Lihua International: We Think Undisclosed Related Party Transactions Occurred

Aug. 4.11 | About: Lihua International (LIWA)

As reports alleging wrongdoing at U.S.-listed Chinese companies become more commonplace, it's easy to gloss over some of the potentially egregious violations of fiduciary duty that a number of these companies are committing.

On Monday, Absaroka Capital released a report discussing concerns on Lihua International (NASDAQ:LIWA), a producer of copper products that went public via a SPAC in 2008. A key finding of the report was evidence that the company's COO, who is the wife of the CEO, owns a privately-owned copper scrap products company at the same address as Lihua, yet the company has never disclosed this ownership to public investors.

Related Party Transactions in the Chinese RTO Sector

This sector has been plagued by numerous instances of undisclosed related party transactions. For example, in 2009, Yuhe International (OTCPK:YUII) saw its auditor Grant Thornton resign due to "certain related party loans between the Company and Shandong Yuhe Food Group Co., Ltd." (see here). Similar to LIWA, Shandong Yuhe Food was a related party controlled by the company's management that operated a similar business to the publicly traded entity. A year later, Geoinvesting LLC revealed that YUII had completed a sham acquisition to justify a capital raise from U.S. investors. The stock dropped 70% and was halted and de-listed. The related party red flag was the canary in the coal mine. In the case of Gulf Resources (NASDAQ:GURE), there is substantial evidence that the company's top customer is similarly owned by its chairman.

Related party transactions can allow companies to inflate sales or depress costs and therefore show higher margins and revenue / profit in their financial statements. They can further be used to transfer funds out of the publicly-owned business to insiders who own the related party.

Lihua and Danyang Huaying Materials Recycling Co., Ltd.

In its report, Absaroka revealed that Danyang Huaying Resource Recycling, Ltd., a copper scrap supply company that is registered at the same address as LIWA, is owned by LIWA's COO, Wang Yaying. Ms. Wang is also the wife of Lihua Chairman Zhu Jianhua. SAIC filings show that Ms. Wang and her sister own 90% of Huaying and that Huaying generated $43.2m in revenue in 2009 while having $14.4m in assets. Management admitted on the 8/03 conference call that Huaying is owned and controlled by management, and that Huaying has its registered address at the same location as LIWA.

The question remains on whether LIWA conducted any transactions with Huaying subsequent to LIWA going public. No such transactions, nor the existence of Huaying and its ownership by management, have ever been disclosed in SEC filings. Based on evidence from its investigators, Absaroka concluded that Huaying currently sells copper to LIWA and includes LIWA as one of its customers. Outside of Absaroka's conclusions, there exists additional indications that Lihua has had a relationship with Huaying subsequent to going public in 2008.

First, the company's CFO stated on the August 3rd conference call that LIWA and Huaying had an agreement in place determining the price at which LIWA would purchase scrap copper from Huaying.

Below is an excerpt from the call (emphasis added):

Global Hunter Analyst: I have a number of questions about your relationship with Huaying Resource Recycling, so please bear with me for a few minutes. Have you ever disclosed any information about Huaying publicly in the past to either the SEC or your investors?

Lihua CFO: Dmitri, yes we did. Back in the year 2008, Lihua did the PIPE transaction with Vision Capital and CMHJ, who still are one of our large stockholders. We did disclose Huaying to them, and the purpose why we set up this company. So Vision Capital's lawyers did a full due diligence on Huaying and set up an agreement with Huaying and Lihua. In the agreement, it states that they, Huaying, can sell only scrap copper to Lihua and we can only buy at 10 RMB per ton as the offering cost. So and that's a part of the agreement for the PIPE transaction back in the year 2008…

It strikes us as counterintuitive that LIWA would enter into an agreement with Huaying such that Huaying would sell scrap copper to LIWA at a specified price, if LIWA was never to transact with Huaying subsequent to going public. The presence of the agreement would indicate that LIWA and Huaying have a copper supply relationship. We remind investors that Huaying generated $43.2m in revenue in 2009, according to SAIC filings, and had an operational business.

