Until earlier this year, China had a largely approval-based regulatory regime of initial public offerings ('IPOs'), under which any company wishing to sell its shares to the public needed to obtain the approval of the China Securities Regulatory Commission ('CSRC') following a strict vetting process. The regime helped to boost investors’ confidence in China’s capital markets in the early days, but it became increasingly onerous and inefficient in recent years – as of February 2023, there were more than 800 companies waiting in different phases of the IPO approval process, which takes more than one year in most cases (not including the prior preparation stage).
To break the logjam, reform of the IPO regime has been on the government’s agenda for at least a decade and various liberalisation proposals have been made. For example, registration-based IPO rules were piloted in a number of markets (such as the STAR Market of the Shanghai Stock Exchange and the ChiNext Market of the Shenzhen Stock Exchange) from 2018. On 17 February 2023, the CSRC and the stock exchanges finally issued a package of regulations to roll out the registration-based IPO regime across the full spectrum of China’s capital markets. On 10 April 2023, the first ten companies debuted on the main boards of the Shanghai and Shenzhen stock exchanges under the new IPO regime.
Like other major reforms, it will take time for the new regime to bed-in and for the market to feel its full impact. But there are a number of key changes brought about by this new regime, of which investors, whether foreign or domestic, financial sponsors or strategic investors, can take note now for their investment activities in China.
Streamlined process and relaxed criteria
As mentioned above, previously, companies contemplating an IPO needed prior approval from the CSRC, which involved a lengthy process comprising, among other steps, pre-filing reviews, enquiries by the CSRC and potentially inspections and audits.
Under the new regime, however, the stock exchanges, by their listing review committees, can review and determine whether a company meets their IPO criteria and information disclosure requirements. The CSRC will take a supervisory role, responsible for registration of the listing applications based on the stock exchanges’ decisions. The review by the CSRC during its registration process will focus on limited issues such as whether the company complies with national industrial policies and is suitable for listing at the relevant board.
A timeframe is also prescribed under the new rules, e.g. the issuer shall not take more than three months to respond to enquiries, and the review by the exchange and registration with the CSRC (excluding the time of the issuer responding to enquiries) must be completed within three months of the application being accepted. Overall, the entire process is expected to take six to nine months to complete.
Meanwhile, the new regime also cuts back the listing criteria for IPO applicants. For example, issuers to be listed on the main board of the Shanghai or Shenzhen stock exchange no longer need to have a track record of three consecutive profitable years. Similarly, the requirement of no-unrecovered-losses at the end of the most recent accounting period and the 20% cap on intangible assets are also removed. With respect to the other boards, pre-profit companies can be listed on the ChiNext Market now (as has been the case for the STAR Market).
As a result of these changes, China IPOs will become more desirable as an exit option for pre-IPO investors. It may not be on par with overseas IPOs yet, given that IPOs in Hong Kong and foreign venues in general still take less time and are governed by less stringent listing rules. But the gap is being narrowed, especially considering China’s latest overseas listing rules that came into force in late March this year, which are set to tighten the regulation and supervision of overseas IPOs by Chinese companies.
Valuation adjustment mechanism ('VAM')
As far as investment in Chinese start-ups is concerned, VAM is a common feature to mitigate the risks associated with the target company’s uncertain prospects. It usually involves a contractual agreement between investors, the target company and/or the founders of the target company whereby the target company/founders agree to compensate the investors, by cash or by shares, if the target company falls short of certain pre-specified conditions such as launch of an IPO by a certain date or achievement of certain financial metrics.
However, due to the concern that VAM, if surviving an IPO, could be unfair to public investors as it gives more favourable treatment to the pre-IPO investors, the CSRC used to require issuers to terminate any VAM before an IPO. In 2019, the CSRC created a narrow safe harbour which allows VAM to survive an IPO if all the of following four requirements are met:
- the issuer is not a party to the VAM agreement;
- the VAM agreement will not lead to a change of control of the issuer;
- the VAM agreement will not be pegged to the market value of the issuer; and
- the VAM agreement will not have a serious impact on the issuer’s ability to continue to operate and will not seriously affect the rights and interests of investors.
The new rules retain the safe harbour and task the advisors, including sponsors, legal counsel and accountants, with the responsibility of verifying fulfilment of the four requirements. Interestingly, if a VAM agreement does not meet all four conditions, the advisors are nevertheless required to opine on its impact on the issuer, including whether the shareholding structure is clear and stable and whether the accounting treatment meets proper standards. It is yet to be seen whether, under these guiding principles, the safe harbour will be expanded in practice.
