Trading in shares of Chinese vegetable producer Le Gaga Holdings (GAGA) has been fairly quiet in recent days given the horrendous fate that befell close competitor Chaoda Modern Agriculture (CMGHF.PK) several weeks ago. Chaoda until recently seemed to be a pioneer in consolidating the massive Chinese produce industry. Its shares listed in Hong Kong more than a decade ago and it reached a market cap of more than 20 billion Hong Kong Dollars ($2.6 billion). For many years, Chaoda enjoyed investors’ favor, and had steady access to the capital markets, completing various equity and debt offerings.
But Chaoda’s shares have been in freefall after a Hong Kong magazine, Next Media, leveled sweeping fraud allegations (translation here, original Chinese language document) against the company earlier this year. Several weeks ago, Hong Kong financial regulators launched proceedings against Chaoda in the country’s Market Misconduct Tribunal, and trading of the company’s Hong Kong shares (HK:682) was halted. In addition, a new research report from Anonymous Analytics laid out more allegations against Chaoda. The stock has fallen 80% in 2011 year-to-date.
Chaoda’s collapse is most interesting for investors in Le Gaga, since Le Gaga and Chaoda’s management team have close – extremely close – ties. Le Gaga’s board of directors is a who’s who list of prominent ex-Chaoda employees. The Chairman of the board and CEO of Le Gaga is Shing Yung Ma, who served as Chaoda’s VP from 1999 to 2003. The Vice Chairman of the Le Gaga board is Na Lai Chiu, who was a co-founder of Chaoda and worked there for many years. Le Gaga Independent Director Gordon Wang served as CFO and executive vice president of Chaoda from 2003 to 2005. Finally, Le Gaga VP of operations Hang Cheng previously served as an executive director at Chaoda. In total, four of Le Gaga’s board members spent significant time at Chaoda.
Most shocking is current Le Gaga Vice Chairman of the Board Na Lai Chui’s relationship with Chaoda. Na Lai Chui co-founded Chaoda. The other co-founder is none other than Na Lai Chui’s husband, Mr. Ho Kwok. And unlike Ms. Chui, Mr. Kwok remains at Chaoda, where he continues to perform the CEO and Chairman duties he has held since Chaoda was founded more than a decade ago. Long story short, the second in command at Le Gaga, Ms. Chui, helped found Chaoda. Furthermore, she is married to the co-founder and current CEO of that same allegedly fraudulent company.
But while unbelievably strong connections between Chaoda and Le Gaga are noteworthy and raise eyebrows, we must dig further into the timeline of the alleged fraud at Chaoda to determine what role, if any, current Le Gaga personnel may have played. Chaoda was listed on the Hong Kong exchange in 2000, and things seemingly went smoothly at first. The first sign of trouble hit in 2003, when PricewaterhouseCoopers resigned as Chaoda’s auditor.
Chaoda claimed this resignation was due to a fee dispute, though the Anonymous Analytics report suggests this was fairly unlikely since auditors tend not to resign over fees. It seems more likely that PricewaterhouseCoopers would resign due to concerns about excessive audit risk in Chaoda’s books. This is supported by a 2005 report by the Hong Kong Institute of Certified Public Accountants which wrote:
In many cases, fee disputes are stated to be the reason for the change. Concern has been expressed that certain auditors have been relying on purported fee disputes to disguise the real reasons for the change. As a result, potentially significant and fundamental matters about the listed issuer may not be disclosed to investors and creditors and the market is not therefore being kept fully informed.
If Chaoda was misstating its books in 2003, this would be during a period when both of Le Gaga’s leading executives – CEO Shing Yung Ma and Vice Chair of the Board Na Lai Chiu – were still in executive positions at Chaoda according to the Anonymous Analytics report and Le Gaga's biographical information found on its website. It is hard to imagine Chaoda engaging in fraudulent practices in 2003 without the involvement of Mr. Ma and Ms. Chiu. The PricewaterhouseCoopers resignation becomes even more interesting considering the fact that just three months later, a Chaoda board member who happened to be a certified public accountant also resigned from the company. Circumstantial evidence leads one to suspect that something was seriously amiss with Chaoda’s books by the end of 2003.
The next noteworthy event occurred in 2004, when Ms. Chiu suddenly resigned from Chaoda due to “health reasons,” according to the Anonymous Analytics report. She also transferred all of her ownership stake in Chaoda to her husband Mr. Kwok, who is also that company’s CEO. Fortunately her health recovered enough for her to take on a senior position at Le Gaga in 2008. Le Gaga’s VP of operations, Hang Chen, was next to resign from Chaoda. He left Chaoda in 2005 – supposedly to pursue further education according to the Anonymous Analytics report. He arrived at Le Gaga in 2008.
By 2007, Chaoda was showing more outward signs of being a potentially fraudulent company, highlighted by the bizarre simultaneous resignation of both of the company’s auditors – Baker Tilly Intl. and CCIF CPA Ltd. The company again blamed a dispute over auditing fees, though given the low likelihood of this being a reasonable explanation once, the odds of it happening again are even smaller.
