Regaining Investor Confidence for US-Listed Chinese Companies

Author：Zhouman Liao, Lijie Zhu
Editor： Barry Sine

A number of high profile scandals have given Chinese companies a bad name among US investors. Portfolio managers who previously held extensive investments in US listed Chinese equities now avoid the sector and some of the previously largest underwriters of US listed Chinese equities have exited this market.

Between 2006 and 2010, a total of 339 Chinese companies listed on the major US stock markets, 106 on NYSE and 233 onNASDAQ. During this period of high interest in investing in Chinese companies, few anticipated the coming scandals and delistings.

Now the main topic of discussion for investment professionals in the US and China is how to stem the tide of problems, and restore confidence in Chinese equities. In order to help both Chinese companies and the US investors understand the overall picture of Chinese companies as well as an individual stock, we have adopted a unique perspective to analyze Chinese companies listed in US:
1. Analyze fraud of Chinese companies listed in US.
2. Understand the relationship between Chinese companies listed in US and the short sellers.
3. Explore how Chinese companies can regain US investor confidence.

Fraud of Chinese Companies Listed in US

Chinese companies are facing accusations regarding accounting irregularities and a wave of auditor resignations. As of November 29, 2011, 41 class action lawsuits have been filed against U.S. listed Chinese companies in the federal courts since early 2009. Most of these lawsuits (39 out of 41) claim that the Chinese companies and their management issued false and misleading information and failed to disclose material adverse facts about the company's business, operations, and prospects. Jie Xiu, an attorney of Troutman Sanders LLP, conducted a research on Chinese companies’ litigations. The tables below provide more details of these legal cases:

Zero-Sum Game Between Short Sellers and Chinese Companies Listed in US

Short sellers published a series of critical reports on Chinese companies this year that resulted in significantly battering the prices of US listed Chinese equities. Among these aggressive short sellers, Muddy Waters created the most attention after its 12 reports targeting four Chinese companies in 2011.The founder, Carson Block, is an entrepreneur who practiced law and pioneered industries in China. Some of the alleged scandals that have been revealed by Muddy Waters are as follows:

I.China MediaExpress Holdings (NASDAQ: CCME)- Feb 3,2011

- Significantly inflated revenue and profits

- Largest purported contractwith Shanghai Ba Shi did not exist

II.Duoyuan Global Water Inc. (NYSE:DGW)- Apr 4,2011

- Engaged in improper undisclosed related party transactions that transferred money to its chairman.

- Four errors were identified in its US audit

III.Sino-Forest Corporation (TSX:TRE , OTC:SNOFF)- Jun 2,2011

- Most of its revenues were through"authorized intermediaries".

- Exaggerated its assetssignificantly.

- Capital raising was a multi-billion dollar ponzi scheme.

IV.Spreadtrum, Communications Inc. (NASDAQ: SPRD)- Jun 28, 2011

- High risk of material misstatement in the reported financial.

- Problems with financial statements in 2010 and 2011.

V.Focus Media Holding Ltd. (NASDAQ: FMCN)- Nov 21, 2011

- Significantly overstated the number of screens in its LCD network.

- Overpaid for acquisitions.

Short sellers hope to profit from a decline in the price of a stock. Short sellers borrow stock through the stock exchange trading structure with the expectation of returning the stock at a later date and lower price. Sophisticated short sellers are now earning significant profits by taking advantage from some common characteristics of Chinese companies in the United States, such as lack transparency and consistency.

Short sellers usually target small Chinese companies that went public through reverse mergers, which is the most obvious feature of a typical Chinese company in US. According to Public Company Accounting Oversight Board (PCAOB), the combined market capitalization of all Chinese companies listed through reverse mergers is less than half the value of companies that have taken the traditional listing route. Chinese companies, especially small-caps, have historically preferred reverse mergers to traditional IPOs as a way of avoiding stringent filing requirements and high financing costs. In a March interview with Barron’sabout the reason why he focuses on Chinese reverse merger stocks, Carlson Block answered, “I came across a stock that was a substantial fraud. It happened to be a reverse merger, and that is how the whole Muddy Waters saga started when asked about what American investors need to know about Chinese reverse mergers, he added, “Not only is the business far away from you, it is an entirely different culture, language and legal system.”

Short sellers are continually seeking new investment ideas. In many cases, short sellers are very interested in small Chinese companies with high prices. Short sellers often take two to three months to analyze a company. According to Mr. Block, “If it sounds too good to be true, even in China, it is often too good to be true. Understand there are conflicts of interest.” Factors such as long-serving independent directors, ownership concentrated in the hands of a small number of individuals, significant revenue and capital-expenditure growth and a high cash-to-debt ratio do not mean a company is fraudulent, however, these factors is going to raise short sellers’ curiosity regarding financial statement quality and the effectiveness of corporate governance.

