By Maj Soueidan
As I have begun to perform quality checks on the ChinaHybrid Space, I have received criticism from some investors who have questioned the relevance of some of the items on my check list. I had expected this, but blind ignorance is not the path I choose to follow, at least not yet. Such tact would be would be irresponsible to my readers. If I have to delay an opportunity to purchase a stock worth $20.00 at $5.00 as opposed to $8.00, the only harm done is damage to my ego.
One of the items on my check list that has received constructive criticism is the validation of whether SEC files match Chinese State Administration for Industry Commerce (SAIC) files. My critics hold the general belief that the SAIC financial statements have no relevance to those filed with SEC.
SAIC functions in maintaining market order and protecting the legitimate rights and interests of businesses and consumers by carrying out regulations in the fields of enterprise registration, competition, consumer protection, trademark protection and combating economic illegalities. Source: http://www.saic.gov.cn/english/aboutus/Mission/
My original motivation for this mission was not necessarily to find the truth, but arose from an understanding that the "perception" of risk can affect portfolios. Just like the majority of body building depends upon proper diet, psychology can play a large role in determining short-term stock valuations. By at least identifying mis-matches, I can be aware of the possibility that bad press may influence my investment until this issue may finally be put to rest. In the interim, I can buy put options, write calls against my long positions, establish larger positions in stocks where filings do match and adjust portfolio diversification.
Ultimately, I set out to gain an understanding of why filings don't match and determine if the fear created by the skeptics has led to unique opportunities to purchase insanely cheap stocks, especially those related to companies participating in an industrial revolution.
I almost published an article a couple weeks ago on the imbalance of SAIC filings versus SEC filings. My references for my original conclusions came from various blogs and matter of fact of opinions from investment professional; but what about auditors and lawyers? I paused for a second and thought if I continued upon this conjecture fueled by the "he said, she said" mentality, I would be just adding to the rumor mill. So I set out to analyze SAIC filings first hand and obtain a written legal opinion on this subject from an attorney with knowledge of Chinese law.
I am still perplexed that IR firms and analysts have not pursued this path. My opinion as to why they have not is because they know the truth. As luck would have at, one of my GeoTeam associates enrolled in a Mandarin class that is taught by an instructor who is friends with a Chinese lawyer (let's call him "Bob") who recently moved to the U.S. My luck did not end there as he also has an exceptional understanding of financial statement analysis. Initially, I asked Bob to get in touch with various SAIC and Local AIC agencies to learn more about them and any tax related issues. (See attorny letter. Comments are welcome).
There are two types of taxes relevant to this discussion. The value added tax (VAT) is levied as a percentage of revenue. (In the service industry there is a business tax; there is no VAT. The Business Tax is similar to VAT and the PRC government is transferring Business Tax into VAT) China has a sophisticated mechanism for collecting the VAT that involves a process of tracking invoiced transactions among all parties involved in a particular sale chain. Thus, the payment of this tax is difficult to circumvent. However, companies can underreport the top line through what is called white receipts, or transactions without invoices. On the other hand, underreporting income to lessen the burden of income tax appears possible. This arises from an inefficient income tax oversight process. Taxes are paid to the State Administration of Taxation (SAT).
I also learned that the SAIC is referred to as the "last stop", meaning that by the time financial statements reach the SAIC, a company has probably already filed reports with the SAT and disclosed its tax liability.
The most important factoid I received was that SAIC documents can be audited. Most supporters, including investment banks, have commented that SAIC filings are not audited or used in the tax system. This is generally true for companies that have a Variable Interest Entity (VIE) structure in which the U.S holding company does not have direct ownership in a PRC firm. The flow of funds is set forth by a series of contractual agreements that establishes control without direct ownership. On the other hand, for companies that have direct ownership (FIE, Foreign Invested Enterprises), the SAIC does police the PRC firm and requires AUDITED financial statements, which can be shared by several government authorities. Furthermore, this financial statement is also provided to the SAT. The audit is normally completed by a local auditor. (You will understand why after reading my lawyer's legal opinion).
