In recent months, reporting for U.S.-listed Chinese companies has been a primary target for short sellers, with many pointing to discrepancies between Chinese and U.S. filings as evidence of fraud. These critics and their cohorts have taken advantage of the average investor’s lack of understanding of cultural differences and reporting requirements between the two countries.
It has proven quite easy to create fear among investors, since many lack answers to several basic questions surrounding China small-cap companies, such as: how does Chinese financial reporting differ from U.S. reporting? And, if Chinese and U.S. filings don’t match, does that mean a company is guilty of fraud?
Let’s start at the beginning: who are U.S.-listed Chinese companies required to report to, and why is it important for you to understand?
For this discussion we’ll focus only on the mandatory financial filings that are of the utmost importance to you as an investor. There are of course industry-specific issues that do arise (such as the SFDA for Chinese pharmaceutical companies), but for this conversation we only want to focus on the financially related filings.
First and foremost, U.S.-listed China small-caps have to file what all experienced investors are used to reviewing: U.S. Securities and Exchange Commission (“SEC”) filings, including 10-Ks, 10-Qs and 8-Ks, as well as S-1s and other less frequent filings. These of course can easily be accessed through the SEC’s website.
Next, and the crux of this post since we are discussing U.S.-listed companies with operations in China, we also need to understand what entities these companies must report to in the PRC: the State Administration of Industry and Commerce (“SAIC”) and the State Administration of Taxation (“SAT”).
State Administration of Industry and Commerce
The SAIC’s role has often been misunderstood by U.S. investors. In some ways, its role is more analogous with a state-level Secretary of State in the U.S. in that the SAIC is the government’s administrator for the filing of official documents such as business licenses and corporate registrations, in addition to overseeing other basic compliance issues. From the SAIC’s mission statement on its website:
“[The] SAIC functions in maintaining market order and protecting the legitimate rights and interests of businesses and consumers by carrying out regulations in the fields of enterprise registration, competition, consumer protection, trademark protection and combating economic illegalities.”
Every year between March and June, companies operating in China must renew their business licenses by filing an annual inspection report with the SAIC. While this report does include financial statements, it is more a formality required for compliance purposes, and the financial statements are not audited or verified by the department.
Historically, the average Chinese company didn’t bother with ensuring the accuracy of financial data submitted to the SAIC. This lax view of reporting to the SAIC was a byproduct of their view that the agency was merely responsible for renewing a company’s business license. Additionally, Chinese companies, no different than companies in other parts of the world, often want to keep competitors, customers and suppliers from learning valuable information about their business operations. Going forward, now that these corporate managers realize the negative impact on perception that inaccurate SAIC filings can cause for investors, we believe many companies will begin to take these filings more seriously and ensure they are materially in line with actual business operations.
State Administration of Taxation
Unlike the SAIC, the SAT, being the government body responsible for collecting a variety of taxes in China, requires audited financial data from companies. As with the IRS and tax agencies in other Western countries, the SAT often tests the veracity of financial filings by auditing the reports themselves and levying fines on those that misstate their tax liabilities. This by its very nature makes SAT filings much more relevant to investors – should there be material discrepancies between SAT filings and SEC filings, an investor would have very good reason to be highly concerned. Unfortunately, SAT filings are not accessible by the general public. Only a company itself can release such data.
Comparing SAIC, SAT and SEC Filings
The vast majority of U.S.-listed China small-caps are holding companies with several operating subsidiaries in the PRC. That being the case, should a company release its SAT filings for public review, the first step in comparing them often will require an investor to combine the various individual subsidiary reports so that a consolidated view can be matched up with SEC filings. This holds true for a company’s SAIC filings as well.
Complicating matters a bit further, even after consolidating the Chinese filings, at face value there will likely be inconsistencies between the China reports and SEC filings. This is a result of many factors, including variances between China GAAP and U.S. GAAP, as well as the all-too-common inter-company transactions between various subsidiaries that make up a U.S.-listed China holding company.
The laid-back attitude of many Chinese small-caps toward the accuracy of easily accessible SAIC filings, combined with the multiple reasons for additional variances between PRC and SEC filings, created a rich and easy target for short sellers. That said, being easy targets for rampant allegations of malfeasance does not immediately indicate that fraud has taken place.
To begin to effectively reverse this overbearing negative sentiment, it is imperative that U.S.-listed China small-caps begin to accurately report their financials to the SAIC. While we’ve laid out reasons that can explain past inaccuracies, moving forward there is no reason for companies to open themselves to what may be baseless attacks from short sellers.
While making sure they file the proper information with the SAIC moving forward is an important step, at RedChip we believe companies wrongly accused of fraud and those who wish to preemptively protect themselves from potential future false allegations should go the extra mile by making their SAT filings available for public review.
The first known U.S.-listed China small-cap to make its SAT filings available is ONE Bio Corp. (OTCBB: ONBI). With an experienced U.S. management team, ONBI recognized the importance of building and maintaining credibility with the investment community. We hope more companies follow the lead ONBI has taken.
Disclosure: The subject security is a client of RedChip Companies, Inc. RedChip Companies, Inc., employees and affiliates may have positions and affect transactions in the securities or options of the issuers mentioned herein. For full financial disclosures for all RedChip clients, please visit http://www.redchip.com/disclosures.asp?src=rcv.