The Investor Guide: Are Chinese Companies Still Worth Investing In?

It is a truth universally acknowledged that an investor in possession of a good fortune must be in want of a Chinese investment. ¹A reference to Jane Austen, Pride and Prejudice 1 (Tribeca Books 2011) (1813) (“It is a truth universally acknowledged, that a single man in possession of a good fortune, must be in want of a wife.”). The facts in favor are clear: China is the world’s second largest economy, its economy continues to grow at a high rate and its companies have been making themselves available to western investors by listing on New York’s stock exchanges. However, the reality is not so simple; instead U.S. investors have recently been fleeing in flocks from Chinese companies with many taking short positions against U.S.-listed Chinese companies. ²Chris Dietrich, Rodman & Renshaw To Shut Down Stock Research As Interest Wanes, The Wall Street Journal, Oct. 14, 2011 (“Over the last year, investor demand for Chinese stocks listed on U.S. and Canadian exchanges has fallen sharply after a string of reports questioning the accounting practices of a range of companies.”). Even sophisticated investors, such as hedge fund titan John Paulson, have recently found themselves in sticky situations as the SEC stepped up investigations into Chinese companies. ³Steve Eder and Gregory Zuckerman, Paulson to Investors: Sino-Forest Bet Was Well-Researched, The Wall Street Journal, Jun. 24, 2011. See also Scott Eden, Bigtime Investors Loose Big on China, The Street, Jun. 23, 2011. And while an approval stamp from the Big Four accounting firms was always seen as a safe bet, Chinese companies have been able to fool even their sage judgment. ⁴Dinny McMahon and Michael Rapoport, Challenges Auditing Chinese Firms, The Wall Street Journal, Jul. 12, 2011. So is navigating the treacherous Chinese market and investing in Chinese companies still worth it for investors? The answer is: yes but with caution.

The mantra of any investor should be “Due Diligence,” and this is especially true when considering a Chinese investment. However, the type and scope of due diligence required when investing in a Chinese company is very different from that of traditional western investments. The most important concept to understand when approaching a Chinese company is that many Chinese companies have three different books (and sometimes more). One book understates profits to minimize tax liability, one overstates profits to attract investors and one is the true book. Although not true for every company in China, investors should still approach the due diligence process with a fine tooth comb. The main items to consider when conducting due diligence of a Chinese company and the ones that this article will discuss are the following: reverse mergers and their implications; taking a closer look at the company’s financial statements; looking beyond accounting sheets and conducting on the ground due diligence; and scrutinizing the company’s independent auditors.

1. Much Ado About RTO

A lot has been written and said about the reverse take-over (“RTO”), or reverse merger, phenomenon that saw many Chinese companies listing on stock exchanges in the U.S. by using the back door. However, there has been a general misconception regarding RTO’s and their implications. Not all RTO’s are automatically non-investment grade, just like not all RTO’s are created equal. Furthermore, the mere fact that a company has gained entrance to the U.S. capital markets through a RTO does not necessarily signal that the company is illegitimate. Certainly, despite all the negative press of late, there are legitimate reasons for going public in the U.S. such as prestige, liquidity and credibility. Foreign firms that cross-list on U.S. exchanges also enjoy valuation premiums and a reduction in their cost of capital. ⁵Luzi Hail & Christian Leuz, Cost of Capital and Cash Flow Effects of U.S. Crosslistings 18 (Weiss Ctr. For Int’l Fin. Research, Working Paper No. 05-2, 2005), available at http://finance.wharton.upenn.edu/weiss/wpapers/2005/05-2.pdf. There are also legitimate reasons for going public using RTO, especially for small to mid-cap companies who do not wish to get bogged down in a lengthy and expensive IPO. Investors should take a more nuanced view on Chinese RTO companies.

In a RTO, a private operating company will merge with a publicly listed non-operational entity or shell. As a result of the merger, the private operating company’s assets and liabilities would be transferred into the public shell company and the public shell company will become controlled by the shareholders of the private operating company. Any outstanding shares continue to be owned by the investors holding them, but the name and operations of the shell are morphed into the name and operations of the former private company. For example, a former public Nevada gaming company can re-emerge as a Chinese dairy company. The RTO process allows Chinese companies to gain exposure to the U.S. capital and consumer markets as well as build a pool of U.S. investors. The RTO is viewed by many as the back door to going public since going public through an RTO enables companies to list faster and cheaper than through initial public offering (“IPO”). ⁶Gabriel Nahoum, Small Cap Companies and the Diamond in the Rough Theory: Dispelling the IPO Myth and Following the Regulation A and Reverse Merger Examples, 35 Hofstra L. Rev. 1865 (Summer 2007).

