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I am a 27 year old investor. I have experience purchasing distressed real estate, particularly finished residential lots in Northern California. I'm on here to learn from other investor's ideas and to have a forum to write down my investment ideas and receive feedback. I don't hold on to any of... More
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  • CCME Fraud Debate- Teeth in the Starr deal 26 comments
    Feb 9, 2011 8:26 PM | about stocks: CCME
    The past week we have seen an absolute assault on Chinese inter-city bus advertiser, China Media Express (OTCPK:CCME), from bloggers alleging that the entire company is a massive fraud. Many individuals on the long side have made very compelling arguments dispelling the criticism. However, I personally do not have the knowledge and understanding of Chinese business practices, language, and culture to adequately weigh in on the such arguments.

    There is another way to look at the issue, though, without getting into the he said she said game between the shorts and longs, and that is to look at the incentives. Since incentives for short seller are easy to understand, let's look at the management's incentive. Generally speaking, corporate frauds tend to develop by attempting to hide the losses of a previously legit business. I have not seen many that were frauds right off the bat, and I would imagine the management of a company that is fraudulent from inception would take the cash and run first chance they get. CCME has not been around all that long, and it would seem that if they were a fraud, that they always have been. 

    This leads me to the 30MM investment made by Starr International in Jan. 2010. Many have argued that Starr got too sweet a deal. For reasons that are not the point of this post, I disagree with this argument.  But what stands out to me with respect to the issue of the veracity of the company's reported earnings, is that the deal with Starr has some serious teeth in it. Take a minute to review the following paragraph from the 10k:


    "In addition, for so long as Starr owns at least 3% of the Company’s Common Stock on a fully-diluted and as-converted basis, Starr will have the right to purchase a pro rata portion of any additional shares of capital stock proposed to be issued by the Company, and will have the right to join certain stockholders in their sale of capital stock of the Company on a pro rata basis, in each case in proportion to Starr’s then current percentage of ownership of the issued and outstanding shares of Common Stock, on a fully diluted, as-converted basis. As long as Starr owns at least 3% of the issued and outstanding shares of Common Stock, on a fully diluted, as-converted basis, it will also have the right to require certain stockholders to purchase its Preferred Stock and the Common Stock held by Starr or issued upon the conversion of Preferred Stock or exercise of the Purchased Warrants upon the occurrence of the Company’s failure to achieve audited consolidated net profits (“ACNP”) for 2009, 2010 or 2011 are less than $42 million, $55 million and $70 million, respectively (each, a “Profits Target”) or to fulfill certain of its obligations under the Purchase Agreement. The Performance Adjustment Amount payable in any of 2009, 2010 or 2011 will be a fraction of $343,462,957 which is proportionate to the amount by which the Company’s ACNP in such year falls short of the then applicable Profits Target. The Performance Adjustment Amounts will be payable in cash or stock, but only to the extent such stock, together with the shares of Common Stock acquired or acquirable as a result of Starr’s ownership of the Preferred Stock, the Purchased Warrants and the Transferred Shares, will not exceed 19.9% of the total number of shares of Common Stock of the Company issued and outstanding as of the date of the Purchase Agreement. In the event that the stockholders subject to the obligation to purchase Starr’s shares under the put right or to obligations under the performance-based adjustment provisions do not comply therewith, Starr will have the right to require such stockholders to sell up to all of the Companys’ capital stock directly or indirectly held by them to a third party pursuant to a managed sale process."


    Essentially what this paragraph describes is a put option agreement directly with the company's management- presumably CEO Cheng Zheng- that is triggered in the event specified performance measures are not achieved. Needless to say, the discovery of fraud would trigger the put option. I don't feel like going through the math on it here, but if you'd like to work it out on your own you will find that if fraud were uncovered, this put option would likely wipe out the CEO entirely. An additional part of the deal, I should note, gave Starr a seat on the board and allowed Starr to pick the auditor-Delloitte Hong Kong.

    So back to incentives. It takes a pretty confident CEO to enter into this type of transaction. If it were a fraud, this would require him to keep it going into 2012 with substantially increased scrutiny, and with serious financial consequences if he fails. In fact, this would be about the dumbest agreement I could imagine a fraudulent CEO entering into. 

    For many reasons I just don't see how the short argument adds up. However, since I have yet to see a discussion of this part of the Starr deal, I thought it would be worthwhile to post here. I welcome your comments.


