Longtop Financial, Sino-Forest, Oceanus: 3 Manipulation Cases We Can Learn From
Case studies of companies which have been accused – but not necessarily ascertained guilty – of manipulating their financial statements provide timeless lessons to an investor.
Longtop provides a range of software solutions and services to financial institutions in China. On 26th April 2011, Citron Research released a report which alleged the following:
- Margins far in excess of competitors. Peers reported much lower gross margins of between 15%-50% and operating margins of 10%-25%. This was highly suspicious in cost-competitive China.
- Unconventional staffing model. Staffing model allowed the company to transfer the majority of its cost structure off balance sheet to another unconsolidated, affiliated company.
- Key management background misdeeds. Before founding Longtop, the Chairman and CEO were sued by their previous company for unfair business practices.
- Non-transparent management transactions. Longtop’s Chairman transferred 70% of stock holdings to employees and friends in the first four years of the company going public.
What happened: Longtop’s shares fell by 97.5% within a year from $1.20 to $0.03.
Sino-Forest was the largest private forestry operator in China with USD2.5bn of forestry assets in book value. On 2 June 2011, Muddy Waters released a report accusing Sino-Forest of fraud. Some warning flags include:
- Sino-Forest’s use of authorized intermediaries allowed the company to report sales and purchases without verification.
- From 2007 to 2010, receivables grew by 506.7% against revenue growth of only 169.5%.
- Consistently negative free cash flow despite its strong revenue and profit growth. Between 2003 and 2010, the company also raised USD3.0bn in capital from debt and equity issues.
- Listing through reverse takeover enabled Sino-Forest to avoid the typical IPO due diligence.
What happened: The Chairman and CEO resigned in August 2011 following suspension of the stock. The Ontario Securities Commission (OSC) filed fraud charges against the management of Sino-Forest in May 2012.
Oceanus is a Singapore-listed supplier of abalones. In July 2011, the company had a market capitalisation of USD310.0mn. In November 2011, the company reported an USD140.0mn write down of its abalone assets, resulting in a Q3 YTD net loss of US103.0mn. According to Asian Financial Statement Analysis: Detecting Financial Irregularities, these were the warning signs:
- Listing through reverse takeover enabled Oceanus to avoid the typical IPO due diligence.
- Revenue and net profits were generated almost entirely from valuation gains of abalone stock. In 2009 and 2010, gain on biological assets comprised 90.8% and 74.2% of total revenue respectively.
- Increase in value of abalones came from an increase in quantity rather than in value per unit (which will imply growth of the abalones). This can be derived by taking the value of biological assets on the balance sheet and dividing by the reported quantities of abalone.
What happened: The share price fell by more than 65%.
Not every fraud is detectable by retail investors like us, especially when special purpose vehicles come into play. But the least we can do is to protect ourselves against the relatively conspicuous ones. We have showcased the above cases as examples of detectable manipulation. Common tell-tale signs include high receivables growth and exceedingly high margins. In addition, investors should be more cautious when a company is listed via reverse takeovers. Lastly, management background checks are a simple way to verify that a company is in good hands.