Bloomberg News

Hong Kong’s Li Says Bourse to Avoid Worst China Accounting

June 22, 2011

(Adds comment from TMX in 21st paragraph, updates returns in second, fourth and 19th paragraphs.)

June 23 (Bloomberg) -- Chinese companies in Hong Kong are less likely to fool investors than those in the U.S. because the city’s bourse does more to prevent fraud, said Charles Li, chief executive officer of Hong Kong Exchanges & Clearing Ltd.

The MSCI China Index of 147 stocks available to foreign investors is down 10 percent since reaching a five-month high on April 21. That compares with a 28 percent plunge by Chinese companies that went public through U.S. reverse mergers, in which a closely held company buys a publicly traded shell and retains the U.S. listing. While bearish bets on the MSCI China have climbed to a record, Li says companies listed in Hong Kong are subject to too much scrutiny to deceive the market for long.

“I’m not saying we have a superior system, but we do have a more prescriptive system for vetting issuers and we have a more prescriptive and sometimes a little more burdensome process,” said Li in an interview from Hong Kong. For some Chinese companies that listed in the U.S, “particularly through reverse takeovers, I don’t know how they ended up there,” he said, without referring to any specific offerings. “They wouldn’t have seen the light of day here.”

China’s reputation among investors was strained after short sellers said companies from Longtop Financial Technologies Ltd. to Sino-Forest Corp. were exaggerating operations. Sino-Forest has slumped 84 percent in Canadian trading since June 1, the day before Carson Block of Muddy Waters LLC said it overstated timber holdings.

Reverse Mergers

Li, the 50-year-old former editor of the government-run China Daily newspaper who was named CEO of Hong Kong Exchanges in January 2010, said companies with share structures that concentrate voting power with management and that don’t directly own their operating subsidiaries may not be eligible for listing in Hong Kong. The exchange also cited rules that subject some companies using takeovers to go public to the same vetting process as initial offerings. John Nester, a spokesman for the SEC in Washington, declined to comment.

There are 98 Chinese reverse-merger companies listed on U.S. exchanges, according to data compiled by NYSE Euronext, the biggest American bourse operator. Nasdaq Stock Market has 70, NYSE Amex has 21 and the New York Stock Exchange has seven, the data show.

More Screening

“Nasdaq takes seriously the concerns which have arisen with reverse merger transactions and has responded by adopting enhanced screening procedures in our initial listing process,” Wayne Lee, a spokesman for New York-based Nasdaq OMX Group Inc., wrote in an e-mail. The exchange operator has also sent the “SEC a proposal to apply more rigorous listing requirements to companies which go public through reverse merger transactions,” he said.

“We review all listing applicants to assess compliance with financial, corporate governance and qualitative listing standards as set forth in our rules, pursuant to a rigorous, risk-based due diligence process,” Richard Adamonis, a spokesman for New York-based NYSE Euronext, which runs NYSE Amex and the New York Stock Exchange, wrote in an e-mail.

Americans face obstacles to getting information on Chinese companies, said James Angel, a professor at Georgetown University in Washington.

Hong Kong’s Advantage

“Hong Kong has the advantage of being much closer to the mainland language-wise and culturally,” he said. “If I were going to run a fraud, I would find the most gullible people and if the locals in my backyard know that I don’t have a business here, then I will go abroad.”

Li said investors in Hong Kong aren’t immune to fraud, either.

“Regulation can always improve and it’s there to prevent detectable fraud, but when you have people that are determined to scheme the system, there’s only so much regulators and professionals can do,” Li said. “No matter how stringent your regulatory system works, the bad apples will still exist.”

The former management of China Forestry Holdings Co. falsified bank documents and logging permits, the company said in an April 29 filing with the Hong Kong stock exchange. China Forestry halted trading in its stock in January and replaced Chief Executive Officer Li Han Chun. Li was detained by police in China’s Guizhou province in February for allegedly embezzling 30 million yuan ($4.6 million).

‘Lower Quality’

“While there’s a great macro story about China, the micro story is still one of lower-quality companies,” said Nicholas Yeo, the Hong Kong-based head of China and Hong Kong equities at Aberdeen Asset Management, which oversees $290 billion. “It’s only now that investors are starting to wake up and pay attention to the individual companies. You can’t go in blindly.”

About 4.8 percent of shares available for trading among companies in the MSCI China have been shorted, the highest level on record, according to data compiled by Data Explorers since 2006. That compares with 2.9 percent at the beginning of the year. Short investors bet against a stock by selling borrowed shares with the hope of buying them at a lower price.

The Public Company Accounting Oversight Board in Washington rejected Hong Kong-based Zhonglei CPA Co.’s application to become a U.S. auditor on June 10, citing an inability to inspect its work for companies based in China. It was the first time the PCAOB blocked an auditor since toughening rules in October.

The SEC has increased its focus on Chinese-based companies. The agency cautioned investors on June 9 about buying stakes when they gain listings through reverse mergers.

‘Shadowy’ Operations

“A lot of the reverse takeovers and shadowy shareholder operations, which is a very unique territory, it’s a breeding ground for issues,” said Li. “It’s easier to go to a place where the entire ecosystem is less familiar and less experienced in dealing with China and has less opportunity to verify and cross check some of the stories.”

Longtop Financial has fallen 48 percent this year. The maker of banking and insurance software said on May 23 that Deloitte Touche Tohmatsu CPA Ltd. resigned as its auditor after finding falsehoods in the company’s financial records. The SEC is investigating matters related to Deloitte’s claims, the company said.

“Inconsistencies” have been found in the valuation of Sino-Forest’s holdings in China’s Yunnan province, Canada’s Globe and Mail said June 18, citing Chinese government officials and forestry experts it didn’t identify. Sino-Forest’s primary listing is on the Toronto Stock Exchange.

‘Robust’ Standards

“Our initial listing standards are robust,” Carolyn Quick, a spokeswoman for TMX Group Inc., which owns the bourse, said in an e-mail.

Paulson & Co. sold all its stock in the Hong Kong and Mississauga, Ontario-based company, which owns tree plantations, according to a June 20 regulatory filing. John Paulson’s New York-based hedge fund, which made $15 billion in 2007 wagering against subprime mortgages, was previously Sino-Forest’s biggest shareholder. Armel Leslie, a spokesman for Paulson, declined to comment.

“He’s probably absolutely top-notch in figuring out subprime, but in figuring out China, he’s probably most like everyone else on the other side of the Pacific,” Li said of Paulson. “The investor base, the practitioners and the professional advisers here have done a lot more with the Chinese companies because when you live here and you speak the language, you can easily check in the same time zone and smell out the problems.”

--With assistance from Inyoung Hwang and Nikolaj Gammeltoft in New York. Editors: Chris Nagi, Nick Baker

To contact the reporter on this story: Lynn Thomasson in Hong Kong at

To contact the editor responsible for this story: Nick Gentle at

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