If a VAM agreement has to be terminated, many pre-IPO investors will agree to do so if the company can launch the IPO successfully. But there is often a catch-22 problem – the VAM agreement must be terminated prior to IPO, but if the IPO does not take place eventually, the investor will end up empty-handed on both sides. Some investors and target companies/founders have, as a middle-ground solution, entered into a conditional termination agreement, pursuant to which the VAM agreement is terminated provisionally, but will be reinstated if the contemplated IPO fails or is aborted. Such agreement has been accepted by the CSRC on a number of occasions. Although the new regime does not touch upon this issue explicitly, we expect the practice to remain acceptable to the stock exchanges.
In any case, the IPO prospectus should disclose details of the VAM agreement (including termination and conditions for reinstatement, if applicable) and its potential impact on the issuer. The prospectus should also provide risk warnings about the VAM agreement.
Competition with shareholders
Competition between listed companies and their shareholders has long been another area under close scrutiny by the CSRC and stock exchanges. It is a major hurdle for strategic investors to invest in Chinese listed companies that conduct the same or similar businesses.
Under the old approval-based regime, controlling shareholders (and to some extent other shareholders holding more than 5% of the shares of the issuer) were prohibited from engaging in businesses substantially the same as the issuer. The STAR Market and the ChiNext Market loosened this requirement in 2019 and 2020 respectively by allowing controlling shareholders, actual controllers, and other companies controlled by them to engage in the same businesses as the issuer as long as they do not have any “material adverse effect” on the issuer. There were several factors to inform the determination of “material adverse effect”, for example, whether it will give rise to unfair competition, loss of corporate benefits, (mis)allocation of business opportunities and/or potential adverse impact on future development of the issuer. “Material adverse effect” would also be presumed (i.e., unless there is contrary evidence to suggest otherwise) where the shareholder’s revenues or gross profits from the competing business equal or exceed 30% of those from the issuer’s main business. The Beijing Stock Exchange adopted a similar position when it opened for business in 2021.
The new IPO rules bring the “material adverse effect” standard to the main boards and keep the rebuttable presumption. Notably, the new regime does not enumerate the factors to be taken into account in determining the “material adverse effect” and indicates a more holistic and flexible approach to the competition issue. In practice, the stock exchanges are also increasingly amenable to bespoke solutions, including demarcation of geographic markets, distinction in products, services or customers and agency/distribution arrangements. While some of these solutions will have their own challenges, e.g., competition law concerns, overall the strategic investors now have more wriggle room to tackle the competition issue when they consider investing in (or taking over) listed companies in the same or adjacent sectors.
Special voting rights
“Same rights for same shares” is a long-standing principle under the Company Law of China, which does not recognise multiple classes of shares except in certain special circumstances prescribed by the State Council (e.g., preference shares issued by financial institutions to replenish capital). In 2018, the State Council allowed technology companies to adopt multiple classes of shares for the first time, and it paved the path for the STAR Market and the ChiNext Market to allow listing of issuers with special voting rights in 2019 and 2020 respectively.
The new regime allows issuers with special voting rights to be listed on the main boards too, provided that, like the STAR Market and the ChiNext Market, the prospectus should fully disclose the details of such rights, the risks they may bring and their potential impact on the corporate governance of the issuer. Also, the sponsor and legal counsel of the issuer are required to opine on the arrangement, including the qualifications of holders of such shares, the ratio of such shares to ordinary shares, the scope of matters that holders of such shares may vote on, as well as any lock-up arrangement and transfer restrictions.
Although there was no company with special voting rights among the first ten listed on the main boards under the new IPO regime, IPOs of such companies are expected to be launched soon given that most of the founders of Chinese start-ups tend to retain a tight grip of the company even after an IPO. Special voting rights will be an effective tool to achieve this objective without having to limit the size of the public offering to avoid dilution.
Besides the new IPO rules, the Company Law itself is also being revised to lay down a clearer framework of special shareholders’ rights. In late 2021, a draft amendment to the Company Law was published, which would allow all public companies to issue multiple classes of shares with not only special voting rights but also preferred or subordinated profit or asset distribution rights. If the amendment gets passed, it will give potential issuers more choices to arrange its shareholders’ rights through a classified share structure.