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  2. Oct 26, 2017 By Morris & Megan

    This August, the China Securities Regulatory Commission (the “CSRC”) slapped Xintai Electric Co., Ltd. (“Xintai Electric”) with a record fine for fraudulent issuance, ordering it to officially delist from A-shares and banning it from ever listing again, making it the first company delist from the growth enterprise board. As demonstrated below, if problems arise in an IPO project, not only will the issuer take relevant responsibility, the intermediary institutions involved will also be subject to severe penalties.

    Legal Miner has issued a report with respect to administrative penalties on law firms’ securities practices of the last five years. On that basis and taking into account the CSRC’s current rules, Legal Miner collected and combed through administrative penalty cases related to IPO projects in the last four years in forming this report, providing a reference for enterprises, securities trading service institutions and law firms.

    1. Background

    On July 7, the CSRC circulated a notice regarding its processing of cases in the first half of 2017. As of June of 2017, the CSRC has issued 113 administrative penalties, with a total fine and confiscation of up to 6.361 billion yuan, a 149% increase compared to that of last year. In addition, the market access ban imposed on 30 people approached the number for the entire 2016.

    With a successful IPO, a company can not only expand its financing channel, but also increase its operation size and improve product value through various capital operations such as mergers and acquisitions. For its shareholders, the improved price-earning ratio resulted from an IPO is highly attractive. Driven by such benefits, certain companies, even without the qualification, independency, standardized internal control system and performance index stipulated by Measures for the Administration of Initial Public Offering and Listing of Stocks (hereinafter the Administrative Measures), still attempt to go public by means of fraudulent issuance and withholding of important information etc. Therefore, it is not uncommon to see administrative penalties and lawsuits against intermediary institutions. Although administrative penalty provisions on subjects involved in IPO projects are complicated and scattered, there are applicable provisions for each type of violations, making it worth reference to conduct further analysis after classifying the collected data.

    2. Brief Introduction of Administrative Penalties on IPO Projects Issued by the CSRC

    Legal Miner has collected a total of 21 cases with respect to administrative penalty notices on IPO-related projects disclosed by the CSRC from January 1, 2014 to July 31, 2017. (Notice: The cases referred to above only include administrative penalties the CSRC imposed on companies and relevant persons in charge during (and after) the process of IPO examination. They do not include administrative penalties imposed by other administrative agencies or entrusted institutions.)

    2.1 Cases of Violations by Categories

    The administrative penalties of the CSRC on relevant violators are mainly concentrated on three aspects, i.e., fraudulent issuance, illegal information disclosure, and violation of provisions on relevant institutions engaging in securities business. Compared with the past, this year the CSRC has intensified its supervision, reflected in its broadening the scope of penalty subjects, increasing the amount of fine and shortening the timeframe for investigation and punishment.

    Case information regarding illegal information disclosure and fraudulent issuance:

    Fraudulent issuance and illegal information disclosure are identified on the basis of the following behaviors of the issuers:
    1) False statement in submitted or disclosed information;
    2) Inaccurate statement, insufficient basis, selective and exaggerated disclosure, and misleading statement;
    3) Material omission of the information submitted and disclosed, including failure to disclose affiliation and affiliated transactions, material change in equity structures, major issue of independency and material debts, breach of contract or guaranty.

    Where any of the three circumstances above constitute the concealment of material facts or fabrication of material fraudulent contents, it will be identified as the fraud and illegal information disclosure.

    In practice, most cases of illegal information disclosure can be seen where on the one hand, issuers provide false statements and on the other hand, due to insufficient examination and verification as well as lack of expertise, sponsors and securities service agencies provide opinions or reports that contain false information, misleading statements or material omission. Such information are mainly reflected in the following aspects:

    1) Company borrows fund to offset and reduce accounts receivable;
    2) Company discloses false statements about main business operations;
    3) Company fabricates increase of business income;
    4) Company falsifies fake contracts;
    5) Company employees also hold position in the controlling shareholder, actual shareholder and other companies controlled by the issuer.

