CMFO’s Auditor’s Role in Another Alleged Fraud
ZYCPA’s Involvement in an Alleged Fraud
Please see disclosures at the bottom of this article.
Throughout my past few posts on China Marine Food Group, I have implied that the small size and unknown reputation of CMFO’s auditor, ZYCPA Company Ltd., should give investors pause.
This article takes a far more concerned stance. According to a lawsuit filed in Hong Kong last year, ZYCPA (or, more accurately, its predecessor firm) and its majority shareholder were active participants in a series of frauds committed against a foreign investor. According to the allegations, ZYCPA and the shareholder, Johnny Tang, were not mere bystanders in the fraud. Rather, Tang was allegedly an active co-conspirator who helped a Chinese businessman steal HK$108mm from the foreign investor.
My prior post on CMFO’s Xianghe acquisition provides compelling evidence that China Marine Food is defrauding investors. Specifically, I believe that the company is much smaller than its SEC filings indicate. Previously, I simply thought that the company was able to falsify its financial statements because it was receiving negligible oversight from its auditors. But if the lawsuit’s allegations are true, the actual circumstances may be far more sinister.
Primary Documents
There are several primary documents worth reading.
First, here is the Statement of Claim for the lawsuit.
Second, here is a link to a 9-page report written by Target Newspapers, a Hong Kong business periodical, discussing the lawsuit.
Third, here is a lawsuit for defamation filed by Tang against the foreign investor.
The Lawsuit
Issued on March 23, 2009, the original lawsuit is between Christian Emil Toggenburger, and two holding companies he owns, against (i) Hung Viet Derrick Luu, (ii) Zhong Yi (Hong Kong) C.P.A. Company Ltd and (iii) Ka Siu Johnny Tang (the majority shareholder of Zhong Yi).
Zhong Yi (Hong Kong) C.P.A. Company Ltd is the predecessor to ZYCPA Company Ltd, CMFO’s auditor. Zhong Yi changed its name to ZYCPA as a result of potential bad press coming out of this lawsuit.
I will first show a graphic timeline outlining the order of events that transpired during the alleged fraud.
The cast of characters are as follows:
Christian Emil Toggenberger is the foreign investor who was allegedly defrauded and was cheated out of HK$108mm.
Hung Viet Derrick Luu is the Chinese “businessman” who allegedly defrauded Toggenburger and to whom the HK$108mm was transferred.
Ka Siu Johnny Tang is the majority shareholder of ZYCPA Co. Ltd. (successor to “Zhong Yi (Hong Kong) CPA Company Ltd.”), and actively helped Luu execute the fraud, according to the allegations. ZYCPA is CMFO’s current auditor.
Here is the timeline:
The Allegations
I will first discuss a summary of the fraud allegations. Then I will focus on the active role that the majority shareholder of ZYCPA played in the fraud, according to the allegations.
The events that follow are based on the allegations in the lawsuits I provided above, primarily from Toggenburger’s original lawsuit. Tang has countersued Toggenburger for defamation. The litigation is ongoing. The following allegations have not yet been proven in a court of law, and I am merely summarizing the sequence of events as alleged in the lawsuit.
Warderly Fraud Allegation
The events began when Tang introduced Toggenburger to Luu in November 2006. Tang represented Luu to be a billionaire entrepreneur who was well-connected in China and Hong Kong.
Shortly after the initial introduction, Luu and Tang met Toggenburger in January 2007 to pitch a HK$25mm loan to Warderly International Holdings Ltd, a publicly traded company on the Hong Kong Stock Exchange. Over the course of two meetings, Luu proposed that Toggenburger make a convertible loan for HK$25mm. The loan would be convertible to 20%-25% of Warderly’s equity, or pay 2% per month for 2 years until maturity. Warderly would use the loan to acquire an oil re-processing plant in Beijing from a business partner of Luu.
Toggenburger agreed to make the investment.
In March and April 2007, Toggenburger lent HK$23mm to an intermediary escrow agent. HKD$5mm was transferred to a subsidiary of Warderly, while HK$18mm was transferred to a separate unrelated investment project of Luu’s. Luu promised Toggenburger that the HK$18mm transfer was temporary and would soon be repaid, with the funds being redirected to Warderly.
Toggenburger never received any bonds or shares of Warderly. Luu received shares in Warderly for the contribution of HK$5mm to the Warderly subsidiary, and kept the shares for himself. The remainder of Toggenburger’s investment stayed locked up in Luu’s separate investment project.
Here is a graphical representation of the flow of funds:
As we can see from the graph, HK$23mm left Toggenburger and was essentially redirected to Luu.
In April/May 2007, Tang called Toggenburger to say that Warderly “was in trouble” and the Warderly agreement “was not working out”. Simultaneously, Luu was “in trouble” and could not repay the money transferred to his investment project.
In May, shares in Warderly were suspended and in January 2008, the Warderly subsidiary in which Luu had received shares was wound up.
Toggenburger had lost HK$23mm.
Car Racing Fraud
Our story doesn’t end there.
When Toggenberger found out that his HK$23m investment was lost, he was naturally not pleased. Tang, however, told him not to worry and that Luu would make it up to Toggenburger by offering another attractive investment opportunity. Luu had an equity stake in a racing car project in mainland China, and would offer part of that stake to Toggenburger at a reduced valuation.
Specifically, in a May meeting also attended by Tang, Luu offered to sell to Toggenburger a 15% share in a car racing project in mainland China. The 15% stake was valued at ~HK$40mm, according to Luu, but he offered to sell the 15% stake at a discounted price of HK$16mm to make up for the failed Warderly investment. Luu told Toggenburger that the car racing project was so profitable that investors would earn a return of 100% on their investment every 6 months. He also said that broadcasting minutes for commercials to be shown during car races had already been sold and such cash flow alone was enough for Toggenburger to get repaid his initial investment within two months.
Tang also claimed that he had seen and checked the documentation for the project (ie. contracts with Champ Car World Series LLC, the leading US car racing association); that the project was a good investment for Toggenburger; and that it was the only way for Toggenburger to recoup his losses from Warderly.
Toggenburger agreed.
