WASHINGTON (AP) — Few American investors have ever visited Hong Kong's stock exchange, a cavernous trading hall at the base of a skyscraper in the city's central district. Their money, however, is far more likely to be acquainted with the Hong Kong Market.
As a primary venue for Chinese companies listing their stocks overseas, Hong Kong's stock market thrived over the past decade as the matchmaker between mainland Chinese companies and global capital. US investors — largely pension and mutual funds — now account for more than 10 percent of trading, making overseas Chinese equities a part of millions of Americans' stock portfolios.
At least in Hong Kong, that exposure has been unrewarding of late. Hong Kong's benchmark Hang Seng index has vastly underperformed the U.S. stock market over the past five years, and regulators have grappled with how to address recurring instances of misrepresentation and fraud by mainland Chinese companies.
That history weighs on Tianhe Chemicals Group Ltd., a company partially owned by a Morgan Stanley & Co. LLC private equity fund, after Tianhe's initial public offering in June. After a shadowy investment research group alleged that Tianhe (pronounced TYEN-ha) overstated the size of its business, the $7.9 billion company's stock fell dramatically. Despite rebuttals by the company and a decision by Hong Kong Exchange officials to let Tianhe's stock resume trading after a five-week halt, investors may "just no longer want to be involved," Morgan Stanley's own stock analysts wrote in a research report last month.
A two-month investigation by The Associated Press uncovered discrepancies in the story that Tianhe told investors. The AP largely confirmed some claims by Anonymous Analytics, the mysterious group that targeted Tianhe, and uncovered new information the group did not. But beyond the specifics of Tianhe, the controversy highlights questions about the credibility of due-diligence work by the stock exchanges and investment banks that serve as the Chinese financial market's gatekeepers.
Because of China's political and legal environment, holding executives of mainland companies accountable for misleading foreign investors can be difficult or impossible. Protecting investors is largely a matter of keeping rotten stock offerings from reaching the market.
In Hong Kong and elsewhere, primary responsibility for this task often falls to investment banks like Morgan Stanley, Bank of America Merrill Lynch and UBS AG, all of whom were underwriters of Tianhe's IPO. The firms' standard due diligence involves scrutinizing a potential IPO client's financial records, visiting its facilities, interviewing its customers and checking that its legal affairs are in order.
The effort should catch all but the most sophisticated frauds. But according to Hong Kong's Securities and Futures Commission — which plays a role similar to the U.S. Securities and Exchange Commission — investment banks have historically done poor work.
In 2011, the regulator's outgoing chief executive lambasted banks for lacking "reasonable professional skepticism" about their clients' financials records. That same year, the commission reported that out of 100 prospective public offerings submitted for approval, 82 had defects.
Later, in 2012, the commission again faulted banks for shoddy work, declaring that some IPO proposals included assumptions "that were apparently at odds with observable facts."
"Everyone competes against everyone, and the only way you're going to get paid is to get a lot of deals," said Philippe Espinasse, a former investment banker for UBS and Nomura Holdings Inc. who has written guides about IPOs. "A lot of these things are staffed by people who don't have a lot of experience."
During the same period, other stock exchanges and regulators — including the New York Stock Exchange and NASDAQ — were also blindsided by a wave of fraudulent mainland listings. For Hong Kong, however, an inability to prevent fishy listings posed a more serious threat: Despite efforts to broaden the geographic base for Hong Kong listings, mainland Chinese stock issuers still dominate.
Hong Kong created new rules in 2012 that tightened requirements for investment banks' due diligence and gave regulators the ability to hold IPO sponsors criminally liable for stock issuers' misstatements. Espinasse said the changes have had a positive effect.
Hong Kong regulators may have further to go, especially in regard to forcing companies to disclose their past and present ties with the Chinese government, said Paul Gillis, an accounting professor at Peking University's Guanghua School of Management. Given concerns about corruption in China's transition to a market economy, he said, investors should know how and when ownership of companies passed into private hands.
"I've never seen that story told properly in a Hong Kong prospectus," Gillis said. "That's one of the reasons these companies tend to list in Hong Kong instead of the U.S., because I don't think the SEC would tolerate this."