China's Impending Foreign Direct Investment Armageddon, Part 1

The biggest China story for 2013 that you're not hearing about

There’s a showdown brewing that could presage a historic shift in world capital markets, but because of the western press' preoccupation with the US presidential election and China’s change in leadership it hasn't garnered much coverage: The looming "fiscal cliff" faced by Chinese companies that are traded on US stock markets and the investors who have bought in to them.

Case in point, check out this post from the Council on Foreign relations' website. In it, they list the "Changes and Challenges for China in 2013", but nowhere is this issue mentioned. This is, I think, a tragic oversight, because what’s going on could have more real word effects on people’s lives (in China, anyway) than the hubbub over the South China Sea.

It's a complex situation that is wrapped up in legal and political knots on both sides of the Pacific, so I'm going to break this post into two parts in order to keep it readable. First up, a primer:

Chinese companies have been listing themselves in US markets for years. Right now, shares of just over 200 companies are being traded on the New York Stock Exchange, the NADAQ and the AMEX markets. China has the largest number of companies of any country outside of the US trading in our markets today.

There are lots of reasons why a company might want to trade on a US stock market, but in China the most common are 1) prestige, which allows companies to compete for more international contracts; and 2) access to capital, which is in short supply in China since Chinese banks, which are state-owned, make almost all of their loans to other state-owned companies. Money from foreign markets/investors, or “Foreign Direct Investment” has been one of the few sources of capital that small- and medium-sized businesses have had access to and it has been one of the main drivers of China’s economic growth over the past decade.

These issues, coupled with the difficulties conducting transactions in Yuan (due to China's strict currency controls) led to a boom of listings by China-based companies on US markets from 2008-2011.

Many of these companies’ listings were done through “reverse mergers”, which are pretty shady deals. Basically, a Chinese business buys out a bankrupt or otherwise defunct company in the US that still has a valid stock ticker and then just starts trading under that ticker. This method is much easier and faster than the normal process, which requires all sorts of regulatory hurdle-jumping and accounting disclosures.

Of course, these quickie listings don’t allow for the kind of weeding out of companies with secretive or blatantly fraudulent accounting practices. In 2011, a series of reports were published by investment research firms that exposed many Chinese companies' corrupt dealings and falsified disclosures. Investigations by the US Securities and Exchange Commission (SEC) were launched and delistings ensued. As a result, we've see a massive devaluation of Chinese companies in US markets since then. This has not only led to many companies closing down or going private, but it has wiped out billions of dollars of investors' wealth.

This drama has been playing out for almost two years and you can read my August 2011 post about the reasons behind the reverse merger boom and bust here. In it, I broke down the phenomenon and speculated that even though you'd see lots of companies fold, it could turn out to be a good thing for China's economy.

[Companies that survive will] set the stage for a new era of Chinese corporate governance. In the end, it will be the companies that decide to adhere to the rules of the Western game that will be successful. Their success will breed imitators here (it's what the Chinese do best, after all) and just as Big Macs and blue jeans helped to conquer to Soviet Union, the Chinese's own drive to get rich and access Western markets will drive them ever further towards our way of doing business.

While I still hold to that idea, it appears that the timing of this evolution could be significantly delayed, and/or the context of it radically altered. The investigations that the SEC launched have since turned into lawsuits, with the US government seeking court orders against US-based accounting firms and their Chinese clients for internal accounting documents. In effect, they're trying to apply US law to companies that are based in China.

The Chinese government isn't having any of it. Saying that any disclosures to US regulators would be a violation of their sovereignty, they're telling the SEC that not only can they not see Chinese bank/corporate documents, but that any accounting firm or corporation based in China that hands any of these documents over could be subject to the State Secrets Act. Violation of that law carries penalties like life in prison or the death sentence.

Given those consequences, its understandable why US accounting firms are loathe to demand that their Chinese affiliates (which are, buy law, at least 50% owned by a Chinese concern) hand over anything. And so… a stalemate.

Both countries have a legitimate beef with the other. On the US side, the government has a vested interest in maintaining the integrity of its capital markets. As far as they're concerned, Chinese companies have chosen to sell their shares in the US and they should follow US disclosure and reporting requirements. On the China side, the government doesn’t see any reason why they should subject any of their citizens or corporations to the laws of a foreign country. In their minds, Chinese disclosure and reporting laws should suffice for Chinese companies.

This pissing match between the SEC and the Chinese government reached its final stages in early December when the SEC went to federal court to compel the US-based accounting firms to give regulators access to the accounting documents of the Chinese companies that they're investigating.

The result of this suit will have a lot of very important consequences. And they'll manifest themselves very soon. The case, by law, must be acted upon by November 2013. This means that the SEC must come to some sort of arrangement, or the Chinese branches of the accounting firms must hand over their internal documents by then, possibly in violation of Chinese law, or… well, nobody is quite sure what happens after that.

In part 2 I'll get into what I think will go down and what the benefits/concequences to China and the US might be.