Directors Refuse to Go Naked for Chinese IPOs
Stephen Markscheid holds one of the riskiest jobs in the world -- or so say insurers.
The 59-year-old former banker, a Mandarin-speaking American, sits on the boards of five U.S.-listed Chinese companies, including JinkoSolar Holding Co. (JKS)
The group of about 500 Chinese firms came under scrutiny over the past two years as a rash of accounting scandals and irregularities sent shares tumbling, sparked investor lawsuits and halted new stock offerings on U.S. exchanges. The U.S. Securities and Exchange Commission has revoked more than 50 Chinese company registrations since early 2011.
“The work that I’m doing now, it’s not for the faint of heart,” said Markscheid, who travels to China for board meetings from his home near Chicago, in Wilmette, Illinois, eight to 10 times a year. “I’ve been sued quite a few times.”
As a result, the cost of insurance to cover directors and officers of Chinese companies against lawsuits has skyrocketed, with premiums reaching as high as $100,000 per $1 million of coverage in some cases, up from a range of $10,000 to $15,000 a few years ago. Now, as Chinese firms start listing in the U.S. again and the pace of lawsuits slows, insurance carriers are still charging higher rates and have imposed stricter policy terms, according to brokers, underwriters and directors.
Buyers of the coverage are “really getting socked,” said Brendan Dolan, an Irvine, California-based senior vice president at Willis Group Holdings Plc (WSH)’s North America unit, who has brokered policies for Chinese companies since 2005. Insurers are “being opportunistic, because they know they can.”
Rising costs for directors and officers, or D&O, policies have led some Chinese businesses to look at scaling back coverage, said Markscheid. One of his companies, which he declined to identify, did so recently. After speaking with a broker, he said he was comfortable with the lower limit.
“I don’t know of any directors who would go naked and serve on a Chinese company board without the benefit of D&O insurance,” he said. “I certainly would not.”
Chinese companies are again lining up to seek U.S. listings as the Standard & Poor’s 500 Index hit a record high in May. Regulators in China suspended initial public offerings there.
The first Chinese company to go public in the U.S. this year, LightInTheBox Holding Co. (LITB), raised $78.9 million in a June 6 IPO. The Beijing-based online retailer has soared 81 percent since then in New York.
GDC Technology Ltd., a maker of digital-cinema equipment backed by Carlyle Group LP, has filed for an IPO in the U.S. EHi Car Rental, a vehicle-sharing network, is also planning an offering, people with knowledge of the matter have said. Analysts are also anticipating an IPO by Hangzhou, China-based Alibaba Group Holding Ltd., the online retailer. Spokesmen for LightInTheBox and Alibaba declined to comment on insurance or other IPO-related costs.
Chinese companies looking to sell shares in a U.S. IPO can expect to pay more now for D&O than they would have before the lawsuits, said Dana Kopper, a Los Angeles-based managing director at broker Lockton Cos.
Most of the Chinese companies bought a total of $5 million or less in protection to defend all board members and top managers against suits, though some with directors living in the U.S. obtained more than $50 million, Willis’s Dolan said.
The prices Chinese companies pay now are about two-to-three times more than what a comparable U.S.-domiciled business would face, said Dolan. Retentions are also higher, meaning Chinese firms have to spend more out of pocket before their policies cover a claim, he said.
Cole Capener, a former corporate lawyer who resigned as a director of China Medical Technologies Inc. in 2007, isn’t taking chances either. He said he’d have to be convinced that a company had enough coverage and good governance to be persuaded to join the board of another publicly listed Chinese firm.
Investors sued China Medical, Capener and other directors, saying that the company made false statements about its cash balances and that revenue was inflated through “fictitious sales.” Capener, 57, said the case was groundless and that he resigned to focus on his charity and over disagreements about the role of the board. The suit was dismissed last year, after China Medical filed for bankruptcy.
“What’s happened is a number of companies that haven’t been playing by the rules have been caught,” said Capener, who splits his time between Park City, Utah, and Beijing. “Unfortunately, it has tarnished the image of the other companies that are better at compliance.”
XL Group Plc (XL), one of the insurers that’s still underwriting primary D&O policies for Chinese companies listing in the U.S., has also raised rates and boosted retentions. Bernie Horovitz, global head of professional operations at Dublin-based XL, said the premiums his company charges are justified given the volume of claims and continued litigiousness.
“There is a heck of a lot of risk in writing these accounts,” he said. “Plaintiffs’ attorneys are looking at these companies to make the slightest mistake and jump in.”
Prior to the wave of lawsuits, rates for D&O coverage had been falling for public companies in general because of competition among insurers. That meant revenue could decline at carriers keeping the same clients. Chinese companies accessing U.S. capital markets were an opportunity for more sales.
In 2010, short sellers including Carson Block, who runs Muddy Waters LLC, began targeting Chinese companies listed in the U.S. and Canada such as Rino International Corp. and Sino-Forest Corp., saying that they manipulated financial information, embezzled money and lied about factories and customers. That sent a gauge of the stocks tumbling from its January 2011 peak.
Rino, which lost most of its market value, agreed to settle an SEC lawsuit that claimed two executives diverted $3.5 million in company funds to buy a home, luxury cars and clothing. The executives, who didn’t admit or deny the allegations, will pay investors at least that sum, according to court filings in May. Sino-Forest filed for bankruptcy protection last year.
In addition to revoking registrations, the SEC has filed fraud cases against more than 60 companies and executives as part of its investigation into Chinese firms. Many entered U.S. capital markets through reverse mergers, in which a closely held firm buys a shell company already public on an exchange, allowing it to list without the scrutiny of a public offering.
As the lawsuits spiked, insurers began telling Chinese clients that they would let D&O policies expire without writing new ones, said Kopper. Chubb Corp. (CB) stopped renewing coverage in mid-2011 because of what it believed to be inadequate prices, said Mark Greenberg, a spokesman for the Warren, New Jersey-based company. Allied World Assurance Co. (AWH) said it stopped writing new business on Chinese reverse mergers in September 2010 and began letting contracts run off in early 2011.
“Fortunately, we were somewhat ahead of the curve,” Thomas Kennedy, senior vice president of public D&O for Allied World U.S., said in a statement. “We began seeing lawsuits on this coverage later in that year.”
The higher prices are persisting even as the number of new lawsuits tapers. There were 18 new U.S. federal securities class-action filings in 2012 against companies with headquarters in China, compared with 40 in 2011, according to a report by consulting firm Cornerstone Research and Stanford Law School in January. The majority of the decline was from a decrease in filings related to reverse mergers.
“The dust seems to be settling,” Kopper said. “People are still very nervous, but they are realizing that there are valid, worthwhile and underwritable risks in China.”
The lawsuits prompted carriers to change policies and be more selective about which risks they insure, said Louis Lucullo, global head of D&O underwriting at American International Group Inc. (AIG), one of the largest sellers of the coverage worldwide. Still, some of the initial settlements have been “modest,” he said, giving underwriters more confidence.
“Some carriers are going back cautiously,” Lucullo said, adding that AIG “remained in the space” by focusing on risk selection, rate and managing the limits it extends to clients.
For Markscheid, who previously worked at Chase Manhattan Bank and is on the board of China Integrated Energy Inc., the higher insurance prices are reasonable based on the risk. While the lawsuits have made the work more dangerous, the insurance, indemnification and his own conduct give him confidence.
“If I’m not incompetent, negligent or dishonest, I think my exposure is limited,” he said.
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