Shanghaied by Chinese Small Cap Shengkai Innovations?

Mar.20.11 | About: Shengkai Innovations, (VALV)

Shanghaied: To conscript services aboard a ship by force or deception, often with the use of drugs or liquor.

It would seem as if Somalian pirates are not the only ones we have to worry about. Chinese micro caps have run aground amidst allegations of fraud. In the past, I have stood against such general claims for two companies: Keyuan Petrochemicals (OTCPK:KEYP) and Shengkai Innovations (OTCPK:VALV).

I have done my best to objectively defend Shengkai Innovations with all the evidence that a student in college could be expected to come up with and more. I have spoken with investors who structured the initial reverse merger, employees of one of the institutional investors who held large stakes in the company, and members of the current underwriter all in an attempt to verify the existence and operations reported. I wanted to make sure that I had done all that was possible to make sure that I would not play in role in events that may lead investors to feel as if they had been shanghaied.

I went through the company's 10-k looking for discrepancies and validated the company's patents to make sure they actually existed. I have attempted to contact the CFO of the company on two or three different occasions but I have not heard back from him. This result, though disappointing, was not unexpected. I have attempted twice to find a way to access the companies tax documents for the Chinese government and failed both times. Through all of this digging and the fifteen months that I have followed the company I never saw anything that caused me to question its existence and nothing suggested to me that its reported numbers might be exaggerated or fabricated and I was comforted by the auditor, underwriter, and insititutional investors all claiming due diligence had been done.

It would seem as if the company had done everything right to build investor confidence. They adopted a new auditor who is respected by international standards. They hired an Investor Relation firm to give them more public face-time and to help coordinate transparency with investors. They moved up from the pink sheets to the American Stock Exchange and eventually found themselves listed on the NASDAQ. All the while, management was completely forthcoming with investors and, despite the recent trouble, the stock has performed well over this entire amount of time though it has underperformed the market over the past fifteen months.

So why my recent cause for concern? Well, it has been rough sailing to say the least. Stock prices doubled and then plummeted to never recover and have consistently sunk lower. The allegations of fraud within the industry continue in even greater numbers, with even more popular companies, and with far great ramifications and consequences than the individual fraud in question.

I'm sure many of you have read about, or may have personally been affected by, the alleged pillaging of wealth via the fraud that is China Media Express (OTCPK:CCME). Though I am not intimately familiar with the details, it is my understanding that the company’s CFO has resigned, Deloitte has walked away from the company as its auditor, and the NASDAQ has halted trading in the company’s shares.

What I have taken from this situation is that top ranked auditors can no longer be trusted to accurately validate these companies’ financial statements and we as investors can no longer trust them to do so in this sector. Institutional investors lost their shirts on this one too suggesting that we cannot trust their proposed due diligence. On top of this, an investment bank by the name of Global Hunter Securities endorsed and defended the company through the allegations. Their research report, which has since been removed from SA by their request, attempted to prove the legitimacy of the company.

This has all caused me concern in regards to my position in Shengkai Innovations because Global Hunter Securities has underwritten Shengkai's last couple of stock offerings. I contacted members of this firm questioning the specifics of their due diligence process on Shengkai and was given the following response:

click to enlarge
Click to enlarge

While not surprising, it is disappointing nonetheless.

This means I can no longer take solace in the appointment of BDO China Li Xin Da Hua CPA Co. as Shengkai's auditor. I can also take no comfort in Global Hunter Securities’ supposed due diligence (which has shown to be questionable at best) when they were underwriting the company’s most recent offerings. Lastly, I can no longer stand behind Bank of America’s due diligence on its initial investment in the company. On top of all of this, Shengkai has become associated with the newest of fraud allegation through its network of investors.

China Integrated Energy announced blow-out results that were audited by KPMG this past Wednesday. That same day, a 40+ page report released by Sinclair Upton Research suggests that the company has been defrauding American investors and funneling money to its executives and their family members through a string over acquisitions and business arrangements that involve severe conflicts of interest. For those of you who do not know, the group of investors who brought China Integrated Energy public through a reverse merger are the same investors who brought Shengkai Innovations public through its reverse merger.

Nothing definitive has been released on China Integrated Energy yet. KPMG has not said anything in regards to leaving the company, no executives have resigned, and they have mentioned that they will address the report soon. So really, it is simply a waiting game for the folks invested in Shengkai. If China Integrated Energy proves to be a fraud we can lose all confidence any sort of supposed due diligence by this initial group of investors as well.

Let me be clear: there is nothing that suggests to me that Shengkai Innovations has defrauded investors. It is simply that this most recent string of events has created the perfect storm and called into question just about everything that I had ever used to support the company’s legitimacy. If this newest situation with China Integrated Energy ends up as many others have, investors should really consider whether or not the risks of investing in this company are worth the rewards. I personally have taken steps to substantially reduce my holdings, even at a 20% loss, as I am no longer certain that the rewards are worth the risks. It is unfortunate that investors can no longer place confidence in any of these companies due the inability of institutions to live up to their responsibilities as auditors and underwriters.

That being said, investors should also take every allegation of fraud with a grain of salt given the questionable background of several of the individuals leading the some of these research firms detecting the fraud. It is possible for average investors like you and me to be pinched on both sides by lying and manipulative cheats.

For those of you who are willing to hold on for the ride: prepare for rough seas. You can no longer say that you have not been warned or that you were Shanghaied into your position in Shengkai Innovations.

Disclosure: I am long OTCPK:VALV, OTCPK:KEYP.

Additional disclosure: I have written in the past about Keyuan Petrochemicals and my interview with their CEO can be found under my instablogs. I am more confident in this company going forward as a cash dividend is hard to fake.