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Systemic Fraud In China?

June 02, 2011 | About:
Barel Karsan

Barel Karsan

17 followers
China's high growth rates have encouraged foreign investment, which have in turn helped fund China's incredible growth. But such large capital inflows are bound to give way to sector imbalances and fraudulent behaviour. Recently, some fraudulent behaviour has been uncovered among small-cap Chinese stocks that trade in the US. But as the story continues to develop, it is beginning to increasingly appear as if the fraudulent behaviour could be operating on a much more massive scale.

Many of the reverse takeover stocks that have been uncovered as frauds have been small cap stocks with auditors with small operations. Perhaps these could be dismissed as a small number of one-off incidences of poor oversight and unethical management. But recent events make it clear that these occurrences are not limited to the small-cap space, and nor are they limited to mom-and-pop auditor operations.

The auditors of some of the recently uncovered fraudulent companies in China have been chided on this site and others. But more and more it is starting to look as if the facilitators of the fraud were not limited to employees of the companies themselves, but included the companies' banks as well. This, of course, makes it clear why auditors were signing off on such large cash balances when they didn't even exist.

For example, Longtop Financial Technologies (LFT) is a billion dollar Chinese company trading on the NYSE. It claimed to have a cash balance of over $400 million. Auditor Deloitte Touch Tohmatsu signed off on the company's financials for six years. This year, however, perhaps because of the recent fraud uncoverings (including that of China Media Express, a company which Deloitte also audited), the auditor went the extra mile. For one thing, it didn't just trust the statements the local bank provided; instead, it made further inquiries. The result was as follows, according to Deloitte:

"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.

"In that connection, we must insist that you promptly return our documents.

"Then on 20 May the Chairman of the Company, Mr. Jia Xiao Gong called our Eastern Region Managing Partner, Mr. Paul Sin, and informed him in the course of their conversation 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”.


Auditors are likely going to step up their game this year when it comes to auditing companies in China. As a result, more fraud uncoverings are likely, and the risk is there that one or more "Enrons" are about to go down. This could damage investor confidence, and seriously dampen investment flows into China, serving as a catalyst for a recession.

The economic miracle in China has lifted millions out of poverty and has been a great thing not only for Chinese citizens but for the rest of the world. It would be nice if the economy always grew in a straight line, but it doesn't. Investors counting on China to supply the kind of uninterrupted growth the world has become accustomed to are destined to be disappointed at some point. When that will happen, however, is unknown; but ignoring the warning signs that appear to be emerging could be disastrous for investors.

About the author:

Barel Karsan
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 4.6/5 (15 votes)

Comments

rwinder
Rwinder - 3 years ago
I have been concerned about this for several years knowing the Chinese propensity for fraud as a whole. It is embedded in the culture, not just gift giving, but theft on all levels that gets wrapped in a pretty bow waiting to be sold to some unsuspecting schmuck as the cost of doing business.

I wrote a little something on it recently as well. The Chinese are literally defrauding U.S. investors and those of the world in the capital formation markets and then hiding behind a quietly complicit Chinese government.

Any money they steal from the investors of the world is just money in their pockets.
paulwitt
Paulwitt - 3 years ago
I guess Warren Buffett picked the good chinese stocks - Petrochina and BYD

AlbertaSunwapta
AlbertaSunwapta - 3 years ago
Yeah - in a weak minded moment I decided FUQI International would be my first purchase of a Chinese stock. It's now among my largest losses ever. Interestingly, it sounds like a bank played a roll in some 'unusual' transactions.

Just last night I was reading about SinoForest (TSX: TRE ) sounds like another interesting story may be developing. Trading is halted.

So now, may be the time to watch for the Chinese equivalent of the Salad Oil Scandal.

AlbertaSunwapta
AlbertaSunwapta - 3 years ago
The Sino-forest issue is actually turning out to be one that readers of this site might find interesting.

i.e. If Muddy Waters is wrong, it raises serious issues of the influence of short sellers.

Sino-Forest pushes back against analyst’s claims

http://www.theglobeandmail.com/globe-investor/sino-forest-pushes-back-against-analysts-claims/article2048824/

excerpt:

"Sino-Forest Corp... is pulling out all the stops to prove that the nefarious allegations levelled against the company have no merit."

"On Monday the company opened an online ‘data room’ in which everything from bank statements to land purchase agreements are posted..."

Interesting unrelated article on Muddy Waters...

Orient Paper: Story Behind 'Fraud' Report

http://www.thestreet.com/story/10797742/orient-paper-story-behind-fraud-report.html
AlbertaSunwapta
AlbertaSunwapta - 3 years ago
According to WSJ, in April Paulson & Co., owned nearly 35 million or 14% of the company's shares and so was the company's largest shareholder.
paulwitt
Paulwitt - 3 years ago
Even VIT and HSFT are releasing information - and these are some of the more reputable china stocks.

If someone can vet the chinese small cap space, I believe there is SERIOUS money to be made. Low PE's, low debt, and high growth rates are a nice combination.

