Chinese Fraud is Widespread

The downfall of China MediaExpress (CCME) has changed the landscape of U.S.-listed Chinese stocks forever. The events of last week, including developments at China Agritech (CAGC), Subaye (SBAY), China Integrated Energy (CBEH) and ShengdaTech (SDTH) prove that Chinese fraud on U.S. exchanges is much more widespread than I originally thought. Numerous trading halts initiated by the exchanges, and more details about the SEC investigation in Chinese reverse mergers, deal-makers and investment banks involved show that U.S. regulators are stepping up to address the issue. Even though we have always advised extreme caution when investing in this space, we have clearly been too optimistic going forward, put too much weight on auditor integrity (incl. Big Four) and third party due diligence (analysts, institutional investors).

China MediaExpress

The battleground for longs versus shorts was China MediaExpress, a high profile self-proclaimed leader in the booming Chinese advertising industry that reported stellar quarterly results throughout 2010. The company was considered among the safest of the RTO/SPAC stocks based on a large number of indicators which supported the credibility of the company and its reported financials. CCME had a Big Four auditor (Deloitte Touche Tohmatsu) since 2009, a large institutional investor (CV Starr) that even increased its position in the stock last fall, consistently bullish analyst reports (Northland called it its Top Pick 2011, Global Hunter repeatedly released detailed research and raised price targets), and supposedly $170 million cash on its balance sheet. The company announced a share buyback program (although never executed) and promised to pay a dividend this spring.

Despite all these bullish signs, short interest in the stock kept rising to staggering levels, even before Muddy Waters and Citron Research released their short reports. The warning signs were always there, both CCME longs and shorts were engaged in a fierce battle over details, but in the end this was a battle between short sellers, who wanted to profit from a collapsing share price, and the reputation of Deloitte, Starr, Global Hunter and other well-known names in the industry, backed by magnificent financial reports. Longs could easily argue that jumping on the Deloitte-Starr-GH bandwagon would be a much safer bet than following the short argument that all those big names got it totally wrong.

Now the battle is over. Deloitte resigned as CCME's auditor. Dorothy Dong, the representative of CV Starr on China MediaExpress's Board of Directors resigned as well, and Global Hunter's senior analyst, Ping Luo, is no longer working for the firm. CCME's stock is halted indefinitely, without an auditor and CFO - Jacky Lam resigned as well - it is unclear when (if ever) we see another 10-K from the company, and the fallout of this scandal sent the average Chinese RTO stock down another 20% last week. Dorothy Dong's resignation letter gives us a good account of what happened with China MediaExpress:

As you know, numerous allegations of a serious nature relating to the conduct of certain members of CCME's management (and that of its subsidiaries) have come to light in the past several weeks. Specifically, by letter dated 3 March 2011, Deloitte Touche Tohmatsu issued a letter to CCME's Audit Committee detailing numerous irregularities it encountered during its audit of CCME, including in particular, irregularities concerning the bank account balances for CCME's PRC subsidiaries.

Subsequently, by letter dated 11 March 2011 to the Audit Committee and the Board of Directors of CCME, Deloitte resigned as auditor of CCME, citing "no tangible process" had been made with respect to the issues raised in its 3 March 2011 letter, and stating that it had "lost confidence in the representations of management (which underpin any audit) ... and reliable financial reporting."

What do we learn from this? CCME's cash balance is most likely massively overstated, and with that the likelihood that we have seen correct financial quarterly reports for 2010 is very low, as most of the cash is supposed to come from operating cash inflows last year ($30 million in Q3/2010 alone). When Deloitte now speaks of numerous problems "of a serious nature", it heavily devalues the quality of its own work over the past 16 months, and especially also the work of Starr and all the analysts we were supposed to rely on. The most plausible scenario is that CCME's founder, majority owner, Chairman and CEO Zheng Cheng, was deliberately defrauding investors with the sole purpose to enrich himself.

China Agritech

Adding to this scandal is the story that is unfolding around China Agritech (CAGC), another Chinese reverse merger that got heavily attacked by short sellers. The stock was halted by NASDAQ on March 14 before the open, and NASDAQ said trading will remain halted "until China Agritech has fully satisfied NASDAQ's request for additional information." More details came to light after the halt, and all of them point to what I would call highly deceptive behaviour by the company:

On March 13, China Agritech issued a press release, announcing a delayed 10-K filing due to the formation of a special committee in order to "investigate certain allegations made by third parties with respect to the Company and certain related issues." The next day, right before the stock was halted, CAGC announced the dismissal of Ernst & Young Hua Ming (another Big Four) as auditor, based on the management questioning Ernst & Young's independence and "in order to give the public fair and truthful financial results."

The real reasons for both the formation of the special committee and the "dismissal" of Ernst & Young were hidden from investors. In fact it turned out that the "third parties" making allegations included Ernst & Young, and that the auditor threatened to resign if the company wouldn't correct its deceptive press releases. An 8-K form, filed on March 18, tells us a more detailed story of what has really happened at CAGC:

"On March 13, 2011, the Company announced that it formed a special committee of its board in order to investigate certain allegations made by third parties with respect to the Company and certain related issues and that the Company would not be able to meet the its Form 10-K filing deadline. E&Y informed the Company that, in its view, there was a material omission of fact from the Company's press release relating to the formation of the special committee, as the press release did not specifically disclose that the independent investigation was related to issues which were identified during the performance of the Company's year end audit. E&Y further advised the Company's representatives that E&Y may resign as the Company's auditors if a revised press release was not issued. The Company, however, believed that the specific disclosure in the press release about the investigation combined with the disclosure of the indefinite delay in the 10-K filing, was a clear indication to the market that issues had arisen in connection with the annual audit which would have to be addressed.

E&Y informed the Company that the issues identified in performing their audit may, if further investigated, have adverse implications for the financial statements covering the three quarterly reports filed by the Company on Form 10-Q during 2010, and advised the Audit Committee to inform the predecessor auditors of the issues identified, so that they can assess the impact on prior financial reports."

Immediate Conclusion

Last week was a game changer, and right now it is no longer possible to reasonably contain the risks when investing in Chinese small caps, especially reverse mergers and blank-check deals. The number of fraudulent companies in this space is much higher than a common sense approach would even have considered possible - maybe even higher than 50% - and for a retail investor those risks are just too high here. The only stocks we should consider for an investment, at any price, are those with a clean 2010 full-year audit backed by a tier one accounting firm. And even those are not free of fraud-risk.

The shake-out will continue, we will see more Chinese RTO stocks imploding in the next few weeks. And, most importantly, the magnitude of fraud will force U.S. regulators to act swiftly. We have seen as many as five Chinese RTO stocks with an exchange-forced trading halt last week, and this trend will continue. Wall Street can not afford to be seen as a facilitator of systemic Chinese securities fraud, and investors in those stocks are simply not protected.

We will make the necessary adjustments to our China Model Portfolio later today.