant behavior.

The Supreme People’s Court issued rules in January of this year allowing investors to sue for disclosure fraud, but so far no cases have been decided by a judge, even though some trials concluded months ago. A big suit against Daqing Lianyi is going on right now. If shareholders could discipline companies, directors managers, bankers, accountants and lawyers for IPO fraud through civil litigation, then the CSRC’s role could simply be to require companies to tell the truth about themselves. At least the administrative and criminal penalties would be augmented by civil threats.

The CSRC has an enormous challenge in trying to improve mainland securities markets. And unfortunately they are not starting with a blank slate. Decision made early on about how to structure and control these markets–which may have been politically necessary at the time–have given PRC stock markets very problematic DNA.

Moreover, as more insurance money and social security funds enter the markets, the risks of destroying current valuations and having poor quality listed firms increase.

So I am sympathetic to the goals and dilemmas of the CSRC, but I do not think paternalism of the kind in this Notice is the fundamentally right approach.

China’ merit requirements do not create listed companies of merit. Letting private companies and foreign-invested companies list in the PRC in real numbers and letting PRC investors invest abroad would create merit, because issuers would be in competition for capital. Investors will select quality better than the CSRC, given choice.

Of course, allowing real choice would threaten the status quo of the markets, so the CSRC has a very big problem on its hands, and I think this Notice is evidence that they are tweaking what they have, not moving towards fundamental reform. The cost is that China’s huge and deeply talented population lacks access to capital that could help them drive growth and innovation that would make China and the rest of us better off.

The PRC press reports here that prison sentences have been given to some of the manipulators of the shares of PRC listed company Yorkpoint Science & Technology. Under the Supreme People’s Court’s rules on private securities litigation, a criminal sentence can be the basis for follow-on civil lawsuits. However, a cause of action exists only for misrepresentations (breach of disclosure duties), not market manipulation or insider trading. Nonetheless, there may be a breach of a disclosure duty among these traders so that they could still be sued for misrepresentation under the PSL Rules, with their criminal convictions meeting the requirement of prior government action.

Caijing Shibao, a weekly financial paper, has published this story on the contested state owned assets law.

I came across this story from a while back that discusses cumulative voting systems (translated as lie3ji1 toupiao zhidu) in corporate governance.

I found a collection of articles here discussing whether PRC stock markets have become marginal.

Are PRC stock markets unimportant? Obscure, surely. But unimportant? PRC stock markets are unimportant in terms of PRC corporate finance, contributing less than 2% of the capital needs of PRC companies last year, according to this report in the China Daily. Carl Walter and Frazier Howie point out that the number of investors is actually marginal, too–not even 10% of the routinely-cited number of “70 million brokerage accounts” in existence in China.

Given that I am trying to make a career of studying PRC stock markets, this might seem disconcerting. But actually their “failure” (if the effort to develop stock markets in the PRC proves in time to be that) would still be a richer intellectual vein than many other topics people have turned into academic careers. I mean, economic impact is not the sole–and often not even a principal–criterion for determining what is a good academic agenda. PRC stock markets could be of marginal economic importance but still be very important in a political or theoretical sense.

Why are stock markets marginal contributors to PRC financing? How does the legal environment contribute to this? Is there likely to be any change? Anytime soon? What would China need to do to make its stock markets work better? What did it do to make them of marginal importance now? Can anything from the PRC experienced be generalized as a principle, as in, “to flourish stock markets require. . . . ?” These questions–not to mention just the task of trying to understand what is going on factually in PRC sec reg and market development–provide plenty to keep me busy for the foreseeable future.

The Legal Daily has an article here about suggestions to work on revision of the PRC Company Law in tandem with revision of the PRC Securities Law. Much of what one might expect to find in the PRC Securities Law is actually in the Company Law, so to re-tool how securities markets (or venture capital) operate in China, you would have to change both laws.

I have learned recently that the Chinese for “hurricane” is “ju4 feng1.”

Because of hurricane Isabel, the Univ. of Maryland was closed on Thursday and Friday. My house, near campus, was without electrical power from some time Thursday night until about 10 p.m. Sunday. Consequently, I have been offline for several days.

A couple of large trees fell in the vicinity of my house–one across the facing street (literally, as in a big old tree stretching from the middle of someone’s yard to the other side of the street), one on a sidewalk running beside my yard. Thankfully, no damage was sustained, other than to power lines and poles.

I once read–I forget where–that while it seems living on a space station would make you vulnerable to the failure of some system (such as the one supplying oxygen), most people are already vulnerable to system failures but do not recognize it. For instance, without power, not only could I not get online, but I couldn’t cook, and I had to throw out everything in the freezer or refrigerator. Fortunately, some nearby restaurants had power, but suppose if they had not, and suppose the outage lasted not a few days but a few weeks, and suppose the water system simultaneously failed. Very quickly, serious problems would arise. So, yes, this experience reminded me how contingent my lifestyle is–how dependent I am on networks (power, water) that I am fortunate enough to generally take for granted.

