A Short History of Short Attacks, Part Two

China Marine Food Group (CMFO) has come under pressure from short sellers several times throughout 2010. A person posting under the alias "Chinese Company Analyst" on Seeking Alpha repeatedly called the company a fraud: "The main thrust of our argument that CMFO is a fraud is that the Company's SAIC and SEC filings don't match." (June 1, 2010) and "Investors ... should be concerned about whether ZYCPA is actively aiding China Marine Food management in falsifying its SEC financial statements." (June 16, 2010).

ZYCPA, China Marine Food's auditor at that time, is a small Hong Kong firm that has several U.S.-listed clients, including NF Energy Savings (NFEC) and China Sun Group (CSGH). The firm had repeatedly been accused of participating in alleged frauds, and whenever that happened the auditor changed its name: from Zhong Yi (Hong Kong), to ZYCPA, and now they use the moniker "HKCMCPA" - the original firm is no longer recognizable. China Marine Food engaged BDO China as its new auditor in October 2010 and is no longer connected with ZYCPA/HKCMCPA.

Another Seeking Alpha author attacking the company was Chimin Sang, when he wrote in June 2010 that CMFO's "business itself is nearly impossible. It has $400 fixed assets, little inventory, zero finished product inventory, but it has a magic ramp-up of sales." None of those attacks had an immediate effect on CMFO's stock price. The stock traded in a relatively narrow range for the remainder of 2010, and closed the year unchanged from the levels of mid-June. However, the performance for 2011 is terrible and CMFO printed new lows this Friday, to close at $2.92, down 45.93% for the year.

Muddy Waters Research, perhaps the most famous of all China short-selling outfits, emerged on June 28, 2010, with its initial "Sell Short" report on Orient Paper (ONP): "We are confident that ONP is a fraud. Its purpose is to raise and misappropriate tens of millions of dollars." The company swiftly responded by stating that it "categorically denies these allegations and has instructed its legal counsel to contact Muddy Waters and explore all legal options against it for publishing and distributing such a report." However, the stock lost some 20% of its value within three days from the release of Muddy Waters' report.

A whole battalion of short sellers jumped on Muddy Waters' bandwagon and published further attacks over the next few weeks. Again we have "Chinese Company Analyst" - whose website is no longer active today - questioning the integrity of Orient Paper's auditors BDO Limited, the Hong Kong member firm of BDO International. He also published another article where he claims to "provide compelling evidence that Orient Paper is falsifying its financial statements." And Chimin Sang, a very vocal China bear who posted negative articles on a growing number of Chinese reverse mergers (FUQI, CCME, CHBT, ZSTN, SCEI), meant to let the world know that he "side[s] with Muddy Waters: ONP has more likely than not committed fraud."

Orient Paper initiated an internal investigation of these fraud allegations, which, according to the company, did not find any evidence for fraud. Drew Bernstein, the head of ONP's audit committee and a partner in the New York-based accounting firm Marcum Bernstein & Pinchuk, concluded that: "When you look at Muddy Waters' allegations in totality, you'd have to say they are false." He said that ONP is "by now perhaps the most vetted company in China."

Muddy Waters hasn't admitted defeat, instead they questioned the validity of the company's internal investigation. And Orient Paper's share price? The stock recovered nicely after the investigation concluded, yet it is now trading at lower levels than any time in 2010, printing new lows last week and sitting on a 44.34% loss for the year.

Sharesleuth picked on Chinese telecom equipment company Telestone Technologies (TSTC) in an article published on August 11, 2010. The article focused on TSTC's growing accounts receivable issue and concluded that "investors who are considering the company because of its sharp increase in sales and earnings and its attractive profit margins might want to know more about the underlying numbers." The article was explicitly "not alleging any wrongdoing by Telestone," but it set the tone for further negative articles this winter.

On January 10, 2011, The Forensic Factor called Telestone "a RINO in sheep's clothing," stating that they are "nearly convinced that Telestone has misrepresented its prospects, size, and business to the investment community." TSTC swiftly rejected all allegations and called the article "an unjustified swipe at a reputable and successful Chinese business." The Forensic Factor remained unimpressed and posted a follow-up two weeks later with the telling title "The Great Wall of Deceit".

TSTC suffered its steepest losses in 2010 already, when the share price was roughly cut in half. Most of these losses can in fact be attributed to the accounts receivable issues, unrelated to any specific short-selling attack. For 2011 the stock is down 29.67%, yet it has recovered almost 50% from its early April low. It is one of the very few Chinese reverse merger stocks that seems to be in an uptrend for the past four weeks. But TSTC is not for the faint of heart, the Trading China Risk Model suggests that this is one of the highest risk stocks in the China small caps universe.

To be continued...