However, investors should consider other factors that might affect the company’s credence beyond its public status through RTO. For example, investors should look to the amount of information available for each public company. Some companies do not list on the NASDAQ Stock Market (“NASDAQ”), the New York Stock Exchange (“NYSE”) or other registered national securities exchange. Instead these stocks may be quoted on an over-the-counter (“OTC”) platform. As of this year, there are over 300 China-related companies quoted in the OTC market in contrast to around 50 on NASDAQ and under 30 on the NYSE Equities and NYSE Amex Equities respectively. ⁷FINRA, Investor Alert: “China” Stocks – Look Beyond the Name Before You Invest, available at http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/FraudAndScams/p018895. OTC securities can differ substantially in their risk-profile and transparency from exchange-listed trading securities. Generally, there are no minimum quantitative standards that a company must meet to have its securities quoted on the OTC market. OTC-traded securities are not subject to as many or as rigorous reporting standards as those traded on exchanges such as NASDAQ or NYSE. This, coupled with the general lack of liquidity of the OTC market, can restrict the amount of information available to investors and raise the risk profile of the stock. On the other hand, OTC securities are less likely to fall victim to predatory short selling as many exchange-listed Chinese companies have done after recent scandals with accounting irregularity and other fraud allegations against U.S.-listed Chinese companies.

2. The Conundrum of Foreign Private Issuers

To add to the mix, RTO or IPO are not the only means by which a Chinese company might become publicly listed in the U.S. A foreign corporation incorporated outside the U.S., with fewer than 50% of its outstanding voting securities held directly or indirectly of record by residents of the U.S., and (i) having U.S. citizens or residents as the majority of its executive officers or directors or (ii) more than 50% of its assets located in the U.S. or (iii) its business administered principally in the U.S. can become a foreign private issuer (“FPI”) in the U.S. There are numerous accommodations made in the U.S. to make reporting standards more flexible for a FPI. An investor must become familiar with the difference in reporting standards for FPI’s in order to be able to fully ascertain the risk profile of such issuers. Some of the main differences from domestic issuers include ⁸IFLR, Frequently Asked Questions About Foreign Private Issuers, available at http://www.iflr.com/pdfs/web-seminars/Foreign-bank-financing-in-the-US/FAQs_foreign_private_issuers.pdf. :

• Annual Report Filings: A FPI must file an Annual Report on form 20-F (instead of 10-K) within four months of the end of the fiscal year. ⁹At the time this article was written the requirement was to file the Annual Report within six months from the end of the fiscal year. Effective December 15, this requirement is shortened to four months.

• Quarterly Financial Reports: Unlike domestic issuers (including RTO’s), a FPI is not required to file a quarterly report or 10-Q.

• Proxy Solicitations: A FPI is not required to file proxy solicitation materials on Schedule 14A or 14C in connection with annual or special meetings of its shareholders.

• Audit Committee: FPI’s are awarded flexibility with respect to the nature and composition of its audit committee or permitted alternative.

• Directors/Officers Equity Holdings: Directors and officers of a FPI are not required to report their equity holdings and transactions under Section 16 of the Exchange Act. However, shareholders, including directors and officers, may still have filing obligations under Section 13(d) of the Exchange Act.

• IFRS Accounting Standards: A FPI is allowed to prepare its financial statements in accordance with International Financial Reporting Standards (“IFRS”) and does not have to reconcile them to U.S. generally accepted accounting principles (“GAAP”).

• Easy Deregistration: A FPI has the ability to terminate its registration of equity securities and cease filing reports with the SEC, subject to certain conditions. This allows FPI’s to exit the U.S. capital markets with relative ease.

The FPI option offers many advantages to foreign corporations with respect to gaining access to the U.S. capital markets without the extensive burden of U.S. disclosure requirements. To investors, FPI’s can present a conundrum, which can be frightening. However, investors need not be frightened by the fact that a potential investment is listed as a FPI on the U.S. exchanges. In fact, most FPI’s have to undergo more extensive disclosure procedures in order to list in the U.S. than RTO companies. In order to become publically traded, a FPI must register its shares using Form F-1, which is similar to Form S-1 filed by U.S. domestic issuers. Registering through Form F-1 requires extensive disclosure about the FPI’s business and operations. Some FPI’s choose to wait and file a short-form registration statement instead. A short-form registration statement allows a company to disclose minimal information in the offering prospectus by incorporating by reference the more extensive disclosures already filed with the SEC. A short-form registration is only available to FPI’s that have been subject to the U.S. reporting requirements for at least twelve consecutive calendar months. Therefore, FPI’s should be regarded by investors as having undergone an extra vetting process, which RTO companies have sought to avoid.