The Investigation Begins
I asked Bob the following:
1. Verify that SAIC filings can be audited.
2. Retrieve the filings of seven ChinaHybrid firms, including two IPOs (one of which is an ADR) and five reverse merger firms. I also made sure that four of the companies did not have VIE structures.
3. If filings do not match, offer an explanation as to why.
Although my sampling is not large enough to draw a statistically reliable conclusion, I deemed it as a good start to my due diligence process that will eventually cover over 70 companies. Thus far, the results are unanimous. None of the filings come even close to matching on sales, net income and taxes paid. One company even showed revenue growth on the SEC filings from 2007 to 2008 to 2009, while the SAIC filing showed growth from 2007 to 2008, followed by a decline in 2009.
Are we to believe that all these companies and likely the majority of ChinaHybrids are a hoax? Fraud would be a much easier circumstance to phantom if it was related to just a few firms. If you accept the fraud argument, you are basically subscribing to a well orchestrated conspiracy theory.
The excuses as to why filings do not match may have some merit and include such things as varying accounting rules, complicated ownership structures, pawning off reporting duties to "agents" and the SAIC not being a tax agency. But I can't be convinced that possibly over 80% of companies (as some would have it) will fall into this "circumstance" by accident. This is more than just a random force of ineptness and bureaucratic mayhem. I challenge an auditor or investment bank to show me how diverging accounting rules can account for a company reporting revenue of $100 million and huge profits in an SEC filing compared with revenues of $1 million and substantial losses in the SAIC filings.
As for CFOs not having a good handle on audited financial statements at the time a filing is submitted to the SAIC - that is a troubling thought in and of itself. What some firms have listed as "filing agents" may be entities that the company has paid in order to purchase a generic financial report. Furthermore, what am I supposed to make of the certification signature conveying the accuracy and reliability of the SAIC document? As I indicated earlier, by the time a company files with the SAIC, taxes may have been paid and some SAIC reports even audited. So the excuse of not having a good handle on the financial statement seems illogical. The misrepresentation of SAIC filings appears deliberate.
Through information provided by my lawyer and other fact finding means I have come to the following conclusions.
Although I have found that SAIC filings do not match SEC filings, proving the fraud case is easier to conclude for FIE than for VIE structures. So far, I have pulled the SAIC filings of four FIE firms; one IPO and three reverse merger. In one case, sales, income and tax provisions matched at the SAIC and SAT level, but did not match at the SEC level. In two cases sales, net income and provision for taxes did not match the at the SEC level. In the last case sales matched at the SEC level, while net income and tax provision did not. Most firms showed losses on the China filings and healthy profits with the SEC.
Worse yet, some of the SEC audits were performed by top tier firms. In a case like this, you can not help but surmise that a deeper level of misrepresentation and/or lack of auditor oversight has taken place. Is the company showing the auditor a different tax receipt? Did the auditor see the actual tax receipt and dismiss it? Are there existing tax documents that take precedence over SAT records? Finally, where did the reported taxes shown on the SEC flings go?
In the cases of VIE structures, I have only proven that SAIC files do not match SEC files. My attorney has commented that this can occur since SAIC filings are not usually required to be sent to the SAT. It is basically just a waste of time. Also, companies do not want to reveal information to competitors. The more accurate information will be in the SAT files which are unavailable to the public.
I still believe that VIE's are involved in some type of fraud. For example, in one of the companies I came across where sales in the SAIC and SEC did not match, the cash balance matched.
Drawing a Conclusion
Tax evasion may be prevalent across the ChinaHybrid space. However, what we call fraud could basically be common practice in China and possibly acceptable, as evidenced by my attorney's findings that the punishment for tax fraud does not seem harsh. As ChinaHybrid supporters have expressed, SEC filings are likely a better representation of a company's financial standing than SAIC filings, at least for VIE structures. Auditors, knowing that the income tax paid is unreliable, are likely looking at the VAT tax, white receipts and the "real" numbers contained in "secondary books" to verify sales numbers.
I also don't buy that auditors are in the dark on this issue. I am learning that it common knowledge that many Chinese firms have more than one "book". I am not sure what to make of a situation where, in the case of an FIE, we know that the SAT and SAIC documents are identical, yet diverge from SEC filings. In actuality, the SEC document is what the Chinese company should have filed in the PRC. (It makes more sense that the tax liability should be logged as taxes payable).
