Mar 15, 2018 By Morris & Megan

On 27 December 2017, the 17th Issuance Examination Committee (the “IEC”) unveiled the examination results of the 83rd meeting, which marked the end of 2017’s IPO examinations. According to the official website of the China Securities Regulatory Commission (the “CSRC”), by the end of 2017, a total of 479 IPO applications were examined by IEC, among which 380 were approved, 86 were denied, 7 were cancelled, and 6 were suspended.

Legal Miner will analyze the basic situation of the 86 enterprises denied and the key issues raised by IEC during the inquiry.

Data time range of the report: 1 January to 31 December, 2017.

I. Analysis of the Basic Situation of the 86 Companies

Given that 2017’s IPO examinations is related to IEC’s personnel changes in October, Legal Miner takes such month as the dividing line and introduces separately the basic situation before and after October.

(I) Board Analysis

31 main board applications were denied, accounting for 36%; 12 small-and-medium enterprise (SME) board applications were denied, accounting for 14%; 43 growth enterprise market (ChiNext) board applications were denied, accounting for 50%.

Denied companies split by board

(II) Stock Exchange Analysis

31 Shanghai Stock Exchange applications were denied, accounting for 36%; 55 Shenzhen Stock Exchange applications were denied, accounting for 64%.
1 Previous IEC: refers to the IEC responsible for the examination of IPO applications before October, 2017.
2 New IEC: refers to the IEC responsible for the examination of IPO applications after Oct. 17, 2017.

Denied companies split by stock exchange

(III) Industry Analysis: Most Denied Applications are Manufacturing Enterprises

56 manufacturing enterprises were denied, accounting for 65.1%. 13 information transmission services, software and information technology enterprises were denied, accounting for 15.1%. 4 leasing and business service enterprises were denied. The denied enterprises of 1) scientific and technical service, 2) water conservancy, environment and public facilities management, 3) mining and quarrying, 4) construction, 5) agriculture, forestry and fishing, 6) culture, sports and entertainment, 7) residential service, repairing and other services enterprise, 8) wholesale and retail trade altogether accounted for 15.2% ( denials).

Denied companies split by industry

Most denied applications are from manufacturing enterprises, accounting for over 60%. Considering that manufacturing has a wide scope and includes various secondary activities such as food processing, textiles, equipment manufacturing, and comprehensive utilization of waste resources, manufacturing enterprises constitute a huge proportion not only in denials but also in all applications.

2.1 The issue that caused denied companies under repeated inquiry during the quarter

Most denied applications are from manufacturing enterprises, accounting for over 60%. Considering that manufacturing has a wide scope and includes various secondary activities such as food processing, textiles, equipment manufacturing, and comprehensive utilization of waste resources, manufacturing enterprises constitute a huge proportion not only in denials but also in all applications.

(IV) Regional Analysis

In 2017, most enterprises denied are located in Zhejiang, Guangdong, Shanghai, Jiangsu, Beijing, Fujian, and Chongqing (in that order). Enterprises located in these 7 regions occupy in total 67.3% of all denials. 28 denials are from other regions, accounting for 32.7%.

Denied companies split by region

(V) Month Analysis: Increase of Denials Since the Current IEC Took Office

According to the statistics, most denials appeared in June, November and December. These 3 months witnessed over 10 denials respectively, accounting for altogether 43%. 49 denials took place in other months, accounting for 57%. An obvious increase of denials can be found after the new IEC took office.

Denials split by month

II. Analysis of the IEC’s Opinions on Denials

(I) Summary of IEC’s focus points

By analyzing IEC’s focus points on the 86 enterprises denied, we have found that non-compliance, internal control system, discrepancy in gross profit margin, affiliated transaction, sales expenses, and sales model are the 5 important reasons for the denial of IPO application.

Legal Miner will focus on the issues of legal compliance, horizontal competition, and affiliated transaction in this annual report.

(II) Key Issues Analysis of Denied Applications

1. Compliance

Considering the complexity and variety of legal compliance issues, Legal Miner has classified the 86 denials and found that the stability and compliance of shares, environmental compliance, and business qualification compliance were emphasized in CSRC’s inquiry. This article will provide a further analysis with specific cases.

