Luckin Coffee Inc.’s accounting scandal, in which it was accused of fabricating sales figures, has yet to subside. Apart from other China concept stocks* such as iQiyi and Genshuixue coming under fire from short-sellers, US Securities and Exchange Commission (SEC) chairman Jay Clayton has also recently warned investors against investing in China-funded enterprises listed on the US stock exchanges — the first time an SEC Chairman has ever done so on national television.
Chinese companies have been in the US capital market in the 20 years since the very first company — privately-owned Qiao Xing Universal Resources, Inc. — was listed on Nasdaq. According to the latest statistics from China's Wind, there are currently over 480 China-funded enterprises listed on the US stock exchanges, which make up a unique basket of China concept stocks on Dow Jones and Nasdaq. However, while the overall number of US-listed Chinese companies is steadily increasing, so are problems of information disclosure violation, accounting fraud, and overpackaging associated with these companies. Overall, the journeys of China-funded enterprises to being listed in the US seem precarious and fraught with issues.
Bad hats give Chinese companies a bad name
Luckin Coffee’s accounting scandal has caused its share price to plummet but the impact doesn't stop there; any Chinese enterprise listed on the US Stock Exchange found to have violated the law would lead to a collective plunge of numerous other China concept stocks. Short selling of many other US-listed foreign enterprises would follow shortly after. Otherwise, they could also become targets for investigation by local regulators. On top of these, credit rating interrogations of China-funded enterprises already listed in the US, are also bound to implicate similar enterprises in the midst of getting listed, greatly increasing the opportunity costs and difficulties involved.
Even the smallest negative effect could be blown out of proportion and cast serious doubt on the integrity of the entire Chinese economy, the government and its citizens.
Ten years ago, four enterprises including Orient Paper and RINO International were delisted for accounting fraud such as overstating revenues and fabricating sales contracts. Following that, the doors to entering the US IPO market seemed to be completely closed to China-funded enterprises.
This year, only four Chinese enterprises were successful in its US IPO. A dark history is repeating itself.
Undoubtedly, the series of bad effects brought about by the trust crisis of China concept stocks would not merely remain on the capital market level.
On one hand, the plunging of China concept stocks prices and the slowing of IPO processes would directly impact on venture capital/private equity (VC/PE) exits. Economists, venture capitalists and private equity firms would favour and trust China-funded enterprises much less due to the high risks involved, and even make the decision to “vote with their feet”. Such a fall in creditworthiness could also possibly implicate the entire venture capital investment value chain, thereby slowing the development and maturing of China-funded enterprises, especially growing companies.
On the other hand, the listing of China-funded enterprises on the stock exchanges of foreign markets — in this case, the US capital market, which is the most developed in the world — not only symbolises their investment value, but also represents the reputation of a country and its people. Even the smallest negative effect could be blown out of proportion and cast serious doubt on the integrity of the entire Chinese economy, the government and its citizens.
...ultimately, they pushed their luck and thought like a gambler.
It is clear that any US-listed China-funded enterprise carries the heavyweight of relevant interests and profits upon its shoulders. As an enterprise that has entered a foreign capital market, they should not be content with the label of being “listed”, but instead be a good ambassador of high-quality credit ratings. Similarly, as a public enterprise with a commercial mission, they should not stagnate after having achieved an IPO, but should instead maintain a sense of crisis at all times while displaying all-round business ethics in their conquest of the overseas capital market.
Between 10 and 20 years ago, numerous Chinese enterprises seeking to be listed on US stock exchanges were unfamiliar with the rules of the US capital market and were adapting to the overseas investment environment. As a result, many of them had repeatedly overstepped regulatory and ethical red lines. The situation is entirely different now. The majority of Chinese enterprises attempting to gain a US IPO today are industry leaders like Luckin Coffee. Their strong grasp and acceptance of overseas capital market policies and the strong backing from their team of experts and professionals are indisputable. Moreover, there are also the prior experiences of Orient Paper, RINO International, and Mecox Lane — enterprises delisted as a result of violating rules — to learn from.
Why then, did famed enterprises like Luckin Coffee still falsify their accounts and embark on a path of no return?
It is clearly not because of a superficial or erroneous understanding of the rules of the US capital market — ultimately, they pushed their luck and thought like a gambler. Such mindsets and motives have driven Luckin Coffee to believe that they would be lucky and be able to escape punishment for their illegal deeds, to the extent of underestimating and even being oblivious to the massive preying and killing capabilities of the US capital market.
