Tuesday, July 12, 2011

Two events of the Chinese fraud saga, and what it means.

When people call me up and want to talk about Chinese frauds, I get very excited. It's not just about COGO. Yes, COGO is very interesting and almost a textbook example of fraud. Yet, the reason I get excited, is due to a much larger story. A story about shady lawyers and IR firms; a story about hilarious and secretive investors; and possibly, a much larger story about China itself.

The whole story won't fit in a blog post, so for now I'd like talk about two seminal events in the Chinese fraud saga. 

Event Number One: China Media Express (CCME)
If a year ago, you were interested in US listed Chinese companies and wondered if some of these Chinese companies were frauds, people would point to Chinese Media Express as the poster boy for the great Chinese investment. Not only did CCME have a big four auditor but also had a star investor - the storied ex-CEO of AIG, Hank Greenberg. CCME was growing at break neck speeds and had fifty percent profit margins. For some investors, they perceived this as their meal ticket to riches.

Then reality struck home. Very smart analyst from Muddy Waters, Bronte Capital and Citron Research all smelled something funny. How exactly could this company get such fat profit margins while all their competitors have lower profit margins? Why would CCME go public and sell their stake of such a great company?

On March, 14 2011the rubber met the road: CCME's auditor and CFO resigned.

Now, here is the significance of this event. If CCME could fool Deloitte and Hank Greenberg, how could anyone trust any of the other Chinese RTOs that didn't have a big name auditor or a well regarded investor? All at the same time, doubts were cast on every Chinese RTO.  In the following months Chinese RTOs dropped like flies and even the SEC commissioner was condemning Chinese RTOs

Event Number Two: Longtop Financial Technologies (LFT)
This is the most under appreciated event in the Chinese fraud saga. Longtop wasn't a shady RTO or a recently publicly traded company. Longtop had been around since 2007, the CFO was on the board of hot stock issue RenRen, Deloitte was their auditor and none other than Goldman Sachs was their lead co-underwriter. This was basically knighted by all the holy members of the capital regulatory system.

Yet, it went under. Now what's under appreciated about Longtop is how it went under. Read this statement from the auditor:

Background and significant issues encountered by Deloitte Touche Tohmatsu CPA Ltd. (China) (“Deloitte”)
As part of the process for auditing the Company’s financial statements for the year ended 31 March 2011, we determined that, in regard to bank confirmations, it was appropriate to perform follow up visits to certain banks. These audit steps were recently performed and identified a number of very serious defects including: statements by bank staff that their bank had no record of certain transactions; confirmation replies previously received were said to be false; significant differences in deposit balances reported by the bank staff compared with the amounts identified in previously received confirmations (and in the books and records of the Group); and significant bank borrowings reported by bank staff not identified in previously received confirmations (and not recorded in the books and records of the Group).
In the light of this, a formal second round of bank confirmation was initiated on 17 May. Within hours however, as a result of intervention by the Company’s officials including the Chief Operating Officer, the confirmation process was stopped amid serious and troubling new developments including: calls to banks by the Company asserting that Deloitte was not their auditor; seizure by the Company’s staff of second round bank confirmation documentation on bank premises; threats to stop our staff leaving the Company premises unless they allowed the Company to retain our audit files then on the premises; and then seizure by the Company of certain of our working papers.
In that connection, we must insist that you promptly return our documents.
Then on 20 May the Chairman of the Company, Mr. Jia Xiao Gong called our Eastern Region Managing Partner, Mr. Paul Sin, and informed him in the course of their conversation that “there were fake revenue in the past so there were fake cash recorded on the books”. Mr. Jia did not answer when questioned as to the extent and duration of the discrepancies. When asked who was involved, Mr. Jia answered: “senior management”.
This is the most shocking letter I have ever read from an auditor, and if you aren't shocked, you need to read it again.

There are two under appreciated consequences of Longtop and they are both very significant. The first deals with the cash flow statement. If Longtop was defrauding their auditor with pocketed bankers, then that means, there might be more companies using bankers to defraud their investors. As a consequence, sharp investors can no longer look at the disparities in the cash flow statement for signs of fraud. A company could look just peachy perfect when looking at their financials, but that might just be a bag of hot air.

The second consequence is far more startling and my keen readers need to stake a step back. Normally banks act as the staid law enforcer of the capital markets. They dot their 'i' and cross their 't's, they make sure their client isn't overburden with debt and is honest enough to repay the loan. Above all bankers worry about being defrauded, so they definitely don't defraud other people.

If Chinese bankers are not to be trusted, and the capital system depends on honest bankers to keep the system in check then China could very well be facing a financial crisis of epic proportions. These Chinese RTO scandals might be the subprime mortgage crisis to the US financial crisis. 

I hope I am just being hyperbolic.


  1. An interesting difference between Longtop Financial, CCME, and COGO is their reported operating margins. Longtop and CCME claimed to have operating margins well above those of their competitors (like 60 percent), while COGO claims to have margins of less than 10 percent going back to 2008.

  2. Another interesting difference might be age. CCME's IPO in the United States was in 2007, I believe. That is the same year for Longtop's IPO. A Forbes article mentions several Chinese IPOs in that year: But COGO entered the U.S. market in 2004.

  3. Hi Scott,

    Thanks for Forbes article.

    COGO also has a big four auditor (and has had one ever since it went public) and has raised capital with major investment banks as the underwriter. COGO is a peculiar plausible Chinese fraud, but that doesn't mean all those red flags should be swept under the table.

    I would like to know if COGO's profit margins are abnormal, but I am not sure who their direct competitor is (partly because I am still not exactly sure what they do) and if they had one, their filings would have to be public.

    What are you thoughts on COGO? Would love to have someone throw some daggers against my COGO thesis.

  4. Josh,

    I have no specialized knowledge in the technology fields -- I am an English professor -- so you have more informed insight than I do. You also are much closer to the situation than I am, since you are in Asia and I am in California.

    As best I understand it, COGO is kind of like ... IBM? They don't really make anything (IBM doesn't make anything either); they help other people decide which are the best components to integrate into their current hardware/software systems in order to achieve or boost results. I saw a Bloomberg interview online with Kang, and he didn't explain it very well. I was hoping his difficulty was a mixture of two language barriers -- Chinese to English and Engineer to Layman.

    For what it's worth, in case you haven't seen it already:

    P.S. -- I enjoyed "Brits Get Rich in China."

  5. Do you have any thoughts about the nature of COGO's annual report vs. the annual reports of more suspect companies? The COGO annual report seems to have a lot of information, a lot of specific references to other companies it does business with, the percentage of revenues derived from particular parts of its business. I don't know that CCME and Longtop have that in theirs.

  6. Hi Scott,

    I never read the annuals of CCME & LFT.

    Enron probably had a finely detailed annual report as well, but that didn't mean they were misrepresenting their financials.

    This post I made about CCME & Longtop wasn't really about COGO, but it was more about a bigger picture of the Chinese listed companies and their impact.