THE DRAGON AND THE EAGLE: REFORMING CHINA'S SECURITIES IPO LAWS IN THE U.S. MODEL, PROS AND CONS. (initial public offerings)

• Published date: 22 March 2018
• Author: Cohn, Stuart R.,Yinzhi, Miao
• Date: 22 March 2018

Introduction: A Move Towards Reform 330
                I. The Historical Development of the Chinese Securities Exchanges 333
                 1. The Death and Rebirth of Securities Markets in P.R. China 333
                 2. Government Control Over the Exchanges: From Local to
                Central 335
                 3. Administrative Powers over IPOs 336
                 4. How Arc the Candidates for IPOs Selected? 336
                 A. Initial Policy: Quotas Allocated to Provinces 336
                 B. The CSRC Takes Control 337
                 i) Securities Companies as Sponsors 337
                 ii) The Offering Review Committee 339
                 iii) IPO Suspensions 339
                 iv) IPO Price Controls 340
                II. Prospects for a Registration System Reform 341
                 1. The Tentative Framework in the Draft of the New Securities
                Law 342
                 2. Reform Suspended: The 2015 Market Crash 344
                III. Reform Concerns and Recommendations 345
                 1. Merit Review of Proposed Offerings 346
                 2. CSRC Disclosure Review 350
                 3. The Link between an IPO and an Exchange Listing 351
                 4. Eliminate Mandatory IPO Sponsor 353
                 5. Improve Class Action Procedures for Civil Actions 354
                 6. Eliminate Prerequisite of an Administrative Sanction for Civil
                Actions 357
                 7. Improve Liability Provisions for Misleading Prospectus
                Disclosures 360
                 8. Create Enforceable Suitability Requirements for Securities
                Dealers 361
                 9. Increase Training of Prosecutors, Lawyers, and Judges 362
                Conclusion 362
                

INTRODUCTION: A MOVE TOWARDS REFORM

The Chinese government has historically exercised tight control over the securities market through the China Securities Regulatory Commission ("CSRC"), (1) China's equivalent to the U.S. Securities and Exchange Commission. The principal control has been in determining what companies will be permitted to engage in public offerings. Whether a company can engage in a public offering involves more than meeting the formal application and disclosure requirements listed in the statutes and rules. In addition, a "stock offering review committee" appointed by the CSRC makes an independent judgment as to whether the proposed offering can go forward. Such a screening system may help unsophisticated retail investors, who constitute the mainstream of Chinese investors, to encounter better investment targets, but it possesses several serious drawbacks:

First, the entire system is biased against smaller non-state-owned companies. The fiscal conditions for a company to be allowed to issue shares publicly are high, and there is a demanding profit requirement for three consecutive years. (2) Given the institutional favoritism toward state owned enterprises (the securities market was originally established with a clear goal to save financially distressed and capital thirsty state owned enterprise (SOEs)), it is much more difficult for smaller non-state-owned companies to have access to the market, especially start-ups and new technology companies. Not surprisingly, almost all of the Chinese internet companies, none of which is a SOE, have chosen to be listed outside China. Currently, hundreds of companies are waiting in the queue for the CSRC to review their submitted IPO application files.

Second, the system lacks transparency. Inasmuch as companies being reviewed have met all the explicit IPO requirements, there are no clear standards for the decisions made by the offering review committee. Vital decisions are left to the subjective judgments of the committee members. Rejection decisions cannot be legally challenged. The securities law provides no remedy to the rejected companies which also have no official operative guidance on how to enhance their chances if they intend to submit future applications.

Third, the offering control system becomes even more rigid and paternalistic after IPOs are allowed. The CSRC imposes its own determination upon the offering price, often demanding a lower-than-market figure based on average industry price/earnings ratios.

Fourth, the CSRC approval process is both volatile and unpredictable. As the CSRC retains the unconstrained power to control the number of firms and shares to be permitted in the primary market, it is never certain how the power will be exerted. Whenever the market turns bearish there are discussions and predictions among securities market professionals and investors as to whether restrictive actions will be taken. Administrative suspensions of IPO offerings have taken place nine times since 1994, some of which extended more than one year, seriously affecting the capacities of firms planning to raise capital in the market.

