Saturday, May 28, 2011

The audacity of Chinese frauds

NEW YORK: To pull off a fraud that humiliates the cream of the global financial elite, you need to have some friends. And where better to have them than at the local bank?
Wall Street-listed Chinese firms like Longtop churn out lies with the help of local banks. Fraud in Chinese stocks is not new. But it had seemed that the worst problems were in small companies without Wall Street pedigrees. What is stunning about Longtop and some other recent disasters is the list of smart people who were fooled.

The fraud at Longtop Financial Technologies, a Chinese financial software company, was exposed this week in an amazing letter from its auditors, Deloitte Touche Tohmatsu. It appears to be a tale of corrupt bankers and their threats to auditors who had learnt of the lies.

Deloitte, which had given clean audit opinions to Longtop for six consecutive years, apparently was well on its way to providing a seventh, for the fiscal year that ended March 31.

But for some reason - Deloitte did not say why - the auditor went back to Longtop's banks last week to again seek confirmation of cash balances.

It appears Deloitte sought confirmations from bank headquarters, rather than the local branches that had previously verified that Longtop's cash really was on deposit. And that set off panic at the software firm.

'Within hours' of beginning the new round of confirmations on May 17, the confirmation process was stopped, Deloitte stated in its letter of resignation, the result of 'intervention by the company's officials including the chief operating officer'.

The company told banks that Deloitte was not really the auditor. It seized documents, Deloitte wrote, and made 'threats to stop our staff leaving the company premises unless they allowed the company to retain our audit files'.

Despite the company's efforts, Deloitte learnt that Longtop did not have the cash it claimed and that there were 'significant bank borrowings' not reflected in the company's books.

A few days later, Deloitte said, Longtop chairman Jia Xiao Gong told a Deloitte partner that there was 'fake cash recorded on the books' because there had been 'fake revenue in the past'.

The stock has not traded since that confrontation. The final trade on the New York Stock Exchange was for US$18.93, a price that valued the company at US$1.1 billion (S$1.4 billion).

At its peak in November, it had a market capitalisation of US$2.4 billion.

It now seems likely that the stock is worthless. It is a real company, but its revenue and profits probably were a small fraction of the amounts reported.

The existence of the 'significant' debt means that whatever assets are left are likely to be owned by the banks, not the investors.

Deloitte may have decided to check the numbers again because it knew a growing group of bears on the stock had been challenging the Longtop story as too good to be true, questioning both its financial statements and the claims it made for its software.

A month earlier, Deloitte resigned as the auditor of another Chinese company, China MediaExpress, in part because of questions about bank confirmations.

It is never good for an auditor to have certified a fraud, but Deloitte seems to have acted properly.

It got bank confirmations, and it got them directly from the banks rather than relying on the company to provide them, as PricewaterhouseCoopers had done when it failed to notice a huge fraud at Satyam, an Indian technology company.

But the confirmations were lies.

'This means the Chinese banks were in on the fraud, at least at branch level,' said Mr John Hempton, chief investment officer of Bronte Capital, an Australian hedge fund. He was one of the bears who questioned Longtop's claims and now stands to profit from the stock's collapse.

'This is no longer a story about Longtop, and it is not a story about Deloitte,' he added.

'Given the centrality of Chinese banks to the global economy, it's a story much bigger than Deloitte or Longtop.'

The US Securities and Exchange Commission (SEC) has started an investigation, and no doubt more details will emerge, including the names of the banks involved.

Just what, if anything, Chinese officials choose to do could provide an indication about whether defrauding foreign investors is deemed to be a serious crime in China.

Fraud in Chinese stocks is not new. But it had seemed that the worst problems were in small companies without Wall Street pedigrees.

Many of the fraudulent companies went public in the United States by the reverse-merger shell route, a course long favoured by shady stock promoters. That route allowed companies to start trading without going though a formal underwriting process or having its prospectus reviewed by the SEC.

And many used tiny audit firms based in the US that seemingly did little if any work.

What is stunning about Longtop and some other recent disasters is the list of smart people who were fooled. Longtop did not go public through a reverse merger. Its initial public offering, in 2007, was underwritten by Goldman Sachs and Deutsche Bank. Morgan Stanley was a lead manager in a 2009 offering of more shares.

Major owners of the stock included hedge funds run by people known as 'tiger cubs' because they got their start at Julian Robertson's Tiger Fund.

But the audacity of this and other frauds, as well as the efforts to intimidate auditors, stands out.

If investors such as Goldman cannot fend for themselves, something more needs to be done if Chinese companies are to continue to trade in American markets.