Friday, April 15, 2011

Bucket Foot

During trading this week stocks of China-based companies sunk ever lower in what was otherwise a troubled U.S. equity market.  Revelations of fraudulent accounting by a few have inspired short-sellers to take positions in fully valued stocks in the group and orchestrate public campaigns across on-line information platforms.  Coupled with media reports such as the Herb Greenberg commentary on the television news organization CNN, have given the impression that none of the China companies that have used the reverse merger process to become public in the U.S. are legitimate businesses. 

Chinese management teams appear to be walking around with the proverbial bucket on their collective foot.

The situation as laid bare the abject inadequacies of the management teams in these companies to fulfill the requirements of being a public company in the U.S.  The nature of Chinese business practices is so very different from the principals of transparency and accountability that are at the core of securities regulation and accounting standards.  To prosper in China is to hold your cards very, very close to the vest.  Half-truths and stonewalling are considering appropriate tactics in dealing with adverse situations.  Unfortunately, U.S. regulatory authorities look dimly that sort of thing.  For example, trading in RINO was originally halted because RINO International management simply failed to respond to Nasdaq official inquiries.  

Sections of financial reports for management’s discussion and analysis of results frequently offer inadequate explanations for even material events and changes.  Sometimes the language is just wrong.  For example, in 2008 and 2009 quarter and annual filings, disclosures and notes for LandL Energy, Inc. (LLEN:  Nasdaq) described a balance sheet figure as “due to related parties”  or a liability even though it was listed on the balance sheet as an asset and was labeled “receivable due from related parties.”  Even after the discrepancy was pointed out to management it was not corrected, leaving investors to wonder whether related parties owed L&L Energy millions or the company was in debt by that amount.  In fact, it was an asset, a note receivable from individuals who had sold a coal mine to L&L.  The sellers had fretted over the way L&L was using cash that had gone to L&L in the deal.  The sellers wanted the cash back, so L&L handed it over for a note.  The understanding, unwritten of course, was that once L&L had raised capital in the U.S. markets, the sellers would pay back the receivable, thereby returning the cash balance.

Indeed, balance sheets of China-based companies are filled with evidence of business as usual in China - lengthy negotiations, complex agreements based on loans and advances, cross ownership.  While that might get the job done in China, little of it translates well into U.S. GAAP accounting, even when assets and liabilities are described properly.  Besides the related party assets and liabilities that arise from acquisitions, balance sheets of Chinese companies are filled with “advances to suppliers” and “deposits and advances.”  Few U.S. investors understand such practices and immediately assume there is something fraudulent going on.

Chinese management teams appear reluctant to provide more than a cursory mention in footnotes of some major events and balance sheet changes.  U.S. investors assume full explanation is the answer, failing to understand that more than one audience has access to filings with the SEC.  A whole host of constituents, including competitors, can use SEC filings for their own purposes.  Furthermore, partners and friendly parties may not want their business dealings laid out for the world to see.  As I said, to prosper in China is to play it very, very close to the vest.

Unfortunately, we have more at play than the need to be discrete and the inexperience of Chinese management teams in the U.S. securities laws.  There appears to be evidence of real fraud.   RINO International, China MediaExpress (CCME:  Nasdaq) and Duoyuan Global Water (DGW:  NYSE AMEX) are among the most recent to come under scrutiny.  In both of these cases, there appears to be evidence, yet unconfirmed, that management has falsified contracts and revenue.  Resignations of senior offices have added fuel to the fire.

We have not had such widespread allegations of fraud since the days when Enron, Worldcom and HealthSouth dominated the headlines in U.S. financial press.  U.S. investors would do well to review what happened in each of these debacles.  Failure of auditors and inadequate regulatory oversight were elements in each of these cases.  We suggest the same issues are at play in this case as well.  We note that a number of small China companies filed annual reports late, using the extra time to dot I’s and cross T’s.  We have found footnote disclosures relating to income and value added taxes have been amplified to explain the timing differences between the recording and payment of China taxes and proper reporting in U.S. GAAP.  During conference calls China management teams are confirming that their auditors have received bank statements  -  the real bank statements.  Such issues have been popular with short-sellers as timing differences in paying VAT taxes in China and reporting in U.S. GAAP make for great fodder to make a short-case.

The stocks of Chinese companies should probably have not traded as high as they did.  The payment of dividends by China companies is restricted by Chinese law and so far there has been no test of the PRC’s humor with this regard.  That the stocks traded for higher than justified valuation multiples is not the fault of Chinese management teams.  Rather that is entirely at the feet of U.S. investors.  Chinese companies do need to play fair, with honest financial reports.  We have made progress and expect the tide is turning on the reliability of financial statements.

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 CGA and TSTC and a hold recommendation on RINO.


WSM said...

"We have made progress and expect the tide is turning on the reliability of financial statements."

Based on what?

WSM said...

But, please by all means, keep pumping your Chinese reverse merger stocks.