The Red Collar Crime Wave
- Joshua M Brown
- May 15th, 2011
We are under attack.
Chinese corporate criminals and their US-based enablers are committing Capital Genocide against American investors. We're not talking about "a few bad apples" or "a handful of exceptions", we're talking about a full-blown epidemic. Subterfuge and malicious avarice are simply the tools of the trade when many Chinese companies do business with outsiders.
This undeniable Red Collar Crime Wave is larger in scope and financial consequence than any other international criminal enterprise in the history of the world. We are talking about hundreds of millions of dollars, possibly billions should the Yahoo - Alibaba revelation prove itself to be a harbinger of shocks to come.
At the low end of the spectrum, corrupt representatives of sketchy or even non-existent Chinese companies are conniving their way onto US exchanges via backdoor IPOs, reverse mergers and SPACs. They are slithering through every exchange and regulatory loophole they can find to raise money and establish their fraudulent beachheads here. The penalties for Chinese nationals fudging numbers on a local exchange could range from exile to imprisonment to disappearance. The penalties they face for pulling that stuff here in the US? I don't know, a letter in the mail? "Don't ever do it again"?
Mainland Chinese fraudsters are untouchable, they can only be barred or banned from US exchanges once caught, and so they will get away with whatever they can as long as there are investors here who are stupid enough to capitalize them. And so the ownership of one factory in China becomes the ownership of three for the purposes of a quarterly balance sheet calculation. The ticker symbols will be cutesy and clever while the names of the companies will almost always include the word "China". After all, let's not forget that the name of this game is the exploitation of Americans who "want to play the growth".
It has become an absolute free-for-all.
For a nation that was so economically backwards and pathetic that it could barely feed itself 15 years ago, China's executives have certainly come a long way. They're employing every scam and dirty trick in the book against American corporations and investors while we say thank you and send even more opportunity and cash their way.
I've held my tongue for the last 9 months, watching one scam after another appear on our exchanges. I've said nothing as these financial landmines have been detonated beneath the feet of whichever unfortunate shareholders happened to find themselves in the wrong place at the wrong time. No longer.
We'll limit the scope of my rage here to corporate fraud. For the purposes of this post I'll leave out the Chinese poisoning of America-bound toothpaste, pet food and toys at their manufacturing operations. I'll also leave out the FoxConn factory at which all the Apple products are assembled, a workplace so abusive and abhorrent that the employees must take an oath that they won't kill themselves.
But no, let's not get distracted here, we should simply focus on the accounting chicanery and falsified filings with which Chinese companies are daily relieving US investors of their capital.
The reverse mergers are by far the most insidious manifestation of the contempt that Chinese companies have for our exchanges and rules. Working with American law firms and shameless stock promoters, these companies have found a financial engineering solution that lets them steal on our shores. They've been able to subvert the more highly scrutinized public offering process that would normally have weeded them out. By "cleaning up" shell companies, which should not be trading or available to begin with, the disease gets a foothold first on the pink sheets and then onto the American Stock Exchange where the real grifting can begin.
White Collar Crime columnist Walter Pavlo has collected a slew of recent examples on his blog at Forbes, including:
- China Electric Motor – Shareholders lawsuit filed claiming underwriters violated federal securities laws by issuing materially false and misleading information.
- China Natural Gas – Class action lawsuit alleges directors and officers issued materially false and misleading statements. CFO of company resigned in late 2010.
- Duoyuan Printing – SEC investigating company for fraud, NYSE delisted April 4, 2011
- China MediaExpress Holdings, Inc. – Deloitte quit as auditor because “no longer able to rely on the representations of management”. CFO resigned. Stock trading halted March 11
- China Agritech – Shareholder lawsuit pending. Dismissed its auditor Ernst & Young.
- China Sky One Medical – Under investigation by SEC.
- Orient Paper, Inc. – Reauditing previous financials due to license issues with previous auditor (Davis Accounting Group)
The full list is actually quite larger, it includes some of the higher profile blow-ups you may remember with stocks like RINO International and China Green Agriculture - spectacular flame-outs complete with massive insider selling prior to the denouement.
