Reverse Mergers, Improper Accounting, a Lack of Transparency and Poor Governance Threaten the Recent Success of Capitalism Chinese Style

Is the Chinese capitalistic bubble about to burst under the weight of fraud investigations and back-door stock listings? The dark side of Chinese capitalism has become very apparent the past few months. I have previously blogged about the Chinese brand of capitalism using state-owned entities to control business operations. Most people expected these entities to present challenges to the success of capitalism. In fact, it is the privately and publicy-owned companies creating the regulatory stir.

Let's start with the "reverse merger." In a reverse merger, a Chinese (or any foreign company) is "bought" by a publicly traded U.S. shell company. The Chinese company assumes control and gets the shell's U.S. stock listing without the SEC's usual level of scrutiny of an IPO. It's a backdoor way of getting listed on  U.S. stock exchanges. The Public Company Accounting Oversight Board (PCAOB) recently reported that nearly three-quarters of the 215 Chinese companies listing in the U.S. from 2007 to early 2010 did so using the reverse merger.

The SEC has turned its attention to some accounting firms over their audits of Chinese companies with U.S. listings in order to follow through on the Commission's mandate to protect the U.S. investing public. Concerns exist over accounting practices, disclosure and transparency issues. Questions have been raised about the truthfulness of financing Chinese operations. Also, the audit profession is at risk over allegations of improper professional conduct that could lead to the filing of administrative proceedings against firms. The problem seems to be that some U.S. audit firms outsource accounting work to inadequately trained Chinese accounting firms, and China has blocked the PCAOB from inspecting audits onsite. What's worse is the alleged failure of U.S. auditors to verify that work by Chinese auditors conforms with U.S. auditing standards.

It was somewhat surprising to me to learn that it is mostly the publicly-owned Chinese companies that have come under scrutiny. Moreover, mostly small audit firms issue audit reports on the companies in question. From 2008 to early 2010, at least 40 U.S. firms with fewer than five partners and ten professional staff issued these reports. One explanation for alleged deficient audits might be the less sophisticated quality control systems in small firms including a lack of reviewing partner oversight of audits and vigorous staff training of audit staff.

The problem starts even before audits are performed. There is little or no vetting from underwriters and investors that companies typically undergo when they perform a traditional IPO. Here are some recent examples of the problem:

(1) Sino-Forest Corp., a Toronto-listed timber company, saw its stock tumble by 72 percent during June on accusations of inflated assets and sales, and

(2) China MediaExpress, an advertising entity, saw its audit firm resign in mid-March, saying it could no longer "rely on the representations of management." Its shares are no longer traded on Nasdaq following months of investor concerns over the size of its business and questions over its accounting.

The SEC reported that in March and April alone more than two dozen Chinese firms listed in the U.S. announced auditor resignations or other conflicts.

MediaExpress is larger than the other troubled Chinese companies and its international audit firm of Deloitte Touche Tohmatsu resigned in March, saying that it had raised concerns over "possible undisclosed bank accounts and bank loans," and "issues concerning the validity of certain advertising agents/customers and bus operators," among other issues, according to a MediaExpress regulatory filing verified by Deloitte. The firm also said it had lost confidence in the MediaExpress board of directors' commitment to "reliable financial reporting."

As if things couldn't get worse for Chinese companies listing shares outside mainland China, a regulator at the Hong Kong stock exchange, where many Chinese companies list their stock, warned investors in early June against rushing headlong to buy shares in Chinese companies, calling China "the new dot.com" of the investment world. Martin Wheatley emphasized the failure of investors to properly analyze the fundamentals and likened it to the run-up to the Internet stock boom of the late-1990s in the U.S. Wheatley is concerned about lax corporate governance procedures and its possible effect on the level of trust that has been grudgingly gained by Chinese listed companies in a country with deep-rooted ethical problems and notorious for product-safety scandals and fake goods.

I believe we are witnessing growing pains and the maturation process of Chinese state-owned companies that have been morphing into public companies with limited state ownership and are transitioning from a controlled environment to a more open culture where risks are taken, global competition exists, and the destructive temptations of the capitalistic ethic to pursue self-interest above all else has reared its ugly head. We need to give China time to work it out -- the Chinese way -- and be patient while strengthening oversight and approaching future IPOs of Chinese companies with a healthy dose of skepticism.

 Blog by Steven Mintz, aka Ethics Sage, June 22, 2011