Hearts must have sank at 58.com and Qunar Cayman Islands late last month when a report from short seller Muddy Waters sent shares at the US-listed Chinese firm NQ Mobile plummeting by 47%. The two firms, both based in China, planned to list on Nasdaq only days later.
Two years earlier, it was reports such as these that sapped every last bit of trust in mainland companies listed on US markets. Chinese IPOs in New York all but dried up in 2012 after more than 150 Chinese firms were either delisted or simply stopped filing reports with US regulators.
The NQ short no doubt stirred up painful memories among investors, some of whom in 2011 discovered that the Chinese firm they had bought into was little more than a stack of inflated sales figures.
Still, it didn't conjure enough negative sentiment to hurt 58.com. Quite to contrary: The company that runs an online classified ad business and has been described as the Craigslist of China had surged 18% on Tuesday to US$27.38. Qunar, an online travel outfit, hasn't done as well, down 15% from its original listing price of US$31.19.
While a far cry from the surge of Chinese listings the US saw in 2009 and 2010, appetite for mainland firms is growing. Two more Guangdong-based firms, 500.com and Sungy Mobile, plan to list soon. Shares at YY, a social media application maker and one of the two mainland companies to list in the US in 2013, have climbed more than 375% since its IPO about a year ago.
Still keeping secrets
It's a slow restart for Chinese companies in New York and, by most measures, a miraculous one. Just a year ago, many market watchers expected all US-listed Chinese companies to eventually be struck from the trading boards in what would have been the greatest slew of delistings in market history.
At the time, the Public Company Accounting Oversight Board (PCAOB), a body appointed by US Congress and entrusted with monitoring the accounting practices of US-listed firms, was locked in a long, drawn-out battle with Chinese regulators.
The PCAOB wanted access to the working papers of the accounting firms that audit US-listed Chinese firms. Without the power to thumb through such documents in search of irregularities, it said it would recommend the Securities Exchange Commission in the US to deregister those accounting firms, which included the China affiliates of Deloitte & Touche, Ernst & Young, KPMG and PwC.
China refused, calling the paperwork “state secrets” and threatening harsh punishment to any company that allowed US officials a peek into their files. Finally in June, after several years of negotiation, China gave the PCAOB a little face, permitting it to request working papers from Chinese auditors for investigation – but only if it could show reasons for suspicion.
As Chinese companies return to what was an unwelcoming environment just one year ago, investors should remember that very little in the way of oversight has changed between 2010 and today.
The deal between China and the PCAOB will not prevent malpractices in the future. Rather, cases of fraud can only be checked after they have happened. Working papers are still very much locked away from the prying eyes of the US – a continual violation of the Washington’s securities regulations.
Meet me in the Caymans
This deficit in oversight isn't the only worry these days. There's another vestige of the past still lurking in US equity markets called variable interest entities, or VIEs.
A VIE is a method of structuring a Chinese business so that it appears to be a Chinese-owned firm and at the same time a company owned by investors in New York. Businesses opt for this route because China does not allow firms operating in sensitive sectors such as the internet to list abroad.
However, it is possible to get around this obstacle by establishing a wholly owned foreign company and then making a contractual ownership agreement with a shell company based offshore. Many successful Chinese companies have used VIEs, including Baidu, Sina, and Qihoo, to name a few.
That's not to say the continued use of this structure – which is designed to blur the lines of true ownership – is wholesome. Anyone who bought into 58.com or Qunar last week, both of which use VIEs, should know the risks. The same goes for investors looking at 500.com or Sungy.
The simple fact that the listed company is connected to the actual Chinese-based firm is one of the biggest dangers of a VIE. In cases of malpractice, fraud or ownership disputes that happen on the Chinese side of the arrangement, investors in New York have few legal means of getting to the actual owners. Plus, even if investors were to pursue legal action against the company in China, the Chinese government doesn't recognize the VIE because it’s a method of circumventing Chinese law.
NQ Mobile was structured with a VIE. However, if investors take legal action against the company over the recent accusations, it's yet to be seen how they will pursue the owners in China.
For 58.com and Qunar, Paul Gillis, a professor at Peking University's Guanghua School of Management, said that due to the structure of the VIE, it will be impossible for the proceeds from the IPOs to be legally used to finance their businesses in China.
“This, of course, is a huge risk factor,” he wrote in a blog entry late last month, noting that 58.com has reported significant losses. “If companies cannot use the IPO proceeds to fund losses in the VIE, how is the business going to survive?”
Fool me twice
When it comes to eking out an existence without clear channels of capital, Chinese firms have it well figured out. Gillis pointed out that there were several ways of getting capital raised in the US back to the Chinese operation through a VIE – albeit not legal ones.
Investors eyeing new Chinese IPOs should keep well advised on the often regulation-bending tactics companies must go through to list in the US. They should also recognize that they are working in a regulatory environment little changed from 2010.
A report from corporate investigator Kroll released last month showed that international companies doing business in China felt far more exposed to fraud this year than they did in 2012, largely because foreign executives dozed off to the threat for most of last year.
Wall Street should resist that kind of collective amnesia and learn from what transpired in the past.
