The confidence of investors seeking to participate in the vibrant growth of emerging market companies has been shaken by a spate of scandals in the US markets involving reverse mergers
The American comedian Groucho Marx once said, "I don't want to belong to any club that will accept me as a member." He understood that there was an economic advantage to maintaining the quality of an exclusive brand. It is a lesson that stock markets in the developed world would be encouraged to emulate, but the economic incentives are pushing the other way.
Information has value. It will only be disclosed for two reasons. Consideration—someone pays for it—or legal punishment—someone pays a fine or goes to jail. Many times, in emerging markets, the local legal infrastructure is not up to the job. Lack of money, independent courts, free speech, and insulation from political pressure conspire to rot the teeth of potential watchdogs.
If investors wish to participate in some of the vibrant growth of emerging market companies, they often take some confidence that companies listed in New York or London operate under the scrutiny of established well-funded regulators. Recently, this confidence has been called into question.
In the US, the markets have recently been plagued by a spate of scandals involving reverse mergers. Normally, to sell securities to investors it is necessary to go through a lengthy and expensive registration process. The process requires extensive disclosures and certifications. Providing false information can subject the promoters, lawyers and accountants involved in the listing to both civil and criminal penalties. Reverse mergers involve none of these hurdles.
If only US companies used this device, which has been around for years, there might not be any problems. But markets in developed countries are under pressure to remain competitive and global. Or to put it another way, the investment banks that thrive on these deals don't want the regulators to scare away business. The result is that many firms from emerging markets, especially from China, have been able to raise capital with a premium granted to firms that list in developed markets. Of the more than 600 firms that listed through reverse mergers since 2007, over 25% were Chinese.
One of the main reasons why it is difficult for developed country watchdogs to police firms in emerging markets is that much of the information is beyond their reach. For example, although an accounting firm certified by American standards must sign off on the books, often the American firm is relying of information provided by Chinese firms. This is not just an issue in the US. The regulators in Hong Kong have a similar problem. Listings in Hong Kong are supposed to be subject to the heightened scrutiny of local regulators, but most of the information is out of reach on the mainland.
Although China is attempting to clean up its reporting standards in order to assure the flow of foreign direct investment, some recent rules may simply make the problems worse. Information beyond the government's control is not allowed in China. The Chinese finance ministry has published guidelines that require Chinese firms with foreign listings to choose auditors with established reputations and international-caliber skills. The catch is that they can only choose firms that will protect 'national economic information', which is whatever the Chinese government wants it to be.
It is not just New York and Hong Kong that have had problems. London went out of its way to attract listings from firms in the former Soviet Union. The results have not always been promising. For example, a company called Baltic Oil Terminals, which operates facilities in the Russian enclave of Kaliningrad, stated that it's "local financial records had either been destroyed, or removed, and an attempt made at replacing these with falsified information".
And it is not just small companies. Eurasian Natural Resources Corp (ENRC) is a Kazakhstan company owned by Kazakh oligarchs and the Kazakh government. It is also part of the UK's blue chip FTSE 100 index, which automatically makes it a necessary holding for ETFs and many pension funds.
To clean itself up prior to its listing, the Kazakh owners were replaced by reputable British businessmen as independent directors. It didn't help. This window dressing was recently removed in a board room coup that reinstated directors more subject to the commands of ENRC's owners. The company's shares have fallen 36% from this year's high.
Of course there are demands to tighten up the regulations of emerging market companies on developed markets, but it is hardly surprising that these are met with resistance. Additional rules in the West often result in howls of protests as the new rules are supposed to be responsible for "driving" listings to Asia. The finance industry should understand, though, that it is the honesty inherent in the brand that makes them money, and that every bad apple that they keep out will mean more money that comes in.
(The writer is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected].)