    Disclosure: Long CCME

    Stocks: CCME
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Comments (26)
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  • BrianHunter
    , contributor
    Comments (2) | Send Message
     
    Excellent post about a part of the CCME story that no one has discussed. It is my contention that private equity is smart money. A lot smarter than even the hedgies. Starr structured a really nice deal with CCME- from an upside and loss mitigation standpoint. Starr's initial investment and the PP from Lin this fall should hold serious weight with investors. However the shorts don't see it that way. They argue why would the company raise cash when they already had so much in the bank? That is true that the company probably didn't need the money-however the did need the credibility of a large US PE firm.

     

    If CCME wants to shut the shorts up once and for all, the company needs to buy back or issue in dividends MORE than Starr has invested. Cash speaks louder than words. I believe the company will do it, however being in a quiet period complicates things. To be continued...
    9 Feb 2011, 09:12 PM Reply Like
  • noahfarb
    , contributor
    Comments (5) | Send Message
     
    Author’s reply » Well put, Brian.

     

    Can you please explain exactly what limitations the quiet period puts on the company?

     

    Thank you.
    9 Feb 2011, 09:47 PM Reply Like
  • User 35951
    , contributor
    Comments (27) | Send Message
     
    It is actually referred to as a "quarterly blackout period". A "quiet period" is associated with an IPO. The following link should help:

     

    www.mobilitypr.com/blo.../
    10 Feb 2011, 01:41 AM Reply Like
  • BrianHunter
    , contributor
    Comments (2) | Send Message
     
    It doesn't matter what you call it. Prior to earnings management effectively has their hands tied behind their back. They have material non-public information (about the most recent quarter) that they cannot disclose or act on. Meaning they are not able to buy back any stock before reporting earnings. They also wouldn't want to do something like present at an institutional investor conference.

     

    The only way that CCME can buy back stock here is if they pre-release earnings. Then the public knows what they know.
    10 Feb 2011, 09:59 AM Reply Like
  • User 35951
    , contributor
    Comments (27) | Send Message
     
    SEC Publicity Regulations
    Does the law require a quiet period before every quarterly earnings announcement from public companies?

     

    This is a difficult question to answer with a clear bright-line rule. The general answer here is "no", but for the reasons discussed below one has to think about this question very carefully. The question often results from confusing "quiet period" and "quarterly blackout period". If one only thinks about "quiet period" applying during an offering, one would almost certainly conclude that if there is no offering, there is no quiet period restriction, and thus no requirement for any sort of "blackout period" period prior to quarterly earnings announcements.

     

    However, the law in this area, around quarterly earnings announcements for public companies, has much more to do with other anti-fraud oriented securities laws than "quiet period" rules we’ve discussed above; and it’s a very fact-intensive area. The basic issue presented to a company is this: As a company comes to the end of a quarter, it gets increasing visibility on its results for that quarter, arguably the single most material piece of information about the company at that particular moment in its stock trading life (each quarter). And most companies are not prepared to announce their results for a period of time following the end of a given quarter, as they need to close their books for the quarter, ensure the proper reviews have occurred with respect to same, and then prepare the public announcement of those results. As a result, during that preparation time, there can be a lot of market anxiety about how the company performed during the most recent quarter. Many companies therefore impose a "quarterly blackout period" on PR activities (as well as stock trading by company board members and executives), as they do not want to make announcements during that period, prior to their earnings release, based on a legitimate fear that the market may react strongly to the non-earnings announcement (up OR down), and then days later when the earnings release comes out (which is very likely to cause the stock price to move up or down), the stock may move the opposite direction. And someone may then accuse management of trying to manipulate the stock price for selfish reasons. The classic illustration of that situation is as follows:

     

    Company X has a bad quarter ended March 31. During early April, Company X puts out lots of announcements that are very bullish on the company’s products, management team successes, and maybe even general trends (arguably, though doubtfully, true as to the future, despite the bad March quarter). Company X’s stock price moves up on the announcements – and many company employees (even assume non-executives who don’t know about the bad quarter) decide to sell stock in light of the movement. A week later, the Company announces the bad results for the March quarter and the stock gets whacked.

     

    Clearly, someone might suggest that the Company was trying to manipulate its stock price prior to announcing the bad news (the quarter’s results). That someone could be a regulatory agency, or a securities lawyer that believes the company was committing securities fraud. Often, a lawsuit or regulatory agency investigation follows.

     

    So companies have to decide very carefully whether they want to set a practice of allowing "normal course" announcements (and if so, the process around such announcements) during that end of quarter period. And note that there is no magical set of dates defining that period – it is an intensely fact-based analysis depending on the company and its industry. It can and frequently does start prior to the end of a quarter, and it usually runs through the date of the company’s earnings release, plus one or two days). Alternatively, companies may decide to "go dark" during that period (meaning, talk to no one in the analyst community, stop press activities that may be viewed as "market moving" or analyst oriented, and the like).