If Chaoda is a fraud as multiple research reports have implied, we can be fairly confident that it became a fraud no later than 2007 when the bizarre auditor double-resignation occurred. However, no current Le Gaga executives were still in managing roles at Chaoda in 2007. This leaves two possibilities for Le Gaga’s management team; either they are honest businessmen who resigned from Chaoda as they discovered it was fraudulent, or they worked for Chaoda while they knew it was engaged in fraudulent activities and resigned later. Unfortunately for Le Gaga’s shareholders, evidence from a Hong Kong magazine Next Media’s exhaustive investigation into Chaoda would indicate that the company was rotten from its launch onward, thus tarnishing the reputations of all the Choada-turned Le Gaga executives.
The report from Next Media claims that Chaoda engaged in “five lies” in running its fraudulent business. These include overstating the amount of farmland Chaoda owned, exaggerating the quality of Chaoda’s machines and facilities, claiming its products were “organic” when they were merely “unpolluted”, claiming the existence of exclusive retail stores that were in fact figmentary, and deceiving investors into thinking a mere transport container yard was a “processing plant.” As you’ll see, it is very hard to accept the idea that all five of these deceptions could be carried out without the knowledge and approval of members of Chaoda’s executive team that now work for Le Gaga.
For example, the first falsehood is that the Chaoda Xiaoyou farming facility had 8,000 mu (533 hectacres) of land. But in 2002, according to the magazine report, “media exposed that the size of the farmland was only 1000+ mu (67 hectacres).” A reporter for the magazine visited the facility and found that to the present day, “the leopard had not changed its spots at all – [it was] still addicted to lying.” For a decade, the company has overstated its land holdings at a key production facility. This deception began while all of Le Gaga’s ex-Chaoda employees were still gainfully employed there.
Falsehood #2 also predates the exodus of executives from Chaoda over to Le Gaga's board of directors. In 2003, Chaoda stated that it was spending 100 million RMB (15 million USD) to build an irrigation system and other infrastructure at its farming facilities in Nanjing and Beijing. A reporter for Next Media found only “two tractors, three corn machines, one packing machine and five freezers,” at the site of those facilities that were to have been upgraded. The company also failed to upgrade its automatic sprinkler system as it had stated it would do. Where did all that $15 million of capital expenditure funding go?
Falsehood #3 is also difficult to explain for Le Gaga’s apologists. In 2003, the company claimed in its annual report that it produced “organic” vegetables and fruits, making organic produce “the company’s signature.” Chaoda’s manager of produce admitted to Next Media’s reporter that its produce had not been “organic” but merely “unpolluted.” Produce rated as unpolluted carries less pesticide and fertilizer than conventional produce, but is far from organic and is priced accordingly.
Falsehood #4 complements the previous one. Chaoda claimed to have an exclusive network of retail stores for their produce. But when Next Media investigated, it became clear that Chaoda was misleading investors. Next Media’s correspondent could not find Chaoda’s vegetables in local supermarkets where Chaoda’s representative said they could be found. Chaoda also claimed to have exclusive retail shops. But in a China Biotics-esque (CHBT.PK) twist, the stores simply disappeared. Next Media reported,
Chaoda claimed to be well-known in Fujian and the company said there were eight exclusive shops at the time when it went public. But now, all of them have disappeared without a trace.
To be clear, we know that as early as 1999, when Chaoda went public, it claimed to have eight exclusive store locations in Fujian. But a visit to one of the alleged store locations found no Chaoda produce there. The disappearing stores also cast a negative light on Le Gaga’s management team; if Chaoda was lying in its going-public offering documents, then blame would seem to fall on Chaoda’s co-founder (now Le Gaga’s board vice chairwoman), and Chaoda’s logistics/distribution manager (now Le Gaga’s CEO). It would be hard to create the illusion of fake stores without those two people being involved.
The final lie identified by Next Media was that Chaoda’s alleged processing plant for products was nothing like what was claimed. A reporter visiting the site of Chaoda’s ‘processing plant’ found only a container yard. One employee found there said, “I’ve worked here for 5 years and never heard about any processing plant.” Remember that Chaoda’s longtime head of logistics/distribution, Shing Yung Ma, went on to become Le Gaga’s founder and remains Le Gaga’s CEO. With Chaoda seemingly misstating the scope of its logistics operations, one must wonder what involvement Shing Yung Ma had, and whether he took any of Chaoda’s deceptive practices with him on to Le Gaga.
Investors must ask themselves how trustworthy Le Gaga’s management team is given the fact that four Le Gaga board members served in important roles at Chaoda, including co-founder, CFO, and head of logistics/distribution. As they say, the apple never falls far from the tree. With Chaoda being seemingly exposed as one of the largest frauds on the Hong Kong Exchange yet, investors should feel more than a bit of trepidation. It seems a rather risky gamble to believe that Ms. Chiu could oversee an entirely legitimate produce growing operation at Le Gaga while her own husband engaged in a seeming multi-billion dollar fraud running the same type of business at Chaoda.
Disclosure: I am short GAGA.
Additional disclosure: I and researchers who assisted me have short positions in or own options on the equity covered in this article. We stand to gain significantly if the equity of the company discussed markedly declines in price. Following publication, we may transact in securities of the company discussed. To the best of my knowledge, all information in this article is accurate, reliable, and has been obtained from public sources. However, I present the information "as is" and I will not necessarily update or supplement this article in the future. This information is not a recommendation or solicitation to buy or sell securities, nor am I a registered investment advisor.