June 22, 2011 - Beware The China Con Game

Chinese businessmen are like all others: Some are good. Some are bad. Some run great businesses. Some don't run a business at all, just a front that looks like a business, taking proceeds from equity offerings and pocketing them or milking the business dry or reporting false numbers. In other words, they run the gamut of personalities, just like the ones in the U.S., Japan, India, England, France.....you get the picture. The problem for investors is that it's harder to spot the Chinese con men.

Of the 14 stocks investigated, 9 have been delisted and sent to the over-the-counter market, where the liquidity is thin and so are many of the companies. Being delisted doesn't boost the value of a stock.

YUII got in trouble from its most recent conference call where management stated that while they reported buying 13 chicken farms in 2009, in truth, they hadn't bought them, that the seller changed his mind at the last minute. The company allocated $12 million for the purchase, and stated that the deal was consummated. However, it wasn't. Then what happened got more interesting.

The chairman and CEO took the money and put it into a private bank account. Then he went looking for more chicken farms. He bought 11 of them for the $12 million. When the news came out, the stock was delisted, sent to the OTC market, then opened for trading, down 39% at $1.20. The underwriting firm was caught off guard and tried to explain the lie as a way for the CEO to save face for not getting the deal done. The underwriter suspended coverage of the stock. Oddly enough, it did a secondary offering of YUII in October of 2010 for $25 million. You have to wonder how strong the due diligence was.

The second, latest example is China Biotics (CHBT). It was suspended on Wednesday of last week. Its auditors refused to sign off on the numbers for the annual report. The firm claimed in a June 10 letter that there were certain serious issues identified as part of its ongoing audit work. Of course, without filing the 10-K report, the company is in violation of its listing requirements with NASDAQ and the SEC. Management has denied the charges of problems and has its audit committee investigating the issues.

Other recent scams from Chinese companies: forged bank documents to show to auditors that pump up the business, making it look more profitable and robust than it really is.

One more notable fraud: China Expert Technology. This company came public, raised tens of millions of dollars. Then management took the money and ran, disappeared into the netherlands of China or Singapore or somewhere no one can find them.

So what should investors do? First check their portfolios to see if they own Chinese companies. Then find out who the accountants are (it's in the SEC filings at www.sec.gov). If they are an international, well known firm, there's some comfort in that, but not enough to be assured that all is well. If it's a local Chinese firm, suspicions may be warranted.

Also, look for news on the company. When there are announcements, are there numbers involved or does it only contain the fact that a contract was signed, suggesting business will be forthcoming. That's a flag to watch. Many times there is only an announcement, period. There is no business behind it.

One thing these frauds should not do: deter investors from investing in China. As mentioned above, there are criminals all over the world. The ones in China are just new. That's all. There are plenty of great opportunities left in China to make a great deal of money. But investors need to allocate a small, reasonable amount of their portfolio to China, keeping their risk exposure at comfortable levels. Until there is more and full disclosure that can be verified, caution is definitely warranted. But that's true for any country.

- Ted Allrich