‘They’d Find Fraud, Fraud, Fraud.’

Illustration by Cornelia Li

Illustration by Cornelia Li

A small group of short sellers, spurned investors, a former journalist, and an ex-prosecutor are intent on revealing large-scale fraud in China.

You can’t accuse Ideanomics of failing to think big.

The electric-vehicle and fintech company boasts on its website of “empowering a new economy” and “forging the new paradigm on how emerging technology companies grow and how industries embrace innovation.” Its slogan: “Digitizing tomorrow.”

It’d be a heck of a thing if they got tripped up by Photoshop.

Ideanomics, which is headquartered in New York but has much of its operations in China, has touted a big, recently opened sales center for electric vehicles in Qingdao, in China’s Shandong province. But in June, short sellers betting against the company alleged the sales center didn’t actually belong to Ideanomics.

The company had issued a photo of the center, but shortly thereafter short-seller Hindenburg Research unearthed a 2018 Chinese news photo that looked strikingly similar to Ideanomics’ photo. The only difference was that the “MEG” logo of the company’s Mobile Energy Global electric-vehicle operation was on a banner. Hindenburg contended that the company had doctored the photo to make it appear the sales center was its own.

Short sellers also say they’ve spoken to purported customers of Ideanomics who deny they’ve bought vehicles from the company. Short-seller J Capital Research says one purported customer told it that an Ideanomics announcement to that effect was “fake news.”

Ideanomics counters that the shorts’ reports are inaccurate. The company says it has a 15-year rent-free agreement for the Qingdao center — which is being rebranded under the MEG name — and proffered statements from customers to support the company’s position. No regulatory action has been brought against the company.

Ideanomics also said in June that the shorts had acted “to seek financial gain from a drop in the company’s stock price.” The company’s shares, which had spiked from as low as 38 cents to over $3 a share in the weeks before the shorts weighed in, lost more than half their value in the days after the Hindenburg and J Capital allegations.

Multiply the tussle over Ideanomics by dozens, or hundreds, and you’ve got a dilemma that’s beset U.S. investors off and on for nearly a decade: They’re eager to reap the benefits from investing in China’s enormous market, but can they trust the numbers, the disclosures, and the honesty of China’s companies?

Fraud allegations involving Chinese companies that trade in the U.S. have plagued investors for years. In the early 2010s, a wave of often-outrageous fraud schemes at such companies cost U.S. investors billions of dollars. Now the issue is back, with high-profile cases like Luckin Coffee, which admitted in April to a $310 million fraud.

It’s a problem as difficult to solve as a Chinese puzzle box — one of those fiendishly difficult puzzles that requires hard thinking and creativity to open. Not every Chinese company is a fraud, of course, but so many have been plagued by accounting questions that just being from China is a red flag.

Yet investors keep pumping in money. U.S. regulators who try to sniff out fraud are stymied by China’s government and the difficulty of pursuing executives in a semi-closed nation halfway around the world. When all else fails, China has been known to simply throw critics of its companies in jail.

Some are still fighting to hold Chinese companies accountable, from Robert Seiden, a New York investigator who pursues shady Chinese companies as a court-appointed receiver empowered to seize their assets, to much-maligned short sellers like Carson Block of Muddy Waters Research, who came to prominence by alleging Chinese frauds.

U.S. officials are trying too. The Securities and Exchange Commission has ramped up its warnings to investors about the risks of investing in Chinese companies. And in May, the U.S. Senate passed a bill aimed at tackling a key part of the problem: China’s refusal to allow U.S. regulators to scrutinize the work of audit firms that vet the finances of many Chinese companies.

But so far, the people trying to curb irregularities and alleged fraud at Chinese companies admit they’ve had limited success at best. Their experiences suggest that investors losing money in Chinese companies now have a rough road ahead — and may want to think twice before investing in the next highly touted Chinese stock that comes around.

From the perspective of Chinese companies, says Dan David of Wolfpack Research, a frequent critic, “really, it’s a feather in their cap to say you stole from American investors.”

The story of Chinese fraud goes back a decade and a half, to the mid-2000s, when a wave of Chinese companies rolled onto U.S. exchanges via a backdoor maneuver known as “reverse mergers.” Chinese companies would merge with a U.S. shell company and take over its public listing, gaining access to American exchanges, trading, and investors — all without the regulatory scrutiny a traditional initial public offering would have brought.

But starting around 2011, revelations spilled out about the accounting and disclosure of company after Chinese company — that they’d inflated their revenues, pretended they had businesses they didn’t, or seen their coffers looted by executives.

