eshi – “happy view” in English – is an online video platform with a story at least as dramatic as the films and television series it carries. In 2010, the company became the first online video platform in China to go public. But since 2012, questions have persisted about whether the company exaggerated its revenue before and after it listed on the Shenzhen Stock Exchange. In July 2017, co-company founder Jia Yueting admitted he was in the US and said he would be back in China “the following week” to help weather Leshi’s heavy debts. However, he later announced he would stay in the US, apparently to focus on his dream of making an electric car. His promise to return has become something of a joke among investors. The company suspended its shares from trading in April to prepare for “major asset restructuring arrangements.”
While investors are deciding what to do with their Leshi assets, this development has brought the Chinese regulators and the regulatory mechanism into question. At the end of October, several members of the committee who reviewed Leshi’s application to list in 2010 were themselves reportedly under investigation. An official responsible for listing the companies with the China Securities Regulatory Commission, China’s stock market watchdog, was tried for allegedly taking bribes from nine companies, including Leshi, to allow them to issue shares. Although Leshi has denied involvement and the court has not yet ruled, it is worth reflecting on the effectiveness of a system that is supposed to prevent stock market fraud and protect the legitimate interests of investors, especially when the majority of them are personal or retail investors.
n July 2016, Dandong Xintai Electric became the first listed firm on the Chinese mainland ordered by regulators to delist from the stock market, owing to fraud in the financial statements for its 2014 listing. In other words, the company went public on false information. Its underwriters and auditor were punished for having failed to detect the fraud, and the company completed delisting in August 2017. That both listing and delisting are complicated processes in China has made this a high-profile case. Once listed, a public company – no matter how badly it performs on the market – is immediately recognized as a rare “shell” which offers a path for other companies lining up to get approval to list. Observers have long argued more companies should be delisted over irregularities like cooking the books before listing, and insider trading afterward.
There is consensus that a better listing process before the fact is perhaps as important as reactive crackdowns over misconduct that follows the listing process. Under the current system, the stock issuance review committee of the China Securities Regulatory Commission (CSRC) plays an important, if increasingly controversial, role. Candidate companies submit their application to the CSRC for preliminary review, and those found eligible are then subject to review by the committee. Committee members are drawn from the CSRC itself, as well as audit companies, securities companies, law firms and universities. The review committee assesses not only whether a particular company has provided accurate information, but also whether it is willing and able to bring value to investors. This is because the Securities Law requires applicants to prove their sound financial position and “sustainable profit-making capability.”
The committee’s independence and professionalism have been questioned. Professor Xia Lijun, head of the Department of Accounting at Antai College of Economics and Management at Shanghai Jiao Tong University, highlighted the inherent relationship between securities service providers and their clients – candidate companies applying to list. In 2014, Deng Ruixiang, a manager with rich experience in investment at several financial institutions, was suspended four months after he became a member of the listing review committee. He was later put on trial for insider trading alleged to have occurred before he was appointed.
The watchdog is supposed to be more independent than securities service providers. However, several CSRC officials engaged in approving listings have been convicted of corruption. Yao Gang, a former CSRC vice chairman, was in charge of the review and approvals process from 2002 until he was himself subject to investigation in November 2015. Investors had dubbed him the “emperor of listings.” The CPC Central Commission for Discipline Inspection alleged in July 2017 that Yao took bribes from companies seeking to go public.
Committee members are professionals who must be able to assess the authenticity of companies’ financial reports and prospective profits. However, their competence has been increasingly questioned as more and more cases of fraudulent listings have been disclosed over the past four years. One of the reasons for this failure to detect fraud during the review process is thought to be a lack of research about the business practices of applicants.
But so far, no review committee member has been held accountable for these failures. “Members of the review committee should be liable for penalties if they take advantage of their position for exchanges of interests with candidate companies, but there is no legal basis for holding them responsible for unsound technical judgment,” Chen Xin, associate professor at the Shanghai Advanced Institute of Finance, told NewsChina.
