China's Big Risk: Corporate Fraud

NEW YORK ( TheStreet) -- Ask a random group of people who follow the markets what the greatest risk facing China is these and you'll likely hear:
  • Rampant inflation
  • Resource scarcity like water, food, fuel, and other commodities
  • Property bubble
  • Growing disparity between the rich and the poor
  • An artificially high yuan relative to the dollar

But there's a new risk on the horizon facing China -- and it's one that's totally within its own power to control: the perception of rampant corporate fraud.

Notice I didn't say there is currently rampant fraud, but there is an undeniable unease and distrust growing in America over increasing cases of Chinese fraud.

It started last year in the relatively small but prolific world of "reverse take-over" IPOs. There have been a number of high-profile cases of Chinese companies -- including RINO International ( RINO), China MediaExpress ( CCME) and China Agritech ( CAGC) -- with market capitalizations in excess of $500 million being accused of fraud by short-sellers, failing to supply an adequate response, and then seeing their shares delisted back to the pink sheets.

Although the details from these cases were shocking, the casual observer could believe that the problem had been ring-fenced to this particular sector of the market: smaller companies, dealing with smaller auditors, and lesser-known investment banks. The cases certainly call out for action from the NYSE and Nasdaq, as well as the SEC and PCAOB, but at least they were relatively small companies.

But the case of Longtop Financial ( LFT) --- a financial software firm whose stock is currently halted on the NYSE -- is more troubling. It's a much larger company than the reverse mergers; its stock was worth over $2 billion last year. It went public in the traditional way, with Goldman Sachs ( GS) no less as its underwriter. And it had Deloitte, a "Big Four" auditor, vetting the books. Yet, its CFO and Deloitte both resigned a couple of weeks ago and the stock will most certainly see a significant drop in value when it re-opens.

Yesterday, the Central Commission for Discipline Inspection of the Communist Party of China announced it was launching an anti-corruption investigation into China's largest telcos: China Telecom ( CHA), China Mobile ( CHL) and China Unicom ( CHU).

Also, the equivalent of the Chinese auditor general has recently spoken out about the need to clean up at least 17 cases of a certain amount of fraud among the largest state-owned enterprises.

A few years ago, India had a high-profile fraud in the well-known Satyam Computer. It was shocking and sizable, but it was seen as an isolated case and easily forgotten once the global economy started to recover and there was renewed interest in investing in the fast-growing Indian economy.

Up to now, China has been able to avoid any significant blowback from any corporate frauds that have surfaced to date. They've either been seen as too small to matter or non-systemic. And, at the end of the day, the macro growth trends of the Chinese economy have always been too hard for investors to ignore compared to the relatively low chance of stumbling onto the next Enron or Worldcom.

We are still far from crossing the precipice and believing that fraud is rampant among large and small Chinese companies but I have been surprised how difficult it has proven to be to put out this growing wildfire. Just when you think the firefighters have the blaze contained, it seems to jump over the highway barrier to light a whole new section of brush with renewed vigor.

Part of the problem in China is an immature corporate governance system. Chinese boards are much more deferential than American boards to the CEO, who is often a founder and carries a 20%-to-40% stake in the company. They need to ensure that the most qualified candidates are serving on these boards, that they know the industry well-enough, how to read financials, and how to challenge a dominant CEO.

But stronger boards are not enough to alleviate problems. We have weak boards in America, but that doesn't provoke a widespread crisis of confidence too often. What's really troublesome in China is the growing lack of confidence in the auditors.

Deloitte was the auditor for Longtop and China MediaExpress. They were also on the job for Duoyuan Printing ( DVP), another reverse merger accused of fraud. One fraud - Enron - was shocking enough to take down Arthur Andersen. How will anyone ever trust Deloitte's audits of Chinese companies in the future after all these problems?

We know that the PCAOB has no jurisdictional right to go in and inspect Chinese audits. We also know many of the smaller American audit firms outsource their audit work for Chinese clients to local providers. The quality control has apparently been quite poor. We assumed the "Big Four" used much more rigorous standards.

The Chinese government cannot allow the "Big Four" or their own companies to monitor themselves on governance and financial controls in an American laissez-faire way. If there was a crisis to erupt in China where there was widespread panic among international investors that numbers of all Chinese companies couldn't be trusted, it would significantly hurt their own economic interests and international reputation. They should institute IFRS standards for all Chinese companies to reassure investors in the numbers. They should also adopt rigorous corporate governance standards.

Until now, the Chinese government has had to focus on more immediate challenges in a hot economy desperately needing to put a foot on the brakes. Also, the positives of investing in China have always far outweighed the negatives. However, now is the time where the government should be taking steps to prevent a bigger crisis of confidence down the road.

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At the time of publication, Jackson was held no positions in any stocks mentioned.

Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd. You can follow Jackson on Twitter at or @ericjackson

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