Cheat sheet

There are over 100 Chinese companies on US exchanges that got there by way of the now-infamous reverse takeover (RTO). Many of these firms are unique in the amount of wealth they have destroyed for those who bought their shares in good faith. Nevertheless, they provide insight into financial irregularities that are present in other Chinese firms, including some that did not list through an RTO.

For reference, opposite is a list of the RTO firms with the largest market capitalizations on major US exchanges. Depending on the investment thesis, these companies are either ripe for shorting, or cheap stocks with the potential for recovery in the longer term.  Investors considering dabbling in them or other Chinese firms should be aware of these typical governance risks:

Related-party transactions

Chinese companies listed in the US often fail to meet disclosure requirements for related-party transactions. The seriousness of transgressions can vary wildly; some companies fail to disclose out of ignorance, while others are trying to hide the fact that funds are being skimmed off the top.

Exaggerated market position

It is difficult for investors based in the US to independently verify claims made in a Chinese company’s annual report. The company might say it is the national market leader in a certain product category but a site visit reveals production facilities that are incapable of meeting the reported output scale. Further channel checking might reveal that products cannot be found in shops; that consumers have never heard of the brand; or that suppliers, distributors and other customers either don’t exist or have little or no relationship with the company.

Inflated revenue figures

A company exaggerates its market position to justify inflated revenue figures which are, in turn, intended to stimulate investor interest. Short-seller research firms often use the due diligence processes outlined above to call into question listed companies’ financial reports. Anecdotal evidence abounds of companies being encouraged by promoters, investment banks and private equity investors to massage the numbers in order to achieve higher multiples and generate fees for their advisors.

Contradictory SEC and SAIC disclosures

Onlookers often point to disparities between financial statements made to the US Securities and Exchange Commission and the Chinese State Administration of Industry and Commerce (SAIC) as a warning sign. However, discrepancies in these filing don’t necessarily indicate that a company is deceiving investors. Companies must file their most recent audited financial statements with the SAIC to obtain business licenses. However, the SAIC – unlike China’s State Administration of Taxation – is not obliged to verify these statements. Furthermore, the SAIC doesn’t require companies to submit consolidated financial statements; each subsidiary can register separately. Companies sometimes defend discrepancies in information reported to the SAIC by saying that they didn’t want commercial information falling into the hands of competitors. Some market watchers dismiss this as a convenient excuse.

Cash problems

Keeping track of cash has been one of the biggest challenges facing auditors of Chinese RTOs. The worst case scenario is that the entire cash consideration process is corrupt. Faking receipts is not difficult and there has been no shortage of employees at local bank branches willing to turn a blind eye in return for a red envelope. In some cases, auditors have resigned after companies refused permission for receipts to be verified with a bank headquarters. A centralized, more automated system to keep track of company finances is badly needed.