Avoiding foreign-based fraud
An investor warning about firms abroad that went public in the U.S.
By Erin E. Arvedlund
First, let’s address how to avoid foreign-based frauds listed in the United States. Second, it’s important to understand that the underlying growth of the Chinese economy might be taking a breather soon.
The Securities and Exchange Commissionissued a recent bulletin warning investors about foreign companies, especially those domiciled in China, entering U.S. capital markets by way of reverse merger.
The Chinese companies that came over to list in the United States were a mixed bag: Some were private and some were already public, but they merged with a U.S. shell company that was also already public. Thus, reverse merger.
Both the NYSE and NASDAQ have halted trading in these reverse-merged companies and the Public Company Accounting Oversight Board has pressured accounting and auditing firms working for U.S. public companies to raise their standards.
Some of America’s biggest mutual funds invested in (and were fooled by) Longtop Financial (symbol: LFT), a Chinese software company that went public here in 2007. This was no backdoor reverse-merger either; Longtop’s IPO was underwritten by Goldman Sachs and Deutsche Bank. Then on May 22 of this year, Longtop’s auditor, Deloitte Touche Tohmatsu, resigned, alleging it had found fake revenues in company financials. The SEC halted trading in the stock and is now investigating Deloitte’s claims.
Among the biggest shareholders in Longtop were household mutual fund names: Calamos Growth Fund, Fidelity Advisor Mid-Cap II Fund, Munder Mid-Cap Core Growth Fund, Janus Global Technology Fund, and Legg Mason ClearBridge Small Cap Growth Fund.
Chinese conglomerate and timber concern Sino-Forest (TRE) is also under investigation, and huge institutions such as Davis New York Venture Fund, Ivy Global Natural Resources Fund, Growth Fund of America, Hartford Capital Appreciation Fund, and billionaire hedge-fund manager John Paulson were all heavy investors in Sino-Forest. China MediaExpress Holdings Inc. (CCME), the provider of advertising on buses in China, has seen its stock delisted from NASDAQ.
An SEC task force is now looking for fraud in overseas companies with listings on U.S. exchanges, with particular interest in Chinese reverse-mergers. The agency has revoked the registrations of nearly a dozen China-based companies, and more than 24 firms have disclosed auditor resignations or accounting problems to the agency. (If you have suspicions about any frauds yourself, you can always report them to the SEC’s director of the Philadelphia office, Daniel Hawke, now also head of a new task force charged with cracking down on a variety of market abuses.)
Norm Goldberger, the head of Ballard Spahr L.L.P.’s securities litigation practice, has experience with Chinese reverse-merged companies and has been counseling investors in ways to avoid becoming a victim of these frauds.
“Make sure the company has assets in the U.S., real plants and real bank accounts,” he advises, so they have U.S.-based collateral. SEC registration statements should tell you where the bank accounts are located. “The other thing to look for is directors and officers who reside in the U.S., and who carry Directors & Officers insurance,” which at least offers someone to sue in case of fraud, Goldberger adds.
Then there is the possibility that China’s red-hot economic growth may slow, which would mean these companies might not be the best investment anyway until the next wave of emerging-market dynamism.
Already some other new listings, such as Chinese social network Renren (RENN), China Xiniya Fashion Ltd. (XNY), and Internet television company Youku.com (YOKU) have declined in value.
Michael Aronstein, president of Marketfield Asset Management, told Bloomberg News, “China . . . is going to disappoint people. The basis was sound fundamentally initially . . . so you had a tremendous influx of capital. Now it’s just a flows story.” That is, investor money is gaining traction due to popularity, not necessarily good fundamentals.
Kynikos hedge-fund manager Jim Chanos has said U.S. investors are “not bearish enough” on Chinese real estate, which he argues is approaching bubble proportions.
But fraud – as in Enron, WorldCom, Tyco, Fannie Mae, and Freddie Mac – is universal. Beware when you read warnings like this: China Century Dragon Media (CDM), a Chinese television-advertising firm that went public in February, warned it may “experience difficulties in implementing and maintaining adequate internal controls.” Trading was halted in the stock in March.