     

    Companies are all over the map on this point. Many "go dark" completely. Many only issue product-related announcements to trade publications (as opposed to financial analysts), presumably concluding the announcements are ordinary course and not material to the company in the aggregate sense (and therefore unlikely to affect the company’s stock price). Some certainly do nothing to limit their press and just take their chances (that is not at all recommended). A company needs to weigh the content of the announcements it will allow very carefully. And additional complexity exists when third parties make announcements relating to the company during that period (for example, a vendor or other third party announces that Company X has done a deal with it – and the announcement is going to run during that "quarterly blackout period"). It’s a difficult question to answer with a general rule.
    10 Feb 2011, 01:11 PM Reply Like
  • jim2000
    , contributor
    Comments (40) | Send Message
     
    I believe that everyone should read this.

     

    www.nyggroup.com/libra......
    10 Feb 2011, 08:25 AM Reply Like
  • Chad Brown, CFA
    , contributor
    Comments (131) | Send Message
     
    jim2000-
    Why should everyone read your link? (The link is broken)
    11 Feb 2011, 04:07 PM Reply Like
  • Mike Labadi
    , contributor
    Comments (8) | Send Message
     
    Great blog. One other point that I would like to point out relative to Star's 1,000,000 prefered shares. As per CCME mandate these shares will convert to 1:3 common shares only after one of the three things below happen:

     

    1. Share price closes above $25 for 20 consecutive days
    2. Market cap of 1.2 Billion or more
    3. After 5 years from agreement.

     

    Talk about a company that wants to preserve share holder value.

     

    That said, I'm still eager to see some announcements from the company, specifically a dividend date and amount. I don't think this information will be blacked out due to end of quarter quiet period. GLTA- Longs.
    10 Feb 2011, 04:59 PM Reply Like
  • Business Economics Analyst
    , contributor
    Comments (2562) | Send Message
     
    You haven't addressed any of the facts of the short arguments, so how can you say it doesn't add up. The shorts provided independently verifiable facts that shows CCME is a fraud. If those facts are not true, you could easily verify independently that they are false and provide it to us. Such you couldn't do that, I will look through the noise of your article and take it as an admission from you that CCME is a fraud.
    11 Feb 2011, 03:42 PM Reply Like
  • noahfarb
    , contributor
    Comments (5) | Send Message
     
    Author’s reply » Looks like you missed the point of the article. The point is not to refute the short's ALLEGATIONS, as many others have already done that, but to look at the incentives and actions of management and see what they suggest. To me, the FACTS suggest that the company is the real deal.
    12 Feb 2011, 03:15 PM Reply Like
  • Business Economics Analyst
    , contributor
    Comments (2562) | Send Message
     
    first of all, nobody has refuted the proof provided by Muddy Waters. Second, since CCME has been proven a fraud, why are you looking for weak arguments about alleged incentives to suggest they are not. Why spend time suggesting that the sky might be red by inference, when we can look up at the sky and see for sure that it is blue?
    But I will go through your argument point by poorly made point.
    First, one of your premises is that if CCME were fraudulent fomr inception, they would take the cash and run the first chance they got. You say this is something you imagine, and I would agree with you that it exists in your imagination, but not in reality. There is simply no basis for this argument. If you actually did a past study of frauds and were familiar with them, you would not make such a unsupported point. You also make the point that if CCMe were a fraud, they have always been - again a point without any support in reality whatsoever. Perhaps a suggestion here, deal with facts, not things as you imagine them without a basis in reality, in facts, or in experience.
    Now, with regards to human motives or incentives, a little education would be in order as well. First, only a complete fool or crook would agree to the provisions with Starr in the first place, basically giving away millions of dollars, if CCME's business is as represented. If the business was as represented, CCME could have easily raised much money on much more favorable terms. It is hard for me to imagine that Starr did not know this when the deal was cut and is either part of the fraud, most likely, or hoped to profit from it, otherwise they are just not acting with much intelligence. No company would agree to such severe penalties if they didn't increase net profit 30.9% (from $42 million to $55 mil) and then 27% (from $55 million to $70 million). These guys are either complete fools - the worst businessmen of all time, lets not get me started as I might mention the agreement with buses to raise the cost form 10% to 30% every year - or they are perpetrating a scam.
    If CCME are the worst business men ever, then they also can't be doing as well as claimed, so in either scenario, fool or crooks, we end up back at crooks.
    Now, here is where the education on human incentives comes in. Once the agreement is in place that CCME is to report such large increased in net profit, or suffer severe penalties, then the incentives are all to report the required increases in net profit. Of course, as a fraud in the first place, that was probably their intention all along.
    And, of course, this is what fraudsters do, when they are working a fraud, they just don't pack up and leave. They usually try to milk their fraud for all it is worth, most often till it implodes. Look at Bernie Madoof, he could have packed up and run anytime. Look at Hemsley, she had a fortune and didn't stop committing tax fraud. No, these people that are the in the business of fraud usually keep operating in their business and certainly don't abandon a fraud while it is working.
    Finally, none of your points actually go to the short argumet not addiing up, so your conclusion is a nonsequitor.
    My conclusion is that the Starr deal is a sure indicator of fraud for the reasons outlines above.
    13 Feb 2011, 01:03 PM Reply Like
  • Dkincyder
    , contributor
    Comment (1) | Send Message
     