Check out LLEN and its very impressive board of directors. I am long this stock. This stock was climbing strong until one day, when I was watching a business channel, someone gave it a thumbs down. Minutes later it dropped like a rock and has been stuck there ever since.




Disclosure: I am long 5 chinese smallcaps, with 2 of them delisted (note: there is safety in the pink sheets. smallcaps can't withstand a short attack). The china stocks are about 15% of my portfolio.

superguru
Superguru - 3 years ago
@paulwitt- "I am long 5 chinese smallcaps, with 2 of them delisted "

What is the risk reward you see with chinese stocks with such high probability of fraud?

It is almost like angel investing in startups where 7 out 10 will definitely fail.

paulwitt
Paulwitt - 3 years ago
@Superguru

How many chinese companies have been convicted of fraud? I haven't heard of too many. I've heard of Enron, Worldcom, and B. Madoff - but I haven't heard of too many chinese companies going to trial and getting convicted. For the 2 delisted companies I have they are still in business.

superguru
Superguru - 3 years ago
"but I haven't heard of too many chinese companies going to trial and getting convicted." - paulwitt

Now I get why many investors prefer investing in US and Europe only.

Hmm, I guess I will stick to investing in US, Canada, Europe and India and keep looking at Brazil

AlbertaSunwapta
AlbertaSunwapta - 3 years ago
I'm coming around to agreeing with Paulwitt - there is serious money to be made here.

I don't short so I'm missing the huge downside gains being made these days but one has to wonder if the shorts aren't abusing their new found power and influence over these RTOs.

The conditions are ripe - China is on the cusp of a crash of some sort. Seems real estate is a given. Then these RTOs get tons of bad press and after being targeted by the shorts get driven into the ground thus confirming everyone's perception that all Chinese stocks are bad if not evil.

In my own experience I've lost most of my first investment in Chinese equities - FUQI - but continue to hold it on the pink sheets. (The reaction seemed to far exceed the scale of the problem but definitely involved major ethical beaches of conduct involving cash transfers with seemingly chinese bank collusion.)

So despite my early losses, I'm thinking there could be great opportunities here for multi-bagger returns. For instance, I've been reading that Muddy Waters went after Orient Paper and the stock was driven into the ground. However, auditors apparently addressed all the issues raised by MW and said Orient Paper was sound. So why hasn't the stock recovered?


Does Paulwitt or anyone else care to list their beaten down small cap chinese stocks for the rest of us to ponder over?


"Be fearful when others are greedy and greedy when others are fearful." - Warren Buffett
AlbertaSunwapta
AlbertaSunwapta - 3 years ago
Fascinating... The thing is - "correct" or not, the short seller only has to be "effective" the first few times and then he could close up shop and retire.

Moody's puts Sino-Forest ratings under review for possible downgrade

http://www.google.com/hostednews/canadianpress/article/ALeqM5jXLXP83x2o1qoeVy3F3hUOEBkQug?docId=7077648

"Sino-Forest has refuted the allegations, but Moody's raised concerns the company's business may be affected even if the accusations are proven false."

Skepticism mounts against Sino-Forest short seller

http://www.canadianbusiness.com/blog/business_briefings/29215--skepticism-mounts-against-sino-forest-short-seller

"During the call, Block didn't adequately address this discrepancy, according to Swetlishoff. "This is a very basic error regarding one of the primary allegations by [Muddy Waters], considering the large number of purported man-hours spent in the 'investigation,'" he wrote.

Secondly,..."

Analysis: Muddy Waters is 5-for-5 on China short calls

http://www.reuters.com/article/2011/06/06/businesspro-us-china-stocks-muddywaters-idUSTRE7556D020110606

"Many would envy the firm's record as even the most experienced short sellers have a number of misses before they hit the jackpot..."

""If you're going to make accusations of fraud the way Muddy Waters does, you're going to have to be correct" to be effective, said Michael Shaoul, chairman of Marketfield Asset Management in New York..."
paulwitt
Paulwitt - 3 years ago
@AlbertaSunwapta

I wrote about one stock in this thread. For other emerging market stocks, detective work, logic, and risk management will take you where you want to go!

Time will tell if you are right or wrong about FUQI.

paulwitt
Paulwitt - 3 years ago
Another misunderstood thing is bankruptcies. A lot of people think that you lose everything in a bankruptcy. However, there are a class of investors who specialize in distressed debt and bankruptcies,

and sometimes original shareholders get good returns at liquidation.

AlbertaSunwapta
AlbertaSunwapta - 3 years ago
In watching the volatility of Sino-forest I'd say that you don't even have to wait out bankruptcy proceedings. The shorts and the assumption that they are correct in their dire valuations of China connected firms are creating huge opportunities.

At the moment I don't own Sino-forest. That may change.

I have gone long with small speculative positions in ONP and YONG

(Possibly on the assumption or personal bias that shorts, more so than longs, are an immoral bunch. :-) )

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