On an April afternoon in 2009, in his home office outside Austin, Tex.,
John Bird was hunched over his computer trying to figure out if a
Chinese company some 6,500 miles away was anything close to what it
claimed to be. Silver-haired and retired, Bird, 62, likes to project an
air of relaxed amusement. His personal philosophy is reflected in a
sticker from
The Big Lebowski over his office door: "The Dude abides..."
Some things, however, Bird takes very seriously, including what he calls
the "sanctity of math," which on that afternoon was being defiled in
his eyes by the claims of China Sky One Medical (
CSKI),
a maker of products such as "magnetizing" hemorrhoid ointments and
patches that would "dispel fat." Sky One, according to its annual report
filed just a few days earlier, was selling out of its inventory every
seven days.
Bird's first business venture—before real estate development, a music
venue called Club Foot, and a direct-mail marketing firm—was a chain of
nine movie theaters in Austin in the 1970s. Audiences ate through stocks
of popcorn and candy every three days or so, but supplies of cups and
buckets took months to run through, adding up to an average turnover of
eight to 10 days. Sky One's inventory, Bird figured, ought to move more
slowly, since things like cardboard boxes for packaging and adhesives
for patches are bought and stored in bulk and used bit by bit as orders
come in.
They're turning their inventory over faster than a doughnut shop,
thought Bird. Or, as he later put it, "It's like somebody telling you
they just drove over here at 600 miles per hour. It's not going to
happen."
Sky One, Bird would find, wasn't the only stock recently arrived from
China, and it wasn't the only one seemingly exceeding financial speed
limits. Sky One, which declined to comment for this story, is one of
more than 350 small Chinese companies to have listed in the U.S. since
2004 through a process called a reverse merger, in which an operating
Chinese company takes over an all-but-defunct publicly traded U.S. shell
company.
The capital at stake is significant. Shares of such reverse mergers are
held by many funds available to retail investors, including Oppenheimer
Main Street Small Cap Fund (
OPMSX)
and the PowerShares Golden Dragon Halter USX China Portfolio, and are
scooped up by small-cap index funds. Roth Capital Partners, an
investment bank in Newport Beach, Calif., that has been one of the most
active in helping such Chinese companies raise money, recently tried to
measure the Chinese reverse merger market. It came up with a list of 94
companies with market capitalizations of between $50 million and $1
billion that trade an average of at least 50,000 shares daily, with a
total stock market value of more than $20 billion.
Bird's involvement would evolve from irritation that a company could get
away with making a claim that so obviously defies basic business logic
to the conviction that many pieces of the Chinese miracle that trade in
the U.S. are, in his words, "flat-ass" frauds. And what started as a
retiree looking into a company has turned into a dispute that has drawn
in other shorts, the Securities and Exchange Commission, auditors, and,
according to recent reports, the U.S. House Committee on Financial
Services. It has also revealed significant flaws in U.S. markets and how
they are regulated. Although the stocks trade on U.S. exchanges, and
thus project a sense of having to play by American rules, the assets and
the principals of many of the companies reside in China. The companies
operate on their terms, leaving injured parties and the SEC powerless.
Bird says the carnage is just beginning. "The whole thing has no place
to go but to blow up," he says. "That's a rational position for an
investor to start with, that every one of these Chinese reverse mergers
is a fraud."
Bird didn't start out on a mission against Chinese stocks, but he
doesn't believe in doing things by halves. His art collection includes a
nine-ton copy of a Babylonian horse figurine from 600 BC that sits next
to his pool and two six-foot-tall mosaic eggs that spin in the field
beyond; those are two of 18 large sculptures that dot his 70-acre
property northeast of Austin. His wife of 39 years, Jenny, gave him a
backgammon set a few years ago, and he now travels to Las Vegas to
compete in tournaments.
Bird has never been to China; his closest brush came on a visit to Hong
Kong in 1959. He came to shorting Chinese companies through a website
run by Manuel P. Asensio. Now a financial adviser, Asensio was barred
from the brokerage industry in 2006 by the National Association of
Securities Dealers (now known as Financial Industry Regulatory
Authority) for failing to cooperate with an investigation into
misleading research reports. (The noirish world of short-selling is full
of such compromised figures; Bird himself declared bankruptcy in 1985.)
