Are You Safe From the Research Vigilantes?

When I wrote my book, The China Investor: Getting Rich With the Next Superpower, in 2002, one of my stock picks was a Hong Kong-listed vegetable grower called Chaoda Modern Agriculture. “It has created its own Chaoda trademark, sells its branded produce in company-owned outlets and third-party supermarkets in the prosperous coastal provinces, boasts net profit margins of better than 60% and has started paying cash dividends,” I wrote.

The subsequent years appeared to affirm my faith. When I wrote the book, Chaoda was trading at HK$1. By April 2008, the market was valuing the stock at HK$10.77 – a gratifying 977% rise. The stock did slide along with almost every company in the world after the bankruptcy of Lehman Brothers later that year, but it came roaring back in 2009. Last year, Chaoda traded at the HK$7-to-HK$9 level.
But the bottom fell out in 2011. As the year progressed, the stock price steadily spiraled downward until trading was suspended on September 26. Chaoda remains in limbo as I write. Its last price: HK$1.10, barely budging from where it was in 2002.
What happened? The proximate cause of the suspension was a complaint filed by Hong Kong Financial Secretary John Tsang with the Market Misconduct Tribunal, accusing Chaoda Chairman Kwok Ho and CFO Andy Chan of selectively imparting material information in 2009 to six institutional investors, which allegedly allowed one of those briefed to engage in insider trading.
Rise of the vigilantes
But, in fact, Chaoda had come up against a new phenomenon that CFOs should be aware of. This is the rise of what I call the research vigilantes, the likes of US-based Muddy Waters Research, which accused Toronto-listed Sino-Forest of overstating the extent of its timber holdings,, whose allegations against Nasdaq-listed SinoTech caused the company's CFO to resign, and Anonymous Analytics, which released a September 26 report that accused Chaoda of “lies and corporate fraud.”
Think of them as the WikiLeaks of the business world, bent on uncovering corporate wrongdoing by “acquiring information through unconventional means,” as Anonymous Analytics ominously declares.
On its website (, the group describes itself as a faction of Anonymous, “a decentralized network of individuals . . . that has made international headlines by exposing The Church of Scientology, supporting anti-corruption movements in Zimbabwe and India, and providing secure platforms for Iranian citizens to criticize their government.”
Anonymous Analytics aims to move “the issue of transparency from the political level to the corporate level. To this end, we use our unique skill sets to expose companies that practice poor corporate governance and are involved in large-scale fraudulent activities.”
One indication of how seriously the research vigilantes’ allegations are beginning to be regarded is the inclusion of the Anonymous Analytics report in the list of reasons advanced by credit ratings agency Moody’s Investors Service in downgrading Chaoda’s credit rating from Ba3 to Ba2 on October 7.
The downgrade followed Chaoda’s failure to release its annual results on September 30, the due date. “The delays breach the Hong Kong Stock Exchange’s listing rules, and introduce further uncertainty in respect of Chaoda’s financial reporting and financial position,” says Moody’s Vice President and Senior Analyst Ken Chan.   
“Such negative developments, on top of the ongoing share suspension, the proceedings of the Hong Kong Market Misconduct Tribunal . . . and the allegations from Anonymous Analytics have raised the company’s overall risk profile to a level which is no longer commensurate with the previous Ba2 rating level,” Chan explains.
Moody’s red flags
Arguably, Moody’s itself can be said to be going down the vigilante path, albeit in a more analytically rigorous and responsible fashion. In a report released 11 July 2011, the agency identified 20 ‘red flags’ that it believes “highlight issues meriting scrutiny to identify possible governance or accounting risks for non-financial corporate issuers in emerging markets.”
In that inaugural Moody’s report, Chaoda tripped six red flags. Moody’s said it had:
  • significant related party transactions
  • a major shareholder that has material business outside the company
  • an extraordinarily high profit margin
  • below-par quality of cash flow generation 
  • more than 20% change in working capital measures
  • paid low tax relative to accounting profit
Chaoda actually has fewer flags than many of the 48 other Chinese issuers that Moody’s assessed. Hong Kong-listed China Forestry Holdings, for example, whose shares have been suspended for trading since March 2, tripped 12 red flags. Building materials firm West China Cement also had 12, while Winsway Coking Coal had 11 and chemicals company China Lumena New Materials had 10.   
Moody’s takes pains to stress that it has not changed its rating methodologies. The red flags that pertain in particular to governance and accounting risks “can help identify areas to investigate,” it says, but these “cannot serve as mechanisms to rank order credit risk.”
It adds: “Our ratings already account for the inherent challenges in assessing these Chinese companies: their short history of operations, their diverse industries with limited peers for comparison, their concentrated family ownership structures, and high-growth environments.”
Five categories
Still, CFOs should examine the 20 red flags in Moody’s framework and see where their company (or the enterprise they are considering joining or which their firm is thinking of signing up as partner or supplier/customer) stands in relation to them. These flags are grouped into five key categories:
Weakness in corporate governance
  • short track record of operations (< seven years)
  • short listing history (< three years or unlisted)
  • concentration of family ownership (>30% stake)
  • change of CEO/CFO
  • significant related party transactions (>10% of sales, cost of goods sold; or receivables > 10% of total assets
  • existence of material business by major shareholder outside of company
