Systemic Fraud in China?

China's high growth rates have encouraged foreign investment, which have in turn helped fund China's incredible growth. But such large capital inflows are bound to give way to sector imbalances and fraudulent behaviour. Recently, some fraudulent behaviour has been uncovered among small-cap Chinese stocks that trade in the U.S. But as the story continues to develop, it is beginning to increasingly appear as if the fraudulent behaviour could be operating on a much more massive scale.

Many of the reverse takeover stocks that have been uncovered as frauds have been small cap stocks with auditors with small operations. Perhaps these could be dismissed as a small number of one-off incidences of poor oversight and unethical management. But recent events make it clear that these occurrences are not limited to the small-cap space, and nor are they limited to mom-and-pop auditor operations.

The auditors of some of the recently uncovered fraudulent companies in China have been chided on this site and others. But more and more it is starting to look as if the facilitators of the fraud were not limited to employees of the companies themselves, but included the companies' banks as well. This, of course, makes it clear why auditors were signing off on such large cash balances when they didn't even exist.

For example, Longtop Financial Technologies (LFT) is a billion dollar Chinese company trading on the NYSE. It claimed to have a cash balance of over $400 million. Auditor Deloitte Touch Tohmatsu signed off on the company's financials for six years. This year, however, perhaps because of the recent fraud uncoverings (including that of China Media Express, a company which Deloitte also audited), the auditor went the extra mile. For one thing, it didn't just trust the statements the local bank provided; instead, it made further inquiries. The result was as follows, according to Deloitte:

Within hours however, as a result of intervention by the Company's officials including the Chief Operating Officer, the confirmation process was stopped amid serious and troubling new developments including: calls to banks by the Company asserting that Deloitte was not their auditor; seizure by the Company's staff of second round bank confirmation documentation on bank premises; threats to stop our staff leaving the Company premises unless they allowed the Company to retain our audit files then on the premises; and then seizure by the Company of certain of our working papers.

In that connection, we must insist that you promptly return our documents.

Then on 20 May the Chairman of the Company, Mr. Jia Xiao Gong called our Eastern Region Managing Partner, Mr. Paul Sin, and informed him in the course of their conversation that "there were fake revenue in the past so there were fake cash recorded on the books". Mr. Jia did not answer when questioned as to the extent and duration of the discrepancies. When asked who was involved, Mr. Jia answered: "senior management.

Auditors are likely going to step up their game this year when it comes to auditing companies in China. As a result, more fraud uncoverings are likely, and the risk is there that one or more Enrons are about to go down. This could damage investor confidence, and seriously dampen investment flows into China, serving as a catalyst for a recession.

The economic miracle in China has lifted millions out of poverty and has been a great thing not only for Chinese citizens but for the rest of the world. It would be nice if the economy always grew in a straight line, but it doesn't. Investors counting on China to supply the kind of uninterrupted growth the world has become accustomed to are destined to be disappointed at some point. When that will happen, however, is unknown; but ignoring the warning signs that appear to be emerging could be disastrous for investors.