Authorities clamping down on errant companies
It is worth noting that the US market has shifted targets from small China-funded enterprises to take aim at industry leaders. Just this year, Lenovo, 58.com, iQiyi, and Genshuixue were attacked to various degrees.
Besides the SEC and Public Company Accounting Oversight Board (PCAOB), which are familiar to listed companies, many would also know short-sellers such as Muddy Waters Research and Citron Research. However, enforcement in the US bonds market is not based on government monitoring and penalties, but driven by market-oriented interests. So, not only do short-sellers openly act on any listed company, but they usually work with independent research companies, which have strong market research and analysis capabilities to home in on “targets” that they deliver to short sellers as prime specimens.
More noteworthy are the “stock market vultures” — the law firms that are so active in the US bonds market. They specialise in studying the documents of listed companies, and once they find flaws leading to losses for investors, they immediately mobilise investors to file class-action lawsuits. It is worth noting that the US market has shifted targets from small China-funded enterprises to take aim at industry leaders. Just this year, Lenovo, 58.com, iQiyi, and Genshuixue were attacked to various degrees. But we learn from mistakes. While keeping themselves absolutely clean, China-funded companies should keep on their guard and have more respect for the market.
Most of the US-listed foreign companies that have broken the rules — such as falsifying finances — or those who have been delisted, have been China-funded ones. This is not just because Chinese and Canadian companies make up the bulk of foreign companies on the US stock market; another consideration is the “fraud culture” that is so deeply rooted in China’s A-shares (RMB-denominated shares of mainland China companies traded on the Shanghai and Shenzhen stock exchanges) market, which has spread and morphed among foreign listed companies.
Indeed, with improvements to the regulatory system and stronger counter-measures, accounting fraud in China’s domestic capital markets have been effectively brought under control. But according to the China Securities Regulatory Commission, since last year, 22 listed companies have been investigated for accounting fraud, with another six referred to public security agencies, and 18 slapped with administrative penalties.
Many cases of accounting fraud in China concept stocks have to do with covering up losses or making their finances look better.
Some US-listed China companies are unable to enter the A-shares market, but they might still be familiar with fraudulent practices of China-listed companies, and may indulge in these practices out of self-interest or misguided judgement. But they need to be warned that besides the “hungry wolves” that are ever ready to pounce, the penalties for fraud in the US are much harsher than in China, and companies will end up paying a heavy price.
Denounce fraud culture
So, as a survival tactic for finding a foothold and thriving in the US capital market, China-funded companies should consciously cast aside and consciously distance themselves from the fraud culture of the A-shares market, maintain the moral line of not falsifying accounts, uphold the professional ethics of integrity, and adhere strictly to a core belief in legal operations.
Many cases of accounting fraud in China concept stocks have to do with covering up losses or making their finances look better. But then, just as the US bonds market allows loss-making companies to get listed, it is highly tolerant of losses in companies that are already listed. Whether China- or US-funded, as long as a company’s stock price does not fall below US$1, even if it consistently makes annual losses, there is no risk of getting de-listed, and it can still legally get financing and increase capital stock.
For a US-listed company, investors may sympathise with a company that has no choice but to de-list because its share price has fallen below US$1 due to the failure of its business model or poor profits, but a company that is removed from listing due to accounting fraud would only be harshly criticised. The former might be picked up at a significantly lower price before it is delisted; the latter would only be thrown on the rubbish heap.
China-funded companies need to hold to the tenets of toning down capitalist dreams and getting down to real work.
Admittedly, many US-registered, China-funded companies may be listed despite being “diseased” with an undeveloped profit model or heavy losses, and their profit growth may be unstable or unsustainable. US investors are also unclear about the realities of China concept stocks, and irrationality in the market cannot be ruled out. In such cases, high share prices do not reflect the true value of a company. In particular, when an IPO shows a deceptively high price-to-earnings ratio but subsequent share prices are shown to be a bubble, company management should not play up their capitalist dreams or worse, misread the company’s strategic direction.
More than capital operation, China-funded companies need to stay pragmatic and come up with an effective business model that is constantly improved upon. They have to prove themselves and grow through profitability. Looking for any other rewards offered by the capitalist market is going to be like a futile dive for the reflections.
Note:
*Stocks of companies operating in mainland China but listed on stock exchanges elsewhere are referred to as China concept stocks.
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