Another conclusion could be that some of these firms are real but smaller than they purport to be. This would involve a much more intense due diligence process.
Navigating These Findings
Even if we can come to the conclusion that SEC documents are more reliable than SAIC documents, should China Hybrids really expect to garner unconditional investor loyalty when a level of misrepresentation exists. The uncertainty surrounding this topic can still reduce the appetite and P/E expansion for the ChinaHybrid space, where many stocks have had muted reactions to spectacular 2010 second quarter financial results. The unfortunate circumstance is the collateral damage imparted on the quality companies.
In order to invest in this space you have to accept that what we may consider fraud is the norm in China. If all we have is tax fraud, it appears doubtful that China will levy punishment that would jeopardize the existence of so many companies. However, we cannot fully assume that serious monetary punishment will escape tax violators in the future. My lawyer's letter confirms this thought. It is more logical to assume that China will have to improve its tax system. Will monetary fines need to come from the company and necessitate capital raises to meet obligations? We also need to consider what interest the SEC may take in an issue where fraud and lax accounting oversight may abound. The Public Company Accounting Oversight Board (PCAOB) has already begun sniffing around the ChinaHybrid sector. (See more: http://pcaobus.org/News/Releases/Pages/07122010_SAPA.aspx and http://www.macpa.org/Content/25643.aspx)
Although SEC filings are likely more accurate, proving that they are 100% accurate would require firms to show why their filings don't match, or basically admit to some level of fraud and show us receipts. In the end, we have to trust auditors, a tough commitment now that we know of a few suspect FIE scenarios.
Our focus should be to use the available information in SEC documents, interviews and on site visits to validate a company's story.
1. Follow the cash. Cash in the bank is the easiest source of funds to verify. In order to fool an auditor, the majority of companies would have to be conspiring with bank tellers to forge bank accounts. Thus, we would prefer companies with healthy cash balances. When filings are off, attempt to identify clues that prove SAIC files are junk. The example of cash matching SAIC filings when everything else does not match is an example. Reference companies that use cash that is greater than balances outlined in SAIC filings to that pay regular dividends or large special dividends, enact stock buy backs and to complete acquisitions. Furthermore, we know that many of these firms completed offerings. It would be odd for them to have virtually no cash on the books as evidenced in many SAIC filings.
2. Look for clues in credit ratings, which ironically the SAIC administers. For example, when observing a company that has no debt, pristine financial ratios, healthy cash balances and steady operating cash flow in SEC filings, a low credit rating could indicate a red flag.
3. While I am not a fan of debt, companies that utilize debt as part of a growth strategy were likely scrutinized by the lender.
4. Look for companies that have canceled an existing financing transaction or given weak excuses for changing ownership structures from a FIE to a VIE.
5. Realize that companies who retain top U.S auditors with a strong presence in China will likely get more investor love.
6. Be aware of companies with internal control problems as defined in SEC filings.
7. Be aware of more than routine changes in CFOs.
8. Understand that SAIC filings for FIE structures should match SAT filings.
Please Prove Me Wrong
My intent for this article is not to cause abandonment, but to inspire debate and comments from regulatory bodies to eliminate conjecture on this topic, giving investors comfort to focus on fundamentals. I actually want to be proven wrong. In the end, my hope is that the current mayhem will make the sector stronger by increasing the pool of quality companies. The ChineseHybrid universe is evolving and will surely experience hurdles and pockets of fraud as it matures. Firms must become more familiar with the demands of U.S. investors, increase disclosure and eliminate uncertainty. The SEC needs to crack down on individuals who may be spreading "conceivable" lies to bring down companies. More importantly, these firms that we have helped make rich should just pay their fair share.
Please note that I am still probing into the Chinese tax system, especially to determine if SAT documents are actually representative of taxes paid. We will continue to highlight companies on the basis of fundamentals in SEC filings. Investors need to formulate their own opinion on the severity of the SAIC vs. SAT vs. SEC issue.
Disclosure: The GeoTeam continure to take a very tepid stance on the ChinaHybrid space as our due diligence process continues.
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