by Junheng Li
Block got his big break uncovering a company called Sino-Forest, which many American investors consider the granddaddy of Chinese frauds. Block’s 40-page report described how the Chinese lumber company milked $6.1 billion from the Toronto exchange, essentially by erecting a Ponzi scheme. Block showed step-by-step, with photographs, charts, and diagrams, how the company fabricated its assets, inventory, and employee numbers, and booked phantom transactions. Sino-Forest’s shares plunged by 82 percent immediately after the report was published.
Sino-Forest fooled several high-profile investors, including John Paulson, the hedge fund titan who reaped an estimated $3 billion to $4 billion betting against the U.S. housing market (believed to be the largest one-year payday in Wall Street history). But the ingenious Mr. Paulson was not able to avoid a loss of $720 million on his bet on this Chinese company, an expensive price to pay for his China wake-up call.
Paulson was not the only hedge fund titan who got burned by China: Hank Greenberg, the former CEO of insurance company AIG, had his fund Starr International defrauded by a company called China Media Express, a bus advertising company with a $400 million market cap.
Sino-Forest stirred market panic, but it was Longtop Financial Technologies that finally galvanized the SEC to go after Chinese criminals. The outing of the Chinese financial software company as a fraud provoked a vehement outcry from its outraged shareholders, among them some of the world’s largest money managers.
Longtop was a seemingly first-rate company: Goldman Sachs and Deutsche Bank underwrote its 2007 IPO, and U.S. investors awarded the company a valuation of more than $1 billion. Longtop counted among its clients some of China’s most prestigious financial institutions, including China Construction Bank and Agricultural Bank of China. But in April 2011, a short-seller firm named Citron published a report alleging that Longtop had fabricated its balance sheets. The company’s auditor, Deloitte Touche Tohmatsu confirmed in its resignation letter one month later that the company’s financial statements were inaccurate.
Deloitte, which had given clean audit opinions to Longtop for six consecutive years, alleged that it had been in the dark until it finally showed up at the bank to check Longtop’s financial statements. Only then did the auditors realize that Longtop did not have the cash it reported; instead, it had “significant bank borrowings” not reflected in the company’s books. When being questioned about its auditing quality, Deloitte defended itself by claiming that it had followed proper procedures to confirm the company’s bank accounts (although via e-mail) but that it failed to detect the fraud because Longtop colluded with bankers at the branch level. Longtop’s management later admitted to its auditor that the company had effectively been running a Ponzi scheme. But as of mid-2013, the CEO had not been prosecuted.
I personally met and interviewed Longtop’s CFO a few times at various investor conferences after its IPO. I tried but failed to arrange calls with IT executives at banks alleged to be Longtop’s clients. Typically, small companies in both China and the United States were eager to put me in touch with their supply chain, both as a goodwill gesture and as a means to convince a potential investor that firms should give them money to grow. But Longtop’s clients, the state-run Chinese banks, mostly ignored investors’ attempts to conduct due diligence because they considered themselves as bankers to be a strategic industry in possession of confidential government information. So instead I went to Longtop’s competitors, other IT outsourcing companies that sold similar products to banks. No one I spoke with found Longtop’s margins credible. Longtop consistently reported a 64 percent profit margin, almost double the average profit margin of 35 percent for the IT outsourcing industry.
My gut reminded me that if something looks too good to be true, it usually is. So I built a short position, even in the absence of perfect information. By that time, I had come to trust the instinct I had honed by analyzing similar situations. Whether American or Chinese, companies are run by people, and human behavior shares a lot of commonalities.
The case of Longtop demonstrated why investors, especially foreign ones, must have investigative due diligence capacity and a reliable network of contacts on the ground in China. In the United States, investors rely on reputable auditing firms to verify the integrity of a company’s financial records. The Longtop case showed that even reputable Big Four accounting firms are not entirely adequate in China, and it also made it clear that having high-profile names among a company’s investors or underwriters does not preclude the possibility of fraud.
If management cannot be trusted and if auditors and other institutional checks and balances are similarly tainted, investors must bear the responsibility of doing their own due diligence from the bottom up—for most, a daunting challenge. Performing exhaustive and meticulous channel checks is the only way for investors to penetrate China’s many layers of opacity (government and corporations) and avoid being conned. Unless one has a network of reliable local intelligence as well as a thorough understanding of Chinese culture to decode the data, it is impossible to eliminate risk altogether. If investors lack the infrastructure and network to provide them with exhaustive due diligence, they are better off not investing at all.
Longtop’s downfall triggered a flurry of investigations into China-based listed companies and auditors, as angry investors who suffered losses in the hundreds of millions of dollars turned to the SEC for “justice.” But the SEC’s ability to impose legal repercussions on foreign private issuers like Longtop was limited due to the conflicting laws of the two jurisdictions—China, where the companies were registered and operated, and the United States, where they raised financing by issuing securities. Foreign private issuers, including all China-based U.S.-listed companies, had never been subject to the same compliance measures as U.S.-registered entities. However, U.S. investors caught up in the China gold rush often ignored this critical risk. For its part, the SEC did not adequately highlight the risks inherent in investing in non-U.S.-registered foreign entities until after the damage was done.
