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CCME Fraud Debate- Teeth in the Starr deal

|Includes: China MediaExpress Holdings, Inc. (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