U.S. SEC Tough on Asian Disclosure, Accounting Abuses as Investment Professionals Demand Progress

Unfortunately the news of bogus financial reporting appears to be never-ending. It is still a big concern in China — so big that even U.S. regulators are getting involved. Recently investors were again reminded about the potential challenges posed in the case of companies that are listed in foreign countries, be it through reverse mergers or IPOs. Readers of our blog are certainly aware of the Hontex case, just one example of how corporate governance and regulatory enforcement concerns have caught the attention of regulators and the public.

At the end of February 2013, the news broke that the U.S. Securities and Exchange Commission (SEC) had charged a China-based petrochemical company and its former CFO with accounting and disclosure violations, with the company and CFO agreeing to pay more than US$1 million combined to settle the charges.

The company in question, Keyuan Petrochemicals, manufactures and sells petrochemical products in China. Formed through a reverse merger, Keyuan Petrochemicals filed the securities registration statement back in May 2010 and listed on NASDAQ in the same year. Not long after, in 2011, there were already hints of dubious disclosure practices as it was made public that the company had received a notice from NASDAQ stating that it was not in compliance with the listing rules and had not filed its Form 10-K for 2010 by the due date. After submitting a plan of compliance to NASDAQ to maintain the listing, Keyuan Petrochemicals decided to move to the over-the-counter (OTC) market where its stock has been trading around US$1.

These days Keyuan Petrochemicals’ new U.S. investor relations officer, appointed just last October, must be very busy when communicating to shareholders, as there is much need for explanation. The SEC in a recent complaint alleged that between May 2010 and January 2011, Keyuan Petrochemicals, in what was its first year as a U.S. public company, systematically failed to disclose in its SEC filings numerous material related-party transactions between the company and its CEO and controlling shareholders, entities controlled by or affiliated with these persons, and entities controlled by Keyuan Petrochemical’s management or their family members. The related-party transactions took the form of sales of products, purchases of raw materials, loan guarantees, and short-term cash transfers for financing purposes.

In addition, the SEC alleged that Keyuan Petrochemicals also operated a secret off-balance sheet cash account to pay for cash bonuses to senior officers, travel, entertainment expenses, an apartment rental for the CEO, and cash and non-cash gifts to Chinese government officials.

Investors, who rely on transparent and relevant disclosures from the companies they invest in, may well receive the impression that the actions taken by the management of Keyuan Petrochemicals puts them at a disadvantage as shareowners. As a consequence, shareholders may develop an attitude of distrust toward the company, and this would likely not be beneficial to them or even to other shareowners.

Besides, Keyuan Petrochemicals is not an isolated case. Recognizing the importance of trust when investing in listed companies is not at all uncommon, as is also evidenced in the results of the recent CFA Institute Global Market Sentiment Survey. For example, 21% of respondents globally thought that the integrity of financial reporting was the biggest ethical issue facing global markets in 2013. So, naturally one asks what can be done to improve the status quo. In this regard, more than one-third of respondents globally emphasized improved transparency of financial reporting and other corporate disclosures, improved auditing practice and standards, and improved corporate governance practices as actions most needed in the coming year to help improve investor trust and market integrity.

In the case of Chinese companies listed on stock exchanges abroad, improvements in regulatory enforcement may not be so far away anymore, and in the process, fewer suspect business practices should be expected. According to an article in Accounting Today, the Public Company Accounting Oversight Board (PCAOB) has reached a tentative agreement for U.S. authorities to begin observing Chinese regulatory authorities during inspections of auditing firms in China as a kind of “trust-building exercise.” Not yet a perfect solution, but at least a step closer to it. 

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