Tiger Woman on Wall Stree (20 page)

At the same time that many American investors were trying to get their money into China to benefit from its economic growth, Chinese investors were trying to get their money out—even if they had to break the law to do so. A survey by Global Financial Integrity, a nonprofit research organization in Washington, D.C., showed that China was the source of nearly half of the world’s $5.9 trillion in illicit capital flows, or money that leaves its home country illegally,
between 2001 and 2010
.

There is a gaping disconnect between the American perception of modern China’s economic miracle and its reality. China’s economy is buzzing, but it hinges on an institutional environment in which the rule of law and transparency have not kept up with its growth and success. Despite the vast wealth generated in China over the past 30 plus years, the country has begun to stall. Fear, uncertainty, and a sense of injustice and resentment toward the government are prominent, including among those who work for it and benefit from the unequal opportunity. This disconnect might take a while to travel to the Western world and reach U.S. investors, but ultimately it is sure to get there. It is just a matter of when.

February 2011

M
Y SIX-WEEK TRIP TO
C
HINA WAS PRODUCTIVE FOR WORK AND
for healing on a personal level. Being close to my family provided much-needed strength and confidence to start a new chapter in my life in New York. At the same time, everything I saw in China convinced me that both Wall Street and the rest of the world had gotten the China growth story wrong.

On the 14-hour flight from Shanghai to New York, my mind was buzzing with new ideas. The conversation with Nick and my private equity friend, enhanced by Johnnie Walker and green tea in the lobby of the Four Seasons; the visit to my childhood home and Nanjing Road, so transformed with its neon lights and luxury brand stores; the milk scandals, the high-speed rail crash, the rampant growth of Macau casino business, and the burgeoning corruption economy—all swam around in my mind.

The China miracle had happened all too fast, at the cost of the quality of the transformation. Those who have spotted the disconnect between the quality and quantity of China’s growth are still ahead of the curve and stand to profit handsomely from
this observation—or at least not crash and burn when the illusion crumbles.

  *  *  *  

My plane came to a halt outside the gate at JFK airport. I collected my luggage and wheeled it outside to wait in the taxi line. The New York air felt pristine and fresh compared with the thick Shanghai smog I had breathed in just hours before. I inhaled deeply. Then the ping of my BlackBerry brought me back to earth.

Skimming through the dozens of e-mails I had received during the flight, one caught my eye. An independent research firm had issued a report alleging that CLF was a fraud and detailing its dubious corporate governance and financial reporting. The report alleged that the company’s managers pocketed most of the proceeds they raised from shareholders for personal use, rather than buying equipment to grow the business as promised. The report backed up its claims with photos of idle factories, empty store shelves, and interviews with purported clients who claimed they actually had no affiliation with CLF.

In the following months, CLF failed to file its annual report for 2010 and fired its auditor, Ernst & Young, one of the Big Four accounting firms. As a result, Nasdaq halted trading in the company’s stock in May 2011.

The banker buddy I bumped into at the Four Seasons did not fare any better. Shortly after I returned, I read in the news that the SEC was investigating Nick’s advisory firm regarding its activities in China, although I never heard any definitive results.

As in many other SEC investigations of U.S.-listed Chinese companies, no one was ultimately held responsible for these frauds. CLF’s managers are still at large and living well on the money they stole from investors, just like many other Chinese executives who were involved in fraudulent dealings. The company’s stock is still
drifting on the Pink Sheets, an over-the-counter market with fewer restrictions than the Nasdaq.

CLF’s downfall held an important lesson for investors: stick to sizable companies with proven operating records in major cities. The longer a company is around, the more historical information its investors have to base their analyses on. The company’s location can also affect its performance. Small companies in obscure locales have a hard time accessing and retaining talent; therefore the quality of their employees and their management is often compromised.

