Serving as China’s IPO assembly line has enriched the Hong Kong Stock Exchange, making it the world’s biggest bourse. But, this also means tolerating the inconsistent if not outrageous quality and outcomes of fraudulent mainland Chinese listings and conduct risk. Two recent incidents test the limits of even the most liberal and cynical investors.
Last week, Hong Kong’s top financial official, Chan Ka-keung, Secretary for Financial Services and the Treasury, urged listed companies to disclose information about its key officers following a growing number of those whose senior executives are reported missing.
A rising number of Hong Kong listed companies recently saw their chairmen go missing or out of contact due to mainland Chinese government anti-corruption investigations. Only in Hong Kong do mysterious disappearances of company directors elicit a phlegmatic response that assumes that detainment without due process is a normal regulatory event in modern capital markets. These filings might as well claim that directors were victims of extraterrestrial alien abduction. It would certainly be more believable.
The outright sting of 2015 came from China Metals Recycling Holdings, whose seven-year-old listing was cancelled by the Hong Kong stock exchange on December 31. According to HKEx it “obtained its initial listing by fraud” and is “no longer suitable for listing.”
HKEx added: “Through the fraudulent scheme, the company obtained its initial listing, for which it should not have qualified. It also misled the investing public to rely on the fabricated operations and financial position presented in its accounts published at the time of the IPO and years thereafter.”
Last February, the Securities and Future Commission (SFC) won a landmark court order to wind up China Metals Recycling. It claimed to be the country’s largest recycler of scrap metal, but was alleged by the SFC to have grossly inflated sales and profit by forging documents and transactions. The SFC said China Metal Recycling had overstated its sales by about 46 per cent, or HK$8 billion, and its gross profit by 72 per cent or HK$1 billion between 2007 and 2009.
The SFC remarked: “These accounts were set out in its IPO prospectus for the purposes of its application for initial listing and inducing investors to subscribe for shares. In the circumstances, the company or its business should not have qualified for initial listing in the first place.”
Sadly, regulatory enforcement only kicked in when an independent research firm, Glaucus Research Group, alerted investors. Its 2013 report brazenly challenged China Metals Recycling’s entire business model. “The Company purports to be the largest scrap metal recycling company in China. We believe that this is a lie. Publicly accessible import data from the Chinese government suggests that the Company is a blatant fraud that has deceived the market about the size of its business.”
Taking seven years to rectify what they confess to be a fraudulent listing without a judgement for civil or criminal penalties reveals a major weakness for both HKEx and SFC. And that’s the very problem- that even after a global financial crisis, Hong Kong’s regulators cannot seek anything more than sanction.
The SFC has issued new directives placing more due diligence responsibilities on the listing candidate’s sponsors, which are financial institutions. But, only a legal challenge will determine if sponsors can actually be held liable for a fraudulent IPO applicant. Shifting blame to sponsors is a misguided policy because they are incentivised to sell stock, not act as guardians.
The auditors for China Metals Recycling during the IPO were Deloitte Touche Tohmatsu and the sponsors were UBS and China Merchants. Both consider their role and the entire transaction- from their perspective of acting for the IPO to be a closed deal. So how they could be culpable can only be decided if regulators take action against them under their new policy.
The HKEx and SFC’s due diligence and compliance teams are not really prepared, robust, aggressive and diligent enough to deal with completely flagrant and outright attempts at fraud. Depending on independent research firms to uncover fraud or criminal intent is no way to run a regulator. But, they will be facing more as China’s economy slows down.
Perhaps the starting point is understanding that mainland Chinese business people define fraud differently than westerners. It simply doesn’t carry the same level of reputation risk compared to other corporate cultures. That is why its resolution in China is different than in the west. HKEx and SFC need to act from that perspective.