    It is noteworthy that not only shall the application documents and materials concerning the above five aspects be authentic and complete during the IPO examination and verification process, but the relevant contents in the periodical reports disclosed after listing shall contain no false record as well. Even if the application passed the examination, the CSRC will follow up with the periodical reports in respect of such information.

    Taking into account the timeframe standard with respect to the business income identification of the sponsor agencies mentioned in the administrative penalty case for Xinda Securities Co., Ltd. issued by the CSRC: According to Article 11, Paragraph 2 of Securities Law, a sponsor has to supervise and urge its issuers to operate in a regulative manner. In addition, Article 25, 26, 27, 36, and 37 of Administrative Measures for the Recommendation Business of the Issuance and Listing of Securities also stipulates that a sponsor shall give guidance to the issuer before the initial public offering and listing of stocks of an issuer, and shall provide continuous supervision and guidance after the listing. The pre-IPO guidance, recommendation of IPO and continuous post-IPO supervision and guidance together constitute the entire process of sponsorship. Therefore, a sponsor institution shall provide continuous supervision and guidance on financial statements or announcements and notices made public by the issuer after IPO, thereby fulfilling its due diligence obligations.

    Since cases of violations of provisions on relevant institutions engaging in securities business relate to multiple subjects and the applicable provisions also differ from one subject to another, they will be discussed below based on different type of violators.

    2.2 Subjects of violations split by categories

    In recent years, apart from traditional cases against issuers for illegal information disclosure, insider trading and market manipulation, the CSRC has also strengthened the degree of penalties imposed on intermediary institutions for violations such as failure to fulfill due diligence obligations and fabrication and spreading of false information. Below is a list based on different type of violators:

    2.3 Reference Case: The Fraudulent Issuance of Xintai Electric Co., Ltd.

    In August, the compulsory delisting of Xintai Electric made it the first company delist from the growth enterprise board in China due to fraudulent issuance. Zhang Xiaojun, the spokesman of the CSRC, recently stated that Xintai Electric can never list again and therefore withdraw from the A-share market permanently.

    In that case, all the relevant subjects, including the issuer, sponsor institution, law firm and accounting firm, were subject to administrative penalties by the CSRC.

    - Issuer:

    Violations:
    1) There are false records of financial data in the IPO application materials for the growth enterprise board;
    2) There are false records and material omission in the periodical reports disclosed after listing.

    According to documents disclosed by the CSRC, Xintai Electric falsified income from accounts receivable by outside borrowing, using equity funds or fabricating bank bills prior to IPO in order to meet the CSRC’s listing requirements. It falsified its financial statements in its IPO application materials. The total number of fabricated income in the three years from 2011 to 2013 approached 477 million yuan. After listing, Xintai Electric continued its fabrication of financial record in its Annual Report of 2013, Semi-Annual Report of 2014 and Annual Report of 2014, and had material omission in the Annual Report of 2014.

    Penalties:
    1) Xintai Electric was ordered to take corrective action, given a warning letter and imposed a fine of 8.32 million yuan;
    2) Wen Deyi was given a warning letter and imposed a fine of 8.92 million yuan;
    3) Liu Mingsheng was given a warning letter and imposed a fine of 600 thousand yuan;
    4) Yu Xiaoyang and Wang Yongheng each was given a warning letter and imposed a fine of 200 thousand yuan;
    5) Sun Wendong, Cai Hong, Chen Bochao, Song Liping and Chen Yuchong each was given a warning letter and imposed a fine of 80 thousand yuan;
    6) Jiang Guangfu, Zhao Chunnian, Fan Yongxi, Han Dong and Sun Honggui each was given a warning letter and imposed a fine of 60 thousand yuan;
    7) Wang Jianhua and Hu Xiaoyong each was imposed a fine of 50 thousand yuan;
    8) Du Xiaoning was imposed a fine of 30 thousand yuan.

