With the rise in popularity of U.S.-listed Chinese stocks among American investors came a tumultuous and, ultimately, ineffective battle among the SEC, the public companies, auditors, and the Chinese government. The process was difficult: The SEC's demands clashed with Chinese laws, leaving mega audit firms nervous about their status with the U.S. regulator. In the meantime, countless cases of fraud sank the value of small- and mid-cap Chinese companies and their U.S. investors. Now, the SEC has initiated a hardline approach that is rattling the big four audit firms and putting in question the future of U.S.-listed Chinese companies. If you weren't already tired of the endless struggle to invest safely in China, know that things may get worse before they get better.
The big four audit firms in the U.S. are Deloitte & Touche, PricewaterhouseCoopers, Ernst & Young, and KPMG. These are big, big companies with a presence in all four imaginary corners of the Earth. Their Chinese affiliates have recently come under fire and are refusing to cooperate with the SEC on nine accounting-fraud cases involving U.S.-listed Chinese companies.
If this sounds like 2009 and 2010 all over again, it isn't -- that never ended.
Investing in China, while at times very lucrative for astute investors, is extremely difficult for U.S. retail investors. Differences in standard business practices, a lack of corporate transparency, rampant fraud, and the fundamental difficulty of geographic distance make it incredibly hard for the average investor to conduct thorough and accurate due diligence. To invest in a nonmultinational, small- or mid-cap Chinese company requires on-the-ground research and an experienced forensic accounting team with access to the rare Chinese SAIC (an SEC equivalent) documents. In my former work with a China-focused private-investment fund, we went to great lengths (and expense) to view these reports, which often differed greatly from what was stated in SEC documents.
The story may not be new to investors who followed the debacle a few years back -- or who were unfortunate enough to participate -- but the issue continues on today.
The latest and (not) greatest
The big four audit firms' Chinese arms allege that they cannot legally comply with the SEC while under jurisdiction of contradictory Chinese law. With no resolution in sight, one of the few remaining options -- and what many believe will be the ultimate outcome -- is for the SEC to deregister the Chinese affiliates of the Big Four, which would result in the delisting of U.S.-listed Chinese companies audited by those firms.
One of the main culprits during the recent time of tremendous fraud among Chinese securities was the reverse merger process. In a reverse merger, or RTO, a public shell company that is listed on U.S. exchange becomes the home for a China-based company, avoiding the costly and more inquisitive IPO process. Between January 2007 and March of 2010, these China-based auditors had their names attached to 159 of these deals, with few protests regarding the integrity of their financial statements.
Companies such as China MediaExpress (NASDAQOTH:CCME) and Subaye (NASDAQOTH:SBAY), which are now worthless penny stocks, promised investors huge growth. They outright lied, facing no investigations at the time from the Chinese government or the SEC. Many of these fraud cases were uncovered by private due-diligence reports. The companies flooded the market with equity offerings, which were eagerly picked up by growth-hungry U.S. investors who trusted the integrity of a company that was listed on a U.S. exchange. But this was a false sense of security. CCME and SBAY were just two of many fraudulent companies that now trade around zero or have been delisted.
The SEC, to its credit, does what it can with its available staff and funding. With so many U.S.-based companies to worry about, the SEC didn't have Chinese companies at the top of its to-do list. Even mega-investors with billions in capital wanted in, including John Paulson, who took a large position in Sino Forest -- another fraud.
At this point, most U.S. investors who were interested in the space have abandoned it, making the SEC's latest push a bit too late. But it serves as a reminder to investors in any emerging-market space to take extreme caution in their international stock-picking and, if possible, gain access to trusted on-the-ground due diligence.
As for the Big Four auditors, in my opinion it's about time they take responsibility for raking in millions in fees for companies that defrauded a large number of investors on U.S. exchanges.
Fool contributor Michael B. Lewis has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.