(1) Whether the issuer's equity is stable and compliant

A. Anhui Taida New Materials Co., Ltd.

Situation: the reason to pledge the shares of the senior executives; whether the limits on shares affect the stability of the issuer’s shares
Inquiry: "By the date of signature of this prospectus, the Board Secretary and Chief Financial Officer of the issuer, namely, Zhang Wuxing, directly and indirectly holds 9.6% of the issuer’s shares. Among the 3,695,150 shares pledged by Zhang Wuxing, 2,000,000 shares were pledged as counter-guarantee for a bank loan of Huangshan Xincheng Trade Co., Ltd., and 1,695,150 shares were pledged as guarantee for Liu Jiehua’s loan. The Issuer’s representatives are required to explain the reason to pledge the shares, and whether the limits on these shares will affect the stability of the issuer’s shares. The sponsor representatives are required to deliver verification opinions.”

B. HiTrend Technology (Shanghai) Co., Ltd.

Situation: the sponsor’s actual controller indirectly holds the issuer’s shares; whether the independence of sponsor is affected.
Inquiry: “Chen Jinxia, the actual controller of the sponsor, holds 75% of the shares of Shanghai Nami Venture Capital Co., Ltd., which is the general partner and executive partner of Shanghai Honghua. Shanghai Honghua holds 2.31% of the issuer’s shares. The sponsor representatives are required to explain clearly: 1)whether the actual controller’s indirect holding of shares will affect the independence of sponsor’s practice; 2)whether this situation is in accordance with related regulations on IPO sponsor practice; 3)whether the Rules for the Direct Investment Business of Securities Companies and the Rules for the Administration of Privately Offered Investment Fund Subsidiaries of Securities Companies, stipulated by Securities Association of China(SAC), can be applied by analogy in this case; and 4)whether it is strictly and sufficiently compliant to apply only the regulations concerning sponsor and direct investment in this case.”

(2) Whether the issuer has environmental violations

Suntar Environmental Technology Co., Ltd.

Situation:whether the issuer’s disposal of sewage is compliant.
Inquiry:"The issuer confirms revenue based on the higher value between basic water amount and actual sewage disposal amount. The issuer’s representatives are required to: 1) explain the legal compliance, whether the internal review process is implemented, and whether the relevant accounting practice complies with the accounting standards when using the basic water amount to determine revenue; 2) calculate the income, cost and net profit based on the lower value of basic water amount and actual sewage disposal amount, and provide special risk warning in the prospectus. The sponsor representatives are required to explain the verification methods, process and basis, and deliver verification opinions.”

Shandong Yuanli Science and Technology Co., Ltd.

Situation:whether the operation of environmental protection facilities and the environmental protection investment during the reporting period are compliant with relevant laws and regulations.
Inquiry:"The issuer’s representatives are required to further explain 1) whether the operation of environmental protection facilities and the environmental protection investment during the reporting period comply with relevant laws and regulations, 2) whether the issuer’s environmental protection measures are effective, 3) why both the production capacity and the yield of HDO manufacturers around the world have declined considerably in recent years. Are there environmental factors? Are the markets and technology prospects of this product involved? 4) Whether relevant information and risks have been fully disclosed. The sponsor representatives are required to deliver verification opinions."

(3) The Issuer does not hold business qualification certificate or runs related business without authorization.

A. Chongqing Radio and Television Digital Media Co., Ltd.

Situation:the issuer has not obtained the Information Network Audio-Visual Program License.
Inquiry:“the Issuer does not directly hold the Information Network Audio-Visual Program License. By the exclusive authorization of Chongqing Radio and Television Group (general station), the issuer has the operation rights of the related business in Chongqing IPTV’s license and Chongqing Network Radio and Television’s license. The issuer’s representatives are required to explain 1) whether the assets are complete, whether the business is independent, and whether the issuer has independent market operation capability; 2) whether there is significant dependence on the actual controller, and 3) whether the business can be guaranteed to continue in the event that the issuer cannot obtain the authorization or exclusive authorization of the Chongqing Radio and Television Group. The sponsor representatives are required to explain the verification methods and basis, and clearly deliver verification opinions.”

