Soon after he began working in China in 2008, Taylor Price was ushered into a boardroom in the province of Hebei by a bevy of catwalk models and a man who looked identical to chairman Mao Zedong.
Mr Price was visiting the talent and modelling agency – of which the Mao impersonator was an employee – to discuss taking it public in the US through a process known as a reverse takeover. To attract potential investors, the company’s management was keen to throw in sundry other assets it owned, including a bottled water producer and a retirement home intended to be a tourist attraction in the grim, polluted heart of China’s steel country.
“The thing was a mess and there was basically no way it was going to make a viable public company so we left it alone,” says the former actuarial analyst from California.
Companies that conduct most or all of their business in mainland China accounted for 11 out of the 12 companies whose shares were suspended from trading by Nasdaq as of July 4. More than a dozen others have been delisted or suspended from other exchanges.
The US Securities and Exchange Commission and the Public Company Accounting Oversight Board have launched investigations into some Chinese companies and their US auditors. Short-sellers – who borrow shares in order to sell them in the hope the price will fall so they can buy them back for less – smell blood and are circling the sector.
In the past few years, many Chinese companies with only slightly more plausible business plans have sold shares to North American investors, taking advantage of the hype surrounding China’s growth and the fact that the reach of regulators does not extend across the Pacific. But in recent months, Chinese companies listed in North America have been rocked by a wave of fraud allegations that have led to dozens of suspensions and delistings from Nasdaq, the American Stock Exchange and the New York Stock Exchange.
Investors and regulators are asking how so many apparently toxic companies could end up trading in what are thought of as the most highly regulated markets in the world – and why Chinese companies seem so susceptible to allegations of fraud.
According to Mr Price and many other people involved in taking Chinese companies to market, the simplest answer is that most of the companies trading publicly in the US should never have been there to begin with. “When you talk about fraud and what’s fraudulent, you have to take into account the fact that China is a country that has endemic corruption and systematic problems with the rule of law,” Mr Price says. “These businessmen are often trying to run good businesses but they’re working in a system where the rules are flexible and things like your tax bill are negotiable. When you talk about being a public company in the US, there are no flexible rules.”
His assessment is backed up by countless anecdotes and examples from western and Chinese business owners, as well as government officials. It does not mean that all Chinese companies that list in the US are frauds. But the reality is that maintaining good relations with Communist party officials, who wield enormous power over economic policy and the courts, is far more important in doing business in China than strictly complying with the country’s laws and regulations.
“In the US context, nearly every Chinese company is dodgy in terms of their accounting and disclosure because it really is a completely different game here,” says one Beijing-based forensic accountant, who asked not to be named because of the sensitivity of his business. “But in China you are hugely disadvantaged in business and sometimes can’t even operate if you follow the letter of the law.”
The vast majority of the hundreds of Chinese companies quoted on US exchanges or bulletin boards, where public companies can trade without listing on the New York Stock Exchange or the Nasdaq, were brought to market in the US through the back door in reverse takeovers, or reverse mergers. This perfectly legal procedure allows a company with all its operations abroad to merge with an existing publicly traded US shell company and eventually raise money by selling shares to American investors.
The company’s ultimate goal is often to graduate from the bulletin board where it has merged with the shell to a bigger, more prestigious exchange such as the Nasdaq, where it can raise further funds. Through this process, companies are often able to evade the stricter regulatory scrutiny and listing requirements involved in a direct initial public offering on a big US exchange.
A PCAOB investigation between January 2007 and the end of March 2010 estimates that more than one-quarter of the 603 reverse merger transactions in the US involved companies from China. Almost all the others involved US companies merging with listed American companies. The number of Chinese companies that carried out reverse mergers in the US was nearly triple the number that listed there through a standard IPO.
Virtually all the companies mired in scandal today went public in the US through a reverse merger. In the US alone there are now nearly 900 China-based companies trading publicly on exchanges and less regulated, smaller forums. By comparison, there are fewer than 2,200 companies listed on all of mainland China’s stock exchanges.
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The flow is understandable: many entrepreneurs in China have difficulty obtaining loans from state-owned banks, let alone securing a coveted domestic listing. A US ticker symbol can bring subsidies and other favours from local Communist officials, who gain prestige from having foreign companies in their jurisdictions.
