Investor Relations: Lessons From an IPO Debacle

It wasn’t too long ago that Ernst & Young was in the news as it fought a lawsuit by the liquidator of bankrupt electronics company Akai. Today, the Big Four accounting firm is part of the headlines again – but thankfully not as the main protagonist. Ernst & Young has been asked by China Zhongwang Holdings to review the information and claims made in the aluminium-maker’s initial public offering (IPO) prospectus in April, when it raised a massive HK$9.8 billion (US$1.3 billion) in Hong Kong.

No one knows what Ernst & Young will say when it completes its review. But investors in Hong Kong and the U.S., regulators, analysts and the media will be closely parsing the report. A mainland newspaper has accused Zhongwang of misrepresenting its list of major clients in its IPO prospectus. The publication has since retracted the claim, but a new allegation has surfaced. One of Zhongwang’s customers, it is said, has links to the Chinese military, something that was not disclosed in the prospectus.
The whole thing may strike some observers as nothing more than a minor storm in a teacup. Aren’t investors over-reacting to what could well be an honest mistake, if indeed the list is not accurate, the result of an oversight or clerical error? It’s not as if Zhongwang is charged with falsifying its financial statements or making misleading statements about the prospects for its business going forward.
But this is the reality of the post-crisis world, which CFOs need to keep in mind particularly in overseeing investor relations. People are skittish and hypersensitive even to the appearance of deception or non-disclosure, no matter how minor, because they have become suspicious of business. Long-running pyramid schemes like Bernie Madoff’s, the demise of Lehman Brothers and other banks, the failings of regulators – all these have sapped confidence in the basic honesty of commerce.
Add to this the ease with which claims can be verified and disseminated through the Internet and other electronic means and you have an environment where the momentarily careless CFO can be tripped. The first lesson from the Zhongwang case is that a company must be very careful about each and every piece of information it puts into its IPO prospectus, or any other document, for that matter. The second lesson is that, if questions arise, executives must take swift action to clear things up.   
The Zhongwang Saga
Earlier this year, China Zhongwang Holdings’ decision to do an IPO was a hot topic of debate. Many questioned the wisdom of going public in a recessionary environment, even by one of China’s largest aluminium manufacturers. Based in Liaoning province, Zhongwang claims total assets of RMB8.9 billion (US$1.3 billion), employs more than 3,200 workers and can produce 500,000 metric tons of aluminium a year.
Zhongwang went ahead anyway, guided by UBS as the leading advisor, flanked by Citic Securities and JPMorgan as sponsors, and supported by Deloitte as the reporting accountant. 


The IPO was a success. It was the first IPO in nine months to tap over US$1 billion in capital on any global exchange and paved the way for other companies to go to market. The stock initially traded below its HK$7 IPO price in Hong Kong when trading started in May, but by June, it reached a high of HK$11.35, up 62%.
Then in mid-September, the mainland newspaper China Economic Observer alleged that Zhongwang had falsified IPO prospectus information regarding its customer base. It said that Shanghai-listed Baotou Beifang Chuangye, which makes railway carriages, was in fact not a major Zhongwang customer. Vincent Cheung Lap-kei, Zhongwang’s finance director, disputed the assertion.  
But Chen Tiangang, Baotou’s company secretary, in replying to a query by Hong Kong’s South China Morning Post newspaper, stated: “We had signed a contract with them, but it was not executed, because we didn’t get the [railway cars] order we needed to use their products.” In the story, the Post cited a Nomura research report that said Baotou Beifang had its supply contract with Zhongwang terminated this year because of a “restrictive policy” on extruded aluminium products used in freight wagons.
Meanwhile, the Observer came out with another story claiming that other customers named in the IPO prospectus did not actually buy from the company last year. This particular article was later retracted in response to demands by Zhongwang, but not before the company’s share price plunged 11% following the story’s publication.  
In October, Cazenove research analyst Ole Hui tried to verify the Observer’s claims. He interviewed Zhongwang’s top customers, but was met with conflicting claims. Xian Feibao Airport Equipment, which Zhongwang identified in its prospectus as a major customer, told Cazenove it mainly used steel. (Zhongwang does not say in its prospectus that it makes steel products.) But Cheung, the company’s finance director, wrote Cazenove in an emailed statement that “Xian Feibao is our customer in [the] aircraft segment.”
Another customer, Baoji Dekang City Railway Equipment, told Cazenove that it had bought materials worth between RMB400 to 500 million from Zhongwang last year. The rest of the companies listed in the IPO confirmed that Zhongwang was a supplier, Cazenove reported, although they did not verify the details of their orders. Hui concluded in a research note: “At best, the [interview] results are inconclusive.”
Despite the apparent inconsistencies, Zhongwang finance chief Cheung maintained: “Zhongwang confirms the accuracy of its operational and financial information.”
Military Links
In November, the South China Morning Post reported that Zhongwang actually supplied aluminium products to Baotou Beifang, which confirms Cheung’s statements. But the newspaper also noted that a Baotou subsidiary, Baotou Beifang Chuangye Dacheng Equipment Manufacturing, makes tank components for the Chinese military. (Baotou’s 2009 third-quarter report, which clearly indicates this military aspect of its business, can be viewed in Chinese here; see page 42.)
Questions arose as to which parts of Baotou’s businesses the aluminium was actually used for. In a response to the Post, Chen, Baotou’s company secretary, said that Baotou has been a regular customer of Zhongwang for years, but only for businesses other than railway cars. “This is a complex question,” he said, when asked what products were made from the aluminium. “We are part of a big manufacturing concern which makes many products.”

