The last several months have seen a dramatic turn-around in the market for initial public offerings in the U.S. by Chinese companies. Companies such Linktone Ltd., which Morrison & Foerster LLP represented in its global IPO and continues to represent in ongoing compliance and corporate work, have recently raised significant money on Nasdaq or the New York Stock Exchange and received significant press coverage worldwide.
In this environment, it is important for the board, management and in-house legal counsel of private companies planning their IPO's, or of public companies thinking of spinning off and listing one or more subsidiaries, to consider the basic elements which lay the groundwork for a successful IPO. Equally important, but sometimes overlooked in the excitement of the IPO process, are the practical implications of being a U.S. public company in the long-term and how these issues can impact companies' overall goals and resources. The following summarizes some of the key issues at the pre- and post-IPO stages that we have seen arise in our recent work.
Pre-IPO
The obvious goal of any IPO is to complete the process in as short a period of time as reasonably possible, while concurrently preparing public disclosure documents that are complete and accurate to minimize any potential liability to the company, its advisors and parties which control the company. While this principle won't be disputed by any members of an IPO working group, its implementation is often complicated by a number of IPO "hot buttons":
- Accounting issues: appoint an internationally recognized auditor, identify key accounting issues and agree on scope of, and nature of the engagement for, the comfort letter. Accounting issues almost always affect the timing of IPO's, particularly for companies with their principal operations in China which can give rise to unusual accounting issues. For example, some companies providing wireless value-added services in China have to engage in fairly complex revenue estimations due to the nature of the wireless industry in China. The financial statements must also be prepared in accordance with U.S. GAAP or a reconciliation between the foreign accounting principles used and U.S. GAAP must be provided. In addition, in this Sarbanes-Oxley era of heightened liability for securities offerings, increasing emphasis is being placed on the scope of "comfort letters" which a company's auditor provides to the underwriters and the company's board as part of their due diligence. A particularly sensitive issue in this regard is whether the auditor will require the lead underwriters to sign an engagement letter for the provision of the comfort letter which defines the permissible use of the comfort letter and the auditor's liability in connection with it.
- The company's "story": consider the "story" that will be presented to potential investors and make sure management and the board fully understands and can effectively communicate this story as the road show nears. As illustrated by a recent IPO by a Chinese manufacturing company, statements by company management or its board which are inconsistent with the disclosure in the IPO prospectus can be embarrassing and have a lingering effect on the company's stock price. It could also lead to potential liability under the U.S. securities laws.
- Management and board composition: identify positions in senior and middle management that may have to be upgraded/expanded and any necessary changes in board composition. Companies should take steps to identify any weaknesses in their current management team and fill-in any gaps that may exist so that they can comply with the demands of the U.S. securities laws and listing rules, particularly in the areas of financial reporting (e.g., chief financial officer and financial controller), publicity (e.g., shareholder relations officer), and legal compliance (e.g., in-house legal counsel). In addition, non-U.S. companies will be subject next year to enhanced Nasdaq and New York Stock Exchange board composition rules which will require, among other things, that a majority of the board be "independent." (This is in addition to the current requirement that all members of audit committees must be independent directors, except in limited circumstances.) Companies operating in China may find it challenging to locate suitable independent board members.
- Due diligence and exhibits: get corporate records and agreements organized for comprehensive due diligence and identify material contracts. One of the most common causes for delays in an IPO is the company's inability to provide the necessary documentation/information in a reliable and timely manner for the due diligence investigation by counsel for the company and the underwriters. Young companies in China, as in many other jurisdictions, are often somewhat casual in their recordkeeping by, for example, failing to properly sign or renew contracts or document option grants. Dealing with these various due diligence issues can significantly increase legal fees and slow the process during the all-important period between the kick-off of the IPO and the first filing of the company's registration statement with the U.S. Securities and Exchange Commission. A related concern, which commonly arises before and during the Securities and Exchange Commission's review of the registration statement, is identifying which contracts are material to the company. The key terms of material contracts must be disclosed in the registration statement with the contracts themselves attached as exhibits, absent the granting of confidential treatment for all or a portion of the contract by the Commission which is a long and involved process. Companies in China, in particular State-owned enterprises, often have an instinctive reaction to deny any requests for public disclosure of contracts to which they are a party, which can generate friction between the company conducting the IPO and its business partners. Educating these partners early about the SEC requirements in this regard, especially the highly limited bases on which confidential treatment can be requested, is key to ensuring that no last minute disclosure show-downs occur.
- Publicity: consult with legal counsel regarding publicity of the IPO or the company itself, particularly when potential underwriters have been identified. Once a privately-held Chinese company becomes profitable and/or starts attracting the attention of investment banks, its officers sometimes make ill-advised pronouncements in the press about the company's future profitability and its plans to soon complete a U.S. IPO. However, excessive publicity regarding the IPO and/or the company itself can delay or, in serious circumstances, preclude the offering. In the U.S., this is particularly the case commencing from the time when the company reaches an understanding with the lead underwriter to proceed with an IPO (even if the understanding is unwritten). These rigid restrictions on communications during the IPO process also necessitate careful planning and structuring if the company and its underwriters want to bring in a strategic investor at or before the IPO, which is fairly common among Chinese IPO candidates (but less so among U.S. companies).
- Chinese regulatory issues: identify any regulatory issues that could delay or preclude the IPO. There are a number of established methods for addressing the common Chinese regulatory issues which arise in an IPO, such as establishing an offshore company structure to allow a Chinese company to conduct a U.S. IPO and using affiliated Chinese companies to operate on behalf of the foreign listing vehicle in sectors in which foreign participation is limited, such as operating an Internet Web site in China. Nonetheless, company management will need to work with its Chinese and international counsel to identify early in the IPO process whether these or more novel, company-specific issues might present problems.
