By Therese Poletti, MarketWatch
MarketWatch photo illustration/iStockphoto
It was less than a decade ago that a series of scandals involving Chinese companies going public in the U.S., some through reverse mergers, blew up — resulting in billions of investor dollars lost.
Undeterred, investors have dumped billions more into Chinese companies in recent years, even as shareholder advocates such as the Council of Institutional Investors — and this columnist — have repeatedly pointed to the inherent dangers of stocks with little visibility or recourse for investors who are wronged.
Just last month, history repeated itself when Luckin Coffee blew up publicly, after admitting that a top executive inflated sales figures at the biggest rival to Starbucks in China. Luckin’s inflated numbers were initially exposed in an anonymous short-seller report that was made public in February by Muddy Waters Research — the same short seller that shone a light on some of the problematic Chinese companies nearly 10 years ago, including Sino-Forest.
As other Chinese stocks sank at the time, and investigations here and in China began; the Securities and Exchange Commission issued a warning to all investors about such stocks that boiled down to: “Buyer beware.”
Yet the lesson does not seem to have sunk in even now. As a pandemic washes across the globe and freezes much financial activity, another Chinese company managed to go public last week at a multibillion-dollar valuation that pulled hundreds of millions of dollars from the U.S. to China.
Investors were so excited to dump money into Kingsoft Cloud Holdings Inc. /zigman2/quotes/217977560/composite KC -8.11% , a cloud-computing spinoff of software giant Kingsoft Corp. Ltd., that the company increased the number of shares it sold at the last minute to sate demand. It raised more than half a billion dollars in its IPO, and its market capitalization topped $4.4 billion after investors sent shares more than 40% higher in its first day of trading on the Nasdaq.
The huge Chinese market is just “so alluring” to investors that they can’t turn down a chance to get a piece of it, even with the obvious high risks, said Paul Zarowin, a professor of accounting at the Stern School of Business at New York University. “It’s an enormous market, [and] everybody wants a piece.”
Certainly not all Chinese deals are fraudulent — Kingsoft Cloud is tied to two respected Chinese tech companies, the long-established software company Kingsoft Corp. /zigman2/quotes/208824086/delayed HK:3888 -3.57% and smartphone maker Xiaomi Corp. /zigman2/quotes/208140246/delayed HK:1810 -4.84% , both of which agreed to buy shares in the deal at the IPO price, buying up to $25 million and $50 million in newly issued stock, respectively.
But investors need to understand the risks of what they are investing in: Every single Chinese company that goes public in the U.S. has a complex and convoluted structure, ostensibly a loophole to enable Western investment in a market that prohibits outside investors. But it also protects the core Chinese company through a host of offshore shell companies and subsidiaries. On top of these structural issues is the biggest problem of all: that the accountants who sign off on company financial statements in China don’t have access to those company’s actual books and records, only what they are allowed to see.
“The basic problem is that they don’t have the same auditing standards that we do here,” Zarowin said. “And compounding that problem is that the PCAOB [Public Company Accounting Oversight Board] which oversees the auditing firms, generally can’t get access to audit the Chinese auditing firms. So a lot of firms go public from China into Western capital markets that don’t meet the same disclosure and auditing standards that we would here.”
That was part of the lesson that SEC Chairman Jay Clayton and other top leaders of the regulatory body stressed in their recent missive , fueled by the Luckin Coffee blowup. Shares of the once-high-flying IPO, halted April 7, have still not reopened for trading.
“Shareholder claims that are common in the United States, including class-action securities law and fraud claims, generally are difficult or impossible to pursue as a matter of law or practicality in many emerging markets,” the SEC said last month in a statement about the risks of investing in emerging markets, describing China as the world’s biggest emerging market.
The SEC is now investigating Luckin Coffee, while China’s top regulator began an investigation and raided its headquarters late last month, demanding access to company records. That was a rare move by Chinese officials, who have said they are cooperating with the SEC.
Thanks to the Kingsoft Cloud deal last week, Chinese IPOs are now slightly ahead of last year’s pace, despite the broader market meltdown that’s marked the coronavirus era and a general pullback in new offerings as virus fears and the economic downturn have dented sentiment.