Some of the more eyebrow-raising schemes, according to regulators: Universal Travel gave its auditor an address for a purported hotel customer of the company’s that turned out to be a public restroom. AgFeed Industries, an animal-feed and hog-production company, inflated its revenues by claiming sales of hogs that didn’t exist, and later tried to cover up the fraud by claiming the fake hogs had died. The CEO of TV ad-network company China MediaExpress offered a $1.5 million bribe to an outside accountant helping to look into the company’s finances. (The accountant declined.)

With these revelations, many Chinese companies’ stocks plunged, leaving shareholders with huge losses. The SEC barred about 180 Chinese companies from U.S. trading and filed dozens of lawsuits against the companies, their executives, and “gatekeepers” like auditors and consultants who helped them get access to U.S markets. And for a while, relatively few Chinese companies braved U.S. markets because of concerns about fraud.

But since 2017, there have been 93 Chinese IPOs in the U.S., according to data provider Dealogic. Chinese companies have gotten savvier, Block says: They’re less prone to claiming outsize successes than they were in the past. “They know they have to look human from time to time.”

All of which helped lead to frauds like Luckin Coffee. The company went public on Nasdaq with a splash last year; at one point it boasted a market value of $12 billion. But in April, the company said $310 million of its 2019 sales had been fabricated, and its shares have plunged to a fraction of their peak.

The Wall Street Journal reported Luckin had inflated its revenue by selling vouchers for tens of millions of cups of coffee, many of them to companies that had ties to the company’s chairman and controlling shareholder. Luckin fired its chief executive, chief operating officer, and other employees, and the SEC is reported to be investigating.

Other U.S.-traded Chinese companies have come under scrutiny recently: TAL Education Group, a tutoring company, is under SEC investigation after acknowledging in April that its sales had been inflated. Short sellers claim that GSX Techedu, another tutoring provider, and iQiyi, a video-streaming company, have overstated their revenues and user numbers. GSX and iQiyi have denied the shorts’ allegations and couldn’t be reached for comment.

The concerns even extend to e-commerce giant Alibaba Group Holding, the biggest Chinese company trading in the U.S. Alibaba went public to great fanfare in 2014, but critics have raised concerns about its complex structure and opaque disclosures. “There were significant questions about its accounts from the moment it filed its prospectus, but nobody cared,” Block says.

The SEC launched an investigation into some of Alibaba’s accounting practices in 2016 that is still active, but no case has been brought. The company said in a statement that it had “fully responded” to the SEC’s inquiries and “[w]e stand by the integrity of our financial statements and the transparency of our disclosures.”

Many investors in China have stories about the obstacles they’ve faced and the money they’ve lost. But the example of Ned Sherwood — a private-equity fund manager whose investor group lost $20 million years ago in a Chinese education company — should give any investor pause.

“I would never put another dime in any Chinese company, and I would never trust a financial statement of a Chinese company in any way as being accurate,” Sherwood says. “They want to let Chinese companies list here and go public here, but I think they shouldn’t be allowed unless they follow the rules and open their books.”

Sherwood has spent years trying to get accountability from former officials of ChinaCast Education Corp., the direct-broadcast education company in which he suffered big losses. After he became suspicious they were hiding something, he wrested control of ChinaCast from them — only to find, he says, that they’d stolen a fortune.

ChinaCast began trading in the U.S. in 2007. In an omen of the obstacles investors would later face, it did so by merging with a U.S. shell company named Great Wall Acquisition Corp. Initially, it seemed a success: Revenues surged, and its market capitalization rose to $350 million.

Sherwood invested in ChinaCast in 2009. But after his suspicions began that all wasn’t well, ChinaCast CEO Ron Chan and his allies tried to throw Sherwood off the company’s board. Sherwood waged a proxy fight and won — even though, at the midnight meeting where the proxy vote was to take place, the building was locked when Sherwood’s representative tried to get in, according to his statements in court documents.

Sherwood and his allies fired Chan, but soon after, a group of people forced their way into ChinaCast’s office and made off with hard drives that contained key company records, according to regulatory filings and court documents. A ChinaCast lawyer who tried to stop them got punched in the head for his trouble, requiring him to go to a hospital to get checked out, according to Sherwood.

Court complaints filed by Sherwood and his allies later alleged ChinaCast executives had misappropriated tens of millions of dollars. The SEC ultimately sued Chan, alleging he’d stolen $41 million, and obtained a judgment against him for nearly $49 million.