Riskier or more opaque business models
  • reported EBITDA margin > 40%
  • top five customers > 30% of revenue
  • complicated group structure (investment in JV/associate to total assets > 30%; dividends or profit from JV/associate to net profit > 30%)
Growth strategy
  • total asset or revenue doubled over three years
  • negative free cash flow > 50% of operating cash flow
  • intangibles/total assets > 25%
Quality of earnings and cash flow
  • operating cash flow/net income or operating cash flow before interest & tax/EBITDA <  1
  • year-on-year change in accounts receivable days, accounts payable days or inventory days > 20%
  • tax paid in cash/profit before tax < 10%
  • change in property, plant & equipment/revenue > 20% from prior year
Concerns over auditors/financial statements
  • change in auditors
  • signing auditor located in a different country from where the key business operations are located
  • delay in results announcement or filing of audited statements in past three years
  • qualified accounts (including internal control weakness)
Anonymous who?
As it happens, many of the Moody’s red flags are the same ones that Anonymous Analytics is making much of in its attack on Chaoda – only in more intemperate and incendiary language. In the section “Chaoda: A History of Deceit,” the report cites “several resignations by auditors, executives and directors” as proof that “Chaoda is a fraud and misstating the scope of its business.”
Anonymous Analytics also accuses Chaoda’s management of misleading shareholders about the company’s financing needs, falsifying financial statements, inflating capital spending, “egregious” related party transactions and a host of other sins.
“Chaoda’s long history as a public company is mired in lies and corporate fraud,” the report summarises. “Under the cover of inflated capex spending and related party transactions, management has transferred more than US$400 million out of Chaoda. In so doing, the company has overstated its cash balance and falsified its financial statements.”
It goes on: “The CEO, with the support of the board of directors, has invested in risky projects that have robbed shareholders of returns in order to line his own pockets. In an attempt to cover their egregious actions, management has paid a fraudulent company to provide Chaoda positive marketing exposure.”
Finally, the coup de grace: “In addition to what has been presented here, we have reason to believe Chaoda will not be able to survive scrutiny [by Hong Kong’s Securities and Futures Commission]. Accordingly, we expect this company to be eventually delisted.”
Waiting for a rebuttal
Chaoda has yet to directly respond to the Anonymous Analytics report, beyond filing a notice with the stock exchange on September 26 requesting the suspension of trading in its shares “pending a further announcement from the company to address a report issued by Anonymous Analytics.”
In that announcement, Chaoda also addressed the insider trading allegation. “Mr. Kwok and Mr. Chan do not accept that they engaged in the alleged market misconduct,” it said. The Financial Secretary has not alleged misconduct by the company, Chaoda noted, so the tribunal proceedings scheduled from 30 January 2012 should not have “any material effect on either the operations of financial position of the company or any of its subsidiaries.”
Moody’s analyst Chan agrees that the Market Misconduct Tribunal proceedings are unlikely to affect Chaoda. “The specific event has to do with individuals and we do not think that is likely to materially impact the company’s operations or credit quality in the near term,” he says. “However we are monitoring the situation and the company’s responses regarding the allegations in the report published by Anonymous Analytics.”
On 30 September, Chaoda announced that it would be delaying the release of its financial results for the year ended 30 June 2011 so its auditors, BDO Limited, can include “additional audit procedures to the audit of the annual results.”
The company does not have the luxury of time. In announcing the 7 October downgrade, Moody’s noted that the holders of Chaoda’s outstanding US$200 million convertible bonds can demand accelerated repayment if stock trading is suspended for more than 60 consecutive days, or if it fails to file its full-year results within 180 days from its fiscal year-end.
Protecting your company
It remains to be seen whether Chaoda can survive the vigilante onslaught. Its prospects do not look bright, if the Sino-Forest case is anything to go by.
After the allegations of fraud by Muddy Waters, the Ontario Securities Commission said that Sino-Forest may have “misrepresented some of its revenue and/or exaggerated some of its timber holdings” and “appears to have engaged in significant non-arm's-length transactions which may have been contrary to Ontario securities laws and the public interest.” Company Chairman and CEO Allan Chan has resigned.
Victories such as this are emboldening the vigilantes to target more companies, especially since they can make money by shorting their target’s stock. Muddy Waters is a declared short-seller. Anonymous Analytics says it holds no direct position in Chaoda, but adds that its “associates, partners, affiliates, consultants, clients and other related parties” should be assumed to be shorting the securities and derivatives profiled in the report.
How can you protect your company? At this point, the vigilantes appear to be targeting the low-hanging fruits first – small companies that are opaque and have a reputation for self-dealing by their majority shareholders. If your company is reasonably transparent and boasts solid governance, it is probably not on their radar.
However, if you judge your company to be vulnerable, perhaps because it trips a lot of the red flags in the Moody’s framework, you probably have reason to worry. As CFO, it is time for you to exert more effort into putting the company’s financial house in order – or find another job in a more professional enterprise.
About the Author
Cesar Bacani is Editor-in-Chief of CFO Innovation.   

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