"On the Road" from China to NASDAQ: Perspectives from the Front Lines
The past twelve months have seen a tremendous increase in the number of China-based private companies and PRC state-owned companies accessing the U.S. capital markets, including Hurray! Holding Co., Ltd. and Linktone Ltd., which Morrison & Foerster LLP represented in their global IPOs and concurrent NASDAQ listings, and KongZhong, in which Morrison & Foerster LLP represented the lead underwriter UBS Investment Bank. At the same time, corporate governance compliance has become increasingly involved due to the adoption of the Sarbanes-Oxley Act. In this environment, it is critical for companies, investors and underwriters to focus on the right issues in preparing for a successful IPO and maintaining a successful track record after the IPO. As advisors to some of China’s leading technology companies, private equity investors and underwriters, we offer the following practical observations:
Implement best practices in corporate governance
In the Sarbanes-Oxley era, several Chinese companies, fresh from a successful IPO, quickly lost their sheen in the aftermarket as they became subject to intense regulatory scrutiny and litigation related to their alleged failures to adopt best practices in corporate governance. In the wake of such experiences, the US capital markets have heightened corporate governance expectations for the next wave of Chinese companies in the pipeline for a NASDAQ listing. It is imperative that the Company’s directors, officers and shareholders apprise themselves of and implement such best practices from the outset.
Plan early to fill any open independent directors and key management slots
Companies that are publicly listed in the US are subject to significant obligations and potential liability. NASDAQ rules currently require all members of audit committees be independent directors. NASDAQ rules that will become effective for Chinese companies as of July 31, 2005 will also require that a majority of the board be independent. Companies operating in China find that it can be challenging to locate suitable independent board members and experienced managers. Companies should take steps to identify and fill, as early as possible, any gaps that may exist in its board and management team so that the company can comply with these demands. In particular, companies and their boards need to make sure they have in place qualified management in the areas of financial reporting (e.g., chief financial officer and financial controller), publicity (e.g., investor relations officer), and legal compliance (e.g., in-house legal counsel).
Bring in experienced auditors early
China-based companies can present a variety of challenging accounting issues. Failure to address important issues such as revenue recognition methodology and accounting for acquisitions in advance of the IPO will result in increased expense and, more importantly, a delay that may cause the company to miss a critical window to get the deal done. Involving experienced accountants early on is critical to avoid loss of momentum later in the IPO process.
Effectively manage stock option grants and pricing
The SEC will closely review all option grants within the one-year period prior to the IPO, with a particular focus on any grants after the company has begun discussions with underwriters. Currently the SEC will deem the fair market value of options granted during this period to be the IPO price, often resulting in significant compensation charges for options granted months before an IPO was contemplated and at strike prices well below the IPO price. These compensation charges can affect the company’s financial presentation and, to some extent, marketing of the offering. Companies should coordinate closely with counsel and accountants to:
- ensure that option plans and agreements are in an appropriate form to facilitate desired accounting treatment under US rules;
- address any issues presented by prior option grants; and
- plan appropriately for any new grants or plans.
Manage publicity carefully
The SEC is increasingly active in monitoring pre-IPO publicity of companies in registration. Historically, many China-based companies assumed that they were beyond the focus of the SEC and therefore could leverage looser practices common in Greater China. This is no longer the case. The SEC has made clear that it is willing to delay offerings or require revision and recirculation of prospectuses in certain cases of inappropriate pre-offering publicity. For example, statements made by China-based companies on their websites constitute re-publications into the United States and accordingly are subject to scrutiny by the SEC. Companies should consult closely with counsel regarding publicity activities throughout the IPO process.
Plan and implement any restructuring transactions
Chinese companies that list in the US often undertake a restructuring process in order to facilitate the offering of shares from an offshore vehicle. Since the process can involve significant lead time if PRC regulatory approvals are required, companies should begin any needed restructuring transactions early with the assistance of legal counsel and other professional advisors.
Secure adequate directors and officers insurance
Although directors and officers (D&O) insurance is expensive and available only from a very limited group of insurers, it is an important tool to recruit and protect qualified directors and executives of a China-based company. Given variations in D&O policies, directors and executive officers should understand the protections that are appropriate for their companies’ needs and acquire appropriate coverage.
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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