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Fraud at Chinese Companies Raise Questions of Transparency and Oversight

SEC Brings Charges against Ming Zhao, chairman of Puda Coal Inc., and its former CEO, Liping Zhu

I have previously blogged about ethical problems in Chinese Businesses and financial reporting practices that bring into question the trustworthiness of accounting and financial reporting practices by Chinese companies. In particular, a massive fraud at Longtop Financial, a popular Chinese software company raises doubts about whether and when China will be accepted as playing by the free market rules that depend on financial accuracy and transparency.

Additional problems have been identified by federal regulators after filing civil fraud charges on February 22 against the chairman and the former CEO of a Chinese company, accusing them of duping people to invest in a coal company that was an empty shell.

According to the Associated Press, The Securities and Exchange Commission announced the charges against Ming Zhao, chairman of Puda Coal Inc., and its former CEO, Liping Zhu. The SEC said they conspired to “loot” and sell the company’s main asset, a coal mining firm.

Puda Coal’s stock traded on the New York Stock Exchange from September 2009 to August 2011. The SEC said Zhao and Zhu raised money from U.S. investors in two public stock offerings during which time they stole and sold the company’s assets before they raised more than $100 million from public investors in the United States.

Because Zhao and Zhu failed to disclose their moves in regulatory filings, the investors were unaware that Puda Coal no longer owned the coal mining firm and was a shell company with no business operations, the SEC said in a lawsuit filed in federal court in Manhattan.

Their “massive fraud ... wiped out hundreds of millions of dollars in shareholder value,” George Canellos, director of the SEC’s New York regional office, said in a statement.

The agency also alleged that Zhao and Zhu obstructed its investigation of Puda Coal, forging a letter from a large Chinese state-owned financial firm attesting that the coal company’s investors weren’t harmed by the sale of the mining firm.

The SEC is seeking unspecified fines and restitution from Zhao and Zhu, and a ban against them serving as officers or directors of any public company.

There have been troubles at several other Chinese companies, most of which went public in the U.S. through a back-door procedure known as a reverse merger that doesn’t require an initial public offering. A private company can access the public markets by buying a shell company that is already listed.

The most interesting aspect of the Puda Coal case is how easy it turned out to be to discover the fraud. It was basically spelled out in documents that were publicly available in China months before American and Canadian investment banks, advised by major law firms, raised the money from investors. But it appears no one bothered to look — not the underwriters and not the auditors.

“They charge a lot for due diligence,” says the man who uncovered the fraud, Dan David, a 43-year-old money manager from Skippack, Pa. “But they don’t do it.”

What the documents showed was laid out last week by the S.E.C. Puda’s principal asset was a coal mining company, Shanxi Puda Coal. But in 2009, chairman Zhao transferred that interest from Puda to himself. The next year, he sold a controlling interest in it to Citic.

Puda, which had gone public in the US through a merger with a shell company in 2005, did not disclose those crucial facts when, in February 2010, it raised $12.8 million selling stock to American investors, in an offering underwritten by Brean Murray, Carret & Company of New York and Newbridge Securities of Fort Lauderdale, Fla. In December 2010, a $100 million share sale was underwritten by Macquarie Capital, a Canadian firm, and Brean Murray. Investors in that offering paid $12 a share for stock that now trades for about 25 cents.

The fraud blew up last spring. On Friday, April 8, Mr. David posted his analysis on his Web site, GeoInvesting, and a similar analysis was posted on the Web site of Alfred Little, a firm that had a reputation for spotting Chinese frauds. That analysis was unsigned, but it was written by Andrew Wong, the head of the IFRA Group, a Hong Kong research firm.

“In contrast to most of the other Chinese frauds, where the business was not real, this was a profitable company that the chairman just stole,” Wong said in an interview last week. He said he had looked into the company after David asked him to review his own research.

“Incredibly,” Wong wrote in his report, “Puda’s auditor, Moore Stephens, failed to catch this theft of an entire company that is clearly documented in government ownership filings that any lawyer can obtain directly from the source.” In July, Stephens quit as the company’s auditor and said its previous audits could not be relied on.

The company’s audit committee investigated the allegations, and eventually concluded they were accurate. But there was contradictory statement by Zhao who in April produced a letter, ostensibly from Citic, saying that it had not purchased the company, and sought to reassure investors by saying he was considering taking the company private at $12 a share. Eventually, Citic said the letter was false, and the company said Mr. Zhao had admitted forging it.

The readily available documents were filed with China’s State Administration for Industry and Commerce, known as S.A.I.C., showing transactions affecting the filing companies. Chinese companies must publish lists of all their subsidiaries, and it is necessary to check filings by all the subsidiaries.

The Chinese authorities appear thus far to have shown no interest in bringing charges against the men named by the S.E.C. and, according to David, the Chinese government was restricting access to some S.A.I.C. filings and asking why people they were interested in a certain company, a fact that has scared some investigators who fear reprisals.

A basic requirement of investment markets is for investors to have a reasonable confidence that they are not being defrauded, and — if it turns out they are — that the government will seek to punish those responsible. It is quite clear to me that businesses in China have failed to establish a corporate governance system that prevents fraud from occurring and fully discloses it when it does occur. For those of you who are considering investing in Chinese companies to take advantage of their economic boom I can only offer two words of advice – caveat emptor.

Blog posted by Steven Mintz, aka Ethics Sage, on February 27, 2012