Published: September 5, 2011

The granddaddy of all China RTO frauds, the Muddy Waters Research report on Sino-Forest Corporation reads.

In June 2011, short-seller Muddy Waters Research brought allegations of fraud and mismanagement against Sino-Forest Corporation, which listed on the Toronto Venture Exchange 16 years ago by way of a reverse merger (also known as a reverse takeover). A legal and legitimate financial technique particularly popular among Chinese companies, reverse mergers are also frequently misused as a cover for financial fraud, as seems to be the case for Sino-Forest.

Following the Muddy Waters report, Sino-Forest hired PricewaterhouseCoopers LLP to assist in the independent investigation, which was delayed due to data-collection challenges and is expected to be complete by year end. Largely as a result of this delay, the companys long-term corporate credit rating was reduced from B+ to B and all of Sino-Forests ratings are being kept on CreditWatch with negative implications, S&P said August 22. The Ontario Securities Commission temporarily halted trading of Sino-Forest Corp stock on August 26 and Sino-Forest Chief Executive Officer and Chairman Allen Chan resigned two days later.

It seems impossible that a Chinese RTO coming public in 2010 could ever get to where TRE [Sino-Forest Corporation] did. But for many years, TRE [Sino-Forest Corporation] sat barely noticed on the Toronto exchange. It was committing fraud from the very beginning; but, there were not enough similar frauds to raise investors awareness, the Muddy Waters Research report stated.

Sino-Forest is just the latest in a long line of problem Chinese companies that have listed on Western stock markets, whether by IPO or a reverse merger, and it is unlikely that it will be the last. Previous such companies have included:

• China MediaExpress Holdings (CMEC), which was exposed by a special Seeking Alpha investigative report in Spring 2011 as a rank fraud
• China Sky One Medical, for which American investor John Bird found discrepancies between the financial filings with the U.S. Securities and Exchange Commission and the Chinese regulatory agency, the State Administration for Industry & Commerce and which, in February 2011, announced it has submitted amended filings to U.S. Securities and Exchange Commission the years 2007-2009
• China Energy Savings Technology, which was suspected of murky activity as early as 2006, and by 2009 saw all of its top executives fleeing the venture, four of them liable for fraud

The best method of investor protection against problem Chinese companies listing abroad? Due diligence, due diligence, due diligence. And take off the rose colored glasses.

For more information, check out the Conducting Due Diligence in China report and September 2011s China Briefing magazine, Reevaluating Joint Ventures and M&A, both available at www.china-briefing.com.

What are Reverse Mergers?

Reverse mergers are performed for various strategic business reasons, including but not limited to expanding business scope, raising new capital, repairing tainted reputations, saving an acquired entity from bankruptcy, taking private companies public, creating spinoffs, and hostile takeovers.

Most significantly, this type of merger in the United States allows private companies to list publicly through the acquisition of smaller, often dormant public companies without incurring the hefty and time-consuming costs of orchestrating traditional IPOs.

The reverse merger approach also allows for companies to establish private empty, shell, blank-check, or special-purpose acquisition company (SPAC) companies in the U.S. called such because they are solely composed of an organizational framework and register on U.S. stock exchanges. Though some of these launch on OTC lists or pink sheets, many that have set up as Form 10 shell companies have skipped directly to major boards such as NASDAQ or NYSE because of such technical loopholes.

Reverse mergers are attractive to Chinese enterprises in particular because they effectively allow Chinese companies to avoid both Chinas profitability requirement, in which companies have to post a stable profit before filing for an IPO, and the lengthiness of the IPO listing process in China.

After registering shell companies in the U.S. the parent companies can then complete reverse mergers by acquiring the penny-stock listing companies in as little as three months. The IPO approval process can take up to three years in China. Thus, reverse mergers are particularly attractive alternatives to companies that find it difficult to secure capital quickly.

Registering on Chinas stock exchanges is especially difficult for smaller companies that lack the Chinese governments support provided to large state-owned enterprises. Since 2005, over 350 Chinese companies have gone through this reverse merger process.

Reverse Merger Fraud

Reverse mergers are legal in the U.S. but lax regulation allows companies to easily misuse this financial technique. One of the biggest issues with reverse mergers is the lack of investigation and evaluation of a company prior to acquisition. In the U.S. companies can bypass SEC scrutiny to some extent, because the private company mainly deals with the public company shareholders rather than government regulators. For example, a company can more easily report fictional financial data, often by overstating revenues, to inflate stock value and to exploit the process for quick profit.

Though U.S. regulators released tighter laws in 2005 for reverse mergers, requiring companies to increase the amount of information disclosed to the SEC after merging with shell companies, suspected fraudulent behavior is still rampant. Audit reports on financial data filed by issuers operationally based in China should be handled carefully, according to an official warning released by the Public Company Accounting Oversight Board (PCAOB) and the SEC in July 2010. The National Economic Research Associates reported 12 percent of private securities cases filed in the U.S. were against non-U.S. issuers, 38 percent of which were based in China.

Prosecution of corrupt Chinese companies involved in reverse merger fraud is difficult to complete, as the SEC has virtually no authority to demand compliance with subpoenas in China and can only pressure Chinese regulators to prosecute the Chinese companies and individuals involved.

However, reverse merger fraudulent behavior involving Chinese companies is not always entirely on the part of Chinese companies and individuals, but rather among a large number of people in the U.S. and China. There is a mushrooming market of middlemen firms claiming to have the resources and expertise necessary to guide the companies through the merger process.

