14 August, 2017


Hong Kong needs them

Gillem Tulloch

It’s not just because Hong Kong allows short-selling that there are so many short-sellers’ reports, it’s because (by our estimates) Hong Kong is the corporate fraud capital of the world. A small but meaningful percentage of mainland companies seem predisposed to defrauding investors. In general, the sellside is not incentivised to uncover these frauds while auditors and regulators have been unsuccessful in spotting them. Meanwhile, as an accounting research firm, GMT Research is able to detect companies we suspect of being fake cash flow frauds but cannot definitely prove it. Given the expense involved in researching and uncovering frauds, short-sellers are best positioned to expose them. Let’s hope the regulator regards short-sellers as an asset and not a threat given that there seems to be a worrying temptation to shoot the messenger.

Problematic financials

By almost any measure, Hong Kong’s listed companies have some of the most problematic financials in the world. In our report, GRADING FINANCIALS: Is Hong Kong Asia’s ticking time bomb? (10 Feb 2017), we used a number of metrics to gauge the quality of financials for listed companies around the globe. Whether it was Piotroski, Altman, Montier, Beneish or our own model, Hong Kong’s companies were amongst the worst scoring. But it’s not just that Hong Kong’s companies have weak financials or are fudging the numbers a bit, what we’re most concerned about is the number of absolute frauds listed in Hong Kong…

Watch our video on FAKING CASH FLOWS: And how to spot it

The world’s corporate fraud capital?

In our report, FAKING CASH FLOWS: And how to spot it (10 May 2017), we explained how to spot Fake Cash Flow Frauds. These are listed companies where revenues and assets have been largely created from thin air. Short-sellers have their greatest success when they correctly identify these companies. We took close to 100 Chinese frauds and put them through our accounting screen, which maps a company’s entire financial statements, to see if there were any similarities. We then devised a scoring system which correctly identified over 73% of past frauds but was triggered by less than 3% of all companies globally. However, there were enormous discrepancies between markets: between 6-7% of companies in Hong Kong and China looked like fake cash flow frauds, whereas the figure was less than 1% in most other markets. Indeed, 72% of all of these potential frauds were domiciled in Hong Kong and China. While we are not suggesting all these companies are actual frauds, this is very concerning. It’s no wonder that a fund manager recently remarked that Hong Kong listed companies were the new US listed RTOs (reverse takeovers or backdoor listings).

(You might want to know which listed companies we suspect of being fake cash flow frauds; however, this information is reserved for our institutional subscribers. You can watch the accompanying videos to get an idea of how we come to our conclusions.)

Limited legal recourse

But, why are so many problematic companies listed in Hong Kong? The main reason would appear to be the sheer number of mainland Chinese companies which have decided to list there, now totalling 60% of all those listed and should companies be suspected of fraud, management can simply skip over to the mainland and disappear.

Watch our video on ASIAN SHORT SELLERS: The bogeyman is coming

Chinese audit papers a state secret

There are also a number of regulatory failings that would appear to work to the advantage of aspiring frauds from the mainland. The working papers of mainland auditors are considered state secrets and must not be disclosed to foreign regulators or moved outside China without approval by the Chinese government.

Deteriorating audit standards

Even before this regulatory spat with the mainland there were concerns over the quality of Hong Kong’s audits. A weak auditing regulatory regime has resulted in Hong Kong losing accounting equivalency with the European Union. In addition, Hong Kong’s auditors appear to be far more tolerant of malpractice than many other markets, as evidenced by the failure to investigate and sanction in a timely fashion a senior EY auditor who was found to have violated auditor independence rules. In most cases, the auditors have been incapable of detecting frauds in the companies they audit.

Over-regulation of research

While it is relatively easy for companies to publish dubious financial statements in Hong Kong, it is increasingly difficult to criticise them. Writing research is a regulated activity in Hong Kong and yet it is difficult and expensive to get regulated (from personal experience). As such, most research is provided by investment banks which are not incentivised to write critical research, especially on smaller companies which is where there is the greatest incidence of fraud. Over-regulation means that there is limited innovation within the sector with many research start-ups preferring to be based elsewhere. Indeed, to have a lively debate on Hong Kong stocks, interested parties must go to internet forums based in Singapore, such as Smartkarma, The Motley Fool or ShareJunction. Hong Kong’s regulator does not seem to have realised that the way information is absorbed by the market has changed since the 1990s[7].

