On an April afternoon in 2009, in his home office near Austin, Texas, 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.
A silver-haired short seller, Bird, 62, projects an air of relaxed amusement. His philosophy is reflected in a sticker from “The Big Lebowski” over his door: “The Dude Abides...”
Some things he takes very seriously, including what he calls the “sanctity of math.” On that afternoon it was being defiled in his eyes by the claims of China Sky One Medical Inc., a maker of slimming patches and hemorrhoid ointments. Sky One, according to its annual report, was selling out its inventory and resupplying almost every seven days. That, Bird says he knew from experience in business, was impossible.
Sky One, Bird would find, wasn’t the only stock recently arrived from China to defy financial speed limits, Bloomberg Businessweek reports in its Jan. 17 issue. It’s one of about 370 Chinese companies -- with a combined market value of at least $20 billion -- that have obtained U.S. listings since 2004 without the rigors of initial public offerings.
Some of them have reported numbers making Bird suspect what he calls “flat-ass” fraud. The Securities and Exchange Commission hasn’t until recently paid much public attention to what Bird describes as a pattern, at a time when investors are still recovering from the Bernie Madoff Ponzi scheme.
Chinese Reverse Merger
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 stores of popcorn and candy every three days or so, while cups and buckets took months to run out, for an average turnover of eight to 10 days. Sky One’s inventory, Bird figured, ought to move more slowly, because cardboard boxes for packaging and adhesives for patches are bought in bulk, and used bit by bit as orders come in.
They’re turning their supplies over faster than a doughnut shop, Bird says he thought. 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 and the other companies have moved onto U.S. exchanges through a process called a reverse merger, in which a closely held company buys a publicly traded shell company -- and retains the U.S. listing as its own instead of extinguishing it, as usually happens in takeovers. Bird says that many reverse merger companies are deceptive, at best, about their numbers.
‘Thumbing Their Noses’
The questions Bird raised from his 70-acre spread northeast of Austin touched off a dispute among short sellers, auditors and regulators over the quality of companies with operations in China and shares on U.S. exchanges.
“The whole thing has no place to go but to blow up,” Bird says. “That’s a rational position for an investor to start with -- that every one of these Chinese reverse mergers is a fraud.” Executives of the companies in China, he says, are “thumbing their noses” at investors in the U.S.
Sky One officials declined to comment for this story.
The company’s shares are available to retail investors through such funds as the Oppenheimer Main Street Small Cap Fund 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, California, that has been one of the most active in helping Chinese reverse merger companies raise money, recently tried to define the size of the market. It came up with a list of 94 companies with a market capitalization 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.
Returns for Chinese reverse merger companies totaled 43 percent for the five years through 2010, even with a slide of 23 percent last year, according to Roth Capital’s analysis. The Russell 2000 Index was up 25 percent in 2010 and the Nasdaq Composite Index climbed 17 percent.
Bird says he didn’t start out on a mission against Chinese stocks. It’s just that he’s not one who believes in doing things by halves. His art collection includes a nine-ton copy of a Babylonian horse figurine from 600 B.C. that sits next to his pool and two six-foot-tall mosaic eggs that spin in a field. 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 says, while his father was stationed with the U.S. Air Force in Japan.
Blank Check Companies
He came to shorting Chinese companies through a website run by Manuel P. Asensio. Now an investment advisor, Asensio was barred from the brokerage industry in 2006 by the National Association of Securities Dealers, now called the Financial Industry Regulatory Authority, for failing to cooperate with an investigation into misleading research reports. Shorts bet against a stock by selling borrowed shares with the plan to repurchase them at a lower price and pocket the difference.
Asensio.com publishes short-selling ideas, and initiated coverage of Sky One in April 2009, questioning a history of restatements and frequent changes in auditors. That sparked Bird’s investigation.
Sky One was a merger of Comet Technologies Inc. and American California Pharmaceutical Group Inc., Bird found. Comet Technologies was a so-called 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 Co., which had made over-the-counter medicines based on herbal remedies since 1994 in the Chinese city of Harbin.
