Tuesday, November 16, 2010

Sighting Icebergs in China

It is becoming a predictable pattern. A self-proclaimed financial watch dog publishes a scathing exposé suggesting fraud and embezzlement by a China-based company with publicly traded stock listed on U.S. exchanges. The argument rests largely on comparisons of local tax reports submitted to China authorities and U.S. SEC filings submitted by the public company. This report is then followed by a series of financial blog posts by individuals claiming particular expertise in China tax law and U.S. GAAP accounting rules, singing the praise of the watch dog. Various law firms then begin issuing press releases describing an investigation into potential fraud and requesting shareholders to register for a possible class action lawsuit.

Pollution control solution provider RINO International (RINO: Nasdaq) is the latest China-based company to come under scrutiny by Muddy Waters, a relatively new watch dog focused on China companies. Muddy Waters' recent report on RINO details a number of infractions that suggest management is skimming the corporate coffers for personal gain, mismanaging cash and over-reporting revenue to U.S. investors. It could all be true….or not.

Anyone with even a bit of sense knows that such a sequence of negative articles and press releases will drive a stock price down whether the allegations, insinuations and suggestions are rooted in fact or not. A shareholder with a short position in the stock before the first article will likely realize a profit in the first few days.

RINO International is not the first China-based company to confront wildly negative allegations. Orient Paper, Inc. (ONP: NYSE), a producer of paper products in China, and China Green Agriculture, Inc. (CGA: NYSE), a producer of fumic acid fertilizer for China's large and growing agricultural sector have also been the subjects of Muddy Waters publications.

With the cry of “Danger, Iceberg!” shareholders with long positions have a tough decision to make: 1) jump with the rats from the sinking ship and maybe take a loss or 2) hang in there with the captain pending an investigation or such other revelation that allows for an intelligent, fact-based decision.

U.S. investors in China-based operations rely even more heavily on audited financials than when making an investment in a U.S.-based company. Few U.S. investors have the luxury of visiting a corporate office and if those facilities are in China that visit is nearly impossible. Auditors with adequate combined knowledge of China business practices, the Chinese language and U.S. GAAP are difficult to find.

In the case of RINO International, a small accounting firm called Jimmy c.H. Cheung & Co. CPAs was responsible for audits through calendar year 2007. Moore, Stephens Wurth Frazer and Torbet, LLP audited RINO books in calendar years 2008 and 2009. Earlier this year certain partners of Moore Stephens formed Frazer Frost, LLP, which is now RINO’s independent accounting firm. Kabani and Company is the auditor for China Green Agriculture. A small firm in Utah, Davis Accounting, had been the auditor for Orient Paper until BDO Ltd. took over beginning in the 2009 calendar year.

Investors with no other means to validate or discredit the allegations made by Muddy Waters are left with a simple comparison of credentials. Which IS more credible? - self-proclaimed analyst group with unknown affiliations or the audit firms with unverified experience in China. It would not be the first time that auditors failed to pick up on bookkeeping discrepancies that later pointed to mismanagement or even fraud. Then again it would not be the first time that short-sellers were able to close out a highly lucrative short-position on unfounded allegations.


Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein. Crystal Equity Research has a buy recommendation on RINO and CGA. RINO is included in the Emissions Control group in Crystal Equity Research’s The Mothers of Invention Index.

1 comment:

Anonymous said...

Well written article.

Investors are right to punish companies that select unknown auditors with little China experience. However, deciding that SEC reports are wrong based on government filings that no Chinese company takes seriously is a a serious mistake.