    It is noteworthy that Wen Deyi as the directly responsible person and actual controller of the issuer was subject to double penalties by the CSRC, the amount of which was as high as 8.92 million yuan.

    Market Access Prohibition:
    Permanent ban from the securities market was imposed on Wen Deyi and Liu Mingsheng, who would be prohibited for life from conducting securities business or taking any position as the director, supervisor or senior executive of a listed company from the date the CSRC issued its decision.

    - Sponsor Institutions:

    Violations:
    1) There are false records in the recommendation report issued by Industrial Securities Co., Ltd. (hereinafter the Industrial Securities); 2) The Industrial Securities failed to examine and verify the authenticity and accuracy of Xintai Electric’s IPO documents in a prudent manner.

    According to documents disclosed by the CSRC, in the process of recommending the application of Xintai Electric, the Industrial Securities failed to examine and verify the application documents of the issuer in a prudent manner per business rules and industry standards. Failing to carefully examine and verify the accounts receivable and the bank deposits of Xintai Electric, the Industrial Securities had issued the recommendation documents with false records.

    Penalties:
    1) Industrial Securities was given a warning letter and had 12 million yuan from the sponsoring income confiscated, along with a fine of 24 million yuan; it also had 20.78 million yuan from underwriting income confiscated, along with a fine of 600 thousand yuan. 2) Lan Xiang and Wu Wenxiang were given warning letters, imposed a fine of 300 thousand yuan respectively and had securities practice licenses revoked.

    Market Access Prohibition:
    A ten-year-old ban from the securities market was imposed on Lan Xiang and Wu Wenxiang, who would be prohibited from conducting securities business or taking any position as the director, supervisor or senior executive of a listed company from the date the CSRC issued its decision.

    It is noteworthy that after receiving the CSRC’s penalty decision, the Industrial Securities set a special fund of 550 million yuan to compensate the unwitting investors of the secondary market suffering from the fraudulent issuance of Xintai Electric.

    - Accounting Firm:

    Violations:
    1) Xinghua Accounting Firm (hereinafter Xinghua Firm) failed its due diligence obligation when auditing the financial statements during the period of the IPO of Xintai Electric, leading to the false records in the audit report.
    2) Xinghua Firm failed its due diligence obligation when auditing Xintai Electric’s financial statements of 2013, leading to the false records in the audit report.
    3) Xinghua Firm failed its due diligence obligation when auditing Xintai Electric’s financial statements of 2014, leading to the false records in the audit report.

    According to documents disclosed by the CSRC, Xinghua Firm failed to give proper attention to the abnormal large-sum of red-ink entry in the detail accounts of receivable business income, accounts payables, and the advanced payments of Xintai Electric during the period of IPO. Meanwhile, with the absence of reply to the confirmation requests of accounts receivables and advanced payments, it failed to adopt the substitute procedure, failed to obtain sufficient and proper audit basis and failed to pay attention to the abnormality of the bank accounts.

    Penalties:
    1) Xinghua Firm was ordered to take corrective action, had business income of 3.2244 million yuan confiscated along with a fine of 9.6732 million yuan.
    2) Wang Quanzhou, Yang Tiehui and Wang Quansheng were each given a warning letter along with a fine of 100 thousand yuan respectively.

    Market Access Prohibition:
    1) Wang Quanzhou and Yang Tiehui were imposed a 5-year market access prohibition. Specifically they were prohibited for 5 years from conducting securities business or taking any position as the director, supervisor or senior executive of of a listed company since the decision being announced by the CSRC.
    2) Wang Quansheng was imposed a 3-year market access ban. Specifically, he was prohibited for 3 years from conducting securities business or taking any position as the director, supervisor or senior executive of of a listed company since the decision being announced by the CSRC.

    - Law Firm:

    Violations:
    1) There were false records in the legal opinion issued by Eastbright Firm.
    2) Eastbright Firm also violated other provisions of Rules for the Securities Legal Practices of Law Firms.

