It’s a case of buyer beware when investing in stocks of Chinese companies, not to mention businesses with significant operations in China.
And Canadians are more vulnerable than Americans are to financial fraud by Chinese businesses—such as overstated revenue and asset values—due to Canada’s use of international accounting standards that give greater leeway to a firm’s executives, according to investigative forensic accountant Al Rosen.
“People think they have this comfortable investment, but the point is, it’s wide open to manipulation,” Rosen told The Epoch Times.
Financial deception is part of a Chinese master plan, according to Carson Block, founder and chief investment officer of Muddy Waters Capital. He says China is waging an undeclared economic war against the West.
“This system whereby they protect frauds that list in the United States, and raise capital from U.S. investors, I think is one leg of a capital markets strategy. That is one leg of this undeclared economic war,” Block said.
He was speaking at a Securities and Exchange Commission (SEC) panel in Washington, D.C., on July 9, about investing in emerging markets (EM). The discussion concentrated on China almost exclusively, as it is the biggest allocation in EM at 41 percent, according to Morgan Stanley’s indices.
Corruption Leads to Fraud
Block explained that many EM lack the standard of rule of law found in western democracies. What’s problematic is that even if a company is listed on a North American stock exchange, the ability to enforce a Canadian or American court decision is limited in the foreign country.
With China having a much weaker rule of law, Block questions why business leaders there would be inclined to adhere to the more stringent western standards.
In China, the corruption cascades from the top down, Block said.
“If you have a corrupt leadership, much of the society will operate that way. And what that means is many of the people who come to control significant businesses—the kinds that list in the U.S.—are beneficiaries and participants in that system,” he said.
In a book Rosen co-authored with his son Mark, “Easy Prey Investors: Why Broken Safety Nets Threaten Your Wealth,” Rosen said some of the common financial manipulations include overstating profits and cash flows. Other schemes include excessive executive pay through flawed compensation agreements.
Investors looking for growth were fooled into thinking that the once TSX-listed Sino-Forest was a proxy for China’s economic rise. But the Ontario Securities Commission (OSC) found that the company had falsified assets and sales records and given inaccurate statements to external auditors. In 2017, the OSC ruled that Sino-Forest had defrauded investors and misled investigators.
The U.S. firm Muddy Waters was instrumental in bringing about the end for Sino-Forest in 2011.
Companies like Sino-Forest locate themselves in Canada by design, Rosen wrote.
“In fact, Canadian investors are much better protected by U.S. regulators than they are by regulators in their own country,” he said in his book.
Where Canada is more vulnerable than the United States, Rosen argues, is due to the accounting standards it follows—international ones that use “current value accounting.” This method is more easily abused, as companies can apply overly rosy assumptions, such as the likelihood of revenue collection or price appreciation of an asset—as opposed to recording it at cost, according to the U.S. standard, the Generally Accepted Accounting Principles (GAAP).
For Chinese or other EM assets, such as infrastructure and even some infrequently traded stocks—known as Level 3 assets, where there are no recent prices determined between buyers and sellers—Rosen says it’s a bad combination for Canada to be using international accounting standards.
“You’ve got a problem of how can I possibly calculate a current value, without making a dozen or so assumptions,” Rosen said.
In recent months, the United States has ramped up efforts to crack down on Chinese companies, as it is a matter of grave apprehension for the White House; however, similar concerns in Canada fall on the shoulders of the provincial authorities, who have not attempted similar efforts.
Investor Protections Insufficient
Roger Robinson Jr., president and CEO of RWR Advisory Group, a firm that specializes in tracking and assessing the risks of foreign state-controlled enterprises, told the SEC panel that the Chinese Communist Party controls all Chinese enterprises and implants its cells in their senior management structures.
Article 7 of China’s National Intelligence Law enables the state to call upon Chinese firms and citizens to “support, assist, and cooperate with state intelligence work” and to “keep the secrets” of that work from the public.
What troubles Robinson is that some Chinese companies are illegal for U.S. firms to do business with, yet investors can invest in them. The companies could be complicit in human rights abuses and be threats to national security, but such information is not required to be disclosed as material risks—ones with a significant potential for harm— to U.S. investors, according to Robinson.
For example, investors can own the FTSE Emerging Markets All Cap China A Inclusion Index via an investment management company’s exchange traded fund (ETF). Investors buying shares in such an ETF are unwittingly providing U.S. dollar capital to some of the 20 companies that the Pentagon says are owned or controlled by China’s military, like China National Nuclear Power Corp. and China Shipbuilding Industry Corp. Such companies could face additional U.S. sanctions.
Robinson reiterated that China is an authoritarian police state and that the United States needs far more discipline in regulatory enforcement. Due diligence is lacking on these Chinese companies, and the SEC should be regarding human rights abuses and national security risks as material to investors. So should the Public Company Accounting Oversight Board, a U.S. body created to protect investors by overseeing audits done for publicly traded companies.
“We need far more discipline and far more regulatory enforcement than we have today. This multi-trillion-dollar free-lunch program for China is unsustainable,” he said. “We’ve looked at the prospectuses. We’ve looked at the SEC filings. And some of the most obvious risks are not there. So I think we have a lot of work to do here.”
Rosen said Canadian provincial financial markets regulators cannot do much about this nefarious risk.
“You would need a change in their whole mandate legislation and so on for them to take a look at it,” he said.
The British Columbia Securities Commission (BCSC) told The Epoch Times that company management itself is responsible for determining what is material to investors, and the regulator can prevent a company from listing if it believes the company is not conducting its business with integrity.
“Securities laws do not limit business activities. Instead, they require timely disclosure of material information so that investors can make informed investment decisions,” the BCSC told The Epoch Times.
More Sino-Forests Out There?
It would appear ambitious for U.S. and Canadian regulators and accounting bodies to expect greater cooperation from China given the inherent corruption, its disregard for the rule of law, and its capital markets strategy that is part of a larger “undeclared economic war,” as Block put it.
The China expert, in a recent interview with Bloomberg Asia, said he believes the country has no real intention of cooperating with U.S. authorities.
“China is to stock fraud as Silicon Valley is to technology,” Block said. In his firm’s investment strategy of shorting stocks—profiting from the drop in value of a stock—China will be 20–25 percent of their focus.
He also warns that audits can provide a false sense of security for investors. They are meant to check that accounting standards have been properly followed. They are not meant to catch or prevent fraud.
Rosen has testified in Singapore’s high court on some of the financial shenanigans there that caused huge losses for Canadian-based investors.
“It has to blow up at some point,” Rosen said.
The $400 billion Canada Pension Plan, one of the world’s largest pension funds, plans to ramp up investment in China to 20 percent of the fund’s assets by 2025.