B. Beijing Quanshi Tiandi

Situation:the issuer has not disclosed the relevant qualifications and information necessary for business operation.
Inquiry:"The issuer’s representatives are required to explain: 1) whether the issuer has relevant qualifications and licenses necessary for business operation; 2) whether the issuer has established and improved relevant systems such as registration, supervision and file management, whether the issuer has checked relevant supporting documents and advertising contents, and whether there are legal violations in the business operation; 3) whether there has been situation where the issuer designs or makes the advertisement which is knowingly or should have been known to be false or has other illegal conditions, and whether downstream clients have had illegal actions; 4) the issuer’s responsibilities in the business operation and their impact on the performance, based on the relevant laws, regulations and the agreement between the issuer and the supplier or the customer; 5) whether there are obstacles to obtain business qualifications in other regions, given that the issuer's business is mainly concentrated in Beijing; if the business in other regions cannot be effectively expanded, what will be the future impact; and 6) whether the disclosure of the information related to the above-mentioned problems is true, accurate and complete. The sponsor representatives are required to explain the verification methods and basis, and clearly deliver verification opinions.”

2. Affiliated transactions and horizontal competition

In the Analysis of IPO Examination Feedback in Q2&Q3 of 2017, we have mentioned three categories of subjects restricted by horizontal competition as well as the requirements for full disclosure of affiliated transactions. Based on the 86 denials of the whole year, Legal Miner will extend further research on horizontal competition and affiliated transactions.

(1) Horizontal competition

According to Article 52 of the Standards for the Contents and Formats of Information Disclosure by Companies Offering Securities to the Public No. 1—— Prospectus (2015 Revision), the issuer shall disclose in the prospectus whether the controlling shareholders, actual controllers and the enterprises controlled by them are engaging in the same or similar business with the issuer. According to the current cases, if the issuer has a subsidiary, whether there is horizontal competition between the issuer’s subsidiary and above-mentioned affiliated entities shall also be taken into consideration. On the other hand, it is hard for the issuer to define and distinguish the same and similar business in practice.

In fact, based on the relevant cases, we have found that CSRC has developed a set of systematic examination criteria, as demonstrated in the following aspects:

   A. Sales and procurement channels: If there exists a partial overlap, the issuer is required to explain whether the transaction complies with the market pricing principle, whether the transaction price is fair, and whether there is any transfer of benefits; (Case: HiTrend Technology (Shanghai) Co., Ltd.)
   B. Supplier and buyer: there shall not be common suppliers and common buyers; if there are some common suppliers or common buyers, reasons for the common suppliers shall be explained in terms of the diversity of raw materials, the wide application of raw materials in the upstream industry, and the regional concentration of the industry. However, the common suppliers’ proportion shall be small and in decline. The transaction price and the market price shall converge. As for the common buyers, the issuer shall explain in terms of their large scale and the diversity of products or services. Nevertheless, the proportion of the common buyers shall be small and in decline, and the transaction price and the market price shall converge; (Case: Chongqing Radio and Television Digital Media Co., Ltd.)
   C. Intellectual property rights (including patents, copyrights, trademarks) and other intangible assets: the existence of commonly used or owned intellectual property rights and other intangible assets may suggest the possibility of horizontal competition. The issuer is required to explain the necessity and rationality of their common or joint ownership; (Case: Shanghai Tongling Automotive Technology Co., Ltd.)    D. Fixed assets used in production and transportation: the existence of commonly used or owned fixed assets may suggest the possibility of the suspected existence of horizontal competition, and the necessity and rationality of joint or shared ownership shall be explained. (Case: Hunan Guangxin Technology Co., Ltd.)

The issuer needs to note that if some products or services provided by the controlling shareholders or actual controllers of the issuer are same or similar with those of the issuer, the issuer should specify whether there exists horizontal competition among the parties in the prospectus. First, the detailed measures to avoid horizontal competition should be emphasized (more detail below). Second, it should be disclosed that the controlling shareholders and actual controllers have promised to avoid horizontal competition, and that there exists no horizontal competition in essence.

In addition, in the prospectus, the issuer in turn explained reasons for the differences of the gross profit rate between the company’s products and those from similar businesses. Also it emphasized that since one of the issuer’s main profit sources was the engine cooling fan assembly products, which have not been produced by any listed company, a comparable company producing same products with the issuer was difficult to find.