On May 21, 2007, Toggenburger paid HK$16mm to Zhong Yi as escrow agent, with the escrow agreement stipulating that the funds would be released to Luu only if the transfer of certain racing contracts were transferred to the holding company that Toggenburger was investing in.
The HK$16mm was released to Luu without this stipulation being met.
No car races have been held pursuant to the car racing project. No revenue has been earned from the car racing project. Toggenburger received no return on his investment.
Toggenburger lost HK$16mm.
Listed Company Fraud
It still doesn’t end there.
On the last week of May, Luu and Tang introduced a further investment to Toggenburger. They told Toggenburger that they could assist him to acquire a listed company (ie. a “shell” company), and that the car racing project or any of Luu’s other projects could then be injected into that shell. Luu and Toggenberger would ultimately become shareholders of the listed company.
Toggenburger agreed.
Between June and July 2007, Toggenburger wired HK$73mm to Zhong Yi CPA Company, Ltd, which again acted as the escrow agent. In July 2007, Luu and Tang introduced Toggenburger to a firm that introduced Toggenburger to the owners of a publicly listed shell company in Hong Kong. In October, Toggenburger signed a contract with the shell’s shareholders to purchase a majority of the shares of the shell.
In December, Toggenburger told Tang and Zhong Yi to transfer the escrowed funds to the shell’s shareholders. Tang told Toggenburger that there is “some problem”, and the transfer could not be carried out. Toggenburger was not able to complete the transaction with the shell’s shareholders.
In February 2008, Tang told Toggenburger that the HK$73mm “was being used in another account” belonging to Luu. It was “still locked” in Luu’s “other investments”.
Zhong Yi, acting as escrow agent, had transferred the funds to Luu and/or used them to the benefit of Luu, without the knowledge of Toggenburger.
Toggenburger had lost HK$73mm.
As collateral for the HK$73mm, Toggenburger had been given 1mm shares of China Oil and Methanol Group Inc., a company incorporated in Nevada. On June 23rd, 2007, Luu took Toggenburger on a day trip by car to Guangdong province and showed him 3 refineries, which Luu said were assets belonging to 3 of China Oil’s operating subsidiaries.
Ultimately, it surfaced that China Oil has no operating subsidiaries, does not own any industrial complexes and is not earning any revenue.
In total, Toggenburger was cheated out of HK$108m, according to the lawsuit:
Tang’s and Zhong Yi’s Roles in the Fraud
As can be seen from the above events, Tang allegedly played an active role in the frauds. He was present in many of the meetings between Luu and Toggenburger. He also allegedly made a variety of untrue claims that were fraudulent in nature.
In two instances, his majority-owned firm, Zhong Yi CPA, acted as escrow agent between Toggenburger and Luu. In both instances, Zhong Yi violated the terms of its escrow agreements and transferred funds to the benefit of Luu and to the detriment of Toggenburger.
In the car racing project, Zhong Yi CPA was contractually obligated to hold in escrow Toggenburger’s funds until certain racing contracts were transferred from Luu’s entity into another legal entity that Toggenburger was indirectly investing in, and certain other conditions pursuant to “closing” were met. Zhong Yi transferred the funds to Luu’s benefit without these conditions being met.
In the listed company fraud, Toggenburger transferred HK$73m to Zhong Yi for the purpose of investing in a listed shell company. Zhong Yi instead transferred the funds for the benefit of Luu. When Toggenburger asked for the funds to be transmitted to the owners of the shell company, Tang told him that there was “some problem” and that the funds were locked in Luu’s investments.
Tang also represented that he had viewed the car racing contracts with Champ Car, as well as the land title agreements to land near the car racing project to which Luu planned to develop properties, and to which Toggenburger was to receive interests. Instead, the Champ Car contracts were materially misrepresented to Toggenburger, and the land titles didn’t exist.
Tang was present in many of the meetings between Toggenburger and Luu, and recommended Toggenburger to invest funds with Luu. He was also responsible for originally introducing Toggenburger to Luu.
Conclusion
The same man who owns a majority stake in ZYCPA is alleged to have actively aided the defrauding of a foreign investor out of HK$108m. Johnny Tang is one of two partners at ZYCPA and its majority owner.
Investors should not be merely concerned that CMFO is receiving inadequate oversight from its auditor. They should be concerned about whether ZYCPA is actively aiding China Marine Food management in falsifying its SEC financial statements. As discussed in previous posts, the business claims made by Xianghe are simply not possible. The Xianghe financial statements are very likely falsified.
These same financial statements are audited by ZYCPA.
Disclosures:
At the time of writing, I and affiliated entities have a short position in CMFO.
In no part of this post do I attempt to provide false or misleading information. The discussion of events in this post are primarily based on allegations in a lawsuit from March 2009, which I’ve included in the post. This lawsuit is ongoing and none of the allegations have been proven in a court of law.
CMFO: 2009 SAIC financials
Today, CMFO announced that its 2009 SAIC financial statements match its 2009 SEC financial statements. I also posted a comment to that effect on Tuesday on my Seeking Alpha post on the historical SAIC financials. I’m going to re-paste that comment below:
——————-
I’ve received the 2009 SAIC financial statements and have had them translated.
The Chinese version is attached here.
The English version is attached here.
The 2009 SAIC statements match the company’s 2009 SEC financial statements.
This by no means leads me to believe that CMFO has been accurately representing itself in its SEC filings. Rather, the chief financial officer of CMFO has indicated that he was alerted several months ago to the fact that the historical SEC and SAIC financial statements did not match. An investor on sumzero.com (login required) has also identified himself as having asked the CFO about this discrepancy several months ago. I believe that as a precaution to future allegations of fraud, such as mine, China Marine Food made sure that the 2009 SAIC filings matched their 2009 SEC filings.
I believe that I have overestimated the veracity of SAIC filings in my previous article. Now I think that they can be falsified just as SEC filings can.
The chief financial officer of CMFO naturally has a different story, and I will let him argue his case on his own. Investors can then decide whether my story or his story is the more compelling one.
