In Depth: Why China’s Tightening Its IPO Regulation

25 Jun 2024

China is tightening its grip on the country’s stock market with a set of new guidelines, hoping to arrest the protracted slump in share prices, improve the quality of listed companies, and restore investor confidence. Market observers, however, warn that the measures could jeopardize the landmark overhaul of the IPO system introduced five years ago and shut out innovative small companies in emerging industries.

The guidelines, released by the State Council on April 12, focus on improving oversight and regulation of the equity market and cover a host of issues including listing standards, delisting rules, oversight of intermediaries to reinforce their role as gatekeepers, and supervision of high-frequency trading.

They aim to provide targeted solutions to regulatory shortcomings and loopholes exposed by previous market turbulence, and also serve as a solution to some of the longstanding and deep-rooted conflicts in the market, Wu Qing, chairman of the China Securities Regulatory Commission (CSRC), said in an interview with state-run broadcaster CCTV that day.

“The guidelines aim to promptly address weaknesses, respond to investor concerns, resolve deep-seated contradictions accumulated over time in the capital markets, and accelerate the development of a safe, standardized, transparent, open, dynamic, and resilient capital market,” Wu said.

The commission has issued several rules since the publication of the guidelines to flesh out details and help with implementation, and the country’s stock exchanges have revised their business regulations to comply with the State Council requirements.

Known as the National Nine Articles, the guidelines followed relevant State Council opinions issued in 2004 and 2014 to support and direct the development of China’s capital markets. But while the previous versions focused on stable and healthy development, the latest one emphasizes strict supervision and management.

IPO tightening

“Although the core content of the new National Nine Articles is a continuation of recent regulations, the comprehensiveness of the policies set out by the State Council, the CSRC and the exchanges, plus the detail of the requirements have rarely been seen in recent years,” Liu Jiawei, an analyst focused on the nonbanking financial sector at Dongxing Securities Co. Ltd., wrote in an April 15 report. “If all market participants can be mobilized to implement the requirements of the new policies comprehensively, quickly, and efficiently, we can expect a qualitative change in the market.”

One of the most significant changes in the guidelines is the tightening of criteria for IPO candidates as part of efforts to improve the quality of listed companies. The exchanges have raised the thresholds of key financial indicators, such as revenue, net profit, net cash flow, and market value. They also give more weight to a company’s value attributes, emphasizing its ability to generate stable returns and withstand risks.

The new guidelines also aim to enhance the responsibility of the exchanges in the pre-IPO review process and improve the approach to setting up and running committees overseeing new listings. A retrospective accountability mechanism for IPO reviews will be established, the quality and effectiveness of guidance provided to candidates will be improved, and onsite inspections of companies and their intermediaries will be stepped up.

Following the release of the guidance, the CSRC published an updated checklist on April 30, which increases the random inspection rate to 20% of IPO candidates from 5%.

Many analysts say that the tightened regulations on IPOs walk back much of the reform to a new system announced in 2018 aimed at dismantling barriers that had been preventing up-and-coming companies from listing on domestic stock markets. A shift to a registration-based system from one based on regulatory approval was rolled out for the new STAR Market in 2019, a transformational change that took much of the responsibility for IPOs away from the CSRC and put it into the hands of companies and investors.

The main responsibility for reviewing whether a company meets IPO conditions and information disclosure requirements was shifted to the stock exchanges, while the CSRC would decide within 20 business days whether to allow an IPO registration based on the exchanges’ review.

New rules were introduced lowering requirements for listing criteria including revenue and profitability that had effectively shut the door to many young, high-growth companies because they were money-losing.

The updated Securities Law, which took effect in March 2020, established the legal foundation for implementing the registration-based system across all domestic exchanges. The system was rolled out to Shenzhen’s ChiNext in 2020, and to the Beijing Stock Exchange when it was launched the following year. In February 2023, the Shanghai and Shenzhen stock exchanges issued rules for implementation on their main boards after gathering public feedback.

Although the registration-based IPO system simplified and shortened the previously lengthy approval process that companies had to go through before they were allowed to list, problems emerged. The quality of information disclosure mandated for listing candidates and their intermediaries — such as sponsors, accountants and law firms — was often inadequate and sometimes fraudulent, forcing some companies to withdraw their applications. Many ordinary investors often weren’t equipped to judge the merits and risks of an IPO and its investment value.

Concerns grew that China’s stock market was not mature enough for such a system and that the CSRC needed to step back in to take back some control.

“Moderately raising the threshold for the main boards and ChiNext is an essential and urgently needed step to optimize the registration-based IPO regime,” analysts from Soochow Securities Co. Ltd. wrote in a report published on April 14. “Although China has completed the registration-based reform, the market still cannot rationally price the value of listed companies.”

There has been a trend of gradually returning to the approval-based IPO system, a former employee at a stock exchange told Caixin.

The exchanges’ IPO reviewers “have to continue to increase their standards and scrutiny, so, in essence, the system is still approval-based,” the person said. “Coupled with stricter retrospective accountability, reviewers would rather reject 100 applications than let one potential bad apple through.”

The application process is getting more difficult, and the reviews are increasingly stringent, Shi Donghui, a professor of finance at the International School of Finance at Fudan University, wrote in an analysis last year. “Regulators have once again intervened in a forceful way in the market-oriented operations of the registration-based IPO system,” wrote Shi, who is also a former director of the Shanghai Stock Exchange’s Capital Market Research Institute.

Although the new guidelines are aimed at addressing shortcomings in the registration-based IPO system and weeding out weak companies, some analysts say they will make it more difficult to list.

Hopes dashed

Companies wanting to join the STAR Market, a board for companies specializing in science and technology innovation, for example, now have to meet higher requirements for the amount of funding allocated to research and development and the number of patents obtained.

The changes have ended the IPO hopes of some companies. A report by analysts at Guotai Junan Securities Co. Ltd. released on April 14, which evaluated companies whose IPO applications were pending review as of that day, found that 28 out of 155 main board listing hopefuls could be disqualified under the guidelines. For the STAR Market, the analysts estimated the new rules could impact at least 10% of the companies waiting for review.

A person from a mutual fund firm told Caixin that previous financial requirements such as profits and revenue for IPO candidates on ChiNext and the Shanghai and Shenzhen main boards were relatively low. There have been a number of occasions when companies amended the numbers soon after listing, notably those with low profitability and a weak risk profile. Tightening the IPO entry criteria could allow more truly good companies to go public, the person said.

The new measures appear to discourage companies from even applying for IPOs, a person from a private equity firm told Caixin. “It’s like saying: ‘Don’t bother submitting an application. IPOs have been tightened up for now and the threshold will be higher. You might as well just withdraw.’”

Against this backdrop, the market is widely anticipating a continued decline in IPO financing this year. An April 17 report published by a Beijing-based research institute expects a sharp decrease in the number of IPOs in the current year. “Assuming one to three companies per week can be listed in Shanghai or Shenzhen, a moderate forecast would expect a total of 100 companies can go public this year raising 102.5 billion yuan ($14.1 billion). That would represent a year-on-year decline of 56% and 71%, respectively,” the report said.

In the initial stages of the registration-based IPO reform, officials lauded the system for having “no [regulator] intervention” as part of its core principles to give more autonomy to the market in the process of listing.

Disrespect for market rules has been a long-standing issue in the Chinese stock market, a finance veteran told Caixin.

“One cannot use the banner of protecting investors as an excuse to control everything, as protecting investors does not mean controlling (stock) index fluctuations or guaranteeing returns,” the person said. “‘Paternalism’ and ‘overbearing regulation’ will only push the A-share market further away from market-driven principles.”