China Securities Regulatory Commission (CSRC) has sped up the pace of IPO review remarkably since the beginning of 2017. As of 31 August 2017, 352 IPO applicants have undergone CSRC’s review procedures, of which 47 were rejected, translating into a rejection rate of 13.35%, compared with 6.54% throughout 2016. A study on the 47 rejected applicants unveils an increasingly clear picture of underlying rules and criteria.
According to the Measures on the Administration of IPO and Listing of Shares, an issuer must have posted positive net profits in each of the three fiscal years as of the IPO and the accumulated net profit for this period shall be more than RMB30 million (US$4.5 million). Similarly, the Measures on the Administration of IPO and Listing on the Growth Enterprise Market require that in order to be eligible for an IPO, an applicant shall have made profits (of not less than RMB10 million in aggregate) for two consecutive years as of the IPO or it shall have made profits in the recent year from a business revenue of not less than RMB50 million. However, it has been rumored that the CSRC adopts much higher annual net profit thresholds, including RMB30 million (after deduction of non-recurring gains or losses [NRGL]) for an IPO on the GEM and RMB50 million (after NRGL) for an IPO on the SME board and main board.
Of the 16 applicants with annual net profits of less than RMB30 million that had submitted IPO applications to the CSRC as of 24 August 2017, only two have succeeded in obtaining CSRC approval. The other 14 applicants were either rejected or terminated from going through the review procedures. The actual rejection rate was 87.5%. Among the 24 enterprises whose applications for an IPO on the GEM were rejected in the first half of 2017, approximately 13 (i.e. 54%) have generated net profits (after NRGL) of less than RMB30 million in the recent year. During the same period, 17 enterprises applying for an IPO on the main board and the SME board were rejected, about 10 (i.e. 59%) of which have posted net profits (after NRGL) of less than RMB50 million in the recent year.
It seems indisputable that CSRC imposes an invisible threshold of RMB30 million, in spite of the success by a few applicants with annual net profits of less than RMB30 million in passing CSRC review in the first quarter of 2017. The CSRC is less tolerant of flaws in applicants of relatively small sizes. In order to gain CSRC approval, these enterprises should invest more time in bringing their financial and legal practices in line with CSRC criteria, paying attention especially to the authenticity of their revenue and stability and sustainability of their profitability. Probability of success will be higher if the applicant is from an industry that provides attractive opportunities.
As a matter of fact, the authenticity of revenue and stability and sustainability of profitability have been considered absolute red lines by the CSRC given that they are always among the CSRC’s key concerns. About 80% of the rejections in 2017 were attributable to issues relating to revenue authenticity or business sustainability, which include, but are not limited to, lack of operational independence or the ability to carry on business on a going concern basis, suspicious revenue recognition methods, reconciliation of costs or profits, or suspicious gross margins.
Take Ruyiqing Bio-Technology, an agricultural producer, as an example. Despite its annual average revenue of RMB400 million during the reporting period and a net profit (after NRGL) of RMB88 million in 2016, its IPO application was rejected due to the suspicious authenticity of its revenue. The CSRC cast doubt on the authenticity of its sales activities, which included sales without contracts, sales paid in immediate cash, sales through distributors and on some occasions at prices lower than the cost.
As legal issues are concerned, more than 60% rejected applicants are exposed to varied problems, including connections that may impact their revenue authenticity or their ability to carry on business on a going concern basis, flaws with respect to their independence, problems with business or environmental qualifications, illegitimate business models, material contracts concluded without a tender process, involvement in commercial bribery, receipt of preferential tax treatments or allowances without a legal basis, and change or potential change of the management.
Another example is Zhejiang Nutriease Health Technology (Nutriease), whose business model involved obtaining business by providing customers (i.e. patients) with “health education and guidance” through medical institutions. The medical institutions received sales discounts from Nutriease, or collected payments on behalf of Nutriease and subsequently transferred the payments net of sales discounts to Nutriease. There was a task force responsible for soliciting cooperation from medical institutions. The CSRC questioned the legitimacy of this business model and whether the underlying cooperation should therefore be deemed illegal and invalid. This case explains precisely how a potentially illegitimate business model poses significant risk to sustainable operation.
The CSRC also focuses on ensuring honest disclosure of related parties, especially whether any customers or suppliers are related parties, and whether any related-party transactions are executed at obviously unfair prices that lead to the reconciliation of profits.
It now seems clear that a well-defined and stable ownership structure is another legal red line that must not be crossed. Bearing this in mind, shareholders of Jingbo Agrochemicals Technology designed an asset acquisition scheme that was supposed to cut through Shandong Chambroad Holding’s complicated history and get rid of the impact from a serious lack of substantiating data. In short, under the scheme, Jingbo Agrochemicals Technology was incorporated to acquire all assets from Shandong Chambroad Holding and the IPO application was not submitted until the new entity had been running for three years. Unfortunately, the application still failed due to unclear ownership structure of the predecessor.
As intermediaries, law firms must be constantly vigilant in ensuring honest disclosure especially of significant information, because failure to do so often leads to the applicant being rejected and relevant intermediaries punished.
To put it simply, all IPO applicants are likely to have flaws here and there. What needs to be done is to avoid the true minefields, which is bound to be a long process.
Author: Zhang Ne is a senior partner at Co-effort Law Firm
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