‘Dead Stock Walking’
The shares of the new combined company -- China Sky One Medical -- finished 2006 at $8 and climbed 75 percent in 2007 to $14, as the company promised it was stepping up from wart-removal spray to gene recombination techniques. In 2008, Sky One moved from the OTC Bulletin Board to trade on the American Stock Exchange and then on the Nasdaq.
Bird turned up credit reports on Harbin Tian Di Ren from data providers in the U.K., India and China. The numbers in all three matched each other, but they did not match SEC filings made by Sky One.
After two months of e-mails and phone calls, Bird says he reached a woman named Terry at Qingdao Inter-Credit Services, a credit report provider in China, who sent Bird the government filings Inter-Credit used. They were from the State Administration for Industry & Commerce, or SAIC.
The SAIC filings were “like getting X-rays of a terminal patient,” Bird says. “It was dead stock walking.”
The SAIC is the Chinese government agency responsible for market supervision, regulation, and enforcement. According to a SAIC 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 Tian Di Ren accounting for at least 65 percent, or $59.7 million.
Bird ordered more reports to trace Sky One customers and suppliers; he says the paperwork showed companies too small to generate the orders or inventory Sky One reported.
By August 2009, Bird was ready to place a serious bet. He logged onto 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 posted a selection of his evidence.
He chose the Internet address waldomushman.com -- Waldo Mushman being the occasional pseudonym of the actor Steve McQueen, at least according to Bird.
Focusing on ‘Gatekeepers’
Bird sent his evidence to the SEC, Sky One and Sky One’s auditor, Cranford, New Jersey-based MSPC Certified Public Accountants and Advisors P.C., then called Moore Stephens P.C. Bird says an SEC official in Los Angeles named Junling Ma called him about the SAIC documents, as did a Nasdaq enforcement officer. Nasdaq spokesman Wayne Lee didn’t respond to requests for interviews with exchange officials.
The SEC in the last few months has begun to look more closely at reverse merger companies with foreign management and ask for more disclosure on financial reporting and controls, said John Nester, an agency spokesman. He said the SEC created an enforcement working group to focus on the “gatekeepers” involved in bringing the companies to U.S. exchanges. He declined to comment on specific cases.
From his home office in Texas, Bird made regular posts to websites, such as Seeking Alpha and Yahoo! Finance, arguing his case. None of it, at first, proved much of a setback for Sky One, whose price mainly climbed.
Bird’s approach did interest other investors, who began to use his method of checking up on Chinese-American stocks through SAIC filings. The far-flung crew included short sellers such as Andrew Left of Citron Research in Los Angeles as well as newcomers, including Muddy Waters Research, based in Hong Kong, and Sahm Adrangi, a 29-year-old Yale graduate running the hedge fund Kerrisdale Capital in New York.
Listing in the U.S. through a reverse merger is easier than joining a market in China. Companies face a waiting period and profitability requirements for a domestic listing on the main exchanges in Shanghai and Shenzhen. A Hong Kong listing on the Growth Enterprise Market presents hurdles, with minimum cash flow thresholds and expected market capitalization.
A U.S. reverse merger can take as little as three months and cost under $1 million in fees, according to Los Angeles-based CCG Investor Relations, which specializes in Chinese companies. In 2010, 78 Chinese companies listed in reverse mergers, according to DealFlow Media Inc. figures as of Jan. 6. They joined 294 other companies that did so from 2004 through 2009, DealFlow data show.
The Sky One deal cost between $600,000 and $800,000, according to Charles Hung Jr. of American Eastern Group Inc., the Los Angeles investment firm that set it up. He says he and his father, Charles Sr., visited the company for more than a week to meet management and see the products on store shelves.
Sky One was led then and now by Chairman and Chief Executive Officer Liu Yan-Qing. Liu’s background is in drug marketing, journalism and research and development, and he has a bachelor’s degree from Harbin Medical University as well as an executive master’s degree in business from Tsinghua University, according to his biography on the company website.