Under U.S. securities law, the SEC was empowered to investigate alleged fraud and subpoena financial records from a company’s auditors. Under Chinese laws, however, such records were deemed sovereign confidential material and sometimes even “state secrets,” and therefore they could not be shared with a U.S. regulatory body (although it is hard to believe that a fertilizer company like CLF would possess any sovereign secrets). Without the cooperation of the Chinese government, U.S. regulators and prosecutors had no means to punish Chinese managers and their affiliates and bring justice to U.S. investors.
In the end, short sellers played a far more significant role than the SEC in unearthing fraud and encouraging transparency in China by exposing unethical and unlawful corporate behavior. Short sellers may be unpopular, but they help investors minimize risk in the long run by improving and maintaining the market’s integrity.
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The lack of transparency was a problem not just for stock investors but also for the American and multinational companies that bought businesses and assets in China. The financial crisis in the West prompted a cross-border M&A wave, and even some of the world’s most notable international companies, including Caterpillar, were fooled into purchasing Chinese businesses rife with corporate governance issues or outright fraud.
The global recession was not contained in the West: as the factory to the world, China quickly saw its exports slow. But Beijing showed the world the upside to being a command economy: in an adverse environment, it could use its policy tools to boost economic growth far more quickly than could market capitalism’s invisible hand.
Beijing released its 4 trillion RMB stimulus package at the end of 2008, which brought about approximately 10 trillion RMB in bank (and shadow bank) lending, to stave off the ripple effects from the crisis and bolster the economy. People in the West marveled at the resilience of the Chinese economy, and some even argued that the Chinese version of state capitalism was superior to t
he Western version of free market capitalism. Books like When China Rules the World by Martin Jacques (editor of the journal of the British Communist Party for nearly two decades) and What the U.S. Can Learn from China by Ann Lee popped up in bookstores and on Kindle reading lists.
Corporate America continued to buy Chinese companies, some with dubious qualities, even as Muddy Waters was undermining investor confidence in Chinese stocks. Loaded with cash and facing gloomy prospects at home, the multinationals felt the heat from their investors and boards to deliver growth by jumping into emerging markets. When their competitors all rushed into China, they had to follow or risk being blamed for a lack of vision.
Generally speaking, a company can grow either by expanding its business organically or by acquiring or merging with other companies. Organic growth tends to be slower but healthier, because the company has better internal control of its operations. Growth by acquisitions delivers more immediate results but brings more execution risks, such as when cultural or organizational differences between companies complicate the integration process. China presented an additional challenge in that, just as in the public market, companies involved in the M&A chain had a tendency to inflate the value of local acquisitions.
Pearson, the London-based multinational education and publishing company, fell prey to just such a situation. As a public company, it was under constant pressure to deliver growth, even as its core publishing businesses, Penguin and the Financial Times, were declining. Meanwhile, China’s English tutoring and test preparation industry was booming. So at the end of 2011, Pearson announced a deal to buy out Global Education and Technology (GET) at a generous price of “four baggers,” the Wall Street term for four times a company’s 30-day average share price (GET’s stock had been hammered prior to the announcement). For each American depositary share trading at $5.37 on the day-of-deal announcement, Pearson would pay $11.01 in cash. When the deal was announced, GET’s stock rose 97 percent.
Since the company’s IPO lunch at the St. Regis, I had watched GET from a distance without getting involved myself—I didn’t long; I didn’t short. I didn’t buy long because I didn’t like the managers—they seemed provincial, and yet they intended to build a nationwide business. A big portion of the company’s business was franchises, as opposed to directly owned schools. Adequately trained staff and management are the key to running franchises, but an industry friend told me that the couple who headed the company hated traveling, and the company’s schools outside Beijing, where the couple lived and worked, were run-down and poorly managed. Even so, I didn’t short. I knew the U.S. market at the time was crazy for Chinese education companies, and I didn’t want to be killed in the rush.
Shortly after the deal was announced, the SEC sued four Chinese citizens affiliated with GET for insider trading. It seemed that GET’s management had told the brother-in-law of the CFO (who was also the chairwoman of the board of directors) and his friends about the possibility of a deal before the takeover was announced. They started to accumulate company shares and doubled their money after the announcement. The SEC obtained a court order to freeze their assets only two weeks after the suspicious trading took place, but some of the insiders had already liquidated or transferred their illicit profits.
Despite the SEC investigation and vocal opposition from Pearson’s shareholders, the acquisition proceeded, and the deal closed by the end of 2011. Almost a year later, the SEC brought charges against a new defendant in relation to the case. By mid-2013, no further information on the status of its investigation had been released publicly.