Asensio.com publishes short-selling ideas. It initiated coverage of Sky
One in April 2009, questioning a history of restatements and frequent
changes in auditors and sparking Bird's own investigation.
Sky One, Bird found, was a combination of Comet Technologies and
American California Pharmaceutical Group. Comet Technologies was a
"blank check" company, incorporated in Nevada, with no business other
than finding a promising acquisition. American California Pharmaceutical
Group was a holding company for Harbin Tian Di Ren Medical Science and
Technology, which had been making over-the-counter medicines based on
Chinese herbal remedies since 1994 in the northern city of Harbin. The
shares of the new company, merged and renamed China Sky One Medical,
finished 2006 at $8 and climbed 75 percent in 2007, to $14, as the
company promised it was stepping upmarket from wart-removal spray to
gene recombination techniques; the stock also likely benefited from the
seemingly unquenchable enthusiasm for China's prospects. In 2008, Sky
One moved from the OTC Bulletin Board to the American Stock Exchange and
then to the Nasdaq Composite Index.
Bird turned up credit reports on Harbin Tian Di Ren from providers in
Britain, India, and China. The numbers in all three matched each other,
but they did not match the SEC filings. After two months of e-mails and
phone calls, Bird reached a woman named Terry at Qingdao Inter-Credit
Services, a credit report provider, who sent Bird the filings it used.
They were from a Chinese agency called the State Administration for
Industry & Commerce (SAIC). For Bird and those who followed him, the
SAIC filings were "like getting X-rays of a terminal patient," he says.
"It was dead stock walking."
The SAIC is the Chinese government agency responsible for market
supervision, regulation, and enforcement. According to the filing, Sky
One's operating unit, Harbin Tian Di Ren, had 2008 sales of 6.93 million
yuan, roughly $1 million at 2008 exchange rates. Yet to the SEC, Sky
One reported 2008 sales of $91.8 million, with Harbin Tian Di Ren
accounting for at least 65 percent, or $59.7 million. Bird ordered
reports to trace Sky One customers and suppliers; the paperwork showed
companies too small to generate the orders or inventory Sky One posted.
By August 2009, Bird was ready to place a serious bet. From his home
office, he logged on to his account and sold short 30,000 shares at
$15.70. The natural next step of a short-seller is to get the word out,
and Bird soon posted a selection of his evidence on the Web. Bird chose
the URL waldomushman.com, Waldo Mushman being the occasional pseudonym
of Steve McQueen, at least according to Bird.
Bird also sent his evidence to the SEC, to Sky One, and to Sky One's
auditor, Cranford (N.J.)-based Moore Stephens P.C. (now known as MSPC
Certified Public Accountants and Advisers). An SEC official in Los
Angeles, Junling Ma, called him about the SAIC documents, as did a
Nasdaq enforcement official, according to Bird. He also made regular
posts to sites such as Seeking Alpha and Yahoo! Finance (
YHOO),
arguing his case. None of it, at first, proved much of a setback for
Sky One, whose price mainly climbed, along with Chinese shares in
general.
But Bird's method of checking Chinese-American stocks through SAIC
filings did interest other investors, who began to use it as well. This
disparate, far-flung crew included short-sellers such as Andrew Left of
Citron Research in Los Angeles, the eccentrically named Muddy Waters
Research, based in Hong Kong, and Sahm Adrangi, a 29-year-old Yale
graduate running tiny hedge fund Kerrisdale Capital in New York.
Listing in the U.S. through a reverse merger is easier than joining the
main exchanges in Shanghai and Shenzhen, where local companies face a
long waiting period and profitability requirements. A public market for
startups, ChiNext, only started in October 2009. A Hong Kong listing on
the Growth Enterprise Market also presents hurdles, with minimum
thresholds for cash flow and expected market capitalization.
