GEO Investing

By Stephen Gandel

Chinese software company Longtop Financial Technologies did everything it could to make U.S. stock buyers believe it was a safe investment. Perhaps it was doing too much.

The company regularly reported income that was slightly higher than what executives had predicted the company would earn months earlier. On its balance sheet, Longtop said it had $412 million in cash – a huge stockpile for a company of its size, prompting some to compare it with Microsoft. In late January, the company reported its latest in a string of ever rising financial results. Sales were up 41% to nearly $77 million in the last three months of 2011; earnings, up 21% to nearly $36 million. Longtop’s chief financial officer Derek Palaschuk told investors he was “particularly pleased” with his company’s performance. “During the fiscal third quarter,” said Palaschuk, “the Company was once again able to report higher-than-guided top and bottom line results and our industry leading margins give us significant room for additional investments in our business.”

Palaschuk is probably less proud of those results than he was four months ago. That’s because they were probably made up. In mid-May, Palaschuk resigned from Longtop amid accusations of accounting fraud. The company’s auditor Deloitte Touche Tohmatsu quit as well, saying it feared the company had far less cash than it claimed. The accounting firm said Longtop employees had blocked the auditors from verifying its bank accounts. Longtop’s shares lost half their value. The New York Stock Exchange, where the stock traded, has since halted the shares. The Securities and Exchange Commission is investigating. Worse, among Chinese companies, Longtop’s story is far from unique.

This year a number of Chinese companies that have listed their shares on US exchanges in the past few years have been exposed as accounting frauds. Last week, shares of Sino-Forest fell 64% after a research report was released that said the Chinese forestry company was overstating its assets. Another company China Mediaexpress, which placed TVs on buses, was shown to have far fewer customers than it claimed.

Stock fraud and accounting fraud is nothing new. And we have plenty of home-grown frauds. Remember Enron. But so far this year, the vast majority of stock fraud seems to coming to American investors by way of China. In mid-May, 15 of the 19 stocks that were halted on the Nasdaq were shares of China-based companies. The shares of two other Chinese companies, including Longtop, have been halted since then. Lawyers and U.S. regulators say gaps in international regulations make it easier for Chinese companies that list their shares in America to falsify financial reports. The Securities and Exchange Commission has launched an investigation into U.S. accounting firms with Chinese clients to see if any of the auditing firms were complicit in the frauds. Also in early June, the SEC warned investors against investing in Chinese firms that list their shares via so-called reverse mergers. Those deals allow companies to sell shares to investors without undergoing the normal scrutiny that goes along with a typical initial public offering. What’s more, some say with the U.S. economy looking sluggish, the zeal of investors in America to invest in China, one of the world’s fastest growing economies, has blinded many to the risks, opening the door for crooks.

Warnings of fraud at U.S.-listed Chinese stocks have been growing quietly for months. But the unraveling of Longtop Financial, which had been fighting charges of accounting inaccuracies for months, in mid-May has greatly intensified the concerns among investors and regulators about Chinese stocks. Compared to some of the other companies that have been exposed as frauds, Longtop Financial is a relatively large company. What’s more, the company came public through a traditional IPO. The offering was underwritten by Goldman Sachs and Deutsche Bank. Morgan Stanley managed a follow-on offering of shares. A number of prominent hedge funds had bought into the stock. You would think all of those investors and investment banks had reviewed Longtop’s books.

Regulators have long fought penny stock fraud in the US. Markets can exist with some level of fraud without losing investor confidence. So it is likely that as long as small, untested companies from China are allowed to trade in the U.S. there will continue to be some fraud. Still, the levels of fraud we are finding now appear to be unacceptable for a healthy market.

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