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It received much media attention when Muddy Waters cracked down a once 5 billion USD business – Sino-Forest Corporation (OTC:SNOFF). Nevertheless, Sino-Forest was not the only one. Citron Research has also spotted 18 Chinese stock frauds so far. According to Citron, “13 have suffered losses of 50% to 100%, and 2 are halted, a total of 15 with losses we would deem catastrophic.”

As a retail investor without much access to and expertise in Chinese capital markets, what are the red flags to look for in order to screen out the potentially fraud Chinese companies?

Investor's Business Daily summarized 6 Rules of Sucessful Investing in Chinese ADRs a while ago. The article doesn't seem to be very practical if we apply the rules to Longtop Financial (NYSE:LFT), or Sino-Forest Corp, along with others.

As an investor who's been following and researching Chinese stocks, I have come up with my own check list for red flags:

1. Lack of Chinese Media Exposure

Issue: Lack of Chinese media exposure, such as industry news, marketing news, recruitment information, online message board discussions, management interviews, including a company’s local website, significantly indicates that the company’s operation, business activity and industry position are suspicious.

Most Chinese ADRs will provide their company websites in both English and Chinese. At first glance, it is important for an investor to check out the Chinese website to evaluate the quality of contents and sophistication of function. For example, ChinaCast Education Corporation (NASDAQ: CAST). Their English website provides information for the investor relations section only and their Chinese website seems to always be in maintenance. The company has been accused of fraud by a few research agencies and individuals ever since it went public. Another instance can be Chinese Education Alliance (NASDAQ: CEU); the main Chinese websites “have non-functioning payment methods and are full of broken links and HTML errors” according to a recent Kerrisdale Capital report. Along with other evidence, Kerrisdale Capital also believed the company has inflated its revenue.

Furthermore, investors should either Baidu or Google the company’s news in Chinese. Baiduing Sino Forest in Chinese (嘉汉林业) and looking at news prior to the Muddy Waters' report, we only discover several pieces of news related to the company, most of which were recruitment advertisements and a couple interviews with the management. It is hard to imagine that a company with a 5 billion USD market cap and more than 10 years of operating history would have very limited local media reporting and marketing, which should raise concerns for investors.

A more sophisticated investor can also check out the company’s partners/suppliers/clients/competition information on the internet as cross reference. In my previous article on Spreadtrum Communications (NASDAQ:SPRD), I found news reports on Spreadtrum’s partnership with Wingtech, contracts with China Mobile (NYSE:CHL) and interviews of Mediatek’s (Taiwan: 2454.tw) management (Spreadtrum’s major competition) as cross reference to answer Muddy Waters’ question on the credibility of company’s market position.

As I understand, it is easier for a single company to commit a fraud with a few related parties - as in the Sino-Forest case. But it is much harder to convince the media, suppliers, customers and especially your competition altogether to inflate your top line and deceit your investors. Given the recent Chinese stock fraud, many of these companies do fail this media exposure test.

2. Weak Corporate Governance

Issue: A weak mechanism of corporate governance leaves room for management to manipulate or inflate earnings, engage in related party transactions, and make decisions favouring short term stock price performance. I found it true for emerging markets equities specifically.

Signals for weak corporate governance in China's case can be a concentration of insider ownership, dependence of the board, and related party transactions.

Contrary to traditional beliefs that insider ownership is a positive sign since it aligns the management’s interest with shareholders', the rule seems to be broken when it comes to Chinese companies. See the following table of companies accused of fraud lately:

Ticker

Company Name

Management's holding

SEED

Origin Agritech

33%

SCOK

SinoCoking Coal & Coke

31.74%

OTCQB:CHBT

China-Biotics

22.95%

BORN

China New Borun

57.71%

OTC:CVVT

China Valves Technology

35.28%

OTCPK:CCME

China MediaExpress Holdings

35.95%

LFT

Longtop Financial

25%

MOBI

Sky-Mobi Ltd

58.28%

DGW

Duoyuan Global Water

48.75%

OTC:DYNP

Duoyuan Printing

57.46%

CEU

China Education Alliance, Inc

39.97%

OTCPK:CAST

Chinacast Education Corporation

5.51%

OTC:SNOFF

Sino-Forest Corp

2.68%

It can be interpreted that with a large chunk of equity in the company, the management will have stronger motives and more influence over the board to make decisions as they see fit. Such influence can be reinforced by a dependent board.

Theoretically, a board is responsible for the shareholders and is supposed to govern a company's management. In practice, however, the board can become a subsidiary of the CEO, who is sometimes the Chairman of the Board. As a result, good corporate governance should mandate a more independent board, which independent directors account for 75% preferably. In addition, the role of Chairman of the Board and CEO should be separate.

One can tell from the following table that only Longtop Financial has separated the role of Chairman and CEO, and not surprisingly, none of these companies reached the 75% threshold.

Ticker

Company Name

CEO/Chairman

% of Independent Board Members

SEED

Origin Agritech

NOT

23%

SCOK

SinoCoking Coal & Coke

NOT

50%

OTCQB:CHBT

China-Biotics

NOT

50%

BORN

China New Borun

NOT

0%

OTC:CVVT

China Valves Technology

NOT

40%

OTCPK:CCME

China MediaExpress Holdings

NOT

67%

LFT

Longtop Financial

Separated

33%

MOBI

Sky-Mobi Ltd

NOT

25%

DGW

Duoyuan Global Water

NOT

0%

OTC:DYNP

Duoyuan Printing

NOT

40%

CEU

China Education Alliance, Inc

NOT

25%

OTCPK:CAST

Chinacast Education Corporation

NOT

50%

OTC:SNOFF

Sino-Forest Corp

NOT

67%

The existence and extent of related businesses are hard to spot for investors, though important. According to Citron Research, Longtop Financial didn’t disclose its transactions with related party Xiamen Longtop Human Resources (XLTHR). XLTHR was therefore able to help the company hiding salary expenses. Despite the similarities between the names, are there other ways to detect probable related-party transactions?

Personally, I believe a concentrated number of clients or suppliers are worth further investigations. For example, if some client accounts for more than 10% of the company’s sales or cost of goods sold, and/or if receivables due is more than 10% of total assets.

Investors have long focused solely on the top line growth and earnings release. As the recent fraud demonstrated, it still makes sense to perform a basic background check, go through the footnotes, and evaluate the board before buying into a fancy China story.

To be continued...

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: How to Detect Potential Chinese Stock Frauds