GET’s case was an obvious transgression of corporate governance under American standards. The consolidation of power within the company created conflicts of interest and compromised the board’s ability to protect the interest of minority shareholders. In the case of GET, the CEO and the CFO—the husband and wife team that co-founded the business—also chaired the board. Many Chinese companies appoint a few individuals—sometimes family members and friends—to multiple senior executive positions. What Americans might call corruption, the Chinese call family values.
Besides Pearson, construction equipment maker Caterpillar also joined the China rush too quickly. And its executives also found out that they had not bought what they anticipated.
Caterpillar, the world’s largest maker of tractors and excavators, was long held up as one of the biggest success stories for a foreign company in China, a huge market for construction machinery. It was also a highly successful stock, with a market cap of nearly $67 billion in early 2012. That is, until Caterpillar agreed to acquire Zhengzhou Siwei.
In June 2012, Caterpillar purchased ERA Mining Machinery Ltd. and its subsidiary Siwei, China’s fourth-largest maker of hydraulic mine-roof equipment, for $887 million.
The Chinese company seemed like an excellent target: it was recording surging sales and offered Caterpillar access to the lucrative mining market. ERA Mining Machinery was also owned by two American entrepreneurs, which conceivably instilled the buyers with a sense of confidence and trust. Including Western faces on the board had become a common practice among Chinese companies seeking to boost their corporate image.
In January 2013, seven months after the deal closed, Caterpillar announced it would write down a noncash charge of $580 million against its earnings. The U.S. company had uncovered evidence that Siwei overstated its profit for years by fabricating nonexistent sales. Caterpillar was alerted to the possibility of fraud after it noted discrepancies in the company’s routine inventory count, something its auditors should have discovered before the deal went through. Caterpillar’s management defended itself to the board by saying that its due diligence was “rigorous and robust”—after all, the entire deal team, including the lawyers, auditors, and bankers, missed the blatant fraud as well.
It is my belief that most of the black-and-white frauds that originated in China have been largely flushed from U.S. exchanges. The majority of the Chinese companies left behind, however, still have some issues with corporate ethics and governance. These issues are common to all emerging markets, but they are more pronounced in China.
A story told to me by a former senior executive of Camelot Information Systems, an NYSE-listed provider of IT services for China’s financial industry, shows that this degree of opacity and lack of corporate governance can be as destructive as outright fraud.
The executive found out, after the fact, that Camelot’s CEO had been using the company’s brokerage account, which was secured by its American Depository Receipts (ADRs), to fund his personal investments. When Muddy Waters’ reports triggered a collapse in investor confidence and in the prices of ADRs across the board, the CEO got a margin call from his broker and was forced to sell millions of shares to bring the account back up to the minimum margin. Camelot’s stock price plummeted. Today the stock trades between $1 and $2 per share, down 90 percent from its IPO price of $17 per share and 95 percent off its peak of nearly $27 per share.
The CEO kept the board and other members of the management team, including the CFO, entirely in the dark about his actions, and none of the loans from the company toward his personal investments were disclosed in the SEC filings as they should have been. After trying his best to explain and apologize to angry and confused investors, the CFO decided that he couldn’t work for a boss who had deliberately misled him and the company’s investors, and he resigned soon after. When even the CFO is kept in the dark about the company’s financial situation, investors have no way to know what they are getting involved in.
To a large degree, China’s weak corporate governance can be attributed to a lack of common values and moral standards. In the United States, education, religion, and social norms instill in most people some sense of ethical obligation and responsibility. Chinese business executives, on the other hand, seem to only respond to the prospect of punishment. And thanks to the structural loopholes, the U.S.-listed Chinese companies operating in two jurisdictions have little to fear i
n terms of reprisal. Corporate governance also has to be legislated and enforced by a strong, independent legislature and judiciary—neither of which is present in China. Securities litigation for Chinese capital markets did not even exist until 2001, when the Supreme People’s Court of China began developing a framework for investors to sue listed companies for losses incurred through financial fraud. Today, the process is still slow and cumbersome, and the court can be bribed. It is not uncommon for Chinese lawyers to work out a “revenue-sharing scheme” with the judge to secure a ruling in their favor. Chinese investors have filed more than 1,000 cases against 14 domestically listed companies, but most remain in legal limbo and are unlikely to be settled in favor of investors.
Fabricating financial reports has become a serious problem among Chinese companies. In addition to a business culture that has long tolerated corruption, the problem stems from weaknesses in the accounting profession and lack of independent media. Recently, the Chinese media has made more progress than before in exposing corporate fraud, often after being prompted by vocal, outraged local investors on social media. However, red envelopes containing kickbacks still too often influence reporters and editors. Chinese accountants, meanwhile, have little independence from management, and the industry as a whole suffers from a severe shortage of qualified auditors. A CFO friend once shared a stunning story she experienced when interviewing someone for a controller position in her firm. She asked the interviewee, “In a situation where you disagree with your boss, what would you do?” The interviewee answered with no hesitation, “I’m very flexible. I’ll do the books however I’m told to.” In many Chinese companies, this attitude is a prerequisite for a job.