The mismatch between the 2006, 2007 and 2008 SEC and SAIC financial statements was one element of my case that China Marine Food is much smaller than its SEC filings indicate. The Company’s dubious acquisition of Xianghe plays a more central role in my argument.
I will end with a final point. In this link, I have included comparisons of SEC and SAIC financial statements for four companies: FUQI, YUII, SOLF and CMFO.
I provide backup for FUQI’s and YUII’s SAIC financial statements on my blog at here and here, and SOLF’s SAIC financial statements are available at www.waldomushman.com.
For FUQI, YUII and SOLF, the SAIC and SEC financial statements are in the same ballpark. But you’ll notice that the numbers are not identical; rather, Chinese GAAP and other reporting norms will always result in differences between SEC and SAIC filings. For SOLF, for instance, 2008 SAIC revenue was $809mm while 2008 SEC revenue was $712mm. Similar differences exist in other line items as well. But in CMFO’s 2009 filings, the revenue, gross profit, net income, total assets and total equity are nearly identical, different only by a couple million dollars at most. YUII’s are fairly close as well, but there are still more discrepancies than CMFO’s filings.
While it’s ironic, my evidence for fraud when looking at the 2009 SAIC financial statements is that they match the SEC filings too closely.
Disclosure: I hold a short position in CMFO.
CMFO and Xianghe: A Dubious Acquisition
This article discusses a questionable acquisition that China Marine Food made in January 2010 that was used to justify a $30mm equity capital raise.
As I wrote in my last post, the financial statements that CMFO files with the SEC are substantially different from the audited financial statements that it files with the Chinese government. Whereas companies like YUII, FUQI and SOLF have matching financials when comparing US and Chinese audited financial statements, CMFO’s revenue in its Chinese filings for 2008 were 85% lower than in its SEC filings. Other financial line items were smaller by similar orders of magnitude.
The company is falsifying one set of financial statements – that’s an obvious fact. The question facing investors is whether CMFO is falsifying the SAIC financials that they file to seven branches of their own government, or whether they’re falsifying the SEC financials that they used to raise $30mm of cash from U.S. investors in January 2010.
In this article, I explain why an acquisition that the company made in January 2010 provides strong evidence that CMFO is engaged in fraudulent activities. Specifically, the company which CMFO acquired is clearly fraudulent itself.
A Questionable Acquisition
In January, CMFO raised equity capital partly to fund an acquisition of Shishi Xianghe Food Science and Technology Co., Ltd. (“Xianghe”). Xianghe is a manufacturer of algae-based soft drinks. The purchase price was $27.8mm.
Here is the description of Xianghe’s product:
“Xianghe is a Fujian based manufacturer of the branded Hi-Power algae-based soft drinks. Hi-Power was developed by the Yellow Sea Fisheries Research Institute Chinese Academy of Fishery Sciences in coordination with the founder, Qiu Shang Jing. Hi-Power is marketed as a high-protein content drink, low in calories and fat, which provides the consumers a combination of immune system benefits, improved digestion and reductions in hyperglycemia and hypertension. Hi-Power’s target market focuses on health conscious consumers in China’s fast-growing beverage market.”
Here is a link to an informative 8k dated March 16, 2010 about the Xianghe acquisition. Most of the following discussion is disclosed in this 8K. In this link, we discuss specifically where in the 8K we get supporting material for the statements we make below.
From the 8k, we learn that Xianghe’s product actually originated in January 2009, when Qiu Shang Jing paid Yellow Sea Fisheries Research Institute (YSFRI) $8,776 for “know-how” regarding the development of an algae-based drink. To repeat, Xianghe basically began 1.5 years ago, when Mr. Qiu purchased “know-how” on how to make a certain algae-based drink for eight thousand seven hundred and seventy six dollars.
In April 2009, Mr. Qiu leased office space from CMFO (CMFO waived the rent beginning in July) to set up his new algae-drink company. On July 28, 2009, Mr. Qiu incorporated Xianghe as a legal entity with $43,979 (that’s forty three thousand, nine hundred and seventy-nine dollars). On October 2009, Mr. Qiu contributed an additional $689,504 for a total registered capital of $733,483.
Xianghe was then purchased by CMFO for $27.8mm in November 2009, through a 2-step acquisition that was completed in January 2010.
I’ll repeat the key points. Xianghe began when Mr. Qiu bought “know-how” regarding how to make an algae-based beverage for ~$9k in January 2009. Over the following 9 months, Mr. Qiu contributed an additional ~$733k (with 90% of that in October, one month before the acquisition).
In November, CMFO purchased 80% of Xianghe for $27.8mm.
Based on my calculations, Mr. Qiu achieved a 139,160% annualized return on his investment in the algae drink.
For the avoidance of doubt, here is a graphic representation of what happened.
I find it extremely implausible that a company essentially begun in January 2009 and that received less than $750k of capital in its first 11 months of operation (with 90% of that in the 10th month) would be worth $28mm at the end of the 11th month, unless it had a truly unique patent or technology. Xianghe is a maker of an algae-based beverage. I doubt that this qualifies as a sufficiently unique product that’s worth $28mm purely because of the inherent attractiveness of the product.
Equally absurd is the fact that the “know-how” which Mr. Qiu purchased for $9k is now valued on CMFO’s balance sheet at $23.5mm.
Incidentally, Li Xiaochuan is “the researcher” of YSFRI and also an independent director of CMFO.
More Dubious Financial Statements
Xianghe was begun when “know-how” was purchased in January 2009 for $9k. The company wasn’t actually incorporated until July 28, 2009.
So one would think that Xianghe would have negligible revenue and profit in its first 5 months of operations, correct?
Not according to Xianghe’s financial statements. Keep in mind that Xianghe was audited by CMFO’s same poorly qualified auditor: ZYCPA Company Ltd. ZYCPA, according to its website, has 2 partners and 25 personnel. It received its PCAOB designation in December 2008.
Between July 28, 2009 and December 31, 2009, Xianghe claims to have generated $7.6mm in revenue, $3.0mm in gross profit, $1.7mm of net profit and $1.2mm of cash flow of operations.