A U.S. reverse merger, by contrast, can take as little as three months
and cost under $1 million in fees, according to CCG, a Los Angeles
investor relations firm that specializes in Chinese companies. In 2010,
78 Chinese companies listed in reverse mergers, according to DealFlow
Media figures as of Jan. 6, adding to the 294 that did so from 2004
through 2009.
The Sky One deal cost between $600,000 and $800,000, according to
Charles Hung Jr. of American Eastern Group, the Los Angeles investment
firm that set it up. According to Hung, he and his father, Charles Sr.,
visited the company for more than a week to see the products on store
shelves and meet the management. The company was led then and now by
Chairman and Chief Executive Officer Liu Yan-qing. Liu's background was
in drug marketing, journalism, and research and development, and he has a
bachelor's degree from Harbin Medical University as well as an
executive MBA from Tsinghua University, according to his biography on
the company website.
Starting in the early 2000s, the Hungs engineered four Chinese reverse
mergers, the last one for China Shen Zhou Mining & Resources (
SHZ)
in 2006, soon after Sky One's. In three of the deals, including Sky
One's, the Hungs paired off the Chinese companies with shell company
vehicles linked to Utah businessman Jack M. Gertino. Filings list
Gertino as investing in real estate and having run a car tune-up
franchise. He received 163,581 shares of Sky One, warrants for more
shares, and a consulting deal for "financial and management planning"
covering the two years after the merger. Gertino says he passed on
dozens of deals before pursuing the China Sky One reverse merger, for
which he visited the company in China twice. He adds that it's a
"terrific" company.
The Hungs also paired Sky One with E-Fang Accountancy, a two-partner
firm in City of Industry, Calif., that prepared two years of
U.S.-audited financials. Hung remembers E-Fang as being "very thorough."
In December 2008, the California Board of Accountancy suspended
E-Fang's license for 30 days and imposed three years' probation for
gross negligence and violating professional standards, without
specifying which company work triggered the action. Hung now says that
he wouldn't do a reverse merger unless the company agreed to a top 10
auditor.
Others in the business include Benjamin Wey, who has built a career
bringing companies over from China and onto exchanges such as Nasdaq.
Wey was born in China and likes to recount how he arrived in the U.S. in
1992 with $62 in his pocket and worked part-time as a Chinese chef
while attending Oklahoma Baptist University. He now has offices on Wall
Street, 60 employees in China, and says he accepts just 1 percent of the
companies that seek him out.
Wey says that his clients don't want to wait to list at home, and a
full-blown initial public offering in the U.S. is expensive and
difficult, partly because banks don't want to underwrite tiny companies.
"The reason these companies do reverse mergers is not because it's good
or bad...they have no alternative," he says.
From a 38th-floor conference room overlooking the silver and grey glints
of lower Manhattan, he describes how a typical deal works: List via
reverse merger with private funding from his company, New York Global
Group, jump up to a name exchange such as Nasdaq, then raise much larger
amounts of money with a secondary offering once the company has
established credibility. He says he assigns up to nine Chinese local
staff members to lead a company through seven to 11 months of due
diligence before a U.S. listing. "There's a lot of traps to try to
avoid," he says.
In 2007, the American Stock Exchange delisted a fertilizer company that
Wey had brought over, Bodisen Biotech, for incomplete and inaccurate
disclosures related to share ownership by officers as well as payments
to Wey's company. The move came in the wake of a series of stories in
the
New York Post and MarketWatch. The Oklahoma Securities
Dept. also censured Wey in 2005 for not advising customers of the risks
of stocks he sold and not disclosing consulting relationships with some
of the companies. Wey agreed to a ban on working in the securities
business in the state without admitting to the allegations.
A couple of weeks after waldomushman.com went live, Sky One acknowledged
that its SAIC and SEC filings were "materially different" but assured
investors of the accuracy of its U.S. filings. Its shares slid gradually
from almost $15 to under $12 by November, then began to climb again.
Bird was disappointed.
