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Throughout my past few posts on China Marine Food Group (OTCPK:CMFO) (see here and here), I have implied that the small size and unknown reputation of CMFO’s auditor, ZYCPA Company Ltd., should give investors pause.

This article takes a far more concerned stance. According to a lawsuit filed in Hong Kong last year, ZYCPA (or, more accurately, its predecessor firm) and its majority shareholder were active participants in a series of frauds committed against a foreign investor. According to the allegations, ZYCPA and the shareholder, Johnny Tang, were not mere bystanders in the fraud. Rather, Tang was allegedly an active co-conspirator who helped a Chinese businessman steal HK$108mm from the foreign investor.

My prior post on CMFO’s Xianghe acquisition, as well as Chimin Sang's, provides compelling evidence that China Marine Food is defrauding investors. Specifically, I believe that the company is much smaller than its SEC filings indicate. Previously, I simply thought that the company was able to falsify its financial statements because it was receiving negligible oversight from its auditors. But if the lawsuit’s allegations are true, the actual circumstances may be far more sinister.

Primary Documents

There are several primary documents worth reading.

First, here is the Statement of Claim for the lawsuit.

Second, here is a link to a 9-page report written by Target Newspapers, a Hong Kong business periodical, discussing the lawsuit.

Third, here is a lawsuit for defamation filed by Tang against the foreign investor.

The Lawsuit

Issued on March 23, 2009, the original lawsuit is between Christian Emil Toggenburger, and two holding companies he owns, against (i) Hung Viet Derrick Luu, (ii) Zhong Yi (Hong Kong) C.P.A. Company Ltd and (iii) Ka Siu Johnny Tang (the majority shareholder of Zhong Yi).

Zhong Yi (Hong Kong) C.P.A. Company Ltd is the predecessor to ZYCPA Company Ltd, CMFO’s auditor. Zhong Yi changed its name to ZYCPA as a result of potential bad press coming out of this lawsuit.

I will first show a graphic timeline outlining the order of events that transpired during the alleged fraud.

The cast of characters are as follows:

Christian Emil Toggenberger is the foreign investor who was allegedly defrauded and was cheated out of HK$108mm.

Hung Viet Derrick Luu is the Chinese “businessman” who allegedly defrauded Toggenburger and to whom the HK$108mm was transferred.

Ka Siu Johnny Tang is the majority shareholder of ZYCPA Co. Ltd. (successor to “Zhong Yi (Hong Kong) CPA Company Ltd.”), and actively helped Luu execute the fraud, according to the allegations. ZYCPA is CMFO’s current auditor.

Here is the timeline (click to enlarge images):

The Allegations

I will first discuss a summary of the fraud allegations. Then I will focus on the active role that the majority shareholder of ZYCPA played in the fraud, according to the allegations.

The events that follow are based on the allegations in the lawsuits I provided above, primarily from Toggenburger’s original lawsuit. Tang has countersued Toggenburger for defamation. The litigation is ongoing. The following allegations have not yet been proven in a court of law, and I am merely summarizing the sequence of events as alleged in the lawsuit.

Warderly Fraud Allegation

The events began when Tang introduced Toggenburger to Luu in November 2006. Tang represented Luu to be a billionaire entrepreneur who was well-connected in China and Hong Kong.

Shortly after the initial introduction, Luu and Tang met Toggenburger in January 2007 to pitch a HK$25mm loan to Warderly International Holdings Ltd, a publicly traded company on the Hong Kong Stock Exchange. Over the course of two meetings, Luu proposed that Toggenburger make a convertible loan for HK$25mm. The loan would be convertible to 20%-25% of Warderly’s equity, or pay 2% per month for 2 years until maturity. Warderly would use the loan to acquire an oil re-processing plant in Beijing from a business partner of Luu.

Toggenburger agreed to make the investment.

In March and April 2007, Toggenburger lent HK$23mm to an intermediary escrow agent. HKD$5mm was transferred to a subsidiary of Warderly, while HK$18mm was transferred to a separate unrelated investment project of Luu’s. Luu promised Toggenburger that the HK$18mm transfer was temporary and would soon be repaid, with the funds being redirected to Warderly.

Toggenburger never received any bonds or shares of Warderly. Luu received shares in Warderly for the contribution of HK$5mm to the Warderly subsidiary, and kept the shares for himself. The remainder of Toggenburger's investment stayed locked up in Luu’s separate investment project.

Here is a graphical representation of the flow of funds:

As we can see from the graph, HK$23mm left Toggenburger and was essentially redirected to Luu.

In April/May 2007, Tang called Toggenburger to say that Warderly “was in trouble” and the Warderly agreement “was not working out”. Simultaneously, Luu was “in trouble” and could not repay the money transferred to his investment project.

In May, shares in Warderly were suspended and in January 2008, the Warderly subsidiary in which Luu had received shares was wound up.

Toggenburger had lost HK$23mm.

Car Racing Fraud Allegation

Our story doesn’t end there.

When Toggenberger found out that his HK$23m investment was lost, he was naturally not pleased. Tang, however, told him not to worry and that Luu would make it up to Toggenburger by offering another attractive investment opportunity. Luu had an equity stake in a racing car project in mainland China, and would offer part of that stake to Toggenburger at a reduced valuation.

Specifically, in a May meeting also attended by Tang, Luu offered to sell to Toggenburger a 15% share in a car racing project in mainland China. The 15% stake was valued at ~HK$40mm, according to Luu, but he offered to sell the 15% stake at a discounted price of HK$16mm to make up for the failed Warderly investment. Luu told Toggenburger that the car racing project was so profitable that investors would earn a return of 100% on their investment every 6 months. He also said that broadcasting minutes for commercials to be shown during car races had already been sold and such cash flow alone was enough for Toggenburger to get repaid his initial investment within two months.

