Global Fraud Focus

Chinese Stock Investment Fraud? Separating Fact from Fiction

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Written by: Richard Hurley, Ph.D., J.D., CFE Tim Harvey, CFE
Date: January 1, 2012
read time: 6 mins
Fraud Schemes Securities Fraud

Examining Cross-Border Issues

[Some links may no longer be available. —Ed.]

According to a June 5 article, "China foreign listings dogged by scandal," by Robert Cookson in the Financial Times, a spate of scandals at Chinese companies listed in New York, Hong Kong and Toronto is unsettling investors.

"It seems to have bubbled into a hysteria and creates an unfortunate overhang over all Chinese companies seeking to raise capital in the U.S. markets," said William McGovern, Hong Kong-based partner at Kobre & Kim and former enforcer at the U.S. Securities and Exchange Commission. "It has become hard for investors to separate fact from fiction." 

And a May 26 article in The New York Times, "The Audacity of Chinese Frauds," by Floyd Norris, explains how Deloitte Touche Tohmatsu exposed fraud at one of its long-time clients, the Chinese financial software company Longtop Financial Technologies. Apparently, the company fooled some smart people into buying devalued stock. 

Are these stock scandals "legitimate" frauds aided by backdoor investment listings and outsourced by auditing firms? Or are they works of fabrication initiated by short sellers reaping profits selling on stock price declines either by allegations or innuendo? The reality is that there is probably a mixture of everything from fact and fraud to analysis and anxiety within the perceived red-hot Chinese stock market.

Would-be investors should be aware of the potential for fraud in any investment no matter its national origin. The U.S. Public Company Accounting Oversight Board (PCAOB) released a report on March 14 on the "Activity Summary and Audit Implications for Reverse Mergers Involving Companies from the China Region" (the China region refers to the People's Republic of China, Hong Kong Special Administrative Region and Taiwan) from Jan. 1, 2007, through March 31, 2010 (Research Note #2011-P1).

The report summarizes the concept of reverse mergers (also known as backdoor mergers) as: "… any acquisition of a private operating company by a public shell company that typically results in the owners and management of the private operating company having actual or effective voting and operating control of the combined company. Through a reverse merger transaction, although the public shell company is the surviving entity, the private operating company's shareholders control the surviving entity or hold shares that are publicly traded. In a reverse merger transaction, the entity whose equity interests are acquired (the legal acquiree) is the acquirer for accounting purposes." The end result is that:

1. The private company has access to the U.S. financial markets as a registered SEC reporting company without filing a registration statement under the Securities Act of 1933 or the Exchange Act of 1934, but the public shell company must file Form 8-K filing with the SEC. 

2. The private company probably incurs a lower accounting, legal and filing fee and gains faster access to capital markets than filing an IPO. 

3. Investors may perceive added value to the public shell company. (See here and Investor.gov's report on reverse mergers.)

The PCAOB's March 11 report on reverse mergers identified 159 companies, with a market capitalization of $12.8 billion, that have accessed the U.S. capital markets via a reverse-merger transaction from Jan. 1, 2007, to March 31, 2010. During that same time, only 56 Chinese companies, with a market capitalization of $27.2 billion, completed the initial public offering (IPO) process.

Although Chinese auditors completed 24 percent of the audits of Chinese reverse mergers, the PCAOB staff takes issue with some U.S. registered accounting firms because "they may not be conducting audits of companies with operations outside of the U.S. in accordance with PCAOB standards." On July 12, 2010, the PCAOB issued Staff Audit Practice Alert No. 6, Auditor Considerations Regarding Using the Work of other Auditors and engaging Assistants from Outside the Firm, which highlighted the PCAOB's concerns with auditors hiring external auditors and staff to perform audits outside the U.S. including ones in the Chinese region. 

The PCAOB inspection staff observed that in "some situations it appeared that U.S. firms provided audit services by having most or all of the audit performed by another firm or by assistants engaged from outside the firm without complying with PCAOB standards applicable to using the work and reports of another auditor or supervising assistants. In one case the U.S. firm's personnel did not travel to China region during the audit, and substantially all of the audit documentation was maintained by the Chinese firm that did the audit work." (See footnote 37.)

SEC Chairman Mary Schapiro is also working with Chinese regulators to address areas of concern. One key issue is the PCAOB's inability to inspect the reverse-merger firms in China. SEC Commissioner Luis Aguilar was a little more emphatic with his concerns when he addressed attendees of the Council of Institutional Investors Annual Conference on April 4, 2011: "While the vast majority of these companies may be legitimate businesses, a growing number of them have accounting deficiencies or are outright vessels of fraud."

The PCAOB also has difficulties in inspecting Chinese audit firms that have registered with the agency. Michael Rapoport reported in the August 8 article, "Progress Cited on Audits in China," in The Wall Street Journal, that Chinese authorities have not granted permission to the PCAOB to enter their country to evaluate audit firms who are registered with the agency. 

On April 4, PCAOB Chairman James Doty said in a speech to the Council of Institutional Investors that, "If Chinese companies want to attract U.S. capital for the long term, and if Chinese auditors want to garner the respect of investors, they need the credibility that comes from being part of a joint inspection process that includes the U.S. and other similarly constituted regulatory regimes. In light of these risks, the PCAOB's inability to inspect the work of registered firms from China is a gaping hole in investor protection." 

The recent wave of accounting issues and scandals involving Chinese firms has raised regulatory concern levels from a small crack to a chasm. Furthermore, short sellers are not helping to distinguish reality from rumor. Take, for example, Sino-Forest, a Chinese forestry company listed on the Toronto exchange. Robert Cookson, reporting in the June 6 Financial Times article, "China foreign listings dogged by scandal," writes that in a few days Sino "lost more than two-thirds of its market value since Thursday after Muddy Waters, a research firm founded by short-seller Carson Block, accused the company of overstating its sales and the value of its forest land."

Sino denied the allegation and claimed Muddy was "muddying the waters" to profit from short selling. However, another forestry group, China Forestry, had its shares suspended in January, 2011 after its chief executive was arrested for the alleged embezzlement of $4.6 million.

Cookson, reporting in his June 6 Financial Times article, writes that in the last six months "more than 25 New York-listed Chinese companies have disclosed accounting discrepancies or seen their auditors resign. … Nasdaq and NYSE Euronext have halted trading in the shares of at least 21 small and micro-cap Chinese companies in the past year, and kicked five of them off the exchanges."

Doty is optimistic that the PCAOB can reach an agreement with Chinese regulators on inspections. In the interim, investors should understand that investing in China has its own sets of investment risks. Then again, they should realize that in a post-Enron, Madoff, Paramlat, Satyam, Siemens and Societe Generale world, fraud has no national boundaries. Just remember: No nation has a monopoly on stock fraud. Investors must be diligent and be aware of the risks and act accordingly. Caveat Emptor — Let the buyer beware.

Tim Harvey, CFE, JP, is director of the ACFE's UK Operations, a member of Transparency International and the British Society of Criminology. 

Richard Hurley, Ph.D., J.D., CFE, CPA, is a professor in the University of Connecticut (Stamford) School of Business.

The Association of Certified Fraud Examiners assumes sole copyright of any article published on www.Fraud-Magazine.com or ACFE.com. Permission of the publisher is required before an article can be copied or reproduced.

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