Chapter 4: Regulatory Releases
This is the fourth installment in a series of articles on Investing in China A-Shares. The prior articles can be found here:
1) Allocating to China A-Shares
Quick and important disclaimer: The analysis and views expressed in this discussion are my own and do not necessarily represent the views of my employer or any organization I am affiliated with. Nothing in this article constitutes investment advice or a recommendation to buy or sell any security.
China is often portrayed as impenetrable with data of questionable quality that are hard to verify. But Chinese publicly listed firms have a standard of disclosure that is unparalleled in any large economy. That is not to say that there is not manipulation and outright fraud. Indeed, earnings manipulation is rampant both in the positive and negative direction often through real earnings management, but that will be a topic for another chapter. However, regulators require numerous releases from companies that are unique to China. Moreover, regulators themselves issue information on specific companies, publicly inquiring about their accounting practices.
If I wanted to paint a general statement about Chinese regulation, it would be that regulators are paternalistic and want market stability. Fraud does not reflect well on them, so they go through great efforts to avoid it, with regulators poring over financial statements to look for inconsistencies or issues. They worry that investors will be drawn to loss-making firms, so they delist stocks if they lose money too many years in a row. They worry that investors will move prices too quickly and will fail to have time to digest information, so they create daily price limits on stocks. They worried that short sellers were depressing prices during the 2015 crash, so they effectively banned securities lending for years. All these regulations make sense in context of a paternalistic regulator.
This is in striking contrast to most developed market regulators. A company can lose money for many years, but developed market regulators generally trust investors to make an accurate assessment of a firm’s prospects. They trust the market to set prices reasonably efficiently without the need to intervene. However, they are generally harsh and swift when it comes to financial fraud and market manipulation. After all, the market cannot assess a stock correctly if they do not have accurate information.
But understanding this contrast is important and can help you understand not only why Chinese regulators do what they do but why there are so many regulatory disclosures that other countries simply do not have. The purpose of all these disclosures is to provide investors with more information to make decisions. Of course, practically, retail investors are generally not reading this information. But we can, and that can give us an edge.
We won’t be covering the standard annual, semi-annual, and quarterly reports that are currently required for all firms and stick fairly closely to International Financial Reporting Standards.
If ever there was an article that I would say, “Let me just summarize this for you,” it would be this one. This article is relevant for folks who really want to deeply understand China A-shares, but if you just want to get a lay of the land, I would summarize the article as follows: 1) read companies’ profit notices to get a sense of significant changes in profit before they are released in a company’s financial report and 2) read regulatory inquiries on and punishments for specific companies from the exchanges and China Securities Regulatory Commission to understand which firms are manipulating earnings or engaging in fraud.
Earnings Pre-Announcement
In China, firms can pre-announce earnings, which is effectively a firm guidance on earnings soon after the fiscal yearend. These can be amended, and indeed, there are some incredible amendments to profit notices that have drawn investigation. However, it is critical to act fast on this information; while there is a delayed reaction, the longer one waits, the more information is incorporated into prices. Certainly, waiting until the actual release of the financial report will miss out on most of the price movement.
Profit Notice
A 2007 law on disclosures requires listed companies to make announcements if there will be any loss or big change to its business performance. Such announcements are called “profit notices.” The Shanghai Stock Exchange and Shenzhen Stock Exchange have slightly different rules for which companies are required to issue profit notices and timing of such releases, but note that not all news from such profit notices is bad; both exchanges require companies to make an announcement if it expects to turn a profit from a loss in the previous period, or if net income will go up by 50%.
Companies can choose to opt out of a profit notice if they do not meet the criteria set out by the exchanges. But the Shenzhen Stock Exchange specifically requires all firms on the SME and GEM boards to issue a profit notice.
Profit notices are issued soon after a fiscal period ends. For example, for annual reports, both exchanges require profit notices to be available to the public by January 31st. Considering that all Chinese companies have a fiscal yearend of December 31st, this is a fast turnaround.
Although issuance of profit notices was intended to provide investors up-to-date financial information, some companies have been known to drastically reduce their earnings either in amended profit notices or audited annual reports. These large changes in forecasted earnings attract attention from investors, the media, and regulators, and have even earned the nickname face change, referencing the famous technique from Sichuan opera, in which actors quickly change one mask for another.
There are eight types of profit notices. One set is positive: slightly increased (略增) earnings, loss to profit (扭亏), continued profit (续盈), and predicted profit (预增). The other set is negative: slightly reduced (略减) earnings, a first loss (首亏), a continued loss (续亏), and a predicted loss (预减). Firms that issue positive profit notices in the prior month outperform those that do not issue profit notices who in turn outperform those that issue negative profit notices in the prior month.
Profit Express
Unlike profit notice, profit express is not required for any company, but encouraged by the stock exchanges for more timely disclosure. It includes more information and provides a comprehensive picture of the company’s operations, before the audit for annual reports is finished.
Perhaps not surprisingly, less than 15% of China A firms issue profit expresses. On average, profit expresses convey good news and enjoy a favorable market reaction, but it is incorporated quickly such that there is little advantage to trading on profit express.