CLF was just one of the many Chinese frauds that floated to the surface in 2010 and 2011. Several independent research firms had begun making names for themselves by uncovering suspicious practices at Chinese companies in a broad range of industries. These research outfits were mostly small or even one-person firms, staffed by forensic accounting nerds and former investment bankers who operated out of homes and coffee shops. They worked like a pack of lions, circling the herd and separating the weakest companies for the kill.

Muddy Waters, the China-focused research firm, emerged as the most influential of these outfits. Carson Block, its Harvard-educated American founder, had possibly been burned a few times doing business in China. Muddy Waters’ business model is to uncover fraudulent business practices.

Block issues only one rating on the companies he covers: strong sell. Judging from stock price movements around the time he publishes his reports, most of Muddy Waters’ clients are fast-moving hedge funds equipped with short-selling instruments—as well as perhaps some mutual funds, which subscribe to his research
to avoid any stock in his radar screen. Here’s how I believe the model works: Block typically sells his latest findings about a specific target to his inner circle of clients first, allowing them time to build a short position (or unload a long position) on a stock. Then he hands the evidence he has gathered to regulators such as the SEC, sometimes prompting an investigation and therefore investor panic. Finally, he releases a report, filled with data, pictures from on-site visits, interviews with related parties, and other supporting evidence, detailing how the target of his allegations has committed misconduct or fraud.

As Block built up his credibility, his attacks became self-fulfilling prophecies. Just by issuing a report, Muddy Waters would trigger panic selling and a sharp decline in the value of the stock, enabling his clients to make a handsome profit or avoid a deep loss. Although it has never been publicly stated, I suspect that this is his business model.

Block got his big break uncovering a company called Sino-Forest, which many American investors consider the granddaddy of Chinese frauds. Block’s 40-page report described how the Chinese lumber company milked $6.1 billion from the Toronto exchange, essentially by erecting a Ponzi scheme. Block showed step-by-step, with photographs, charts, and diagrams, how the company fabricated its assets, inventory, and employee numbers, and booked phantom transactions. Sino-Forest’s shares plunged by 82 percent immediately after the report was published.

Sino-Forest fooled several high-profile investors, including John Paulson, the hedge fund titan who reaped an estimated $3 billion to $4 billion betting against the U.S. housing market (believed to be the largest one-year payday in Wall Street history). But the ingenious Mr. Paulson was not able to avoid a loss of $720 million on his bet on this Chinese company, an expensive price to pay for his China wake-up call.

Paulson was not the only hedge fund titan who got burned by China: Hank Greenberg, the former CEO of insurance company AIG, had his fund Starr International defrauded by a company called China Media Express, a bus advertising company with a
$400 million market cap
.

Sino-Forest stirred market panic, but it was Longtop Financial Technologies that finally galvanized the SEC to go after Chinese criminals. The outing of the Chinese financial software company as a fraud provoked a vehement outcry from its outraged shareholders, among them some of the world’s largest money managers.

Longtop was a seemingly first-rate company: Goldman Sachs and Deutsche Bank underwrote its 2007 IPO, and U.S. investors awarded the company a valuation of more than
$1 billion
. Longtop counted among its clients some of China’s most prestigious financial institutions, including China Construction Bank and Agricultural Bank of China. But in April 2011, a short-seller firm named Citron published a report alleging that Longtop had fabricated its balance sheets. The company’s auditor, Deloitte Touche Tohmatsu confirmed in its resignation letter one month later that the company’s financial statements
were inaccurate
.

Deloitte, which had given clean audit opinions to Longtop for six consecutive years, alleged that it had been in the dark until it finally showed up at the bank to check Longtop’s financial statements. Only then did the auditors realize that Longtop did not have the cash it reported; instead, it had “significant bank borrowings” not reflected in the company’s books. When being questioned about its auditing quality, Deloitte defended itself by claiming that it had followed proper procedures to confirm the company’s bank accounts (although via e-mail) but that it failed to detect the fraud because Longtop colluded with bankers at the branch level. Longtop’s management later admitted to its auditor that the company had effectively been running a Ponzi scheme. But as of mid-2013, the CEO had not been prosecuted.

