Bill Black: Countering Chinese Accounting Control Fraud and Predation Against U.S. Investors

By Bill Black, the author of The Best Way to Rob a Bank is to Own One, an associate professor of economics and law at the University of Missouri-Kansas City, and co-founder of Bank Whistleblowers United. Jointly published with New Economic Perspectives

On December 13, 2018, the Wall Street Journal published an interesting op ed by Jesse M. Fried, a famous law professor in multiple areas of corporate law, and Matthew Schoenfeld, who works at a hedge fund that is the leading funder of civil lawsuits, primarily fraud and tort suits.  The title is “Will China Cheat American Investors?  The answer, of course, is yes – it will continue to cheat American (and non-American) investors.  Fried also has a strong background in economics, which is relevant to his op ed and my blog article.

The op ed is interesting in part because it was published just after a documentary on Chinese stock fraud (“The China Hustle”) had its general video release.  The China Hustle explores the pervasive defrauding of primarily U.S. investors by those that control Chinese corporations.  Though the documentary does not make the point, it is describing “accounting control fraud.”  A ‘control fraud’ is a seemingly legitimate entity used by the person that controls it as a “weapon” to defraud or predate.  For the sake of brevity, I use “CEO” rather than “the person that controls the corporation.”

Accounting control frauds target creditors and shareholders as their primary intended victims.  Their primary weapon of fraud and predation is accounting.  The art is to inflate assets and understate liabilities, which overstates capital and income.  White-collar criminologists, economists, accounting academics, and regulators have explained the ease with which the CEOs running control frauds are able to suborn supposed “controls” (auditors, appraisers, attorneys, and credit rating agencies).  The art is to suborn, not destroy, supposed ‘controls’ so that they will “bless” the CEO’s frauds, lending their reputation as supposedly independent professionals to aid the CEO in defrauding creditors and defrauding and predating on shareholders.  The CEOs leading the fraud and predation can even use their ability to hire and fire the key officers at these supposed independent professional controls to generate a “Gresham’s” dynamic within their profession.  George Akerlof, in his famous 1970 “lemons” article that led to award to him of the Nobel Prize in Economics in 2001, first named that perverse dynamic.  Akerlof explained how it worked.

[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.

What all of these factors mean, plus a host of other factors that make controlling a seemingly legitimate firm uniquely valuable to CEOs running sophisticated, massive fraud and predation schemes, is that control frauds and predation cause vast harm and can become epidemic.  When I say that the control frauds are “seemingly legitimate” and that the supposed ‘controls’ are seemingly legitimate I mean that they both actually function frequently as ‘criminal enterprises.’

The “China Hustle” documentary is deeply flawed in its apparent belief that endemic fraud can only occur in places like China that have no effective rule of law.  The GFC, the three most destructive financial fraud epidemics in history that drove the GFC, the astonishing level of elite financial predation in the United Kingdom, the U.S., and Australia, and the complete failure to prosecute the financial elites that led those fraud epidemics combined to prove that the United States does not have an effective rule of law.

I now routinely use the phrase “control fraud and predation” because Bastiat’s warning has proven true.  Frederic Bastiat is the patron saint of economists that worship laissez faire, so it is ironic that his famous warning has revealed why laissez faire ideology creates an intensely criminogenic and predatory environment.  Laissez faire ideology ignores the ability of elite frauds and predators to use their exceptional power to corrupt the rule of law.  Vigorous regulation, supervision, and prosecution of elite crimes and predation is essential to the effective rule of law.  Laissez faire proponents wage a continuous, unholy war in favor of the three “de’s” – deregulation, desupervision, and de facto decriminalization and “glorify[y]” elite white-collar criminals as their heroes.

When plunder becomes a way of life for a group of men living together in society, they create for themselves in the course of time a legal system that authorizes it and a moral code that glorifies it.

