The US Securities & Exchange Commission (SEC) surprised no one on April 6 with the announcement of a formal investigation into Chinese firms listed on US exchanges. Luis Aguilar, the SEC commissioner, said special attention would be paid to “back door” listings, also known as reverse takeovers (RTO). The news was shrugged off by the markets, which had already priced in the rumors that began circulating last December, but the investigation may yet cause an uproar.
In an RTO, an operating firm injects its assets into a defunct shell company that retains a valid ticker symbol, effectively listing the private company without requiring it to pass the more stringent auditing and disclosure requirements applied to initial public offerings. Since 2007, over 300 Chinese companies have listed in America this way, with 80 or so making it onto the main boards.
While there is no reason to doubt the repute of the majority of these firms, in the last six months several have become embroiled in controversies over suspect accounting standards. This has sparked concerns that the China RTO phenomenon is little more than a variation on the Chinese product scandal theme: fake companies painted to look like the real thing.
Recent investigations by China Economic Review have thrown up evidence of inflated revenue statements by Duoyuan Printing and China Biotics; the former is now relegated to trading on the over-the-counter exchanges and the latter has seen its share price nearly halve.
The list of other companies similarly accused is long and undistinguished: China Century Dragon Media, Orient Paper, China Green Agriculture and China Natural Gas.
However, perhaps pride of place should go to environmental equipment manufacturer Rino International, which was forced to delist last year after an investigation by short seller group Muddy Waters revealed the firm had fabricated sales contracts, thus overstating revenues by nearly US$178 million. In Rino’s case, investor fraud appears to have been an explicit management goal: After the company raised US$100 million from investors, a manager promptly borrowed US$3.2 million of it to build a luxury home in California.
Although the mud appears to be sticking to Brand China, the SEC must proceed carefully in its investigation. Throwing an undignified tantrum will benefit no one. While it is obvious that there were some very bad apples in the RTO barrel, there are also companies that listed through reverse mergers for the same reasons Western firms do: necessity, ignorance, and bad advice.
Exonerating the innocent is just as important as castigating the guilty, and speculators should not be absolved of their responsibility. Even given fraudulent statements by management, it could be argued that risk-averse investors had all the information they needed to stay away.
A bit of digging into the history of many Chinese RTOs throws up a network of small foreign auditors, investment banks, consultants and PR firms. These financial service providers facilitated, even encouraged, unqualified Chinese companies to list. In Rino’s case, a Western auditor appears to have helped Chinese managers defraud US retail investors. But in other cases, particularly in the over-the-counter markets, Chinese firms were more the victims of fee-based scams than the perpetrators.
Beijing too gets its share of the blame. Why are Chinese firms not listing in their home market, where investors understand them better and can value them more accurately? The queue for the Shanghai and Shenzhen bourses is long and state-owned enterprises get to jump it anyway, so entrepreneurs have little choice but to venture overseas.
For some firms, an overseas exit is the only viable option for foreign investors. But why do these companies need foreign backers in the first place? Because state-owned banks prefer lending to state-owned enterprises. It is a vicious circle.
Were the regulatory environment better in China – and the stock markets more mature – domestic firms would have no need of complex instruments like RTOs, and bad accounting would be the China Securities and Regulatory Commission’s problem, not the SEC’s.