On the Financial Edge:
Lessons in handling S-chips for SGX
Written by Leu Siew Ying
Tuesday, 26 April 2011 10:46
Anne Stevenson-Yang wanders into a large conference room in between corporate presentations and meetings during a glitzy investment confab in Shanghai and finds rows of tables manned by representatives from small accounting firms and investor relations outfits hoping to snare Chinese companies seeking overseas listings as their clients. The event is the Rodman & Renshaw Annual China Investment Conference, which was held at Shanghai’s Le Royal Meridien Shanghai last month and was said to have featured 150 presenting companies, a live performance by 1990s R&B band En Vogue and drawn some 1,000 attendees.
US investment bank Rodman & Renshaw was looking to connect Chinese enterprises looking for cash with investors in the US and to facilitate introductions with the various providers of corporate services the enterprises will need as public listed entities in the US. And, despite a string of stories recently of egregious fraud and corporate governance scandals at US-listed Chinese companies that wouldn’t be unfamiliar to investors in Singapore’s S-chips, business was evidently booming.
Stevenson-Yang was at the Shanghai investment conference for a somewhat different reason, though. The managing partner of J Capital Research provides independent research on Chinese companies, which she says are often poorly understood in developed markets. Just weeks before the Shanghai conference, J Capital Research had published a report alleging that Xian-based fertiliser maker China Green Agriculture had been inflating its revenue. Among other things, the report cited discrepancies in revenues reported by the company in the US versus revenues reported by its key operating unit in its filings with China’s authorities. That sparked a steep sell-off in its US-listed shares.
China Green Agriculture, which is already under investigation by the US Securities and Exchange Commission (SEC), later issued a letter to its shareholders, responding point-by-point to the J Capital Research report. Among other things, it said that there are differences in accounting standards in China and the US, and that companies do not reveal all their financial information to China’s authorities for fear of losing their competitive edge if the information were to become public.
Whatever the case, accounting irregularities and corporate governance issues at US-listed China companies are now making investors there as nervous as investors in Singapore are about S-chips. In fact, the spate of bad news prompted SEC commissioner Luis Aguilar to remark that the number of Chinese companies with accounting deficiencies or that are “outright vessels of fraud” seems to be growing.
That’s spurring business for the likes of Stevenson-Yang and J Capital Research, as hedge funds and bear raiders scramble for information about US-listed Chinese companies to take short positions in their shares. Another company benefiting from this negative interest in Chinese companies is Hong Kong-based Muddy Waters Research, a firm founded by US lawyer Carson Block. In November, Muddy Waters published a report on Rino International Corp, alleging that the accounts of the water treatment equipment supplier based in Dalian had “serious flaws”. That sparked an investigation by the SEC and eventually led to the suspension of trading in the company’s shares on April 11.
Then, there is OLP Global LLC, which bills itself as an “alternative” research and consulting firm with a track record of “bridging the information and research gap” between companies and investors. Earlier this year, OLP alleged there were questionable dealings at US-listed ChinaCast Education Corp, but no action has been taken on the company so far. Interestingly, ChinaCast Education was originally listed in Singapore as ChinaCast Communication Holdings. In 2007, it was delisted following its acquisition by a US-listed company called Great Wall Acquisition Corp.
Not all of these firms confine themselves to producing “negative” research on Chinese companies, though. In fact, J Capital Research says it began examining China Green Agriculture because it was initially excited about its prospects. It was only after it looked closely at its business that it discovered what it believes to be evidence of inflated reported revenues. Yet, demand for such negative research is clearly growing, says Stevenson-Yang, because of a “clash of civilisations” when Chinese companies are listed in developed markets.
According to her, analysts and investors in developed markets are incapable of examining Chinese companies properly. Besides differences in accounting and financial reporting standards, companies in China just don’t work the same way as in developed markets. “And, if they list overseas, [China’s] attitude is that what happens there is none of its business as they are regulated by the overseas regulator,” Stevenson-Yang says. That creates a “black hole” that enables unscrupulous promoters to take dodgy Chinese companies public overseas, supported by a host of fly-by-night accounting firms and investor relations outfits, she adds.
To be sure, not all Chinese companies that seek overseas listings are fraudulent. Yet, the methods that analysts and regulators in developed markets use often aren’t sufficient to separate the ones that are from the ones that aren’t. “Investment bankers and research analysts do not begin with the point of view that the [financial] reports are incorrect,” Stevenson-Yang tells The Edge Singapore. “You don’t assume that people are lying to you.”
Even when Chinese companies are genuine, investors don’t always understand the business ethos in China and they underestimate the potential for things to go wrong after the company is listed. “To a Chinese entrepreneur, IPO capital is just revenue. It’s for the taking and not for building the company,” says Stevenson-Yang. And, if the business performs poorly or begins to fail, some companies have little compunction in fabricating their financial accounts to keep their share prices up and continue raising cash, she adds.