Predatory acts (“plunder[ing]”) are not criminal.  Predatory acts, however, are so deeply unethical that if the poor committed those acts the wealthy, with dominant political power, would make those acts crimes.  This point is similar to one that the media has been describing considerably in recent weeks – the fact that campaign finance crimes require the prosecution to prove that the defendant “knowingly and willfully” committed the crime.  This means that ignorance of the law can be a defense for people like President Trump unless the prosecution can prove he knew he was violating the law.  Laws that criminalize behavior undertaken primarily by elites are far more likely to require the prosecution to demonstrate that the defendant willfully violated the law.  The President and members of the Congress share a common interest in protecting their political contributors from prosecution, so they drafted the statutes governing contributions (and bribery) to make it exceptionally difficult to prosecute the elites that enrich them and help them win elections.  Our greatest ability to predict judicial decisions by conservative jurists is when the case involves business interests.  Conservative jurists are most likely to vote to advance business interests (as opposed to factors such as national security or views on federalism).  Conservative jurists, over the last 30 years, have recurrently made it more difficult to prosecute elite white-collar crimes and corruption and to gut regulatory actions essential to prevent a criminogenic and predatory environment.

I emphasize predation for two other reasons.  First, two Nobel Laureates in economics, George Akerlof and Bob Shiller have written a book to try to get economists to take predation seriously.  The standard neoclassical assumption channels the false laissez faire claim that predation cannot occur, or, in the alternative, cannot be serious.  Second, the WSJ op ed that prompted this article focuses on a classic example of predation frequently observed – and then ignored – by bad economists.  The predation is by controlling shareholders that loot minority shareholders.  This is a common pattern for hundreds of years all over the world.

There are two semi-remarkable facts about this form of predation in China that the op ed discusses.  The first is remarkable only to bad economists.  The op ed explains:

Americans now collectively own most of the public equity of China’s biggest tech companies, including Alibaba, Baidu and Weibo. This relationship is strange (imagine if the Chinese owned most of Amazon, Facebook and Google). It’s also extremely risky, at least for American investors.

China’s tech darlings began tapping U.S. investors in the early 2000s, when mainland capital markets were unsophisticated and strict profitability requirements shut out most fast-growing tech firms. Dozens of Chinese unicorns and near-unicorns went to New York to raise capital from Americans eager for exposure to China’s explosive growth.

American investors became dispensable, and thus vulnerable to expropriation.

It started around 2014 with a wave of confiscatory “take private” transactions led by Chinese controlling shareholders. The objective was to delist U.S. shares at low buyout prices and later relist them in China at a much higher valuation.

Consider the July 2016 take-private of Qihoo 360, an internet security firm. The founders squeezed out U.S. shareholders at $77 a share, reflecting a value of $9.3 billion. In February 2018, they relisted Qihoo on the Shanghai Stock Exchange at a valuation north of $60 billion. That’s a 550% return. Qihoo’s chairman personally made $12 billion upon relisting, more than he claimed the entire company was worth 18 months earlier.

Public investors in a firm with a controlling shareholder always face the risk of an unfair take-private. But investors in U.S.-listed Chinese companies are particularly vulnerable. Most incorporate in the Cayman Islands. This jurisdiction affords investors much less protection than Delaware, home to most U.S. companies. Neither U.S. nor Cayman court judgments can be enforced in China, where insiders and assets are based. Chinese controllers can thus squeeze out the minority on terms that would make American controllers blush. More than 60 U.S.-listed Chinese companies have been taken private since 2013.

Despite the warning signs, American investors continue lining up for Chinese initial public offerings. In fact, Chinese companies have raised more than $8.5 billion in U.S. markets this year, the most since 2014. This week, Tencent Music Entertainment went public in the U.S., raising about $1 billion at a valuation exceeding $20 billion.

This form of predation allows the controlling shareholders to transfer to themselves the great bulk of the market value of the minority owners’ shares.  The China Hustle fraud works by massively overvaluing the firms’ assets, capital, and profits.  The predation scheme does the opposite.  (Though the explanation it is beyond the scope of this article, shareholders need to know that the controlling person can use both the fraud and predation schemes at the same company at different times.)

“Unicorn” is investor jargon for an initial public offering (IPO) with $1 billion or more in capitalization.  The op ed indicates the extraordinary scale and success of the predation.  Bad economists’ dogma is that material predation is a fiction.  The op ed shows that after literally tens of thousands of cases of predation by controlling shareholders against minority shareholders conducted over hundreds of years in hundreds of countries – it proved to be child’s play for none-to-sophisticated Chinese predators to fleece American shareholders out of billions of dollars.  (As I often explain, the key to successful fraud is audacity, not genius.)  Worse, the American investors were often purportedly sophisticated institutional investors.  Still worse, the Chinese controlling shareholders’ predation scheme has been in successful action for over 15 years.  To top it all off, the Chinese are still attracting record amounts of new money successfully from American investors despite having repeated the predation scheme 60 times in the last five years.  Only laissez faire ideologues would believe this was impossible because predation was impossible.

