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Taking Stock

In an unprecedented move, two companies will be cut from Shanghai’s sci-tech board for financial reporting fraud, highlighting the urgency to improve information disclosure in the country’s capital market

By Xu Ming , Ha Like Updated Sept.1

Data storage discs by Amethystum Storage Technology are demonstrated at the second Digital China Summit, Fuzhou, Fujian Province, May 7, 2019 (Photo by VCG)

On May 31, the Shanghai Stock Exchange (SSE) announced the delisting of software developer Essence Information Technology and optical storage company Amethystum Storage Technology from China’s Science and Technology Innovation Board (STAR).  

Both companies stated they were delisted for financial reporting fraud, including inflated profits, after authorities halted trading in them on April 24.  

The two companies are the first to be booted from STAR, which was created in 2019 to better cultivate China’s most innovative firms as the country seeks technological independence.  

The China Securities Regulatory Commission (CSRC) fined Guangdong Province-based Amethystum 36.68 million yuan (US$5.13m), while Essence in the city of Tianjin will pay a penalty of 86 million yuan (US$12.04m).  

Shareholders and executives at both companies were fined and banned from holding senior positions at any company that issues securities. Investigations have also been launched into the intermediary companies that facilitated their listings.  

The move shows China’s determination to protect investors and maintain the smooth operation of the IPO system, which is conducive to cultivating a healthy capital market environment, said Zhong Huiyong, an associate professor of the School of Finance of Shanghai University of International Business and Economics.  

Both companies listed on the sci-tech board in 2020 through the registration-based IPO system, which piloted in 2019 and is rolling out in full scale. Analysts believe their delisting will serve as a future reference for avoiding listing fraud, as more and more companies are listing in this way. 

Cooked Books 
The investigation started two years after Amethystum got listed in February 2020 and Essence in June 2020. Their illegal behaviors occurred before and after listing, an official investigation revealed.  

In its prospectus, Amethystum inflated its revenue and profits through fabricated sales contracts, falsified logistics documents and fake invoices, investigators said.  

Between 2017 and in the first half of 2019, Amethystum reported inflated revenues of 220 million yuan (US$30.79m) and inflated profits totaling 85.99 million yuan (US$12.04m), according to the CSRC’s release on April 21. During this time, the proportion of inflated to actual revenue increased every year, from an initial 13.9 percent to 42.97 percent. The proportion of inflated profits surged from 35.82 percent in 2017 to 137.33 percent.  

Its prospectus claimed profits of 18.44 million yuan (US$2.58m) in the first half of 2019. But the total inflated profit was 25.33 million yuan (US$3.55), which means the company was 6.89 million yuan (US$964,378) in the red.  

Essence’s fraud was more severe. Investigators found the company inflated its revenue by 340 million yuan (US$47.59m) and its profits by nearly 190 million yuan (US$26.59m) from 2016 to 2019 through fake contracts and bogus business deals with its fully owned subsidiaries.  

Over the four years, the company’s proportion of inflated revenue to its actual revenue fluctuated around 50 percent, peaking at 59.67 percent in 2017. In 2019, right before its listing, inflated profits reached 65.28 million yuan (US$9.14m), accounting for 67.69 percent of its profit for that year.  

Essence also ran at a loss during two of the four years covered by the prospectus. According to the CSRC, the gap indicates a loss of 1.01 million yuan (US$141,367) in 2016 and 1.93 million yuan (US$270,138) in 2018.  

These inflated profits played a major part in its smooth listing. Among the sci-tech board’s IPO requirements is a minimum market value of 1 billion yuan (US$139.97m) and a two-year cumulative net profit prior to listing of no less than 50 million yuan (US$7m).  

“Companies seeking to list may resort to fraudulent practices to turn losses into profits to maintain their eligibility,” said Chen Xuan, a veteran banking adviser.  

“The enormous benefits of listing prompt some companies to take risks. In addition, the sci-tech board was new, so some intermediary agencies and the stock exchanges may not have done due diligence, which allowed the two companies to take advantage of this shortcoming,” Chen added.  

As Essence was in the red in 2018, it was not eligible to list. But given its profits in 2019, the company likely met the board’s requirements for market value and profits. Nevertheless, it still committed fraud “probably to raise the market value of the company and win more investment from the stock market,” Zhong Huiyong said.  

Chen Xuan said that the board’s price earnings ratio is relatively high, which means high stock valuation and higher risk for investors, so inflating profits helped Essence boost fundraising. “Without inflated profits, their fundraising scale would have been much smaller,” Chen said.  

Some industry insiders believe that by inflating profits the company aimed to make it easier for shareholders to cash out.  

Both companies continued their fraudulent practices after listing. In 2020, inflated profits accounted for 150.21 percent of Amethystum’s total profits. In 2021, the proportions of inflated revenue and profit for Essence reached 21.59 percent and 56.23 percent.  

What’s more, both companies failed to reveal the external loans they guaranteed in their prospectus. Zhang Shengchao, a securities and investment banker, explained that guaranteed loans reflect a company’s debt scale. Too large a scale means financial changes and draws questions from brokers and media. “It was all done for smooth listing,” said Zhang, referring to the failed disclosure.  