Frequently, the prime movers in the process are Chinese, and never leave China. They enlist the help of bankers, auditors, and stock promoters in the U.S. with promises of huge profits in the event of success. Often, the promoters some Chinese and some American are bailing out just as the public gets in, wrote one reporter for www.thestreet.com in 2010.

Financial Due Diligence

So, how to protect investors from reverse merger fraud? Until regulators step in to better protect investors, due diligence is the best form of investor protection. Financial (and legal) due diligence is critical to evaluate not only the soundness of the companies involved, but also to protect from any fatal holes in financial data audited in China, where compliance with government corporate regulations is in no way guaranteed.

As a general statement, the level of financial reporting of Chinese companies falls short of Western standards and trying to shoehorn Chinese companies into Western financial/accounting standards and business practices is a difficult process. The expectation gap — between what foreigners expect in financial reporting and what is actually delivered by Chinese companies — is still very wide.

This issue is not just of relevance to reverse mergers and IPOs by Chinese companies. In fact, we are seeing an increase in M&A activity (both asset and equity purchases) by foreign companies in China and a resultant increase in the level and scope of due diligence.

Heightened Scrutiny is the Order of the Day

In our firms 19 years of experience in China, when called upon to examine accounts prepared by Chinese businesses, we have consistently found accounts have been incorrectly prepared. This can be due to deliberate attempts to deceive, as were seeing in exposed reverse merger frauds, but is often also due to tax avoidance, incompetence or simply bad accounting practices. Whatever the reason for incorrectly prepared financial accounts, uncovering the true financial standing of a Chinese company is essential knowledge for all investors.

Below, find some common areas of inaccuracies in Chinese accounting books.

Practices specifically for tax avoidance and deferral

Two or more sets of financial accounts

Multiple sets of financial accounts are far more common in China than you may imagine. While these multiple books are quite often used to avoid tax, they are also sometimes used to cover up other inappropriate financial behavior within the company itself. Moreover, often the official set of accounts are prepared electronically whereas the other set is maintained manually, and accordingly, it is often very difficult or impossible to reconcile these accounts.

Revenue received off the books to avoid paying tax

Another method of tax avoidance that may have implications beyond those with the tax bureau — keeping payments off the books. Accounts receivable is usually under-reported in China in an attempt to hide sales to reduce taxable income.

This relates closely to the issue of fapiaos (described in the last article in this issue), which are required for all legal transactions, partially to ensure that business tax and value-added taxes are paid.

Often, a companys assets will become mixed with those of a shareholder, senior executive or related/associated company, and vice versa. This discrepancy can go both ways — understatement or overstatement. Of particular note is the review of the major contracts of a company to ensure validity, enforceability and even existence.

Practices based on general industry practice or incompetence

Accounting undertaken on cash or invoice basis rather than an accruals basis

This point of incorrect preparation speaks for itself. This leads to cutoff issues, understatement and overstatement of assets liabilities, income and expenses. When two sets of books are being maintained, this issue causes particular problems.

Bad inventory control and management

The inventory control and management practices expected by Western investors are often a far cry from the reality of the stock rooms of Chinese companies. In many cases a company cannot update inventory movements in real time. Variances between actual stock and book figures have to be made manually.

Often we encounter situations where the physical stocktake is not conducted thoroughly, and any investigation work is not soundly performed. In many cases, there is simply a lack of communication between the shop floor and the accounting department in relation to stock control.

Accounting management

Often the internal financial and accounting staff of Chinese companies is simply not equipped to undertake more than just a bookkeeping role. They lack up-to-date knowledge of accounting principles, treatments and standards including international GAAP rules.

Furthermore, there is often a disconnect between the accounting and financial staff and the operating divisions resulting in a lack of coherence between the financial statements and the operating results of a company.

In foreign-owned local companies, there is the perpetual problem of communication difficulties between the head office and the Chinese subsidiary.

Audit practices

We find that local auditors often only act as a rubber stamp to local management rather than providing a reliable system of checks and balances to the Board of Directors and shareholders. Lack of audit planning and execution are the main problems. In extreme cases, we see that local auditors are on site for less than a day. Often local auditors are reluctant to make any adjustments which detract from the reliability of the overall audit. A further common complaint is the inability to prepare a local audit report in English, and the reports nonconformity with the most basic of international forms and standards.

A two-to-three day site visit by an experienced auditor should show whether accounts and financial statements presented are indeed a statement of fact or whether there are areas within them that warrant further investigation.

We advise you to contract a professional accounting practice that has experience supervising the local audit of Chinese companies. A well-planned and complete financial due diligence or financial health check is essential to discovering the true picture of Chinese companies.

About the Author

Richard is an Australian lawyer/CPA who has worked in business and commercial consulting both in Australia and China for the past 20 years. He was previously a partner at Ernst & Young Australia and holds an LLB from the University of Adelaide and a Master of Laws from the University of Sydney. Richard is a Director of Legal & Accounting Services for Dezan Shira & Associates in Shanghai and contributes both legal and accounting content to the news section and magazines at China Briefing.

Richard assists foreign individuals and companies establish, maintain and expand their businesses in China. His areas of practice include:

• Corporate accounting services including accounting, audit and taxation compliance;
• Business advisory services including establishing businesses in China and Hong Kong;
• Financial, legal and operational due diligence on Chinese companies and businesses;
• Merger and acquisition transactions in China;
• Taxation planning and structuring

Richard also makes a number of presentations to professional, trade, government and other international organisations on setting up and doing business in China