IPO VIEW-Risks mount from U.S. exchanges big China push

Fri May 20, 2011 6:20pm EDT

* Chinese IPOs pouring onto NYSE, Nasdaq

* Chinese companies pose risk to exchanges' reputation

* Reputation is key asset for exchanges

By Clare Baldwin and Alina Selyukh

NEW YORK, May 20 (Reuters) - U.S. stock exchanges make a lot of money from listing Chinese companies, but that business may come back to haunt them.

The revenue that these companies generate is so tempting that NYSE Euronext NYX.N and Nasdaq OMX Group (NDAQ.O) are scouring China for new companies to list.

But more listed Chinese companies are being accused of fraud, which could drag down the reputations of the stock exchanges that list them.

"The only thing the exchanges have, really, is their brand image," said James Angel, associate professor of finance at Georgetown University's McDonough School of Business. "If their brand image gets tarnished by fraudulent companies, it's going to make it really hard to attract listings."

Chinese listings have become more important to U.S. exchanges. They made up a quarter of U.S. initial public offerings last year, compared with 5 percent in 2006, according to University of Florida finance professor Jay Ritter.

When a company lists shares, the exchange gets steady fees, which can make a big difference to a bourse's profits. The major United States-based exchanges generate about a fifth of their global net revenue from listings. <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ SPECIAL REPORT-Chinese stock scams are latest U.S. import

link.reuters.com/xub59r FACTBOX-Chinese companies delisted or halted [ID:nN1099368] ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>

The exchanges might not have much direct legal liability when Chinese companies fail. Underwriters, lawyers and accounting firms, which do most of the due diligence on companies interested in listing in the United States, have a much bigger risk of getting sued.

But exchanges rely on their reputations to win new business. Companies want to list on the NYSE or Nasdaq because they believe there is prestige associated with such a listing.

"(NYSE and Nasdaq) have decided to sacrifice reputation for their short-term competition purposes, short term listing revenue purposes," said John Hempton, chief investment officer at hedge fund Bronte Capital Management in Australia, which has shorted Chinese stocks.

The exchanges acknowledge the importance of their image, and stress that listing in the United States is not easy.

"Some companies are going to want to come to the U.S. markets for the global imprimatur that it brings to a Chinese company," Nasdaq head of listings Bob McCooey said at a China-focused investment conference in New York this month.

"The SEC sets standards, the exchanges set standards -- they're the highest listing standards in the world," he said.

Nasdaq said in a statement it has rigorous listing criteria. "That doesn't prevent situations from arising," it said, adding that this is true of companies from any jurisdiction.

NYSE's co-head of U.S. listings Scott Cutler acknowledged that fraudulent accounts can shake confidence in markets.

"This is not an issue of the reputation of the exchange. This is an issue that goes to the veracity of financial statements," Cutler said, adding that the exchanges rely on financial statements that have been certified by company management, auditors and lawyers. "If fraud is not rooted out it will create a larger problem for China."

"The whole system relies on trust," he added. "We're looking at (it) for China and for all other markets, quite frankly, because this goes to confidence in the entire system."

ACCUSATIONS

One example of a recent Chinese IPO company that has had problems is water treatment equipment maker Duoyuan Global Water Inc DGW.N, which went public in June 2009.

In April, Muddy Waters Research, which publishes investigative reports about companies and seeks to profit from stock moves, claimed that Duoyuan forged its audit reports and does not have the distribution network it claims.

On the same day, the company's chief financial officer said he would leave the company to pursue another professional opportunity, according to a press release filed with the U.S. Securities and Exchange Commission.

A company spokeswoman said the report and the CFO's resignation were unrelated.

Since then, four of the company's six independent directors have resigned after raising concerns about management's cooperation with a review of its business practices, and law firm Skadden Arps withdrew as special counsel to the firm's audit committee and special investigation committee, a filing said.

Duoyuan Global Water shares were halted on April 20. A spokeswoman for the company declined further comment.

An even more recent example is financial software maker Longtop Financial Technologies Ltd LFT.N, a Chinese company that went public on the NYSE in 2007. Short sellers have recently published reports questioning financial and operating disclosures that do not seem to tell the whole story of how the company can be as profitable as it is.[ID:nN02259771]

The company held a conference call and issued two press releases refuting the reports.

SHORTING CHINESE COMPANIES

Some of the most passionate arguments that the exchanges put themselves at risk come from investors shorting Chinese shares, who have a profit motive.

Companies often argue that short-sellers have unfairly targeted them, but shorts have a track record of picking up on big problems at companies such as Enron and Lehman Brothers.

So far, most of the highest profile Chinese companies to flame out came to U.S. exchanges through the back door -- they sold themselves to shell companies that listed without any real business. These deals are known as "reverse mergers."

Investors know that these companies have not received the same vetting as a company that lists directly on a U.S. exchange.

But now the difficulties may be spreading to companies that did list directly on U.S. exchanges, such as Duoyuan Global Water and Longtop.

The risk for the exchanges is that fraud cases could sour investors on Chinese companies with better pedigrees, and perhaps make investors trust the exchanges' brand names less.

Some companies might switch their listing to other exchanges, including upstart competitors such as BATS Global Markets, which has filed for an IPO and plans to provide a platform for listings.

"If they let in too many fraudulent companies, that certainly is going to hurt the brand image of that U.S. listing exchange, and, in particular, if investors start to mistrust every Chinese company, other foreign companies may very well not want to list in the U.S.," said Georgetown's Angel.

Bronte's Hempton said he believes things may be getting out of hand.

"Once upon a time, the stock exchanges were a virtuous circle," he said. "They enforced laws which engendered trust and produced higher prices, and on it went...Now we're in a vicious circle in the U.S." (Reporting by Clare Baldwin and Alina Selyukh in New York and Rachel Armstrong in Singapore, additional reporting by Carlyn Kolker, Jonathan Stempel, Jonathan Spicer and Brett Gering in New York. Editing by Dan Wilchins and Robert MacMillan)

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