“A prospectus is an important reference for evaluating a company. If it provides false data, it will misguide investors,” said Zhong Huiyong, adding that such behavior “sets a bad example for other companies seeking IPOs and erodes trust in the market.”  

These issues have tarnished the scitech board’s image. At the 14th Lujiazui Forum, a platform to encourage international financial cooperation, held on June 8 in Shanghai, Qiu Yong, chairman of the Shanghai Stock Exchange, stated that the board has become the first choice for Chinese “hard-tech” companies (those based on innovation and with high technical thresholds) to go public.  

At the end of May, STAR had 528 listed companies that had raised a total of 822 billion yuan (US$115.05b) through IPOs, according to Wind Information, a financial data provider. The funds were mainly concentrated in industries such as information technology, biotechnology, and high-end equipment manufacturing.

The booth for Essence Information Technology at the first China (Fuzhou) International Digital Product Expo, Fuzhou, Fujian Province, held from April 25-27, 2021

Disclose No Evil 
“The heavy fines and severe punishments show the regulator is increasing the penalty for illegal practices, which we expect will be a strong deterrent for all listed companies and help nurture a healthy capital market,” Zhong Huiyong said.  

Since April, at least 25 companies have been forced to delist from China’s stock market, mainly due to financial fraud and disclosure violations, NewsChina learned from publicly available data. 

Zhong Huiyong said that more companies will be forced to delist this year amid the economic downturn. Facing big declines in business, some companies have forged financial reports to maintain their listing eligibility. However, the increase in exposed fraud shows that securities market regulators have strengthened supervision.  

Investigations were also launched against intermediaries such as securities firms, accounting firms and law firms, as well as individuals. Many interviewed industry insiders told NewsChina these intermediary gatekeepers enabled financial fraud to occur by failing in their due diligence. 

“It’s very hard to fool intermediaries with financial fraud, which involves not only the fabrication of business documents but also accounting for all funds involved. Some intermediaries simply don’t want to find these issues. If there is no exchange with their customers and they play the supervisory role, fraud is almost impossible,” Zhang Shengchao said.  

The CSRC stated that precision strikes will be implemented against violators such as securities companies that underwrote the IPOs for Essence and Amethystum, as well as the accounting and law firms that provided them with auditing and legal advice.  

On April 1, Dongxing Securities announced the CSRC was investigating it for negligence in sponsoring Essence. The CSRC noted that Beijing-based China Securities, the sponsor and broker for Amethystum’s listing, had set up a 1-billion-yuan (US$138.5m) investor compensation fund.  

In 2022, 36 intermediary firms were investigated for failed due diligence in 44 cases probed by the CSRC. “It’s a problem with almost every listing that ends up being dubious,” Zhang said.  

This year, securities firms including Northeast Securities, Donghai Securities and GF Securities were investigated for similar reasons. 

Gatekeeper Gaffes 
Due diligence is a complex process that takes lots of dedicated resources. As many projects have tight deadlines and limited personnel, discrepancies can be overlooked, Chen Xuan explained.  

“Besides, if companies planning for an IPO deliberately falsify information, it’s often difficult for securities firms to detect due to verification limitations. They may find points of suspicion but continue with the project because they have performance indicators and the cost of giving up is high for them,” Chen said.  

The first two companies delisted from STAR highlight the role of intermediaries as gatekeepers for IPOs in the now nationwide registration-based system.  

To make its stock market more market-oriented and reduce government intervention, China piloted its registration-based IPO system with its newly launched technology board in 2019. Compared to the decades-old system that required advance government approval of an IPO and regulated stock prices, the new system eases the listing thresholds and lets investors decide whether a company is worth supporting, focusing instead on disclosure to help guide their decision-making.  

The system was later tried in the Shenzhen Stock Exchange’s ChiNext market (which focuses on small- and medium-sized companies) in 2020, and the Beijing Stock Exchange in November 2021. In February, the CSRC officially rolled out the system nationwide.  

According to data from Wind Information, 1,075 companies had listed through the registration system by the end of 2022, with IPO fundraising totaling 1.18 trillion yuan (US$165.2b).  

As the number of companies listed through the registration system increases, improving the quality of information disclosure will be imperative to its operation.  

This naturally places more responsibilities, and more power, in the hands of intermediary agencies, securities firms, accountants and lawyers.  

According to the CSRC’s rules for registration-based IPOs released in February, the issuer, sponsors and securities service agencies will be held legally accountable for any submitted documents for listing. Industry insiders believe the rule will push intermediaries to verify disclosed information more thoroughly.  

Instead of enabling companies to commit fraud, intermediary agencies need to probe deeper into the internal operations of companies, improve their professionalism and internal controls, and further hone their skills in identifying problems, Zhang Shengchao said.  

Chen Xuan believes that the key to reducing financial fraud lies in deterrents such as post-remedial and punitive measures. “If there are cases of banks colluding with companies in fraud, they also need to be severely punished,” Chen said.  

“The CSRC can also enhance spot-checks on listed projects to decrease the risk of illegal activity. This can create positive expectations in the market and help the system operate healthier,” Zhong Huiyong said.