LIABILITIES' LONG ARM
Faced with the increasing legal risks that come with a US listing, Asian issuers are thinking twice.
By Abe de Ramos

New York Stock Exchange CEO John Thain minces no words when talking about the impact of the Sarbanes-Oxley Act on the world's largest bourse. The corporate reform law, he declared on May 27, has put off some of the world's largest companies from listing on the NYSE. "Companies around the world are voting with their feet," he complained, citing two most common grievances: "The costs of compliance are too high. The risks of litigation are too great."

Four days later, corporate executives and securities professionals in Hong Kong listened closely to a lecture on the "dark side" of a US listing: class-action lawsuits. The talk, sought by the Hong Kong Securities Institute, came after American investors filed a securities class-action suit against China Life Insurance in March. They allege that the largest life insurance company in the mainland had failed to disclose accounting irregularities when it raised US$3 billion in American depositary receipts (ADRs) on the NYSE last December.

Although the case against China Life has nothing to do with any provision of Sarbanes-Oxley, the case demonstrates the increasing legal risks that are making potential issuers in the US think twice: empowered by stringent regulations, American investors are demanding better corporate governance practices from foreign companies, and they will not hesitate to bring to court those who they think fall short of their standards. "To some extent, the China Life case reflects a risk that's out there especially for non-US companies," says Marc Gottridge, a New York-based partner with law firm Lovells who spoke at the Hong Kong seminar. "There is now a very different approach to [securities class-action litigation] in the US than there was a few years ago."

For finance chiefs, the obvious risk lies in the Sarbanes-Oxley requirement that they certify the accuracy of corporate financial reports. "What you're going to start seeing is that the plaintiffs' bar will seize upon these certifications to say that the defendant did not just innocently or negligently make a false statement, but knew that those statements were false, or at least were reckless about it," Gottridge says. "This increases the odds that plaintiffs will in the future continue to name CFOs and CEOs as individual defendants, because of the controlling-person standard."

In the US in 2001, the latest available data, CFOs were named as defendants in shareholder class actions 67 percent of the time, versus 87 percent for CEOs and 69 percent for chairmen of the boards of directors, according to a PricewaterhouseCoopers report published in Chief Legal Executive magazine. The typical shareholder class action, the audit firm says, "alleges that corporate officers and directors artificially inflated their company's stock price by issuing false and misleading statements or failing to disclose material non-public information." A record 22 foreign companies were named in securities class actions in the US in 2002, from 15 in 2001. Of these cases, 77 percent were related to accounting, ranging from overstatement of revenues and assets to understatement of liabilities.

Cruise Control

In China Life's case, CEO Wang Xianzhang is a defendant, among other directors, while CFO Liu Jiade is not. The complaint alleges that China Life, the entity created by a restructuring by its parent, China Life Insurance Corp (CLIC), knew but failed to disclose that it and/or CLIC engaged in a US$652 million financial fraud, and that the National Audit Office of China was going to publish an adverse audit finding imminently. The NAO eventually did in March, three months after the IPO. "That caught a lot of people by surprise, because it happened so fast," says Gottridge. "If it happened a year after the listing, it probably wouldn't have gotten the notoriety."

China Life has made no statements to the press about the case, other than to say it will contest the case vigorously, and that the audit was carried out against its predecessor CLIC and not itself. (The restructuring, completed in June 2003, involved the transfer by CLIC of its bad assets to a separate entity, and the good ones to China Life.) Gottridge says China Life may have a valid defense. "It might be a good argument that [the fraud] isn't material, because these liabilities stay with the bad company, so why would that be material to the investors in the new company?" he says.

But Greg Terry, a partner at Lovells when this article was reported, says China Life may be vulnerable on one point. "My guess is the plaintiff's lawyers are going to [try to paint a picture of] a pretty inadequate internal regime for financial controls and disclosure," he speculates. They could pose the question: What controls were in place to make sure that, if someone from the NAO called your finance department and raised an issue, it was instantly reported to your audit committee?

Such internal systems are not normally required to be certified in Hong Kong and the rest of Asia. "In the UK, when a company comes to listing, you always get a long-form report (on the quality of internal financial controls) so that the (external) accountants would do a very thorough review," notes Jamie Barr, another lawyer at Lovells. "I think the same would happen in the US [because of Sarbanes-Oxley], but it's generally not done in Hong Kong and I would suggest that's quite a big gap."

