It’s Time for Chinese Firms to Play Offense Against the Shorts; Boosting transparency from the start can keep investors from questioning the books

It’s Time for Chinese Firms to Play Offense Against the Shorts

Boosting transparency from the start can keep investors from questioning the books.

MATT FORNEY AND PAUL GILLISMatt Forney

Oct. 30, 2013 12:55 p.m. ET

Once again, China has New York on edge. Despite renewed faith in China’s economy, a sudden shock among investors has reversed a steady climb in the share prices Chinese companies listed in the U.S., and rising fears of Chinese firms may even imperil the pending initial public offerings of four Chinese firms that have filed with the Securities and Exchange Commission. The sudden volatility of Chinese stocks comes from one source: short-side attacks. The most prominent shorter, U.S.-based Muddy Waters, struck again last week with its 81-page skewering of NQ Mobile, NQ +11.26% a Chinese maker of mobile-phone security software. The report says the company’s cash balances are misstated, revenues are inflated and customers are non-existent. NQ Mobile denies the allegations and has released information on its bank accounts and taken the extraordinary step of transferring some of its cash to another bank.Muddy Waters in 2011 also took down Sino-Forest, the Toronto-listed forestry company that became highest-profile Chinese firm to be axed from its stock exchange after a short attack. Such attacks have Chinese executives asking: “How can I avoid that?” While a handful of companies have rebutted short-selling accusations, the best course is to avoid the crosshairs in the first place.

Most important, Chinese companies must understand that they come under more scrutiny in the U.S. than they do in China. They should respond with extra transparency, despite advice from lawyers and accountants trained to limit disclosures. Those professionals worry that as soon as Chinese companies move beyond minimum disclosures, they expose themselves to lawsuits.

That advice might work for Western companies, but for a Chinese company trying to stave off shorts, the risk of clamming up is greater than the risk of talking a bit too much. The less information Chinese firms release, the more opportunities for short-sellers to find “dots” to connect, and the harder investors must work to judge the plausibility of a short attack.

Short sellers know cash is king, and if reported cash is missing, entire financial statements fall apart. They expect fraudulent companies to declare phantom revenue, and then provide fake bank statements showing where that income supposedly sits. That’s what Longtop Financial Technologies was accused of doing in 2011, and the resignation of its auditor, Deloitte, led to Longtop’s delisting. The auditors of China-Biotics even accused the company of faking its bank’s website. The SEC revoked the firm’s registration and the company is fighting to get it back.

To assuage investor skepticism, the financial statements of cash-rich Chinese companies should disclose all bank accounts together with the legal entity that owns them. Such disclosure is not required but would help assure investors that auditors have verified the balances. NQ Mobile has begun to make such disclosures in response to the Muddy Waters report.

A recent survey of investors in U.S. listed Chinese stocks conducted by Professor Gillis found that 89% of the respondents wanted to know about the procedures that the auditor followed to verify cash balances. Auditors and companies have never disclosed that kind of information. But investors want it, so Chinese executives should give it to them.

Executives need to explain the ingredients of their success—show, don’t just tell. If a company’s profit margins far exceed what competitors report, the company should let the market see why. If fat profits derive from a great logistics system, show that system to journalists. Vertically integrated companies should allow stock analysts to tour the supply chain. If labor is outsourced, introduce the third-party human-resources supplier.

Executives at listed Chinese companies must pay more attention to due diligence when they buy smaller companies. Short sellers will look up the names of an acquired company’s previous shareholders in search of red flags, such as undisclosed related-party transactions, so executives should anticipate that. They should also confirm that official paperwork includes correct business addresses. A favorite pastime of short sellers is visiting deserted company offices that correspond with business registration forms. Empty offices at a payment processor of NQ Mobile became ammunition for the latest Muddy Waters attack.

Executives should pony up for good auditors. Short sellers check to see if a company’s auditor is not in the “Big Four”—EY, KPMG, PwC and Deloitte. This isn’t entirely fair since there are other qualified auditors. But Chinese companies should at least avoid smaller auditors who have faced regulatory problems of their own.

Finally, Chinese companies should get real talent on boards and audit committees. Professor Gillis’s survey discovered that 90% of investors in Chinese companies want an audit committee chairperson with professional accounting qualifications. Audit committees need to be more active making sure that disclosures are complete enough to head off short-selling attacks.

All of this sounds like a lot of extra complexity for executives who already faced the daunting challenge of navigating Western securities regulations, not to mention running their companies. But Chinese firms don’t have a choice if they want their overseas listings to be successful. Transparency is the best defense to short attacks.

Mr. Forney is president of Fathom China. Mr. Gillis is a professor of practice at Peking University’s Guanghua School of Management.