In the situation that an enterprise is classified within the scope of horizontal competition, successful IPO cases have proved that the following two measures may be feasible for the issuer:

   A. If the main business of the target enterprise with horizontal competition is single, and its impact on shareholders’ interests are not considerable, the actual controller of the target enterprise (also the controlling shareholder or actual controller of the issuer) can cancel the registration of the enterprise or change its main business of the enterprise, avoiding being classified within the scope of horizontal competition. To note, the verification method and process during the cancellation shall be fully disclosed if the date of cancellation is too close to the date on which the IPO is applied;
   B. If the target enterprise with horizontal competition is running profitably, the actual controller of the target enterprise (also the controlling shareholder or actual controller of the issuer) can make the issuer acquire the competitive business of the target enterprise, but this measure is not recommended for enterprises with bad performance.

(2) Affiliated transactions

As for affiliated transactions, it is emphasized that the issuer should sufficiently disclose previous affiliated transactions in the prospectus, which is also reflected in Article 10 of the Stock Listing Rules of the Shanghai Stock Exchange (2014 Revision) (2014 revision) (hereinafter referred to as the "Rules Governing the Listing of Stocks"):

An affiliated transaction of a listed company refers to the transfer of resources or obligations between the listed company or its controlled subsidiary and a related party of the listed company, including the following 17 categories of transactions: purchase or sales of assets; external investment (including trustee investment and entrusted loan, etc.); providing financial assistance; granting guarantee (to the exception of counter-guarantee); leasing in or out assets; appointing others or being appointed for management of assets or business; donating assets or accepting asset donation; credit or debt restructuring; entering into a licensing agreement; transferring or acquiring R&D projects; purchasing raw materials, fuels and power; selling products and commodities; providing or accepting labor services; selling by consignment or selling on commission; co-investment with an affiliated finance company; other matters that would lead to transfer of resources or obligations through agreement; and other transactions as recognized by the Exchange.

Among the foregoing issues, the CSRC puts a special emphasis on the disclosure of whether the sales and purchase price to each related party are fair. The CSRC requires the issuer to compare item by item the sales and purchase price with those of a third-party, and compare item by item the gross profit margin of each related party with that of a third-party.

The CSRC has strict requirements on affiliated transactions. In addition to the full disclosure of the related parties, the CSRC further focuses on the necessity of affiliated transaction, whether there exists any transfer of benefits and whether it affects the independence of the issuer; whether the issuer deliberately circumvents affiliated transactions.

As for the definition of a related party (including related legal person and related natural person) of a listed company, the specific standards have already been provided in "Rules Governing the Listing of Stocks". They have been strictly applied in practice and will not be repeated here.

III. Review of IPO Market in 2017 and Analysis of IPO Market Trend in 2018

(I) Review of IPO Market in 2017

1. The CSRC issued two regulatory Q&As, clarifying the applicable situations of the suspension of examination and the procedures of IPO examination

(1) The CSRC clarified the applicable situations and notices of the suspension and termination of examination

A. Under what circumstances will the application be suspended during the IEC examination period?

a. The issuer, the controlling shareholder or the actual controller of the issuer is suspected of illegal actions or violations;

b. The intermediary of the issuer or its signatory (the intermediary refers to the sponsor institution and the law firm; the signatory refers to the signatory sponsor representative and the signatory lawyer) is suspected of illegal actions or violations involving IPO, refinancing, merger or acquisition;

c. The intermediary of the issuer or its signatory (the intermediary refers to the sponsor institution and the law firm; the signatory refers to the signatory sponsor representative and the signatory lawyer) has been imposed supervisory measures by the CSRC, such as restricting business operation, suspending business operation for rectification, designating other institution for trusteeship or take-over, and the relevant measures have not been lifted by the CSRC;

d. The issuer issues other securities, which results in a conflict of the examination procedures;

e. The Issuer and the sponsor institution actively request the suspension of the examination, with justified reasons approved by the CSRC.

B. Under what circumstances will the application be terminated during the IEC examination period?

The financial information recorded in the IPO application documents has expired and has not been updated for 3 months.