"Here I put the SAIC documents out and I expect to shake the world, and
nothing much happens," Bird says. "So I thought, 'This is going to take
more effort.'" Bird found a private investigator in Harbin who charged
$59 an hour to take photos of Sky One's facilities and investigate land
records, which Bird hoped would turn up incriminating evidence. It
didn't. He also began delving into the company's patents, which Sky One
valued at $1.6 million in 2007. The same seven patents were valued at
$15.1 million in 2008. In the meantime, Sky One shares rose to a high of
$24.25 on Dec. 28, 2009. and ended the year up 42 percent.
The rise meant Bird needed cash to cover his losses, as brokerages call
for a cushion or "margin" to ensure that short sales can be settled. At
the time of the stock's climb, Bird was in New Zealand with his wife
and, because of the time difference, had to make trades at 3 and 4 a.m.
to cover the margin call.
He returned home exhausted and down almost $90,000. Instead of cutting
his losses, however, he filed suit in March against the company's
auditor, MSPC, for failing to acknowledge misrepresentations in Sky
One's financial statements and errors in its audit work. Bird didn't sue
Sky One directly because the U.S. company's assets are in China. "I
just got pissed-off, and I'm a stubborn man," he says. Michael G.
Mullen, the head of MSPC's audit department, declined to comment on the
ongoing litigation. MSPC audits three U.S.-listed Chinese companies and
some that want to list, according to Richard J. Montalbano, a partner in
the firm who focuses on China-related work. MSPC has had other problems
in the field. In an April 2009 inspection report, the Public Company
Accounting Oversight Board (PCAOB), part of the SEC, noted "audit
deficiencies" in one case so significant that the team declared MSPC
didn't have enough evidence to support its opinion on the issuer's
financial statements.
By May 2010, other shorts began to emerge, waving SAIC filings, just
like Bird. A Detroit forensic accountant, Steven R. Chapski, citing Sky
One, posted an analysis of the 2009 SAIC and SEC filings for another
company, cable- and wire-maker Lihua International, on Seeking Alpha.
Lihua responded by making its 2009 SAIC filing and a reconciliation with
SEC filings available on its website. Lihua gained 7.6 percent last
year, but Chapski continues to question the company. "It just doesn't
add up, and I've never heard anybody tell me a good reason why my
thinking is wrong," he says.
In June, Chinesecompanyanalyst.com, a blog run anonymously by Kerrisdale Capital's Adrangi, accused China Marine Food Group (
CMFO)
of fabricating SEC financial statements, citing SAIC documents that
showed 2008 revenue 85 percent lower than reported in the U.S. Adrangi
also questioned China Marine's acquisition of Shishi Xianghe Food
Science and Technology in January 2010 for $27.8 million, pointing out
that Xianghe's proprietary algae drink formula had been worth just
$8,776 in 2009, when Xianghe purchased it. China Marine shares slumped
30 percent in June. The company says that for 2009 its SAIC filings were
consistent with its U.S. filings.
In November, Adrangi went after China Education Alliance (
CEU),
an online education company. After meeting with its executives in
August, he asked a Chinese friend to look at the company's website.
Nonfunctional, the friend reported. So Adrangi followed in Bird's
footsteps: "If there's any person who started this, it's John Bird," he
says. "He's the reason anybody is looking at the SAIC filings."
Adrangi obtained China Education's SAIC filings and sent locals to look
for its products in stores and to check out its training center. The
allegations seemed, by then, familiar. Local SAIC filings showed online
revenue of less than $1 million in 2008, vs. $16 million in revenue from
"online education" in its SEC filings. The company also had a cast of
four auditors in six years and financial metrics that strain credulity
when compared with those of competitors. Adrangi's report, published on
Nov. 29, sent China Education shares tumbling 39 percent in two days,
helping his fund to a more than 30 percent gain for the month. China
Education, whose stock has lost 59 percent in 2010, denied all the
allegations made in the Kerrisdale report, launched a stock repurchase
program, and filed documentation of its bank balances to the SEC.
In June 2010, Hong Kong research outfit Muddy Waters took on Orient Paper (
ONP),
a paper maker based in Baoding, Hebei province, whose stock had surged
from 24 cents to $10.48 in 2009. Muddy Waters was the brainchild of
Carson C. Block, a lawyer and founder of Love Box Self Storage in
Shanghai ("Get Self Storage Without BS") who also consults for his
father's company, W.A.B. Capital, which promotes small companies to
investors.
