China's State Council recently announced the cessation of the sale of State-owned shares on the domestic securities market. The move comes after barely a year of selling State-owned shares domestically, with proceeds going to national social security funds. The legislation that put domestic sales into effect last June is generally perceived to have impact on the securities, banking and insurance industries in China. The legislation has not been abolished entirely and is continuing to affect PRC companies' overseas listings.
- On 12 June 2001, the State Council promulgated the Tentative Administrative Measures for Raising Social Security Funds through the Sale of State-owned Shares (the "Tentative Measures"). According to the Tentative Measures, a joint stock company (including one which is listed or to be listed overseas) in which the State holds an interest shall, when conducting an initial or secondary offering to the public, arrange for part of the existing State-owned shares (equal to 10% of the total offered new shares) to be sold as part of the offering. The proceeds from the offer for sale will be contributed to national social security funds.
- On 22 October 2001, the China Securities Regulatory Commission (the "CSRC") issued an order to suspend the requirement of selling State-owned shares on the domestic securities market.
- On 23 June 2002, the State Council announced its decision that with immediate effect, the provisions of the Tentative Measures providing for the sale of State-owned shares on the domestic securities market cease to apply.
Sale of State-owned shares on the domestic securities market
All PRC incorporated listed companies have two types of shares: tradeable shares (including A shares, B shares, and H shares) which are traded on domestic or overseas stock exchanges, and non-tradeable shares. Non-tradeable shares include State-owned shares owned directly by the State and State-owned legal person shares which are owned by State-owned enterprises.
In most cases, more than 70% of the total issued shares of a PRC incorporated listed company are non-tradeable shares.
Previously, non-tradeable State-owned shares can only be transferred by agreement between State-owned enterprises or from a government authority to a State-owned enterprise. After the implementation the sale of State-owned shares under the Tentative Measures, such shares can be sold to the general public as long as the listed company conducts a public offering, whether initially or in the secondary market.
Pricing of State-owned shares
The Tentative Measures provide that State-owned shares shall be sold at market price. As State-owned shares were not tradeable prior to the Tentative Measures, such shares did not carry a "market price". In the limited circumstances where State-owned shares are transferred, the underlying net asset value of the listed company has often been used as the benchmark for valuing State-owned shares.
However, tradeable shares of the same company can easily be trading at a much higher price. The price-earnings multiple of a domestic listed company can be as high as 40 to 60 times. This is partly because the domestic market only attributes the value of the entire listed company to the tradeable portion of its shares, resulting in a higher "market" valuation of the tradeable shares and a lower "market perceived" value for the non-tradeable shares.
After the implementation of the Tentative Measures, some of the State-owned shares can be sold at market price, which presumably will be the same as the price of the new shares offered under the initial public or secondary offering. This market price is typically much higher than the previous "market-perceived" value for the State-owned shares. The forced inflow of "lower-valued" stock into the securities market results in the dilution of the value of the entire stock market.
Market reactions to the sale of State-owned shares on the domestic securities market
Following the promulgation of the Tentative Measures, the domestic securities market plunged into a considerable decline.
As at 14 June 2001, the next trading day after the promulgation of the Tentative Measures, the Shanghai Comprehensive Component Index stood at 2245 points. From then on it plummeted all the way down to 1514 points as at 22 October 2001, the date that the CSRC issued the order to suspend the sale of State-owned shares on the domestic securities market. This represents a decline of 32% and a depreciation of market value by nearly RMB600 billion.
Indirect impact on other industries
Apart from the direct impact on the domestic stock market, it is also generally perceived that the sale of State-owned shares on the domestic securities market has, to a certain extent, affected the development of the securities, banking and insurance industries in China.
For the securities industry, the trading volume on the secondary market has shrunken significantly at the same time when the market plummeted. This led to a decline in the gross revenue and profits for the securities companies in China in 2001. Some securities companies were even driven into the red.
For the banking industry, most State-owned commercial banks and asset management companies hold a significant amount of non-performing loans lent to State-owned enterprises. The prolonged poor performance of the stock market has made it difficult for these State-owned enterprises to conduct restructuring or raise funds from the domestic securities market. This in turn makes it difficult for commercial banks and asset management companies to recover the non-performing loans. The decrease in stock market activity generally has also led to the continued increase in individual bank savings, thus creating a heavy interest burden for the commercial banks.
For the insurance industry, as a large amount of insurance premium has been injected into the securities market through investment funds, the poor performance of the securities market has indirectly led to a decrease in income from investments for the insurance industry. The market value of some insurance funds has even fallen below their nominal value in some occasions.
Reasons for the suspension of the sale of the State-owned shares
At a press conference held in June 2002 after the State Council decided to cease the sale of the State-owned shares on the domestic securities market, the CSRC gave two reasons for the cessation:
1. that at present, it is difficult for the relevant government authorities to formulate an appropriate scheme for the sale of State-owned shares that could be systematic and widely accepted by the market; and
2. that one of the main objectives for the sale of State-owned shares is to raise social security funds. The deposits in the national social security fund have reached a sufficient level not to require injection of significant amount of cash each year. Hence, it is not necessary to raise further funds through the sale of State-owned shares on the domestic securities market.
Sale of State-owned shares by enterprises listed or to be listed overseas
It is worth noting that the Tentative Measures apply to all joint stock companies including those that are listed or to be listed overseas. However, the State Council's decision to cease the sale of State-owned shares only relates to offerings done in domestic securities market. That is to say, if a PRC incorporated company conducts an offering in an overseas market, the 10% sale of State-owned shares rule under the Tentative Measures will continue to apply.
In fact, PRC incorporated companies listed overseas have "complied" with the 10% sale of State-owned shares rule even prior to the promulgation of the Tentative Measures.
In April 2000, PetroChina conducted its initial public offering and dual listings on the New York Stock Exchange and the Hong Kong Stock Exchange. As part of the offering, existing State-owned shares (equal to 10% of the total offered new shares) were sold to the public and the net proceeds of the sale of existing State-owned shares were contributed to the social security funds.
Following the listing of PetroChina, other H-share companies, such as Sinopec and CHALCO, have also sold State-owned shares during their initial public offerings and overseas listings to comply with the Tentative Measures to raise social security funds.
It is interesting to note that although the Tentative Measures only apply to PRC incorporated companies, CNOOC Limited, a red-chip company incorporated in Hong Kong, also conducted an offer for sale by its parent company during its initial public offering and overseas listing in February 2002 and the proceeds raised by such offer for sale went to the national social security funds.
Impact on PRC companies overseas listings
The continuing application of the Tentative Measures to PRC incorporated companies which conduct overseas securities offering may cause considerable inconvenience in structuring an offering. Securities offerings, like the offering of convertible bonds, are also caught by the Tentative Measures. In practice, it is difficult to design an offering structure to cater for a part exchangeable bond and part convertible bond offering because State-owned shares are not by nature freely transferable. However, bondholders would expect certain level of flexibility in terms of timing of conversion and the time taken to receive shares.
It is not clear at this stage how prepared are the regulatory authorities in granting waiver to strict compliance with the Tentative Measures.
Celia Lam is head of Linklaters' Beijing office and Wei Jie is an associate in Beijing.