BY MICHAEL RAPOPORT | Institutional Investor
‘They’d Find Fraud, Fraud, Fraud.’
JULY 22, 2020
The story of Chinese fraud goes back a decade and a half, to the mid-2000s, when a wave of Chinese companies rolled onto U.S. exchanges via a backdoor maneuver known as “reverse mergers.” Chinese companies would merge with a U.S. shell company and take over its public listing, gaining access to American exchanges, trading, and investors — all without the regulatory scrutiny a traditional initial public offering would have brought.
“Until that happens, there’s Robert Seiden”
But starting around 2011, revelations spilled out about the accounting and disclosure of company after Chinese company — that they’d inflated their revenues, pretended they had businesses they didn’t, or seen their coffers looted by executives.
Some of the more eyebrow-raising schemes, according to regulators: Universal Travel gave its auditor an address for a purported hotel customer of the company’s that turned out to be a public restroom. AgFeed Industries, an animal-feed and hog-production company, inflated its revenues by claiming sales of hogs that didn’t exist, and later tried to cover up the fraud by claiming the fake hogs had died. The CEO of TV ad-network company China MediaExpress offered a $1.5 million bribe to an outside accountant helping to look into the company’s finances. (The accountant declined.)
“Some are still fighting to hold Chinese companies accountable, from Robert Seiden, a New York investigator who pursues shady Chinese companies as a court-appointed receiver empowered to seize their assets. . .“
With these revelations, many Chinese companies’ stocks plunged, leaving shareholders with huge losses. The SEC barred about 180 Chinese companies from U.S. trading and filed dozens of lawsuits against the companies, their executives, and “gatekeepers” like auditors and consultants who helped them get access to U.S markets. And for a while, relatively few Chinese companies braved U.S. markets because of concerns about fraud.
But since 2017, there have been 93 Chinese IPOs in the U.S., according to data provider Dealogic. Chinese companies have gotten savvier, Block says: They’re less prone to claiming outsize successes than they were in the past. “They know they have to look human from time to time.”
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Why does this keep happening? Why do these problems recur, even after investors should be on notice that Chinese companies can be risky and difficult to hold to account?
Part of it, some observers say, is that people have short memories, are eager for easy trading gains, and keep wanting to benefit from the opportunities China presents. China and its companies know that.
“Investors forgot” and “just needed to say no,” Block says. China is “this environment where fairy tales are created because investors can’t get enough.”
Many investors have exposure in China without even knowing about it. They hold mutual funds or other investments whose managers invest in Chinese stocks. “There’s a lot of money looking for targets,” says Anne Stevenson-Yang, co-founder of J Capital Research. “A ton of money that’s flowing around, and there are people who figure out a way to harness it.”
For their part, U.S. exchanges are hungry for Chinese listings too. “The public markets are desperate for listings, and they’ll list anything,” says Steve Dickinson, an attorney who specializes in China with law firm Harris Bricken.
There’s also a cultural gap. When Westerners invest in a Chinese company, many assume it has emerged in the same kind of market environment they’re accustomed to in the U.S., that it’s been subjected to the same kind of vetting and regulatory oversight. That’s not the case.
“There’s a certain amount of self-delusion there,” says Jim Peterson, an attorney and author specializing in accounting issues.
On the other side, many Chinese companies aren’t prepared for the level of disclosure and communication with investors that’s required of them when they’re listed in the U.S. Even if they have legitimate businesses, their response when they face criticism may be to avoid dealing with it — to pull up stakes and retreat to China, leaving investors holding the bag.
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It doesn’t help U.S. investors that they can’t be sure that the auditors who review the finances of Chinese companies are doing a good job. In a fraud, the auditors are often deceived along with everyone else. “It’s devastating when skepticism is supposed to be one of the key elements of [an auditor’s] performance,” Peterson says.
The problem is compounded by China’s intransigence. U.S. regulators inspect the work of any auditors who audit U.S.-traded companies. But China has refused to allow such inspections for Chinese audit firms, including affiliates of the Big Four accounting firms that audit most major companies.
China regards the sensitive financial information about its companies that their auditors handle as akin to “state secrets.” Nearly 200 Chinese and Hong Kong companies traded in the U.S., including giants like Alibaba and Baidu, are audited by these firms.