My three year old daughter–whom I had imagined could not live without television (or, more precisely, various cartoon DVDs)–took all this in stride surprisingly well. She’s currently obsessed with puzzles, so during the daylight hours we put together many puzzles (some of them many times), and she played happily with her Thomas train set–a wooden (and to some limited extent battery-operated) contraption.

One upside to this storm is that I met a half dozen or so of my neighbors. Around dusk the lack of light inside encouraged people to congregate on the sidewalks and streets. Friday night someone fired up a grill and there was an impromptu block party, salvaging at least what could be consumed that night from everyone’s freezers. Today they had assembled along the sidewalks in lawn chairs to cheer on and observe the progress of the power company repair crews. Thus in some ways it was a nice respite from the typical anonymous suburban existence.

CITIC Securities has announced it will issue bonds, as allowed by recent CSRC rules.

The Shanghai Stock Exchange has an online glossary of securities market terminology here.

The CSRC has approved the application of ING to obtain QFII status.

PRC Economist Wu Jinglian is still crusading for the idea that developing a market economy in China requires the development of a good legal system, according to this press report.

Wu is among the most progressive and outspoken PRC public intellectuals. He wrote a commentary on the political implications of SARS that was in the banned issue of Caijing this past summer.

Often, we think of the young as being the most progressive elements of a society. In China, at least nowadays (since 1989?), it seems the opposite is often true. Septuagenarians like Wu (or law professor Jiang Ping, or the group of Party elders that petitioned for Jiang Zemin to step down) are often the most vocal for change. Perhaps, having substantially lived their lives, they feel they have the least to lose and the most credibility to draw on as a shield against reprisal.

The PRC State Administration of Foreign Exchange has released new rules related to the operation of Qualified Foreign Institutional Investors. A press commentary on the new rules is here.

Shang Fulin, who has been chairman of the CSRC since Zhou Xiaochuan moved over to head the PRC’s Central Bank, has recently given speeches at a few “international” conferences, according to reports such as this one in the PRC press.

Being Shang’s speechwriter would be one cushy job. Having written one of his speeches, all subsequent ones are pretty much done. You just have to recycle the tao hua (set phrases).

The basic outline of a Shang Fulin speech is: PRC stock markets are important, we’ve done well in developing them, but there are of course many problems we must solve, and to do so we must coordinate reform (gai ge) with stable development (wending fazhan).

Shang never seems to get more specific than such platitudes. What’s interesting is that his remarks about the challenges faced by PRC stock markets, though brief, do acknowledge that there are fundamental problems. This article reports he said, “the structure of the market is irrational” (shichang jiego bu heli). In fact, he said that China’s regulatory methods do not suit the markets’ developmental needs (jianguan fangshi hai bu neng wanquan shiying shichang fazhan de xuyao). All this is quite striking coming from the CSRC chairman.

But when he turns to what specifically should be done, Shang just reels of a long list of vapid generalizations such as “we must improve corporate governance, market efficiency, regulatory oversight, etc.”

Well, yes, but the problem is that all that requires letting the market function more like a market, not like a ponzi scheme for funding state-owned enterprises that are not subject to market discipline.

Acknowledging that, however, would threaten I think the conjoining of “reform” and “stable development” that Shang always chants. What would be good for the long term development of stock markets in China is NOT likely to help the status quo, which means PRC stock markets, like Shang’s career as a PRC bureaucrat, seem trapped within the historical inheritance of a bad system.

Shang is no revolutionary, so the “lishi yiliu de wenti” (problems left by history) continue to fester.

Today’s Washington Post includes in the business section this article on blogs.

This bit didn’t impress me:

Blogs (short for “Web logs”) sometimes take the shape of online diaries for the lonely hearts set or digital soliloquies for those who seek an audience for their sometimes-hourly musings. They’ve also acted as a sounding board for would-be political pundits and pseudo-experts on any given topic.

All that’s true enough, but vastly incomplete. Of course the blogsphere includes adolescent journals, the obsessive typing of solipsistic adults and many people spouting off about topics about which they have more opinion than information. But deriving a characterization from this parade of examples is like looking at some of the stuff published on paper and saying paper is a medium for uninformed or uninteresting rants.

The “sometimes” modifier saves the passage in some strict grammatical sense from being a general characterization of blogs, but the clear intent was to set up this image of blogging as the domain of various inconsequential types in contrast to the trend of blogs “going corporate,” the topic of the article. But long before “suits” in corporate PR or marketing departments discovered blogging, the medium was embraced by many authentic experts.

I’d like to think my blog is more than “the sounding board of a pseudo expert” with regard to PRC securities regulation. Indeed, in my experience many journalists writing in this area are at best pseudo experts–they often are astoundingly uninformed.

More generally, securities regulation is covered by authentic experts blogging at The Securities Law Beacon, The 10B-5 Daily or the Corp Law Blog. Lawrence Lessig is no pseudo-expert. These are of course only a few of many possible examples.