With so many Chinese companies wanting to go public in the US, and American investors eager to get in on the China story, a thriving industry has emerged to service demand. But the intermediaries, lawyers, accountants and stock promoters who specialise in taking smaller Chinese companies to market in the US are generally small, without the resources to carry out extensive due diligence or proper audits.
The PCAOB found that 74 per cent of the Chinese reverse merger companies it looked at were audited by US-registered accounting firms, some of them tiny companies that outsourced “most or all” of their audit work to firms or assistants in China. The rest of the companies were audited by China-based accounting firms.
Some of the promoters and underwriters that are most active in bringing Chinese companies to market have a history of run-ins with US regulators. Of the 10 recent Chinese listings arranged by Westpark Capital, a Los Angeles-based investment bank and securities brokerage, four have had their shares halted or delisted after their auditors resigned and accused them of fraud.
Last year, Westpark was fined $400,000 by the US Financial Industry Regulatory Authority (Finra) and had its chief operations officer and chief compliance officer suspended for failing to supervise brokers who “churned customer accounts and engaged in unauthorised and unsuitable trading in multiple accounts”.
In 2004, Westpark was censured and fined $50,000 by Finra for issuing misleading and exaggerated research reports and Richard Rappaport, chief executive, had his securities supervisory licence suspended for 30 days. In 2006, Westpark was censured and fined $10,000 for not stopping Mr Rappaport from acting in a principal capacity during that earlier suspension period.
In all three cases Westpark did not admit or deny the findings but agreed to pay the fines and accept censure. “We felt it was more efficient for us to settle with Finra,” Mr Rappaport says of the most recent fine. “I would never knowingly violate a Finra rule or regulation.”
Mr Rappaport says he is not aware of any regulatory agency investigation into Westpark in relation to the four suspended Chinese companies that it took public in the US – China Electric Motor; China Century Dragon Media; NIVS IntelliMedia Technology; and China Intelligent Lighting and Electronics. “We know [the auditor for the four companies, a small Houston-based accounting firm called MaloneBailey] has resigned and made accusations and they’re probably the closest to the situation and we know the SEC is investigating,” he adds. “If the management teams of these four companies lied or cheated or faked things then we are victims.”
The SEC has revoked the registrations of at least eight China-based companies since the end of last year, which prevents them selling to US investors. More than two dozen others have disclosed auditor resignations or accounting problems in recent months. Despite suspicions about many Chinese reverse mergers, however, US regulators and investors are severely hampered in terms of proving or disproving fraud because Beijing does not allow them to carry out investigations in China.
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Into this regulatory vacuum has stepped an unlikely group of individuals. In many cases, suspensions and delistings of US-quoted Chinese companies have been prompted by allegations of fraud posted on websites such as Muddy Waters Research, each run by a single self-avowed short-seller.
Carson Block, the man behind Muddy Waters, is the owner of a small self-storage company in Shanghai who has issued reports in the past year on six Chinese companies listed in North America. Following his allegations of fraud and malfeasance, each of these companies has seen its share price tank. Two of them – Rino International and China Media Express – have subsequently been delisted from Nasdaq. A third, Duoyuan Global Water, has had its shares suspended since April 19. Four of its six independent directors have resigned, claiming that the company’s management was obstructing an investigation of its internal controls and finances.
One of Muddy Waters’ latest targets is Toronto-listed Sino-Forest, which has seen its share price eviscerated since Mr Block released a report on June 2 alleging serious fraud at the company. It has fought back at what it calls Mr Block’s “shock jock approach”, appointed an independent committee to review the allegations and hired PwC, the audit firm, to assist. But its shares are still trading at about one-sixth of their high at the end of March. The Ontario Securities Commission has also opened an investigation into Sino-Forest.
Promoters and arrangers of reverse mergers say short-sellers are making huge profits by releasing defamatory reports full of innuendo but little hard proof to back up their assertions of fraud. However many of the assertions made by Mr Block and his peers have turned out to be credible. Without them, problems at these companies may never have been exposed.
None of the companies Mr Price worked with is among those delisted or suspended. Even so, he says his days of working on Chinese reverse mergers are over.
“After all this time and everything I’ve seen, I do believe there are a lot of Chinese entrepreneurs with integrity who have scrabbled their way to success,” says Mr Price. “But there’s a lot of grey area in China and if you take all that grey area and try and apply US standards to it, then you’re bound to get into trouble.”