In addition, committee members from securities service companies are paid far less for their reviewing work than for providing underwriting, auditing or legal services for companies. Xia thinks this created a dilemma in which professionals from these institutions are unwilling to join committees if they will be held accountable for technical mistakes on one hand, and they may be involved in misconduct if they are not supervised sufficiently on the other.
In July 2017, the CSRC revised regulations governing the review committee, making them stricter in policing conflicts of interest. A separate committee was established to choose the committee members. Members found irregularities would be revealed publicly, instead of privately in many cases. On November 20, Liu Shiyu, chairman of the CSRC, said at the oath-taking ceremony of the first committee selected under the new rules that the review committee would be supervised by a new team to be set up soon.
The way Xia sees it, improving the independence and professionalism of the review committee is an important but expedient step to take before adopting a new listing system by law. Whenever share prices go down, investors have blamed regulators for choosing the wrong companies, or the wrong time to let more companies go public. No securities regulator in the world is expected to guarantee returns for investors. It has already been put on the policy agenda to build a system allowing companies to list as long as they do their due diligence on information disclosure, no matter if they have reported profits or loss before their application, let alone whether they will continue to make profits after they list. The review committee may not even be there to represent investors to vote on whether the company will be profitable or not in the future. Wu Xiaoqiu, vice president of the Renmin University of China and a prominent scholar on China’s capital market, strongly opposes the current review system which he says pays too much attention to the business prospects of a candidate company. He has repeatedly criticized it for unfair intervention into the chance of growth for companies from the outset.
The new system was proposed to make listing easier and fraud more costly. But it seems more progress has been made on the latter than the former. Since 2013, majority shareholders and underwriters of three companies, including the recently delisted Xintai, have paid back a total of US$100 million to around 20,000 investors who suffered losses inflicted by the companies cooking their accounts before listing. Such mass compensation was rarely seen in the past. In addition, the CSRC has stepped up its crackdown on stock market misconduct, particularly insider trading.
More players, including fund managers, securities staff and auditors have been fined, deprived of their licenses and even jailed than ever before. These remedies brought in after the fact may pave the way for a shift to better pre-listing regulation.
Meanwhile, revisions to the Securities Law to create new listing procedures and standards of listing have been delayed. Debate continues as to whether a company should be judged by investors and who should be held responsible for their own investment decisions, instead of by regulators. There are fears the market may not be ready for this. Unlike in developed markets, the majority of investors in China are personal or retail investors who may be ignorant of how to read financial statements, but tend to try their luck speculating on small, highly volatile shares. As Xia explained to NewsChina, this predisposition is heightened by loopholes in the accounting standards for delisting and loose implementation of rules for delistings and irregularities. Local governments and regulators are reluctant to have companies delisted as this would often see them shut down, and put people out of work. Given this, Xia said easier access to the stock market would help investors change their behavior. When there are sufficient shares to select from on the market, poorly performing companies will lose their value as a “shell,” and good companies will be more attractive to investors.
However, easier access to the stock market means bad companies, with either fraud or poor prospects, may have more chances of listing than ever. Wu and Xia both warn there will be “growing pains” as the new system is implemented. Wu is concerned that a lack of preparedness for this pain may be the weak point. Investors who lose money under the new system may even ask to return to the old one. Wu compared the differences between the current and new system with that between bricks-and-mortar stores and online outlets. He told NewsChina people running online outlets were often regarded as swindlers in the early years of e-commerce due to rampant fraud. Today, however, online consumption has become part of life, and the quality of online outlets has improved. This would not happen if e-commerce had been prohibited. The same is true for the history of the stock market not only globally, but in China too. There would be no stock market at all if it had been shut down in its early years due to volatile bubbles and fraud. Wu stressed that the key is not to give up in the face of pain.
In the past two years, the media has taken many guesses at when the old system will be replaced with the new one. A better question might be whether the market and regulators are prepared.