Sherwood has been trying to recover ChinaCast’s assets ever since, with “a little bit of success,” says Doug Woodrum, ChinaCast’s chief financial officer. They’ve obtained a judgment in Shanghai against one of ChinaCast’s former officials, who is now serving a 13-year prison sentence, and they have legal actions pending against others. “We’ve worked from the bottom up,” Woodrum says.

Why pursue this so vigorously and for so long? Obviously, Sherwood and his investors want to recoup the millions they’ve lost, but Woodrum maintains that also, “very simply, it’s the right thing to do.”

Yet Sherwood and Woodrum don’t hold out much hope that Chinese companies will start toeing the line more. “I just think there are powerful interests and money involved all along the route,” Sherwood says. Auditors, underwriters, and lawyers of Chinese companies “get big fees, and there’s very little standard of due diligence, and the SEC lets it happen most of the time.

“There doesn’t seem to be much difference between our day of ChinaCast and the current day of Luckin Coffee. Not much has changed.”

In situations like this, when American investors are victimized, you’d think the SEC would lead the way in pursuing those responsible. But it’s been a tough slog: A lot of the documents the SEC needs to conduct its investigations are in the hands of companies and audit firms inside China, and China’s authoritarian government has often thrown up roadblocks to the SEC’s efforts to get them.

Even when the SEC does sue a Chinese company and prevails in court, it’s often hard to enforce its judgment and collect what’s owed. Some Chinese companies and executives have “gone dark” — surrendering their U.S. listing, ignoring their U.S. investors, and retreating into China, where it’s hard for U.S. regulators to find them.

If the SEC can’t reach a settlement, “it’s incredibly difficult” for it to enforce a U.S. court judgment against a Chinese company, said Stephanie Avakian, the SEC’s enforcement co-director, at a July 9 commission roundtable discussion on the risks for investors in China and other emerging markets.

“You can’t compel production of anything. You can’t force executives to come to the U.S,” adds a former SEC official who helped investigate Chinese companies while at the commission.

A spokesperson for the China Securities Regulatory Commission couldn’t be reached for comment.

Without a better option, the SEC has fallen back on rhetoric. Twice in the past 19 months, the commission has warned of the risks of investing in Chinese companies. In April, the SEC said there is “substantially greater risk” of incomplete or misleading disclosures in many emerging markets, including China. U.S. authorities face “significant legal and other obstacles” in obtaining information and “substantial difficulties” in bringing actions against companies.

With regulators stymied, short sellers are all the more important in investigating Chinese companies, despite the pushback they often face. It’s shorts who do the on-the-ground legwork in China — staking out Chinese factories, for instance, to show they had so little activity that the company couldn’t possibly be doing as much business as it claimed.

It was Muddy Waters that publicized the anonymous 89-page report in January on Luckin Coffee that first prompted significant questions about the company. The report concluded that much of Luckin’s revenue must be fake, based on thousands of hours of observation of Luckin locations.

In China, “you assume you’re being lied to,” Block says.

Wolfpack Research’s David traveled repeatedly to Washington over a two-year period at his own expense to try to alert people in Congress to the problem of fraud by Chinese companies. “It was very frustrating,” he says. “Nobody down there had a clue or an inkling as to what was going on.” (He subsequently ran for Congress himself — and lost.)

The shorts have a financial interest in tearing these companies down, of course. “You really have to take it with a grain of salt,” says Mitchell Nussbaum, an attorney with Loeb & Loeb who has represented many Chinese companies.

Nussbaum cautions against “profiling” a company. Sure, some have issues, he says, but so do some companies everywhere else. “In some situations, the shorts are right; in some situations, there are frauds at some of these companies.”

And, ominously: “In some situations, the short sellers commit the fraud.”

Some people have lost money because of investigations into Chinese business. Others have lost their freedom.

Peter Humphrey, a U.K. investigator who did due diligence on companies in China, was one of them. In 2013, Chinese officials arrested and imprisoned Humphrey for nearly two years on charges of illegally acquiring the personal information of Chinese nationals, charges he’s denounced as false.

In prison, Humphrey was interrogated frequently while locked inside a steel cage, with Chinese agents pressing him to confess and threatening him with dire consequences if he didn’t. He developed prostate cancer that went untreated and that he’s still fighting, along with post-traumatic stress disorder.

“The aim is to isolate, crush the spirit, break the will,” Humphrey wrote of his imprisonment in the Financial Times in 2018, after diplomatic pressure led to his release. “Many crumble quickly.”

Humphrey, who had been a journalist in Hong Kong for Reuters, became an investigator because “it became very obvious that fraud was a major problem in China,” he says in an interview with Institutional Investor. “It became clear to me there was a need for my skill set.”