3. Blazing the Paper Trail

Company disclosures and records can speak a thousand words about the company, if you know where to look. An investor considering a Chinese investment should be diligent at unraveling the company’s SEC disclosures but should also be aware of the company’s domestic disclosures. There are distinct cultural differences and reporting requirements between the U.S. and China. In China, companies must report to the State Administration of Industry and Commerce (“SAIC”) as well as to the State Administration of Taxation (“SAT”). Beyond conducting a simple online search for disclosures, there are several other important aspects specific to Chinese companies to consider as part of any investment evaluation. From fake receipts (or hei fapiao) to off-balance sheet subsidiaries, it is easy to overlook key indicators that might signal red flags when approaching a Chinese company investment with the same process as any other western investment. In addition to SEC and domestic disclosures, investors should be aware of the company’s record-keeping policies, full corporate structure and any government subsidies affecting the company’s income.

The obvious red flags can be detected from careful scrutiny of the company’s SEC filings. For example, if a company has frequently changed its name or trading symbol, jurisdiction of incorporation or its business focus then the company may spell trouble for any investor. Additionally, a more thorough look at the company’s domestic filings might give away more subtle signs of malfeasance. A simple look at the company’s public filings with SAIC would reveal little and could lead to unfounded suspicions. SAIC is China’s government administrator for official documents such as business licenses and corporate registrations, in addition to overseeing other basic compliance. Chinese companies have to renew their business licenses annually by filing an inspection report with SAIC. These reports are not audited by SAIC and, historically, the average Chinese company spent few resources ensuring the accuracy of these reports. ¹⁰Joseph Sternberg, Falling Out of Love with China, The Wall Street Journal, November 17, 2011 (explaining that the fact that various financial data reported to shareholders by Sino-Forest did not match up to data submitted to SAIC because that’s “just the way things are done in China – the numbers often don’t match up”). Yet, misunderstandings can and often do arise when numbers from reports submitted to the SEC and SAIC don’t match up. Investors would be wise to ask the tough questions upfront, while at the same time being sensitive to the cultural difference in viewing domestic reporting requirements. However, many of these documents are not in English or easily accessible to foreign investors. Investors should consider engaging counsel with local expertise to facilitate the process of navigating the web of Chinese disclosure statements.

The more important document to consider is the financial report filed with SAT. Since SAT is charged with collecting taxes, the agency will often audit these reports and levy fines on inaccurate information. Unfortunately, SAT filings are not public records. However, investors can put pressure on potential investment targets to disclose their SAT filings as part of the due diligence process. As the pressure grows, more U.S.-listed Chinese companies will recognize the importance of maintaining their credibility with the investor community and will disclose their SAT filings. One such company, One Bio Corp. (OTCBB:ONBI), has already began paving the road for others to follow by willingly disclosing its SAT filings.

4. Consider the Intangibles

The general lesson to be taken away from reviewing a company’s regulatory disclosures is that, when it comes to Chinese companies, investors should not take anything at face value including the company’s audited reports approved by a big four auditor. Inflated business expenses designed to evade taxes and backed up by fake fapiao (or receipts) are virulent. The black market for fake fapiao is equally widespread and accessible. Walking down a crowded commercial district in any city in Mainland China you will be accompanied by the resonating shouts of fake fapiao peddlers. Also, part of the cultural phenomenon that every Western investor should understand is the importance of guanxi (or relationships), which permeates every aspect of Chinese business culture. This can have significant impact on a company’s ability to perpetrate and get away with fraud.

A recent scandal involving a public Chinese company illustrates this problem well. The resignation letter of the company’s auditor suggested that the auditor was unable to get correct information even from local bank branches where local officials falsified documents verifying cash balances. ¹¹Joseph Sternberg, Uncovering Chinese Companies’ Secrets and Lies, The Wall Street Journal, September 29, 2011. In fact, there has been a rise of instances reported by experienced auditors involving routine falsification of documents at local branches of large, state-owned banks. The problem stems from loose local oversight and regulation enforcement and from greater loyalty to guanxi over laws. The concept of guanxi transcends the western concept of favors. You do a favor for a friend and you expect that favor to be returned with interest. If you do not return the favor you loose face, which is a fate much worse than any possibility of legal punishment for the Chinese. Loosing face has no Western equivalent, however, when underestimated, can cause many problems for any Western investor. Aggressive and confrontational behavior can be as off-putting to a Chinese businessman as Chinese subtlety and insinuation can be frustrating to a Western investor. Understanding the cultural nuances can often be a better method of gleaning real information about a company than any balance sheet can provide. Doing business in China is a social and ritualistic affair. Without proper local expertise and guidance from a trusted adviser, it’s Westerner beware.