With approximately $742k of equity capital (comprised of $9k for know-how in January 2009, $44k of cash contribution on July 28, 2009 and $689k of cash contribution on October 8, 2009), Xianghe was somehow able to generate $7.6mm of revenue and $1.2mm of cash flow from operations in its first 5 months of operations, from selling an algae-based beverage.
Again, I’ll demonstrate my points with a graphical representation:
Conclusion
The financial statements for Xianghe provided in the 8K that is “audited” by ZYCPA are indisputably fraudulent. The Xianghe story is completely implausible, and any investors who think otherwise simply didn’t take the time to read the March 8K. Xianghe does exist and does make algae-based drinks. But it is not worth remotely close to $28mm and it did not generate remotely close to $7mm of real revenue in its first 5 months of operations. The numbers, like those of CMFO, are fabricated.
The acquisition of Xianghe served as a way for the creators of CMFO to justify a $30mm equity capital raise in January 2010. The vast majority of the $28mm that was used to purchase Xianghe was either redirected to personal bank accounts or used for some other dubious purpose.
Disclosure:
At the time of writing, I and affiliated entities have a short position in CMFO and a long position in YUII. I intend to trade in these securities subsequent to this post. I may also initiate positions in other stocks mentioned in this article, including CSKI and LIWA.
In no part of this post do I attempt to provide false or misleading information. All facts presented in this post are true to the best of my knowledge. All opinions presented on this website are my own and accurately reflect my actual opinion on the relevant subject being discussed. To the extent you believe I have provided false or misleading information, please list your concerns in the comments section and I will address them.
References for “CMFO and Xianghe” article
This post is meant to serve as reference material for some of the discussion points in my post “CMFO and Xianghe: A Dubious Acquisition”.
I’m going to provide the primary source material behind various statements that I make in “CMFO and Xianghe: A Dubious Acquisition”. Most of the source material is from the Amended 8K that CMFO filed on March 16, 2010.
I will list the statement in italics, and then the supporting language from the SEC filing on which I base that statement.
Statement:
Xianghe’s product actually originated in January 2009, when Qiu Shang Jing paid Yellow Sea Fisheries Research Institute (YSFRI) $8,776 for “know-how” regarding the development of an algae-based drink.
Support from 8K dated 3/16/10:
“In January 2009, Mr. Qiu paid on behalf of [Xianghe] an amount of $8,776 (equivalent to RMB 60,000) to Yellow Sea Fisheries Research Institute (YSFRI), Chinese Academy of Fishery Sciences for the development of the algae-based drink know-how.”
————
Statement:
In April 2009, Mr. Qiu leased office space from CMFO (CMFO waived the rent beginning in July) to set up his new Algae-drink company.
Support from 8K dated 3/16/10:
“In April 2009, the director and sole owner of the Company, Mr. Qiu leased an office space under an operating lease with Shishi Huabao Jixiang Water Products Co., Ltd (“Jixiang”) for a term of 3 years with fixed monthly rental, expiring in April 2012. According to a release letter signed between Jixiang and the Company, [Xianghe] was released from paying any rental for the period from July 28, 2009 (Inception) to December 31, 2009.”
————
Statement:
On July 28, 2009, Mr. Qiu established Xianghe as a legal entity with $43,979 (that’s forty three thousand, nine hundred and seventy-nine dollars). On October 2009, Mr. Qiu contributed an additional $689,504 for a total registered capital of $733,483.
Support from 8k dated 3/16/10:
At the date of inception on July 28, 2009, the registered capital of the Company was $43,979 (RMB300,000), which was fully paid-up by Mr. Qiu.
On October 8, 2009, the Company approved to increase its registered capital from $43,979 to $733,483 (equivalent to RMB5,000,000) by additional cash contribution.
As of December 31, 2009, the registered and paid-in capital totaled $733,483.
————
Statement:
Equally absurd is the fact that the “know-how” which Mr. Qiu purchased for $9k is now listed on CMFO’s balance sheet as $23.5mm.
Support from 10Q from 3/31/10:
The “know-how” is valued at $23,471,410
————
Statement:
Content of section titled “More Dubious Financial Statements”
Support from 8K:
From the audited financial statements of Xianghe provided in the 8K
China Marine Food: There’s Something Fishy Going On
Please read the disclosures at the bottom of this article.
In my previous two articles, I’ve written about how several Seeking Alpha contributors have used locally filed Chinese financial statements to provide compelling evidence that certain U.S.-listed Chinese companies may be frauds.
All foreign-invested enterprises must file financial statements with the State Administration for Industry and Commerce branch of the Chinese government. These documents are not available electronically; rather, a local Chinese citizen must go to the appropriate local branch to access these documents. Fortunately, certain third-party credit agencies provide this service to foreigners for a fee.
In previous articles, I compared the SAIC and SEC financial statements of YUII, CSKI and LIWA. The numbers for YUII matched, whereas they did not for CSKI and LIWA.
In this post, I compare the SAIC and SEC financial statements for China Marine Food Group Limited (CMFO). The numbers do not match.
This provides evidence that China Marine Food Group Limited may be a fraud. In addition, I note additional data points that raise questions about whether CMFO’s financial statements accurately represent the financial condition of the underlying business.
I also present the response of the chief financial officer of CMFO to a question on why the SAIC and SEC documents don’t match, and provide my opinion on his response.
Organizational Structure
Before discussing CMFO’s SAIC statements, let’s discuss the legal organizational structure of CMFO. This is important because each subsidiary files separate SAIC financial statements. Chinese GAAP does not consolidate subsidiaries, and therefore it’s important to determine which subsidiary generates most of the company’s revenue. We can then compare the SAIC financial statements of this main operating subsidiary with the SEC filings.
Here is CMFO’s legal organizational structure, from an annual report. We use the 2008 org structure, because we are comparing their 2006, 2007 and 2008 financials.
The U.S.-based, publicly listed entity is China Marine Food Group Limited. Nice Enterprise Trading H.K. Co., Limited, its subsidiary, is based out of Hong Kong. Nice Enterprise has one subsidiary, Shishi Rixiang Marine Foods Co., Ltd (“Rixiang”), which is based out of China. Rixiang is a foreign invested enterprise that owns two other subsidiaries: (1) Shishi Huabao Mingxiang Foods Co., Ltd. (“Mingxiang”)and (2) Shishi Huabao Jixiang Water Products Co. Ltd (“Jixiang”).
