Asia Market Watch: Keeping Chinese Companies Accountable

Posted on December 29, 2008 at 10:12 PM

The recent dismissal of the first major securities class action suit against China Life got us thinking about the stock market again (something we've been trying to avoid for the past several months).  What kind of liabilities will we find at Chinese public companies as the market shines its light upon Chinese accounting practices that have been largely unscrutinized to date?

In September, the Southern District of New York threw out a 2004 class-action lawsuit against China Life filed by US investors who accused China's biggest life insurer of failing to disclose sensitive information during its listing.  The listing was the world's largest in 2003.    The suit coincided with an informal investigation by the SEC and spooked not only investors in Chinese securities, but Chinese companies considering listing in the US.  The investors, represented by Milberg Weiss (now Milberg LLP), accused China Life of failing to disclose that an audit by the National Audit Office of China (NAO) of its state-owned predecessor company had unearthed accounting irregularities worth about RMB5.4 billion yuan ($789.8 million) up to 2002.  Analysts said the case highlighted shoddy disclosure among China's largest state-owned enterprises.

Given all of the financial scandals we’ve seen in the US over the last few months, it seems a little unfair to focus on China.  But since the rising tide lifted all ships for many years, it seems like the first companies to cause accounting scandals as the tide turns will be the ones who haven’t been reporting the barnacles on their hulls.

Even in good times Chinese companies had problems.  Independent research firm RateFinancials criticized the NYSE in 2007 for allowing certain Chinese listings.  It issued a report which showed that the 10 largest Chinese companies with American Depositary Receipts (ADRs) listed on the New York Stock Exchange had poor earnings quality.   Problems were found such as insufficient reserve provisions and negative working capital, in addition to signs of possible earnings management via "cookie jar" accounting (where companies report lower reserves in order to show higher revenues).   No accounting or listing rules were deemed broken, although it would be unlikely for an independent researcher to find anything given their poor level of disclosure.

A 2005 survey by CFO China showed some of the institutional problems confronting transparent accounting in China.  The survey found that most CFOs in China thought that their auditor would change its opinion if offered more fees, 56% said their Big Four auditors perform their auditing duties "roughly” and only 16% of local Chinese auditors were considered thorough.

In these tough times, many people are too broke to sue.  But if Milberg LLP isn’t too busy with its Madoff clients, it may have some good securities class-action coming its way.

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