Lax US laws allow scores of fraudulent Chinese companies the glamour of American listing through reverse mergers. Many are now collapsing
Moneylife Digital Team
Hundreds of small Chinese companies have entered the US markets through reverse mergers. Many of them, it appears, have phoney financials. For Chinese companies to register on the Shanghai Stock Exchange is an arduous task. The easier route for them is to merge with US companies and list on a US exchange. What usually would take a year or more in China is completed in a few weeks in the US. Chinese companies merge with defunct or nearly defunct US public companies which, at any given time, hold thinly-traded penny stocks. By merging with such American companies, Chinese companies become instantly public.
Ironically, while lax US laws are allowing suspect Chinese companies the glamour of US listing, smart US investors also find it a great opportunity to take advantage of short-selling these dubious companies and make a killing. Investment companies have identified these fraud companies listed on the US exchanges and have gone short on the scam-ridden stocks to register huge profits.
Kerrisdale Capital is one such company which identified these reverse merger frauds that had allowed it to generate an amazing 89.1% return (gross of fees) and 73.2% net, beating the performance of the S&P 500 Index by about 68% in the March 2011 quarter. The top five contributors to Kerrisdale Capital were the shorts on the Chinese reverse merger fraud companies. Since its inception in July 2009, Kerrisdale has grown by 299.5% (net of fees), up to the quarter ended March 2011.
Look at some examples of reverse-merger frauds. China MediaExpress Holdings Inc (CCME) was able to dupe Deloitte Touche Tohmatsu—one of the top four auditing firms worldwide, to audit its 2010 financial statements. It was also able to con CV Starr & Co, the private equity firm run by former AIG (American International Group, Inc) chairman Hank Greenberg, to purchase a large stake in the company. Starr is now suing CCME. By duping them, this Chinese company was able to lure investors. The shares were touted on sites like Yahoo! that cater to retail investors. The company even had its own Facebook page.
CCME had margins, revenue growth and return on capital that defied common sense and were too good to be true. The company was much smaller than what the SEC (US Securities and Exchange Commission) filings indicated. It was when Deloitte resigned that the Chinese ‘fraud-cap’ space began to implode. Investors are now staying away from owning Chinese reverse merger stocks. Hence, there has been a huge decline in prices.
Another example is the case of China Education Alliance (CEA). Apparently, the company’s websites do not work, despite the fact that CEA is an online education provider and its websites are the company’s main revenue-generating assets. Videos show that the main www.edu-chn.com and www.pk1234567.com websites have non-functioning payment methods and are full of broken links and HTML errors. The company’s websites receive a fraction of the visitor traffic generated by comparable sites, such as those operated by China Distance Education Holdings (DL), which reports lower revenue and lower margins than CEA, despite having functioning websites, a larger number of Web assets, operational payment schemes and no broken links. The company’s training centre in Harbin (the capital and largest city of Heilongjiang Province in northeast China) was found to be barren of desks and teaching equipment. The company’s local filings with the Chinese government show that the online business generated less than $1 million in revenue in 2008. CEA has had four non-reputable auditors since it went public in 2004. The company also raised capital in 2009 at an irrationally low valuation without providing a sensible rationale for the capital requirement.
Audits are undertaken before two companies merge but many of these audits are about as reliable as the income figures claimed by the Chinese company. It appears that the financials are, at times, verified by equally fake audit firms. Auditing a Chinese business has its own set of issues. There are language barriers and vast cultural differences. American auditors, therefore, have a tough time verifying the financials claimed by the newly-merged company. Auditors cannot be held for wrongdoing apart from negligence.
The fraud may be unravelling now. A recent Kerrisdale letter notes: “As one of the first funds to expose scams within the US-listed Chinese reverse merger universe, we benefited from our intimate knowledge of the sector. Most of the frauds exposed this quarter contributed to our returns in some shape or form, as did equity declines in many Chinese ‘fraud-caps’ that were not exposed.
“Shorts like us have long argued that SAIC (State Administration for Industry & Commerce of China) filings provide meaningful data-points on whether certain Chinese companies are scams and that SEC financial statements are not worth the paper they’re printed on. Rather, investors need to conduct independent diligence on these companies to verify whether their business claims are accurate.”
As per the Kerrisdale letter, the Chinese ‘fraud-cap’ space imploded in the March quarter. Chinese reverse merger stock scams were down anywhere from 10% to 80%; many stocks were down 50%+. On average, one or two frauds were exposed per week; long, detailed reports were put out by several research firms. In the first three weeks of January, more than half-a-dozen US-listed Chinese companies have been the subject of published fraud allegations. On 22nd May, Deloitte Touche Tohmatsu Ltd resigned from Longtop Financial Technologies Ltd (LFT), a Hong Kong-based financial software company, because of the “falsity of the company’s financial records in relation to cash at bank and loan balances (and possibly in sales revenue).” Also, it experienced “deliberate interference by certain members of the Longtop management” in the audit process, including ‘unlawful detention’ of audit files.
Amazingly, this kind of fraud is going on full scale in the world’s most litigious society. How and why have the SEC and the NYSE (New York Stock Exchange) allowed this to go on? Kerrisdale analyses the situation as follows: “Shareholders apparently hold stocks in a US-based firm which holds a share of the Chinese subsidiary run by Chinese management. US investors, therefore, have no legal recourse to the Chinese management teams committing fraud even though the US firm is regulated by US regulators. The Chinese management team committing fraud is not governed by US laws. The only way to prevent fraud is to establish an appropriate extradition treaty between China and the US which will allow the US regulators to apprehend and punish the guilty Chinese management teams. This being a difficult task and not likely to happen any time soon, foreign companies will continue to take advantage by filing fake financials with the SEC and listing on the US exchange,” according to Kerrisdale.
All this looks surreal to us. We thought Indian regulators and auditors were lax. If the SEC and NYSE can allow such fraud to go on, it shows how much worse it can be for Indian investors. As the Americans would say: “You ain’t seen nothin’ yet.”