Benefit of ‘negative’ research
Such views might seem fanatically negative in a market like Singapore, where analysts tend to express deeply unenthusiastic sentiment on a stock by simply dropping it from their coverage. Yet, the absence of “negative” research in the local market hasn’t left S-chips any better off than China stocks listed in the US. On the contrary, in recent months, S-chips like China Gaoxian Fibre Fabric Holdings, Hongwei Technology and China Hongxing Sports have crashed and then been quickly suspended after giving investors only scant explanation of what exactly has gone wrong.
Peter Choo, who organised the listing of several S-chips over the past decade, first at DBS Bank and later at Westcomb Securities, a boutique investment bank he founded, says the Singapore market would be better off if the negative research and shorting activity promoted by firms like Muddy Waters and J Capital were more widespread here.
“They are superior to analysts,” he says, noting that some of these firms not only provide information to short-sellers but also take short positions themselves. “They spend a lot of money and time investigating a particular company and they put their money there to short the stock. If they make money, well and good. We must have this kind of community.”
Besides alerting investors to trouble brewing at companies, such firms might also help uncover questionable behaviour by investment banks, accounting companies and investor relations firms. In her report on China Green Agriculture, Stevenson-Yang says the company is surrounded by a cluster of US-based promoters “whose record at best presents weak judgment and at worst could suggest a cross-border collaboration to defraud”.
These US promoters, she says, have worked closely with a group of investors in Shaanxi, one of whom was jailed for four years in China for securities fraud and indicted in the US. Roth Capital, the underwriter of an issue of US$25 million worth of new shares for China Green Agriculture in July 2009, also has a pattern of backing problematic companies, Stevenson-Yang claims. Its clients include Orient Paper, ChinaCast Education, Fuqi International and Harbin Electric, which are alleged to have misrepresented their results.
Stevenson-Yang says the SEC ought to bar reverse takeovers, which appears to be the route that many troubled Chinese companies took to obtain their US listings, and start prosecuting the investment banks, accounting companies and investor relations firms that are colluding with these companies. “It’s not going to get rid of fraudulent companies, but it will reduce their numbers,” she says.
That already seems to be happening now. The SEC established a special unit late last year to investigate reverse takeovers. The probe is reportedly targeting Chinese companies and a web of small investment banks, accounting firms, law firms and investor relations advisers.
Obtaining negative and even incriminating information from a company and its promoters to support a bearish call on its stock is no easy task for an independent analyst, though. Stevenson-Yang says she and her team often rack up costs in the region of US$100,000 (RM299,000) for research on a single company.
With the lack of short-selling activity in Singapore, can analysts who specialise in negative research make money in the local market? How can local investors tell a good S-chip from a bad one? What can the Singapore Exchange do to prevent the slew of accounting irregularities and corporate governance problems at S-chips from poisoning sentiment towards the whole sector and derailing its efforts to turn itself into a capital-raising hub for promising young companies?
Stock exchanges in the US, UK and across Asia, including SGX, have worked hard over the last few years to attract Chinese companies. Now, shares in these companies trade alongside shares in well-established companies in those markets. Yet, Stevenson-Yang says Chinese companies listed overseas are inherently risky and unsuitable for many investors. In her view, pension funds and mutual funds looking for steady returns should avoid them, because of the high chance of fraud or corporate governance failures.
Indeed, the victims in these cases haven’t just been small mom-and-pop investors but major institutions with the resources to do extensive due diligence. For instance, private equity firm The Carlyle Group held a 10.9% stake in China Forestry Holdings and a 16.5% stake in China Agritech. Hong Kong regulators suspended trading in China Forestry after its CEO sold a huge block of shares and its auditors uncovered “possible irregularities” in its FY2010 accounts. China Agritech received a delisting notification from Nasdaq on April 12 after a self-professed short-seller, LM Research, called the company a scam and said its factories were all idle.
Even so, few exchanges, bankers and investors are likely to completely avoid Chinese companies because of the tremendous opportunity for growth they offer. “Despite the troubles, we must continue to engage China businesses for obvious reasons,” says Choo. “The benefits of having S-chips outweigh the negatives. No one ever gets full marks or 100% success.”
Investors with the stomach for such risk ought to size up their targets from first principles, rather than rely entirely on their financial reports. As Stevenson-Yang sees it, investors should simply avoid a Chinese company if they have never heard of the products it sells, or if their products have no comparables. She also recommends being wary of companies that keep raising funds, even when their books show they are flush with cash. “If a company wants to prove it’s for real, then if they have cash, they have to pay dividends,” she says. Also, watch out for small companies that provide precise earnings forecasts that they then meet without fail, she adds, especially if those companies are using the services of second- or third-tier auditors, investment banks and investor relations firms.