In short, the CSRC controlled IPO system has led to inequalities, inefficiency, and instabilities in the Chinese securities system. The possibility of reforming the system has been a consistent topic in the Chinese law academia. Unfortunately, the discussions produced loud thunders but small raindrops until 2013 when Xi Jinping and Li Keqiang took over the leadership of the country as General Secretary of the Communist Party/Chairman of the State and the Premier, respectively. Xi was educated at Beijing's prestigious Tsinghua University, and Li has both a law degree and doctor's degree in Economics from equally prestigious Peking University. (3) Given the unprecedented higher education backgrounds of these top leaders, it was not surprising that shortly after their ascension to leadership the government announced proposals for a major economic reform.

In November 2013, The Decision on Major Issues Concerning Comprehensively Deepening Reforms (4) was passed by the Third Plenary Session of the 18th Central Committee of the Communist Party of China. This is intended as the fundamental economic agenda of the party-state for the next five years. The Decision document included statements of economic system reform such as "letting the market be decisive in the resources allocation" and "incompetence in the market system, excessive state intervention and inadequacy in regulation should be curbed." (5) Most significantly, the administrative control of initial public offerings became a target of the reform. A policy goal quickly developed to eliminate CSRC control of market access and "push a registration system reform for stock offering," as described in the Decision. (6)

The resolution of the ruling party left open the technical details of the so-called registration system. The initial common perception of what a "registration system" would look like was a system in which a firm that has met the substantive registration requirements would be qualified to go forward with an IPO without further CSRC or other governmental review, similar to the U.S. registration system. However, this simplistic picture docs not exactly reflect the practice in the U.S., given the application of state Blue Sky laws. Moreover, any legal transplant in such a crucial area could be impractical, given the markedly different cultural, experiential, and financial distinctions between China and the United States.

The change from agency approval to a pure registration system was expected to be implemented as early as 2015. However, reform is on temporary hold as a result of China's stock market crisis in July 2015, which saw a substantial drop in share prices, suspensions of trading, and a freeze on new offerings. (7) Attention will again turn to reform efforts when the government concludes that the Chinese markets have regained stability. On December 27, 2015, the Standing Committee of National People's Congress formally authorized the State Council to adjust the application of relevant provisions in the Securities Law as it carries out the reform concerning the stock issuance registration system. (8) The authorization became valid on March 1, 2016 and was renewed on Feb. 24, 2018 for another two years before the original two terms expired. Thus, the final overhaul of the securities law may be postponed for as much as two years within which the State Council has the flexibility to implement reform measures. This allows additional time for deliberate thought for how the abstract goal of an open registration system may be achieved within the Chinese market structure. (9)

The primary element of reform, an open registration system, necessarily raises questions as to company eligibilities, stock exchange listings, and investor protections. Inasmuch as the expected registration system is analogous to that in the U.S., we will explore whether and to what extent reforms should be adopted based upon the U.S. experience. This article compares and contrasts Chinese and U.S. securities laws in several major respects and offers recommendations in light of China's particular circumstances and goals.

Part I of this article describes the historical development of China's stock exchanges, including the authority of the CSRC and its exercise of powers. Part II discusses the potential market reforms being considered. Part III discusses concerns and potential policy issues raised by the proposed reforms and sets forth recommendations for measures to be implemented prior to or concurrent with the reform effort.

I. THE HISTORICAL DEVELOPMENT OF THE CHINESE SECURITIES EXCHANGES

1. The Death and Rebirth of Securities Markets in P.R. China

Before 1949, when the Communist Party had not yet taken over the country, there were flourishing securities markets in China, especially in Shanghai. But after the People's Liberation Army marched into the cities, all forms of capital markets and related financial activities were eliminated as obvious evil symbols of capitalism. On June 10, 1949, police stormed into the Shanghai Securities Exchange and put thousands of people in the building into custody, ending the exchanges. (10) The national economy became one system in which every aspect was planned and directed by the central government.

Following 1956, there was no entity with the name or essence of "company" (gongsi). The usual names of the institutions which had been enterprises were "factories" (chang), machine factory, clothes factory and so on. They were production units whose products would be allocated...