Tang also claimed that he had seen and checked the documentation for the project (ie. contracts with Champ Car World Series LLC, the leading US car racing association); that the project was a good investment for Toggenburger; and that it was the only way for Toggenburger to recoup his losses from Warderly.

Toggenburger agreed.

On May 21, 2007, Toggenburger paid HK$16mm to Zhong Yi as escrow agent, with the escrow agreement stipulating that the funds would be released to Luu only if the transfer of certain racing contracts were transferred to the holding company that Toggenburger was investing in.

The HK$16mm was released to Luu without this stipulation being met.

No car races have been held pursuant to the car racing project. No revenue has been earned from the car racing project. Toggenburger received no return on his investment.

Toggenburger lost HK$16mm.

Listed Company Fraud Allegation

It still doesn’t end there.

On the last week of May, Luu and Tang introduced a further investment to Toggenburger. They told Toggenburger that they could assist him to acquire a listed company (ie. a “shell” company), and that the car racing project or any of Luu’s other projects could then be injected into that shell. Luu and Toggenberger would ultimately become shareholders of the listed company.

Toggenburger agreed.

Between June and July 2007, Toggenburger wired HK$73mm to Zhong Yi CPA Company, Ltd, which again acted as the escrow agent. In July 2007, Luu and Tang introduced Toggenburger to a firm that introduced Toggenburger to the owners of a publicly listed shell company in Hong Kong. In October, Toggenburger signed a contract with the shell’s shareholders to purchase a majority of the shares of the shell.

In December, Toggenburger told Tang and Zhong Yi to transfer the escrowed funds to the shell’s shareholders. Tang told Toggenburger that there is “some problem”, and the transfer could not be carried out. Toggenburger was not able to complete the transaction with the shell’s shareholders.

In February 2008, Tang told Toggenburger that the HK$73mm “was being used in another account” belonging to Luu. It was “still locked” in Luu’s “other investments”.

Zhong Yi, acting as escrow agent, had transferred the funds to Luu and/or used them to the benefit of Luu, without the knowledge of Toggenburger.

Toggenburger had lost HK$73mm.

As collateral for the HK$73mm, Toggenburger had been given 1mm shares of China Oil and Methanol Group Inc., a company incorporated in Nevada. On June 23rd, 2007, Luu took Toggenburger on a day trip by car to Guangdong province and showed him 3 refineries, which Luu said were assets belonging to 3 of China Oil’s operating subsidiaries.

Ultimately, it surfaced that China Oil has no operating subsidiaries, does not own any industrial complexes and is not earning any revenue.

In total, Toggenburger was cheated out of HK$108m, according to the lawsuit:

Tang’s and Zhong Yi’s Roles in the Fraud

As can be seen from the above events, Tang allegedly played an active role in the frauds. He was present in many of the meetings between Luu and Toggenburger. He also allegedly made a variety of untrue claims that were fraudulent in nature.

In two instances, his majority-owned firm, Zhong Yi CPA, acted as escrow agent between Toggenburger and Luu. In both instances, Zhong Yi allegedly violated the terms of its escrow agreements and transferred funds to the benefit of Luu and to the detriment of Toggenburger.

In the car racing project, Zhong Yi CPA was contractually obligated to hold in escrow Toggenburger’s funds until certain racing contracts were transferred from Luu’s entity into another legal entity that Toggenburger was indirectly investing in, and certain other conditions pursuant to “closing” were met. Zhong Yi allegedly transferred the funds to Luu’s benefit without these conditions being met.

In the listed company fraud, Toggenburger transferred HK$73m to Zhong Yi for the purpose of investing in a listed shell company. Zhong Yi instead allegedly transferred the funds for the benefit of Luu. When Toggenburger asked for the funds to be transmitted to the owners of the shell company, Tang told him that there was “some problem” and that the funds were locked in Luu’s investments.

Tang also represented that he had viewed the car racing contracts with Champ Car, as well as the land title agreements to land near the car racing project to which Luu planned to develop properties, and to which Toggenburger was to receive interests. Instead, the Champ Car contracts were allegedly materially misrepresented to Toggenburger, and the land titles didn’t exist.

Tang was present in many of the meetings between Toggenburger and Luu, and recommended Toggenburger to invest funds with Luu. He was also responsible for originally introducing Toggenburger to Luu.

Conclusion

The same man who owns a majority stake in ZYCPA is alleged to have actively aided the defrauding of a foreign investor out of HK$108m. Johnny Tang is one of two partners at ZYCPA and its majority owner.

Investors should not be merely concerned that CMFO is receiving inadequate oversight from its auditor. They should be concerned about whether ZYCPA is actively aiding China Marine Food management in falsifying its SEC financial statements. As discussed in previous posts, the business claims made by Xianghe are simply not possible. The Xianghe financial statements are very likely falsified in my opinion.

These same financial statements, as well as the financial statements of China Marine Food, are audited by ZYCPA.

Disclosures: At the time of writing, I have a short position in CMFO.

In no part of this post do I attempt to provide false or misleading information. The discussion of events in this post are primarily based on allegations in a lawsuit from March 2009, which I've included in the post. This lawsuit is ongoing and none of the allegations have been proven in a court of law.

Source: China Marine Food Group: Auditor's Role in Another Alleged Fraud