The second remarkable fact is probably remarkable only to people like me, who spent a decade working with thousands of effective regulators.  What the China Hustle accounting control fraud schemes and the predation schemes described have in common is that neither would be possible if the SEC and either the Bush, Obama, or Trump administration were not so utterly spineless for at least 15 years as to allow the fraud and predation schemes to persist.  The Chinese context should have been the easiest context for the U.S. to deny the ability of Chinese corporations to list on the U.S. markets unless the SEC had the power to prevent fraud and contract provisions in the U.S. that China agreed in a binding fashion were enforceable in China.  The SEC has not required such a grant of power as a condition of approving Chinese stock listings in the U.S. and has not insisted on enforceable contract terms to prevent predation.  The SEC is not even asking for such powers, warning Americans not to invest in Chinese stocks, or seeking to ban such listings.

The Trump administration is making a great deal of noise about China being the great threat to the U.S., but it is refusing to act to prevent endemic fraud and predation against U.S. citizens by Chinese elites.  The Chinese government is deeply complicit in these fraud and predation schemes.  In January, the new House of Representatives should introduce a bipartisan bill to stop the Chinese fraud and predation schemes and hold oversight hearings on the SEC’s bipartisan failure to protect American investors.

The op ed, presumably due to space limitations, calls for no action.  It ends with a wish that the authors know to be false.  “Let’s hope investors price in the risk.”  That ‘hope’ makes sense only if you believe in laissez fairey tales.

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    1. Larry

      I have seen FTAlphaville covering this beat, but they’re a small outlet. And certainly plenty of predators benefit in the US. I imagine the listing and take private fees are great for banks bottom line.

  1. Chris Herbert

    I am of the opinion that the Federalist Society is a form of control fraud. How clever to have a judiciary that will rule all progressive legislation ‘unconstitutional.’

  2. cnchal

    Globalization is a disaster, no matter where one cares to look.

    From an accounting perspective, may I suggest some interesting background reading?

    Check out and peruse the articles there.

    are two that can amuse you for hours.

    A few choice quotes from this post.

    . . . The China Hustle explores the pervasive defrauding of primarily U.S. investors by those that control Chinese corporations. . .
    Public investors in a firm with a controlling shareholder always face the risk of an unfair take-private. But investors in U.S.-listed Chinese companies are particularly vulnerable. Most incorporate in the Cayman Islands. . .
    The Trump administration is making a great deal of noise about China being the great threat to the U.S., but it is refusing to act to prevent endemic fraud and predation against U.S. citizens by Chinese elites. The Chinese government is deeply complicit in these fraud and predation schemes. . .

    When you put your hard earned money to work in the stawk market going with Wall Street’s advice to “invest in Chinese companies” to tap into the big Chinese market and get rich, you are fooled again. Wall Street gets their fat finders fee, the Chinese elite get your money, but you have to ask yourself, what do the Chinese elite do with the loot?

    Remember that Chinese company making magnesium parts for Ford in Michigan that caught fire? They buy stuff like that with the loot.

    To put it plainly, the guy that robs you of your money, uses that money to buy your house out from under you and you now live in a cardboard box under a bridge and work for peanuts for the robber.

    And you wonder, what happened?

  3. rd

    This may be the solution to wealth inequality in the US. I doubt if the bottom 99% are doing much of this investing in Chinese IPOs.

    1. doug

      If they are lucky enough to have a pension or retirement account, the bottom 99% may be affected. I think malfeasance extends beyond IPO’s.

      1. rd

        The MSCI Emerging Market Index is 30% China. I have a RAFI Emerging Market fund in an IRA and it is 20% China. Much of these holdings is in the big Chinese banks, petroleum, and construction firms (they have their own issues with debt which is why the RAFI fund is under-weighted China). Some of the China investment in these firms are technology and communications.

        I think very few small individual investors are going to have more than 3% China total in their portfolios and of that 3% only a fraction of that is likely to be these control fraud type of companies.

  4. georgieboy

    The author refers to the “GFC,” and to “the three most destructive financial fraud epidemics in history that drove the GFC.”

    Can anyone kindly name them?

    I can guess, but in an otherwise excellent piece this bit of shorthand confuses readers not already on the same page as the author.

