On March 29th China MediaExpress Holdings (NASDAQ: CCME) filed an 8-K (here) that included a detailed list of reasons why its auditor, Deloitte, resigned.
Deloitte’s concerns included:
- Authenticity of bank statements
- Suspicious circumstances surrounding bank balance confirmation procedures
- Validity of certain advertising agents/customers and bus operators
- Possible undisclosed bank accounts and bank loans
- Subsidiaries shown in SAIC filings are inconsistent with management’s representations
- Validity of a sampling of tax invoices from certain large transactions
- Subsidiary tax payments to the SAT could not be verified
- Cash salaries to certain employee bank accounts could not be verified
- Production process of advertising programs could not be verified
- Potential double counting of a certain number of buses
Most of Deloitte’s Concerns Share a Common Thread: “Paper”
Bank statements, confirmation letters and contracts of all types, government filings, ownership certificates and tax invoices are all paper documents easily forged by dishonest management with the help of a few dishonest bank and government officials. The consequences of getting “caught” are nil, since Chinese law offers no protections for foreign investors in legally unenforceable variable interest entity (VIE) management contracts used by companies such as CCME and CBEH. Dishonest management can keep turning paper into gold until investors decide the “paper” evidence of profits and growth are contradicted by the reality of the business.
Foreign investors are clearly in a very poor position to perform on-the-ground analysis of business fundamentals. Even China-based investors have to be willing to spend considerable time and resources to verify whether a business is real. For example, the due diligence report (summary here) on CBEH prepared by the International Financial Research & Analysis Group (IFRA) took a team of analysts six months to create and cost hundreds of thousands of dollars. IFRA investigators went to the source to obtain independent audit and tax reports. Field agents spent months observing and photographing CBEH’s biodiesel factories. Videographers created time-lapse films showing the lack of any production. Technical experts evaluated the production process. A team of analysts called and met with CBEH’s suppliers, competitors and technical partners. Certainly CBEH’s auditor, KPMG, did none of this type of tangible due diligence (other than the year-end physical inventory count) before they signed off on CBEH’s 2010 financials.
As shown in this astonishing surveillance video, even a group of Rodman & Renshaw investors who took the time and expense to visit CBEH’s factory were easily fooled by management that simply staged production activity that day. Dozens of additional surveillance videos (see the same link) showed that prior to the Rodman investor visit the factory was not producing any biodiesel at all, despite management repeatedly publicly claiming the factory was operating at 100% of capacity.
What Can Investors Buy When Even "Big Four" Auditors Fail?
Assuming then that the audit opinion, even from a “Big Four” cannot be relied upon, what can investors do? First of all, absolutely avoid buying companies exhibiting more than one or two of the following 12 warning signs:
- Reverse mergers with high short interest
- Management misappropriation of funds to related parties
- Unnecessary dilutive share issuances when the company has excess cash or production capacity
- Amazing revenue and earnings growth relative to peers
- Drastic divergence between financials filed with the U.S. SEC and Chinese regulators
- Weak balance sheet with large receivables relative to sales and unwillingness to disclose customer, distributor or supplier details
- Large growth by acquisitions that appear unusually accretive
- Weak governance indicated by high CFO and auditor turnover and lack of involvement of truly independent directors
- Past involvement of unscrupulous stock promoters
- Huge cash and shares fees paid to investment banks and other middlemen
- Wildly promotional press releases or frequent press releases
- Company provides very detailed financial guidance and always meets it
Second, even if a target investment passes these tests, then an investor still needs to perform at least a reasonable amount of tangible due diligence. Clearly most investors do not have the capacity to conduct time-lapse video surveillance of a company’s factory. Nevertheless, they should at least seek to “piggyback” on investigations performed by those who can afford the due diligence expense.
Unfortunately, in the last year even the most sophisticated investors such as the Carlyle Group have stepped on landmines. In fact I am unable to give even one example of a successful “piggyback” investment in the last few years, since the whole space is apparently riddled with fraudulent companies.
Fortunately, large China-based investors appear to be rethinking their due diligence efforts and are more willing to engage the services of intensive researchers such as Kroll, IFRA, Business Connect China or China Whys. This is a lengthy process and U.S. investors should be patient, watching for hints of the first good “piggyback” opportunities as they will likely emerge on sites like Geoinvesting and Seeking Alpha.
I continue to be confident that eventually there will be some very good buying opportunities once the majority of the fraudulent companies are exposed over the next several months.
Disclosure: I am short CBEH.