Investors have reason to worry as SEC caves on audit disclosures

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NEWS ANALYSIS

Five years ago, Sino-Forest Corp. was one of the largest commercial forestry companies in China and a stock-market darling, attracting capital from legendary hedge fund investors such as John Paulson.

Sino-Forest owned and operated tree plantations throughout China, and manufactured and sold wood products to downstream customers. The company floated shares onto the Toronto Stock Exchange. Its stock soared as investors rushed to participate in a supposedly booming Chinese economy. At one time, Sino-Forests market capitalization eclipsed $6 billion.

Then it all came crashing down.

In June 2011, Muddy Waters Research, then a little-known New York-based boutique with a focus on identifying and shorting fraudulent companies, released a scathing report alleging fraud at Sino-Forest. Muddy Waters called the company a multibillion-dollar Ponzi scheme, and found that Sino-Forest fabricated sales transactions to inflate revenues, while grossly overstating its assets (investments in trees and other holdings).

Within days, Sino-Forest lost almost 80 percent of its market value. Nine months later, it filed for bankruptcy protection and proceeded to liquidate the company. In January 2015, an Ontario judge approved a $9 billion class-action lawsuit to go to trial, brought on by investors who lost their investments.

Lack of Trust

During the last decade, Chinese firms rushed to list their shares in North American markets for access to new capital sources. Analysts have long issued warnings about investing in Chinese state-owned companies. But the perils of investing in Chinese private-sector firms such as Sino-Forest, arguably, are even greater.

Its enormously difficult to build a successful private enterprise in a state-dominated Chinese economy without resorting to lying, cheating, and corruption. Privately owned companies are also constantly at the risk of forced nationalizations and asset-grabbing by local and provincial politicians.

In short, fraud is rampant.

Sino-Forest was headquartered in North America, which made it an accessible target—relatively speaking—once fraud was identified.

A vast majority of U.S.-listed Chinese firms are based in China, which makes identifying fraudulent activity much more difficult. We can assume that Sino-Forest was only the tip of the iceberg.

Because these companies typically arent covered by research analysts from large banks, investors must rely on audited financial statements, which tell of a companys revenues, profits and losses, its balance sheet, and other vital financial information. In the United States, audited financials are periodically reviewed by the Securities and Exchange Commission (SEC), and the auditors themselves (as well as their work) are subject to periodic examination by accounting regulators. Its part of a checks-and-balances system to promote financial market integrity and protect investors.

A Black Hole

Unfortunately for U.S. investors buying into Chinese companies, they get no such comfort. Chinese audit firms have refused to hand over audit-work papers to the SEC even after the regulator issued subpoenas as part of its ongoing investigation of U.S.-listed Chinese companies.

The Public Company Accounting Oversight Board, the American accounting regulator, doesnt have the jurisdiction to examine the work of Chinese auditors. The Big Four accounting firms of PricewaterhouseCoopers, Ernst & Young, KPMG, and Deloitte also cannot help, as their Chinese affiliates are locally owned and must comply with Chinese laws prohibiting disclosure of such work to foreign entities.

In May 2014, Chinas Ministry of Finance issued new rules barring international accounting firms from sending overseas staff to work on audits of mainland Chinese companies. In essence, the Chinese Communist Party has made audit-work papers akin to state secrets, to be guarded with the utmost vigilance.

One can only imagine why that is the case.

Financial statements of U.S.-listed Chinese companies cannot be relied on.

SEC Caves

In 2014, a SEC judge ruled that the Chinese-based accounting firms violated U.S. laws when they refused to turn over audit-work papers of their clients the SEC was investigating, and banned their audits.

To the extent the [firms] find themselves between a rock and a hard place, it is because they wanted to be there. A good faith effort to obey the law means a good faith effort to obey all law, not just the law one wishes to follow, wrote Judge Cameron Elliot. He argued—reasonably—that companies choosing to list in the United States, thus gaining access to its financial markets, should also comply with U.S. securities laws.

But in February 2015, the SEC caved to Beijing. It reached a token $2 million agreement with the Chinese auditors, lifting their suspension of audit work. While some audit-work papers were handed over (but only after passing through Chinese regulators), the agreement does not give the SEC unfettered access to audit-work papers.

More concerning is that while the Chinese Communist Party claims to build a transitional market economy deserving of respect, its simultaneously undermining its credibility. China forces U.S. companies operating there to adhere to its rules, while barring U.S.-listed Chinese companies from following American laws.

The recent development is a huge blow for U.S. investors, and it cements the fact that financial statements of U.S.-listed Chinese companies cannot be relied on.

The consequence is that all U.S.-listed Chinese companies will inevitably suffer from a fraud discount. It is unfair to upstanding companies, and it undermines the integrity and stability of the financial markets. This also means that while retail investors will be at a disadvantage, long-short hedge funds have opportunities to profit.

Consider yourself warned.