Short sellers have significant influence in the US markets. Robert Lawton, Managing Partner at Catoosa Fund LP in Los Angeles, said in a phone interview with Bloomberg on November 21, “As a fund manager, if I see a sell recommendation from Muddy Waters, I’m going to sell and ask questions later, and it looks like that’s what people did.” Moreover, law firms are looking to profit from this trend. There are numerous law firms in the US which are eager to find business opportunities during the accusation process. Hundreds of small law firms approach shareholders of a company when that company is involved in scandals and persuade as many shareholders as they can to join class action suits. It is important to understand that these law firms generally do little or no original researching to confirm their allegations before launching a lawsuit, instead preferring begin the litigation process early, in hopes of winning a substantial number of clients.

Chinese companies under attack by short sellers and litigation face considerable costs of both time and money to deal with negative comments from both investors and media and legal fees to defend the company and its board of directors. Of the six companies Mr. Block has written on before Focus Media, only two continue to trade: Oriental Paper and Spreadtrum Communications. Basically, three major factors are attributed to this situation:

1. As foreign players, Chinese companies lack the market savvy management teams that the US companies have. Most Chinese companies have their operations and management based in China, which make communication with the US investorsmore difficult. Although they do have small teams here in the US, it is far from enough. For instance, Focus Media Holdings mustnow pay sizable legal fees to rebut the accusations or time to communicate face to face with institutional investors and even short sellers. Furthermore, the small size of Chinese companies in US also limitstheir risk resisting ability.

2. Accounting irregularities of Chinese companies listed in U.S have raised red flags. Investor confidence has been shakenafter the plunge and subsequent delisting of more than a dozen Chinese stocks on the New York Stock Exchange and NASDAQ this year. Among numerous examples, Longtop Financial Technologies Limited was charged by SEC’s Division of Enforcement due to failing to file current and accurate financial reports. Shortly after the charge, Deloitte Touche Tohmatsu resigned due to recently identified false financial records related to cash at the company’s banks and loan balances. CEOs of Chinese companies do not pay much attention to accounting quality in accordance with US standards but instead focus on the prestige of going public on NYSE and NASDAQ.

3. The high turnover of senior management produces unsustainable development of Chinese companies and also harm shareholders since CEOs and CFOs have the incentive to make commitments of strong results to shareholders within their tenure. However, shareholders actually concern the risks that management teams cannot stick to their commitments in the long term.

Ultimately, the game between Chinese companies and short sellers is a zero-sum game. The winner depends on how the professional team backing the company and the strategies implemented by management.

How to Regain the Confidence of US Investors

Chinese companies should ensure the effectiveness of their internal controls and the quality of their financial reporting to prevent fraud by maintaining the highest international standards and best practices. Based on a company’s strategy, Chinese companies can integrate their management, directors and financial staff to improve the effectiveness of internal controls. Stable management teams and truly independent audit committees are critical in facilitating communication between independent auditing firms and management. Thus, it is easier for financial analysts and investors to understand the company’s business through financial statements.

An interactive communication platform is aneffective way to bridge Chinese companies and investors in the US. Imagine a supermarket, where you can buy fruit, vegetables and meat at in the same place. An integrated investor relations platform provides a “one-stop shopping” experience for both investors and companies. Investors can look up information about the companies they are interested in, but also can check the feedback from other counterparties who do business with the company. For example, if a company does not pay bills on time, it may receivenegative commentsfrom other users. Companies can use this cost effective way to improve information transparency and build up relationships. Dragon Gate Investment Partners has developed a platform called CorpOnline ®(www.corponline.org), which is a social media website for interaction between investors and issuers.

The problems facing Chinese stocks in the US capital markets have in return pushed the two countries to cooperate more closely on improving the integrity and transparency of Chinese public companies’ accounting information. Development of Chinese companies in the US is not just a commercial issue but a political issue. In the longterm, it remains to be seen who the US investors trust more - Chinese companies in the US or short sellers? Today the answer is clearly short sellers as they have proven to be more credible than many companies. China and the US have started seeking closer cooperation on audit oversight. The Chinese government is also beginning to realize that mutual cooperation may be the best way to repair Chinese companies’ reputation overseas and rebuild international investors’ confidence. At the same time, the US capital markets can in fact provide important opportunities for Chinese companies as originally envisaged during the IPO process if management better understand the characteristics and requirements of the US markets. Looking forward, US listed Chinese companies need more time to prepare them to face short sellers’ criticisms. Accounting transparency, consistent development and effective communication platforms are essential to Chinese companies to rebuild investor confidence.