The Long-Term Value of Short Sellers
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CPA and Big Four survivor Francine McKenna uncovers the games multinational accountants play in her regular Forbes column, Accounting Watchdog and on her indispensable blog re: The Auditors. Her diligence often illustrates that what investors find so egregious in other countries’ financial markets not only can impact Americans, but is also taking place in the US as well – courtesy of the global auditing firms.
[continued from “Maybe Regulators Should Be Having a Macau, Man”]
Slepko: In the wake of all the reverse merger inspired fraud and scandal, Bloomberg recently pointed out that, “Auditors that don’t comply with SEC demands face temporary or permanent deregistration in the US.” Would that ever happen to a Big Four?
McKenna: No. There are too few to fail – and the global auditors are too important to be called to account.
Slepko: Reverse mergers have been of such interest (not all bad until recently) that there’s even a Bloomberg China Reverse Merger Index (CHINARTO) that tracks almost a hundred companies – and a recent academic paper examined its loss of almost three-quarters of its value since its 2010 high. Are reverse-mergers automatically a sign that fraud is going on? What percent are dubious? Is the fear overblown? Afterall, the recent return of Burger King (NYSE: BKW) to public trading occurred through a reverse merger.
McKenna: Based on what we’ve seen over the last ten years, and China in particular, I would not be surprised if 80% of them are crap. It’s a big tell, but the reason why so many do them is they want to bypass the regular scrutiny for an IPO – and this is even after all the watering down via legislation like the JOBS Act that has diluted the integrity of the IPO process for the sake of, “jobs and growth.” We may see a huge concentration from China because China has a certain sexiness, but I’ve seen these reverse merger deals being pitched by Israeli, Indian, and other promoters from all over.
Slepko: Is there a legitimate reason to do a reverse merger? In the past even the New York Stock Exchange (NYSE: NYX) itself used a reverse merger as a cost-saving way to go public.
McKenna: Nowadays it is essentially a quick and dirty way to get a listing, and if someone’s in a hurry to raise money, then this is a way to do it. However, there is tremendous pressure on regulators and legislators, in things like the JOBS Act, for them to reduce or dilute or relax the standards and the requirements on audits, internal controls, and other governance issues so that it is easier for more companies to get listed and raise money under the guise of jobs and growth. But also under the guise of competitiveness we hear, “the US has to have more listings than other exchanges to be competitive in the global market.” And there’s a belief that it is important to have listings for the sake of listings. Sure, people need to raise money so they can get on with doing what they need to do as a legitimate business, but there is a significant (and growing) segment that are doing these things for abusive purposes – to quickly monetize a questionable situation, to do related party transactions, to reduce traceability of activities – and there is so much of it going on that the SEC would never have even started thinking about these sort of things if these analysts and short sellers had not started raising these issues. Einhorn was right about Lehman, Chanos was right about Autonomy (NYSE: HPQ), and Muddy Waters was right about Sino-Forest.
Slepko: Of course, in your most recent posting, you point out that Deloitte actually came out ahead by being able to unload the “Autonomy audit albatross,” and cash in on the consulting side of the dance while US and UK regulators and others that should have known better went along oblivious.
Meanwhile, you write, “It’s sexier for the SEC to pick a fight with Chinato make political points about investor protection than to admit that [US regulators] have not been monitoring the role the US firms play in audits of non-US based issuers audited by foreign member firms very well. The SEC also missed the boat on Longtop, in particular, and can’t blame the reverse merger loophole for letting a possible fraudster sell securities in the US…[US regulators] did not hold the US audit firm accountable.” In terms of the way public numbers are presented, is what is going on in China any different than what goes on in the United States?
McKenna: The end result is supposed to be the same since [Chinese companies listed or quoted in the US] have to follow the same standards (GAAP, IFRS, etc.) The difference for a country that has developing sectors is that they are one or two steps removed from the ultimate investor. People are investing in these kinds of markets for a lot of reasons, and their attractive potential also includes a high level of risk – that’s why they can be so appealing, and often people forget this. Moreover, everyone that invests in China should realize that one of the risk factors is that if you have a problem or think there is something wrong or you want to sue for wrong doing, then tough. Go pound sand. In some ways you have to suspend belief in proper due diligence in the hope of high volatility and high returns as long as you get in and out at the right time.
Slepko: So not just corruption, but actual fraud?
McKenna: Right, just like in Russia or China, you have those governments, you have corruption, you can’t really trust the courts…There’s nothing that’s changed in China, and what we see now is that Western investors think they can do things and then they run into the Great Wall. A multinational can’t even send lawyers or accountants from the US to investigate if something goes wrong. The SEC has no authority there. The [US] Department of Justice has no authority there. The [US Public Company Accounting Oversight Board] has no authority there.
Slepko: You speculate that because Facebook (NASDAQ: FB) and Zynga (NASDAQ: ZNGA), “are actively seeking to enter the online casino gaming business in the U.S. and abroad, that their activities are going to present additional risks of fraud, bribery and other illegal acts given the nature of the business, where they’re going to be doing much of it and the type of people they have to do that business with.” What’s your impression of the China and Hong Kong SECs?
McKenna: Hong Kong and Macau say they are a little bit different, and Ernst & Young is actually under scrutiny from the Hong Kong SEC because some of the Hong Kong firm’s work is being carried out in Mainland China. Hong Kong wants to maintain the integrity of their exchange, and wants to get EY to be more transparent about the work they are doing. However, Mainland China is tightening its grip on Macau because some operators and Chinese mafia guys are reportedly doing business there. So, when you invest in these places, you really need to expect the unexpected because even though it may be glittering and look Western (superior even), the underbelly is still China or the Middle East or whatever. You have to remember that when they don’t want you there anymore, you will be out. Just look at what is happening in Argentina.
Talk with any of the locals. They know that any good news is just the calm before the next storm. Americans are always so quick to think that change is permanent – “Brazil has changed for good. Brazil is now just like everyone else.”
Slepko: What’s the old saying? “Brazil will always be the country of the future.”
McKenna: The Portuguese saying is even better (and similar to what Mexicans sometimes say), “Brazil: So close to the United States, so far from God.”
[continued in “Big (Four) Trouble in Little China – and Middle America”]
Nick Slepko (hukgon) has no position in any company mentioned here at the time of publication. The Motley Fool owns shares of Facebook and NYSE Euronext and has the following options: long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend Burger King Worldwide, Facebook, and NYSE Euronext. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!