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.

Safety/Risk Model - Internal Controls

(Back to Introduction)

Internal Controls

(accounts for 5% of the final score)

Internal Control over Financial Reporting (100/100)

The Sarbanes-Oxley Act (SOX 404) requires management and the external auditor to report on the adequacy of the company's internal control over financial reporting. Management is required to add an "internal control report" to each annual report with the SEC, which must "contain an assessment, as of the end of the most recent fiscal year of the issuer, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting." (U.S. Code, Title 15, §7262)

In this report, management will give details on identified control deficiencies, and if any or all of those constitute material weaknesses, as defined in the standards established by the PCAOB, it will conclude that internal controls are not effective. The cost of complying with Sarbanes-Oxley 404 impacts smaller companies disproportionately, as there is a significant fixed cost involved in completing the assessment. To address this issue, the SEC granted an extension for the outside auditor assessment, currently (with the latest extension of October 2, 2009) until fiscal years ending after June 15, 2010. This temporary rule permits most U.S.-listed Chinese companies to provide only a management report, and the auditor is not required to express an opinion on the effectiveness of the Company's internal control over financial reporting. The PCAOB filed a 62-page document about audits of internal controls, with special guidance for auditors of smaller public companies. It's an interesting read.

• 100/100 - Effective
• 0/100 - Not Effective

Safety/Risk Model - PCAOB Inspection

(Back to Introduction)

Auditors

(accounts for 30% of the final score)

PCAOB Inspection (5/100)

The Public Company Accounting Oversight Board (PCAOB) inspects all registered public accounting firms that regularly issue audit reports for companies and other issuers. In general, they are inspected at least once every three years. Inspection reports are available on the PCAOB Website with the date of the always latest inspection. You will not find reports for CPA firms based in mainland China or Hong Kong, as Chinese regulations block the PCAOB from doing inspections there. Here is a list of all Chinese audit firms that are currently registered with the PCAOB.

Mainland China: AGN China Regal, Alliott, Shanghai J&J, Anthony Kam & Associates, APEX, Baker Tilly China, BDO China Guangdong Shu Lun Pan, BDO China Li Xin Da Hua, BDO China Zhonglian Mindu Shu Lun Pan, Beijing Anshun International, Beijing Ever Trust, Beijing Huaweixin, Beijing Senheguang, Beijing Topson, Beijing Yongtuo, Beijing ZhongXingYu, Beijing ZhongXuanYu, Crowe Horwath China, Deloitte Touche Tohmatsu, Ernst & Young Da Hua, Ernst & Young Hua Ming, Fortune, Gansu Hongxin, Grant Thornton, Grant Thornton Beijing, Guangzhou Good Faith, Guangzhou Zhongxincheng, Henny Wee & Co., Hua-Ander, JTC Fair Song, Kabani International (Consulting) , KPMG, KPMG Huazhen, LehmanBrown Lu Hua, Lvr Financial Consulting, Moores Rowland, Nanjing Shu Lun Pan Yonghua, PricewaterhouseCoopers Zhong Tian, Reanda, RSM China, Shandong Haoxin, Shanghai Linfang, Shanghai Mazars, Shanghai Perfect, Shanghai RISMO, Shanghai Zhonghua, Shenzhen Chengxin, Shenzhen Kung Ming, ShineWing, Shu Lun Pan, Vocation International, Wuhan Zhonghuan, Zhejiang Pan-China, Zhong Cai, Zhonglei

Hong Kong: AGCA, Albert Wong & Co., Anderson Li & Ho, Andrew Ma DFK, Aoba, Arthur Li, Yau & Lee, Baker Tilly Hong Kong, BDO Limited, CCIF, Chan And Chan, Clement C.W. Chan & Co., Cosmos, Crowe Horwath (HK), CWCC Co., Deloitte Touche Tohmatsu, Dominic K. F. Chan & Co., East Asia Sentinel, Ecovis David Yeung, Edward Lau & Co., Ernst & Young, Gary Cheng & Co., Grant Thornton, HLB Hodgson Impey Cheng, Ho And Ho & Co., Ho, Sneddon, Chow, Hong Kong Great Wall, Hopkins, Horace Ho & co., James Ngai & Partners, K.P. Cheng & Co., KL, KLC Kennic Lui & Co., Lau & Au Yeung, Lee, Au & Co., Lo And Kwong, Louis Lai & Luk, Mazars, Moore Stephens, Morison Heng, Morrison, NHL, Parker Randall CF H.K., PKF, PricewaterhouseCoopers, RIW, RSM Nelson Wheeler, ShineWing (HK), Tai Kong, Tom Chan & Co., UHY Vocation HK, Wong Brothers & Co., Wong Lam Leung & Kwok, World Link, Y. H. Lai & Co., Yeung, Chan & Associates, Zhong Yi (Hong Kong), ZYCPA