    You hit the nail on the head -- the put option deal creates a massive incentive to fraudulently report earnings.

     

    A few critical things that haven't been mentioned:

     

    1) China is a massively corrupt country and statistics from there are notiriously unreliable. We have absolutely no idea how much money this company is or is not earning in its home turf and any sales figures should be taken with a bucket of salt.

     

    2) The CEO and a number of other CCME principals are very politically connected. The CEO has a long track record in the Chinese Communist Party and appears to be very close to provincial government regulators. That further increases the opportunities for this company to receive undue accreditation in China, and to commit illegal acts with impunity.

     

    3) Starr and other (non-director) related parties are themselves opaque offshore entities, and the founder of Starr was implicated in a serious scandal some years back. As a result, it is nearly impossible to accurately assess the asset and share transactions within this company.

     

    The point is, that the financial reports of CCME are a riddle wrapped in an enigma. We are talking about a company run by politically-exposed individuals operating is a highly corrupt country, and whose largest (non-director) shareholders are opaque offshore vehicles.

     

    Muddy Waters' findings could be the tip of the iceberg.
    19 Feb 2011, 11:04 AM Reply Like
  • noahfarb
    , contributor
    Comments (5) | Send Message
     
    Author’s reply » VERY interesting article:

     

    ibankcoin.com/flyblog/.../
    12 Feb 2011, 03:19 PM Reply Like
  • Hielko
    , contributor
    Comments (27) | Send Message
     
    That must be one of the most retarded articles I have ever seen - and the author has to be willingly distorting (calling it distoring is too kind - it's just a lie) the facts. He shows that starting with 360,000$ position long (!!!!) in the stocks suggested by Citron the current position would be 247,00$.

     

    So if we would have been short those stocks we would have made a lot of money, and this doesn't even include the fact that the general direction of the stock markets has been up-up-up the past two years making the results only more impressive.
    12 Feb 2011, 07:24 PM Reply Like
  • nomad mike
    , contributor
    Comments (11) | Send Message
     
    No, you misread it. If you'd gone short with $10,000 everytime Citron issued a report against a target your overall portfolio would have lost 30%. Learn to read.
    12 Feb 2011, 08:45 PM Reply Like
  • Hielko
    , contributor
    Comments (27) | Send Message
     
    I have no idea what they did in the spreadshead, but some things certainly don't add up. First line:

     

    CCME went from 17,84 to 13,89 accourding to the spreadsheet, and this results in a loss of 22,14% while short!?!?!

     

    And besides this fact; Citron published their research on 30th january - the weekend - the previous friday it was still trading at 20.86. It dropped to 17,84 based on the Citron report.
    13 Feb 2011, 08:01 AM Reply Like
  • nomad mike
    , contributor
    Comments (11) | Send Message
     
    Look at column F. If it's positive, that's a win for Citron, if it's negative that's a loss. Look at the total at the bottom, more than $100k in losses from following them.

     

    As for your complaint about dates, the chart is meant to show what would happen if you follow their calls, which by definition means you must do it while the market is open. Perhaps some of their naked shorting hedge fund buddies got to short it at 20.86 on Friday, but then that would seem to prove they're a bunch of fraudsters, no?
    13 Feb 2011, 10:38 AM Reply Like
  • Hielko
    , contributor
    Comments (27) | Send Message
     
    I've checked the numbers, and the results are correct although they present it wrong (the sum of column G should be -472125, showing indeed a loss starting with a -320000 short position - aka -31% return).

     

    But if you remove double listed companies - only go short the companies the first time they are mentioned - you will see that citron is outperforming the S&P500 significantly. I have uploaded a copy of the results here: tweakers.net/ext/f/1qL...