Where are the regulators, you might ask? They are finally getting involved. The SEC's Mary Schapiro is aware of the epidemic and is now on the case...
Since March 2011 alone, she noted, more than 24 China-based companies have disclosed auditor resignations, accounting problems or both – following the auditors' inability to confirm the amounts of cash or receivables shown on the companies' balance sheets. The SEC has recently suspended trading in three Chinese businesses that "reverse-merged" into U.S.-traded shell companies
The smarter thing to do would be to halt the entire shell company process in its entirety right this minute until we can get the rules up to a standard that will protect investors outright from these foreign liars and thieves. Capital formation can wait fifteen minutes while we get our act together and crack down on this disgusting shell syndicate.
An even more disturbing development of late is taking place in the large cap arena, in full view of the world's media and the global investor class. With the success of Baidu and Sina, Chinese technology companies are now finding themselves as the Belles of the Ball. In at least one case that we are aware of, they are also finding that they can easily mislead their Western partners and shareholders.
Here in the deep end of the pool, newly-minted billionaire Chinese executives are violating contract law, globally accepted corporate best practices and fiduciary responsibility to shareholders. They are disclosing things when and as they choose. They are "on the level" in their own government's eyes so long as they are playing fair with their fellow Chinese investors. This isn't a brand new phenomenon but as the companies involved get bigger, the danger grows.
This week's still-unfolding fiasco involving Yahoo being tricked out of their Alipay subsidiary by Alibaba, a company in which they hold a 43% stake, is just the latest and most outrageous example of what we're dealing with. Here's what Jacob S. Frenkel, a former SEC enforcement lawyer who is an expert in securities law matters and a partner at Shulman Rogers in Potomac, Maryland had to say (via iChinaStock):
"Yahoo! is a victim, plain and simple. With all the negative attention that US-listed Chinese companies, this action by Alibaba only makes worse an already difficult situation. It creates the unfortunate appearance that executives in China may totally disregard their contractual and fiduciary obligations to shareholders. The important message to US partners and owners is to review the effectiveness and enforceability of contracts under both US and Chinese law."
Yahoo will attempt to sue, but they have lost the asset at the end of the day, an asset whose potential was a big part of the investment thesis for the company to begin with. US shareholders were pummeled over something that took place in secret seven months ago, escaping everyone's notice. If major shareholders like Yahoo and Japan's Softbank can be scammed in front of everyone, what chance have any of us got?
The Red Collar crime wave is beguiling American investors both large and small. These crooks are laughing at our securities laws and manipulating their own. None of us are immune:
Not the savviest and most seasoned asset managers - see Glickenhaus & Co watch $4 million evaporate as China Agritech blows up. (Bloomberg)
Not Yahoo, a player in Asian web properties since the late 90's - listen as Alipay's Jack Ma regales us with his tale of how he bitch-slapped the "declining" web portal company. (iChinaStock)
Not even the diligent Warren Buffett can sleep soundly with his Chinese investments - see how the car company he invested in there (BYD) is essentially a counterfeiter playing games with the rules of the Chinese court system to get away with it. (Reuters)
Can American investors trade and hold Chinese stocks? I suppose they can...but they can also practice juggling with live hand grenades and roaring chainsaws...just because you can do something, doesn't mean you should.
I've disagreed with almost everything Donald Trump has had to say during his part-Presidential run, part final humiliation speech circuit this spring. But where Trump and I do find common ground is in our distaste with how the Chinese do business and the lack of regard they show our companies and investors from almost every perspective.
As long as Chinese corporate officers and executives are going to blow cigarette smoke in our faces as they take advantage both here and on their home turf, I'll gladly sit out. Until I get the sense that they have an ounce of respect for our investors, I'll watch the pickpocketing from the sidelines and focus my capital and attention elsewhere.
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The Reformed Broker is a blog about financial markets and the economy. Joshua Brown is a New York City-based investment advisor for high net worth individuals, charitable foundations, retirement plans and corporations... More.