Perhaps the real story is not that serious people are now discovering blogging but that blogging poses a serious threat to the monopolization of media by pseudo experts working for traditional publishers.

A new story on PRC M&A is here, from FinanceAsia.com. The listing of foreign firms on China’s A share market, like M&A of listed firms, is among the reforms often touted but never meaningfully delivered.

Yesterday the CSRC released (they often seem to release things on Sunday!) a notice concerning capital movement between listed companies and affiliates and the providing of external guarantees by listed companies. This is no doubt aimed at problems of the controlling shareholder of listed companies treating the listed entity as an ATM, stripping it of assets or getting it to pledge its assets to guarantee obligations of the parent or other subsidiaries of the parent. This has reportedly been a serious problem with a number of listed PRC companies, where the state-owned entity that controls the listed firm uses it for its own interest without much regard to the interest of the public shareholders, whose main function is to contribute cash which is often then expropriated from the listed vehicle.

Tonight I surfed over to the blog of Prof. D. Gordon Smith of the University of Wisconsin law school. Previously he was a visiting professor at Washington Univ. in St. Louis, and I was a student there at the time. I took a class he taught on venture capital drafting. It was a great class. I took it the same semester I was taking a seminar on Chinese law, and that alignment of classes helped crystallize my interest in China, law, entrepreneurship & technology. My interest in PRC sec reg, which has now become a professional specialization, grew out of that amalgam, informed by my long standing interest in China and experience working at Apple prior to law school.

The CSRC has announced it will allow PRC securities companies to issue bonds and promulgated regulations concerning how to apply and what information must be disclosed.

This story is about a training program to be held this month for securities companies with regard to such bonds.

To date, few PRC securities companies are themselves listed–CITIC Securities comes to mind.

The State Administration of Foreign Exchange has now approved investment quotas for QFIIs totaling 875 million US dollars, according to this PRC press report. A terse announcement on the SAFE website confirms that HSBC and Deutsche Bank have each recently been approved for a USD 50 million quota.

I don’t know what impact it will have on the A share market, but China certainly gets a lot of public relations mileage–domestically and internationally–out of this QFII system. There is an announcement when a foreign financial institution applies to the CSRC for QFII status, an announcement when the foreign firms chooses a custodian bank inside the PRC, a story when the CSRC approves the firm for QFII status, then a story when SAFE grants an investment quota and then a story when the QFII makes its initial trades, plus all the speculation about how QFII capital will affect the markets.

Interesting story in the Post about PRC citizens traveling outside of the PRC, at least to those few places that allow them to get visas.

Months after being detained (that is, disappearing into the PRC state security apparatus), Shanghai tycoon Zhou Zhengyi has, finally, been formally placed under arrest, according to this story in the PRC English language press. Stories about Zhou were banned from Chinese media earlier this summer, and an issue of Caijing magazine with Zhou on the cover was kept off the newsstands.

PRC press are also reporting that a private equity group will acquire one Zhou’s HK listed firms.

With a high level US official in Beijing and the US election heating up, noise is being made on both sides of the Pacific about the RMB valuation issue. I find it is beside the point.

Let’s assume China “caved in” on this one and revalued the yuan as some US interest groups want it to do. Even if China dramatically increased the RMB’s exchange rate (or even allowed it to liberally float), would this really change the fundamental reason the US is shedding manufacturing jobs and has a substantial trade deficit with China? I doubt it. The difference in PRC and US wages would still be dramatic, even if the yuan were revalued. Even allowing for the cost of transportation and some other inputs, how can a US union worker (or even a non-union one in say my home state of Alabama) compete with a Chinese worker in terms of the cost of labor? I don’t see it.

Plus, I imagine computer technology and other efficiency gains have trimmed more manufacturing jobs than overseas competition in the aggregate, much less China’s contribution alone, much less the part of China’s contribution that is attributable to the falsely valued RMB.

Cheap labor is simply China’s competitive advantage. If the RMB were traded 1:1 to the U.S. dollar, the cost of labor in China would still be much lower than the cost of labor in the US. So is this an economic or only a political issue?

And though I realize there can be enormous pain for the individuals directly affected, how would freezing in place these vaunted US manufacturing jobs be good for the US standard of living in general in the long run? Should we all agree to pay more for everything so we can say it was made in the US, or should we let the creative destruction of capitalism work its magic? Trying to give every worker an iron rice bowl is what China tried, and they didn’t like the results and have been moving away from that approach for 20-plus years.

We certainly need to press China on lots of issues–and I, too, hope the RMB becomes fully convertible (so that creative destruction could come to China’s stock markets), but pressing them to revalue the RMB for the purpose of keeping US factories running seems to me like a mistake. I doubt it will really help those factories much, and I doubt helping those factories, if we could, would really help the U.S. much.

Here is a story about a slow down in the process to update the PRC’s principal banking laws