Nov 01, 2017 By Morris & Megan
Open data indicates that the examination statuses of 451 IPO applications have been updated from April 1 to September 30. Studying the 451 cases, this article will sum up key issues in the feedbacks of China Securities Regulatory Commission (hereinafter the CSRC) in the second and the third quarters (hereinafter the two quarters).
Between April 1 and September 30 of 2017, the 451 IPO applications examined by the department of public offering supervision included 233 feedbacks, 65 approvals, 98 denials (including denial, the termination of examination and the cancelation of examination) and 55 suspensions (including the suspension of voting and the suspension of examination).
The specific statistics are shown as follows.
(Notice: The chart only contains applications with updates of examination statuses from April 1 to September 30 of 2017, and does not contain applications with updates of pre-disclosure only.)
Since the release of the Overview on IPO Denials since the 2014 Lifting of IPO Freeze by Legal Miner six months ago, the CSRC has further intensified regulatory oversight. Specifically, recent feedbacks indicate the following features of supervision:
In comparison to the same periods in previous years, the examination has accelerated this year. With the feedback cycles of most projects being shortened to 3-4 months, the CSRC has achieved the goal of normalizing IPO acceleration. As indicated in the statistics of the two quarters, the rate of denials for IPO applications has increased (as shown in the data below), reasons for which may be related to the recent IPO application of certain problematic companies or the temporary adjustment of examination policies.
In its mid-year investigation report, the CSRC pointed out that, to enhance the supervision of offering, in addition to its strict policy against fraud, it would pay close attention to sugarcoating of business performance by means of reducing headcount in short time, cutting wage and expenses or relaxing credit policies to stimulate sales. The supervision measures may include special examination, on-site inspection, transferring to audit departments for investigation and administrative penalties on intermediary institutions etc. Such decision indicates that, with consistent crackdown on fraudulent issuance, the CSRC will also lay emphasis on the diversity and flexibility of examination by increasing the frequency of random inspection when examining IPO projects.
According to the statistics of denials in the two quarters revealed by the supervision department, comparing to the first quarter of 2017, the number of denials has increased in Q2 and Q3. The specific statistics are shown as follows.
Studying the 41 denials, we find that in addition to common problems like insufficient operating
ability and suspicious sustained profitability, other reasons that often cause companies’ failure to obtain IPO approval
include abnormal employee compensation, defective internal control system (especially commercial bribery) and excessive
reliance on clients that lead to companies’ lack of independence, all of which have been mentioned in the feedbacks and
supervision department meetings.
This week, Legal Miner continues to focus on several issues which are emphasized by CSRC throughout the official feedbacks.
• Failed to actually perform the contract signed with its affiliated party;
• Acquired bank loans through the account of its affiliated party.
• Doubtful whether the applicant is able to acquire bank loan in a normal way;
• Whether the applicant has the risk of break in cash flow or inability to pay overdue debts;
• Whether the applicant has and effectively implements the comprehensive internal control system;
• Whether the legality of the applicant’s operation can be reasonably guaranteed.
• Investigated by a judicial authority for suspected offering bribe by entity;
• Some of the executives and the staff were involved in series of commercial briberies.
• Whether the applicant has and effectively implements the internal control system concerning sales, bidding and capital management;
• Whether the legality of the applicant’s operation can be reasonably guaranteed.
• Purchased agricultural products in large amount from individual suppliers during the reporting period;
• All wet cowhide required in production were purchased from individual suppliers.
• How to make sure the effective implementation of a comprehensive internal control system of purchasing and payment;
• Illustrate the internal procedure of making payment to individuals, payment method, and whether payment is made in cash or by personal cards
The implementation of internal control system has received more attention, for a comprehensive and effective internal control system is the basis to ensure the reliability of the company’s financial report and legality of its business operations. Only if the reasonability, effectiveness and authenticity of the internal control system are ensured, can the financial report avoid false or fabricated information so not to be identified as fraudulent issuance.
• During the reporting period, the ratios of the sales revenues the issuer received from its biggest client’s subsidiary to the issuer’s total business revenues for the same period were respectively 67.39%, 77.42%, and 89.66%. And the ratios of the purchase amounts the issuer paid its largest supplier to the total purchase amounts were respectively 56.67%, 77.43%, and 73.95%.
• illustrate the specific reason and reasonability of the high concentration of customers and suppliers comparing to the comparable listed companies in the same industry; illustrate whether there is any material defect of the issuer’s independency;
• illustrate whether the high concentration of customers and suppliers may exert any serious adverse impact on the sustained profitability of the issuer.
• The prospectus disclosed indicates that the operating income of the issuer in 2014, 2015, 2016, and January to June of 2017 were respectively RMB 211.4M, 159.7M, 215.5M, and 120.9M. The corresponding net profits after the deduction of extraordinary items were RMB 24.5M, 25.3M, 47.5M, and 23.6M. With the significant fluctuation of net profits and performance resulting from its customer structure and the features of the industry, the issuer has the risk of over 50% decline of its performance.
• illustrate whether the issuer has taken any measures to ensure its sustained profitability under current customer structure and industry features.
• Illustrate the basis and calculation process for the risk when its performance declines for over 50%.
