PERILOUS EXPANSION
As Chinese companies grow overseas, so too does their exposure to legal risk in foreign markets.
By Mike Hanley

When ASIMCO, an auto parts company based in China, moved its production lines in the US and UK back home to the People’s Republic, it discovered a whole new world of liability. ASIMCO’s customers – automakers based in China, the US, and Europe – had been happy with its products when they were manufactured in their home markets, but when it made the switch to China in January 2006, the defect rate shot up to over 50%. It turned out to be a transitional problem that was sorted out very quickly. By March this year ASIMCO had brought the defect rate down to around 2% – but not before the company had leapt some expensive hurdles.

“Had these issues been in China it would not have been of concern,” says Kern Lim, CFO of the US$320m in revenues industrial conglomerate. “The level of quality demanded in the US is very different from that required in China’s domestic market. Customers such as Bosch, Cummings, GM, and Ford have very high demands. We had to learn from a very painful experience.”

Luckily, the company nicked the quality problem in time to airfreight out replacements before the defective parts made it into any car. But for Lim, the near-miss highlighted a fact that gives many CFOs of Chinese companies sleepless nights: the risk environment outside China is significantly different from that which Chinese companies face at home.

Risk management as an operational tool is well developed in most Western and many Asian markets, but in China it is just beginning to emerge. While Chinese companies are in growth mode, they tend to focus on costs and delivery, and risk issues come last. But many in the risk-management and insurance industries think that CFOs of Chinese companies with global ambitions would benefit from the kind of awareness that Lim gained from his close brush with disaster.

In particular, many in the insurance industry are saying that as Chinese companies head offshore in increasing numbers, often intending to list on overseas stock exchanges, CFOs need to develop a deeper understanding of the liability regime that exists in mature markets such as the US and the European Union, and the role of those legal strictures as regulators of market capitalism. In China issues such as safety, product, and fiduciary standards are regulated solely by the various levels of government; in the US, Europe, and other developed market economies, the legal system takes care of much of these.

Chinese companies, in other words, may not fully understand the increased legal risk that is marching in step with their global ambitions. No surprise, then, that an increasing number of consultancies and risk management service providers have emerged to make them aware – and mitigate the risk if necessary.

Global risk and insurance specialist Marsh, for instance, recently created a new business division whose purpose is to help companies grasp the differing risk regimes that apply inside and outside of China. “For Western companies going into China the regulatory environment is very mysterious,” explains Paul Clifford, New York-based director of Marsh’s China Client Services. “There has always been a mystique around doing business in China and the risks that companies face when they go there. The same is true for Chinese companies going offshore – the legal and business environment is just as complex and mysterious, but the risks come from different sources.”

Eric Gan, casualty facultative portfolio manager for Greater China at Swiss Re, a global reinsurer, says that there is a clear trend for Chinese companies to face greater liability exposures than their Western competitors, simply because they don’t understand how the system works. “In the US, lawyers operate under a contingency fee system,” he says. “They have nothing to lose by suing you. In particular, Chinese companies face real issues in their manufacturing systems – are they able to track a particular product to a particular batch? What are their product recall systems like? Can they identify the steps in manufacturing that might have led to a particular fault?”

Issues like these become crucial in mitigating the legal risks firms face when distributing into litigious markets such as the US. “CFOs need to understand that a US lawsuit will have a critical impact on the bottom line. Claims of US$10m are not unusual in the US system,” says Gan. How companies handle claims is immensely important to the outcome of any lawsuit, and these things have to be worked out to the last detail before an event, says Gan.

Listing risks

The increased number of Chinese companies listing on foreign stock exchanges has made the issue more urgent. Raising capital offshore demands a higher level of transparency and accountability, and, increasingly, personal liability for company directors and officers. Issues such as the loan scandal that engulfed the Bank of China’s Hong Kong subsidiary following its 2003 listing, or the dodgy accounting that emerged following China Life’s IPO the same year, have highlighted the exposure shareholders take on when they buy into Chinese stock offerings. In markets such as the US, shareholders who suffer will not be slow to call their lawyers.

The increased profile of the risks of going to market has led to the creation of an entirely new kind of insurance – IPO prospectus liability insurance. Offered by the major brokers, directors can be covered for the risks of shareholders suing for errors and omissions in IPO documentation that cause shareholders to lose money. “Five years ago we wouldn’t have seen any interest in this kind of insurance,” says the head of Marsh’s Greater China operations, Paul Wilkins. “But there has been so much focus on going to market that we have seen interest where there was none.”

The new exposure has also created an increased appetite for director’s and officer’s (D&O) insurance. D&O covers personal liability for risks such as the company’s failure to comply with stock exchange and corporate governance requirements, transparency relating to problems in published financial statements, and insider trading.

Two main kinds of companies comprise the market for D&O coverage in China – large state-owned enterprises listing in Hong Kong and on the New York Stock Exchange, such as China Telecom and China Unicom, and smaller, more enterprising dotcom and technology companies listing on Nasdaq. Underwriters in China say they would much rather write a policy for the latter type of company – despite the fact that SOEs tend to have much more stable business and cash flows.

“The state-owned companies do have a systemic issue with transparency,” says Patrick Zhang, a D&O insurance underwriter in Beijing for American International Underwriters, a subsidiary of international insurer AIG. “Because they are controlled by the state government, and many of their operations in China are protected by the state government as monopolies, there is scope for conflict of interest with their shareholders.” Of particular concern is the fact that companies listing a minority of their shares can inject assets into the company or change directors without consulting public shareholders.

On the other hand, Nasdaq-listed companies tend to be headed up by entrepreneurs, many of whom have been educated in the US or Europe, and have a good understanding of corporate governance requirements. The underwriting process is more complicated, because these companies present “bubble issues” and cash flows aren’t so stable, so insurers need to have a deeper understanding of the business and the individuals themselves, but the level of comfort is greater, says Zhang.

Holistic Risk Management

“Over the past 15 years, companies in developed markets have sought to amend their risk management strategies by integrating their insurance coverage with extensive programs to monitor and mitigate operating risk,” says Wilkins. “Chinese firms are just beginning to follow and their encounter with hostile risk environments offshore is a major thing nudging them in that direction.” The China Insurance Regulatory Commission (CIRC) has also made public pronouncements urging Chinese companies to build better risk-management strategies.

“Most Chinese companies do not have risk management, and don’t understand the real meaning,” says H D Shen, insurance manager at Huawei, the US$3.8 bn telecoms equipment manufacturer. While most risk managers in Western companies report directly to their CFOs or other board-level directors such as general counsel or company secretary, the Huawei manager reports into the finance department through the asset management division.

Not everyone agrees with Shen. “China has been open for the last three decades, and many companies have been going abroad,” says Steven Zhang, general manager of the Beijing branch of Zurich Insurance, which was granted an insurance license in late May after many years of negotiating with the Chinese government. “For the SOEs, the Chinese government has strict risk controls, and risk management is a priority for managers of these companies.”

For now, however, risk-management service providers are siding with Shen as they urge Chinese companies to move fast to reduce their exposure.