It is unclear whether Zhongwang knew what the Baotou subsidiary is using its aluminium for, since the company it was dealing with was the parent company, which makes railway cars. Still, the apparent military links, even at second remove, should have been disclosed if Zhongwang was aware that its aluminium was being used to make tank parts, say analysts, since the IPO was being marketed to American institutional investors, who might have concerns about such links.

Ernst & Young to the Rescue
To quell the storm of questions and demonstrate its commitment to transparency, Zhongwang asked Ernst & Young to independently review its IPO and its income tax documents for the financial year ended December 2008. According to the South China Morning Post, it was IPO advisor UBS that urged Zhongwang to do so.
To its credit, Zhongwang had not sat back and simply hoped that the negative publicity would go away. Besides hiring Ernst & Young, the company invited management representatives from four of its major customers to appear in a joint video press conference on November 11, when it announced its results for the third quarter and first nine months. Hong Kong does not require its listed companies to disclose quarterly results, but Zhongwang decided to do so apparently to show its commitment to transparency.
At the presentation, the customers vouched for the accuracy of transactions and their business relationships with Zhongwang as cited in the IPO prospectus. The company also had good news for shareholders. Turnover rose 8% to RMB9.6 billion from January to September, it said, while net profit jumped 48% to RMB2.4 billion (though the company duly notes that the profit number excludes “the effect of the one-off listing expense of approximately RMB36,558,000”).  
Still, the damage to Zhongwang’s reputation lingers. Nomura Securities, which had rated Zhongwang’s shares a ‘buy’, says it will stop following the company until Ernst & Young’s findings are published. One can’t help but wonder whether Zhongwang will clear its name or will be shown to have made more inaccurate statements.

Lessons From the Debacle

What can Asia’s CFOs learn from the Zhongwang saga? First, that inaccuracies and misrepresentations, no matter if inadvertent, can now be more easily found out. In the age of the World Wide Web, public documents can be accessed by digital means, even in a market seen as restricting information, such as China. It took this writer an hour of simple internet research to find a document clearly stating (in Chinese) that a Baotou subsidiary produces military tank components.

Second, recognise that a firm statement reiterating the wholesale accuracy of all your statements can backfire if it is not consistent with what others within and outside the company are saying. The Zhongwang saga was kept going essentially because of the apparent differences between Cheung’s and Chen’s accounts. There was apparently no coordination between the two companies in talking to the media.
Third, pro-active action can help dampen the fire, or at least buy you time. Zhongwang’s success in having the Observer retract its claims could have potentially brought closure to the issue. The company’s decision to release its third-quarter results was also positive, although the market will now expect it to continue the practice of quarterly reporting. Hiring Ernst & Young to conduct a probe is also smart -- if expensive -- and signals the company's confidence in the accuracy of its statements.
Of course, a lot hinges now on what Ernst & Young actually finds and whether its investigation is seen as complete and objective. It’s not only Zhongwang’s reputation that’s on the line here. Rightly or wrongly, UBS and the other financial institutions involved in the IPO may also be seen as not doing their job, if Ernst & Young finds inaccuracies, even though fact-checking may not really be part of what these institutions are supposed to do.
CFOs, you have been warned.    
About the Author
Angie Mak is online editor at CFO Innovation Asia.



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