Finally, despite the fact that China is the second largest consumer of luxury goods in the world, there is a sense of thriftiness in Chinese culture, which dictates consumer choices. Understanding which Chinese companies are able to land coveted government subsidies is a paramount consideration for predicting consumer behavior and ultimately the trend of the company’s growth. Even Warren Buffett was unable to predict the extent to which the Chinese consumers would be driven by price sensitivity induced by government subsidies. Buffett’s Berkshire Hathaway owns ten percent of Chinese electric car manufacturer, BYD Co Ltd. Last month BYD reported a 85.5 percent plunge in earnings and its outlook seemed dim. Behind the slowing for demand for its cars was the Chinese government’s new limitation of subsidies offered to buyers of fuel-saving cars. In October, the number of car models qualifying for the 3,00 yuan subsidy fell from 300 to just 49. ¹²Update 1-BYD 9-Month Net Down 85.5 pct, Outlook Dim, Reuters, October 28, 2011, available at http://www.reuters.com/article/2011/10/28/byd-results-idUSL4 E7LS1CW20111028. Therefore, understanding the motivations behind the Chinese consumer should play an important role in making a decision on where to invest your money. A general trend that the Chinese government is investing millions of yuan in green technology does not automatically signify that the Chinese consumer will be receptive to that trend once the government subsidies run out as Buffett learned the hard way. Ultimately, the same intuition regarding consumer behavior should be applied to the Chinese market as to any investment, but with an eastern twist.

5. Embracing Your Inner Sherlock

Perhaps the biggest lesson a Western investor considering a Chinese investment should learn is that traditional due diligence methods are not sufficient when it comes to Chinese investment targets. Investors must dig deeper than the surface and must employ forensic accounting techniques to investigate the company even in instances where no preliminary red flags have been detected. When John Paulson’s Sino-Forest investment went sour as the company plunged deep into fraud investigations, Paulson defended himself by stating that the investment was well researched. In a letter, Paulson told investors that ample due diligence was performed on Sino-Forest including reviews of public filings, multiple conference calls and visiting Sino-Forest’s operations. ¹³Steve Eder and Gregory Zuckerman, Paulson to Investors: Sino-Forest Bet Was Well-Researched, The Wall Street Journal, June 24, 2011. Similarly, China-Biotics Inc., directed it’s then auditor, BDO Ltd., to a fake website to verify its online bank accounts. China-Biotics Inc. is a Shanghai-based maker of food-supplement products whose stock was suspended from trading in October due to accounting irregularities allegations. Relying solely on traditional methods of investigation simply does not provide a reliable course of action for investors.

Traditional methods of investigation may indicate that fixed assets are overvalued (depreciations not booked), liabilities understated (suppliers not paid or paid late) and receivables no longer coming in (indicating an account may no longer exist). But specific points should also be carefully checked. For example, the real ownership of land use rights must be assessed by official documents and confirmed by the land office. Quite often the company is not the landlord, but instead is a tenant without the right to sell those related rights. Another side of the business that should be analyzed is the pension scheme of the target company. This is especially true for state owned companies that have to pay pensions to their retired workers. Inventories are also a hot topic since manipulating them is of the easiest ways to improve the overall situation of an industrial company. Consequently, accuracy of inventories must be validated by experienced auditors. Purchases should also be scrutinized. When possible, ask to see suppliers’ quotations about raw materials used by the target company. By doing so you will be able to see whether the company is showing its purchases of materials at the true market price or using inflated statistics.

Investors should consider embracing their inner detectives or hiring a forensic accountant to help conduct informal and unscheduled site visits to the investment target’s facilities. Forensic accountants in Mainland China are full of anecdotes of staged customer offices denoted by cardboard signs, fictional departments that disappear overnight and other ingenious tricks designed to fool the gullible investor. All the world’s a stage and Chinese companies have mastered the art of illusion. However, simple steps such as enlisting local help to investigate can go a long way to breaking the web of illusions. Even something as simple as speaking to the investment target’s customers and competitors can illuminate much of the haze behind the company’s operations. In China, due diligence cannot and should not be conducted at an arm’s length. Investors need to be prepared to defer to local expertise and help in gleaning further insight into their potential investment.

6. Falling Back In Love With China

The general sentiment among the investment community towards China has been that the benefit is perhaps no longer worth the ensuing fraud and other scandals that can follow. Yet China covers one forth of the world’s population, which is increasingly being empowered in larger numbers to spend. The Chinese government has been focusing on making China a consumer-driven economy and a value-add economy. What that means for Western investors is that China is not going away anywhere. With increased consumption comes increased demands for products. China has not showed any dramatic signs of opening up the economy to allow free competition with western companies yet. Therefore much of the increased demand will be met by increased supply from domestic Chinese producers. Marry that with the drying up of credit to curb inflation and you have a perfect platform for Chinese companies to seek non-domestic sources of funding. China is no longer a crouching tiger but rather a roaring one. Investors should not discount China but rather should wise-up on how to invest in China in a responsible and diligent manner.