ZT: Investor Alert over Suspect Chinese IPO Prospectuses

步從容

By Elizabeth Fry (Financial Times)



While Hong Kong became the world's largest market for initial public offerings last year, the US capital markets remain first choice for many mainland China companies looking to raise capital.

Worryingly for investors though, an increasing number of Chinese companies are being sued in the US courts for allegedly supplying prospectuses that contain false or misleading information.

According to Stanford Law School's securities class action clearinghouse, the number of securities class action filings made in the US against foreign companies has risen steadily in the past decade and last year accounted for about 20 per cent of the total.

There are currently about 16 Chinese companies facing class actions in the US – more than from any other foreign country – because their financial results following an IPO were allegedly significantly different to the financial statements provided in their prospectuses. This caused their share price to drop, damaging investors who bought in at what they consider to be an artificially high price.

The reasons cited for the lawsuits include failure to disclose that a company's main operating assets were acquired illegally, failure to reveal difficulties in securing a sufficient supply of raw materials, the use of internal estimates in lieu of actual earnings and revenue history, and higher than expected compensation costs because key executives were not secured before the IPO.

The fact that a high number of class actions against foreign firms in the US are from mainland China indicates a serious disclosure issue, according to Jamie Allen, secretary general of the Asian Corporate Governance Association.

Mr Allen believes Chinese companies often do not realise how litigious an environment the US is, do not always understand the rules, and have inadequate risk controls, all of which expose Chinese executives to risk.

"In other cases one could take a more cynical view and say management is wilfully misleading investors to achieve a better valuation since they recognise their business case doesn't stack up," he says.

"Either way, management needs to realise the chances of being caught are pretty high in the US and a class action isn't something a newly listed company wants to go through."

In his view, some young Chinese companies are coming to market too early.

"If they want to raise capital in the future, they should be clearer about the risks they face and more honest about their financial statements. Their reports must fairly present their financial position, results of operations and cash flows, as well as deficiencies and material weaknesses in internal controls."

Mr Allen says Chinese executives need to be aware that if they mislead investors with a dishonest prospectus, and are found out, they will be vilified in the press and there is a high likelihood that their reputation will be badly damaged.

As he points out though, Hong Kong too has its share of offer documents that have been challenged on accuracy grounds.

"We see some companies doing IPOs whose financial figures have been pumped up dramatically in the year or two before they apply for a stock exchange listing."

He says the Hong Kong Exchange and Clearing's listing committee, which vets all IPOs, is on a drive to ensure that companies divulge more about risk since many IPO prospectuses have shown flaws with risk announcements.

The Hong Kong regulator has occasionally sued directors for misleading and false disclosure but it is uncommon, he says.

Mr Allen suggests investors should be wary of IPOs, a sentiment shared by Peter Taylor, investment manager and head of corporate governance at Aberdeen Asset Management Asia.

A perception that there is a high level of false information in offer documents is the reason Mr Taylor prefers to invest in companies with solid track records rather than IPOs.

He says the release of offer documents that contain false or misleading information is an issue in any market, but it is probably a particular issue in China because of the volume of IPOs; Chinese companies accounted for 45 per cent of global IPO volume last year.

"These claims of false information are not surprising; what is surprising is that people are so ready to believe what's in the prospectus and then turn around 18 months later and think they can sue because they believed something they shouldn't have believed."

According to David Smith of RiskMetrics, the risks with IPOs in Asia are twofold: what is in the prospectus, and what is not.

Disclosures around the validity of contracts, relationships with the state, and ambiguity over property ownership rights might be disclosed, but are often buried deep in the document, he says.

"What is more concerning is what is not included. This isn't restricted to China, of course, but it's a big country and sometimes it's difficult to know what you're buying into without actually visiting the factory and kicking the tyres. Relying on a prospectus alone is a big risk," he says.

He advises investors to spend time understanding the governance of the entities being listed – their management team, relations with a parent company, and the degree to which they rely on related party transactions for revenue and/or supply of raw materials, for example.

Importantly, he says where entities are carved out from a state parent for listing, there may be a lack of operating history data as a standalone entity.

"Where projections and internally generated pro forma figures are used, then investors must question the robustness of these projections."