CHINA'S securities regulator has implemented further rules to improve the pricing mechanism of initial public offerings as part of a continuing campaign to cool high valuations, bring down IPO prices and alleviate over-subscription of new stocks.

Initial public offerings have long been a favorite of individual investors on the Chinese mainland because prices usually surge on the first day of trading.

That's prompted some institutions to quote unreasonably higher prices in the book-building process so they can secure share allotments and the new shares are always easily sold to retail investors in the secondary market.

Unwitting smaller investors who buy shares after trading debuts run a high risk that the new stocks may plummet in price as institutions take so-called "stag profits," dumping the stock after the lock-up period expires.

Some institutions have also been found to have colluded with underwriters to push up the IPO price and chose not to bid for the shares so that underwriters can gain more commission from the deal.

Initial IPO reforms instituted by the China Securities Regulatory Commission last year to protect smaller investors have eased the problem somewhat, under which institutional investors no longer enjoy the privilege of taking part in the retail tranche of an IPO.

"Stock price growth at trading debuts has slowed significantly, narrowing the gap between the primary market and secondary market," the commission said.

There's still more work to do to increase transparency and curb speculation, as evidenced by the second phase of the IPO reforms announced by the commission last month.

"The reforms are aimed at making the pricing of newly issued stock more reflective of market conditions and to encourage more long-term and sensible investments," a spokesman for the regulator said. "They will also make participants more responsible and pay attention to interest of smaller investors."

Under the latest rules, more institutional investors will be allowed to participate in the book-building process to work out a price range of new stocks.

At present, prices of IPO shares are ultimately fixed based on demand for the shares on offer and market sentiment. A price range will be worked out in consultation with six kinds of institutional investors - fund managers, domestic brokerages, qualified foreign investors as well as trust firms, finance companies and insurers.

The commission will, for the first time, allow underwriters to recommend a certain number of long-term institutional investors, such as private equity investors, to participate in book-building.

In mature overseas markets, major underwriters already have the right to select institutions to quote prices so that they can introduce long-term and high-quality investors to the process.

"The move is equivalent to introducing strategic investors because investors recommended by underwriters are likely to commit long-term investment and underwriters will consider interests of both investors and issuers," said Liu Yiming, a Changjiang Securities Co analyst.

The proposal also requires issuers and underwriters of small and medium-sized companies to set the number of share allotments in a tranche to increase institutions' investments in the stock so they will be more cautious when quoting prices.

Under the current mechanism, for example, when a company on the main board of the Shenzhen Stock Exchange issues 10 million shares in an offline tranche, if 100 institutions quote prices higher than IPO price, they can get almost equal share allotments.

If the IPO price is set at 10 yuan (US$1.47) apiece, each institution needs to pay only 1 million yuan for the shares.

More cautious

The revised mechanism will allow underwriters to set the number of share allotments in a tranche. If the underwriter requires each tranche of a share allotment to be 2 million shares, then only five institutions will get the shares and they will need to pay a minimum 20 million yuan.

The higher investment will make institutions more cautious and rational when quoting a price range in book-building, the commission hopes.

During IPO roadshows, the share issuers and underwriters are also required to make public their own assessment of the stocks' valuations, information that is currently reserved for participating investors only, according to the proposal.

"Increasing the transparency of pricing information will damp manipulation of IPO prices and restrict rapid price surges on the trading debut," said Zeng Xiaoyong, an analyst at Shanghai Securities Co.

The regulator also ordered the stock exchanges and clearing agencies to create conditions to further shorten the period of time between the completion of IPOs and listings.

Since China resumed initial public offerings in June 2009, 337 companies have gone public as of August 23. Those companies raised a combined 543.26 billion yuan, with the average price-earning ratio of the IPO at 55 times, according to Chinese financial provider Wind Information.

Seven companies on the ChiNext, China's Nasdaq-style board, had PE ratios exceeded 100 times earnings, according to Wind. Of all the IPOs, 238 were oversubscribed.

"The country should increase supplies, such as introducing secondary offerings, and tighten up delisting rules to further curb high valuations of new stocks," said Huang Xuejun, an analyst at Guosen Securities Co.

The new proposal, which is in the public comment phase, is part of broader reforms towards IPO launched last June.

China began introducing IPO reforms last year as part of efforts to make the nation's capital markets more efficient and to rein in large first-day gains for newly listed shares.

Under the arrangement, institutional investors would no longer enjoy the privilege of also taking part in the retail tranche of an IPO. The move may significantly boost the chances for individuals to win share allocations, analysts said.

In China, the new stock sale process is divided into "offline" and "online" subscriptions.

Institutional investors bid for a tranche of the IPO and fix the stock sale price during the offline subscription period. But they won't be allowed to compete with retail investors in the online period.

The securities regulator has set its sights on working out a new pricing system to weed out unfair advantages enjoyed by institutional investors and to narrow the difference between the IPO price and the trading price when a stock debuts.