Relying solely on auditors, SEC filings and investor relations can be hazardous to your wealth!

Okay, I admit it!  I once believed in the integrity of audits performed by top accounting firms and trusted SEC staff to be reliable gatekeepers protecting US public shareholders’ interests.  Given my background as a CPA who began his career with a Big Eight firm that is now one of the Final Four I believed the auditing and SEC staff review process would protect investors from fraud.  Why should I be concerned about independent on-the-ground due diligence when that’s exactly what the auditors are (or at least should be) doing?  As for cross checking local Chinese SAIC and SAT filings with the SEC filings; that’s what the auditors are for.  Surely they must be doing that, right?  Well, as it turns out, wrong!  In the wild, wild west, or east as the case may be, of China investors need to take extra steps to protect their interests.  Recent instances of acknowledged and alleged frauds with prominent Chinese small cap companies  clearly demonstrate that relying solely on the integrity of the auditing process and the ability of the SEC to police the US listed China small cap space can be hazardous to your wealth.

What You Should Know If You Are Going to Invest in the China Small Cap Stocks

Investors Can’t Rely on Auditors to Detect Fraud

Investors in two China small cap companies, China MediaExpress Holdings (NASDAQ: CCME) and China Integrated Energy (NASDAQ:CBEH), have recently seen the values of their investments implode under allegations of fraud.  CCME was until recently audited by Deloitte Touche Tohmatsu and CBEH is audited by KPMG.  So having Big 4 auditors did not protect investors from substantial losses.  Investors are justifiably alarmed and many blame the auditors for their losses but what they fail to understand is the role of the auditor and the limitations they operate under.

First, auditors are responsible for planning and executing audits to obtain reasonable assurance that financial statements are free of material misstatement, whether caused by error or fraud.  Audits are not, however, intended to detect fraud which is particularly difficult to do when collusion with management, employees or third parties is involved.

Further, auditors operate under limitations:

“SAS No. 82 explains many of the limitations under which an auditor operates, including the fact that fraud may be concealed through falsified documentation, including forgery. A financial statement audit rarely involves authentication of documentation, and auditors are not trained as or expected to be experts in such authentication.  Fraud also may be concealed through collusion among management, employees or third parties. Auditors also do not possess investigative powers, such as the power to subpoena witnesses and obtain evidence under oath.  Furthermore, the evidence that auditors gather in an audit is often only persuasive; it is rarely conclusive.  And lastly, audits are designed to detect only material misstatements.”

I don’t want this to sound like a complete copout for the auditors.  Auditors are, after all, responsible for exercising objectivity and professional skepticism in carrying out their duties.  CCME and CBEH are both particularly egregious cases of what are alleged to be blatant and transparent frauds which makes one wonder just how objective and skeptical the auditors really were.  Time will tell.

Ghost Writers and Accountants Who Really do the Accounting and SEC Filings

An appropriate question to ask is not who a company’s auditor is but who really does the work to prepare for and complete the audit and SEC filings.  I learned from a very reliable source in China that many, if not most Chinese small cap companies pay inordinate amounts to consultants to prepare key accounting, financial statements, and SEC filings.  Many of those consultants are Big 4 trained CPAs or experienced attorneys with extensive SEC experience.  The ghost writers and accountants know what the auditors and SEC staff are looking for and are adept at giving them exactly what they want.  For unscrupulous management teams that might include cooking the books and creating documents that support the party line.  Unfortunately, we have far too many recent cases of Chinese small cap companies that apparently engaged in such practices as a means of perpetrating securities fraud.

It would serve investors and analysts well if they started to ask the managements of Chinese small cap companies how they gained and maintain their pubic listings.  Who actually does the work to prepare for audits and complete SEC filings, and to what extent are outside consultants used and how much are they paid.  Good luck getting a detailed response to that question but it is worth asking.  Investors should be very wary of companies that evade or refuse to give insight into their public company costs.  If most of the audit preparation and SEC compliance work is done by consultants while the CFO and other key management team members are traveling around the world doing investor road shows, watch out!

English Speaking Chinese CFOs

I used to think having an English speaking, US educated CFO was an asset for US listed Chinese companies.  It gave me somebody I could talk to and since I am a CPA and former CFO of public companies myself I knew we’d speak the same financial language.  It now occurs to me that the CFOs and I were simply regurgitating the same information and financial operating results contained in the SEC filings and reinforcing each other’s conclusions.  What didn’t initially occur to me was that if the CFO was in the US talking to me at an investors’ conference he wasn’t in the weeds back in China managing the company’s finances, operations and administration.  The CFO was, therefore, almost as disconnected from what was really going on in China as I was.  In short, some Chinese CFOs are little more than an extension of investor relations.  Investors would be better served with a demanding, hands on and competent CFO back in China managing the company’s finances.  The CFO should be the kind of executive who personally knows the numbers are right and doesn’t have to rely on auditors and anyone else to give such assurances.

So Who Can Investors Rely On to do On-the-Ground Due Diligence and to Compare SEC filings with Financials Filed with Chinese Regulators?

China is in what I would call a “wild west” phase of development when it comes to Chinese small cap companies listing their securities on US exchanges.  In the wild west the pioneers took the arrows and it is no different for investors who have ventured into the China small cap space and risked their capital with dreams of high returns.  Many have learned the hard way that when it’s too good to be true, it’s too good to be true.

There is help available for investors brave enough to invest in China’s rapidly growing economy despite the obvious risks.  There are enterprising individuals and websites that provide quality information for investors.  Among them is GeoInvesting.com, a firm founded and headed by Maj Soueidan.  Mr. Soueidan has developed a thorough understanding of the complex corporate structures employed in China (http://portal.geoinvesting.com/forums/yaf_postsm3816_Review-of-Chinese-US-Listed-Company-Ownership.aspx#singleMsg) that are all too often fraught with risk for investors.  He has also developed procedures for obtaining and comparing financial statements filed with Chinese regulators with SEC filings (https://geoinvesting.com//?p=1228).  GeoInvesting also has a Chinese attorney on staff and a network of consultants who do on-the-ground due diligence in China.

I also recommend investors follow the research articles written by Alfred Little who is a contributor to Seeking Alpha and other websites.  Mr. Little has lived in China for 20 years.  He began his career with Deloitte and served as a senior financial executive in industry before becoming a full time analysts and investor.  He has angered and upset many bulls by piercing the bubbles of more than a few China small cap companies including a company I was extremely bullish on last year.  In time, I learned that he was right and my reliance solely on SEC filings and my analytical skills simply wasn’t enough.   I grew to understand and respect his work and research.  He might not always tell investors what they want to hear but he tells it like it really is.  Mr. Little has a staff of Chinese nationals and many other resources in China to do his independent on-the-ground due diligence and research.

One Final Observation

China truly is in a wild, wild west phase of its business and entrepreneurial development.  The business environment and code of business ethics is sometimes bound only by whatever businessmen in China can get away with.  That’s not true of all but certainly is of many.  We are going through a cleansing process as one China small cap company after another falls by the wayside taking unsuspecting US investors’ money with them.  Once the dust settles though there will be ample opportunities to profit from China’s explosive growth for years to come.  In the mean time it is a matter of buyer beware.  Proceed with caution and use the resources that are available to you to help cull out the truly great opportunities and avoid the rest.

Disclosure:  I am (regrettably) long CCME and have no position in CBEH.