US, PRC make world safe for fraud

China and the U.S. are presenting themselves as exemplars of opposite models of political governance.

China has laid out its vision for a rejuvenated nation: a socialist planned economy, built on data and analytics, that will displace market economies. The U.S. is taking the opposite route: withdrawing government from the marketplace, deregulating the economy through executive orders, starving regulators of funds, and appointing agency heads with records of antagonism to their own agencies’ missions.

With both economies breaking away from what was formerly a broad consensus on market governance, the concept of compliance is suddenly in question — as are systems of governance designed to prevent fraud.

The recent documentary “The China Hustle” laid bare the impact of Chinese fraud on U.S. markets. The film made much of backdoor listings, which apply lax standards of review to companies looking to capture capital from public investors. When the companies are Chinese, they fall into a regulatory gap between two systems: Chinese regulators abdicate responsibility, since the investors are American, and U.S. regulators do not have standing to access records in China that might disclose fraud. The move in March to allow Chinese depositary receipts will exacerbate the problem by creating new ways for companies registered in the no man’s lands of the Caymans and British Virgin Islands to collect capital from Chinese investors.

What “The China Hustle” failed to do was draw the obvious connection between the blatantly fraudulent Chinese reverse mergers exposed in the 2009 to 2012 period and the practices of the Chinese tech giants and unicorns who are being embraced by investors around the world today. These unicorns have raised marketing exuberance to a scale that could hobble markets by subtracting hundreds of billions and even trillions in “value” in days if checked against more familiar measures of value.

Their misrepresentations are of a different type, more like Enron’s and less like Crazy Eddie’s. These companies exploit variations in reporting standards that open up opportunities to mislead investors without technically breaking the law: by creating new, unauditable claims, such as  gross merchandise value; by obscuring corporate control with structures such as variable interest entities; by hiding ultimate beneficiaries via partnership structures; by using the fig leaf of “national security” to thwart efforts to verify data; and by turning standards for determining income, cash flow, and even “cash and cash equivalents” into debatable issues.

Regulatory arbitrage now allows entities exposed as frauds to fold up their tents and go raise capital elsewhere. Think about it: Not only is there no penalty for bilking public-market investors, but frauds are actually rewarded, because the trail of audited reports a company leaves behind becomes a foundation for a new listing, while the forensic analysis, regulator queries and class-action suits that got them delisted from one market are not even reviewed by the next one. Classic examples include Focus Media, which delisted in the U.S. after devastating revelations of fraud, then relisted at a higher valuation in Shenzhen.

Among the widest regulatory gaps that support Chinese unicorns and decacorns such as Alibaba Group Holding Ltd. and Tencent Holdings Ltd. is lax acquisition accounting, exacerbated by poor access to financial and ownership records across territories. How purchase prices for acquisitions are calculated and how their receipt is verified are almost entirely opaque and, when acquisitions fall below the line of “materiality,” investors learn nothing at all about them. Companies such as Alibaba have taken advantage of this by marking up the value of their acquired companies even as those companies lose money. Untested asset value claims on their balance sheets constitute a rapidly growing fraction of their balance sheet assets.

National governance systems are ill-adapted to these challenges, and yet the international order for managing trade and investment has largely broken down, as its biggest champion, the U.S., has demonstrated a clear lack of interest in complying with rules it was instrumental in writing. Investors seem eerily comfortable with the lack of stabilizing institutions and the predictability for trade and investment norms they provided.

It may be that the breakdown of international institutions and the low regard the U.S. government has for its international commitments is, in fact, the next evolutionary stage of globalization. The long post-colonial process of emergence of the world’s largest populations would always have challenged the World Trade Organization and the International Monetary Fund, as they were created by developed nations and long served their interests. The Great Game of this century finds its closest analog in the world of social media: beyond regulation, largely invisible from any single viewpoint, shattered into small domains of interest and participation, and brutally competitive for advantage in a world without a recognized, institutional authority. 

As the world’s largest economies realign before our eyes, a question worth pondering for investors is this: In the new Great Game, who will be the referees? Anne Stevenson-Yang, Bloomberg