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Selling China Short

Several Chinese chemical makers are targets of investors betting on falling stock prices

by Jean-François Tremblay
October 13, 2014 | A version of this story appeared in Volume 92, Issue 41

Photo of a plant in China that Gulf Resources claims to own.
Credit: Jean-Francois Tremblay/C&EN
A short-seller claimed that Gulf Resources does not own this plant, which is on its balance sheet.

Is that company a leading producer of a high-priced chemical, or does it just manufacture cheap solvents used to make it? Does this firm actually own the buildings and plants it has on its balance sheet? Is another company’s output really just a fraction of what it claims?

If such basic questions were being raised about a publicly traded U.S. company, the firm would quickly try to defend itself before severe harm was done to its stock price. Next, the company would likely consult its lawyers and initiate a lawsuit against the source of the allegations. But if the company were not able to defend itself, it would likely face charges that it defrauded investors.

It’s a different story in China. In recent years, medium-sized Chinese firms that are listed on foreign stock exchanges, several of them chemical producers, have been devastated by critical reports published by obscure short-sellers—traders that benefit when a stock price declines. In cases involving chemical firms, the stock either crashed or was hit with a trading suspension. None of them has yet to sue anyone for defamation or starting unfounded rumors.

Although the truth is elusive in all the cases, if nothing else they show that China is fertile ground for both questionable companies and traders that target their stocks.

“The problem is that people rely upon Internet research and no one actually visits the site or performs any investigative due diligence to verify business reality,” says Rupert Utley, a former Hong Kong police inspector and forensic accountant who is now a director at the advisory firm Censere. “Many Chinese firms are quite adept at creating fictitious but convincing websites that give a false impression that a company has certain assets and facilities.”

Trading in two chemical companies listed on the Hong Kong Stock Exchange, which is considered a foreign stock market because it is not regulated by China, was suspended earlier this year after the companies were targeted by three research outfits that short-sell stocks. And in 2011, a Chinese bromine chemicals producer saw its stock price collapse after a short-seller issued a scathing report.

One of the two recent cases involves Tianhe Chemicals, a northeastern China producer of lubricant additives and fluorochemicals that listed on the Hong Kong exchange in June of this year.

A few weeks ago, Anonymous Analytics issued a highly detailed report arguing that Tianhe is “one of the largest market frauds ever conceived.” An offshoot of the hackers’ group Anonymous, Anonymous Analytics professes to seek corporate transparency. It claims not to engage in stock short-selling but acknowledges that other people and entities it has contacted may be doing so.

Tianhe’s sales, Anonymous Analytics asserts, are only a small fraction of what the firm claimed in its launch prospectus. Tianhe’s largest customers—which Anonymous Analytics researchers seem to have spent considerable energy tracking down—are either quite small or nonexistent. The most devastating of Anonymous Analytics’ claims is that Tianhe does not actually have the technical know-how to make its most profitable product, an expensive fluorochemical treatment, known as an anti-mar, that protects touch screens from damage.

Earlier this year, two short-selling outfits, Glaucus Research and Emerson Analytics, issued separate reports on China Lumena New Materials, a Hong Kong-listed firm whose stock was later suspended. According to the researchers, Lumena is at best a minor maker of the engineering plastic polyphenylene sulfide and certainly not the world’s largest producer, as the firm claims.

Glaucus and Emerson also expressed doubts about Lumena’s production of other materials. In particular, Glaucus estimated that Lumena’s claimed output of medical-grade thenardite—which is used in the manufacture of laxatives—would be enough to produce 30 doses per year for every adult in China. “Is China so constipated?” Glaucus asked.

Three years earlier, in April 2011, Glaucus attacked Gulf Resources, a northern China company that calls itself China’s largest producer of bromine chemicals. Glaucus alleged that another company owns the plants that Gulf lists on its balance sheet. The facilities, moreover, have a production capacity that is far lower than what Gulf claims, according to Glaucus.

Tianhe, Lumena, and Gulf Resources issued point-by-point rebuttals of the accusations levied at them. But even Tianhe’s denials fell flat, despite the fact that it is backed by Morgan Stanley, a major investment bank that put its reputation behind the Chinese firm. Gulf Resources ended up paying a compensation to its shareholders, who sued the company in a class-action lawsuit.

It has always been hard to establish facts about Chinese firms, according to a chemical industry expert familiar with the recent stock implosions. He asked not to be identified to protect his business relationships.

The lack of transparency opens the door to both fraudsters and people who aim to destroy stock value by issuing negative reports on companies. “It’s a very opaque environment, where, for example, distributors pass themselves off as manufacturers,” he says. “China offers many opportunities to embellish facts.”

In recent years, this expert says, the Hong Kong Stock Exchange has raised its listing requirements to reduce the likelihood of fraud. It is now harder for Chinese companies to list in Hong Kong than to do so in New York. And yet, the recent trading suspensions show that more needs to be done. “In terms of Chinese companies listing overseas, I think the system doesn’t work,” the expert says.

Investors are normally their own best safeguards against fraud because they have an incentive to closely watch their investments. But when a company based in China raises funds abroad, investors can be hard-pressed to learn what’s really going on, according to Matthew Forney, a former Time magazine correspondent who now runs Fathom China, a Beijing-based firm that researches Chinese companies. Owing to capital controls, Chinese investors cannot buy stocks of firms listed outside China. As a result, “the people who are closest to those companies, and could check whether their story is true, don’t have a reason to check.”

The Hong Kong Stock Exchange does mandate that companies name directors to represent outside investors. But in practice, these so-called independent directors are close to the main owners of the companies, Forney says. Fathom does not do any work for short-sellers, he adds.

A table showing claims by companies and their criticism.

An independent third party protecting investors should be companies’ auditors. But again, that safeguard is not as sound as it seems. Companies hire the auditors that look at their statements, and the priority of these accounting firms, Forney contends, is to find new clients and pocket fees for their work.

The accounting firm Deloitte was the auditor for both Tianhe and Gulf Resources. But searching for fraud isn’t the responsibility of external auditors, which detect it only in exceptional circumstances, Utley adds. “Most fraud is detected through whistle-blowers,” he says.

Forney is surprised to see short-sellers targeting chemical companies because the industry’s large-scale operations are hard to invent. “Unlike, say, an Internet company, a chemical company usually has assets you can see and trucks going in and out,” he says.

Censere’s Utley, though, is not surprised. In his 25 years as a financial investigator in China, he has come across all sorts of scams. One company that Utley and his team of forensic accountants was hired to investigate had 12 different sets of accounts that management used to show different groups.

One indication of the large scale of fraud is that an open market exists in China for “fapiao,” which are official sales receipts. Contraband fapiao are easy to acquire and can be used to legitimize all sorts of illegal activities, from padding expense accounts to providing cash to bribe government officials, Utley says.

Everything can be faked in China, from management’s credentials to actual locations of business, Utley claims. He is even aware of a company that took a foreign visitor on a tour of a facility it didn’t own. “The plant workers were oblivious since foreigners are rarely challenged when touring plant facilities in China, and the foreigner just off the plane, and not speaking Chinese, just assumed they were inspecting a legitimate facility.”

One way to guard against fraud and manage risk in China is to engage firms such as Censere that can verify claims and conduct due diligence into the business reality of a company. It’s expensive, but Utley notes that the cost of not doing so can be even higher.

When it comes to the stock market, few people other than short-sellers have an incentive to test the claims that companies make, Forney says. “When a stock is high, the brokers profit, the auditors profit, and the investors profit too,” he says. That is, until the music stops and it all implodes.  


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