Here is an expanded list of red flags that are commonly used to identify potential fraud, or at least begin the process of vetting the legitimacy of a company’s operations and reporting.
- SAIC documents do not match SEC.
- SAT documents do not match SEC.
- Low R&D expense, especially when company has unique technologies.
- Unusually low accounts payable position.
- High margins compared to competitors.
- Allegations of low credit rating when SEC filings look pristine.
B. Internal Controls/Corporate Governance
- Ineffective internal controls, especially when issue exists for an extended period of time.
- High CFO turnover.
- Resignation of several members of the board of directors.
- High auditor turnover, especially if company goes back to old auditor.
C. Ownership Structure Issues
- A significant delay in meeting registered capital requirements upon an RTO transaction. This could imply that original players were not comfortable infusing capital into a company.
- Desire to switch ownership structure to a variable interest entity (VIE) from a foreign invested enterprise (FIE). ONP, CHGY. This could insinuate difficulties in securing capital from original players of the the RTO transaction.
- Establishing a VIE structure when money could not be raised to meet PRC registered capital requirements pertaining to formation of FIE.
- Illegal corporate structure as defined by PRC law.
D. Share transactions
- Several equity offerings within a tight time period.
- Company raises money when it has excess capacity
- IPO that priced well below desired price, yet company does not cancel or delay offering.
- Company raises money despite adequate cash balance.
- Company raises money despite contradictory comments in filings and press releases.
- Equity offerings at low valuations when balance sheet is healthy and at least 30% EPS growth is expected. RTO stocks in general.
- High land right use.
- Company won’t disclose sellers related to certain transactions.
- Company won’t disclose address or names of retail locations, distributors and subsidiaries.
- Lies about date of establishment of acquired business.
- Negative commentary by media outlets in PRC.
- IPO rejected in the PRC if firm claims to be a leader.
- Inadequate Website.
- Low executive salary.
- Regulatory interventions (SEC, PCAOB, etc).
Suggested Steps Companies Should Consider to Establish Credibility
- Disclose SAT through an independent source. PRC law, as it relates to annual inspection process among several governmental bodies, implies that for FIE, SAIC should match SAT. However, a linear relationship for VIE between SAIC and SAT filings can not be assumed which is why SAT verification is particularly important for VIE company structures.
- Reconcile SAT/SAIC filings with SEC fillings when they do no match.
- Auditor should make a statement verifying they saw cash and SAT information and obtain this information independently. Access to documents should be made available at any time without company knowledge to avoid speculation that company has had time to employ fraudulent short-term measures.
- Also consider giving an independent source random access to SAT filings and cash balances.
- If you have engaged in tax avoidance schemes request a letter from PRC government forgiving past indiscretions and/or just settle the issue. ( we understand this may not be practical). Ideally, this should be done before going public.
- Request a letter from the PRC that SAT filings are in line with SEC filings.
B. Internal Controls/Corporate Governance
- Retain a Top 10 auditor (Top 4 is the most ideal)
- Ideally, internal controls should be in check from day one. Even if a company can’t afford a top auditor on a full time basis one should at least be retained to implement effective internal controls such is the case with CBP. Internal control procedures should also be promptly reevaluated upon the completion of acquisitions.
- Qualified Board of Directors should be in place upon going public.
- Consider an independent advisory panel
C. Share Transactions
- Do not issue equity at absurd valuations when you have (a) ample cash on hand, a healthy current ratio, a healthy cash ratio and(b) guidance or EPS estimates that imply at least 30% EPS growth.
Additionally, make a statement that you will not have to issue equity in order to grow EPS and stand by these words, unlike TSTC and SPU. If you do issue equity, reduce the share raise by utilizing cash so that healthy EPS growth will still occur.
- Consider raising post public money with a top tier underwriter as opposed to PIPES or low tier underwriter
- Consider the use of some debt over equity when possible
- Cancel incentive shares to minimize dilution.
D. Establish Investor Confidence
- Issue EPS guidance. (Ideally, for upcoming quarter and year)
- Implement buy back programs when valuations are low as a way to increase EPS growth.
- Release monthly reports on status of buy back program.
- Management buys stock.
- Declare special or quarterly dividend.
- Issue annual reports with letter from Chairman of the Board/CEO/President
- Pay proper taxes
- At some point, dual list shares
Clues that an Equity Raise is on The Horizon
- Be aware that boiler plate language insinuating that current capital is sufficient to maintain current operations can offer a false sense of security vs. explicit language in SEC documents inferring that a company does not see a need for an equity raise.
- Look for contradictions in press releases that infer no need for capital vs. opposite jargon in SEC documents.
- Compare “liquidity” sections in SEC documents to “risk disclosure” sections for contradictions regarding a potential need for capital.
- Look for changes in statements about the need for capital when the level of business has remained unchanged/increased, yet liquidity standing has not seen significant changes.
- Company has never raised money since going public.
- Sudden cancelation to attending investment conferences and not returning calls or emails. This could imply that a company is in a quiet period.
- No Q&A section during earnings conference calls can also signify that a company is in a quiet period.
- The “Offering” document filed with the SEC includes the proposed share amount of a potential offering, the amount of funds to be raised and the expected offering price.
- When a foreign invested enterprise (FIE) has not met its registered capital requirements.
- When a company plans to switch to FIE from a variable interest entity (VIE).
- A company that grows by acquisition.
- A company is at full capacity.
- Requesting the removal of anti dilution provisions
- Company with liquidity issues