Puda Buyout Unlikely After Auditor Resigns

| About: Puda Coal, (PUDA)

Puda Coal (NYSEMKT:PUDA) was halted on April 11 after the stock collapsed following a report (here) by one of our contributors that PUDA's Chairman Ming Zhao:

...transferred the ownership of PUDA's sole Chinese operating entity, Shanxi Puda Coal Group Co., Ltd ("Shanxi Coal"), to himself in 2009 without shareholder approval according to official government filings. Then, in 2010 Zhao sold 49% and pledged the other 51% of Shanxi Coal to CITIC Trust Co., Ltd ("CITIC"), a Chinese private equity fund, for RMB245 million ($37.1 million). Zhao then recklessly leveraged Shanxi Coal by borrowing RMB3.5 billion ($530.3 million) from CITIC at an incredibly high 14.5% annual interest rate (including fees) to finance the development of its coal mines.

Zhao brazenly documented the transfer of ownership and high interest loans in Chinese regulatory filings but failed to disclose his actions to the SEC or U.S. investors, beginning with the transfer of 99% of Shanxi Coal to himself, leaving U.S. investors with nothing.

Incredibly, the Board's three month long independent investigation has yet to divulge any feedback on Zhao's actions despite the unambiguous Chinese public records. Instead, the Board has repeatedly delayed making any of its findings public while the investigation drags on and investors are left clinging to hopes Zhao might buy them out. Without a buyout, most investors agree PUDA shares would trade for pennies on the Pink sheets.

Adding to the uncertainty last week PUDA's auditor, Moore Stephens, resigned, explaining that as a result of Zhao's undisclosed 2009 ownership transfer PUDA's audited 2009 and 2010 financials can no longer be relied upon. Disturbingly, PUDA concealed portions of the auditor's resignation letter by asking the SEC for confidential treatment in yesterday's 8-K (link here). So investors continue to be left in the dark by PUDA. In the resignation letter Moore Stephens warned the Board that:

The circumstances described above could constitute illegal acts pursuant to Section 10A of the Securities Exchange Act of 1934. Accordingly, we remind the Board of its obligations under Section 10A, including its obligations to provide notice to the Commission.

Section 10A of the Act requires the auditor to utilize audit procedures that can detect criminal activity, wherever possible, and to notify the audit committee and the SEC when criminal activity is detected, making note of such activity in the auditor's resignation letter filed with the SEC (a good discussion of this rule can be found here).

Meanwhile, Zhao's only public "defense" is his continued assertion that he intends to buy out PUDA public shareholders. Obviously, a buyout offer is a way for Zhao to side-step criticism of his actions and keep the focus on compensating investors for damages. Nevertheless such a buyout is all but impossible given Zhao's history outlined below. How can Zhao's potential buyout partners, including CITIC, continue their association with him considering the following:

On 9/3/09 Zhao's brother signed off on the transfer of shares of Shanxi Coal to Zhao, without shareholder approval, giving himself 99% ownership of Shanxi Coal and leaving U.S. investors with nothing. An official copy of the "Notification of Share Registry Change" can be downloaded (here), including a partial translation.

On 2/18/10 Zhao raised $14.5 million (8-K here) from U.S. investors, without disclosing to the investors that PUDA no longer owned Shanxi Coal, its sole operating subsidiary in China. U.S. investors were buying "nothing".

On 7/15/10 Zhao sold 49% of Shanxi Coal to CITIC for RMB245 million ($37.1 million) and pocketed the proceeds. An official copy of the "Notification of Share Registry Change" can be downloaded (here), including a partial translation.

On 7/19/10 Zhao pledged the other 51% of Shanxi Coal to CITIC as security so Shanxi Coal could obtain a 3-year loan for RMB2.5 billion ($379 million) at a cost of 14.5% (annual interest plus fees) from CITIC, rolling the dice on his ability to generate cash flow from his coal mines.

Zhao subsequently doubled down and convinced CITIC to increase the loan to RMB3.5 billion ($530.3 million), bringing the combined investment to RMB 3.745 billion ($567.4 million). The official filed copies of the share pledge agreements detailing all these amounts can be downloaded (here and here).

Zhao agreed to annual interest and fees on the high interest loan amounting to an unthinkable RMB507.5 million ($76.9 million USD), over twice the $34 million EBIT shown in PUDA's 2010 10-K filing. Any failure or delay in the expansion and modernization of the mines would lead to default.

On 12/16/10 Zhao raised another $101.5 million from U.S. investors by selling 7.85 million shares at $12 per share (8-K here), failing to disclose all of the above ownership transfers and high interest debt. Again investors were buying "nothing."

In a partial attempt to cover up his actions, Zhao transferred the pledged 51% interest in Shanxi Coal to Shanxi Puda Mining Industry Ltd ("Puda Mining"), a former 100% owned subsidiary of Shanxi Coal that, through suspicious shareholder shuffling, Zhao maneuvered to make it the 51% parent of Shanxi Coal. Puda Mining's 51% interest in Shanxi Coal continues to be completely pledged to CITIC (see official agreement here).

On 3/16/11 Zhao filed PUDA's 2010 form 10-K, again failing to disclose any of the above devastating actions and abuses conducted without Board or shareholder approval.

On April 8th Alfredlittle.com published Zhao's history of shareholder abuses (original report here). The following day PUDA's stock was halted, indefinitely, for PUDA's Board to conduct an independent investigation that so far has reported no meaningful findings other than Zhao's interest in buying out PUDA's public shareholders. So far the Board has only reported Zhao's "positive" buyout news while delaying any negative findings for the final report. The Board's suppression of any negative findings is very damaging to investors trying to value PUDA as its shares should soon reopen for trading on the Pink Sheets.

The Board has abandoned their obligations to investors, who are forced to form their own opinions of the buyout. Many were pleased to see that Zhao raised 668 million HK dollars ($86 million, link here) in the last few months from selling a portion of his King Stone Energy (00663.HK) holdings. But seriously, who knows what Zhao will do with the money? His Hong Kong King Stone shares are one of his few liquid assets. Given the allegations he faces perhaps transferring the proceeds offshore to a Swiss account makes the most sense. Given his long history of abuse of shareholders, Zhao seems unlikely to have a change of heart and suddenly use his own money to fund an honorable buyout. He cannot borrow from banks since all his assets have already been over-leveraged and pledged in the CITIC deal. Nor will any fund partner with Zhao considering the strength of the allegations against him. He has no other source of funds.

Therefore when PUDA shares finally start trading on the Pink Sheets if there is any opening price pop it is merely a bull trap that institutions will wisely use to dump the rest of their holdings. By the close PUDA.PK will be back below $6 and by year-end it could be worthless. Given the history, who would possibly want to bet on Ming Zhao?

Disclosure: I am short PUDA.