• 5/5 - PCAOB Inspected
• 0/5 - PCAOB Inspected (Quality Control Criticisms NOT addressed)
• 0/5 - Not PCAOB Inspected

Safety/Risk Model - History of Auditors

(Back to Introduction)

Auditors

(accounts for 30% of the final score)

History of Auditors (30/100)

Auditor changes are very common in the group of small cap Chinese companies, and it's not necessarily a bad thing if an audit committee finds such a change desirable. As a rule of thumb for the general U.S. markets (statistics from 2007), about two thirds of auditor changes were initiated by the companies (dismissing their previous auditors), while in the remaining cases the auditor resigned.

Companies may dismiss their auditors for reasons that are welcomed by investors, such as enhancing overall audit quality, looking for a new auditor that spends more time with the client, or engaging a new auditor with best-of-class reputation in the market to enhance credibility and strengthen investor confidence. But they might also dismiss their auditors just for getting cheaper audits, or even for avoiding all those unpleasant questions and demands their current accounting firm might force upon the company for signing off on the financials. If auditors disagree with management on key areas of accounting, companies might shop around for an audit firm that agrees with their viewpoints. There are many examples for all those reasons in the China small caps space.

Auditor resignations are similarly ambivalent. We will likely see more small firms, especially U.S.-based firms with no permanent presence in China, to resign from Chinese accounts, in order to avoid the now stricter compliance requirements of the PCAOB. Some small firms might decide to generally withdraw from auditing public companies. There might also be personal reasons, disagreement on the fees, or any other company-specific reason that is not necessarily indicative of any wrong-doings in the audited company. However, auditors that resign are more likely to have reasons that should concern investors. The CPA firm might just decide that this client is no longer worth the risk, there might be restatements looming or the company lacks sufficient internal controls over financing reporting and inadequate professional staff. A worst-case scenario would be that the auditor simply no longer trusts management.

Investors are usually left in the dark when it comes to the real reasons for auditor dismissals and resignations. Confidentiality rules prevent the CPA firms to go public with their findings, and the companies will do everything they can to present auditor changes in a positive light. That makes adding auditor continuity to our safety/risk model a tricky task, and investors are encouraged to dig into the details of frequent auditor changes with Chinese companies. We give the highest weight to a stable, long-term relationship between a company and their auditor, and to companies that have initiated an auditor upgrade when they reached a certain level of maturity as a public company.

• 30/30 - No Changes (Last 2 Years)
• 25/30 - One Change (Upgrade, Last 2 Years)
• 10/30 - One Change (No Upgrade, Last 2 Years)
• 0/30 - Two or More Changes (Last 2 Years)

Safety/Risk Model - Quality of Auditor

(Back to Introduction)

Auditors

(accounts for 30% of the final score)

Quality of Auditor (65/100)

All CPA firms have to be registered with the U.S. Public Company Accounting Oversight Board (PCAOB) if they want to audit U.S. public companies, including U.S.-listed Chinese companies:

"Public companies, whether located in the United States or abroad, access U.S. capital markets by complying with certain U.S. legal requirements, including the requirement to periodically file audited financial statements with the U.S. Securities and Exchange Commission. Under the Sarbanes-Oxley Act of 2002, the auditor of those financial statements - whether a U.S. auditor or a non-U.S. auditor - must be registered with the PCAOB, and the PCAOB must regularly inspect the firm to assess its compliance with U.S. law and professional standards in connection with those audits." (PCAOB)

As of January 25, 2011, a total of 111 China-based CPA firms is registered with the PCAOB, 54 from mainland China and 57 from Hong Kong. This number is not likely to increase in the near future as on October 7, 2010, the PCAOB released a new directive, stating that new registration applications from jurisdictions that do not allow PCAOB inspections will no longer be approved:

