China’s securities regulator is considering raising the bar for candidates looking to list on the country’s two small-cap stock boards in response to growing volatility and a spate of irregularities. The thinking is that, by setting a minimum profit requirement, less established companies won’t be able to go public and so the market will clean itself up.
There may be some truth to this, but the strategy begs two rather important questions. First, in the continued absence of strong pricing and disclosure mechanisms, how can the regulator tell which companies are misbehaving? And second, don’t these minimum requirements go against the very reason for setting up small-cap boards – to raise capital for small yet innovative firms that might otherwise go unfunded?
In 2004, China’s first small- and medium-sized enterprise (SME) board was created in Shenzhen. The listing thresholds were reasonably high and so only a relatively small number of companies actually made it on to the board. ChiNext, a NASDAQ-like growth enterprise board set up last October, was supposed to be the answer. Also based in Shenzhen, it would feed thousands of capital-thirsty start-up firms.
So far, 80-plus companies have listed on ChiNext, but results have been mixed. Although firms raised larger-than-expected proceeds from the initial public offerings, their share prices encountered huge fluctuations without any major change in business operations. Various investigations have been launched into trading irregularities.
Apparently, regulators feel that retrospective action is not enough. They deem some of the publicly-traded firms to be of poor quality and are seeking ways to improve overall listing standards.
A major concern is that these start-up companies lack the financial strength to counter the risks brought about by a possible slowdown in economic recovery. According to official statistics, 78 ChiNext-listed companies posted a combined net profit of US$137 million in the first quarter, up 36% year-on-year, but down 56.8% quarter-on-quarter.
According to proposals, companies would need to post a net profit of at least US$4.4 billion for the latest fiscal year to be qualified for ChiNext, up from the current threshold of US$730,000. The requirement for the SME board would rise to US$7.3 million from US$1.5 million.
The rationale behind the initiative seemed to be “the bigger, the better.” Admittedly, a larger company may be in a better equipped to deal with operational risks, but that doesn’t guarantee it will outperform smaller rivals in the long term.
It is often asked how the poorly governed and poorly performing companies got to market. Did firms deliberately cheat investors? Did underwriters help cover up damaging information? Did the regulators neglect their duties during the review process?
The Shenzhen Stock Exchange recently raised the possibility of de-listing public companies that seriously violate trading rules and encroach upon investors’ interests. Of course, this may do more harm than good to ordinary investors who will be left out-of-pocket as a result of the de-listings.
Certainly, underwriters must be held to account in cases where companies have tampered with financial results to qualify for public listings. Investment banks earn large fees from sponsoring IPOs on the growth boards, but sometimes seem in an indecent hurry to sever relations with their clients once the money is handed over.
One solution is to impose heavy fines on underwriters that fail to carry out proper due diligence. In extreme cases, for example where underwriters deliberately help clients cheat regulators and investors, offenders should have their licenses revoked for a certain period.
Meanwhile, a well-designed pricing system must be put in place for IPOs. ChiNext-traded companies had an average price-to-earnings ratio of about 70 for their initial public offerings, compared to around 30 for main board debutants in China.
It’s not unusual for high-tech firms to trade at a premium – investing in such companies inevitably involves something of a high risk, high reward strategy.
But the consistent price drops after the firms started trading suggests that the initial pricing was largely the product of speculation as opposed to real faith in corporate fundamentals. Investors that quote unreasonably high prices during initial consultations but later give up subscribing to the IPOs should be investigated thoroughly.
Better corporate governance and information disclosures are always desirable. But more importantly, market participants who try to manipulate stock prices must face tougher punishments. Permanent trading bans and jail sentences are required, not just tiny fines.
A successful board for small firms needs high-tech companies with quality assets, strong regulatory processes and oversight, and the participation of prudent investors. Merely setting a new profit threshold for applicants won’t deliver long-term healthy development.