Where are the operations primarily held? Rixiang. We know this by the following disclosures in the 10K:
“With effect from January 1, 2005, Rixiang acquired the business operations of Mingxiang, which subsequently became a property holding company. Rixiang was incorporated as a FIE and was granted the tax incentives for FIEs, and was exempted from income tax for 2005 and 2006… Jixiang is also a property holding company and is not subject to tax.”
Elsewhere throughout the report, the Company also makes clear that Rixiang generates all of the Company’s operating revenue, such as “All of our production is undertaken by our subsidiary, Rixiang” in the “Our Products” section.
From the above disclosure, we also know that Rixiang is an FIE. As an FIE, Rixiang must file accurate annual financial statements with the Administration for Industry and Commerce branch of the Chinese government.
SAIC vs. SEC financial statements
I have had a local third-party credit agency go to the local AIC office in Rixiang’s jurisdiction and photocopy their financial statements.
They are here, in Chinese. And here, in English.
The figures above are in Remnimbi. In the chart below, we convert the Remnimbi to US dollars, and compare key financial line items with CMFO’s SEC financials:
As we can see, CMFO reports much higher numbers in its SEC filings than its SAIC filings. In its SAIC filings, the company generated only $2mm of revenue in 2007 and $7mm in 2008. In its SEC filings, it allegedly generated $36mm in 2007 and $49mm in 2008.
Compare that with Yuhe, which generated $21mm and $34mm of revenue in 2007 and 2008 in its SAIC filings, compared to $22mm and $36mm of revenue in 2007 and 2008 in its SEC filings.
As we discussed earlier, Rixiang is the primary operating subsidiary of CMFO. It is also an FIE. As a result, Rixiang’s financial statements should accurately reflect CMFO’s actual operating results.
But they don’t.
The CMFO’s response to the discrepancies is the following, based on an email:
“It’s a formality in China to file the operating figures with SAIC on an annual basis. We used to hire an independent agent firm to do the filing on our behalf as the process itself is quite tedious though. Guess the agent firm has used kinds of outdated figures to do the filing and thus discrepancies appeared as a result.
Since there won’t be any anticipated influence or harm over those inaccurate historical figures with SAIC, we don’t believe it’s necessary to re-file the statements. That said, we will switch to another sizeable agent firm to do the 2009 filing and will make sure the numbers so filed are consistent with our book record going forward.”
We’ve been down this road with CSKI. The CFO of CSKI said a similar thing in 2008 when asked why CSKI’s SAIC numbers didn’t match the SEC numbers. He promised that 2009 numbers would match. But in more recent discussions, he has revealed they will not.
What is actually going on? My belief is that CMFO is fabricating its SEC financial statements. FIEs in China must file accurate audited financial statements. I’ve spoken with dozens of accountants and CFOs of verifiably legitimate Chinese companies, and they have all confirmed this. It’s understandable to have small differences between SAIC and SEC filings, due to subsidiary consolidation and Chinese vs US GAAP. But CMFO’s 2008 SAIC revenue was 85% lower than its 2008 SEC revenue. That’s not due to GAAP accounting differences.
In my opinion, fraudulent Chinese companies like CSKI, LIWA and CMFO are making up numbers out of thin air. To fool their accountants, the companies are using sophisticated and undisclosed related party and off-balance sheet transactions to inflate financial statements. They are using phony bank statements to fake cash. It’s unclear how exactly they are doing it. But the differences between the SAIC and SEC numbers provides compelling evidence that they are finding a way to do it. After all, there is a lot of money to be made – companies like CSKI, LIWA and CMFO have raised $25mm+ each in secondary equity offerings or private placements, all for dubious purposes. If they are indeed fraudulent, these funds are likely being siphoned to a large degree to personal bank accounts.
These are shocking allegations, yes. But the world of Chinese reverse-merger smallcaps is a shocking one, and given the very low valuation multiples, it’s clear that many other investors suspect similar wrongdoings.
Other Signs that CMFO is a Fraud
The main thrust of our argument that CMFO is a fraud is that the Company’s SAIC and SEC filings don’t match. But as we did with our last two posts on YUII, CSKI and LIWA, we’re going to highlight other signs that make us concerned about trusting CMFO’s SEC financial statements.
Again, we’ll compare CMFO with YUII.
Audit history
In our last post, we explained that Yuhe’s attempt to upgrade to Grant Thornton was a welcome contrast to the audit history of many other Chinese companies that have gone public via reverse mergers.
CMFO’s auditor, ZYCPA Company Ltd., is equally as questionable as LIWA’s and CSKI’s auditors. It is not listed in the top 100 global audit firms. It has 2 partners and 25 personnel, per its web site. Given that CMFO alleges to have generated $70mm of revenue and $15mm of net income in 2009, ZYCPA appears to be a woefully inadequate auditor for the company.
But if CMFO is making up its numbers, it would certainly find an easier time defrauding one of the two partners at ZYCPA than a top-5 audit firm like Grant Thornton.
Capital Raise
As we discussed in our last post, a key thing to monitor when examining whether reverse-merger Chinese companies are frauds is to see how much capital they’ve raised via secondary private placements and equity offerings.
Naturally, we have no issue with capital raises. Companies need to raise funds to grow. But with Chinese companies that have gone public through reverse mergers, we see a tendency to raise large sums of money at large discounts to current stock prices, with dilutive warrants attached, and for dubious purposes. Indeed, if a company is fraudulent, a capital raise is the primary goal of creating a China-based fraud in the first place. The funds are taken from U.S. investors and deposited in the personal bank accounts of the scam artists.
With Yuhe, we have not seen any dilutive and/or unnecessary secondary offerings thus far.
With CMFO, we saw a $30mm private placement on January 20, 2010. The purpose was: “The Company intends to use the net proceeds from this offering for working capital and general corporate purposes.” From its SEC filings, the company allegedly had $7mm of cash at December 31, 2009 and has generated positive free cash flow (measured by cash flow from operations less capital expenditures) for each of the past three years. It’s unclear why the company needed additional cash.
