A growing number Chinese companies listed on US stock exchanges have faced accusations of accounting fraud, and in early June the SEC warned investors against investing with Chinese firms listing via ‘reverse mergers’. While securities fraud is nothing new, the levels seen in the past six months are of extreme concern in what is usually viewed as a healthy market. While over 20 US listed Chinese companies have been de-listed or halted so far this year, a number of others have been hit by the resignation of their auditors. Has the urgency of American investors to plough money into China, one of the world’s fastest growing economies, blinded them to the inherent risks, or are loose listing standards to blame?
Worrying trend
Warnings of fraud in US listed Chinese companies have grown in recent months. In January, the shares of China Forestry Holdings were suspended after the auditor KPMG informed the board of directors of possible irregularities in its accounting books.
On 11 April the SEC suspended trading in RINO International due to questions surrounding the accuracy and completeness of information contained in RINO’s public filings, and the company’s failure to report the resignation of its chairman, directors of the board and an outside lawyer and forensic accountants brought in to investigate allegations of fraud. The finger was pointed at Sino-Forest Corporation, a Toronto-listed forestry firm, on 2 June, after a short-seller accused the firm of inflating its assets. More recently, the unravelling of Longtop Financial Technologies Ltd highlighted the scale of the problem. The company regularly reported income that was slightly higher than executives’ predictions. The company also reported a stockpile of $412m in cash. However, mid-May saw the company’s chief financial officer resign in the midst of accusations of accounting fraud. Deloitte Touche Tohmatsu, the company’s auditor, also quit amid fears that it had been provided with false information concerning the company’s cash-flow. The SEC has since made moves to de-list the company.
Legal loophole
One may well ask how so many apparently ‘toxic’ Chinese companies have come to trade on the US stock market – thought to be one of the most tightly regulated. It turns out that many problem companies have listed by means of a legal loophole. Chinese companies looking to get into North American can take one of two paths: submitting a formal application, or employing the strategy of a ‘reverse merger’. In a reverse merger, a private company buys a public shell company which no longer operates, but which is listed on an exchange. The private company then sells its shares on the exchange through the approvals granted to the previously listed company.
Reverse mergers are arguably less demanding than going through a formal application to be listed, as the process is exposed to less scrutiny. Where the shell is an SEC-registered company, the private acquirer is not required to undergo an expensive and time consuming review by state and federal regulators – this process has already been completed by the public company. The process is also less costly. Where underwriting costs for an IPO often reach 7 to 12 percent of the total price of offered stock, the price for purchasing a shell company is generally around $50,000 to $500,000. A further benefit is that reverse mergers are less time consuming. When experienced professionals are employed to assist the process, a reverse merger can be completed within weeks. The speed and lack of scrutiny involved in the process, however, makes reverse mergers much more susceptible to fraud. According to the US Public Company Accounting Oversight Board (PCAOB) over 150 Chinese companies, worth $12.8bn, have entered US markets in this manner since 2007, with only 50 filing IPOs.
Rigorous requirements
The use of reverse mergers raises the question why, if it is difficult to list in the US through conventional means, do Chinese companies list there at all, especially at a time when China is opening up its own stock exchanges? Until recently, it has been difficult for Chinese companies to list in their home country. A two-year waiting list and rigorous requirements have made a US listing preferable for many, especially when the reverse merger is an option. Additionally, regulatory restraints mean that those companies that list in the US get the best of both worlds.
China does not regulate Chinese companies listing in the US. In addition, the state will not allow the US to come into the country to regulate auditing firms. While foreign-based issuers on US stock exchanges are required to file audited financial statements with the SEC, and the auditors of those financials are required to be registered with the PCAOB, to date the oversight board has been blocked from auditing Chinese firms. Chinese authorities cite concerns of national sovereignty as the motivation behind this.
It must also be asked, if there are so many concerns in the US, how bad might the situation be in other markets, particularly those close to China? Indeed, the Hong Kong Securities and Futures Commission (SEFC) released a report in late March on the role of investment banks in IPOs detailing examples of sloppy due diligence, poor disclosure and inadequate scrutiny of potentially illicit operations. Hong Kong relies on Chinese accounting firms to audit Chinese firms, and the rapid rise of Chinese firms seeking to list means there is a lack of qualified auditors to do the work.
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