A Short History of Short Attacks, Part One

It all started with John Bird a.k.a. Waldo Mushman, one of the most vocal figures in the growing circle of short sellers targeting Chinese stocks. In early August of 2009 Bird proclaimed the TCM (Traditional Chinese Medicines) company China Sky One Medical (CSKI) a fraud: "Based on the massively inflated and inconsistent numbers, I have come to believe that China Sky One Medical is actively committing fraud." Over the next 12 months, Bird reiterated his call numerous times, on any platform or message board he found his way to.

The company responded with press releases and denied all allegations. In one of those attempts (July 23, 2010) "the management of China Sky One Medical reminded investors that Waldo Mushman was misleading investors by counterfeiting SAIC documents and posting them on its website and other blogs." It did not help them. The stock lost 81.63% of its value since John Bird's initial call, so we can safely assume that he made a good chunk of money with his short position.

Bird got help from other short sellers. On February 21, 2010, Manuel Asensio accused CSKI on Seeking Alpha of not disclosing material information: "The Chinese government order to stop selling eight of CSKI's products seems to be material to CSKI's operating condition, yet CSKI has provided no disclosure of the order to U.S. investors." In a similar vein, The Financial Investigator blogged on August 4, 2010, that "China Sky One did not disclose the receipt of its own subpoena in its filings nor did it reference that its auditors had received one." At that time the Securities and Exchange Commission had issued subpoenas to China Sky One Medical and its auditors, MSPC. And roughly one month later, The Street Sweeper published on its website that "MSPC is a past target of securities regulators that has since come under fire for allegedly approving flawed financial reports issued by CSKI itself."

China Sky One is still trading on Nasdaq at the time of writing. Yet the stock price is in a constant decline. From $22.75 at the end of 2009, the stock closed at $6.97 one year later, and now you can buy it for just $2.83. At Friday's close, CSKI is down 59.40% for the year.

The next target on our list of short attacks is L&L Energy (LLEN), a U.S.-based coal mining company with the majority of its operations in China. On January 11, 2010, The Street Sweeper portrayed LLEN as a "relatively new Chinese coal miner accused of misleading investors in the past, [that] has managed to become a stock-market winner by posting some of the most incredible numbers recorded in the entire industry."

The stock kept rising into summer until Herb Greenberg used his platform on CNBC to repeatedly attack the company and its Chief Executive Officer: "CEO and founder Dickson Lee was fined $65,000 by FINRA and banned from the securities industry for a year." Greenberg's attacks on live television sent the stock lower. From $11.05 at the time of the first broadcast (December 21, 2010), LLEN dropped 44.53% to close at $6.13 last Friday. The stock is down 43.25% for the year, but it has recovered some from its all-time lows, printed in early April at $4.29.

On January 26, 2010, a short-selling outfit named "Worthless Pennies" called out pharmaceutical company China Biologic Products (CBPO). "The urgent warning we have for investors today is that the background check and evidence we collected clearly prove direct ties between CBPO management/directors and convicted criminals who exercise control of the company, a criminal background of the CEO of its operating subsidiary and a history of laundering money stolen from investors, none of which the company disclosed in its filings." That call was initially very successful and sent CBPO 25.94% lower on the day of its release.

China Biologic reacted three weeks later by announcing a thorough internal investigation and stating that "the Company believes that this is an attempt to discredit the Company's management and disrupt the Company's business and operations." In December 2010 the company informed investors that "the Special Committee of its Board of Directors has completed its investigation of several allegations that appeared on certain financial websites in January 2010." CBPO's strategy was highly successful as the stock has more than doubled since the Special Committee was formed on February 17, 2010. It moved from $7.62 to $16.10 for a gain of 111.28%, and CBPO is one of the very few Chinese reverse mergers the market has not punished yet - the stock has gained 33.27% since the beginning of 2010, while most of its RTO peers have been thrown into the stock dumpster. The "Worthless Pennies" outfit seems to have closed its doors, and its website does no longer exist.

Citron Research's first target in the China small caps universe was newly uplisted SinoCoking Coal and Coke Chemical Industries (SCOK) on March 11, 2010. Citron called it "an ugly duckling Chinese coal deal with an utterly improbably rise and ridiculously unsustainable run-up." The stock was subsequently destroyed, dropping from $34.09 at the time of Citron's report to $5.93 last Friday, a loss of 82.61%.

Another attack on SCOK was launched by Sharesleuth on September 13, 2010. The author, Chris Carey, wrote "that no fewer than eight people who participated in [SinoCoking's share] placement have been the subject of Securities and Exchange Commission actions or criminal prosecutions." The stock is down 50.46% year-to-date and fails the Trading China Safety/Risk Model with an "Extreme Risk" score.

Lihua International (LIWA), a company that sells wire produced from refined scrap copper, was repeatedly a short seller target. On May 9, 2010, Seeking Alpha published a Steven R. Chapski article stating that "in order for the SEC financial statements to be correct, LIWA paid the Chinese government $4 million for income taxes in 2009, yet reported $0 in profit tax to the same Chinese government on their SAIC financial reports." The company responded two weeks later by providing its most recent SAIC documents on its website and "proving" that these results were consistent with those reported in the company's SEC filings.

