Chinese overseas listed companies under scrutiny

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A string of frauds involving Chinese companies listed on overseas stock exchanges makes it more urgent than ever that regulatory oversight is beefed up.

Chinese stock listings on overseas exchanges such as the NYSE, Nasdaq and Toronto Stock Exchange are under the microscope, following a string of scandals which have seen investors defrauded out of billions of dollars. There are roughly 156 Chinese companies listed on U.S. exchanges with a combined market cap of $1.2 trillion. They include internet retailing giants such as Alibaba and, state owned enterprises like PetroChina and China Telecom, as well as a host of much smaller and more obscure companies.

However, what is often not realised by many buyers of these stocks is that investor protections are much lower compared to investing in shares of U.S. or Canadian companies. One reason for this lapse is that Chinese companies are not audited to the same standards as Western companies. Chinese companies are easily able to circumvent many of the standards and disclosures mandated by the Sarbanes-Oxley Act, enacted after the Enron scandal in 2001. In a December 2018 report, the Public Company Accounting Oversight Board (PCAOB) warned that it faced “significant challenges in overseeing the financial reporting for U.S. listed companies whose operations are based in China.” The business books and records related to transactions and events occurring within China are required by Chinese law to be kept and maintained there.  China also restricts the auditor’s documentation of work performed in the country from being transferred out of China. National security laws have been invoked to limit foreign access to China-based business books and records and audit work papers. As a result, for certain China-based companies listed on U.S. stock exchanges, the U.S. Securities and Exchange Commission and PCAOB have not had access to the books and records and audit work papers to an extent consistent with other jurisdictions. 

To remedy the problem, Senator Marco Rubio and three other Republican and Democratic Senators have introduced the Equitable Act (Ensuring Quality Information and Transparency for Abroad-Based Listings on our Exchanges). The bipartisan bill would increase oversight of Chinese and other foreign companies listed on American exchanges and would force the delisting of any firms not complying with U.S. financial regulations.

Perhaps the poster boy of such egregious listing fraud is Sino-Forest Corporation (SFC), which had its head office in Ontario and was listed on the Toronto Stock Exchange. The company was a forest plantation and products business with assets primarily in mainland China. In the second quarter of 2011 it reported almost $3 billion of assets in the form of “standing timber.” Sales of the timber accounted for $1.3 billon of SFC’s revenue the previous year. As a result of these purported assets and income, SFC was able to raise approximately $3 billion in the debt and equity markets. In June 2011, short-seller Muddy Waters alleged that SFC didn’t hold anything close to the timber assets reported in its financial statements and the company greatly overstated its revenues. 

Following the report, trading in its shares was suspended. SFC defaulted on its debt obligations and went into insolvency protection in 2012. An SFC Litigation Trust was constituted for the benefit of the creditors and the Trustee, Cosimo Borrelli of insolvency and forensic accountancy firm, Borelli Walsh, initiated legal proceedings against the individual who was the co-founder, chief executive officer and chairman of the Board of Directors of SFC (the “Defendant”). 

After a 48-day trial, the trial judge found that the Defendant had directed a “massive fraud, that the assets reported simply did not exist, and that the transactions reported as resulting in revenue and income were paper transactions without substance.” The trial judge found that by the time the fraud was uncovered and “the dust settled”, some $2.627bn in losses had been incurred by shareholders and creditors as a result of the fraud.

Mr. Borrelli, who is attempting to recover the money on behalf of SFC’s creditors, said that much of the defendant’s personal assets were in China and would be difficult to seize. So far, Mr. Borrelli had received no assistance from Chinese authorities. “Your enforcement rights in China are limited relative to the rest of the world and that’s not going to change for a long, long time,” Mr. Borrelli said. So far, the Litigation Trust has recovered $20 million of the defendant’s personal assets in the form of real estate and holds $2 million in cash. But that’s a far cry from the $2.627bn loss incurred by creditors and shareholders. Mr. Borrelli estimated that final recovery for creditors could be “hundreds of millions,” but “certainly not billions.” 

That’s where a change of law along the lines being proposed in the U.S. could help avoid investors being defrauded in the future. Senator Rubio’s bill would compel Chinese companies to submit to the same standards as local companies under US securities laws and their auditors to PCAOB oversight. Had this been done earlier, shareholders and creditors of SFC and other Chinese corporations could have been saved from billions of dollars in losses, years of litigation and tens of millions of dollars in legal and other fees.

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