Hung Jr. says the company wanted to go public for the right reasons -- expansion, as opposed to a chance for the executives to cash out.
Starting in the early 2000s, the Hungs engineered four Chinese reverse mergers, the last one for China Shen Zhou Mining & Resources Inc. in 2006. 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. Regulatory filings list Gertino as investing in real estate and having run a car tune-up franchise.
Gertino received 163,581 shares of the new company, warrants for more shares and a consulting deal for financial and management planning covering the two years after the merger, according to company filings. 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 Corp., a two-partner firm in City of Industry, California, that prepared two years of U.S.-audited financials. Hung remembers E-Fang as “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, not specifying which work triggered the action.
Just 1 Percent
Hung says that he wouldn’t do a reverse merger now unless the company agreed to a top 10 auditor.
Others in the business include Benjamin Wey, who has built a career bringing companies from China onto exchanges like Nasdaq. Wey was born in China and likes to recount how he arrived in the U.S. in 1992 with $62, and worked part-time as a Chinese chef while attending Oklahoma Baptist University.
Wey now has offices on Wall Street and 60 employees in China, and says he accepts just 1 percent of the companies that seek him out. He says his clients don’t want to wait to list at home and that a full-blown initial public offering in the U.S. is expensive and difficult. “The reason these companies do reverse mergers is not because it’s good or bad,” he says. “They have no alternative.”
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 more money with a secondary offering once the company has established credibility in the U.S.
Last year, he helped a Chinese manufacturer of wind turbine towers, CleanTech Innovations Inc., make its U.S. debut, and the shares are now trading on the Nasdaq. He says he assigns up to nine Chinese 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 he brought over, Bodisen Biotech Inc., for incomplete and inaccurate disclosures related to share ownership by officers as well as payments to Wey’s company. The move came after stories in the New York Post and MarketWatch. Wey blames journalists in league with short sellers.
The Oklahoma Department of Securities 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 Bird’s waldomushman.com went live, Sky One acknowledged its SAIC and SEC filings were “materially different,” assuring 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,” he 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 began delving into the company’s seven patents, which Sky One valued at $1.6 million in 2007 -- and at $15.1 million in 2008.
In the meantime, the shares rose to a high of $24.25 on Dec. 28 and ended the year with a 42 percent gain. That meant Bird needed cash to cover his losses, as brokerages call for a cushion or “margin” to make sure short sales can be settled. At the time of the stock’s rise, Bird was in New Zealand with his wife and, because of the time difference, had to make trades at 3 a.m. and 4 a.m. to cover his margin call.
‘A Stubborn Man’
He returned home exhausted, and down almost $90,000. Instead of cutting his losses, he filed suit in federal court in New Jersey in March against MSPC, the Sky One auditor, for failing to acknowledge misrepresentations in 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 lawsuit. The firm audits three U.S.- listed Chinese companies and some that want to list, according to Richard J. Montalbano, a principal who focuses on China work.
In an April 2009 inspection report on MSPC, the Public Company Accounting Oversight Board, which is controlled by the SEC, noted “audit deficiencies” in one case so significant that the board declared the firm didn’t have enough evidence to support its opinion on financial statements. By May 2010, other shorts began to emerge, waving SAIC filings, just like Bird.
‘Doesn’t Add Up’
A Detroit forensic accountant, Steven R. Chapski, posted an analysis on Seeking Alpha of the 2009 SAIC and SEC filings for cable- and wire-maker Lihua International Inc. Lihua responded by posting its 2009 SAIC filings and a reconciliation with SEC filings on its website. Lihua gained 7.6 percent last year. 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,” Chapski says.
In June, Chinesecompanyanalyst.com, a blog run anonymously by Kerrisdale Capital’s Sahm Adrangi, accused China Marine Food Group Ltd. 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 Co. 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.
‘He’s The Reason’
China Marine shares slumped 30 percent in June. The company responded that for 2009, its SAIC filings were consistent with its U.S. filings.