Attorneys at US law firm Robbins Umeda, which is helping shareholders of China Century Dragon Media file a class action suit against the company, advise investors to scrutinise a company’s corporate governance record. That includes its policies and practices on insider trading and related-party transactions. “Good corporate governance, although not foolproof, tends to decrease the likelihood that fraud or insider misconduct will damage a company,” the firm’s attorneys Brian Robbins and Gregory del Gaizo say, in an email response to questions from The Edge Singapore. Large investors can also have their investments monitored by a law firm in order to alert them to corporate misconduct or fraud, they add.
Robbins Umeda says it has handled a dozen cases of irregularities at US-listed Chinese companies so far, and that number is likely to keep rising. “It feels like almost every day that there is an announcement of irregularity at a Chinese company listed on an American exchange,” its attorneys say in their email.
Regulation versus liberalisation
In Singapore, regulators have responded to the surge in reports of irregularities and corporate governance failures over the last few years by demanding higher levels of compliance with the rules. Earlier this year, SGX directed S-chips to beef up their controls and ordered their audit committees to conduct an internal review and file a report by May 31. Bankers and officials at S-chips say SGX has been sending out such notices quietly from time to time, since 2009, when auditors for Fibrechem Technologies found the company was reporting inaccurate cash balances and receivables.
Investment bankers also say that SGX has asked them use private investigators to check the backgrounds of companies they bring to market, and this has now become standard practice. SGX maintains a list of errant directors and it also requests for information on consultants who refer IPO deals. In addition, it requires the professionals involved in an IPO to sign off on the prospectus to ensure they have done thorough due diligence.
What is the result of all these efforts? “There is no gross negligence. I am speaking for everybody, because I have worked with all of them,” says Choo, referring to IPO managers and bankers who are licensed to operate in Singapore. “I think they are all up to the mark. But how can you tell when a boss is unscrupulous?”
Indeed, even as instances of irregularities and corporate governance failures continue to come to light, obtaining and maintaining a listing in Singapore is getting tougher for promising young companies, some market watchers say. A comparison of the thickness of listing prospectuses filed in Singapore versus markets such as London’s AIM and the Australian Securities Exchange is telling.
The latest Catalist prospectuses are 200 to 300 pages long, whereas recent prospectuses lodged with ASX vary from 64 to 220 pages. Meanwhile, companies seeking a listing on AIM only have to submit a form providing rudimentary information that covers not even a dozen pages. AIM’s listing regulations run into a mere 137 pages, while Catalist’s listing rules are contained in 14 chapters with several sections each, not to mention appendices and practice notes.
With the ease of listing, AIM has attracted more than 3,000 companies since it was set up 16 years ago. The companies listed on the market don’t attract much analyst coverage and they don’t stay forever. Yet, it is vibrant enough to keep attracting investors as well as companies looking for capital from around the globe. Some 450 of the 1,174 companies now listed on AIM operate outside the UK, in more than 100 countries. How does AIM regulate these companies? A spokesman for the exchange says companies that flout listing regulations are fined or publicly or privately censured. At worst, they are booted off the board. Cases of fraud are referred to the authorities, the spokesman says.
In Australia, early-stage mining companies are able to obtain listings on ASX with ease, even though they are highly risky and many ultimately fail. Yet, the market has an investor base that accepts such risks. “They intuitively understand the business and they have gone through the learning curve,” says an analyst who covers SGX. That makes ASX a vibrant market for junior mining and natural-resource companies.
“SGX is doing a lot, but I’m not sure more regulation is the answer,” the analyst adds. According to Choo, for a company to obtain and maintain a listing on Catalist is now no less onerous than on the Mainboard. Moreover, the sponsorship system and listing requirements make listing fees expensive on Catalist relative to other exchanges that also target start-up companies, he adds.
Now, some market watchers are suggesting that SGX simply set basic rules to ensure that companies are what they hold themselves out to be, and then spare them the cost of tough regulation.
While that won’t reduce the number of companies failing, it would increase the number of listing aspirants willing to take a chance on a Singapore listing.
Choo says there is a big pool of investors in the region willing to take high risks for potentially high returns and that Singapore now has a window of opportunity to turn itself into the AIM of Asia. “That is the strength of Singapore, but it takes courage to do it. It takes a different mindset.”
Such a mindset might also see the value of having short-sellers and research firms like Muddy Waters and J Capital Research hunting for companies that might not be what they claim and taking them down. Meanwhile, Stevenson-Yang says she is unmoved by the point-by-point rebuttal of her report on China Green Agriculture by the company’s CEO.
“I read his letter and did not see any substantive points.” She insists that she had tried to engage the company while working on her report, but did not get adequate responses to her questions. “I gave them ample time and details to respond to my report and they did not respond. The letter was just hot air,” she says. — The Edge Singapore
This article appeared in The Edge Financial Daily, April 26, 2011.
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