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Missteps of Chinese Securities Firms and Lessons Learned

As important intermediary institutions in the capital market, securities firms provide clients with brokerage, sponsorship, underwriting, asset management, research, and consultancy services. They also play an active role in improving the varieties of market securities, information transparency, and trading efficiency. Competition and pursuit of profits are key to the constant innovations and development of core competitiveness in securities firms. This has resulted in the formation and continuous improvement of competitive edges in the entire financial system. Therefore, they are also key to boosting vitality in the financial system and efficiency of resources allocation in the entire society.

Over the past 20 years, Chinese securities firms have made outstanding achievements in their respective roles. But, due to underdevelopment of the capital market, imperfections in the relevant systems, and yet-to-be-improved regulatory measures and force, securities firms still face problems after more than three years of strict rectification. They have even forgotten their basic functions, thus hindering the healthy growth of the capital market.

Tunneling Caused by Direct Investments and IPOs

After receiving permission for direct investment business in 2007, securities firms started subsidiary companies to reserve projects for direct investments. Among those listed, CITIC Securities, Haitong Securities, and Huatai Securities were first to start subsidiary companies, followed by Everbright and GF Securities. Securities firms usually choose to conduct their direct securities investment engagements in the Small- and Medium-Sized Enterprise (SME) Boards and the Growth Enterprise Market (GEM) Board.

According to reliable stipulations, securities firms performing sponsorship and underwriting could make a small amount of equity investments in the "to-be-listed companies" they represent through their subsidiary companies for direct securities investment, with the proportion of investment capped at 7 percent of the shares to be issued. This policy was intended to tie the sponsorship and underwriting behavior of securities firms with the equity investments of companies to be listed, thereby demonstrating the securities firms' understanding of and confidence in the companies to be listed. This practice usually yields very high returns, thanks to the investment preferences and structures of today's investors. As a result, this has become a new portal of profits favored by many securities firms. For example, according to Wind Info statistics, the subsidiary unit for direct investments of CITIC, Goldstone Investment Ltd., has invested in nine projects sponsored and underwritten by the company since 2010 (see Table 1.13).

How were the returns of the direct securities investment business of securities firms? Data show the following results from venture capital and private equity (VC/PE) institutions in 2011:

- January 15: Received an average return of 13.21 times their investments

- February 19: Received an average return of 9.95 times their investments

- March 19: Received an average return of 10.68 times their investments

TABLE 1.13 List of Projects Funded by CITIC Direct Investment Unit Since 2010

List of Projects Funded by CITIC Direct Investment Unit Since 2010

- April 23: Received an average return of 27.02 times their investments

- May 17: Received an average return of 30.74 times their investments, as yields drastically surged for venture investments

Under the current sponsorship system, securities firms are only responsible for two to three years of supervision for projects they sponsor. They stand to make huge returns after being released from investment locking for their direct investments. Because regulatory requirements for sponsors are hard to materialize under the current system, a strong contrast between the huge benefits and small responsibilities is created. Some securities companies are therefore not performing any protective work, and as a result, scandals have been emerging since the opening of the GEM Board. More legal work is required to restrict the behavior of sponsors, who are currently functioning both as the referee and the athlete.

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