China has changed its securities law to allow for registration-based systems for IPOs and corporate bond issuances. The goal is to move the practice of the government’s involvement in closely vetting IPOs for listings to one where initial offer prices are set by the market and companies have to fully disclose material information to investors. Additionally, disclosure requirements and fines for violations have been increased to improve investor protection.
IFLR’s latest primer looks at how the changes, which came in force on March 1 2020, are affecting securities firms.
What’s new about the securities law?
Under the new rules, the approval systems for IPOs and corporate bonds are replaced with registration-based systems. The new system for IPOs replaces the China Securities Regulatory Commission (CSRC) public offering review committee that authorised stock exchanges to review applications. CSRC will now be responsible for securities registration.
Ricco Zhang, senior director, Asia Pacific at the International Capital Market Association says that the revision will encourage more corporate bond issuance in the exchange market, which is currently much smaller than the interbank bond market.
New violations are incorporated into the revision. For example, violation by programme trading has been added, which was never addressed in the securities law. Another change is that disclosure requirements are further specified. The scope of individuals and entities liable for making disclosures is extended.
“From the perspective of securities compliance, the revision significantly increases the standards of institutions and listed companies,” said an in-house counsel at a Chinese securities firm.
The revision specifies that securities companies are obligated to manage investors’ eligibility and to verify investors’ identities.
Johnny Chan, chief legal and compliance officer at China Merchants Securities adds: “Taking into account the practical needs of cross-border supervision in the capital market, the law has authorised the CSRC and PRC judicial authorities more power to punish overseas illegal activities in the securities sector.”
What aspects of the new law are likely to have the biggest impact?
According to Zhang, a big step forward has been made on market disclosure, especially in light of cases of fake disclosures that have been seen in both bonds and IPOs. This is encouraging, especially for dual-listed companies that list in both China and elsewhere such as Hong Kong SAR or the US. It will bring the level of disclosure onshore to a similar level as offshore.
Securities intermediaries are expected to be the gatekeepers of the capital markets. The revision increases the upper limit of fines the CSRC could impose on securities intermediaries for due diligence violations from five to 10 times the illegal gains.
“As the revision puts a great focus on investor protection and specifies new mechanisms for securities-related fraud litigation, such changes would lead to a significant increase in the number of litigations and the amount claimed against listed companies, which would further increase the costs of violations,” said the in-house counsel.
For example, the upper limit of fines against disclosure violations has increased from Rmb600,000 ($85,603) to Rmb10,000,000. The upper limit against individuals is also increased to Rmb10,000,000.
In addition to the fines, listed companies and individuals are also liable to compensate investors for their losses as a result of disclosure violations.
“While the law is encouraging for investors who want to pursue class actions, similar to the US, what happens in courts is a different story,” says Zhang. “We need to see real cases in favour of investors for this to be truly positive.”
What prompted the changes?
The changes come at a time when China is opening up its capital markets to foreign investors, especially as index providers such as MSCI are increasing the weighting of mainland China stocks.
In terms of the revisions on costs of violation, before the revision, violations have not been effectively restrained, since illegal gains are quite profitable compared to the costs. According to the in-house counsel, certain listed companies took risks to inflate their profits in order to get listed or to avoid delisting. The revision significantly increases the costs of violations, which should further disincentivise the practice, protect investors’ rights to disclosure, and facilitate information transparency of the capital market.
How are securities firms preparing?
“For IPOs, securities firms need to renew their working processes according to the new registration system,” says the in-house counsel. “As for compliance advice to clients, securities firms need to pay greater attention to disclosure requirements as they are materially changed by the revision.”
He continues: “As the upper limit of fines possibly imposed on securities firms is significantly increased by the revision, firms need to pay great attention to the fulfillment of due diligence duties, which would include refining work requirements and improving standards of internal verifications.”
Chan adds that sponsors, underwriting securities firms and their responsible officers need to undertake joint liability for the harmed investor when they fail to perform their duties. “Securities companies need to study the law and continuously review, adjust and improve internal systems and policies, and make sure that they are exercising due skill, care and diligence in conducting sponsor work,” he says.
The overseas subsidiaries of regulated securities companies should also make sure not to violate provisions of the law when conducting cross-border activities regulated by overseas regulators.
How has it worked it practice?
Since the securities law came into place in March, the CSRC has fined two individuals with a record fine of Rmb 3.6 billion ($508 million) for insider trading of the Shanghai-listed Joincare Pharmaceutical Group.
The CSRC has also launched rules for securities litigation in August 2020, creating a channel for class action lawsuit for securities investors in China.
Market participants are expecting to see more instances of fines for financial fraud and delistings of companies that do not meet disclosure standards.
In addition to the tougher punishments set by the securities law, another piece of legislation to watch is China’s criminal law. The draft changes to the law includes harsher punishment for financial fraud in the stock and bond issuance process by raising the maximum criminal sentence to more than five years.
What will be interesting to watch in the coming months is how the Chinese regulators will be applying the securities law and other relevant laws in practice. Against the backdrop of financial fraud committed by Chinese companies, such as Luckin Coffee and Kangmei Pharmaceutical, it will be essential for regulators to ensure that they are acting as the gatekeeper watching out for listed companies marred by financial risk.