China's Madoff Scandal: The Biggest Fraud Being Perpetrated Against US Investors That You Haven’t Heard About (and why it's the best thing to happen to Chinese businesses in a decade)

Back in early February I tweeted about a phenomenon that I had noticed was gaining steam in the run-up to the 2010 year-end earnings season. I'd been noticing an awful lot of Chinese companies delaying their filings or even announcing that they would be delaying their 2010 numbers AND re-stating their 2009 numbers. A few were forced to disclose investigations into their accounting practices by their trading boards (AMEX, NASDAQ, etc.) and/or the SEC. It seemed ominous.

"Biggest story that the media isn’t writing about: The growing number of Chinese companies under investigation for fraud."

I didn’t post anything else about this, but I watched in morbid fascination as things got more and more crazy with each passing week. Company after company delayed their earnings or announced investigations. Accounting firms started dropping their Chinese clients amid allegations that they could no longer vouch for the numbers on earnings reports that they had already certified and that they were being stonewalled by Chinese CEOs and boards of directors. Markets started suspending the trading of companies.

There was even one night when one of our clients needed to get an emergency press release out to disclose the freezing of their stock, but nobody could find the US-based CFO. The CEO had NO IDEA where he was and the release couldn’t go out without his OK. It was just insane. (The CFO eventually surfaced for a few days – back in China. He has since left that company and was immediately hired on as the CFO for another troubled Chinese company. Revolving door, indeed.)

Fraud. Apparent money laundering. Payoffs. Corrupt IR firms. Losses to investors totaling in the billions. A crisis in confidence was brewing in the world's largest developing economy and it was just screaming for attention. But it was getting only whispers in investment industry trades and blogs.

Until now.

What's Going On?

This past Sunday The New York Times ran a fantastic piece on what's been happening with these Chinese companies. In it, David Barboza and Azam Ahmed spell out how dozens of Chinese companies have basically snuck onto the US markets (via "Reverse Mergers" - buying defunct or dummy corporations in the US that are already listed), their meteoritic rise and spectacular crashes once their Chinese practices ran headlong into Western accounting and disclosure requirements.

And today, Reuters ran an amazing story on the subject that spotlights the grand-daddys of Reverse Mergers: Timothy Halter and Zhihao Zhang. The process that they pioneered has lead to an unprecedented opening of the Chinese market to US investors and, ultimately, to tens of billions of dollars in losses.

These stories are very well-written and go into great detail about what has been happening but they don’t really talk about why this all happened in the first place.

Why Did This All Happen in the First Place?

China is booming. We all know this. What most people in the West don’t realize is that, for the most part, China is a pretty closed financial system and there aren’t a lot of ways for people to invest and make money in the ways that we would think of as normal in the US.

There are no mutual funds, 401Ks or brokerage firms that are available to the general public. While a majority of middle class people in the US are participating in the markets in some fashion, very few Chinese have access to what we would consider typical investment vehicles. Liquidity for domestic businesses, therefore, has to come from state-controlled banks or a small cadre of ultra-rich oligarchs.

China's domestic stock markets, excluding Hong Kong, are erratic at best, filled with companies whose SOPs are even worse than those of the companies currently being kicked out of US markets. China's regulatory system is a joke; it's inadequately staffed and funded, obsolete and so corrupt as to be completely self-serving.

Strict controls on the Yuan prevent private money from flowing out to foreign markets. Most of the major investments in American companies and real estate that you've been reading alarming press accounts of have been made by sate-owned companies, the super rich or China's government-owned foreign investment fund.

Essentially, the only way for business people and mid-level party guys (the ones who don’t control entire sectors of the economy themselves) to start really growing their wealth is to build a company that can actually succeed in China's cutthroat economy or just build something that can attract tons of foreign investment, and then set that company up in a trusted foreign market where they will then have access to trillions of dollars of private capital.