The agreement discussed above also indicates that Huaying does indeed have operations in Danyang, where LIWA is located, contrary to the CFO's claims that the company operates out of Guangdong, as per below:

Global Hunter Analyst: Okay, that's great, now can you tell us in more detail what business Huaying [is] engaged in and where its operations located?

Lihua CFO: I don't know about Huaying because we never used that company. So it's Ms. Wang's sister [who is] operating that company. So basically what I've heard is this company has an operating outfit in Guangdong doing like scrap trading, its like a trading company. And they don't have any operations in Danyang.

We question whether LIWA's CFO's statement is accurate. Absaroka's report indicates that its investigators concluded that Huaying operates out of Danyang. The name "Danyang" in the company's title indicates that Huaying operates out of Danyang. Its registered address indicates that the business operates out of Danyang. Its filing of SAIC documents in Danyang indicates that the company operates out of Danyang. And the 2008 agreement struck with LIWA to sell scrap metal to LIWA for a specified price also implies that Huaying is based out of Danyang, given that LIWA would be far less likely to be purchasing scrap from Guangdong (Guangdong and Danyang are 1,500km apart from each other).

Second, it's difficult to believe that a copper scrap recycling business with the same registered address as Lihua's copper manufacturing subsidiaries and owned by Lihua's COO is generating no sales to Lihua, and has generated no sales to Lihua since the company went public in 2008. To review, Danyang Huaying's business scope is specifically the recycling of scrap copper and other metals. Click here for SAIC business registration details retrieved for Danyang Huaying, and a description of its business scope is pasted below (click to enlarge image):

The translation reads:

General Business Scope: recycled illuminated coiled metal, recycled scrap electrolytic copper, copper, recycled scrap nonferrous metal and sales, act as principal and agent for importing and exporting merchandise and technology products (except for the import and export of businesses, merchandise and technology products prohibited by government)

Given that Danyang Huaying is a scrap copper recycler, and scrap copper recyclers typically sell their products to downstream copper manufacturers, it's difficult to believe that LIWA does not conduct any business transactions with Huaying.

So What if Related Party Transactions Did Occur?

Based on Absaroka's conclusions in its report and on our indications discussed above, there is evidence that transactions between Huaying and LIWA may have likely occurred.

The independent party that would know would be Crowe Horwath.

If LIWA has been conducting related party transactions with Huaying, Crowe Horwath would likely have invoices and purchase orders between LIWA and Huaying in their audit work papers. We presume that Crowe Horwath has seen a copy of Absaroka's report, or will see it shortly.

If related party transactions have occurred between LIWA and Huaying, this would be a clear violation of SEC regulations, which require companies to disclose related party transactions. In this instance, we would expect Crowe Horwath to resign. After all, Crowe Horwath is a top-20 globally ranked auditor. The firm has a reputation to uphold to a far greater degree than many of the no-name auditors currently auditing U.S.-listed Chinese RTOs. And the rash of recent auditor resignations have indicated that auditors with reputations to uphold are beginning to conduct deeper audits on their Chinese RTO clients exhibiting red flags.

If Crowe Horwath resigns, we expect a similar fate for LIWA as we've seen for other U.S.-listed Chinese companies that have seen auditor resignations, such as OTCQB:OTC:CHBT, OTCPK:OTCPK:CCME, OTC:OTC:RINO, etc. The stock would likely be halted and de-listed.

Our educated guess is that related party transactions between LIWA and Huaying have in fact occurred during LIWA's tenure as a public company, that Crowe Horwath has evidence for this in their audit work papers, and that Crowe Horwarth will resign when it reviews its work papers. To no one's surprise, we're short the stock.

Disclosure: The author is short LIWA. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Read our full disclaimer at kerrisdalecap.com/legal-disclaimer-3. I have short positions in and own options on LIWA (Lihua International, Inc.) and stand to realize gains in the event that the price of the stock declines. I am also short and may own options in ONP, GURE, OTCQB:CHBT, OTCPK:CCME, OTCPK:YUII, and OTC:RINO. To the best of my knowledge, all information in this article is accurate and reliable, but I present the information "as is". I will not necessarily update or supplement this article in the future. Following publication, we may transact in securities of the company covered herein.