In light of the length of time that has elapsed without successful resolution of the obstacles, and the continuing inability of the Board to inspect PCAOB-registered firms in some jurisdictions, the Board has re-evaluated its approach to new registration applications from firms in those jurisdictions. The Board has determined that its consideration of new applications from firms in those jurisdictions will no longer be premised on an expectation that those obstacles will be resolved without undue delay to any necessary PCAOB inspection of a firm. (PCAOB)

China has prohibited the PCAOB from inspecting its CPA firms, including the Hong Kong firms if the inspection would include mainland Chinese clients. This includes all Chinese accounting firms, including the Chinese or Hong Kong member firms of the Big 4. But China is not alone with this policy, as most European countries block the PCAOB on similar grounds (national sovereignty, legal matters). Let's have a look at Europe's largest economy, Germany, and the reasoning of the German Institute of Public Auditors (Institut der Wirtschaftsprüfer in Deutschland e.V.) for blocking PCOAB inspections.

...the German legal system differs so significantly from that of the U.S., that implementation in Germany of certain provisions of the Sarbanes-Oxley Act, in particular, numerous aspects of the proposed rules relating to inspection, investigation and adjudications would be legally impossible and implementation of others would place extremely onerous burdens on German public accounting firms.

In Germany the auditing profession is subject to professional confidentiality obligations set forth in the legislation governing the profession and audits of financial statements. This legislations prevents our members from providing the PCAOB, as a third party, access to any or all facts and circumstances with which they are entrusted or of which they become aware during the course of their professional work. The German Penal Code makes undue disclosure by an accountant a criminal offence (§203 Strafgesetzbuch). Furthermore, the contract between a public accountant and the client carries an implied duty of confidentiality. (Source: IDW Letter to PCAOB, August 18, 2003)

As we can see, the U.S. legal environment differs greatly from that in Germany, and certainly even more from the Chinese system. But we can safely assume that oversight, regulation and professional standards for European CPA firms - PCAOB inspected or not - follow more closely the outline of U.S. standards (supporting the objectives of the Sarbanes-Oxley Act), than what we find now in China. Chinese regulators have shown no interest in reports that are not used in China and that have been prepared under US GAAP (Paul Gillis, November 14, 2010). Without independent inspections and with very loose regulations by local authorities, the right choice of auditors is of crucial importance for U.S.-listed Chinese stocks when it comes to credibility and investor confidence. The engagement of an internationally operating CPA firm, with an excellent reputation and a strong presence in China, is a necessity for every foreign-listed Chinese company that has reached a certain level of maturity.

In our safety/risk model, the choice and history of auditors has the highest weight. It is our belief that any U.S.-listed Chinese company with a market capitalization higher than $100 million should be in the process of upgrading their auditor to at least a Top10-ranked firm. With a market capitalization above $200 million, a top ten firm should be used, preferably one of the Big Four. Such an upgrade might double annual audit fees, but the value that is created for the company and its shareholders should be significantly higher. We believe that senior management of every single U.S.-listed company is very well aware of this fact, and stubbornness or refusal to proceed with an auditor upgrade leaves the investor with two damaging questions:

1. Is the company afraid that a tier one auditor would ask too many questions? Revealing unplesant details that better stay hidden? Does see company see a risk that a better auditor might not sign off on the prepared financial statements?

2. Has the company tried to hire a tier one CPA firm, but got rejected as a client? Did the company fail to pass a Big Four's due diligence test? Lack of quality internal controls, inadequate documentation, or insufficient or badly trained personell? Or worse?

The Big Four firms are Deloitte, Ernst & Young, KMPG, and PricewaterhouseCoopers. Their PCAOB-registered Chinese member firms are Deloitte Touche Tohmatsu, Ernst & Young Da Hua, Ernst & Young Hua Ming, KMPG, KPMG Huazhen, and PricewaterhouseCoopers Zhong Tian. All four do additionally have a separate Hong Kong member firm.