“We have no ability to verify in China and no prospects on the horizon,” said William Duhnke, chairman of the Public Company Accounting Oversight Board, the U.S. audit regulator, at the recent SEC roundtable.
And not just at Chinese companies. At nearly 100 U.S.-based multinationals that do business in China, including giants like Walmart and General Motors Co., some of the audit work is done by Chinese firms that U.S. regulators are barred from inspecting. Investors and regulators have no way of making sure that these companies’ tens of billions of dollars of Chinese business have been properly vetted to prevent errors or fraud.
U.S. regulators have tried for years to get China to change its stance on inspections, to little avail.
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Pressing China on allowing audit inspections and cooperating more with U.S. regulators may yield progress down the road.
Until that happens, there’s Robert Seiden.
Seiden, a former New York prosecutor, has carved out an unusual legal specialty: When a U.S. court renders a judgment against a Chinese company that’s defrauded or otherwise slighted its shareholders, Seiden gets appointed by the court as a receiver, empowered to seize corporate assets for the shareholders’ benefit — something he’s done at 30 Chinese companies now.
He then takes advantage of a quirk in how many Chinese companies are structured: To get around Chinese government restrictions on foreign investment, the companies use subsidiaries outside China to hold their operating assets, often in the British Virgin Islands or the Cayman Islands.
Seiden pursues a court judgment against a company — and then he can go into China as the legal owner of its assets, not just another foreign creditor who can be shoved aside. He uses his position as leverage to force the company’s executives to sit down and discuss a settlement.
So far, his efforts have yielded $10 million for U.S. shareholders at companies like Oriental Dragon Corp., Advanced Battery Technologies, and Shengtai Pharmaceutical. Admittedly, that isn’t much given the scale of the problem, and Seiden acknowledges it’s tough going.
“We’re making a lot of progress, but it’s slow,” he says. There’s a “huge disconnect between how China works and an open system. Their system is ‘might makes right’ — if they can get away with something, they will.”
Investors in the companies Seiden represents recognize the difficulty, but they’re hopeful his strategy can help. “I think we are able to get some small portion of our money back,” says Gary Wolfson of GEP Capital Group, an investor in Oriental Dragon Corp., where Seiden recently obtained a $3 million settlement for investors.
Seiden’s combination of skills equips him well for the job. He was a prosecutor in the Manhattan district attorney’s office, and later worked in China, overseeing investigators and lawyers doing corporate due diligence. He was also a monitor for the Port Authority of New York and New Jersey, pursuing waste and fraud in the building of the Freedom Tower on the former World Trade Center site after 9/11.
Currently, he’s pursuing Link Motion, formerly known as NQ Mobile, whose co-founder allegedly diverted assets away from investors’ control. Seiden was named receiver by a U.S. federal judge in 2019; he’s seized Link Motion’s Hong Kong bank accounts, and his handpicked CEO won an arbitration proceeding in China giving him control over a key Link Motion entity.
Link Motion went dark without any sort of offer to pay the company’s public shareholders, says Wayne Baliga, a Link Motion investor. “If they could do this, any listed Chinese company could do this, and I don’t know what recourse there would be.”
Seiden knows the obstacles, but he has no intention of stopping. “I’m very persistent.”
For all the efforts by the likes of Seiden, Sherwood, and short sellers, tomorrow will look a lot like today when it comes to ensuring that Chinese companies are straight with their investors. Even if the measure to force Chinese auditor inspections becomes law, companies will have three years to comply. The puzzle box isn’t going to be solved anytime soon.
Some are suggesting ways to flag for investors when a company is using an auditor that hasn’t been inspected, to ensure they know the risks. In the absence of inspections, Block suggests making the U.S. arms of the Big Four accounting firms financially responsible for any failures of their Chinese siblings — just like parents are liable for any mischief by their kids, he says.
Chinese companies remain “very highly speculative stocks to invest in,” Nussbaum says. He suggests making it more difficult for retail investors to put their money into such risky companies. At the end of the day, though, “we’re still talking about a huge market with a very, very bright future.”
Others are more pessimistic about whether Chinese companies will get more reliable. “You hate to say just drop it all, we made a mistake, delist,” Stevenson-Yang says. “But I don’t know how to address it.”