The Wall Street Journal carried a story in June 2013 which opened with ‘At least four Chinese companies are considering U.S. stock exchanges for initial public offerings’. Such a story would have struggled to make the editorial cut three years ago, when Chinese companies were taking the US exchanges by storm. But after a round of investigations into accounting irregularities and fraud, and the resulting de-listings, investor appetite towards Chinese companies changed considerably. Now, as The Wall Street Journal’s headline indicates, Chinese companies are looking to raise capital overseas again. But have we learned any lessons from the investigations so far?An analysis of the issues uncovered by the authorities, not just in the US (although they have probably seen higher volumes than anywhere else, including Hong Kong), but on other exchanges as well, reveals three areas of concern. They are interlinked, and as one person put it ‘all roads seem to lead back to the legal environment in China’. One of the biggest issues is the growing use of entities called Variable Interest Entities (VIEs). Despite the widespread reforms initiated by Deng Xiaoping aimed at opening up China’s economy, large parts of it are still off-limits to foreign investors. For example, one of the fastest growing sectors in China - and the one clamouring for the most capital - is technology, media and telecommunications. But foreign ownership - direct, foreign ownership - is still prohibited. This has been a big problem for players like Alibaba, LightInTheBox, Montage Technology, and many others, who need to raise funds to continue growing. The answer has been VIEs. These complex structures leave the assets and business onshore, in the hands of a Chinese national - usually the founder - to comply with the requirements under Chinese law. Then the US-listed entity signs a series of contracts with the VIE which give it effective control over the profits. The problem is that this set-up is riddled with uncertainty. The structure was established to circumvent Chinese legislation and, despite their widespread use, the authorities have been slow to provide any guidance on whether these structures are legal - a position which works in their favour. But if it comes to it, investors are likely to struggle to enforce the contracts to which the US company’s value is intrinsically linked. While there are questions over the regulatory treatment of VIEs, one of the bigger challenges has been that this set-up leaves US investors at the mercy of the Chinese directors who actually control the company and its assets. Many of the scandals that have plagued overseas-listed, Chinese companies, feature rogue chairmen who plunder the company’s assets and divert funds. There are many examples which illustrate the risks, but the case of Puda Coal demonstrates the extent of control that the Chinese directors have. In February 2012, the Securities & Exchange Commission (SEC) charged Puda Coal’s chairman, Zhao Ming, and Zhu Liping, another China-based executive, with fraud and securities violations. Apparently Zhao transferred Puda Coal’s main asset, Shanxi Coal, to himself, before selling on 49% of it to a fund purportedly controlled by CITIC. The sale, which stripped Puda Coal of its main asset and its value, was not approved by the board or the shareholders, nor disclosed in post-dated regulatory filings to raise capital for more acquisitions. As Alibaba contemplates an overseas listing, it is worth remembering that Jack Ma, the powerful internet entrepreneur behind the company, and Yahoo! were in dispute in 2011 over similar facts: the transfer of Alipay to a company controlled by Ma and one of Alibaba’s other founders, Xie. Yahoo! claimed that the transfer was made without its knowledge, something that Ma always disputed. The two have since settled their differences, but without full disclosure of the details, it is impossible to determine whether there was any wrong-doing or, more importantly, to assess the likelihood of it happening again. Understanding fully who controls the assets is essential to assess the risks involved with investing in these entities. Perhaps most importantly, knowing who controls the company chops is key. Without them, it is difficult to exercise control when things go wrong, as the story of ChinaCast Education shows. In January 2012, ChinaCast accused one of its foreign directors and seven percent shareholder of insider trading and other wrong-doing, and tried to remove him from the board. Through board elections and litigation in the courts in Delaware, where the US company was listed, the director in question, Ned Sherwood, managed to oust the Chinese chairman. But that was only half the battle. Shortly afterwards, the ownership of two universities owned by ChinaCast was transferred to ChinaCast’s former chief investment officer. At the same time, the company chops disappeared. In China, chops are more important than signatures and official documents are only valid once chopped. Without them, it is nigh on impossible to get anything done, including filing suit, leaving US investors powerless, and out of pocket. Regardless of the risks, some investors take solace in the fact that well-known and highly-regarded accountancy firms have audited the Chinese companies and signed off on their accounts. But there have been issues for the ‘gatekeepers’ of Chinese companies too. All audit firms providing services to US-listed companies must be registered with the Public Company Accounting Oversight Board (PCAOB). However, in registering their Chinese subsidiaries, many international auditors tried to carve out exemptions, by explaining the conflicting requirements under US and Chinese law. While the SEC argues that it has the right to examine any documents relating to companies listed on its exchanges, its Chinese counterpart, the China Securities Regulatory Commission (CSRC), begs to differ. It has barred Chinese auditors from producing audit papers directly to the SEC and PCAOB in case they contained ‘state secrets’ and has taken up a position as (a frustratingly slow) gatekeeper. A case in point was that of Longtop Financial Technologies. Longtop Financial Technologies was audited by Deloitte’s China subsidiary until May 2011 when it resigned, claiming that Longtop had provided it with falsified financial records and bank confirmations. Deloitte also announced that its audit opinions could no longer be relied upon. It took the SEC nearly two years of increasingly heavy-handed tactics, culminating in the issuance of administrative proceedings against Deloitte and a number of the other Chinese affiliates of the five biggest audit firms, and a subpoena against Deloitte Shanghai itself, to get the files it needed to investigate the wrong-doing at Longtop. So what has changed? The answer, in short, is not much. The foreign investment rules still require structures like VIEs to facilitate foreign investment; investors are at the mercy of those in China who actually control the company’s assets from which their shares derive value; and the regulators of the exchanges on which Chinese companies list still have little real power to compel production of documents, run full-blown investigations or bring the perpetrators of fraud and securities violations to account. Some countries are increasing the amount of due diligence that is required ahead of IPOs, and anecdotally, at least, the SEC, is reported to be taking longer to scrutinise the companies asking to list on US exchanges. But the onus has shifted towards investors doing their own checks. In countries like China, where there is a lack of transparency, investors should look beyond the regulatory disclosures to see what else they can learn about how the principals conduct themselves and what experience they have in managing a listed company, the experience of other business partners in dealing with the company, and the challenges that are facing the industry in which it operates.
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