I gave an address to CEOs at the China Best Ideas Conference today. There are over 400 people, both investors and executives from Chinese companies at the conference. There is optimism that the U.S. markets might reopen for Chinese companies soon.
Remarks by Professor Paul Gillis at China Best Ideas Investment Conference, September 9, 2013.
Chinese entrepreneurs have had tough time getting capital. The shadow banking system is collapsing, the Chinese A share market is closed, private equity money has dried up, and U.S. exchanges are all but closed.
I am going to talk about the three things that have really hurt this market. I call them the three terrors of investors in Chinese stocks. I am hopeful that we are going to going to come to terms with these issues and that the markets are going to soon recover.
I don’t have to tell you that we have had a lot of accounting fraud among Chinese public companies. Over 150 cases in just the last few years. A lot of investors were wiped out. McKinsey says that investors in U.S. listed Chinese companies lost 72% of their investment in the last two years.
A big part of that problem was reverse mergers. Reverse mergers let companies come to market without much due diligence. It was a fast and cheap way to go public. But it was so easy some not so honest promoters and companies came to market and then were exposed as frauds. Most of those companies and promoters are gone, and new rules take away most of the advantage of reverse mergers. I think this problem is behind us, but it will take some time before investors forget.
Most of the Chinese companies that came to market were not fraudsters. They were honest businessmen who did not want to cheat their investors. But they were in over their head, and did not know how to run a public company. So they made some mistakes, and the short sellers were quick to punish them.
I know short sellers are not popular with this crowd. They have hurt many good companies, but usually good companies that got hit made themselves vulnerable. Chinese companies have to practice extraordinarily good corporate governance. This conference, today and tomorrow, is going to talk about that.
Variable interest entities
Variable interest entities are unpopular with investors. As you know, the variable interest entity is where Chinese companies are controlled through contracts instead of through ownership. The VIE is used to get around Chinese regulations – mostly those restricting foreign ownership in certain industries, but also foreign currency and other regulations. Anytime someone tells you they have a gimmick to get around regulations you should be very careful. Investors learned that lesson painfully.
In the past year we have had some bad news on VIEs. China’s supreme court said that VIE type agreements cannot be enforced, the same conclusion an arbitrator reached in the Gigamedia case. That is bad news. Regulators have not moved aggressively to shut down VIEs, so it appears that the VIE structure works – until you need it to work, and then it won’t work. That is a concern that has many investors scared to jump back into Chinese stocks.
We are stuck with VIEs for now.
Companies need to listen to investors concerns. Minimize the use of VIEs. Don’t use one if you don’t absolutely have to. And when you do, minimize the business that is conducted in the VIE and do everything possible to protect the shareholders.
But the real fix needs to come from the Chinese government. The rules restricting foreign investment in certain sectors are outdated. China should focus on control of sensitive sectors instead of flatly prohibiting foreign investment. Some top Chinese entrepreneurs like Robin Li have called for this at the Lianghui, and I am hopeful that China will listen.
The third area of concern has been a long simmering fight between United States and Chinese regulators over U.S. listed Chinese stocks. These companies have fallen into a regulatory hole. They organized themselves using offshore companies and VIEs to get out from under Chinese regulation, yet China will not let U.S. regulators come to China where the people and the records are located. The result in that the companies are in this regulatory black hole where there is no regulation.
The SEC has been under a lot of pressure to clean up this sector. They have brought some charges against companies and promoters. But in most cases they have not been able to get to the people in China who committed the frauds because China won’t let them.
So, the SEC went after the accounting firms and demanded that they turn over their working papers. Audit working papers are pretty boring things, and would not likely disclose a fraud, but they are a good roadmap to the company. They contain all kinds of representations made by management. Figure out who lied, and you probably have the perpetrator.
The Big Four accounting firms refused to turn over the goods. They said that Chinese regulators told them that they could not do so. If they did, they would toss their partners in jail and kick the firm out of the country.
The SEC said they did not care, and told the firms to cough up the papers anyway. When the firms refused again, the SEC took them to court. The SEC wanted to revoke the right of these firms to practice before the SEC. If the firms lost that right, they could no longer audit U.S. listed companies. While that is bad for the firms, it would be even worse for their clients. U.S. listed companies have to have an auditor with practice rights before the SEC. If the Big Four in China lost their license, they could not audit U.S. listed companies. The companies may not be able to get an audit done, and you have to have an audit if you are to be listed in the U.S. What the SEC was really trying to do is to kick Chinese companies off the U.S. exchanges.
Right before they went to trial in July, the CSRC announced it was willing to turn over the audit working papers for Longtop Financial Technologies. In fact, the CSRC said they had 20 boxes full of workpapers, and they would send them just as soon as the SEC sent them money for postage.
The Public Company Accounting Oversight Board is the regulator of accounting firms that audit U.S. listed companies. I am on an advisory board for the PCAOB, but the opinions I express today are my own.
The PCAOB does three things. It makes the rules for how public companies ought to be audited. It inspects accounting firms to make sure they are following the rules. And it punishes those who do not.
Inspections are the most important function for the PCAOB.
When the PCAOB attempted to come to China to inspect Chinese accounting firms (including the Big Four) that audit U.S. listed companies, Chinese authorities would not give them a visa. China said that allowing a foreign regulator to enforce foreign laws against Chinese people on Chinese soil would be a violation of China’s national sovereignty. China had tried that before – after the Opium wars and during the Japanese occupation and it had not worked out well.
The PCAOB negotiated for years to try to work out a deal. In many other countries the PCAOB worked out arrangements to do inspections side by side with local regulators, but China would not agree to that. China wanted the PCAOB to accept the work of Chinese regulators.
If the PCAOB could not work out a deal, the only real option they had was to deregister the accounting firms and prohibit them from auditing U.S. listed companies, which would likely lead to Chinese companies being kicked off U.S. exchanges. This has been called the nuclear option, since it would completely blow up the market.
In May, the PCAOB reached a deal with China to share documents in connection with enforcement activities. Enforcement activities are a small part of what the PCAOB does. In 2012 there were only 11 sanctions handed out compared to nearly 100 inspection reports that covered many more individual audits. The deal with China does not allow for inspections, and the PCAOB says it will continue to negotiate.
I think that both the PCAOB and the SEC have gotten all they are going to get from Chinese regulators. China is going to be the gatekeeper for any documents that go to the SEC. The SEC hates that, but they aren’t going to get a choice. The PCAOB is not going to be allowed to do inspections.
Where does that leave us?
I think the nuclear option is off the table. I think the SEC lawsuits against the Big Four and BDO will be dropped once the CSRC turns over the working papers. Next time, the SEC is likely to face the same problems, but maybe China won’t let it escalate so far.
The PCAOB is not going to be doing joint inspections anytime soon, if ever. I am hopeful that the profession finds an alternative – perhaps the old system of peer reviews where they look at each other’s work, maybe under the supervision of the CSRC.
Investors are relieved that the nuclear option seems to be off the table, and regulators ought to remove any doubt of that. But investors should remain concerned that Chinese auditors are not held to the same standards as other auditors of U.S. listed companies. That will put a discount of the values of these stocks.
So, there are three big problems – accounting frauds, VIEs and regulatory holes. You can’t fix all of these by yourselves, but you can help by setting a high standard for your corporate governance practices.
Thanks for listening to me today.