Post-IPO
Completing a successful IPO on Nasdaq or the New York Stock Exchange is always an exciting time for a company -- the prestige of having made it on a high profile stock market, the press coverage and, most of all, the cash the company is suddenly sitting on to expand its business. But before a company formally initiates an IPO process with underwriters, legal counsel and accountants, it should give serious consideration to how it will maintain industry interest in its stock and maintain significant liquidity.
Specifically, companies need to be aware that there is a growing “orphanage” in the U.S. public markets, populated by companies whose valuation is below the necessary threshold to command the attention of investment bank analysts, and, as a result, institutional buyers, whose trades typically comprise the majority of trading volume for most companies listed on Nasdaq and the New York Stock Exchange. Reinforcing the bias against small cap public companies, many of the asset managers have merged in recent years. An individual who used to manage $1 billion (and could get in and out of a small cap company without the trade moving the market against the trader) now manages $10 billion.
A company whose stock is "in the orphanage" has almost the worst of all possible worlds. The expense and nuisance of public registration and burdensome ongoing disclosure requirements is not counterbalanced by genuine liquidity or an accurate trading price which real liquidity would bring. Moreover, a thinly traded stock tends to trade down. Stock that came public at a share price of, say, $15, once fallen into the orphanage, can slip into single digits even though the company is doing just fine. We have seen companies follow this downward spiral, including a few which have bounced back dramatically such as NetEase.com, an Internet portal operator in China and a client of our firm, which went from an IPO price of $15.50 to subsequently trading under $1 on Nasdaq and facing potential delisting in 2002 to trading well over $40 in recent quarters and the initiation of analyst coverage by several investment banks.
While being "in the orphanage" is almost the worst of all possible worlds, there is actually an even worse scenario that some unfortunate companies face: delisting from Nasdaq or the New York Stock Exchange due to a severe decline in the stock price for an extended period of time but remaining a U.S. public company. The U.S. securities laws are unusual compared to many other countries in that following delisting, U.S. companies with 300 or more shareholders, or non-U.S. companies with 300 or more shareholders in the U.S., will still be subject to all of the Securities and Exchange Commission's rules regarding public companies, including the periodic public disclosure requirements. The shares of such companies usually fall into trading obscurity on the U.S. over-the-counter markets which are reported on the so-called "pink sheets" or on an electronic bulletin board and have practically no liquidity at all. In our experience, it is extremely difficult for companies which have slipped down to the over-the-counter markets to make it back on a major exchange.
Companies caught in this trap have a Hobson's choice of either continuing to devote time and money to complying with the U.S. securities laws without enjoying any of the benefits or taking the company private again, which typically involves a commitment of time and money that almost approaches what was required for the IPO itself. It is also important to bear in mind that the going private process itself often attracts lawsuits from dissenting shareholders. The discovery process in such litigation would, subject to any available privileges and local law, lead to plaintiffs' access to all the company's internal documents and plans for the transaction. This may also lead to discovery of documents relating to the company's broader strategic deliberations. Accordingly, regardless of the method employed to go private, certain procedural safeguards should be employed (and documented) in the event the fairness of the transaction is challenged by shareholders. In particular, companies typically form a committee of independent directors to evaluate the price to be given to shareholders, who in turn engage an investment bank to render a fairness opinion.
Despite the expense and risk of going private, we have seen increased interest in this topic by companies that went public during the dotcom boom and were subsequently delisted in the bear market. Beyond the elimination of costly public disclosure in the U.S., the oft-cited advantages of going private include:
- potentially making other financing opportunities available,
- relieving management of the pressure to raise the share price in the near term and instead allowing them to focus on long-term growth and strategies,
- increasing confidentiality regarding the company's business because there will be no further required public disclosure,
- reducing shareholder servicing costs because there is a smaller shareholder group, and
- lessening the possibility of shareholder lawsuits following the going private transaction because there will be no more SEC disclosure (and therefore fewer bases for lawsuits) and simply fewer shareholders to initiate a suit.
Staying out of the Orphanage
Staying out of the orphanage is thus critically important to the success of U.S. public companies. To do this, management and the board should be ready to commit themselves for the long-term to not only growing the company and meeting analysts' expectations, but also to:
- maintaining a seasoned, international caliber management team that can effectively communicate the company's message to analysts, institutional investors and the public at large,
- working closely with outside counsel and other advisors, ideally in conjunction with an internal multi-department disclosure committee of the company, in developing consistent public disclosure which accurately informs the public about material developments regarding the company, without creating potential bases for future class action litigation in the U.S. (e.g., overly positive forecasts of future product developments),
- developing a corporate culture that consistently adheres to the company's internal controls and procedures, and thereby helps to minimize the possibility of an accounting restatement which is another red flag for U.S. class action litigation (including against companies with operations in China, which is increasingly common), and
- causing management, the board and key board committees, in particular the audit committee, to allocate sufficient time in working with outside legal counsel and auditors to ensure that the company's periodic public disclosure filed with the U.S. Securities and Exchange Commission is complete and accurate.
Conversely, management and boards need to avoid falling into the trap of effectively conducting a never-ending road show to promote the company's message, which diverts them from the fundamental activity of actually running the company's business and thereby substantively improving the content of that message.
One other tack that many non-U.S. companies take to further bolster institutional interest and liquidity in their shares is to list their shares in a second market, which for Chinese companies will usually be the Hong Kong Stock Exchange. This second listing is usually done at the same time as the U.S. listing, but can be at a later stage as well.