The dilution was not especially egregious though, and the new shares were issued at only a 9% discount to the prior 10-day trading average and a 12% discount to the prior 30-day trading average.
Disclosures:
At the time of writing, I and affiliated entities have a short position in CMFO and a long position in YUII. I intend to trade in these securities subsequent to this post within the next three days. I may also initiate positions in other stocks mentioned in this article, including CSKI and LIWA.
In no part of this post do I attempt to provide false or misleading information. All facts presented in this post are true to the best of my knowledge. All opinions presented on this website are my own and accurately reflect my actual opinion on the relevant subject being discussed. To the extent you believe I have provided false or misleading information, please list your concerns in the comments section and I will address it.
Yuhe International: The Numbers Match
This post profiles Yuhe International (YUII) and explains why YUII accurately represents itself in its SEC financial statements.
Background
There are several hundred smallcap Chinese stocks that trade on the U.S. equity exchanges. These companies have gone public in a variety of ways, but a large number have become public by undergoing reverse mergers with U.S. shell companies. Historically, reverse mergers have been a common way to publicly list fraudulent companies, because reverse merger candidates do not undergo the same scrutiny as IPO candidates. When a company undergoes an initial public offering, it subjects itself to due diligence by the investment banks underwriting the public offering. It must also file an SEC registration statement which must pass through a formal SEC review process. In a reverse merger, on the other hand, a target company merely needs to file a “Super 8K” outlining disclosures, and can then subsequently have its stock become publicly traded. In a sense, reverse merger candidates have not been “pre-screened” by investment banking underwriters. If the “sponsors” behind the reverse mergers have malicious intentions, these Super 8Ks and subsequent SEC filings can often present misleading, or even false, information that can be difficult for average investors to identify.
In my previous article, I discussed how certain Seeking Alpha contributors have used local Chinese SAIC filings to cast doubt on the reported SEC financial of certain U.S.-listed Chinese smallcaps, including CSKI and LIWA. There is evidence that these companies are fabricating numbers out of thin air in their SEC filings. It’s unclear how exactly they would be doing this, whether through undisclosed related party transactions, lax audit firm surveillance, etc. But it’s not especially difficult to believe. Audit firms of companies like CSKI and LIWA tend to be tiny firms that are not in the top 100 global auditors. Cooking the books is not as difficult as many people believe, especially if a company is run by professional scam artists who are dealing with a lax auditor in another country that speaks a different language.
Because of some potentially fraudulent Chinese companies, the entire U.S.-listed Chinese smallcap sector trades at a discount to similarly situated companies in the United States. Investors have difficulty deciphering which companies are presenting accurate numbers, and which companies are misrepresenting themselves in their SEC filings.
This has been troubling to me, because I believe that there are numerous “real” Chinese companies that are being penalized by the false financials being reported by the likes of CSKI and LIWA.
One of those companies is Yuhe International.
Yuhe International
Yuhe International, Inc. sells day-old chickens raised for meat production in China. The company purchases breeding stocks from primary breeder farms, raises them for hatching eggs, and sells live day-old broilers. It also engages in the production and sale of feed stock. The company operates 15 breeder farms and 2 hatcheries with a total annual capacity of 1.2 million sets of breeders and 120 hatchers. Its customers principally include distributors and end users, such as integrated chicken companies, broiler raising companies, and individual broiler raisers. The company was founded in 1996.
In the remainder of this article, I discuss three important data points that provide evidence that YUII is not fabricating its financial statements, whereas CSKI appears to be.
The topics are:
1. Comparison of SAIC and SEC financial statements
2. Comparison of history of audit firms
3. Comparison of history of equity capital raises
SAIC vs SEC financials
The first and most important part of my analysis is to compare the U.S. and Chinese financial statements of YUII.
Below is the summary comparison:
Source: SEC filings, Qingdao Inter-Credit Services
As we can see, the SEC and SAIC financials for YUII are in the same ballpark. Items of the income statement, such as revenue, gross profit, profit before tax and net income, are fairly similar when comparing the SEC and SAIC filings. The balance sheets of the financial statements filed in China and the United States are also quite similar for YUII.
The source documents for YUII can be found here:
YUII 2007 and 2008 SAIC financials in Chinese
YUII 2007 and 2008 SAIC financials in English
The SAIC financials have been acquired from Qingdao Inter-Credit Services Pte Co., Ltd.
This is a marked contrast to CSKI, for instance, where the company reported $50mm of revenue in its 2007 SEC filings, compared to $1.2mm of revenue in its SAIC filings. All other financial information for CSKI also are much smaller in their SAIC filings as compared to their SEC filings. Here is the comparison of CSKI’s SEC vs SAIC numbers.
Source: SEC filings, www.waldomushman.com
Yuhe’s financials match. CSKI’s do not. Given that a company would likely experience significant penalties in China for understating its SAIC financials by more than 50%, a reasonable conclusion is that CSKI is fabricating its SEC financial statements and YUHE is not.
History of Audit Firms
A Chinese smallcap is likelier to be fraudulent if it does not use a top tier accounting firm. These companies frequently cite cost as a reason to avoid using a top tier accounting firm, but I’m not convinced that this is their real reason. Any company making more than $5mm in net profit can definitely afford a top five accounting firm. Given the higher valuation multiple that a top tier firm would bring, it’s a no-brainer to use a top firm as their auditor.
I believe that most Chinese smallcaps don’t use top tier audit firms because they would not be able to pass their audits. In a best-case scenario, the Chinese company does not have proper internal controls or accounting infrastructure in place to give top tier auditors comfort. The cynic’s view is that many Chinese smallcaps don’t use top tier audit firms because the KPMGs and PWCs of the world would be better able to detect fraud.
Let’s analyze YUII, CSKI and LIWA in terms of their history of auditors.
When YUII went public, it initially engaged Child, Van Wagoner & Associates as its accountant. Child, Van Wagoner is not in the list of the top 100 accounting firms in the United States (see here).