    According to documents disclosed by the CSRC, most of the commitment letters, confirmation requests, and interview records contained in the working papers of Eastbright Firm were directly taken from the Industrial Securities, and some of the clients failed to confirm the accounts receivable. In addition, Eastbright Firm failed to prepare the examination and verification plan, with no records of discussion and review of the legal opinion. Also, its working papers were not affixed with the official seal, and some interview records were not signed by the handling lawyers.

    Penalties:
    1) Eastbright Firm was ordered to take corrective action and had its business income of 900 thousand yuan confiscated along with a fine of 1.8 million yuan.
    2) Guo Lijun and Chen Yanshu were each given a warning letter along with a fine,of 100 thousand yuan.

    3. The Analysis of Fraudulent Issuance Cases in Recent Five Years

    Based on cases from the last five years, we have identified three other companies that also committed fraud similar to what Xintai Electric did, i.e., Green-Land Biotech Co., Ltd. (hereinafter Green-Land), Wanfusheng Biotech Co., Ltd. (hereinafter Wanfusheng) and Hirisun Technology Co., Ltd. (hereinafter Hirisun). With the increasing frequency of financial fraud in IPO projects that lead to loss to small and medium investors, the CSRC has intensified the investigation and degree of penalties for such fraudulent behavior. The CSRC has imposed strict penalties on Green-Land, Wanfusheng, Hirisun and Xintai Electric for fraudulent issuance, and punished the relevant intermediary institutions and persons in charge by issuing warning letters, fine, confiscation of recommendation income, confiscation of underwriting income, disqualification and sometimes prohibition from market access in accordance with relevant rules and regulations.

    Comparing these four companies’ illegal behavior, we find that they share a common thread for the false disclosure of financial accounting statements. Meanwhile, Article 13 of the Securities Law specifically stipulates that if a company applying for listing has false records in its financial accounting statements and its lack of profitability continues for the last three consecutive years, its application for listing shall not be approved.

    However, in practice, Xintai Electric was the first company in history subject to compulsory delisting. Why is Xintai Electric the only company ordered to be delisted? Which violations are the essential elements for the order of delisting? What is the policy of advance compensation for intermediary institutions formed since the Wanfusheng incident? With these questions, below we will launch the analysis of the Xintai Electric in depth.

    3.1 Why is Xintai Electric the only company ordered to be delisted?

    Given the administrative penalty decisions of the four companies, we find that the date of the penalty decision is the key factor in determining whether the new compulsory delisting system shall apply. The new compulsory delisting system of 2014, referring to Several Opinions on Reforming, Improving and Strictly Implementing the Delisting System of Listed Companies (hereinafter the new delisting system), was approved by the 24th chairmen’s meeting of the CSRC on February 7, 2014, and has came into force on November 16 of the same year.

    Reviewing the documents disclosed by the CSRC and the announcements of the companies, we can find that, on November 15, 2014, Hirisun received the Decision of Administrative Penalty (No. 94 of 2014) and the Decision of Prohibition from Market Access (No. 16 of 2014) issued by the CSRC on November 14. Although Hirisun’s fraudulent behavior such as cheating for approval and issuing false statements has reached the threshold for compulsory delisting under the new system, per the principles of non-retroactivity of law, since the new system had not come into force then, Hirisun was not subject to delisting. The same applies to Green-Land and Wanfusheng, whose administrative penalties decisions were issued even earlier than those for Hirisun, making Xintai Electric the first company whose fraudulent behavior triggered compulsory delisting under the new system.

    3.2 What circumstances may trigger compulsory delisting? Can a company apply for re-listing after delisting ordered by the CSRC?

    In the document of the new delisting system, the CSRC has specially specified the circumstances of delisting by the appendix, which includes fraudulent issuance and illegal disclosure of material information, two common violations of IPO projects.