Muddy Waters dove right in and said in a June 28 report that Orient
Paper's "purpose is to raise and misappropriate tens of millions of
dollars." The report accused the company of overstating its 2008 revenue
by 27 times and 2009 revenue by 40 times. Orient Paper denied the
allegations, but its shares plunged 40 percent in the four trading days
after the report was released. They rebounded briefly and then dropped
again as the company announced in August that it had retained law firm
Loeb & Loeb to coordinate an independent investigation.
In November, the audit committee released summary findings that largely
dismissed the Muddy Waters report, including the SAIC/SEC mismatch, but
did not make the full investigation public.
Orient's audit committee chair, Drew Bernstein, says that short-sellers
are just exploiting the ignorance of U.S. investors and the inexperience
of Chinese executives. "You have these Chinese chairmen, when they take
green dollars from the U.S., I don't think they fully understand the
obligations and responsibilities that come with it," says Bernstein, of
auditor Bernstein & Pinchuk, which represents 40 U.S.-listed Chinese
companies. Coupled with U.S. investors who "can't find China on a map,"
it's a "perfect storm" for shorts, says Bernstein.
Like many U.S.-listed Chinese companies, Orient Paper was underwritten
by Roth Capital, which responded to the short attacks with a primer that
aimed to explain the SAIC filings. "Divergent PRC [People's Republic of
China] filings and U.S. filings do not, in and of themselves, establish
error, misstatement, or fraud," researchers John Ma and Mark Tobin
wrote in a July 2010 report. "This data should be viewed as one aspect
of a broader due diligence process."
Since 2003, Roth, run by three brothers from Iowa, has made U.S.-listed
Chinese companies (not all reverse mergers) into fully 24 percent of its
business, raising $3.1 billion in capital. Its annual growth conference
last year attracted more than 1,000 institutional investors who got
three days of access to 350 companies, including 100 U.S.-listed Chinese
companies, as well as a Billy Idol concert and an IMAX screening of
Avatar.
In the past year and a half, Roth has run or helped manage share sales
for China Green Agriculture, Harbin Electric, China Natural Gas,
China-Biotics, Wonder Auto Technology, and Orient Paper, all targets of
questions and allegations about some combination of mismatching Chinese
and U.S. filings or inflated claims in U.S. filings, overpayments for
acquisitions, and choosing small auditors. No regulatory action related
to these companies has been announced.
Byron Roth, the company's chairman and CEO, says that as the short
attacks continued, "everybody had that little moment of, 'Am I the
sucker, or are they just full of it?' " Roth adds that there are
doubtless cases of fraud among Chinese companies, but not enough of them
to outweigh the investment opportunity. "There aren't that many
companies in the U.S. growing at 20 percent-plus," Roth says. "You can't
paint every Chinese company with the same brush." He also notes that,
as Roth Capital's due diligence procedures "evolve," it checks SAIC
filings now, too.
In August 2010, Bird learned through discovery in his suit against MSPC
that the SEC was investigating Sky One. Bird promptly posted it to a
Yahoo! chat room hosting conversations about Sky One, though MSPC would
later get a court order making the discovery documents confidential. In
August, Sky One revealed in its second-quarter report that the SEC had
launched a formal investigation of its accounting.
Momentum appeared to be gathering. A July 12 audit alert from the PCAOB
noted that some U.S. accountants were issuing opinions for companies
without visiting China or reviewing the audit work done by local
assistants. The examples cited were all companies based in China, Hong
Kong, and Taiwan. In the 27 months ended Mar. 31, 2010, the report said,
at least 40 U.S. accounting firms with fewer than five partners and
fewer than 10 professional staffers had issued audit reports for Chinese
companies. "If you're investing in a company whose operations are all
in the China region, you may want to ask some questions about the
quality of its audit," says Greg Scates, PCAOB deputy chief auditor.
The board has stepped up investigations and inquiries into audits of
U.S.-listed Chinese companies since the alert and is coordinating with
the SEC, according to its director of enforcement and investigations,
Claudius B. Modesti. "Our inspectors continue to raise concerns in our
inspections of certain U.S. audit firms regarding their audits of
issuers either located in China or that have operations in China," he
says.