When he was arrested, he had been working for drugmaker GlaxoSmithKline, which had hired him to investigate a former employee. His arrest wasn’t an attempt per se by the Chinese to clamp down on due diligence, he says, but the effect was to discourage independent inquiry about businesses in China nonetheless.

“It had a chilling impact on the industry,” he says. People felt, “‘Oh, shit, it could happen to anyone.’” As a result, he says, today “it’s not that easy to uncover what’s going on at companies such as Luckin.”

Ironically, Humphrey says, some of his fellow prisoners were the kind of people he might have investigated himself on the outside — people involved in Chinese-company frauds. “After talking to those people in jail, I actually felt sorry for them,” he says. “They were being sentenced very recklessly and out of proportion.”

Since Xi Jinping took over as China’s leader in 2012, it’s become even harder for outsiders to get good information on Chinese companies, Humphrey says. “The kind of information that enables you to connect the dots — since he came to power, they’ve been blocking off all these avenues.”

It isn’t just small companies, either. “I’m absolutely certain the big Chinese companies would not survive regulatory scrutiny in the U.S. if all the access regulators need to have were made available. They’d find fraud, fraud, fraud.”

Why does this keep happening? Why do these problems recur, even after investors should be on notice that Chinese companies can be risky and difficult to hold to account?

Part of it, some observers say, is that people have short memories, are eager for easy trading gains, and keep wanting to benefit from the opportunities China presents. China and its companies know that.

“Investors forgot” and “just needed to say no,” Block says. China is “this environment where fairy tales are created because investors can’t get enough.”

Many investors have exposure in China without even knowing about it. They hold mutual funds or other investments whose managers invest in Chinese stocks. “There’s a lot of money looking for targets,” says Anne Stevenson-Yang, co-founder of J Capital Research. “A ton of money that’s flowing around, and there are people who figure out a way to harness it.”

For their part, U.S. exchanges are hungry for Chinese listings too. “The public markets are desperate for listings, and they’ll list anything,” says Steve Dickinson, an attorney who specializes in China with law firm Harris Bricken.

There’s also a cultural gap. When Westerners invest in a Chinese company, many assume it has emerged in the same kind of market environment they’re accustomed to in the U.S., that it’s been subjected to the same kind of vetting and regulatory oversight. That’s not the case.

“There’s a certain amount of self-delusion there,” says Jim Peterson, an attorney and author specializing in accounting issues.

On the other side, many Chinese companies aren’t prepared for the level of disclosure and communication with investors that’s required of them when they’re listed in the U.S. Even if they have legitimate businesses, their response when they face criticism may be to avoid dealing with it — to pull up stakes and retreat to China, leaving investors holding the bag.

“There are companies with good products and good business models, legitimate intents, but get caught up and had bad advice and lose hope,” says Matt Mathison, an investor and former employee of Link Motion, a Chinese company that was delisted and went back to China. “When a company loses hope, they can just say, ‘Screw it.’”

It doesn’t help U.S. investors that they can’t be sure that the auditors who review the finances of Chinese companies are doing a good job. In a fraud, the auditors are often deceived along with everyone else. “It’s devastating when skepticism is supposed to be one of the key elements of [an auditor’s] performance,” Peterson says.

The problem is compounded by China’s intransigence. U.S. regulators inspect the work of any auditors who audit U.S.-traded companies. But China has refused to allow such inspections for Chinese audit firms, including affiliates of the Big Four accounting firms that audit most major companies.

China regards the sensitive financial information about its companies that their auditors handle as akin to “state secrets.” Nearly 200 Chinese and Hong Kong companies traded in the U.S., including giants like Alibaba and Baidu, are audited by these firms.

“We have no ability to verify in China and no prospects on the horizon,” said William Duhnke, chairman of the Public Company Accounting Oversight Board, the U.S. audit regulator, at the recent SEC roundtable.

And not just at Chinese companies. At nearly 100 U.S.-based multinationals that do business in China, including giants like Walmart and General Motors Co., some of the audit work is done by Chinese firms that U.S. regulators are barred from inspecting. Investors and regulators have no way of making sure that these companies’ tens of billions of dollars of Chinese business have been properly vetted to prevent errors or fraud.

U.S. regulators have tried for years to get China to change its stance on inspections, to little avail. But now the U.S. may be ready to force the issue, as part of the Trump administration’s broad anti-China campaign over the coronavirus pandemic, trade, and Hong Kong.

The measure the Senate passed in May would require any foreign companies trading in the U.S. to use audit firms inspected by U.S. regulators. If it becomes law, Chinese companies will be thrown off U.S. exchanges unless China changes its stance on inspections. The big U.S. companies using Chinese audit firms to help out might be forced to stop doing so.

