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. Chinese companies tend to have high leverage and problematic financials as well as weak corporate governance. Mainland companies have also been the source of a fraud epidemic on exchanges around the globe, especially in Hong Kong, the US and Singapore – although regulators in the latter two markets have moved to clear up the mess. While there may be many positive reasons to list in Hong Kong, it is possible that Chinese companies are attracted by the territory’s proximity to the mainland and lack of legal recourse. China and Hong Kong do not have an extradition treaty 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. This raises concerns about the quality of audits. Furthermore, if Hong Kong’s securities regulator, the Securities and Futures Commission (SFC), can’t get access to the underlying documentation, it is difficult to put a case together against an offending company. Indeed, the US regulator has in the past complained about China’s lack of regulatory cooperation.
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. Furthermore, we have concerns regarding the interpretation of accounting standards which seem to favour the company, flattering their financial statements. 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.
The SFC appears to have taken a very tough line towards negative research by pursuing cases against Moody’s and Andrew Left of Citron Research. These have been interpreted as an attack on freedom of speech which has intimidated the analytical community. The SFC denies this and claims that “responsible research can all contribute to the overall market quality and price discovery process and has no intention to suppress legitimate commentaries on listed companies, whether positive or negative”. The problem is that the SFC is the one deciding what constitutes responsible research (this is not the case in other markets), and these benchmarks have, in our view, been set way too high, as evidenced by the Moody’s case. While we all try hard to avoid mistakes, it is impossible to be completely error free. It is hard to avoid the conclusion that positive and negative research are treated differently. Perhaps comments by Christopher Cheung, who represents financial services and business interests in Hong Kong’s legislative chamber, best describes the attitude towards short sellers when he claimed that they had caused “serious disturbance to market order” in Hong Kong and hurt investors. 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, long share price suspensions, and blatant share price manipulation. 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 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.
 Reuters: Closer Hong Kong, China ties creates corporate governance challenges, 30 Jun 2017
 ABC News: US Officials: China Refuses to Help Stop Investment Scams, 9 Jan 2013
 GMT Research: HONG KONG AUDITORS: Acting in your best interests?, 3 Aug 2016
 Hong Kong’s Securities and Futures Ordinance was implemented in 2003
 Webb-site Reports: SFAT’s red flag on Moody’s chills negative research, 8 Apr 2016
 Financial Times: Hong Kong negative research crackdown fuels free speech fears, 30 Aug 2016
 Reuters: As short sellers target Chinese companies in Hong Kong, hostility mounts, 07 Aug 2017
 SCMP: HK-listed firms falling behind in corporate govt stakes, 06 Oct 2016
 Reuters: Hong Kong considering revision of share suspension rules, 01 Feb 2016
 Reuters: As short sellers target Chinese companies in Hong Kong, hostility mounts, 07 Aug 2017
 The Telegraph: Standard Chartered faces Hong Kong IPO investigation, 1 Nov 2016
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