Other required releases by listed companies
The law requiring profit notice disclosures also mandates disclosure of other information, such as prospectuses and temporary reports. These disclosure requirements may seem similar to those for U.S firms, required by the SEC, such as Form 424(b)(3) (prospectus) and Form 8-K Current Report. But the complex legal framework governing the Chinese stock market means that firms usually have other administrative orders to follow, adding to the level of disclosure. The rest of this section focuses on unique but less important disclosures, unheard of or rare in other markets, that are required of public companies in China.
One common announcement publicly listed companies in China have to make is for “abnormal stock price fluctuation”. Loosely from a regulation about information disclosure, it gives rise to the term abnormal stock price fluctuation, when a company’s stock price has increased or fallen by more than 20% in total over the most recent 20 trading days. Chinese firms therefore routinely publish abnormal stock price fluctuation announcements, explaining events, or lack thereof, potentially driving the price movement and sometimes quelling rumors, good or bad.
In addition, an interesting provision in a disclosure law states “if the performances are divulged or if there is any hearsay about the performance and if the transactions of corporate securities and the derivatives thereof fluctuate abnormally, the listed company shall disclose the relevant financial data of the current reporting period in time.” Although uncommon in practice, exchanges are known to use the provision to raise questions about potential leaking.
As a result of the magnitude of requirements, Chinese companies tend to provide far more disclosure documents. Take Chevron from the U.S. and SAIC Motor from China as an example. Both are major industrial firms, have December 31st fiscal year ends, and rank amongst the largest corporations in their respective countries. From June 1, 2019 to May 28, 2020, Chevron has filed less than 40 documents with the SEC in the EDGAR online filing database. During the same period, SAIC Motor filed 79 documents with the Shanghai Stock Exchange. Some filings were of very similar events: departure or change of executives or board of directors, earnings announcements, annual and quarterly reports, and approvals from the board of directors. SAIC also had announcements about monthly production and sales reports and online investor reception events. Notably, SAIC had 22 announcements on April 14, 2020, when they released their audited annual reports. The numerous announcements are components of the annual reports, emphasizing important aspects of disclosure, such as share pledging, ESG, audit, internal control, and related party transactions.
Releases by regulators
It is not just companies that release information about themselves. The China Securities Regulatory Commission (CSRC) and the two stock exchanges in China regularly publishes announcements about and decisions from their investigations against securities-related violations, similar to the Accounting and Auditing Enforcement Releases by the U.S. Securities and Exchange Commission. Up-to-date information is available through the main websites of the CSRC and exchanges in simplified Chinese. The releases can be searched by subject, types of documents, and local offices involved in the investigation. The English version of the websites, however, do not provide up-to-date enforcement related information.
Releases by the CSRC
Under the current legal system in China, the CSRC has two large categories of regulatory actions – Supervisory Measures and Administrative Sanctions. The Securities Law stipulated the CSRC and its subordinates, such as the stock exchanges and regional offices, can impose Supervisory Measures, which are less severe in nature than Administrative Sanctions, for violations of regulations. Examples of Supervisory Measures include supervisory talk, warning letters, and public condemnation. They can also order correction, and place restrictions on a company or individual’s activities.
Some of the Supervisory Measures, especially supervisory talk, may be unintuitive. A supervisory talk is when the CSRC invites individuals for conversations about matters being investigated by the commission and announcements for supervisory talk usually involve a description of the subject matter, a date and time, and location (usually one of the CSRC regional offices) for the discussion. A supervisory measure more severe in nature than a supervisory talk is the issuance of warnings letters. Warnings letters are usually posted by CSRC’s regional offices and can be extraordinarily detailed and precise, often criticizing a firm on technicalities uninteresting to most investors.
The graver sanctions imposed by the CSRC fall largely into two categories: Administrative Sanction and the more severe Banning of the Entry into the Securities Market. High profile scandals usually result in Administrative Sanctions, although at a significant delay. Kangmei Pharmaceuticals was exposed in April 2019 to have inflated cash positions by a total of 88.7 billion yuan from 2016 to 2018. The CSRC issued its initial and final decision in August 2019 and May 2020, respectively, and imposed both Administrative Sanction and Banning of the Entry on the company and its executives. The market considered the 600,000 yuan fine on the company a slap on the wrist, which was the top amount allowed for fraudulent financial reporting. The new Securities Law, revised in late 2019, increased the fine limit to 10 million yuan, but was not applicable to the Kangmei case because it became effective only on March 1st, 2020. The Kangmei Pharmaceuticals case is interesting in part for its brazenness, since cash positions can be relatively easily checked.
The number of administrative sanctions has increased over the past two decades. In 2010, 50 stocks faced administrative sanctions while 140 faced sanctions in 2019.
Releases by the stock exchanges
The Shanghai Stock Exchange and Shenzhen Stock Exchange share supervisory duties with the CSRC. As frontline regulators, they issue inquiry and attention letters about firms’ financial reports, major corporate events (such as material asset reorganization), and other matters of interest to regulators. These letters tend to draw negative attention from investors, and companies usually respond promptly by providing answers publicly to the questions posed by the exchanges. In some cases, the exchanges are not satisfied with the answers and will issue a second round of letters, intensifying public scrutiny. For example, Hangzhou Huaxing Chuangye Communication Technology, received an inquiry letter from the Shenzhen Stock Exchange about its 2018 annual report regarding its claim that it had transformed its business into a 5G technology business when its R&D expenditure actually declined over that year. The company responded with a 31-page report arguing their case.
