When the Truth Hurts, Make it More Difficult to Find

Wednesday, August 8, 2012 4:37

“I want to tell everyone that they are wrong, our data is independently verified and it all matches up”
– Sheng Laiyun, spokesman of the national bureau of statistics

Nobody likes to hear bad news, and in China where local officials have a long and storied history of hiding the truth and there are more than a few brooms by which to brush the bad news under the carpet, hiding the truth and making it more difficult to find is seemingly par for the course. A practice that has over the last few months grown easier as actors within the state system have implemented a number of measures. Measures that I feel are a sign that things in China are not only going to get more interesting, but have the potential to make investing in China more difficult.

The most prominent changes thus far have been in the areas of accounting and due diligence, with the most recent news focusing on the fact that the Big 4 accounting firms are now losing their ability to operate at JVs, and are being forced through a localization process that will have clear limitations on the number of foreign partners in the firm. The Caijing article KPMG Starts Localization Transformation in China, sets the stage:

Regulators have allowed the Big Four a five-year transition period upon converting: in the first stage, the four firms will have to show that no more than 40 percent of their Chinese partners have gained their CPA certifications overseas; by Dec. 31, 2017, that proportion will drop to under 20 percent.

May’s notice also requires that the presiding partners in the four accounting firms should be Chinese with Chinese CPA licenses within three years.

To transform joint ventures into special general partnerships will bring a change of legal liability of the audit risk and enhance professional standards and credibility levels of partners as partners may have to face more punishments for potential wrongdoings under the new measures.

KPMG and the PCAOB questions the ability of firms to comply:

KPMG has hundreds of audit partners in China but it appears they had difficulty finding locally qualified partners. I have heard that they organized the new firm with a minimum number of partners and plan to add more in the future. Nevertheless, it is an embarrassment for KPMG that it has so few locally qualified partners and it is shameful that the MOF accepted this situation as complying with the spirit of localization. I do not expect that KPMG has fired the hundreds of partners who are no longer partners in their audit practice. Instead, they will simply ask everyone to look the other way as they call these individuals partners when they are not.

Regardless of timeline, the critical issue at hand is to localize the teams. A move that certainly in the eyes of Beijing is a good thing as (theoretically) this would bring about a long desired change to take Chinese management expertise to the global level, and (theoretically) help drive necessary changes to local practice. Practice which has been the source of more than a few high profile frauds lately, and is a general reason for Chinese stocks being hammered in the market simply because their are Chinese.

So, is now the time to make this transition? According to the few conversations I have had with partners at these firms, there is a real concern that the firms are themselves going to be at risk. That as has been seen in several of the Chinese frauds, the Big 4 are already having issues ensuring their clients are compliant, are being put in a difficult position with balancing S.E.C. demands and Chinese "state secrets". A condition that is ONLY going to worsen as foreign partners exit and Chinese partners who are more easily influenced locally take point.

on the other side of the transparency equation, China has also been working hard to make sure that firms/ individuals who are out to research the quality of Chinese firms are being met with resistance. At times more dangerous, as show by two recent articles: Clampdown in China on Corporate Sleuthing

On April 20, China’s police started a campaign across 20 provinces against companies that conduct private investigations, according to an article in the People’s Daily, the Communist Party’s official publication, a week after the campaign began. That campaign was aimed at preventing investigators from getting personal information on individuals, the article said. In practice, the rules affected investigations of corporations because they often involve background checks into the political connections and other business interests of company executives. […] The campaign came after it became almost impossible to access corporate records at the State Administration of Industry and Commerce, according to lawyers, investors and research companies. Such documents were typically the starting point for investors conducting due diligence on a company they were considering investing in.

[..] Jon Carnes, who runs Eos Global Holdings, an investment fund, said three of his researchers, including a Canadian national, were detained in December during the course of an investigation, and still are greatly restricted in their movement. Mr. Carnes himself left China in October after living here for more than five years, saying it had become too dangerous.

As the WSJ report In China, Little Urge to Audit the Auditors highlights

As it is, there is widespread suspicion of Chinese firms and Chinese audits among many investors. That suspicion almost certainly has depressed share prices for honest Chinese companies, and made it difficult for some Chinese firms to raise capital. But in recent months China has made it harder, rather than easier, for American investors to check the legitimacy of their Chinese investments.

[…] That is the credibility problem China faces. Lewis Ferguson, a member of the American accounting oversight board, says that 67 Chinese companies that trade in the United States have had their auditors resign, and 126 have either been delisted from American exchanges or have chosen to stop filing reports on their finances with the S.E.C.

Wider than this, and wider than the fact that after a string of Muddy Water reports “slandered” several Chinese firms listed overseas, the pattern than I am beginning to see is troublesome from a few vantage points. none more important than the fact that at a period where China needs to be opening up, identifying problems, and fixing them at their core, the warm blanket of denial is being brought out and problems are not just going unresolved, but are blowing up to such an extent that China’s credibility is ultimately taking the hit.

Investors are balking, markets are cold, and Chinese firms at some point will understand that this is a problem for their business as their needs change from a pure China model towards something bigger.

Second, international investors looking at China are growing more vocal in their displeasure with the hurdles that are going up. Before, investors I spoke with spoke of the hurdles as almost a challenge. Every hike needs a machete right? But now, the discussions are more about understanding the fact that perhaps china really doesn’t want international investors coming to China, and shockingly, that is ok. the game has changed mentally, and again, I think that is going to be an issue going forward for China’s economy as the economy goes through the next 10 years of maturation.

And if neither of those scenarios are interesting, then perhaps the delisting of firms (as mentioned in the KPMB and the PBOC) will be:

If the PCAOB decides the firms need new registrations, and then do not allow new registrations because of the barriers to inspection, the result will be that most U.S. listed Chinese companies will be without auditors, and will likely be delisted from U.S. exchanges. We are already facing that risk if the PCAOB and China are unable to reach a deal on inspections, but the issues with the Big Four could accelerate that process from the December 31, 2012 deadline for inspections.

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