Chinese CEOs: Cook Your Books at Your Own Peril

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 |  Includes: CGA, CHNG, PUDA
by: Kevin McElroy

I'm a big believer in the Chinese growth story. As famed commodity investor Jim Rogers says, "The 19th century was the century of the U.K., the 20th century was the century of the U.S., the 21st century is going to be the century of China."

Until recently, one of my favorite ways to play the inevitability of the China growth story was to buy a company called Puda Coal (OTC:PUDA).

If you've been reading my letter for very long, you know what's going on with coal in China. Coal burning power plants produce over 2/3 of the electricity in China, and a significant portion of that coal has to be imported to China from places like Australia.

That means that demand for domestic coal production has a margin of safety. For Chinese firms, domestic Chinese coal is cheaper, easier to access, and absent of political or regional conflicts or difficulties.

I particularly had interest in Puda, because the company produces metallurgical or coking coal. This type of coal is vital to the production of steel, and so, it's vital to the production of high-rises and skyscrapers that seem to be popping up in China today like dandelions after a late-Spring rainstorm.

But it appears that at least one executive at Puda may have ripped off American shareholders. In a report from the notorious Chinese bear-raider Alfred Little, it's alleged that Ming Zhao, the Co-Founder and Executive Chairman of Puda may have "sold half the company and pledged the other half to Chinese … investors.”

I don't know if these allegations are true. And that's part of the problem. If we were talking about an American company, you and I could look up source documentation on the SEC website, or we could refer to audits from trusted accounting firms. There might be a paper trail worth a darn to inspect. By the way, congratulations to Alfred Little for discovering that there's money to be made shorting Chinese companies when their houses aren't in order.

Regardless of whether Mr. Little is correct or not, there needs to be accountability for these firms, and if the SEC can't do it, then the markets will.

That's because we're talking about a Chinese small cap with one set of books that gets shown to the SEC and maybe another set of books that's shopped around with Chinese authorities, and perhaps a 3rd set of books used internally.

It would be one thing if Puda was the exception – but it seems as though malfeasance from Chinese companies, small-caps especially, is becoming the rule.

With very few exceptions, such as Enron and Worldcom, significant malfeasance at the corporate-financial level is a moot point in the United States.

American chairmen at nearly any public company are so well paid and so focused on profitability, that stealing money or front-running shares just isn't worth the risk.

But unfortunately, you can't say the same thing about many Chinese company chairmen.

For instance, our friend Mr. Ming Zhao only made $26,000 last year, according to SEC filings. That includes compensation in the form of salary, stock and exercised options.

For reference – and just to pick a random company out of the air – San Diego based bio-tech firm Vical Inc. (NASDAQ:VICL) is about the same size as Puda, and the CEO Vijay B. Samant made $720,000 in 2009. That's more than the entire board of directors made at Puda last year.

We know that $26,000 is not a lot of money in the United States, and while those dollars might stretch a little bit further in China, it's still a pittance for an executive officer for any publicly traded company.

That's a small part of the problem, of course. The real problem is a lack of transparency – or rather the illusion of transparency that Chinese executives have figured out how to manipulate to their advantage.

It's not the first time we've encountered this type of obfuscation from Chinese firms. Several of my colleagues here at Wyatt Research tell me they've run into the same problem, again and again, with firms such as China Green Agriculture (NYSE:CGA), and China Natural Gas (OTC:CHNG).

I'm not saying that all of these companies are crooked. I'm saying it's really difficult to get an accurate read on these companies just by looking at their "official” filings.

And if there's one thing investors hate more than anything, it's uncertainty. That's reason enough to stay away from Puda today, or to sell your position.

If you're a Chinese CEO and you're reading this – you better make sure your books are not cooked. People like Alfred Little will take you to the cleaners – and for good reason – if you're anything but straight with your shareholders. That won't just make it difficult for your firm to access American capital markets, it will make it difficult for any Chinese company to do so.

Oh, and your government might execute you when you get caught. Remember what happened to two men in China were found guilty of selling tainted milk just two years ago ...

If you have any questions about Puda or any other Chinese company (hopefully commodity related) please drop me a line at editorial@resourceprospector.com.

Disclosure: No positions