Appetite for US-listed Chinese stocks transcends audit dispute

February 11, 2014 2:39 pm

Appetite for US-listed Chinese stocks transcends audit dispute

By Simon Rabinovitch in Shanghai

Not too long ago, Chinese companies listed on US stock exchanges were anendangered species. Bears had pounced on them after short sellers exposed fraud after fraud. And a Washington-Beijing regulatory dispute over auditing threatened them all, even the good ones, with a mass delisting.

But investors are not usually known for their long memories, and so it has proved in this instance. Concerns about both the quality of US-listed Chinese companies and the legal standing of their cross-border listings have melted away like the snows of Sochi. Chinese stocks traded in the US have rebounded and the market has reopened to new listings.

Is the renewed confidence of investors well-founded or misplaced? It is understandable, up to a point. Chinese companies have faced piercing scrutiny thanks to theshort sellers, and those still standing are generally seen to be strong. Investors can also be excused for tuning out the regulatory dispute over auditors – it has rumbled on for two years and could well continue for another two.

Nevertheless, just because the audit dispute has dragged on for so long does not mean it will end well. Events in the past month point to a hardening of attitudes on both the Chinese and US sides that could put US-listed Chinese companies back on the endangered list.

The turnround in these companies’ status from market darlings to pariahs and back again has been dizzying. Their share prices soared in the US in 2009 and 2010 – what better way to play the China growth story than get direct exposure to its companies, or so it seemed.

The music stopped when short sellers, led by the now-famous Muddy Waters, published scathing reports alleging fraud at a series of the companies. The worst were those that had gone public via reverse mergers, a way to avoid the rigours of a formal share offering. With investors suddenly mindful of their flimsy foundations, Chinese reverse merger stocks lost more than 60 per cent in 2011.

The scrutiny soon spread to US-listed Chinese stocks as a whole. While investigating the frauds, the US Securities and Exchange Commission hit a regulatory impasse that remains unresolved to this day. The SEC demanded access to audit working papers in China, but the Chinese arms of international auditors refused to hand them over, saying that doing so would violate China’s state secrecy laws. But the SEC charged the auditors with securities violations for failing to comply with US requirements. The auditors have until this week to appeal. With no resolution in sight, investors are braced for the mass delisting of Chinese companies from US markets.

Yet against all odds, Chinese groups have clawed their way back into fashion. Eight Chinese companies went public in the US last year, and most delivered share price gains of more than 10 per cent on their debuts. Dozens more are queueing up to float this year. The 55 biggest Chinese stocks listed in the US climbed 18 per cent over the past two years, according to a Bloomberg index.

What explains this recovery? The overall quality of Chinese companies on the US market is certainly better than in the past. The most toxic have been rooted out and reverse mergers are no longer on the menu as a listing option.

However, investors are also heavily discounting two very uncomfortable possibilities. First, the regulatory dispute that began in 2012 could turn uglier yet. An SEC administrative judge ordered in January that the Chinese arms of the Big Four auditing firms should be suspended for six months. While that decision may be held up for two years because of appeals, the past two years give little ground for optimism that the Chinese and US regulators will reach a compromise. The US is still demanding access to Chinese auditing papers. China is still insisting they are state secrets.

Second, the audit dispute is also a reminder of the legal dodge that underpins the most popular Chinese stocks in the US markets. Because of restrictions on foreign investment in the Chinese internet sector, China’s tech companies have listed in the US as “variable interest entities”. US shareholders are tied to these companies through contractual obligations – loan agreements, for example – rather than as their actual owners. This has been a clever structure for working around China’s rules. Yet it is also one that can crumble apart under pressure, whether because a Chinese company chooses to ignore the agreement or because the Chinese regulator decides it has had enough of the ruse.

Investors everywhere are in the business of taking risks. But investing in US-listed Chinese companies remains a particularly risky business.