I personally met and interviewed Longtop’s CFO a few times at various investor conferences after its IPO. I tried but failed to arrange calls with IT executives at banks alleged to be Longtop’s clients. Typically, small companies in both China and the United States were eager to put me in touch with their supply chain, both as a goodwill gesture and as a means to convince a potential investor that firms should give them money to grow. But Longtop’s clients, the state-run Chinese banks, mostly ignored investors’ attempts to conduct due diligence because they considered themselves as bankers to be a strategic industry in possession of confidential government information. So instead I went to Longtop’s competitors, other IT outsourcing companies that sold similar products to banks. No one I spoke with found Longtop’s margins credible. Longtop consistently reported a 64 percent profit margin, almost double the average profit margin of 35 percent for the IT outsourcing industry.

My gut reminded me that if something looks too good to be true, it usually is. So I built a short position, even in the absence of perfect information. By that time, I had come to trust the instinct I had honed by analyzing similar situations. Whether American or Chinese, companies are run by people, and human behavior shares a lot of commonalities.

The case of Longtop demonstrated why investors, especially foreign ones, must have investigative due diligence capacity and a reliable network of contacts on the ground in China. In the United States, investors rely on reputable auditing firms to verify the integrity of a company’s financial records. The Longtop case showed that even reputable Big Four accounting firms are not entirely adequate in China, and it also made it clear that having high-profile names among a company’s investors or underwriters does not
preclude the possibility of fraud
.

If management cannot be trusted and if auditors and other institutional checks and balances are similarly tainted, investors
must bear the responsibility of doing their own due diligence from the bottom up—for most, a daunting challenge. Performing exhaustive and meticulous channel checks is the only way for investors to penetrate China’s many layers of opacity (government and corporations) and avoid being conned. Unless one has a network of reliable local intelligence as well as a thorough understanding of Chinese culture to decode the data, it is impossible to eliminate risk altogether. If investors lack the infrastructure and network to provide them with exhaustive due diligence, they are better off not investing at all.

Longtop’s downfall triggered a flurry of investigations into China-based listed companies and auditors, as angry investors who suffered losses in the hundreds of millions of dollars turned to the SEC for “justice.” But the SEC’s ability to impose legal repercussions on foreign private issuers like Longtop was limited due to the conflicting laws of the two jurisdictions—China, where the companies were registered and operated, and the United States, where they raised financing by issuing securities. Foreign private issuers, including all China-based U.S.-listed companies, had never been subject to the same compliance measures as U.S.-registered entities. However, U.S. investors caught up in the China gold rush often ignored this critical risk. For its part, the SEC did not adequately highlight the risks inherent in investing in non-U.S.-registered foreign entities until after the damage was done.

Under U.S. securities law, the SEC was empowered to investigate alleged fraud and subpoena financial records from a company’s auditors. Under Chinese laws, however, such records were deemed sovereign confidential material and sometimes even “state secrets,” and therefore they could not be shared with a U.S. regulatory body (although it is hard to believe that a fertilizer company like CLF would possess any sovereign secrets). Without the cooperation of the Chinese government, U.S. regulators and
prosecutors had no means to punish Chinese managers and their affiliates and bring justice to U.S. investors.

In the end, short sellers played a far more significant role than the SEC in unearthing fraud and encouraging transparency in China by exposing unethical and unlawful corporate behavior. Short sellers may be unpopular, but they help investors minimize risk in the long run by improving and maintaining the market’s integrity.

  *  *  *  

The lack of transparency was a problem not just for stock investors but also for the American and multinational companies that bought businesses and assets in China. The financial crisis in the West prompted a cross-border M&A wave, and even some of the world’s most notable international companies, including Caterpillar, were fooled into purchasing Chinese businesses rife with corporate governance issues or outright fraud.