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China Hustle movie mirrors S-Chip blow-up

Among the many lessons from the documentary is this: "We are our own last gatekeeper."


AS I watched the documentary China Hustle this week, there was a sense that all of it sounded familiar.

Forbes magazine described the film as "the most important movie of 2018". The writer said: "It's a story that could be directly affecting you, endangering your financial stability and your future. If you have a 401(k) that's lost value, or if you've lost a portion of your pension, there's a chance this picture explains part of the reason why."

Well, if it affects the investor who has put a large chunk of his/her personal wealth in such stocks, then it is an important movie to that investor. But it is not important in the sense that it threatens to bring the entire market down.

The movie is basically about the hundreds of companies worth about US$50 billion which were listed in the US stock exchanges via the reverse merger or reverse takeover route.

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Post Global Financial Crisis, businesses dried up in the markets and some institutions had big holes in their balance sheet to fill up. But ever the enterprising lot, the investment bankers, the brokers, financial advisors, banks, auditors, lawyers and others latched on to the next big thing - Chinese companies registering explosive growth.

These financial intermediaries reached out to Chinese companies and convinced them to list in the US by taking over a shell company which already had listing status. By injecting their businesses into these shell companies, the Chinese companies gained instant US listings - bypassing the regulatory scrutiny involved in a traditional initial public offering. Their status was no lower than that of traditional IPOs; they even got to ring the market's opening bell!

Once on the US shores, the story presented by these companies and their intermediaries to investors was one of plenty: huge untapped market potential in the fastest growing economy in the world, and a track record - and continued promise - of exponential revenue and earnings growth.

Brokers and financial advisors then fell over each other to write "Buy" reports on these companies. The hype did drive up the share price of these companies, which reaped returns of a few hundred or even up to 1,000 per cent for those who got in the game early.

But after a couple of years, some research analysts and hedge fund managers started to smell something fishy, and flew to China or engaged China-based investigators to verify the claims made by these companies.

For example, one investigator mounted a camera in front of the factory of a company which claimed to rake in sales of US$100 million a year. For the more than 300 days that the camera was recording, delivery trucks were seen going in and out of the compound perhaps once a week! The volume of business definitely did not amount to a fraction of sales the company claimed it was doing.

A company which was in the recycling business claimed the mound of used and rotting paper it had was worth US$30 million. An analyst who climbed into the rotten heap for a closer look later said: "If this is worth US$30 million, there would be no poverty in the world."

This group then put in their short positions on these stocks, and then released their "Sell" reports and presented evidence of fraud.

Muddy Waters Research was born then.

In the initial period, the writers of these reports were threatened or slapped with lawsuits. An analyst based in China was apparently detained for two years for uncovering evidence which disputed the claims made by a company influential among local law enforcement units.

When more evidence emerged, and the facts became irrefutable, the share price of these companies collapsed and the rest, as they say, is history.

Singapore, of course, went through this in the early 2000s and many of the S-chips, or Chinese stocks listed in Singapore, blew up during the Global Financial Crisis.

At the height of the crisis, a 9,000-word e-mail emerged and started circulating among financial sector participants in Singapore. The letter writer claimed he was a CEO of an S-chip company which had blown up. He detailed how his company was privatised, the difficulties of doing business in China, how he was approached by a Singapore "deal-maker" to list the company, and what the deal-maker suggested they do to inflate the sales of the company to make it attractive to investors.

It also revealed the psyche and motivations of Chinese entrepreneurs, and how, subsequent to the listing, they - tempted by greed - borrowed money against the company's cash to speculate in the Chinese and Singapore stock markets. It also showed how easy it was for these controlling shareholders and managers to dip into the company's cash pile when they faced margin calls on their personal accounts. At the end of the e-mail, the former CEO said he is now retired somewhere in China with money that could last him a few life times.

The events chronicled in the documentary more or less match the confession of the S-chip CEO. That's why there's this sense of familiarity.

The points brought up in the documentary include:

1 There are no good guys - many of the real-life characters in the film had a role to play in bringing or promoting the stocks to the moms and pops, and when some of them uncovered the fraud, they made sure they positioned themselves for profit before exposing the truth;

1 The gatekeepers - the auditors, the lawyers, the regulators - can't be relied on to provide investor protection;

1 Many financial institutions actually budget for fines (to be paid when they are caught for engaging in questionable practices) as a cost of doing business.

Indeed, the "S-chip CEO" ended his 2009 e-mail with: "Yes, I admit I am guilty of being greedy and unscrupulous. But how about those deal-makers who taught us how to cook the books? How about those intermediaries and professionals who were not vigilant enough to protect the interests of the investing public?"

Nothing much has changed.

As the Forbes reviewer Mark Hughes put it: "It's one thing to talk about people who exploit vulnerabilities in the system and take advantage of it, and quite another thing to talk about the system as full of intentional vulnerabilities to allow the enrichment of a few at the expense of the rest of us.

Fraud simply becomes a daily part of doing business, and - as the film notes - companies literally budget money for the payment of fines arising from their inevitable participation in fraud.

Of course, the fines tend to consistently be vastly smaller sums of money than the profits made from the fraud, so there is no real incentive to avoid the fraud and every incentive to engage in it."

In the panel discussion after the screening, which was organised by Singapore Film Society and Singapore Press Holdings, a member of the audience asked: So who do we trust now? The short-sellers?

My take is, ultimately as an investor, the only protection we can rely on is us, ourselves. We have to educate ourselves and understand what we are parting our hard-earned money for. We have to grasp the risks we are taking and the kind of rewards we are getting in exchange for taking those risks. We have to keep in mind the incentive structure of the people selling us the products or telling us something.

We definitely have not seen the last of products where the odds are heavily stacked against the average investor. Typically, many view the rewards as far outweighing the risks when it comes to financial or white-collar crimes, so many are willing to jump at the chance of getting rich quick at the expense of others.

It pays to be vigilant. We are our own last gatekeeper.

  • Hooi Ling is the portfolio manager of no-management fee Asia fund, Inclusif Value Fund (