Throughout the spring and summer of 2010, Bird added to his bet against
Sky One and built positions against Orient Paper, China-Biotics, China
Marine Foods, China Natural Gas, and China MediaExpress Holdings.
In September, Sky One lowered its 2010 revenue forecast from $160
million to $164 million to between $128 million and $136 million, citing
the loss of major distributors. The distributors, Sky One said in a
Sept. 3 statement, didn't want their business information disclosed in
public SEC filings, which had led to increased scrutiny by the Chinese
government. Its shares slumped 31 percent on the first trading day after
the announcement. John Bird found himself with a profit of more than $1
million.
Soon, other bets would begin to pay off. In November, Muddy Waters
issued a report on Rino International, which Bird was not shorting,
accusing the maker of pollution-control equipment of fabricating some of
its customer relationships and overstating its 2009 revenue by 17
times, based on SAIC filings. Days later, Rino admitted that some of its
contracts did not, in fact, exist. Its shares plunged 85 percent in
2010.
Investors also dumped shares of companies that used Rino auditor Frazer
Frost, including Harbin Electric, which Bird had shorted. Harbin dropped
15 percent in two days after trading in Rino shares was halted.
A couple of days later, governance research firm Audit Integrity, which
rates almost 20,000 public companies, warned U.S. investors about
Chinese stocks listed in the U.S. Its system for scoring companies on
100 different accounting and governance metrics had been turning up poor
ratings, often a sign that companies are manipulating their numbers,
says Audit Integrity's chairman, James A. Kaplan. "I noticed this issue
well over a year ago," he says. "But in all candor, no one cared because
of the brand of China. China was flying high. If it was branded as a
Chinese company, it must mean it was going to be good and make money."
"As these companies are scrutinized, investors will uncover the facts
behind the 'Chinese Curtain,' " Kaplan wrote in a Dec. 3 report. "Many
of these stocks may prove to be valueless."
Still, there are believers. Bill Wells of Memphis-based Pope Asset
Management, a major investor in Sky One and other reverse merger
companies, says the China investment thesis still holds. "We see China,
and correctly so for the last few years, as the major country with the
largest amount of growth," says Wells, whose firm manages about $650
million. It started buying reverse merger Chinese companies in 2005
after large-cap Chinese stocks got expensive. "If you can work through
these corporate governance issues, the valuations and the earnings
growth on a lot of these companies look pretty attractive," he says.
According to SEC filings, Pope Asset held 1,040,224 shares in Sky One as
of June 30, 2010. As of the end of September, the fund owned 723,647
shares.
Jeff Papp, a senior analyst for the $300 million Oberweis China
Opportunities Fund, which has less than 5 percent invested in reverse
merger stocks, is also cautiously positive. "Right now, the whole group
is trading at levels implying that they are all frauds, but those who
can tell the difference will hit some home runs," he says. "We're either
never going to see any of these types of Chinese companies listing here
again, or we may be near a bottom in terms of valuations."
Bird did not vacation in New Zealand this past Christmas. Instead he was
serenaded by the sound of waves while in a Hawaii beach rental, and he
heard only good news from his short-selling experiments. Sky One's
shares retreated 69 percent in 2010, and Bird put $500,000 of his $1
million-plus in profits into a startup involved in cancer drug research.
His suit against Sky One's auditors drags on. Bird is still short
175,000 shares of the Chinese company and hopes the next salvo will come
from the SEC. The commission did not respond to two requests for
comment on this story. The SEC's Ma declined to comment.
"The story is not that murky at all. Sky One is a fraudulent company,
and all the ticks on the dog are trying to make as much money as they
can," says Bird. "When you know the stock is going broke, they're
crooks, the SEC is going after them—where are you going to find a better
short than that?" What Bird's not so clear on is why other investors
don't see things the way he does, saying: "It's unbelievable how the
sucker born every minute keeps on wanting to line up and throw their
money at these 'opportunities of a lifetime.' "
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