C. What matters shall call for special attention when the issuer replaces the intermediary or intermediary signatory?

a. The issuer should re-implement the application procedures if the sponsor institution is to be replaced, except in situations that cannot be attributed to the issuer, such as the sponsor institution being investigated or its business operation being restricted;

b. The examination procedures are not to be suspended if the issuer replaces the law firm, the accounting firm, the asset appraisal institution, the signatory sponsor representative, the signatory lawyer, the signatory accountant and the signatory asset appraiser.

(2) The CSRC clarified the time points for the enterprises to submit the disclosure materials

The sponsor institution shall submit the pre-disclosure materials along with the IPO application documents to the CSRC; (not after the acceptance of IPO application documents)

The sponsor institution shall submit the examination materials along with any pre-disclosure update.
(After the written feedback opinion is provided, the issuance supervision department will require sponsor institutions to submit materials to be examined by IEC and the pre-disclosure update.)

2. Establishment of the system of lifelong accountability of IEC members

Liu Shiyu, Chairman of the CSRC, has declared that CSRC's Party Committee decided to establish a Supervisory Committee of Listing, Mergers and Acquisitions. This committee will implement an overall supervision on IPO, refinancing, mergers and acquisitions, and will also evaluate the work performance of IEC and its members. A system of lifelong accountability will be applied to new IEC members.

(II) Analysis of IPO Market Trend in 2018

Different from 2017 when the IEC experienced personnel changes, the year of 2018 will see the continuously strict supervision by the new IEC. It seems that the trend of strict management on IPO has taken shape, and the relevant work is steadily running.

Summary of issues to be focused on by enterprises seeking IPO in 2018:

1. Information disclosure still requires special attention

Three points involving information disclosure will be emphasized in the IPO examination:

(1) Counterfeiting of the financial statements in the IPO prospectus is prohibited, including:

A. Abuse the characteristics of the industry, seeking the "system bonus" in the discrepancy between industry accounting system and the standard accounting criteria for enterprises;
B. Counterfeiting with overseas companies or overseas customers;
C. Fabricating illusory contract disputes, counterfeiting penalty by judicial verdict.

(2) Failure to disclose significant matters in the prospectus is prohibited, including:

A. Delays in disclosing bad news of losses or failed acquisitions of the enterprise;
B. The large shareholder conceals the truth in the process of transferring the controlling interest, or controls the rhythm of information disclosure.

2. Examination standards for three types of shareholders are clarified for companies on the National Equities Exchange and Quotations (the “NEEQ”)

With the increase of IPO applications of NEEQ companies since 2016, "three categories of shareholders" have emerged, such as private equity fund (contract type), asset management plan and trust plan. In light of the special features associated with such "three categories of shareholders", their layer-by-layer overlapping and high leverage, and the non-transparency of shareholder identity and inability to pierce the multiple layers, stricter examination will be applied to these companies. Considering the regulatory Q&A released recently by the CSRC, three criteria will be applied to the "three categories of shareholders" in the future:
    A. In view of the rules of Securities law, Company law, and regulations on IPO, the company's stability and the clarity of controlling shareholders and actual controlling persons are basic requirements. In order to guarantee the stability of the listed company and ensure that the controlling shareholders fulfill the principle of honesty, it is required that the controlling shareholder, the actual controller and the largest shareholder shall not be "three categories of shareholders";
    B. Given that the authorities are strengthening regulations on asset management, in order to ensure the lawful set-up and operation of "three categories of shareholders", they are required to be included in the effective supervision by financial supervision department;
    C. In order to avoid the transfer of interests, prevent potential risks and implement a prudential supervision on high-leverage structured products and layer-by-layer nesting investors, issuers with these situations are required to submit a rectification plan and disclose the identity of “three categories of shareholders”. The intermediaries are required to check if the issuer or its stakeholders hold interests directly or indirectly in “three categories of stakeholders”. The “three categories of shareholders” are required to reasonably manage its duration to comply with the current lock-up period and reduction rules.

3. Sales channels may become a key regulatory issue:

Considering the tables above about IEC’s examination focus, as well as the inquiry points of the current and previous IEC, it is inferred that horizontal competition and affiliated transaction are two key issues during the examination. The previous IEC paid more attention to the difference between the issuer’s gross profit margin with that of peer companies, while the current IEC focuses on the sales model and sales expenses. The current IEC also requires the issuer to explain why there exists discrepancy of business income and gross profit margin under different business modes.

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