Another risk that non-US companies seeking to list in the US should take note of, says Gottridge, is the extra-territorial reach of the securities laws. American judges are increasingly willing to consider the claims of non-US plaintiffs who may not have bought American depositary receipts (ADRs), but rather ordinary shares trading in Hong Kong, London, or Paris. What the courts have done in such cases, says Gottridge, is determine whether there was sufficient activity in the US related to the complaints, such as a roadshow marketing the foreign shares in the US.

"Even if the conduct entirely occurred outside the US, if the effects of that conduct were sufficiently severe in the US, that's enough reason to apply the US law extraterritorially," Gottridge adds. "Instead of just facing the US shareholders as your plaintiffs, you're potentially facing worldwide shareholders." He cites the case of French conglomerate Vivendi Universal, which settled a civil fraud case for US$50 million last December on allegations of false press releases, improper adjustments to earnings, and failure to disclose future financial commitments.

US lawyers are getting into the act. "They've figured out that European and Asian shareholders could actually become the lead plaintiffs in US litigation," says Gottridge. This happened in early June when a Dutch public service pension fund became the main complainant, seeking 156 million euros in damages, in a case against Canadian telephone equipment manufacturer Nortel Networks, which is currently embroiled in an accounting scandal amid investigations by US regulators.

Rock the Vote

In another sign that US shareholders are seeking greater governance from non-US corporations, the International Corporate Governance Network (ICGN), a lobby group of influential institutional investors including CalPERS, the California Public Employees' Retirement System, is demanding what amounts to equal voting rights for ADR holders. The organization floated a set of principles for a model depositary agreement in February.

Among other things, it calls for ADR holders to be recognized as owners of the underlying shares, to be given the right to vote them directly or indirectly through the depositary bank, and to do so without the need for a formal invitation from the ADR issuer.

Non-US companies often restrict the voting rights of ADR holders, in part because of their government's regulations on foreign ownership and control. It is common for depositary agreements to contain a provision on "auto" proxies, for example, giving management the authority to vote shares held by ADR holders. Thus, when Taiwanese telecommunications company Chunghwa Telecom floated US$1.5 billion in ADRs on the NYSE last year, it specified that the company chairman or his designee could vote all ADRs unless 51 percent of all holders voted the same way on an issue.

The ICGN move has won the support of the depositary banks themselves. "JPMorgan recommends that non-US issuers consider moving toward practices that increase investor access to the proxy process," says the investment bank in a position paper. Adds Sanjeev Nanavati, managing director at Citigroup American Depositary Services in New York: "Our view is that all shareholders should be given the same right, and there should be no discrimination." This is especially important as investors are becoming more cautious of new ADR issues.

CFOs had better consider these demands from institutional investors carefully. Public pension funds are growing more aggressive in filing class-action suits. From just four in 1996, the number of suits spearheaded by the funds jumped to 56 in 2002. And they can be expensive for plaintiff companies. Settlements in 15 cases in 2003 averaged out at US$120 million, in stark contrast to the US$7.5 million average settlement value of 85 other securities class-action cases where a public pension fund was not a lead plaintiff.

Risks and Rewards

All these - plus the financial costs of compliance to Sarbanes-Oxley - could well scare foreign companies away from the US market. Still, they must also weigh the potential rewards. The depositary Bank of New York, citing a study by research firm Oxford Metrica covering 767 depositary receipt programs between 1980 and 2003, says: "Companies that have launched [depositary receipt] programs on US exchanges have increased the value of their share prices in their local markets by up to 10 percent over one year, and have improved liquidity by 27 percent on average." For its part, Citigroup concludes in a 2002 study that "ADRs outperformed their home equity markets 83 percent of the time over the past six years."

No update of the Citigroup study has been made, but Nanavati says the principles behind the result of the study remain true. "Critical for that situation to operate is that you need a reasonable pool of liquidity in the other market, where people feel that there is an independent group of buyers and sellers who are making a price on that stock," says Nanavati. "The price of the stock in the US is simply not a reflection of the domestic price." There are also the traditional reasons why foreign companies look to the US market - to establish that they are now global, and to add to their credibility. "Credibility is an underlying business need," says Nanavati. "It does make a difference to say, 'I'm listed on the NYSE or Nasdaq; I comply with SEC regulations.'"

Of course, US shareholders will be the judge of that.