The requirement of sustained profitability specifically demands the issuers to continuously bring profits to the investors after listing, to meet the fundamental expectations of the market, to meet the basic requirements of the stock exchanges and the CSRC regarding profitability for listed companies. The issuance condition of ChiNex requires the company applying for IPO to make profits in the two recent years, and the total net profits of the two years shall be no less than RMB 10M; or make profits in the last year, and the net profits shall be no less than RMB 50M. However, in practice, the issuer’s steady performance growth curve is attached more importance by the issuance examination committee. Therefore, in general, the examination requires the issuer to maintain its performance on the above average level, and no significant fluctuation in performance shall exist in those years.
• Issuer made sales to the customers through its affiliated party
• illustrate the fairness and necessity of the affiliated transactions with several affiliated parties, and the reason and reasonability of conducting sales through those affiliated parties rather than direct sales;
• illustrate the specific de-affiliation process of one of its affiliated parties;
• confirm the basis and reasonability of such process;
• illustrate the affiliated transactions before and after the process, and whether there is any de-affiliated situation of those transactions.
• frequent affiliated transactions between the issuer and its actual controller, including renting land owned by the actual controller for 5 years from January 2010, with the rents of RMB 141 thousand per year;
• during the reporting period, the actual controller and controlling shareholders use issuer fund on multiple occasions.
• illustrate the necessity and reasonability of the affiliated transactions, and whether the equity concentration may influence the management structure and the internal control of the company.
• the issuer developed, produced and sold insulated cardboard and insulated molded parts while the affiliated company controlled by its actual controller developed, produced and sold yarn tube paper;
• during the reporting period, the affiliated party sold wood pulp to the issuer and shared its sales channels.
• illustrate the basis and method of allocating the common expenses, and the procedure of issuing an invoice;
• illustrate the examination procedure and the relevant conclusions of the issues above;
• issue an examination opinion on whether horizontal competition exists among the insulated cardboard business of the issuer and the yarn tube paper business of the affiliated party.
The subjects of horizontal competition are defined as the controlling shareholders, the actual controllers and their affiliated parties (hereinafter the major shareholder), which, generally, excludes other companies and natural persons from the list of competitor. In terms of relatives, immediate and close relatives of the actual controller fall in the scope of competitors; whether or not collateral relatives conducting business similar to the issuers belong to horizontal competitors depends on the specific situation; other situations only require the full disclosure of the shareholders.
In addition, another key element of horizontal competition is the same or similar business among the major shareholder and the issuer (where competition is not required), or sharing the sales or purchase channel (according to the above case, the scope of sharing may expand to producing and processing).
The conditions for horizontal competition are clear-cut compared to those of affiliated transactions. Horizontal competition, once identified as such, will definitely constitute an obstacle to listing and issuance. On the other hand, only full disclosure is required for affiliated transactions, the disclosure of which must be reasonable in proportion, necessary, fair, standard and normative in procedure and decreasing gradually.
In addition to the affiliated transactions and horizontal competition aforesaid in the above cases, following situations may also be questioned in the process of IPO examinations: The gross profit rate from affiliated transactions outpaces that of non-affiliated transactions in a long term; The high reliance of net profits on its affiliated parties; both the major customer and the major supplier rely on the same affiliated party of the issuer; failure to effectively improve payment collection issue from affiliated parties, etc. Therefore, companies applying for IPO also need to sufficiently disclose these risks concerning affiliated transactions.
For companies intending for IPO application, decline in performance in the reporting period, lack of independency, abnormal business operation or financial situation, and failure to meet the requirement of subject qualification are the main reasons leading to denials in IPO examinations. Taking into consideration this year’s cases, the effectiveness of the internal control system, question about sustained profitability, and affiliated transactions and relations remain to be the main concerns of IPO examinations.
Apart from the strict multi-angle examination adopted for several years, early this year, in order to urge intermediary institutions to fulfil their due diligence obligations, and to enhance the supervision and inspection of the securities legal services by law firms and lawyers, the CSRC organized the special inspection of securities legal services for IPO by law firms in March.
In the random inspection, 21 law firms were inspected, and some were found to have problems that call for immediate attention. The problems are shown as follows.
Some firms have loose internal management and little sense of quality control and responsibility, all of which contribute to failure to realize the unifying management of the firm. Some firms have not paid attention to the systems for risk control, internal review, conflict of interest and prevention of insider trading, whose current management systems fail to meet legal requirements. Some firms, albeit having internal management systems, cannot effectively implement such system.
Some lawyers fail to conduct examination and verification by the appropriate measures or the measures required by relevant rules and regulations. Some lawyers, preferring the conclusion rather than the process, issued written legal advice without relevant evidence, which seriously affected the quality of such documents. Also, some firms issued written legal advice with vague wording, wrong words or number, or pay little attention to the production and preservation of working papers.
The inspecting departments strictly handled the problems and took administrative regulatory measures according to the laws, issuing warning letters to 8 law firms and 10 lawyers, holding regulatory talks to 3 lawyers, and ordering 1 firm to take corrective action and having it recorded in the capital market integrity database. Details of such penalties can be found in Legal Miner’s previous Xintai Electric Co., Ltd.: The First Company Delisted from the Growth Enterprise Board--Research of Administrative Penalties on IPO projects of Securities Intermediary Institutions.
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