Finger on the trigger

Weapons firm wants to IPO, as Hong Kong’s auditors come under fire

Artillerists of People's Liberation Army (PLA) attend a firing drill in Hefei

Market information about Great Wall Military is limited by state secrecy rules

The largest yuan note is worth only Rmb100 or about $16, meaning that cash-rich Chinese need cavernous wallets. But Beijing’s finance chiefs have been reluctant to issue larger denominations on concerns that it will make it easier to store and smuggle illicit cash.

Are they being too fearful? Not if the case of Wei Pengyuan is a representative one. A deputy director at the coal division of the National Energy Administration, Wei is currently caught up in the graft purge sweeping through the state energy sector. What makes him stand out is the revelation that he stashed Rmb100 million at his house. Investigators needed 16 counting machines to tally up the haul, which was later calculated to have weighed at least a tonne.

Stacked vertically the cash tower would have climbed to 328 feet, the Chinese media reported excitedly.

Without helpful details like these, many of China’s corruption cases tend to morph into a distasteful but indistinct mass. Prosecutors have probed more than 10,000 officials in the first three months of the year, for instance, with investigations reaching deep into state firms like oil giant CNPC and the conglomerate China Resources.

The sweep doesn’t look likely to delay one of the most talked-about IPOs in the domestic stock market. Great Wall Military, one of the four units of the Anhui Military Industry Group which supplies weapons to the People’s Liberation Army, wants to raise Rmb450 million to fund its future operations. Because of escalating tensions between China and some its neighbours, investors have been chasing stocks that might benefit from higher spending on military equipment, says Shanghai Securities News. Great Wall is exciting market interest because it would be China’s first “pure military play” if the IPO goes ahead later this year.

Great Wall has suffered from its own corruption scandal relatively recently, with its former chairman Huang Xiaohu expelled from the Party last year. But the IPO prospectus doesn’t explain if Huang’s removal should concern investors. In fact, it doesn’t even mention the case, stating only that Huang resigned last March. Great Wall counters that it’s not a concern, telling National Business Daily that the charges against Huang relate to misconduct before he became boss.

That’s not the only area in which Great Wall is being tightlipped. Because of its core business, much of its work is classed as a “state secret”. According to China’s three-tiered standard, Great Wall falls into the “Grade 2” grouping, meaning that it engages in “confidential projects” (firms with “top secret” projects are classified as Grade 1, apparently). That also means that it isn’t required to disclose commercial information such as the identities of its major customers or key competitors. The same applies for product reviews. It positions itself as the leading producer of mortar shells, for instance. But the state secret ruling means that it has no need to outline its market share.

“Weapons makers carry state secrets to the stock market,” the Beijing News reminded its readers. “Selective disclosure could hamper the public from making an accurate judgement on risks.”

Great Wall reported just Rmb1.2 billion in revenues for 2013, a fraction of China’s Rmb720 billion in defence expenditure last year. Selling 25% of its enlarged capital would value it at Rmb1.8 billion, or just 13 times earnings. At those levels, at least the price isn’t too demanding.

Separately, a Hong Kong court queried the state secret mandate, rejecting arguments from accounting firm Ernst & Young (now rebranded as EY) that it couldn’t hand over information because of the confidentiality rules.

The landmark ruling last month – which EY may yet contest – centres on Standard Water, a municipal water firm in China. The stock market regulator wanted a closer look at the audit documents after EY dropped Standard Water as a client on the eve of an IPO four years ago. EY said no because the audit was conducted by its mainland affiliate, which was refusing to turn over the working papers because of secrecy laws.

How a water firm might have state secrets to protect is unclear and the judge in the case was certainly unconvinced, ruling EY’s objections “a complete red herring”. Ashley Alder, chief executive at Hong Kong’s Securities and Futures Commission, agreed. “This case is primarily about the obligations of an accounting firm in Hong Kong to comply with requirements under Hong Kong law,” he insisted. “The case is not about PRC law. Auditors should not withhold information that is in their possession and sought by the SFC in connection with suspected misconduct in Hong Kong’s markets.”

But only a few days before the decision in Hong Kong, China’s Ministry of Finance (MoF) proposed new rules that would prevent international accounting firms from sending staff to audit Chinese companies, requiring instead that they delegate the work to their domestic partners.

The move seems related to mainland fears that Hong Kong accountants might disclose state secrets to foreign regulators, says Paul Gillis, a professor at Peking University and the author of China Accounting Blog.

For US listings, most auditors already have their Chinese affiliate sign the audit report. But the proposals would create a tricky situation for companies hoping to IPO in Hong Kong, as well as those already there. “The problem is that Hong Kong rules require the use of Hong Kong auditors,” Gillis says. “That is the rule that needs to change. I don’t see China allowing Hong Kong regulators the right to regulate anything on the mainland, including Chinese companies listed in Hong Kong.”

Hong Kong’s auditors were soon warning that the proposals would dent investor confidence, while industry representatives are expected to travel to Beijing to lobby against the changes.

“A key issue is that under the Hong Kong listing rules, Hong Kong accountants are responsible for signing the books. But according to MOF’s proposals, they would not be allowed to do the audit by themselves,” admitted KC Chan, the bureaucrat in charge of Hong Kong’s financial services industry. “We would like the Ministry of Finance to clarify how this would work.”

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