     

    Citron archieves a return of -11 percent the past two years while going short in the S&P500 at the same times and with the same amounts of money would have resulted in a return of -28 percent. That's pretty good.

     

    And my complaint about the dates is very valid. Just because you are not able to match their results, it doesn't mean that it's not valid. Lets say they would short a stock on friday at 10$, release a report on saturday that it's a scam, and on sunday management says that citron is right, and on monday it opens on a penny. That would make it a very impressive call, and at the same time no-one else would be able to profit.

     

    Final note; Usually it will take time before a short (or long) thesis is proven correct, so it logical that the recent performance is not that impressive as past performance. And the almost 100% hit rate from 2001 till 2008 is not something you should easily dismiss.
    13 Feb 2011, 12:53 PM Reply Like
  • nomad mike
    , contributor
    Comments (11) | Send Message
     
    OK, I think you're wrong to throw out the double entries which are there for when citron came out with multiple hit pieces, but regardless, you're admitting that for the last 2 years, following their picks would cause you to lose money.

     

    And there's no reason to use shorting the S&P as a benchmark. The bottom line is the last 2 years, when they focused primarily on Chinese stocks they've got a terrible track record. Thanks for agreeing with me.
    13 Feb 2011, 02:38 PM Reply Like
  • Hielko
    , contributor
    Comments (27) | Send Message
     
    Lol, no. Following their picks would have made you money, because if you sell a stock short you get money that you can put in an equally big long position. And if the long position generates more money that the short position is losing - which would be the case here - you make some nice free money.

     

    And yes, I agree with you; the S&P500 is a kinda random benchmark. We probably should use something that is some small/mid cap focused since their picks are in that segment, and in that case the outperformance would be even better (since smallcaps have outperformed large caps the past two years).
    13 Feb 2011, 03:05 PM Reply Like
  • nomad mike
    , contributor
    Comments (11) | Send Message
     
    No matter how much you want to tell me the black is white, you're wrong. Their picks would lose you money. Covering their shorts, per your graph, you'd lose $25k.
    13 Feb 2011, 03:27 PM Reply Like
  • nomad mike
    , contributor
    Comments (11) | Send Message
     
    And it's absurd to claim that you should factor in what you could have done with the money to their returns. Shall I claim that I could have bought a lottery ticket and won $200 mil, therefore their returns are actually 10,000%? Of course not.

     

    The bottom line is their picks over the last 2 years have been losers, you'd have been better off doing the opposite. Just on the basis of picking shorts that would perform well they're doing terrible. Their record of predictions for what would happen to their picks on average is even worse given the magnitude of their claims. How many times have they claimed a company was engaging in massive fraud or didn't exist? Yet somehow, on the average over the last 2 years their picks, rather than go out of business have gone up by an average of 10%, according to your own spreadsheet.
    13 Feb 2011, 03:44 PM Reply Like
  • noahfarb
    , contributor
    Comments (5) | Send Message
     
    Author’s reply » A point that is being disregarded with respect to CItron's record, is that they allege more or less outright fraud. I.e. these companies should be worthless. It would seem that their research reports generally take the stance that it would be wise for an investor to short the stock and ride it all the way to zero. Now it can take some time for a fraud to be fully uncovered (case study: Allied Capital), but it just doesn't look like Citron's record is all that good on this basis.

     

    Let's say, hypothetically, that 20% of the firms he called frauds were in fact fraudulent. I do not find that to be a strong record, because fraud is a very serious allegation, and if you call someone a fraud, crook, or whatever, you better damn well be right.
    13 Feb 2011, 04:40 PM Reply Like
  • nomad mike
    , contributor
    Comments (11) | Send Message
     
    Exactly!

     

    This isn't a research company that is just saying "Company X is overvalued, it should be valued at 75% of what it's currently trading for." They're repeatedly claiming or implying that the companies they write up will go bust. The mere fact that the vast majority of their targets from the past 2 years are still going concerns is a total refutation of their credibility.
    13 Feb 2011, 04:58 PM Reply Like
  • nomad mike
    , contributor
    Comments (11) | Send Message
     
    Just noticed you have LPHI listed 3 times, pulling that one out will make their record even worse.
    13 Feb 2011, 05:02 PM Reply Like
  • BullMarket
    , contributor
    Comments (67) | Send Message
     
    Noahfarb:

     

    Fantastic analysis. You hit the nail on the head with this analysis, "... if fraud were uncovered, this put option would likely wipe out the CEO entirely."

     

    That's why CCME is as sure a thing as CCME's CEO wanting to be wealthy.

     

    -Andrew
    12 Feb 2011, 08:30 PM Reply Like
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