The China hustle lives on

There are reasons as to why Chinese stocks on non-Chinese exchanges have been a problem in the past:

  1. The VIE structure used for many China stocks is dubious.
  2. China is an easily-marketable theme that attracted the pump and dump industry.
  3. No repercussions for egregious accounting fraud.

Have investors learned their lesson?  Apparently not!  More Chinese stocks with VIE structures are being IPOed.  This is despite the VIE structure becoming even more dubious.  China Law Blog has an excellent post explaining why the VIE (should have) died on January 19, 2015.  Go read it.

Draft makes clear that the State Council understands how VIEs work and that their sole function is to evade the requirements of Chinese law. The Draft makes clear that such evasion is illegal and will be prohibited upon the effective date of the new investment law.

I hope that the investors who buy into the newly-minted Chinese VIEs lend their shares out.

VIE structure

China has laws against foreigners owning businesses in certain industries.  The VIE structure tries to circumvent those laws… supposedly ‘allowing’ foreigners to own a business they are not allowed to own.  In my non-lawyer opinion, trying to circumvent a country’s laws is not a good recipe for success.  In practice, VIE structures have been (A) popular and (B) have rarely been tested.  Buddha Steel is one of few times where the VIE structure was tested… it ended badly.

Adverse selection

The American pump and dump industry will push out product in response to hot trends that are easily marketed to investors.  When dot-coms were the hot story stocks, the pump and dump industry created its share of dot-bombs.  Of course, not all dot-coms were created by the pump and dump industry.  Legitimate venture capital firms IPOed legitimate stocks like Amazon, Ebay, etc.  The mix of legitimate stocks versus pump and dumps will affect outcomes of the overall category.  When China became a hot theme (partly due to enthusiasm over emerging markets and BRIC countries), it naturally attracted the pump and dump industry.  This explains why Chinese stocks have an over-representation of pump and dumps.  People of different races and nationalities (e.g. American, Chinese, Canadian) banded together to rip off investors.

Going forward, I think that there will be a limited supply of legitimate China stocks versus the scams.  I don’t see a problem with SOEs (state-owned entities).  But other than that, there aren’t too many reasons why other Chinese companies would want to list (solely) on non-Chinese exchanges.  Chinese companies can raise capital at high valuations on Chinese exchanges.  Of companies listed on both Chinese and non-Chinese exchanges, the shares on Chinese exchanges tend to trade at much higher price (read about the Hang Seng AH Premium index).  If the companies were to list outside of China, there are questions about returning profits to shareholders with minimal tax (VIE structures tend to have tax issues).  I anticipate that the unattractiveness of a non-Chinese listing will drive adverse selection going forward.

Reverse mergers also lead to a similar situation.  Legitimate companies cannot raise capital through reverse mergers, so it is unlikely that a legitimate company will choose to list via reverse merger.  (Things may have been different a long time ago… I’m only talking about the present.)  However, there are reasons why reverse mergers are attractive for the pump and dump folks.  This is why I am very skeptical about every reverse merger stock out there- the pedigree of these stocks is terrible.  This is even more true for Chinese companies listed via reverse mergers… of which there are many.  While the Chinese reverse mergers are disappearing, there are still a few with sizable market caps (e.g. around one or two billion dollars).

No repercussions for accounting fraud

Because there is no/little risk for engaging in thievery (e.g. running off with the company’s cash) or accounting fraud, these practices have been more common with Chinese stocks.  And in general, it has been more blatant.  I don’t know of any cases where these situations have been legally pursued since a judgement in a US court would not have any value in China.  (*Some small US-based accounting firms have faced sanctions for poor work related to fraudulent companies.)

The real world is messy

However, shorting Chinese reverse mergers and/or China stocks has not always been a slam dunk.  In 2013, these stocks rallied strongly and many of them were taken private.  From a risk management perspective, a concentrated short portfolio of Chinese stocks was incredibly risky since the stocks can move in unison even if they are in different sectors.  It was also unusual for so many of them to be taken private in a somewhat short period of time.

New Oriental Education

Muddy Waters made various accusations against New Oriental Education (link).  Their claims about one of New Oriental’s websites advertising franchising opportunities are interesting.  You can check for yourself via  It seems that New Oriental changed the contents of its website following the Muddy Waters report.  I don’t understand the business rationale of that decision but what the heck do I know.  Regardless, EDU stock went up significantly in the years following the short attack.  Part of Muddy Waters’ criticism related to EDU’s use of the VIE structure.  It may be why the SEC asked very detailed questions about EDU’s VIE structure and control of its chops, culminating in this CORRESP filing filed 2012-07-31.  (To understand why controlling the chops is important, see “Gigamedia And The Perils Of VIEs. Dude, Where’s My Chop?“.)  At the end of the day, concerns were raised about the VIE structure and the stock went up a lot despite that.

(*Disclosure: No position in EDU.  I am shorting other China stocks.)

Alibaba versus Yahoo

For larger Chinese stocks, there is the theory that the Chinese government will intervene and protect investors to some degree to protect China’s reputation.  I really don’t have a strong or informed opinion about this.  China Law Blog has its own take.

Historically, the national government has done little to protect foreign investors in small China stocks.  There has been a crackdown on short sellers targeting Chinese firms.  One line of thinking is that the short sellers (not those committing accounting fraud or running off with a company’s cash) should be blamed for harming China’s reputation with misleading/false information.  There have been new barriers in obtaining SAIC filings… presumably because it would be such a travesty if investors were to perform research and use facts to expose accounting fraud.  So I’m not optimistic about the small-cap space.  However, politics can be fickle and the climate could change across the board.  Or, the situation may be different for larger and/or better-known Chinese companies like Alibaba and Baidu than small caps.  I really don’t know and I would note that politics can be hard to predict.

My predictions

  1. SOEs are fine.  They should not be painted with the same brush as other Chinese stocks.
  2. Large caps versus small caps: putting the aside the issue of the Chinese government intervening for better-known Chinese stocks, I think that large caps tend to have much better pedigree than small caps.  With small caps, you have career pump and dump folks who are more willing to sell down the stock right away rather than sell down the stock slowly over a long period of time.  The people tend to be crazier, lazier (e.g. promoting an accounting fraud versus a real business), and less focused on growing the underlying business.  So I would lean towards Baidu, Netease, etc. outperforming small-cap China stocks.
  3. Not all Chinese stocks are the same.  Some of them are better shorts than others.  I’m more interested in (A) the frauds and (B) the stocks with a pump and dump pedigree:
    • The people involved do pump and dumps for a living.
    • The company pays for “investor relations” firms.
    • Stock promotion websites disclose the company as a sponsor/client.
    • Etc.


Law Blogs

China Law Blog

China Accounting Blog – a good blog but I would take the author’s comments about Marcum Bernstein (elsewhere on his blog) with a grain of salt.

China Hearsay (inactive blog)

Arguments that VIEs are ok

EDU CORRESP filing (2012-07-31)

China Hustle

The China Hustle is a film about the ‘horror story’ of Chinese companies on the American stock markets (@TheChinaHustle | TIFF website).  I have never seen the film.

5 thoughts on “The China hustle lives on

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