    1) Where there is false record, misleading statement or material omission in a public company’s IPO application or disclosure materials, which causes such unqualified issuer to obtain listing approval or exert material influence over stock pricing, such issuer will be suspended from listing by the CSRC’s administrative penalty decision. Within one year from the date of the CSRC’s administrative penalty decision, the stock exchange decides to terminate the listing of such issuer’s stocks.
    2) Where the company is punished by the CSRC for false record, misleading statement or major omission in its disclosure materials, it shall be suspended of listing by the CSRC once the circumstance is identified as major violation. Under such circumstance, the stock exchange shall decide to terminate the listing of the company’s stocks within a year from the decision of the CSRC.

    Therefore, the new delisting system clearly stipulates that if a listed company is subject to the administrative penalty decision by the CSRC for fraudulent issuance or illegal disclosure of material information, or is transferred to police for criminal action, the stock exchange will suspend its stock trading and within a year make the decision to terminate the stock listing.

    In terms of the delisting of Xintai Electric, Zhang Xiaojun, the spokesman of the CSRC, has once again emphasized that there is no arrangement for the delisted company to reapply for relisting on the growth enterprise board. After delisting, the company will be transferred to the special board of NEEQ (National Equities Exchange and Quotations).

    3.3 Why intermediary institutions have the advance compensation policy for the loss suffered by small and medium investors?

    As for the compensation to the small and medium investors, Pingan Securities Co., Ltd. (hereinafter Pingan Securities), the sponsor of Wanfusheng, became the first sponsoring institution adopting the advance compensation policy, which is learned by other sponsoring institutions subjected to similar administrative penalties.

    Wanfusheng was punished by the CSRC to the maximum degree due to fabricating business income and falsifying financial statement and operation data. Its sponsoring institution Pingan Securities then decided to set up a fund in the amount of 300 million yuan called the “Special Fund for the Compensation of Investors in the Wanfusheng Statement Fabrication Case”, in order to give advance compensation to investors who suffered loss from the Wanfusheng case.

    In the past, the recourse procedure investors use pursuant to the Interpretation of the Supreme People's Court on Material Fabrication was extremely long and the burden of proof was very high. The CSRC has indicated its desire to push for the advance compensation policy as early as 2013, in order to protect small and medium investors from the loss of fraudulent issuance.

    The advance compensation policy by the sponsoring institutions has been incorporated into the Compilation Rules for Information Disclosure by Companies Offering Securities to the Public No. 1 — Prospectus, whereby the sponsor institution will provide advance payment to cover investor loss due to false record, misleading statement or material omission in the documents such sponsor produced or issued for the IPO project.

    As indicated by the CSRC spokesman, such measure is to effectively urge intermediary institutions to fulfill their obligations, to curb fraudulent issuance and to strengthen the protection of the investors. In substance, the advance compensation policy is an alternative policy arrangement to facilitate investors in obtaining monetary compensation. Under such arrangement, the sponsor institution will provide advance payment to investors who suffer loss from fraudulent issuance or other serious violations, and is entitled to claim payment from the issuer thereafter.

    4. The Subsequent Effects of Administrative Penalties Issued during the Examination of IPO Projects by the CSRC

    4.1 Companies subject to administrative penalties for serious violations cannot be listed for 36 months.

    4.2 How a sponsoring institution involved in alleged illegal activities conducts verification and examination of the issuer?

    According to Regulation Board’s Answers to Several Issues Concerning the Circumstance under which the Review Needs to be Suspended in Initial Public Offering (December 9, 2016 Revision) issued on December 9, 2016, a sponsoring institution shall suspend examination and verification if it is subject to investigation by administrative organ or judicial organ for any suspected illegal activities and the case is pending.

    4.3 How to proceed if intermediary institutions or relevant signatory persons are changed due to administrative penalties?

