Posts Tagged ‘China fraud’

Deloitte’s China woes have gone from bad to worse.

Latest Muddy Waters target Focus Media (FMCN) is yet another company with serious fraud allegations leveled against them which was audited by Deloitte. Something that has led to serious suspicions against the auditors themselves.

The company was already in trouble with American authorities following the Longtop scandal and its aftermath, where they were unable to help in the on-going investigations against the fraudulent company. Should these latest fraud allegations be proven correct, and yet another client of the company found guilty of fraudulent activities, American authorities and investors will not stay silent.

Being audited by Deloitte is becoming a burden for Chinese companies, as the markets have lost so much confidence in the auditor that all of Deloitte’s clients are suspects by association. Deloitte-audited Chinese companies are traded at a discount by some investors, government authorities are increasing their scrutiny of them, and short sellers are looking at them specifically for potential short cases.

Trying to pitch clients on the idea of trading at a discount and facing extra scrutiny from authorities and shorts will make it exceedingly hard for Deloitte to maintain its current market position. This will be especially true for the IPO market where Chinese companies are already facing increased scrutiny from the SEC, which means companies are unlikely to want to add even more potential issues to their offering.

Deloitte needs to move fast to regain the confidence of the market if they want to stay competitive in China, but this will likely be neither easy nor cheap to accomplish.

In fact, the situation has deteriorated to a point where there might have to be a token leadership change at the top, followed by a purge of the company’s entire China operations to indicate that the company is serious about getting to grips with the situation.


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Recently trading stopped on shares of Jiangbo Pharma, because the SEC wants some more information from the company. I have yet to see a good report on exactly what information has been requested, however.

This in itself is no great surprise, the company is reverse listed and used to be audited by the shorters favourite Frazer Frost, which is by now almost synonymous with fraud allegations and delistings.

What is more interesting is that on the face of it, the investment in the company still doesn’t seem so bad, as the market cap of the company was around 42 million while it held cash of 146 million (assuming we can trust the books on this). Thisseems like an odd thing to have happen until you look through their corporate structure and find that basically all of the company’s assets is sitting in the VIE for no apparent reason.

I doubt that this is what the market has been pricing the company for, however, it seems more likely that the market assumed fraudulent books and overstated profits/cash positions. But nevertheless investors could quickly learn just how much 146 million in a VIE could be worth if the owner decides to pack it up.

JGBO’s structure is a very simple VIE arrangement with the entire operating part of the company in the VIE. It should be noted that there is no legal reason for the entire company to be run as a VIE, some areas are restricted but much of it could reasonably be run through a WFOE.

Even though all of the normal contracts are in place the company appears unwilling to transfer any of their assets out of the VIE, even to the extent that they failed to make their interest payments/penalties on convertible notes in the US due to an inability to transfer money out of the VIE.

If the contracts that they claim to have are in place the money should, at the very least, be able to travel to the WFOE without much hassle or expense. Even if transferring it out of China does require SAFE approval, SAFE approval is not a valid excuse for holding all of the company’s assets in a legally questionable VIE arrangement without any security for the investors.

The company seems to be making up excuses for why the money should stay in the VIE, where the investors have questionable control over it. If this turns into a legal case involving fraud my guess is that investors will come to the stark realisation that 146 million in cash stashed in a VIE might well be worth nothing at all.

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Let’s get straight to it, this post supposes some prior knowledge of VIE structures, available at other blogs. But suffice to say that it’s a method of controlling, and consolidating companies in China without actually holding any equity ownership in them.

One of the issues with this is that no one knows whether or not these contracts are enforceable, something which is normally disclosed in the risk sections of the annual filings. It’s the one where the company’s lawyers state that the contracts are enforceable, only to use the very next statement to say that there’s so much uncertainty on the issue that they really don’t know.

Now this is all fine and dandy as long as there is disclosure on the issue, and investors know how to evaluate the risks properly. However, some companies seem intent on trying to seem much more solid than their VIE structures make them, and then we get into trouble.Investors might misunderstand the situation, and thereby not take the risks into account. But the biggest question is why a company would be so intent on hiding this structure when it has become more or less industry standard in certain areas.

Imagine if you were to find a company in a heavily regulated industry in China, say a full-blown IT company with online services and the whole shabang, claiming to have complete ownership of their entire operations. What if they even state that their ICP-license is under a wholly-owned entity (In China an ICP license can only be granted to a foreign-domestic JV, with the domestic player holding the majority, and in practice even the JV is nigh impossible as you need to get it passed government authorities)? You’d expect any such company to be called out even before listing on these strange practices.

Well, as it turns out there is a company like this currently being sued on other grounds, but for some reason it appears like they won’t get into this blatant misleading of their investors.

The company is Subaye Inc. and they are in the cloud computer services business. Here’s what their latest 10-K states as their corporate structure:

Subaye's corporate structure according to their latest 10-K

For a company that cannot possibly legally own every part of their business there’s an awful amount of 100% ownership going around!

On to there risk section where the attempts to illuminate the reader as to their actual structure could be described as lackluster at best [emphasis added]:

In order to comply with Chinese laws limiting foreign ownership of Internet and advertising businesses, we conduct our ICP (independent content provider) and online advertising businesses through our subsidiary, Guangzhou Subaye Computer Tech Limited. If the Chinese government determines that these contractual arrangements do not comply with applicable regulations, our ability to operate could be significantly reduced resulting in loss of customers and revenue.

The Chinese government restricts foreign investment in Internet and advertising businesses. Accordingly, we operate our websites and our online advertising business in China through Guangzhou Subaye Computer Tech Limited ”GZ Subaye,” our wholly-owned subsidiary. GZ Subaye holds the licenses and approvals necessary to operate our website and our online advertising business in China. We cannot assure you, however, that we will be able to enforce these contracts. Although we believe we comply with current Chinese regulations, we cannot assure you that the Chinese government would agree that these operating arrangements comply with Chinese licensing, registration or other regulatory requirements, with existing policies or with requirements or policies that may be adopted in the future. If the Chinese government determines that we do not comply with applicable law, it could revoke our business and operating licenses, require us to discontinue or restrict our operations, restrict our right to collect revenues, block our website, require us to restructure our operations, impose additional conditions or requirements with which we may not be able to comply, impose restrictions on our business operations or on our customers, or take other regulatory or enforcement actions against us that could be harmful to our business.

without getting into too much detail, they first state that the industry is restricts foreign investment, and then that in order to comply with these restrictions they operate in it through a wholly-owned subsidiary. I don’t really know quite where to start with this one, so I’ll just let it speak for itself. But the authors duly go on to show an amazing grasp of the English language when they all of a sudden say that they’re not sure if “these contracts” can be enforced, without any contracts mentioned that they could be referring back to.

This looks like a bad cut-and-paste job to me, and I think it should be added onto any lawsuit being brought against the company.

Perhaps the reason it is not brought up is that the PRC council involved actually signed off on the report, stating that the structure presented complied with current PRC legislation. This in itself is worthy of a blog post on how to judge legal opinions in Chinese statements.

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