Huge Fraud In Chinese Stocks 

June 2011

Investors in Chinese companies have depended upon outside auditors, institutional investors, and global investment banks as substantiation for the notion that their financial reporting is trustworthy. Recently, that trust has been seriously shaken as dozens of Chinese companies have withdrawn financial statements, faced auditor resignations, failed to timely produce current financial statements, and/or announced special financial investigations. In response, investors recently dumped practically all Chinese stocks, causing the entire sector to significantly underperform the rest of the stock market.

There are over 200 Chinese companies that trade directly on U.S. exchanges. The majority of these are small companies that obtained their U.S. status through reverse mergers with dormant U.S. shell companies. The U.S. audit watchdog, the Public Company Accounting Oversight Board (PCAOB) summarized the number of these shady reverse mergers as follows:

“The PCAOB’s Office of Research and Analysis (“ORA”) staff identified 159 companies from the China region that have accessed the U.S. capital markets by means of a reverse merger transaction (a “Chinese Reverse Merger” or “CRM”) from January 1, 2007 to March 31, 2010. As of March 31, 2010, the market capitalization of the 159 CRM companies identified by ORA staff was $12.8 billion, less than half the $27.2 billion market capitalization of the 56 Chinese companies that completed U.S. initial public offerings (“IPOs”) during the period covered by this research note.”

But, not all problems have been with these smaller companies. Software company Longtop Financial Technologies is probably the most notable fraudulent Chinese company traded on a U.S. stock exchange. At its peak, Longtop had a $2.4 billion market capitalization. Longtop’s auditors were Big Four firm Deloitte. Longtop’s IPO underwriters were Goldman Sachs and Deutsch Bank. Morgan Stanley was the lead manager for a secondary stock offering of additional shares. Longtop’s large investors include JPMorgan Chase, the Fidelity mutual fund family, and a $20 billion private investment fund. This prestigious accompaniment would cause most investors to think that a lot of smart people endorsed Longtop as an investment.

Longtop's stock value seriously unraveled when its outside auditors decided to double-check the accuracy of the cash balances the company claimed to have in the bank. Deloitte’s prior audit work included statements from the Longtop's banks showing the accuracy of its claimed cash balances.

Deloitte performed additional audit testing after fraud allegations arose. Deloitte’s resignation letter indicated that their expanded audit procedures:

“… identified a number of very serious defects including: statements by bank staff that their bank had no record of certain transactions; confirmation replies previously received were said to be false; significant differences in deposit balances reported by the bank staff compared with the amounts identified in previously received confirmations (and in the books and records of the Group); and significant bank borrowings reported by bank staff not identified in previously received confirmations (and not recorded in the books and records of the Group).

In the light of this, a formal second round of bank confirmation was initiated on 17 May. Within hours however, as a result of intervention by the Company’s officials including the Chief Operating Officer, the confirmation process was stopped amid serious and troubling new developments including: calls to banks by the Company asserting that Deloitte was not their auditor; seizure by the Company’s staff of second round bank confirmation documentation on bank premises; threats to stop our staff leaving the Company premises unless they allowed the Company to retain our audit files then on the premises; and then seizure by the Company of certain of our working papers. … the Chairman of the Company, Mr. Jia … [informed Deloitte] that ‘there were fake revenue in the past so there were fake cash recorded on the books’. Mr. Jia did not answer when questioned as to the extent and duration of the discrepancies. When asked who was involved, Mr. Jia answered: ‘senior management.’”

There is no indication that Chinese regulators are paying attention to these problems. China does not regulate Chinese companies listed in the U.S., and does not allow the U.S. to do so within China’s jurisdiction. Although China securities regulators (the China Securities Regulatory Commission) periodically vows to combat fraud, there have been few high-profile prosecutions. In an April 27 letter by SEC chairman Mary Schapiro, the SEC commented on challenges in doing more with Chinese companies, as follows:

“… there are certain difficulties associated with investigations of securities laws violations that touch on foreign jurisdictions. The SEC routinely notifies our regulatory counterparts, including the China Securities Regulatory Commission (CRSC) that obtaining voluntary and direct access to witnesses and information is important to our enforcement investigations. … the PRC view[s] such direct efforts as a possible violation of sovereignty and/or national interest …”

Another improvement would be to allow the PCAOB to inspect auditors working for U.S.-listed companies in the PRC. So far, the Chinese have also prohibited this.

But the problem in China is exacerbated by a willingness of Chinese banks and other financial intermediaries to complete fraudulent confirmations. This is part of the issue at Longtop, as discussed earlier. U.S. auditors do not face this challenge because of a different mentality by confirmation respondents in the U.S. But this should be relatively easy to fix with correct Chinese government emphasis. China’s banking industry is dominated by only four large state-owned banks. Alternatively, the Chinese could participate in relatively simple existing technology that allows for centralized direct online confirmation of balances by outside auditors. Such an approach is already in use in the U.S.

U.S. investor appetite for Chinese companies is waning because of skepticism about the veracity of these companies' financial records. Reputation issues run the risk of effectively killing direct U.S. investment in Chinese companies. As an example, Sino-Forest Corporation just lost most of its stock’s market value because of unsupported allegations by Muddy Waters Research. Muddy Waters is an unregistered company (i) whose current website does not report its address, phone number or principals, and (ii) that acknowledges it has a short position in the stock (which has now become very profitable). This author is not saying Muddy Waters’ allegations are not correct. Our point is merely that, absent the current reputation concerns, the current allegations would not have caused nearly as large of a market decline as what has just occurred.

Sino Forest currently has (i) a clean opinion by Big Four firm Ernst & Young, (i) its bonds rated by both Standard & Poor’s and Moody’s at just below the investment grade level, and (iii) has raised billions in the capital markets using notable investment bankers. Sino Forest released its comments rebutting these allegations, but the markets did not trust this Chinese company. Consequently, the shares (as of this writing) remain a small fraction of their value just a few days ago. Sino Forest’s response included:

“Sino-Forest Corporation (TSX: TRE) ("Sino-Forest" or the "Company"), a leading commercial forest plantation operator in China, today commented on the share price decline on June 2, 2011 as a result of the allegations made in a 'report' issued on a website by a short seller operating under the name Muddy Waters, LLC. The Company was not contacted by Muddy Waters for comment ahead of publication of its report.

The Board of Directors and management of Sino-Forest wish to state clearly that there is no material change in its business or inaccuracy contained in its corporate reports and filings that needs to be brought to the attention of the market. Further we recommend shareholders take extreme caution in responding to the Muddy Waters report.

As indicated in the report, Muddy Waters has a short position in the Company's shares and therefore stands to realize significant gains from a share price decline that it precipitated. Muddy Waters expressly admits that it makes no representation as to the accuracy, timeliness, or completeness of any information contained in its report. Further, its website discloses no address or ownership information, nor the credentials of any of the authors of the 'report'. Neither the Ontario Securities Commission nor the Securities Exchange Commission website lists Muddy Waters or its author as being registered as an advisor.”

The economic opportunities in China are almost too great to ignore; however, we did say “almost”. Given the recent hammering of Chinese stocks, this may not be the best time to exit Chinese investments that you already own. However, until the Chinese government wants to seriously address this huge credibility issue, Chinese stocks are only suitable for the most aggressive of investors.

Fulcrum Inquiry performs business valuations, and assists in litigation assessments involving securities fraud allegations.