Stifling discussion

The SFC appears to have taken a very tough line towards negative research by pursuing cases against Moody’s. It appears that those exposing the fraud are seen as the problem, not those committing it.

Other regulatory issues

There are a host of other regulatory issues which we shan’t detail in full here for fear of sending our readers to sleep. However, they include poor financial disclosure for listed companies[12], long share price suspensions[13], and blatant share price manipulation[14]. It seems to us that in Hong Kong the dice have been stacked in favour of companies and the market has become increasingly inefficient. Claims by the SFC that it is addressing these issues by holding IPO sponsors to account[15] seems to be a case of shutting the barn door after the horse has bolted.

Hong Kong needs short-sellers

There is a real need for short-sellers in Hong Kong given the likelihood that there are still a high number of fake cash flow frauds listed and these companies cannot be effectively targeted through traditional means of research. The reports written to uncover these companies are very different from traditional short-selling reports which have become the mainstay of the US market in particular. A traditional short-seller’s report tends to focus on accounting issues or industry trends and can be written without ever leaving the office. However, short-sellers’ reports on outright frauds take far more time and expense to compile. Local filings need to be downloaded, sites visited, employees interviewed and management investigated. Much of the process is outsourced to expensive third party investigators. The bill can run into the hundreds of thousands of US dollars before even writing the report. These costs cannot be borne by traditional subscription or commission-based business models. As a result, shares need to be shorted. Complain you may about short-sellers taking stakes in companies before publishing, but it is not that different from a fund manager touting their favourite buy idea in their monthly newsletter.

It’s a risky business

As for being anonymous, it is often the case that research findings raise strong suspicions but are not conclusive. While the report might be of interest to the market, conclusions probably won’t meet the SFC’s unrealistically high standards for research. Far better to remain anonymous than incur the wrath of the SFC, as Andrew Left found out with his report on China Evergrande. But then again, find someone who doesn’t find Evergrande’s financials odd. Furthermore, named short-sellers frequently come under attack from those they target, both legally and physically. It is, after all, a dangerous game with billions sometimes at stake.

The market can make its own mind up

The market is clearly becoming more discerning with regards to short-sellers’ reports. AAC Technologies (2018 HK) ultimately shrugged off the accusations made by Gotham Research, which appears to have given up writing on the company. Meanwhile, Noble Group is in the midst of an agonising death spiral following attacks from a number of short-sellers and accounting research houses, such as ourselves (we do not short sell).

There is much the regulator can do to help

Put simply, the market does not need the SFC to adjudicate on research; the collective market is far wiser than it will ever be. The regulator can help by encouraging the dissemination of information and alternative views (rather than discouraging it), clamping down on share price manipulation and lobbying for improved corporate disclosure and auditing standards. Hong Kong needs short-sellers to help drain the swamp.

[1] Reuters: Closer Hong Kong, China ties creates corporate governance challenges, 30 Jun 2017
[2] Hong Kong Free Press: Hong Kong and China need extradition agreement, 1 Feb 2017
[3] China Accounting Blog: EY loses on state secrets, 28 Nov 2015
[4] ABC News: US Officials: China Refuses to Help Stop Investment Scams, 9 Jan 2013
[5] China Accounting Blog: The failure of HKICPA regulation, 12 Jun 2014
[6] GMT Research: HONG KONG AUDITORS: Acting in your best interests?, 3 Aug 2016
[7] Hong Kong’s Securities and Futures Ordinance was implemented in 2003
[8] Webb-site Reports: SFAT's red flag on Moody's chills negative research, 8 Apr 2016
[9] Webb-site Reports: Andrew Left and the right to be wrong, 23 Oct 2016
[10] Financial Times: Hong Kong negative research crackdown fuels free speech fears, 30 Aug 2016
[11] Reuters: As short sellers target Chinese companies in Hong Kong, hostility mounts, 07 Aug 2017
[12] SCMP: HK-listed firms falling behind in corporate govt stakes, 06 Oct 2016
[13] Reuters: Hong Kong considering revision of share suspension rules, 01 Feb 2016
[14] Reuters: As short sellers target Chinese companies in Hong Kong, hostility mounts, 07 Aug 2017
[15] The Telegraph: Standard Chartered faces Hong Kong IPO investigation, 1 Nov 2016