The exchanges also issue supervisory letters. These are more severe in nature and could take the form of Supervisory Attention, Circulated Notice of Criticism, or Public Condemnation and Public Recognition. Just like the CSRC’s supervisory talk, the names of these measures may seem odd but it generally implies an increasing degree of criticism from the exchanges, with Supervisory Attention being the mildest and Public Condemnation and Public Recognition being the harshest. Note that while recognition is generally a positive term, that is not how it is meant here.
Public Recognition could be the exchange announcing their recognition or conclusion that someone is not suitable to be an executive or member of board of directors. The example of Anhui Shengyun Environment-Protection Group best illustrates these supervisory letters. On May 25, 2020, the Shenzhen Stock Exchange issued three separate supervisory letters to Anhui Shengyun: Circulated Notice of Criticism, Public Condemnation, and Public Recognition. The letters were based on serious violations the company committed over several years, including concealing loan guarantees and loan defaults, providing “financial assistance” to its chairman and other shareholders, and failing to offer an amended profit notice when previous earnings forecasts deviated significantly from actual earnings. Although the letters cited the same violations, different individuals received different supervisory measures, depending on their involvement in the case. The company’s Secretary of the Board got the lightest measure, a Circulated Notice of Criticism. Several board members were issued a Public Condemnation, and its chairman received both a Public Condemnation and Public Recognition, which stated that for his lifetime, he was barred from serving as a board member or executive of any public company.
Both the Shanghai and Shenzhen Stock Exchange make all these regulatory letters public on their website, in two separate categories, Supervisory Letters and Inquiry Letters. A simple rule of thumb is Supervisory Letters are decisions made against companies and individuals, thus more severe in nature, while Inquiry Letters pose questions to elicit companies’ responses, although the questions are of course not innocent but rather criticism or warnings in disguise. A case in point was Guangdong JANUS Intelligent Group, a manufacturer and distributor of communication equipment components. When it announced an astronomical loss of 2.66 billion yuan in its 2018 annual report, the Shenzhen Stock Exchange soon followed up with an inquiry letter and raised quite a few questions, such as whether the company had insufficient provisions for inventory impairment in the 2017 annual report and 2018 semi-annual report, and whether the company increased the provision drastically in the 2018 annual report to manipulate earnings. Interestingly the company’s accountant, who was specifically named by the exchange to provide an answer to this question, had to admit to a “lack of internal planning management,” causing problems such as “misplacement of the materials on the site,” to account for the increased provision.
Because of the negative attention it attracts, these regulatory letters are usually followed by a drop in the company’s stock price. However, this is hardly universal.
Similarly, although the publication of profit express is entirely voluntary, firms can still be reprimanded or punished if figures from the voluntary disclosure differ too much from those in the annual reports. Zhejiang Talent, a television and film company, got a Supervisory Letter from the Shenzhen Stock Exchange, because it showed a loss of 106 million yuan in its 2019 annual reports filed in April 2020, while forecasting a much lower loss, about 37 million yuan, in its Profit Express dated February 29, 2020.
Regulatory bodies
China adopts a sectoral supervisory model for its financial industry, with securities, insurance, and trust and banking sectors under separate supervision by China Securities Regulatory Commission (CSRC), China Banking and Insurance Regulatory Commission (CBIRC), and People’s Bank of China. The main regulator of China’s stock market is the CSRC, similar to the Securities and Exchange Commission (SEC) in the United States. Established in 1992, the CSRC is a ministry-level agency directly under the State Council, China’s cabinet.
Under the current Securities Law, the CSRC is authorized to carry out “regulation and supervision of the securities and future markets nationwide.” Its functionality and enforcement share much in common with its U.S. counterpart, the SEC. However, notable differences exist. First, not only does the CSRC have 38 regional offices across the country that are the “frontline supervisors” for each region, it also directly governs the Shanghai and Shenzhen Stock Exchanges, unlike in the U.S., where exchanges are privately owned entities.
Second, The Department of Listed Company Supervision in the CSRC supervises information disclosed in the financial reporting for listed companies. The stock exchanges also share supervising responsibilities regarding public companies’ disclosures in their financial reports. This creates an interesting separation of duty because the Ministry of Finance has the sole responsibility of accounting standard setting in China. In the U.S., the SEC is legally responsible for accounting standards setting and enforcement actions. The SEC delegates the responsibility of standard setting to the Financial Accounting Standards Board (FASB), a non-governmental private sector entity. The SEC’s Division of Enforcement issues Accounting and Auditing Enforcement Releases concerning the commission’s financial reporting related enforcement actions.
China does not differ markedly from the United States in its financial regulatory structure, but the regulatory behavior does. As we have discussed, the regulators demand far more information from companies. Since China is largely a retail market, we can capture much of this information before it is fully priced.