On December 8, 2009, however, the Company decided to upgrade to Grant Thornton, a top 5 audit firm. A lot of discussion has been focused on Grant Thornton’s subsequent decision in March 2010 to resign as auditor, due to an inability to reconcile certain related party transactions. What’s missing from the discussion is how YUII is one of the few Chinese reverse merger smallcaps that actually tried to upgrade in the first place! I believe that unlike many other smallcaps, YUII felt that it had nothing to hide, and tried to upgrade accountants to set itself apart from companies like CSKI. While that move backfired when Grant Thornton resigned, YUII management has stated that they intend to upgrade to a top 4 audit firm as soon as they can. My bet is that they will because they’re not making up their numbers.
CSKI’s history of audit firms has been shoddy. Since going public, the company has had 4 different audit firms, none of which are in the top 100. The Company began with e-Fang Accountancy Corp., and then followed it up with Murrell, Hall, McIntosh & Co. LLP in April 2007, Sherb & Co. in December 2007, and finally Moore Stephens PC in May 2008. Currently, MSPC is being sued by a shareholder for signing off on fraudulent patents that CSKI claims to hold but actually doesn’t, according to the lawsuit. The lawsuit is available here. MSPC’s response is here. This will be an interesting litigation to watch unfold.
LIWA’s accounting firm, since it went public, has been AGCA, Inc. AGCA, based out of Arcadia, Californa, is not a top 100 audit firm. It’s a conspicuously nondescript firm for a public company that claims to have generated $17mm of net income in 2009.
History of Capital Raises
Finally, let’s look at the history of capital raises at our three companies.
A key fact to look at when trying to separate real from fraudulent Chinese smallcaps is to analyze the company’s history of raising equity capital. The reasoning is simple. Virtually all Chinese smallcaps are controlled by one or several significant Chinese owners. Typically, these owners were the founders of the company, or purchased the assets from the government during a privatization. If a company is real, the owners treasure the equity and are reluctant to dilute their ownership stake unless they’re being properly compensated, or if they are starved for capital and are using it for high return-on-equity purposes. If a company is a fraud, the owners don’t treasure their ownership stake, since they know that the assets they own are worth far less than the amount that the Company’s market capitalization values them at. They are perfectly happy to raise equity capital from U.S. investors in any way they can, even if that means issuing shares at large discounts to the trading price, or issuing dilutive warrants that wreak havoc on the capital structure.
In a way, the end game of devising a fraudulent Chinese company is to steal money from U.S. investors by raising equity capital and siphoning it off into managements’ personal bank accounts. Management of fraudulent companies don’t care too much about being “diluted” because they know that they don’t own assets that are as valuable as the high market capitalizations of their companies.
In our analysis below, we are going to ignore the capital raises involved with the initial reverse merger. All reverse merger companies must raise capital when they go public, just like all IPO companies must raise capital. Our concern is with private placements and public offerings after the company has already gone public and raised initial capital.
Let’s first look at CSKI. CSKI raised $25mm on January 31, 2008. The capital raise was comprised of 2.5mm units at $10 per unit, whereby each unit contained 1 share and 0.3 warrants to purchase shares at $12.50. The 10-day and 30-day trading averages prior to the capital raise were $12.50 and $13.28. Excluding the warrants, the new shares were issued at 20% and 25% discounts. But there’s no reason we should exclude the warrants – they were issued with a strike price at a value equivalent to the 10-day prior trading average, and at a discount to the 30-day trading average. This was an extremely dilutive financing. Per the Company’s registration statement at the time, use of proceeds was: “for: (a) acquisitions, (b) new product marketing, (c) expenses related to the Offering and the Registration Statement (defined below), and (d) general working capital purposes.”
Next, let’s turn to LIWA. LIWA raised $30mm, in the form of 3.7mm shares at $8.05, on April 8, 2010. That’s an 8% and 9% discount to the 10-day and 30-day average trading price of LIWA prior to the capital raise. It wasn’t an especially dilutive financing. Use of proceeds was “for the construction of a new smelting facility, which is expected to accelerate the production of refined copper products”. According to SEC filings, LIWA had $46mm of cash prior to its capital raise and generated $15mm of cash flow based on cash flow from operations less capex in the last twelve months ended March 31, 2010.
Finally, let’s look at YUII. YUII has not done any capital raises aside from its original reverse merger private placement.
If CSKI and LIWA are frauds, and have used private placement and secondary offering proceeds for bogus purposes, they have effectively stolen $50mm from U.S. investors. We know definitively that YUII has not yet stolen funds raised through a dilutive and/or unnecessary secondary offering from U.S. investors.
Conclusion
I’ve provided three important data points providing evidence that YUII is accurately representing itself in its SEC financials, unlike CSKI. LIWA remains an open question, given the recently emerged dispute between it and Qingdao Inter-Credit Services over whether its SAIC documents are accurate, or whether Inter-Credit’s financials for LIWA are the correct ones. Inter-credit, for its part, currently maintains that its numbers for LIWA are factual and that they doubt the authenticity of the financials posted on LIWA’s website.
The most important data point discussed in this article is the comparison of SEC and SAIC financials. The numbers match for YUII. They do not for CSKI. Any criticism of this article should first and foremost address that fact. From my research, I believe that foreign invested enterprises must file accurate financial statements with their local Chinese governments.
Disclosures:
At the time of writing, I and affiliated entities have a long position in YUII. In the past, I have had a short position in CSKI. I may trade in any of the securities discussed in this article at any time, including within the next three days.
In no part of this post do I attempt to provide false or misleading information. All facts presented in this post are true to the best of my knowledge. All opinions presented on this website are my own and accurately reflect my actual opinion on the relevant subject being discussed. To the extent you believe I have provided false or misleading information, please contact me at chinesecompanyanalyst@gmail.com. If I agree with your assessment, I will make a relevant comment clarifying the false or misleading information in the comments section of this post.
FUQI: SAIC vs SEC comparison
FUQI International, Inc. (FUQI) has been one of the more talked-about stocks within the U.S.-listed Chinese smallcap space over the past few months. The main reason is because the company announced accounting irregularities on March 17, sending the stock down ~40% over the subsequent few days. The stock remains 50% below its March 16th closing price.
