China Ming Yang is a Chinese company listed on the New York Stock Exchange. Many similar companies have turned out to be frauds or have been taken over by private equity. I’m not aware of a single fraudster being jailed, though investigators for short sellers have been thrown in jail. The incentives seem to be perverse and in favour of committing fraud. So far, the danger in shorting Chinese stocks has been:
- Private equity takeovers. Some companies heavily targeted by short sellers (e.g. Muddy Waters) have been taken over by US private equity, causing large losses for the shorts. e.g. HRBN, FMCN, etc.
- Liquidity. In the past, some of these stocks have gone up several times before going to 0.
- Borrow costs. As Chinese reverse mergers have been recognized as an area with extreme levels of fraud, short sellers have piled on.
- Short squeezes. e.g. CMEDY
- (If you own put options.) The stock may be delisted and you may not be able to exercise the puts unless you buy stock on a secondary market.
While I am not going to spent the time going through China Ming Yang’s entire 20-F filing, I believe that it is a compelling short due to the sheer ridiculousness of its related party transactions.
Shares short: 1.01M (0.8% of shares outstanding, 1.47% of float)
Borrow cost: Low single digits
Things that don’t make sense
Oral agreements with related parties
Related parties are always tricky because insiders could be using their controlling position to exploit shareholders. These deals should definitely be documented!!! To say that these deals are covered by oral agreements is very sketchy and leaves no paper trail. One major problem with no documentation is that these oral agreements could be after-the-fact explanations for accounting irregularities. This practice is unbelievably stupid (unless some form of fraud is occurring).
The latest 20-F filing mentions oral agreements 8 times in dealings with insiders.
Interest-free advances to related parties
Giving an interest-free loan is basically like giving away free money. By lending out the money interest-free, the lender is not receiving interest payments that it would otherwise receive. I don’t see the difference between insiders giving away money to themselves and stealing.
China Ming Yang lists numerous advances/loans in its 20-F:
We provided interest-free advances of RMB55,000 and RMB77.8 million (US$12.5 million) to Inner Mongolia Equipment in 2011 and 2012, respectively, which remained unsettled as of December 31, 2012.
During the years ended December 31, 2010, 2011 and 2012, we provided interest-free advances of RMB0.4 million, RMB0.6 million and RMB0.8 million (US$0.1 million) to Mingyang Longyuan, respectively, of which RMB1.0 million, RMB0.3 million and RMB9.0 thousand (US$1.4 thousand) were repaid by the end of 2010, 2011 and 2012, respectively.
During the years ended December 31, 2010, 2011 and 2012, we provided RMB0.8 million, RMB20.1 million and RMB20.7 million (US$3.3 million) interest-free advances, respectively, to Mingyang Energy Investment. The advances were collected as of December 31, 2010, 2011 and 2012, respectively.
We also provided interest-free advances of RMB4.0 million (US$0.6 million) to Huifeng New Energy in 2012, which remained unsettled as of December 31, 2012.
As of December 31, 2012, the amount due from Xinjiang Wanbang of RMB18,000 (US$2,900) represented interest-free advances, and the amount due to Xinjiang Wanbang of RMB19.0 million (US$3.0 million) represented receipt in advance for a wind farm project.
And finally, the transactions with Zhongdan Ruihao are a little different. The US$0.7M advance is interest free. But on the smaller US$0.1M loan, the company decides to charge interest.
During the year ended December 31, 2012, we provided interest-free advances of RMB4.4 million (US$0.7 million) to Zhongdan Ruihao. We also provided a short-term loan of RMB0.7 million(US$0.1 million) to Zhongdan Ruihao. This short-term loan bore an interest rate of 7.2% per annum and the interest income for the year ended December 31, 2012 amounted to RMB42,000 (US$6,700).
A loan guarantee that doesn’t make sense
The company pledges US$3.9M to Zhongdan Ruihao to help it make a guarantee deposit. However, the company somehow received the same amount back from Zhongdan Ruihao. Why didn’t Zhongdan Ruihao make the guarantee deposit with its own money in the first place???
As of December 31, 2012, the amount due to Zhongdan Ruihao of RMB24.0 million (US$3.9 million) represented the guarantee deposit payable to Zhongdan Ruihao. During the year ended December 31, 2012, we pledged RMB24.0 million (US$3.9 million) as security for Zhongdan Ruihao’s bank loan. To mitigate our risk exposure, we received the same amounts from Zhongdan Ruihao.
Selling equipment to itself
The company is recognizing revenues on equipment sold to itself. There are many entities that are mostly controlled by the company. Selling equipment to these entities could be causing revenues to be wildly inflated. Perhaps there is a legitimate business reason for such deals, but I doubt it. From the 20-F:
Zhongdan Ruihao is a jointly controlled entity of us, in which we held 90.51% equity interest as of December 31, 2012. […]
Daqing Dumeng is a jointly controlled entity of us, in which we held 88.89% equity interest as of December 31, 2012.
During the year ended December 31, 2011, certain of our wind turbines were delivered to and accepted by Zhongdan Ruihao on behalf of Daqing Dumeng, for which we recognized RMB123.7 million trade receivables from Zhongdan Ruihao. During the year ended December 31, 2012, we recognized revenue of RMB160.7 million (US$25.8 million) for sales of wind turbines to Daqing Dumeng. As of December 31, 2012, the trade receivables from the transaction was RMB189.9 million (US$30.5 million).
There are similar deals with “Daqing Dairy Farm”, “Huitengxile Generator” and “Huifeng New Energy”.
Cayman Islands Incorporation
As with many Chinese companies listed on US exchanges, the offshore incorporation means that investors have no/little legal protection if insiders commit fraud. Exchanges and investment banks have not respected their fiduciary duty in allowing these stocks to be listed.
Extensive dealings with related parties
There are huge sections of the 20-F devoted to dealings with related parties. This is a red flag to me since it doesn’t make sense for insiders to have related private businesses separate from the public entity. Related businesses should have been part of the IPO. Structuring the company that way would reduce the conflicts of interests between insiders and shareholders.
*Disclosure: No position… yet.
EDIT: This was posted on Oct 13. On Oct 14, I initiated a short position in MY.
EDIT (2/13/2015): On Oct 14, 2013 the stock closed at $2.88. I currently have no short position in this stock.