Historical Performance of the Function of Goodwill
Existing studies show that goodwill does not serve Chinese securities firms well in their underwriting activities. An underwriter's goodwill can effectively help the underwriter refrain from opportunistic behavior and improve its credibility. Chinese researchers have studied the link between the performance of IPO companies and the goodwill of their underwriters in both Shanghai and Shenzhen stock markets. The following is a sample of their findings:
- Tian Jia and Zhan Weihua (2000) formed their studies on almost all the IPO data available to them and found that there is no significant relationship between the goodwill of underwriters and IPO pricing. Hu Xuyang (2003) selected a sample of 578 listed companies at the end of the first half of 2001 for a study of the relationship between the goodwill of underwriters and IPO pricing. They found that goodwill does not play a significant role in the relationship.
- Based on the data of IPO companies that went public in the A-share markets between July 1994 and October 2003, Liu Jianghui and Liu Xiaoliang (2004) conducted an empirical study of the relationship between the goodwill of underwriters and IPO underpricing and found that there is no significant relationship.
- Based on the data of IPO companies between 1991 and 2003, Liu Jianghui, Yin Bocheng, and Yi Xingjian (2005) studied the performance rankings of the underwriters and the quality of the IPO companies and found that there is no significant relationship between the goodwill of underwriters and the quality of IPO companies.
Guo Hong and Zhao Zhenyu (2006) conducted a period study with stock data between 2000 and 2003 and found that the goodwill of underwriters has no significant influence on IPO pricing and initial returns. There is, however, a significant positive correlation between the goodwill of underwriters and long-term IPO returns. Xu Haoping and Luo Wei (2007) studied the relationship between the goodwill of underwriters and the IPO underpricing between 2002 and 2004 and found that an underwriter of good practice and a high market share can help significantly reduce the IPO underpricing.
Huang Chunling and Chen Zhengrong (2007) conducted a period study on goodwill mechanism and found that the quality of IPO companies and their IPO initial returns are not significant explanatory variables for the goodwill of underwriters.
- Guo Haixing, Wan Difang, and Wu Zuguang (2011) studied the IPOs of 82 GEM listed companies and found that the goodwill of underwriters still does not play a significant role in the GEM.
Most early studies show that there is no significant relationship between the goodwill of underwriters and the quality of IPO companies. Based on the mechanism behind how the function of an underwriter's goodwill is shaped, goodwill seems to serve its purpose in a sound market mechanism. At the very beginning, the Chinese securities market and securities firms were still under the shadow of a planned economy. Along with institutional changes, the Chinese market mechanism has been improving. It would seem that the absence of any significant evidence in early times has to do with the Chinese market system and the corporate institution of securities firms.
Effective fulfillment of the function of an underwriter's goodwill depends on the evolution of the market system and corporate institution. Before 2001, IPOs in the Chinese securities market were subject to administrative approval. Back then, the securities market was something new with green participants and a spotty mix of listed companies, and without sound legislation. Under the administrative approval system, the government exercised administrative quota allocation. The central government dictated the quota of issuance or target number of IPO companies. Local government recommended candidates accordingly. The government also determined the number of shares to be issued and the issue price. As for pricing, the CSRC defined the price based on earnings per share (EPS) and a price-to-earning (P/E) ratio, choosing the specific P/E ratio. Under this system, it was the government that allocated resources and underwriters were functionally distorted. The P/E ratio for IPOs was no longer fixed after March 1999, when the CSRC released the Guidelines for IPO Pricing Analysis Report (trial version). The guidelines specified that a pricing analysis report agreed to by the issuer and the underwriter would provide an important basis for IPO pricing.
Since 2001, IPOs have become subject to regulatory endorsement other than administrative approval. Under the regulatory endorsement system, government approval is no longer a prerequisite for IPOs. A company can apply for an IPO having satisfied requirements of the Securities Act and Companies Act. An issuer arises from an underwriter's recommendation, instead of from an administrative process. The regulatory agency specifies eligibility criteria and IPO requirements in regulatory laws and rules. An underwriter selects and recommends an eligible IPO company. The IPO review panel examines and endorses an IPO application as appropriate.
Before 2004, each underwriter would have access to a certain number of "channels" and could use a channel to recommend only one company at a time. Such a process helped put the IPO number and tempo under control. The regulatory agency also kept a rein on each underwriter by keeping score of irregularities, suspending services, and decreasing the number of channels, among other ways.
After 2004, sponsorship came about. A sponsor is required to assist an IPO company through the issuance and underwriting process. The sponsor verifies the information provided by the company for authenticity and integrity. The sponsor also helps the company establish appropriate disclosure rules and continues to offer sponsorship service afterward. The sponsor even accepts joint and several liability in case of a problem.
When IPOs were subject to administrative approval, whether an IPO company was allowed to go public depended on whether the IPO was in line with the interest of local government. The quality of the company did not seem to matter. Therefore, underwriters mainly competed in how to get a bigger quota and more projects.
Once IPOs became subject to regulatory endorsement and availability of channels, regulatory measures such as scorekeeping of irregularities, suspension of service, and reduction in number of channels compelled underwriters to concentrate on the quality of IPO companies. This helped underwriters to some extent refrain from opportunistic behaviors and improved the underwriting practice. Due to limited availability of channels, however, underwriters were less motivated to expand their business.
After sponsorship was introduced, underwriters as sponsors became responsible for the quality of IPO companies. They now accept liability over a long period. Any opportunistic behavior with intent to mislead investors leads to huge business risk. Therefore, sponsorship is an effective constraint mechanism. In its early stages, the Chinese sponsorship system had many defects, including flaws in sponsor eligibility audit and a low level of marketization for securities issuance. Those defects placed some obstacles in the way of goodwill to serve its purpose. Today's sponsorship system is much better, and actually facilitates the fulfillment of the function of goodwill.
Does goodwill serve any purpose in the Chinese stock market with the development and improvement of the securities market system? The following empirical study focuses on the function of an underwriter's goodwill and builds on the latest market data. It may provide an answer.