For anyone who can read a cash flow statement, FUQI has had suspiciously large working capital usages since the company went public. The Company had -$22mm, -$8mm and -$22mm of cash flow from operations in 2007, 2008 and the nine months ended 9/30/09, which equates to a cumulative -$52mm of cash flow from operations during that period. And yet its net income was $14mm, $28mm and $38mm in 2007, 2008 and the nine months ended 9/30/09, summing to a cumulative positive $80mm of net income during that period. The accounting never made sense to me, and it’s no surprise that FUQI “identified certain accounting errors that are expected to have a material impact on the previously issued quarterly financial statements… the cost of sales for each of the periods were understated and gross profit and net income, as a result, were accordingly overstated”.
If FUQI was indeed inflating its net income through aggressive accounting, it was at least cooking its books the old-fashioned way. In this brief post, I intend to compare FUQI’s SEC and SAIC filings. Unlike CSKI, where the SAIC-reported 2007 revenue is 95% lower than its SEC-reported revenue, FUQI’s SEC and SAIC numbers are in the same ballpark. As a result, we can be confident that FUQI has some sort of real, and probably valuable, business behind the murky set of financial statements that it provides to investors. The same cannot necessarily be said for CSKI.
Here are FUQI’s financial statements in Chinese.
Here are FUQI’s financial statements in English.
Here is the financial comparison for FUQI.
Compare that to CSKI:
Naturally, FUQI’s SAIC and SEC filings do not match exactly. SAIC filings are done in Chinese GAAP, whereas SEC filings use US GAAP. Chinese GAAP treats a variety of items differently than US GAAP, including capital expenditures, depreciation, etc. It also does not consolidate subsidiaries, whereas US GAAP does.
For our purposes, we are merely trying to see if the SAIC filings show a real business of some respectable size. For FUQI, the SAIC filings demonstrate that a real company generating a material amount of revenue exists in China. For CSKI, the SAIC filings indicate the opposite.
The CFO of CSKI has claimed that SAIC filings don’t need to be accurate. That doesn’t jive with my discussions with lawyers, accountants and CFO’s of verifiable Chinese companies, who claim that Chinese Foreign Invested Enterprises must provide reasonably accurate and audited financial statements in their SAIC filings. And from looking at FUQI’s numbers, I question why FUQI would provide SAIC financial statements that show revenue and total assets that are of the same magnitude as the items reported in their SEC filings, if it didn’t need to.
The more correct story, in my opinion, is that CSKI reports SAIC revenue that is 95%+ lower than its SEC revenue because its actual revenue is indeed 95%+ lower than its SEC revenue.
Disclosure: I have no position in either FUQI or CSKI. I may initiate a position subsequent to writing this post.
CSKI and LIWA
Recently, there have been several Seeking Alpha contributors that have written posts comparing the U.S. and Chinese financial statements for various U.S.-listed Chinese small capitalization companies.
The relevant articles can be found here:
Manuel Asensio and “Waldo Mushman” on China Sky One Medical (CSKI):
Steve Chapski on Lihua International (LIWA):
http://seekingalpha.com/article/203949-still-not-copacetic-at-lihua-international
http://seekingalpha.com/author/steven-r-chapski/instablog/2
In these articles, the authors compare the SEC financial statements of Lihua International and China Sky One Medical to the financial statements shown in their “SAIC” filings.
SAIC Filings
What are SAIC filings? SAIC filings are the audited financial statements that all Chinese “foreign invested enterprises” (FIEs) must file with the local government offices of the Administration for Industry and Commerce (AIC). The term “SAIC” refers to the “State Administration for Industry and Commerce”. These financial statements are filed annually, as part of the “Annual Inspections Report” that all foreign invested enterprises in China must submit to their local government authorities.
Some people, including the chief financial officer of CSKI, claim that companies can file “fake” SAIC filings, whereby they materially misstate their financial statements in their SAIC filings. Based on my discussions with numerous accountants, lawyers and CFOs of verifiably legitimate Chinese companies, I do not think this is true. My understanding is that there are significant penalties for any Foreign Invested Enterprise that materially falsifies financial statements that it is filing with the local Chinese government. These SAIC audited financial statements should approximate the relevant tax filings that companies file with the Chinese government. If companies falsify their SAIC filings, they would be also falsifying their tax filings. With a company like CSKI, we’re seeing SAIC financials come in at 90%+ below their SEC financials – the Chinese government would not tolerate under-reporting and tax evasion of this order of magnitude.
As a result, the likeliest answer, in my opinion, as to why the SEC and SAIC filings are different is that companies like CSKI are falsifying their SEC filings. This is not especially difficult to believe, because the rapid growth and high margins of the companies are a bit too good to be true.
Dubious Financial Claims
CSKI has seen revenue grow from $8mm to $20mm to $49mm to $92mm to $130mm from 2005 to 2009. EBITDA margins have grown from 20% in 2006 to 38% in 2009. And what exactly does the company do? It makes a variety of traditional chinese medicines, such as the “Sumei Slim Patch”, which is a patch that people wear to foster weight loss; the “Pain Relief Patch”, which is a patch that alleviates fevers, headaches and heart dysentry; Hemorrhoids Ointments; herbal dental ulcer sprays; diagnostic kits for early stage diagnoses of heart attacks, etc. None of its products seem particularly special, and the company reports steady, rapid growth across all its segments, whether it be Patches, Ointments, Sprays or Diagnostic Kits. Read the rest of this entry »
Introduction
This website and blog is devoted to a discussion of China-based companies that are publicly listed in the United States.
The operator of this website and affiliated entities take long and short positions in public securities of the companies discussed on this website. Although I choose to remain anonymous, I provide full disclosure of my positions at the time of the publishing of each blog post.
In no part of this website do I attempt to provide false or misleading information. All facts presented on this site are true to the best of my knowledge. All opinions presented in this website are my own and accurately reflect my actual opinion on the relevant subject being discussed. To the extent you believe I have provided false or misleading information, please contact me at chinesecompanyanalyst@gmail.com and if I agree with your assessment, I will modify the relevant content on my website.
