Cautioning Investors About Chinese Stock Offerings

By Heide B. Malhotra, Epoch Times
December 7, 2011 11:42 pm Last Updated: December 9, 2011 1:37 pm
  • A couple watches brown floodwaters in the Fujiang River in Mianyang City, in China’s southwestern province of Sichuan. (Liu Jin/AFP/Getty Images)

Trading with or investing in Chinese companies, either state held or privately owned, has been fraught with impediments and complications not found in any other market worldwide.

One firm after another has been found to mislead investors and even international auditors. Investors too often have been left holding an empty bag in the end, with the international auditors embarrassed for not having discovered accounting irregularities and being chastised for being less than diligent in their review of financial information.

To protect investors, the U.S. Congress created the nonprofit Public Company Accounting Oversight Board (PCAOB), giving it oversight responsibility for audits of public companies. The Chinese regime has prevented the PCAOB from reviewing audits of Chinese companies traded in U.S. markets, claiming national security issues.

“For six years, U.S. regulators [PCAOB] have been stymied from reviewing China-based audit firms that are doing work for U.S.-traded firms,” according to a press release published on U.S. Sen. Charles E. Schumer’s website in November.

The thorny issue is that U.S. auditing firms’ personnel don’t travel to China to perform an audit, but the auditors hire a local auditing firm to do all the legwork because most of the firm’s accounting documentation is in China.

“The U.S. auditor has inadequate information about the knowledge, skill, and ability of the outside consultants in China engaged by the U.S. auditor,” according to an FTI Consulting research paper released in November. FTI is a global business advisory firm.

Given the problematic accounting issues with Chinese companies, the Securities and Exchange Commission suspended trading of China MediaExpress Holdings Inc., Heli Electronics Corp., China Changjiang Mining & New Energy Co. Ltd., RINO International Corp., Advanced Refractive Technologies Inc., HiEnergy Technologies Inc., AutoChina International Limited, and Digital Youth Network Corp.

The website announced in a headline a few months ago, “26 Chinese Firms Delisted [from the three major U.S. stock exchanges] in 2011; More Are Likely to Follow.”

It is very difficult to get truthful and transparent information when dealing in the Chinese market, especially for investors and trading partners used to the open international market system.

“Western investors and their regulatory systems are inherently unprepared for muddy waters environments [referring to mainland China’s market environment],” according to the Muddy Waters LLC website. Muddy Waters is a market intelligence company that provides investors and traders alike with a snapshot of the true worth of mainland Chinese companies.

Providing Valuable Market Insights

On Nov. 18, U.S.-listed Chinese digital media company Focus Media Holding Ltd. (FMCN) issued its third-quarter earnings. Results were initially cheered by Wall Street.

Seeking Alpha contributor Jiang Zhang praised Focus Media for delivering another strong quarter. Zhang used 585 words to describe what he liked about the company, such as “record high total revenue,” “continued pricing power,” “repositioning on the S-curve” (technical jargon), and “positive guidance” from management. Regarding his concerns about the company, Zhang had this to say, “None. The quarter was spectacular.”

However, on Nov. 21, Muddy Waters Research strongly recommended that investors dump their stock in Focus Media, citing concerns about income overstatement, insider activities, and possible fraud.

Following the Muddy Waters report, the law offices of Howard G. Smith alerted the public of its intent to scrutinize FMCN, inviting anyone holding FMCN stock issued between June 30, 2009, and Nov. 21, 2011, to join a possible class action lawsuit.

“Howard G. Smith believes that during the time period mentioned above the company and certain of its executives violated federal laws. … The company misled investors regarding its financial condition … and then engaged in a scheme of overstating the value of its acquisitions to mask its losses,” according to the announcement on the law firm’s website.

FMCN, which is traded on Nasdaq, has apparently been rather creative in its accounting practices. Muddy Waters uses strong terms, such as “fraudulently overstating,” and “significantly and deliberately overpaying for acquisitions,” in its research report about the company.

“FMCN insiders have sold at least $1.7 billion worth of stock (two-thirds of FMCN’s enterprise value) since FMCN’s IPO [Initial Public Offering—first sale of the stock]. At the same time, the insiders and their business associates further enrich themselves by trading in FMCN assets, while costing FMCN shareholders substantial sums of money,” accuses Muddy Waters in their research report.

FMCN denied Muddy Waters’ accusations in a Nov. 22 press release and conference call, saying the report reflects a misunderstanding of its business.

The jury of investor opinion is still out on Focus Media. Following the Muddy Waters’ report, FMCN’s stock price initially plunged 40 percent, but has since recovered most of those losses, closing at $21.43 on Dec. 7, down 16 percent from before Muddy Waters issued its report.

In June of this year, Muddy Waters issued a similar warning about Chinese forestry company Sino-Forest (TRE) committing fraud by significantly overstating the value of its assets. Sino-Forest saw its stock fall 74 percent from June through August, when its shares were halted on the Toronto Stock Exchange pending investigations by the Canadian securities regulator and police. Sino-Forest replaced its CEO in August.

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