For the Top Ten firms you will find a different order of firms from different sources. Additionally to the three firms directly following the Big Four - BDO, Grant Thornton, and Crowe Horwath - we added Baker Tilly, Plante & Moran, and RSM McGladrey to this group. The Chinese member firms are Baker Tilly China, BDO China Guangdong Shu Lun Pan, BDO China Li Xin Da Hua, BDO China Zhonglian Mindu Shu Lun Pan, Crowe Horwath China, Grant Thornton, Grant Thornton Beijing, and RSM China. And in Hong Kong we have Baker Tilly Hong Kong, BDO Limited, Crowe Horwath (HK), Grant Thornton, and RSM Nelson Wheeler.

For all other auditors, that are not included in the Top Ten, we see the biggest risks with two groups of firms:

1. Small and widely unknown Chinese or Hong Kong firms. They are usually not inspected by U.S. or international oversight authorities, and Chinese regulators do not show much interest in their work for non domestically-listed companies. For all we know, they might do a most excellent job as auditors, or they might just sign off on anything their clients present to them. There is no reasonable assurance of the quality of their audit work for an independent international investor, without having insider knowledge about the audit plan and thoroughness of the work and procedures.
2. Small U.S.-based auditors without any, or just a very limited presence in China. Small firms with just a few partners and limited professional staff, often don't even have the resources to do a proper audit in China. They might fly over some people from California for a week, or even solely rely on third-party work peformed by sub-contracted Chinese accountants, then signing off on those reports.

A company's independent auditor is responsible for reconciling U.S. filings with Chinese tax filings. With each U.S. GAAP audit, the auditor must consider the appropriateness of a company's Chinese taxes filed and paid. Severe discrepancies between U.S. GAAP reported income and PRC reported income and tax should be immediately apparent to a good and responsible auditor, particularly those with extensive experience in China. Risks are significantly higher with small and understaffed CPA firms, with either just limited experience in China or limited U.S. GAAP experience (sub-contracted Chinese accountants).

To reflect those risks we use the following scoring in our model:

• 65/65 - Big Four Auditor
• 60/65 - Top 10 Auditor and Market Cap under $200 Million
• 50/65 - Top 10 Auditor and Market Cap $200-500 Million
• 40/65 - Top 10 Auditor and Market Cap over $500 Million
• 35/65 - Top 100 Auditor and Market Cap under $100 Million
• 30/65 - Top 100 Auditor and Market Cap $100-200 Million
• 15/65 - Top 100 Auditor and Market Cap $200-500 Million
• 5/65 - Top 100 Auditor and Market Cap over $500 Million
• 0/65 - Unranked Auditor

Safety/Risk Model - Going Public

(Back to Introduction)

Going Public

(accounts for 10% of the final score)

Market Segment / Exchange (50/100)

The standards for an initial and continued listing vary greatly between the exchanges and respective market segments. Those standards include financial, liquidity and especially also corporate governance requirements. The requirements for the NASDAQ markets can be found here. In our model, a company that meets the highest standards will score full points in this category, a pink sheets quoted stock that is not fully reporting will score zero points.

• 50/50 - NASDAQ Global Select, NASDAQ Global Market, NYSE
• 40/50 - NASDAQ Capital Market
• 30/50 - NYSE Amex
• 10/50 - OTC Bulletin Board quoted
• 0/50 - Pink Sheets

Type of Going Public (50/100)

The three most common ways for a Chinese company to go public in the U.S. is via Initial Public Offering (IPO), a reverse takeover into a public shell company (RTO, Reverse Merger), or via business combination with a SPAC (Special-Purpose Acquisition Company) or blank-check company. For investors, an IPO provides the highest degree of safety as those companies are generally more mature, went through much more thorough due diligence by the involved investment banks and the public with the IPO process, and they start out trading on a senior U.S. exchange with significantly higher liquidity, market support and the backing of well-connected Wall Street firms with a reputation at stake.

While RTO stocks are not inherently bad, the risks for investors are significantly higher here. Reverse Mergers provide a much cheaper and faster path to getting listed than regular, underwritten IPO's, and for an early-stage growth stock from China this is often the only way to get access to the U.S. capital markets. But for determining the risks in a particular RTO deal, we have to dive into several, often blurry details. What is the history of the shell company, is it clean, who are the current players and promoters involved in the shell? Who owns the company post-merger, what is their history? Do U.S. financial advisors involved in the merger now hold a position in the company? Did they install an investor relations firm, law firm, accounting firm?

