Buying Stock in China’s Publicly Traded Companies: Good Luck With That

I am an international lawyer, not an investment advisor or a stock analyst. So when I tell you that I have never invested in a publicly traded Chinese company and I cannot see myself ever investing in a publicly traded Chinese company, you should (and you probably will) completely ignore me and not change your behavior in any respect.

But I am going to ramble on about China stocks in this post anyway.

What has spurred this post (and my rambling) is having just read a post on the always superb China Accounting Blog, by Paul Gillis, PhD/CPA Professor at Peking University’s Guanghua School of Management and the person who knows more about China accounting practices than pretty much anybody. Paul’s post cites to and agrees with another blog post, one written by Dan David at GEOInvesting, entitled, EB-5: The SEC Has Done an Amazing Job Protecting Chinese Investors – Will China Return the Favor? The GEOInvesting post bemoans how the United States Security Exchange Commission (SEC) does a great job protecting Chinese investors from getting ripped off in EB-5 investor scams but pretty much nothing to protect US investors from getting ripped off by Chinese stocks:

As David points out in his post, the only CEO to be jailed for defrauding US investors was Dickson Lee of L&L Energy. Lee, however, was a US citizen and was arrested on US soil, so Chinese authorities could not protect him.

Perhaps the most egregious case was Ming Zhao of Puda Coal, who faces a $250 million judgment from the SEC for ripping off U.S. shareholders. But Chinese authorities have not helped the SEC to enforce the judgment, and instead elevated Ming Zhao to the Eleventh Standing Committee of the Chinese People’s Consultative Congress. I guess he is viewed as a model comrade.

Now we have the case of ZTE which was recently accused by the Commerce Department of circumventing export restrictions by selling products with sensitive American technologies to Iran, despite having agreed to the export restrictions. The US actions likely make it difficult for American companies to serve as suppliers to ZTE. China has screamed foul, saying the US actions would severely affect the normal operations of Chinese companies.

There was also the recent case where the Bank of China’s New York branch refused to comply with a US court order to turn over customer information related to a counterfeiting case. After facing $50,000 a day fines, the Bank of China relented and turned over the information.

Gillis sees Chinese regulators as “playing US regulators for fools. They are protecting Chinese fraudsters and thereby creating a safe harbor for those who wish to commit fraud against US investors. At the same time, they welcome application of the rule of law in the US to protect Chinese investors. US regulators are letting them have their cake and eat it too.”

Gillis then discusses how the “SEC has been unable to bring Chinese fraudsters to justice; as long as they stay in China they remain outside of the grasp of US regulators. China has shown no interest in prosecuting Chinese fraudsters for crimes committed in China that are clearly crimes in China, apparently on the basis that victims of the crimes were not Chinese. And US regulators have had little success in getting cooperation from Chinese regulators at bringing the fraudsters to justice in the United States.”

But Gillis believes that if the US actually started getting tough with China stock fraudsters, we would start seeing results:

What China is doing is a version of the poker strategy of shooting the angles. In poker, angle shooting is the act of using various underhanded, unfair methods to take advantage of inexperienced opponents. The difference between angle shooting and cheating is simply a matter of degree.

The SEC and PCAOB should take a lesson from the Bank of China case. When the pain was great enough, China backed down and produced the documents. The SEC got a partial victory against the Big Four accounting firms in China when it threatened to ban them because China would not allow the production of documents. I believe that if the SEC/PCAOB can make a credible threat that they will kick Chinese companies off US exchanges they can get China to prosecute fraudsters who rip off US shareholders, to help recover funds, and to properly regulate auditors and listed companies.

Dan David asks one key question: Why is it illegal in the U.S. for fraudsters to steal from Chinese investors, but in China fraudsters are not prosecuted for, stealing from U.S. investors?

Guess what? They are both right. It is very easy for Chinese companies to engage in stock fraud without repercussions. Our China attorneys see this all the time, as hardly a month goes by without someone contacting us to see if we might be interested in pursuing a stock fraud claim against XYZ Chinese company. The problem is that unless XYZ is still operating in the United States (or in Canada, which faces many of the same issues) or purchased American insurance that might cover the fraud claims (which is not likely), these just do not tend to make for great cases, because there is no money pot at the end of the proceedings.

So if you are buying (most) Chinese stocks, you are on your own. In other words, caveat emptor baby. And that (plus the fact that we rarely see a Chinese company with fewer than three sets of books) is why I will not buy Chinese company stocks.

Your thoughts?