Chapski didn't back off, though. In December he posted another article, insisting that in his belief "the SEC financial statements continue to be wrong." None of those reports had any permanent effect on LIWA's stock price. The stock closed 2010 with a 7.5% gain, and has only recently come under pressure, consistent with its Chinese reverse merger peers. For the year of 2011, LIWA is now down 33.9%, and the stock's short ratio has spiked to 25.65% of the float.

To be continued...

China Tracker: New Features

Over the past four weeks we have added several new tools to the Trading China Tracker. The focus is on risks associated with investments in U.S.-listed Chinese stocks. It is absolutely crucial for any China investor to thoroughly assess the risks before making an investment decisions. These tools should work as a starting point for your research.

Safety/Risk Model

We have introduced a two-stage safety/risk model for U.S.-listed Chinese stocks. Stage One is based on publicly available information, Stage Two requires independent research and can not be automatized.

For every stock we are covering on Trading China, you can now find an additional score card for the Safety/Risk Model (Example: CVVT). All the data is compiled into a percentage score that indicates the safety level according to our algorithm. Please keep in mind that this is not meant to be the ultimate truth - it is based on Stage One of the model only - but it will provide a good starting point for your research into the validity of the reported financials, corporate governance issues, and the possibility of fraud.

The following data is compiled on this page and used to determine the safety score for this particular stock:

• Market Segment (Nasdaq, NYSE, Amex, OTC, Pink Sheets)
• Type of Going Public (Reverse Merger, IPO, Direct Offering, SPAC, etc.)
• IPO Lead Underwriter (if applicable)
• Auditor
• Auditor History and Trail (Dismissals, Resignations, Engagements)
• Effectiveness of Internal Controls (Management Assessment)
• Effectiveness of Internal Controls (Auditor Opinion)
• Senior Management Changes (past two years)
• CFO History and Trail (Dismissals, Resignations, Appointments)
• Ownership (Controlling Shareholder)
• Analyst Coverage (Quality of Coverage, Backing)
• Shareholder Dilution (past 12 months)
• Short Interest
• Account Receivables (Balance Sheet)
• Delinquency with periodical SEC Filings
• Reported Corporate Governance Issues (also Trading Halts)
• Recent Short Seller Attacks / Reports
• Detailed Fraud Accusations

The Safety Score is translated into a Safety Label which spans a range from "Extreme Risk" (Score under 30%), over "High Risk" (30% - 50%), "Moderate Risk" (50% - 75%), "Moderate Safety" (75% - 90%), to "High Safety" (Score over 90%). Ideally, all the stocks you want to invest your money in - as in "buy and hold" and contrary to short-term trades - should be labeled with "Moderate Safety" or higher. For all other names you are strongly advised to do your homework before taking any position. Please keep in mind that, with the exception of Account Receivables data, the safety score has nothing to do with reported financials.

From our coverage universe, the companies with the highest safety score are Ctrip.com International (CTRP), E-House (China) Holdings (EJ), and 3SBio Inc. (SSRX). A total of 24 Chinese stocks passed the Safety/Risk Test with a "High Safety" label, and another 20 names scored with "Moderate Safety". Among those 44 companies you will find only two that went public via Reverse Merger, Cogo Group (COGO) and American Oriental Bioengineering (AOB).

A total of 146 stocks failed the test with a "High Risk" or "Extreme Risk" label. The vast majority of them are Reverse Mergers or SPAC deals, but you will find a good number of regular IPOs in that group as well. The overall picture is terrifying. At the time of writing, nine companies do not have an auditor, and trading in 15 Chinese stocks is currently halted by the exchanges (not counting recently delisted CCME and CAGC). 37 companies have not filed their last quarterly or annual reports, some disappeared completely (CGDI, JADA), others filed a "going dark" Form 15 (GHNA, ENHD). I repeat, it is crucially important that you do your own research before taking a position in any of the "High Risk" or "Extreme Risk" stocks. If you don't have the time or means to do that, you should probably avoid this whole group of stocks.

A sortable table with all Safety/Risk scores has been added to the China Tracker.

Auditor Data

We have added tracker pages for all auditors of Chinese companies in the Trading China database. You can find information of all past and current clients of this auditor, if the firm was dismissed or resigned, the exact dates of the engagement/dismissal, and a screen of all related companies with their year-to-date performance. These tracker pages can be accessed from the auditor trails of each individual company within the China Tracker (Example: KPMG).

Another new screen is a chronological list of all auditor changes, starting with the most recent ones. The data is taken from Form 8-K or Form 6-K SEC filings only, not from press releases or other sources. When you click through the pages of this screen you will find that the number of auditor resignations has exploded since the start of 2011.

A similar screen is available for Chief Financial Officers.