    1. JEHR

      I came across this site that lists WorldCom in 2002 as the largest accounting fraud in US history. Bernie Madoff’s Ponzi scheme was next and Lehman Brothers in 2008 the latest and I’m sure there are more to come.

    2. Dave

      Go see The Big Short, or go see it again.

      I think he’s talking about:
      -NINJA loans, and the practice of filing fake mortgage applications.
      -Mortgage-Backed Tranched Bond Pools, Where Every Tranche is AAA!!
      -Bond Ratings Agencies with the Morals of a Streetwalker

      You know, that sort of thing. . .

  5. Oguk

    I realize this is bad, but it feels like a way for China to leverage capital from more developed countries, put it to work, then take the financial gain. If China were socialist, the state would have taken those profits, not a few private parties (e.g. Qihoo’s chairman). And it shouldn’t rely on regulatory arbitrage via e.g. the Caymans. Of course I prefer if it predates on the rich (hedge funds and venture capitalists), not pensions and my retirement funds… probably too much to wish for. Great explainer!

  6. Chauncey Gardiner

    Thank you for an enlightening article, Bill Black. Another example of financial repression by the global power elite. Clearly they have learned from the masters, but it’s a shame that this issue isn’t on the table in the current US administration’s trade negotiations with China. Might be awkward, though, given the shared nature of the behavior. So we have “Socialism with Chinese characteristics”, as Xi said innumerable times in his impressive speech to the Party, military and friends in yesterday’s celebration in Beijing of the 40th anniversary of China’s reform and opening-up. …”Fool me once, shame on you. Fool me twice, shame on me.” … “Fool me 60 times?… WTF!” And keeping in mind the symbol for the next Chinese new year.

    A dilemma for Americans is that by design and intent we have few alternatives to save money where the rate of return is both equivalent to the rate of inflation and that do not leave one vulnerable to control fraud and predatory behavior. In what I consider to be related news, I read yesterday that a large US aircraft manufacturer just announced another $20 billion in stock buybacks despite an order cancellation by a foreign carrier of $22 billion, the delivery of the first aircraft from its new plant in China, a negative reported financial net worth following earlier cumulative stock buybacks of over $51 billion, and analysts’ estimates that it would cost $10 billion for the company to develop a new intermediate range aircraft. For some reason I’m reminded of past actions at GM and GE, their more recent layoff announcements, and why savings are necessary in our Brave New World.

      1. Chauncey Gardiner

        OMG! THAT small substitution would h/b so GREAT, Acacia! Although considering the vacant look in the eyes of many of the attendees on global tv, I suspect one’s attendance, remaining awake, and appearing respectfully attentive to the Hall monitors are key, and the words didn’t really matter to most of the audience.

  7. Scott1

    It was our expectation that our laws concerning investing
    would be enforced. The idea of China having stocks to sell
    in the US, I’d attribute to their acceptance into the World Trade
    Organization. It was expansionist.
    Hong Kong had been a player. Far as I understand Hong Kong
    was fine with the rules.
    Somehow there became some of the most wealthy people in the
    world living in Hong Kong.
    Mr. Black probably knows where these tactics were developed
    and who is responsible for the end of enforcement. He says
    so really.
    Overall the message is that at the least US investors ought
    be warned not to invest in China.
    But then there is the warning that more CEOs everywhere
    are doing this, and the SEC doesn’t care or can’t see how
    to win because perpetrators can simply say “I had no idea
    this was illegal.”
    How this affects the status of the US Dollar as the Reserve Currency
    is another reason to be concerned from my perspective.
    For some years now I’ve judged that we need a Government
    in Exile.
    P.S. I consider myself a neophyte in this area and
    took the time to comment to reflect from my
    neophytic position the thoughts inspired by expert

  8. William D. Markle

    The pattern of opening up to foreign investors is to entice the
    individuals (foreign or domestic) into the markets shortly before
    the bottom falls out or the shades are pulled back on various
    previously unknown schemes that leave the investors worse off.

    This was the pattern in 2015 – the Chinese government told individuals
    to buy stocks as a patriotic move, a few months before the crash.
    This allowed large and connected investors to sell out at the peak,
    and as for the new and relatively unsophisticated individual investors-
    well, caveat emptor.

    The idea of selling local government bonds is now in the same category,
    in my opinion. Far too much in the way of hidden machinations to make
    any such investment anything other than highly speculative. When the
    foreigners have a very large share of the bonds, that will be the time to
    pull the plug. I write about China more generally at chinareflections. com

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