Governance is Key for Chinese IPO Success in U.S., Experts Say

June 5, 2013, 4:16 PM ET

Governance is Key for Chinese IPO Success in U.S., Experts Say

Ben DiPietro

Wall Street Journal

Demonstrating good governance practices will be a key component in determining whether Chinese companies will have success in their latest attempts to break into U.S. capital markets with initial public offerings, governance experts say.

The U.S. market for Chinese company IPOs petered out in 2011 after problems with accounting  led to the delisting of five Chinese companies.

That was followed by a dispute between the Securities and Exchange Commission and the affiliates of five U.S.-based accounting firms, which refused to hand over work papers for audits in China, saying Chinese law prohibited them from doing so.Those two events were enough to spook U.S. investors, but a WSJ story this week about some Chinese companies considering the U.S. for their IPOs indicates a renewed effort by Chinese firms to raise money in the U.S.

To be successful this time, Chinese companies are going to have to show a willingness to adopt U.S. best practices regarding governance, risk management, financial controls and transparency, David Thelander, managing director of Promontory Financial Group LLC, said.

Chinese companies need to think hard about whether their governance, risk management and compliance oversight programs are strong enough to attract the appropriate investor interest, Thelander said. “Chinese companies have to take very seriously their obligations to have an effective, strong corporate governance in place, and the internal financial controls necessary to meet U.S. standards,” he said. “They need to really learn about U.S. practices and seek a strong outside perspective on those leading practices.”

That won’t be easy, given the differences in Chinese culture and American culture, said Donna Boehme, a principal at Compliance Strategists LLC, a compliance and ethics consulting firm.

“Chinese companies typically have a hierarchical ‘command and control’ management style that clashes with a culture of open and transparent environment fundamental to Western notions of internal compliance and ethics,” Boehme said, citing as examples confidential employee reporting lines and nonretaliation. “It remains to be seen how traditionally managed Chinese companies can learn to self-govern when part of the ethos of good internal controls is the ability of employees to raise concerns safely and openly.”

To make this shift will require a “sea change” in how Chinese companies do business, Thelander said.

In addition to issues of transparency and governance, Henry Balani, managing director of risk solutions at Bankers Acuity, said Chinese companies have to weigh the benefits of being able to raise capital in the U.S. with the burdens of having to adhere to U.S. rules regarding anti-money laundering, bribery and even the Patriot Act.

“Any company listing in the U.S. needs to consider how does the Patriot Act affect them,” Balani said. Under the Patriot Act, U.S. regulators can demand access to financial records even if the records are outside of U.S. jurisdiction “so Chinese companies looking at an IPO need to consider the impact of that. Are they willing to share that information or sensitive financial data with U.S. regulators when it is demanded?”

The boards of Chinese companies may be willing to adopt these more open practices to gain the benefit of not only more investment, but the cache and enhanced reputation of listing in the U.S., Balani said. “At the board level it’s about reputation… there is an enhanced reputation in the Chinese market for companies able to raise an IPO in the U.S. The value creation is there from a board perspective. The question is, are they willing to take the risk?”

To gain the trust of U.S. investors, Chinese companies must make sure they hire reputable auditors to avoid the problems that plagued the companies delisted a few years ago, said Reena Aggarwal, professor of finance and business administration at Georgetown University’s McDonough School of Business.

Big institutional investors also will want to see how independent the boards of these Chinese companies are, and will want to see these businesses doing more than meeting the minimum requirements of Sarbanes Oxley’s 50% threshold for independent board members, Aggarwal said.

“Especially for Chinese companies, they need to prove they do have strong governance and are willing to adopt higher the governance requirements in the U.S. That can be quite satisfying for large institutional investors,” Aggarwal said.

There are some hopeful signs these changes are occurring. The U.S. Public Company Accounting Oversight Board last month reached an agreement with regulatory authorities in China to allow the board to review audit records and other documents of Chinese audit firms. And U.S. regulators and Chinese companies reportedly have agreed on language in IPO prospectuses warning investors about the potential downside of using a Chinese-based auditing firm.

None of this will happen overnight, and will require executive-level commitment, Thelander said. But a lot is riding on the outcome of the success of these initial IPOs, as the market may again dry up if they don’t adopt strong governance programs.

“There will be a healthy dose of investor scrutiny,” he said. “A lot depends on the experience with these initial companies now coming out.”