• 20/20 - regular Initial Public Offering
• 10/20 - SPAC / Blank-Check
• 0/20 - Reverse Merger or Self Filing

While we acknowledge a higher safety profile for IPO stocks, we also see a possible difference in the quality of Initial Public Offerings and their lead underwriters. An offering led by a tier one Wall Street firm with the highest reputation in the market will score higher in our model than IPO's led by relatively small firms that are specialized on small-cap China deals. We have grouped all relevant investment banks into two categories, based on Renaissance Capitals statistics for lead underwriters in 2010. The data going into this ranking is Average Deal Size, Proceeds Raised, and Average IPO Returns.

• 30/30 - Tier One Lead Underwriter (Barclays Capital, BofA Merrill Lynch, Citi, Credit Suisse, Deutsche Bank Securities, Goldman Sachs (Asia) L.L.C., Goldman, Sachs & Co., J.P. Morgan, Morgan Stanley, UBS Investment Bank, Wells Fargo Securities)
• 15/30 - Tier Two Lead Underwriter (Baird, Broadband Capital, Cowen & Company, Global Hunter Securities, Keefe Bruyette Woods, Leerink Swann, Maxim Group LLC, Morgan Joseph, Oppenheimer & Co., Piper Jaffray, Raymond James, Rodman & Renshaw, Roth Capital, Stifel Nicolaus Weisel, Suntrust Robinson Humphrey, Thomas Weisel Partners, William Blair, Wunderlich Securities)
• 0/30 - Unranked Lead Underwriter or none at all (non-IPO stocks)

Dual Listing

U.S. listed China stocks that are also listed on a domestic Chinese exchange (Shanghai, Shenzen, Hong Kong) provide a much higher degree of safety for U.S. investors. Those stocks are usually listed in the United States in the form of American Depository Receipts (ADRs), and only Chinese companies with the best financial integrity and corporate governance can usually achieve such a dual listing. Another form of dual listing we acknowledge in our model is the listing of the main operating subsidiary on a domestic exchange. There are very few examples of such a dual listing as the requirements for an IPO in Shanghai or Shenzen are very high. A company that has recently announced a plan to list their subsidiary on the Shenzen exchange is Wonder Auto Technology (WATG), but we would expect this process to take up to one year - if successful. A clearance through China Securities Regulatory Commission supports the legitimacy of the company and its corporate structure, which leads to a much improved safety profile for the U.S.-listed company. In our model a successful dual listing leads to an UPGRADE of the Safety/Risk Score.

Introducing a Safety/Risk Model for U.S.-listed China Stocks

The idea is to create a basic and objective safety/risk score based on public, verifiable, and comparable information, as a starting point to identify possible problems with U.S.-listed Chinese companies (here STAGE ONE).

The two stages are important because STAGE ONE is objective, based on publicly available information, using the same sources for all U.S.-listed Chinese stocks. Every individual investor can assess risks and safety with a bit of work in less than one hour. STAGE TWO is subjective, based on personal, individual research that can be time-consuming, costly, also requires profound knowledge of the Chinese language and legal system. Most investors will not be able to pull this off on their own, and those who rely on other people's work will have to trust their judgment and believe in their thoroughness.

The general idea behind this model is that a company that fails STAGE ONE is not "investment grade" unless it passes STAGE TWO. A company that passes STAGE ONE can very well turn out to be a fraud in STAGE TWO, however the risks should be contained with a good score in STAGE ONE. The thesis is that for a standard retail investor a STAGE ONE pass should provide reasonable safety. For investors looking to build a large position in a Chinese stock, for high net-worth individuals, institutions etc. a STAGE TWO pass should be a requirement.

I will introduce the Trading China Safety/Risk Model in a series of posts over the next 2-3 weeks, followed by a few sample companies for STAGE ONE of our model. Be warned, there will be a lot of text to read, often rather dry information to digest. This is the basic structure of STAGE ONE:

1. Going Public (accounts for 10% of the final score)
2. Auditors (30%)
   • Quality of Auditors
   • History of Auditors
   • PCAOB Inspection
3. Internal Controls (5%)
4. Chief Financial Officer (7.5%)
5. Board of Directors (7.5%)
6. Ownership (10%)
7. Equity Financings (10%)
8. Stock-Based Compensation for Services (2.5%)
9. Legal Matters (5%)
10. Communications (12.5%)