    According to Regulation Board’s Answers to Several Issues Concerning the Handling of the Examination of Initial Public Offering Project where the Intermediary Institutions Is Subject to Administrative Penalty or Changed (December 9, 2016 Revision) (herein after the Answers):

    1) Where the issuer of an IPO application changes the sponsoring institution, the issuer, its former sponsor and new sponsor shall explain the reason for such change. If the former sponsor terminates the sponsoring agreement because the issuer refuses to cooperate with the sponsor in fulfilling its sponsoring obligation or the sponsor believes that the issuer cannot satisfy the listing requirements, or if the issuer terminates the sponsoring agreement for reasons other than its sponsor being under investigation or having its practice restricted, the issuer shall resubmit its application materials. Under any circumstance other than those stated above, the new sponsor shall perform the recommendation procedure in full, review and confirm the guidance work of the former sponsor, and issue new recommendation documents with definitive opinion about whether there is material difference between the current documents and the ones issued by the former sponsor. If the new sponsor believes that there is no material difference between the new documents and the old ones, it will arrange for subsequent examination and verification work. In the event that such material difference does exist, it shall be handled in accordance with relevant rules and regulations; any project that has acquired the approval is required to undergo the examination again.

    2) Where the issuer of an IPO application changes the sponsor representative, law firm, accounting firm, or the signatory lawyer and accountant, the new institution or person shall re-conduct due diligence investigation and issue professional opinions, and the sponsor shall review such investigation and opinions. If the new sponsor believes that there is no material difference between the new documents and the old ones, it will arrange for subsequent examination and verification work. In the event that such material difference does exist, it shall be handled in accordance with relevant rules and regulations; any project that has acquired the approval is required to undergo the examination again.

    3) In the process of examination, if the sponsor, law firm, accounting firm or their recommendation representative, signatory lawyer and accountant is subject to any administrative penalty or regulatory measure, the sponsor and other related intermediary institutions shall review the professional opinions issued and provide review opinions, except if such review has been completed by relevant institution or personnel during the investigation phase. If the review finds no issue that might materially affect the issuer’s listing, subsequent examination and verification will be arranged; any project that has been approved does not need to go through the examination again.

    4) If relevant administrative penalty decision or regulatory measure leads to restriction of practice for any sponsoring institution, law firm, accounting firm or signatory recommendation representative, lawyer or accountant, no subsequent examination work can be assigned to such intermediary institution or personnel until the penalty or measure has been completely implemented. If the issuer of an IPO application changes its recommendation representative, sponsor lawyer, law firm, accountant, or accounting firm, the former signatory institution or person shall issue a letter of commitment claiming full responsibility for the authenticity, accuracy and completeness of the documents signed. If any problem occurs related to the signed document, the CSRC will hold such institution or person accountable and punish them in in a strict manner according to the relevant provisions.

    5. Rules and Regulations Cited

    1. Article 11, Paragraph 2; Article 13, 63 of Securities Law
    2. Article 24, 29, 30 of Administrative Measures for the Recommendation Business of the Issuance and Listing of Securities
    3. Article 6, 22, 41 of Principles of Due Diligence Practice for Sponsors
    4. Article 12, 13, 14 of Measures for the Administration of the Provision of Securities Legal Services by Law Firms
    5. Article 9, 37 of Rules for the Securities Legal Practices of Law Firms (for Trial Implementation)
    6. Article 5, 6 of Auditing Standards for CPAs of China No. 1231 - Procedures in Response to Assessed Risks of Material Misstatement
    7. Article 6, 16 of Auditing Standards for CPAs of China No. 1141 - Consideration of Fraud in an Audit of Financial Statements
    8. Article 29 of Administrative Penalty Law (2017 Amendment)
    9. Regulation Board’s Answers to Several Issues Concerning the Circumstance under which the Review Needs to be Suspended in Initial Public Offering (December 9, 2016 Revision)
    10. Regulation Board’s Answers to Several Issues Concerning the Handling of the Examination of Initial Public Offering Project where the Intermediary Institutions Is Subject to Administrative Penalty or Changed (December 9, 2016 Revision)

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