The move is aimed at putting pressure on China, and China has sent mixed signals in response. On one hand, it denounced the Senate bill, saying it would “harm the interests of both China and the U.S.”

On the other hand, Yi Huiman, chairman of the China Securities Regulatory Commission, said in June that as long as the U.S. “is truly willing to solve the problem, we can definitely find a way for China and the U.S. to cooperate on audit regulation.”

It’s not unlike what China has long done, critics say. U.S. regulators have been talking to China for years about allowing inspections and getting access to Chinese companies’ documents for U.S. investigators, and sometimes China agrees to take steps in that direction — but often, critics say, it doesn’t follow through.

“You talk to them about these issues and you feel like you’re getting some sort of willingness to work through it,” the former SEC official says. “I thought we were making some good headway, and then you start trying to follow up on some regulation, and at the end of the day, they’re very secretive and very closed.”

Pressing China on allowing audit inspections and cooperating more with U.S. regulators may yield progress down the road.

Until that happens, there’s Robert Seiden.

Seiden, a former New York prosecutor, has carved out an unusual legal specialty: When a U.S. court renders a judgment against a Chinese company that’s defrauded or otherwise slighted its shareholders, Seiden gets appointed by the court as a receiver, empowered to seize corporate assets for the shareholders’ benefit — something he’s done at 30 Chinese companies now.

He then takes advantage of a quirk in how many Chinese companies are structured: To get around Chinese government restrictions on foreign investment, the companies use subsidiaries outside China to hold their operating assets, often in the British Virgin Islands or the Cayman Islands.

Seiden pursues a court judgment against a company — and then he can go into China as the legal owner of its assets, not just another foreign creditor who can be shoved aside. He uses his position as leverage to force the company’s executives to sit down and discuss a settlement.

So far, his efforts have yielded $10 million for U.S. shareholders in companies like Oriental Dragon Corp., Advanced Battery Technologies, and Shengtai Pharmaceutical. Admittedly, that isn’t much given the scale of the problem, and Seiden acknowledges it’s tough going.

“We’re making a lot of progress, but it’s slow,” he says. There’s a “huge disconnect between how China works and an open system. Their system is ‘might makes right’ — if they can get away with something, they will.”

Investors in the companies Seiden represents recognize the difficulty, but they’re hopeful his strategy can help. “I think we are able to get some small portion of our money back,” says Gary Wolfson of GEP Capital Group, an investor in Oriental Dragon Corp., where Seiden recently obtained a $3 million settlement for investors.

Seiden’s combination of skills equips him well for the job. He was a prosecutor in the Manhattan district attorney’s office, and later worked in China, overseeing investigators and lawyers doing corporate due diligence. He was also a monitor for the Port Authority of New York and New Jersey, pursuing waste and fraud in the building of the Freedom Tower on the former World Trade Center site after 9/11.

Currently, he’s pursuing Link Motion, formerly known as NQ Mobile, whose co-founder allegedly diverted assets away from investors’ control. Seiden was named receiver by a U.S. federal judge in 2019; he’s seized Link Motion’s Hong Kong bank accounts, and his handpicked CEO won an arbitration proceeding in China giving him control over a key Link Motion entity.

Link Motion went dark without any sort of offer to pay the company’s public shareholders, says Wayne Baliga, a Link Motion investor. “If they could do this, any listed Chinese company could do this, and I don’t know what recourse there would be.”

Seiden knows the obstacles, but he has no intention of stopping. “I’m very persistent.”

For all the efforts by the likes of Seiden, Sherwood, and short sellers, tomorrow will look a lot like today when it comes to ensuring that Chinese companies are straight with their investors. Even if the measure to force Chinese auditor inspections becomes law, companies will have three years to comply. The puzzle box isn’t going to be solved anytime soon.

Some are suggesting ways to flag for investors when a company is using an auditor that hasn’t been inspected, to ensure they know the risks. In the absence of inspections, Block suggests making the U.S. arms of the Big Four accounting firms financially responsible for any failures of their Chinese siblings — just like parents are liable for any mischief by their kids, he says.

Chinese companies remain “very highly speculative stocks to invest in,” Nussbaum says. He suggests making it more difficult for retail investors to put their money into such risky companies. At the end of the day, though, “we’re still talking about a huge market with a very, very bright future.”

Others are more pessimistic about whether Chinese companies will get more reliable. “You hate to say just drop it all, we made a mistake, delist,” Stevenson-Yang says. “But I don’t know how to address it.”