Pam Martens and Russ Martens: October 27, 2021
In 2012, short seller Citron Research released a 57-page report alleging fraudulent accounting at China Evergrande Group, the now teetering Chinese property development conglomerate that is causing severe anxiety in global markets. After spelling out six specific forms of accounting fraud that it believed to be taking place, the Citron report noted the following: “Meanwhile, Evergrande’s auditor, PricewaterhouseCoopers (Hong Kong office) has continued to provide an unqualified opinion.”
The author of the Citron report, Andrew Left, received a 5-year trading ban in Hong Kong by the Hong Kong Market Misconduct Tribunal over what it alleged was a false report.
On November 30, 2016, GMT Research, an accounting research firm that focuses on Asia, released a report titled: “China Evergrande: Auditors Asleep.” The report found that Evergrande had overcapitalized interest and classified its own commercial premises as an investment property.
Yesterday, those previous charges of accounting irregularities were given new meaning when a specialist from the Congressional Research Service, the research arm of Congress, testified before a House hearing and leveled her own charges.
The hearing was conducted by the House Financial Services Committee’s Subcommittee on Investor Protection, Entrepreneurship, and Capital Markets. It was titled: “Taking Stock of China, Inc.: Examining Risks to Investors and the U.S. Posed by Foreign Issuers in U.S. Markets.”
Karen Sutter, a Specialist in Asian Trade and Finance at the Congressional Research Service, told Subcommittee members the following about Evergrande’s accounting:
“Counting unbuilt and unsold properties and interest payments as assets. About 60% of the firm’s assets are unbuilt and unsold properties, and the firm counts loan interest payments as assets. This inflates the firm’s position and increases risks if property values fall…
“Using previously-financed deals as collateral for new loans. This practice allowed the firm to accumulate debt and become leveraged…
“Investing in unrelated sectors beyond the core business. Some Chinese firms use insurance, trust, and wealth management businesses to earn higher returns and invest offshore. The Shenzhen government is investigating Evergrande’s insurance business.
“Use of complex offshore structures tied to the CEO. Evergrande uses overlapping contracts and shareholding to facilitate financial flows that make it difficult to assess liabilities. The CEO and his family reportedly hold a large share of the firm’s offshore debt.”
A report released five days before the hearing by the Congressional Research Service, assessed Evergrande’s debt levels and ability to repay creditors as follows:
“Evergrande owes about $305 billion in debt (2% of China’s GDP). The firm is obligated to repay $124 billion this year—including $19.3 billion in bonds—but may only have 10% of this amount in cash on hand. The firm is said to owe money to 171 domestic banks and 121 financial firms. Off-book liabilities have not been disclosed. As China’s largest issuer of high-yield dollar denominated debt, Evergrande was an attractive investment, despite known risks, because it paid annual interest rates of 7.5% to 14%.”
The Congressional Research Service report noted that the Evergrande situation presents critical questions for Congress, including: “Evergrande’s situation raises questions about the full scope of its liabilities and the potential direct and indirect exposure for U.S. and other firms. The role of U.S. and other underwriters and auditors of Chinese firms also raises questions about whether risks are sufficiently assessed and disclosed to investors.”
Since Evergrande was first listed on the Hong Kong stock exchange in 2009, major Wall Street firms have been among its stock underwriters, including: Bank of America Merrill Lynch, Credit Suisse, Goldman Sachs and UBS. As recently as last October, Credit Suisse, Bank of America, Huatai International and UBS arranged a secondary share offering for Evergrande. Investors will certainly be questioning the caliber of due diligence that was done by the underwriters and their legal counsel.
For almost two decades, China has stonewalled U.S. regulators over access to the work papers of auditors of publicly traded companies that are based in China but listed on U.S. stock exchanges. China has taken the position that the audit work papers hold state secrets and it prohibits audit firms from releasing the documents directly to U.S. regulators.
This past December, Congress finally addressed this critical problem. Both houses of Congress unanimously passed legislation called the Holding Foreign Companies Accountable Act. The legislation requires that the Securities and Exchange Commission (SEC) identify companies that are listed in the U.S. which the Public Company Accounting Oversight Board (PCAOB) cannot “inspect or investigate completely because of a position taken by an authority in the foreign jurisdiction.”
The legislation also requires the listed companies to provide documentation showing that they are not owned or controlled by a governmental entity. It also mandates that the SEC prohibit the trading of the company’s stock in the U.S. if its audits cannot be inspected for three consecutive years.
Evergrande’s stock trades in Hong Kong and has lost 84 percent of its value since February. As of early this morning, its bonds are trading at 20 to 30 cents on the dollar.
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