Banking & Finance

Accounting tricks

Why US stock markets may shun Chinese firms

Accounting tricks

Aguilar: probe into China firms

At a recent lunch with venture capitalists, the Hong Kong tycoon Ronnie Chan asked – apart from cash – what VCs were contributing to the companies in which they were invested. The South China Morning Post reports that one VC manager responded that some of the Chinese firms he’d invested in kept three sets of books. He now ensured that financial records were more accurate.

Chan quipped back: “Wouldn’t that diminish the value of the company?”

US investors may fail to see the joke. That’s because a spate of accounting frauds have beset Chinese companies with American listings.

So far, trading in at least 24 China stocks has been halted or suspended after regulators (and short-sellers) sounded the alarm. The latest (and most serious) domino to fall: NYSE-listed Longtop Financial Technologies.

The software maker was accused of accounting fraud by short-sellers back in April, and trading in its stock was finally suspended last week. (The clue: its profit margin was said to be far too high for such a competitive field).

This week Longtop received another body blow when its auditor, Deloitte Touche Tohmatsu resigned citing “recently identified falsity” and “deliberate interference [from management]”. The SEC is currently investigating the allegations.

According to the Wall Street Journal, Longtop’s CFO Derek Palaschuk has submitted his resignation too.

Longtop was listed in a 2007 IPO, but many of the other scandal-tainted firms had followed a much less rigorous path onto the bourse. China MediaExpress and China Agritech both found their way onto the market through ‘backdoor listings’ (also called ‘reverse mergers’). This proved popular with Chinese firms since backdoor listings receive less scrutiny than if they IPO (where a prospectus is required). That lack of scrutiny now looks problematic.

“This is an area of increasing concern for Western investors,” a Chinese financial consultant told the Financial Times. “They already think that many companies in China are suspect. Episodes like this confirm their suspicion.”

(China MediaExpress runs advertisements on a network of televisions on buses and China Agritech makes fertilisers).

Accusations against the pair are strikingly similar – that they had been faking revenues. “If you invest solely on SEC filings in China, buyer beware,” one investor who lost money investing in China MediaExpress told, “because there is a lot more underlying creativity that is possible in terms of separating investors from their money.”

Short-seller fund Muddy Waters, one of the most prominent in identifying faulty data at Chinese firms, wrote that China MediaExpress was “inflating its revenue and earnings in order to pay management earn-outs and inflate the stock price so insiders [could] sell.”

Similarly, Lucas McGee Research argued that Agritech was “not currently a functioning business that is manufacturing products… but a vehicle for transferring shareholder wealth from outside investors”.

Last month the SEC said it was conducting a probe of foreign firms that had undertaken ‘backdoor listings’. “A growing number of them are proving to have significant accounting deficiencies or being vessels of outright fraud,” explained Luis Aguilar, an SEC commissioner. There have been an estimated 150 such listings of Chinese firms since 2007.

It’s not just day traders that have been caught out by the alleged scams – plenty of sophisticated investors have also been burned. The $1.3 billion New York-based fund Glickenhaus & Co says it sunk $4 million into China Agritech last November, only to see its investment engulfed in controversy just a few months later.

But the reputational fallout has been worse for private equity firm Carlyle, which is planning an IPO of its own. Not only did it own 22% of China Agritech, it also owned 11% of tree-plantation operator China Forestry, a Hong Kong-listed firm also accused of fraud. According to the FT, Forestry’s CEO was arrested in February for allegedly embezzling $4.6 million.

And the worst may not be over. Short-sellers and financial blogs have been predicting more disclosures will follow. If they’re right, it could diminish investor enthusiasm for new listings from China. “It’s an integrity and confidence issue,” Beijing-based lawyer Rocky Lee told Bloomberg, “even IPOs underwritten by major investment banks have felt the impact.”

Newly-listed social networking site Renren appeared to be affected by the unfolding drama, not least because the head of its audit committee was none other than Derek Palaschuk. He resigned ahead of Renren’s May listing – in part because of the publicity around his role as Longtop’s CFO. And Renren’s share price has since sunk below its IPO price – something for other potential issuers to ponder.

The litmus test for whether US investors have lost confidence in China listings could be the forthcoming IPO for Taomee – an internet portal for Chinese children, that hopes to raise $100 million.

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