Chinese companies deceived us. Can they do it again?

What if I tell you an incredible story? A story about how people lost billions, how Wall Street profited from fraud and how nobody is talking about it.

Chinese momentum

After the 2008 financial crisis, many hedge funds managers decided to quit. During the first nine months of 2008, around 700 funds were shut down. The story of a company called Geoinvesting is rather different. Unlike others, they decided to make their money back. The scepticism for Western markets was evident and in the short-term, it was implausible to invest in the US with skyrocketing profits. Yet, there was this new, exploding and dynamic market — China. As seen on the chart, the financial crisis helped China to prosper. During these times, China had especially swift industrial development. New roads, skyscrapers and shopping malls would be built at a rapid pace.

GDP growth was strongest in China during the crisis [1]

The major concern was the ability to invest in China. At the time, foreigners couldn’t invest in China conveniently, still, some businesses managed to find a way around that system. Roth Capital, a small “boutique” investment bank in California, started offering small Chinese companies’ shares to their investors. In order to attract as many investors as possible, they held 2–3 days of conferences with hundreds of Chinese companies. CEOs of these companies would present their company, together with possibly fraudulent spreadsheets and growth charts. The investors, largely motivated by the sweet-talk about 70% growth in the next twelve months, rushed to buy shares. Roth’s events were remarkable for its entertainment. Snoop Dogg, Pitbull, Wiz Khalifa and others were hired to perform. With the simple addition of alcohol, it is a perfect recipe for fundraising.

Magic Behind

Many of these Chinese companies were promoted as risk-free investments and pushed by analysts and salesmen to be bought by average Americans. After the stock was introduced on the New York Stock Exchange, the insiders in the scheme would cash out with a huge profit, while others would be left with overvalued shares. However, introducing a company on a stock exchange is complex. You need to pass many audits and public vetting processes, however, there was a way around this, which the Chinese companies used. It’s called the reverse merger.

Shell companies included bankrupted coal factories in Nevada

In this case, a shell company (for instance not operating mining company in Nevada that is still listed on an exchange) would merge together with the Chinese company. Then, as if by magic, this new Chinese company just appeared on the market.

With the burst of reverse mergers, it was found that there were more than 300 U.S. listed Chinese companies trading on U.S. exchanges until 2012. One of them was L&L Energy whose shares started at around $2, but at its peak traded at $12 allowing investors to sextuple portfolio just with one stock. Similar bitcoin-style growth applied to other Chinese mergers such as Puda Coal and China Agritech, both are not tradable nowadays.

L&L Energy stock price from 2006 to 2016

For a company to grow this rapidly, it would need to be supported by excellent figures in the spreadsheets. The valuation of Chinese mergers would generally be in the hundreds of millions. But how can a rural Chinese paper factory be valued at $130 mil? By faking it. The investors believed the numbers were accurate as the audits of these companies were usually made by a Big 4 firms, which consist of Deloitte, Ernest and Young, KPMG, PricewaterhouseCoopers. But, as a matter of fact, a U.S. based accounting firm could not officially open an office in China. Thus, Deloitte started to operate in China through a foreign affiliate. Similar to McDonald or other fast-food companies, Deloitte established its own franchise in China. The controversy was that the audits were not conducted by Deloitte, an acclaimed accounting firm, but by Deloitte China, that had presumably tight connections to CEOs of Chinese mergers and officials.

Deloitte: the largest professional services network in the world

Billions lost

The overvalued figures were stated in filings submitted to the U.S. Securities and Exchange Commission (SEC). Every public company listed in the US is required to submit them to the database. The process starts when a Chinese-based company submits similar filling in China called SAIC. In SAIC, the Chinese company reports the correct revenue (for instance $10m), then in the US, the company reports $100 mil. These forms are not interchangeable, and Chinese records are not accessible by foreigners.

“When someone breaks the law in the US, there is a process where they’re accountable. At some point, in a China-based company, that accountability ends.” -Dan David from The China Hustle

It is very rare in China to pursue a businessman with illegal activities in a foreign market. As long as the total holds correct in China, these individuals are theoretically untouchable. Now, more than ever, the Chinese-American relationship is at its lowest point. As a result, there is no motivation from the Chinese side to act. With a broken judicial system, local authorities under strong corruption and bank information not transparent, the level of trustworthiness plunges.

TOTAL LOST OF PUBLIC PENSIONS AND RETIREMENTS:

$14 000 000 000

Unfortunately, many of the investors who lost everything were casual people, not bankers, not millionaires, but hard-working people who wished to save for their retirement.

Final thoughts

Predictions forecast China surpassing the US as the world’s biggest economy by 2024. The Chinese economic boom is supplied by the growth of their biggest companies. The list of the largest Chinese companies by revenue suggests that top 5 are at least partially state-owned. This leads to a very important question to be asked. Are all spreadsheets, income statements, financial data published by state or government-owned companies from China are one hundred per cent true? And even if the company is public, how sure can we be that there are no ties to the government officials?

The country with the biggest economy in the world should be democratic, competitive, rely on the free market and with citizens entitled to all the articles of the Universal Declaration of Human Rights. We shall see if China becomes such a Shangri-La.

[1] Gdp_real_growth_rate_2007_CIA_Factbook.PNG: Sbw01f, Kami888, Fleaman5000, Kami888 derivative work

All the other images are self-made or CC0 licensed.

Computer Science student at University College London. I am interested in fintech, geopolitics and emerging markets in the Middle East and Asia.

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