In November, Adrangi went after China Education Alliance Inc. After meeting with 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 sent locals to look for its products and check out its training center. He obtained the SAIC filings, which showed online revenue of less than $1 million in 2008, while SEC filing put the revenue at $16 million. Adrangi’s report, published Nov. 29, sent the shares tumbling 39 percent in two days -- helping his fund to a more than 30 percent gain for the month.
China Education Alliance denied the report’s allegations, launched a stock repurchase and gave the SEC documentation of its bank balances. The shares finished 2010 down 59 percent.
In June, Muddy Waters took on Orient Paper Inc., a papermaker based in Baoding, in Hebei province, whose stock had climbed from 24 percent to $10.48 in 2009. Muddy Waters was the brainchild of Carson Block, a lawyer and founder of Love Box Self Storage in Shanghai (“Get Self Storage Without BS”).
In a June 28 report, Muddy Waters said Orient Paper’s “purpose is to raise and misappropriate tens of millions of dollars” and accused the company of overstating 2008 revenue by 27 times and 2009 revenue by 40 times.
Orient Paper denied the allegations. Its shares plunged 40 percent in the four trading days after the report was released. They rebounded briefly, dropping again as the company retained law firm Loeb & Loeb LLP to coordinate an investigation. The results of the probe, carried out by Deloitte & Touche Financial Advisory Services, were published in November and dismissed Muddy Waters’ report almost entirely, including the evidence based on SAIC filings.
Orient Paper’s audit committee chairman, Drew Bernstein, says short sellers are 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, co-founder of New York-based Bernstein & Pinchuk LLP, 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, Bernstein says.
The SAIC filings are sometimes not accurate because Chinese companies want to minimize taxes and avoid giving competitors too much information, according to 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 Capital, run by three brothers from Iowa, has made U.S.-listed Chinese companies into 24 percent of its business, and has raised $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 Capital has run or helped manage share sales for China Green Agriculture Inc., Harbin Electric Inc., China Natural Gas Inc., China-Biotics Inc., Wonder Auto Technology Inc. and Orient Paper.
All the companies have been 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 choice of small auditors.
Byron Roth, Roth Capital’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?’”
Chat Room Posting
Roth adds that there are doubtless cases of fraud among Chinese companies, just not enough to outweigh the investment opportunity. “There aren’t that many companies in the U.S. growing at 20 percent plus,” he 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. MSPC would later get a court order making the discovery documents confidential. Sky One revealed in its second-quarter report that the SEC had launched a formal probe 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 work done by local assistants. The examples cited were based in Hong Kong, China or Taiwan. In the 27 months ended March 31, 2010, the report said, at least 40 U.S. 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, the oversight board’s deputy chief auditor.
The board has stepped up investigations of and inquiries into audits of U.S.-listed Chinese companies since the July alert and is coordinating with the SEC, according to its director of enforcement and investigations, Claudius 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,” Modesti says.
$1 Million Profit
In Texas, through 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 has led to increased scrutiny by the Chinese government.
The shares slumped 31 percent in 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 Corp., which Bird did not short, accusing the maker of pollution-control equipment of fabricating some of customer relationships and overstating 2009 revenue by 17 times. Rino then admitted some of its contracts did not exist. Its stock plunged 85 percent in 2010.
China ‘Flying High’
Investors dumped shares of companies that used Rino auditor Frazer Frost LLP, including Harbin Electric, which Bird had shorted. Harbin dropped 15 percent in two days after trading in Rino was halted on Nov. 17.
A couple of days later, Audit Integrity Inc., a governance research firm that 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 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, including William Wells of Memphis-based Pope Asset Management LLC, a major investor in Sky One and other reverse merger companies.
“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 and 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.”
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 five 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,” Papp 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 go to New Zealand this past Christmas. Instead he was serenaded by the sound of waves 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 cancer drug company. His suit against Sky One’s auditors drags on. He’s still short 175,000 shares of the company and hopes the next salvo will come from the SEC. The SEC did not respond to two requests for comment on this story.
“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?” Bird says. “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.’”