(An aside: This closed-off system is a BIG reason why China's real estate market continues to be red-hot. Middle class Chinese families really have no other way to save/make money than by buying real estate. Bank interest rates are so low as compared to inflation [4% on a CD vs. 10% inflation – food is up almost 100% in some places in the past year alone] that banks are not an option. So, since they can’t buy into foreign markets without special permission from the government, and their domestic markets are swamps of corruption, the money all flows into homes.)

As far as investors were concerned, Chinese companies showing up on Western trading boards a few years ago were like manna from heaven to nervous investors. With markets jittery about deficits, housing crises, sovereign debt and wars, money managers had been looking for better growth bets. BRIC countries (Brazil, Russia, India, China & South Africa) have been great places to go, but China has shined among them as the best place to park your dollars and make the biggest profits.

When Chinese companies started arriving onto US markets with stellar balance sheets, impeccable-looking business plans and smooth-talking executives at investment conferences, buying in seemed like a no-brainer. And with the safety net of US trading regulations, it appeared safe. So the money flooded in and nobody asked any questions. For a while, anyway. (Sound familiar?)

Hearing the Tree in the Forest

China's economy has developed almost completely independently of the West over the last 30 years. Its near-reckless embrace of capitalism has mixed with its unique culture and system of government to form a murky, near un-navigable business environment. The entities that have grown out of this swamp to reach into the markets of the West were like nothing we have ever experienced before. Consider some of the practices that are commonplace in China:

• Business here is ALL about relationships - Deals just don’t get done unless a relationship exists or is developed over time. Companies that have boards of directors will pack them with Party people or loyalists/allies/relatives of Party people. This ensures that the right relationships exist to grease the wheels of bureaucracy.

• Corruption is a part of life - There are kickbacks on top of kickbacks with just about everything that you want to do here. While that can actually provide a bit of certitude (i.e. you KNOW that things will get done once you've paid off the right people), you're also in danger of falling victim to the always-shifting political winds. If your "sponsor" is on the outs one week you could find your whole deal scuttled, no matter how good it is.

• It's all about the Benjamins – There is an unprecedented amount of cash floating around in China. This is as a result of having such a closed monetary system and it fuels he rampant inflation. It's looking for places to go and you can never be 100% sure if investments are legit or laundering schemes that the government (or some high-level official) has set up to hide their "hot money".

Enter Muddy Waters. This is a research firm dedicated to ferreting out bad Chinese companies and bringing their frauds and shady accounting practices to light. They started blowing the whistle back in November of 2010 and the drumbeat of reports kept coming all through the next few months. No incredible history of hyped earnings was safe, it seemed.

But for all of the chaos that they have caused back in China, and all of the losses suffered by US investors as a result, this collapse is really the best thing to happen to the Chiense economy in about a decade.

So What Now?

Currently, investigations are still ongoing. Many companies are slinking back into the wilds of the Chinese market by going private. Others are allowing themselves to be "taken over" by a rival, their assets swallowed up and recycled. Still others will just cease to be, their owners and backers moving on to other things, their windfalls intact and untouchable by US courts or creditors.

A few, however, are different. Some are vowing to fight the fraud allegations. Some are re-submitting earnings numbers for the past 3 years and having them vetted by large, internationally-recognized accounting firms. I've even seen a few companies submitting earnings reports for the current quarter that are pretty bad compared to what they've posted over the past couple of years. Instead of folding, they're soldering on.

These companies are the game-changers. They'll set the stage for a new era of Chinese corporate governance. In the end, it will be the companies that decide to adhere to the rules of the Western game that will be successful. Their success will breed imitators here (it's what the Chinese do best, after all) and just as Big Macs and blue jeans helped to conquer to Soviet Union (sorry, sweetie), the Chinese's own drive to get rich and access Western markets will drive them ever further towards our way of doing business.

Conversely, one hopes that investors, fund managers and financial institutions in the US will stop seeing China as a get-rich-quick scheme and just dump money into anything that waives a pretty Excel spreadsheet in their faces. As much as we need China to grow, they need us just as much. Start demanding more from them and they'll deliver. Just you wait and see.