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 Tracking 1255 U.S. listed China Stocks and Counting...
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A Fraud Went Undetected, Although Easy to Spot

Thursday, February 23, 2012, 5:00 PM ET -

by Floyd Norris, Chief Financial Correspondent of The New York Times

Without a rule of law, investing is an extraordinarily hazardous undertaking.

The latest charges of fraud in a Chinese company traded in the United States were filed this week by theSecurities and Exchange Commission against two former executives of a Chinese coal company who the commission says stole and sold the company’s assets before they raised more than $100 million from public investors in the United States.

                                
       
Mine in Shanxii Province
A mine in Shanxi Province owned by Puda Coal, which got millions from American investors.

In some ways, the theft was not the most audacious part of the strange case of Puda Coal, which traded on the NYSE Amex stock exchange in New York. The attempted cover-up, involving a forged letter from a Chinese state-owned entity and a fake takeover offer, were even more brazen.

But what is most amazing 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.”

At the same time Americans were investing money in the company, Citic Trust, a Chinese state-owned company, was selling investments in the same asset to Chinese investors, saying — evidently correctly — that it controlled the asset.

What the documents showed was laid out this week by the S.E.C. as it filed charges of civil fraud against Ming Zhao, Puda’s chairman, and Liping Zhu, the company’s former chief executive. Puda’s principal asset was a coal mining company, Shanxi Puda Coal. But in 2009, the chairman 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 United States 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.

All told, the underwriters collected fees of $6.5 million, but they seem not to have acquired the documents that Mr. David said cost him $500. A spokeswoman for Macquarie declined this week to comment, and officials of the other firms did not respond to inquiries.

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,” Mr. Wong said in an interview this week. He said he had looked into the company after Mr. David asked him to review his own research.

“Incredibly,” Mr. 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.”

The stock plunged to $6 by the time the New York Stock Exchange suspended its trading on the following Monday. It would not trade again until it traded over the counter for two days in August, after it was delisted from the N.Y.S.E. The S.E.C. suspended it again. It trades now on the over-the-counter market.

The company’s audit committee investigated the allegations, and eventually concluded they were accurate. But there was excitement along the way. In April, Mr. Zhao 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.

In July, Moore Stephens quit as the company’s auditor and said its previous audits could not be relied on. It did not respond to requests for comment for this column.

In most Chinese fraud cases, the allegations are made by short-sellers, who have bet that the stock will decline. Mr. David, however, is a manager who owned Chinese companies and believed in them. He set out to prove the shorts were wrong.

“We hired our own Chinese team to discredit the short-sellers, because I did not believe what they were saying,” Mr. David told me. “What came back to me was that the short-sellers were right.” He asked the investigators to look at companies in which he had invested or was considering buying. Puda was one of the latter.

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 forms are in Chinese, of course, but for the money that investment banks charge, you would think they could afford a few translators.

The two men charged by the S.E.C. are evidently in China and have no intention of coming to the United States to face the allegations. There is probably nothing the commission can do.

The Chinese authorities appear thus far to have shown no interest in bringing charges against the men named by the S.E.C., but that does not mean the government has ignored what is happening.

Mr. David said the Chinese government was restricting access to some S.A.I.C. filings and asking why people were interested in a certain company. He said the government was telling companies who was asking questions, 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. Those who invest in Chinese companies today have reason to worry.

You might be surprised to learn that you are one of those people. I know I was. Through an employee plan, I own shares in a number of Vanguard mutual funds. It turns out that Vanguard bought more than a half-million shares in Puda, some of them for a fund in which I have an investment. Vanguard sold those shares after the scandal broke, no doubt at a loss.

Source: NY Times (permalink)