Accusations of fraud against foreign-listed Chinese companies are multiplying. Should investors put up with the risk or run away?
On June 2, a company called Muddy Water released a report accusing Sino-Forest, a Chinese forest-plantation operator listed on the Toronto stock-exchange, of flattering its accounts by massively overstating its timber holdings. ‘A stratospheric fraud’, Muddy Waters claimed. Ruffled investors dumped the stock, and the company’s shares lost 78% in a few days.
The story grabbed the headlines mainly because John Paulson, the main shareholder of Sino-Forest, lost $110m after he disposed of all his shares - a massive blow to the star fund manager who predicted the subprime crisis. Yet concerns of fraud among foreign-listed Chinese companies are not isolated. Other big-name investors, such as Fidelity or Carlyle Group, have recently suffered losses on their investments amid doubts over the truthfullness of Chinese firms’ finances and operations; more are currently carrying out investigations.
Inevitably the incriminated firms always deny any wrongdoing. But whether true or not, such stories have opened foreign eyes on a plain fact: nobody really knows what’s going on (or not) in China - even when a Chinese company, listed abroad, should have been subject to rigorous investigation. This raises at least three questions. How extensive is the problem? Who is to blame? And how should investors react?
Judging by the sheer number of cases recently disclosed, the problem is worth being flagged up. The Security and Exchange Commission (SEC) is currently investigating accounting and disclosure at some Chinese companies listed in the US, and has already suspended trading for 11 of them. More than a dozen have been suspended on other exchanges, and reports show that Chinese companies represent the vast majority of delisted companies on US exchanges.
But what’s more frightening is the potential number of cases yet to be discovered. In the US alone, more than 900 Chinese firms trade on exchanges and smaller forums - comparing with fewer than 2200 companies listed in the whole of mainland China. This reflects the huge appeal of a US listing for Chinese entrepreneurs: with restricted access to credit at home, and given the legal and political hurdles to go public on domestic exchanges, tapping into the highly liquid, wealthy American markets is a tempting option. Local communist officials indirectly encourage this, by rewarding entrepreneurs who secure prestigious US listings with generous subsidies. The financial crisis, in addition, has developed a Western apetite for exposure to China’s fast growth, so investment funds have eagerly welcomed Chinese listings on their home turf.
But in their haste and eagerness Western investors have sometimes overlooked the fine print. Most Chinese entities quoted on US boards have been using a mechanism called ‘reverse mergers’, in which a private company goes public by taking over a listed shell company floating in America. This process allows the firm to sell shares to US investors without the constraints of a direct IPO, which usually involves stricter regulatory scrutiny and requirements. The task of taking the company to the market is thus left to private accountancy firms and auditors, and investors have to engage their own means if they want a deeper due diligence.
Yet this is where the problem lies. With so many Chinese firms eager to get listed on US exchanges, the intermediaries and auditing structures responsible for carrying out this research have trouble keeping up. Most of them are small, lacking the resources and knowledge to lead extensive investigation; in a majority of cases, they have to outsource their audit work to local companies or consultants. US regulators themselves are unable to provide assistance as they are not allowed to carry out investigation in China. This has resulted in a rather opaque environment, where investors know as little about their target company as about who actually audits them (if at all).
New actors have been quick to spot there an opportunity to get rich. Short-sellers, who make profits when a company’s share loses value, have started to release reports on alleged Chinese fraudsters, and made massive gains. Carson Block, funder of Muddy Waters, is one of them: his reports have so far targeted 5 firms, and each time investors have given credit to his accusations by dumping their stock. Promoters of reverse mergers and Chinese entrepreneurs question the motives of short-sellers, claiming they aim to shock the market with defamatory reports. Yet many of their accusations have turned out to be credible.
Besides, this is not really the point. The real issue, indeed, is not whether Muddy Waters and the likes turn out to be right - but that so far nobody can prove the contrary. Nobody really knows. And for this, the ones to blame are neither weak/lax American auditing companies (even if some of them have a history of dodgy practices) nor rapacious short-sellers (even if they sometimes back their claims with little hard proof). Rather, they are the Chinese companies that cheat in the first place - or rather, as exposed businessmen argue, they are the endemic corruption and weak rule of law that prevail on the Chinese market.
Most entrepreneurs in China are genuinely trying to run a sound business. Yet they are working in an environment where rules are far more flexible than those of Western markets: local and national Party officials pull so many strings in the economic and legal system that nurturing good relations with them is crucial, often more important than respecting the laws and regulations by the book. This sometimes involves being creative with the company’s accounts so as to follow their preferred narrative - a sort of compulsory fraud.
Also to blame is the intransigeance of Chinese officials themselves, who forbid American regulators to investigate firms based in China. Yet there lies the first reason for optimism: this week American and Chinese regulators met in Beijing to discuss whether US institutions will be allowed to carry-out due diligence on Chinese companies.
This possible step forward is born out of the will of American regulators to better police firms traded on their soil; but it also shows a change of attitude within the Communist party. Chinese officials have come to understand that fraud scandals of a few end up tainting all Chinese firms, and threaten to hurt everyone. At a time when Europe is struggling with weak growth prospects and a debilitating debt crisis, the US faces the end of quantitative easing and the brink of sovereign default, and China itself projects weaker growth as a result of tightening monetary policy, confidence in Chinese companies looks like the world’s life buoy in otherwise tormented waters. Their strength helped the world swim through the financial crisis without drowning - were a second recession to materialize Beijing knows they could be called upon once again.
China’s efforts might take some time to take root, though. In the meantime, the pressure is on the American side to strengthen regulation. The SEC is increasingly being asked to close an obvious loophole in what is the world’s biggest, most liquid equity market. Investors are also adopting wiser strategies: they buy shares in companies that pay dividends (which, according to recent studies, greatly reduces the odds of accounting fraud); invest in markets where the biggest loopholes have effectively been closed (Hong-Kong for instance); or turn to US companies with major operations in China, rather than proper Chinese ones.
Companies in the mainland themselves are going out of their way to show more integrity and alleviate investors’ anxiety, by contracting international auditing firms (PWC, in the case of Sino-Forest), paying dividends, or announcing share buy-backs. In the long-run, this might deprive short-sellers of a chunk of their business.
More efforts needs to be made. China must promote a culture that rewards transparency and good governance, by offering tax incentives to companies reporting accurately and taxing their net profit instead of revenues. Stricter financial rules need to be put in place, like transparent audits in state-owned companies, an option Beijing recently hinted it was considering.
Until these changes come to fruition a vast grey area will remain. Now that it has been partially exposed, concerns combine with high inflation and slowing growth as a factor of volatility in Chinese stocks - who knows to what extent and for how long. One thing is sure: foreign investors willing to find out the true story are not out of the wood…