As 2012 draws to a close, two imminent issues hang over the world economy. The better known one is the so called fiscal cliff, which could result in simultaneous reductions in government spending and increases in taxes in the United States. The second lesser reported issue is the ongoing clash between the U.S. Securities & Exchange Commission (SEC) and the China Securities Regulatory Commission (CSRC), with the Chinese affiliates of the “Big 4” auditing firms PricewaterhouseCoopers (PwC), Deloitte, Ernst &Young (E&Y) and KPMG trapped in the middle, along with their clients. While some suggest that Chinese firms should no longer bother trading on tightly regulated U.S. markets, the problem is actually much deeper, with similar cases pending in Hong Kong, and the overall implications painting a picture that investors in Shanghai and Shenzhen should be wary of too.
To briefly summarize events up until now: two years ago “short-seller” research firms, such as Carson Block’s Muddy Waters or Citron Research, started investigating U.S. / Canada -listed Chinese companies for fraud or inaccurate financial statements/reporting. Teams of investigators travelled across China talking to the companies’ suppliers, customers, current and former staff, as well as examining public records, related filings and presence in relevant markets. If the investigations suggested issues or problems with the accounts and filings, then these firms would “short” the stock (by borrowing the shares and immediately selling them), and then publish their research for free, profiting as market participants digested the data and then sold down their holdings.
Investors in the U.S. and Canada lost billions of dollars as several such companies were found to be deceiving investors in one way or another and their share prices collapsed. Chinese accounting and reporting standards are still sometimes lacking. Although some big name firms which have listed in Hong Kong, New York or London have trusted financial statements, there are numerous difficulties within other companies. In China one joke goes that firms keep three sets of records; one for the tax collectors, one for the investors and the real ones for the managers’ use only. Rumors of corruption, fraud and deception are frequently confirmed.
As Chinese firms’ reputations became increasingly damaged, short sellers began reporting official harassment as they tried to carry out their research. What should have been public records were suddenly less available; researchers were prevented from doing their work, and in one case allegedly detained. Carson Block reported being informed of a “state-backed” attempt to access his Gmail account. Meanwhile, foreign media organizations, including Bloomberg and then the New York Times, published sensitive in-depth reports detailing the huge wealth that had been amassed by some of the Chinese Communist Party’s leading figures based in part on publically available records, which did not help the air of difficulty surrounding access to information.