Analysis: Natural resources face brunt of China stocks scandal (Reuters)

HONG KONG (Reuters) – The accounting troubles and short-seller attacks plaguing Chinese companies have spared few industries, though one sector appears to be a common target.

The natural resources sector is a space prone to loose accounting and one at the center of the recent stock scandals. In China, the industry is especially open to such practices.

If the bearish investors who recently sunk their teeth into U.S.-listed Chinese companies turn their attention to an exchange such as Hong Kong, natural resources is expected to be an area they seize upon.

Investing in Chinese forestry, agricultural, mining and oil companies is a high-risk game. The enormous scale and rapid growth of China's natural resources industry means that assets span from the Sahara to Siberia and some may be thousands of meters underground.

Some of the recent accounting scandals involve "some companies or people claiming they have certain acres of land for whatever purposes and nobody actually does the proper due diligence to determine under what legal conditions the land does not belong to them," said Dane Chamorro, a regional director for risk consultancy Control Risks in Singapore.

The accounting problems that have ensnared Chinese companies listed overseas in the last year involved at least eight in the resources sector spanning agricultural, forestry and mining industries.

The specter that China's resources companies can be nationalized by the government hovers in the background as well and a Chinese fondness for multiple sets of company books remains a distinct liability.

That makes due diligence difficult and the sector more susceptible to accounting fraud compared to other industries.

The Chinese government's iron grip on the resources sector means investors buying into non-state Chinese resources firms routinely face ownership disputes.

"Particularly for forestry and agricultural business, one of the issues is the asset base. A lot of the asset base revolves around land. Land in China and access to it, as you know, are highly politicized," Chamorro said. "When those assets are land-based, the state is always going to have the first claim."

STOCKS ON THE RUN

Companies that have been caught up in the accounting problems include Puda Coal (PUDA.A), a coking coal processor; China Integrated Energy, an oil distributor and biodiesel maker and Duoyuan Water, a water treatment equipment supplier. [ID:nN1099368]

Other companies include Hong Kong-listed Real Gold Mining Ltd (0246.HK), an Inner Mongolian company, that halted trading in its shares on May 27 after a newspaper report said the miner had filed one set of accounts with the Hong Kong stock exchange and a much different one with China's central government. The stock has been suspended from trading since.

Also among the victims was Sino-Forest (TRE.TO), a Toronto-listed commercial forestry operator in China, whose shares have plunged 80 percent since short-seller Carson Block and his firm, Muddy Waters, said Sino-Forest fraudulently exaggerated its Chinese forestry assets.

Four months ago, Hong Kong's securities regulator launched an investigation into another forestry company, Carlyle Group-backed China Forestry Holdings Co Ltd (0930.HK) after the Chinese company said its auditors identified possible irregularities in the audit process of its 2010 financial year.

The regulator also started court proceedings against the company's CEO and trading in the company's shares remains suspended.

In the U.S. more than 20 Chinese companies have been delisted or halted amid allegations of accounting fraud so far this year. The SEC has also censured a number of auditors for inadequately assessing Chinese companies' financial positions.

In China, the government told companies last month to stick to a list of state-approved auditors. But cross-border co-operation has been limited.

The SEC has struggled to get access to witnesses and information in China to help with its inquiries, while audit watchdog the Public Company Accounting Oversight Board, is unable to inspect auditors working for U.S.-listed companies on the mainland.

PAPER TRAILS

Oliver Ramsbottom, a Shanghai-based partner at McKinsey & Co, which does due diligence work for global private equity firms, says understanding the audit trail is vital to preventing losses when it comes to companies in the natural resources sector.

"The company you invest in may have the mining license, but further down the road you could find that license is not valid because the exploration license that went before it wasn't valid," said Ramsbottom.

It is well known in China's financial industry that some Chinese companies often maintain multiple sets of books -- those they show to tax authorities, the numbers they show to investors and the numbers management and owners see.

"If you go and buy a license you don't want to just look at that license paper. You want to go and speak to people in the mining companies and in the ministry of resources to get a sense of how defensible is this. Is there a history behind this license?" Ramsbottom added.

Howard Wang, head of Greater China at JPMorgan Asset Management pointed out a number of situations that raise red flags.

These include comments from rival companies about how they are unable to model the high margins presented by competitors using their known market share and sudden unexplained changes of chief financial officers or a company's auditors.

"We, generally speaking, will think twice or three times before investing in one of the situations, regardless of how good the numbers look and regardless of how many 'buy' reports the brokers issue," said Wang.

But with profit-driven and publicly listed stock exchanges competing to lure listings regardless of their quality, it is likely short-sellers like Muddy Waters will dig up more dirt on Chinese resource companies.

"There is a conflict there because exchanges want to list as many companies as they can. They are in competition with each other," Control Risks' Chamorro said. "There is an inherent conflict there, right, basically between the exchanges and listings, unless you have really strong safeguards."

(Additional reporting by Lee Chyen Yee, Editing by Matt Driskill and Michael Flaherty)

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Analysis: China tries to shine a light on "shadow" loans (Reuters)

BEIJING (Reuters) – Chinese regulators are playing a game of hide and seek with the country's lenders, trying to uncover deals struck with the intention of evading official loan restrictions.

Though far from easy, the search for "shadow" loans -- lending hidden off banks' balance sheets -- is a priority for China's policy hawks, who worry lending limits are not as tight as they used to be, and monetary policy is looser than meets the eye.

Unlike other major economies, China relies not on interest rates but on loan targets as its most potent policy tool. It tells banks how much to lend by lifting or cutting loan quotas.

But China's solid economy, which has buoyed demand for cash, has forced banks to get creative and dream up a bevy of back-up financing in recent months to bypass loan limits.

From designated loans to bank acceptance bills and trust loans, Chinese banks are pushing out a wide variety of off-balance-sheet loans, and weakening Beijing's efforts to contain lending.

"Just look at the amount of cash circulating outside the banking system and you will know the true story," said Du Zhengzheng, an economist at Bohai Securities in Beijing.

"Firms are turning to non-bank channels to get funds while lenders are rushing into off-balance-sheet products to skirt loan controls."

Indeed, data shows that the proportion of financing accounted for by bank loans in China dropped from 85 percent in 2008 to just over half in the first quarter this year.

The off-balance sheet financing boom belies a recent slowdown in bank lending and -- contrary to the arguments of some investors that weaker credit demand augurs a hard landing for China -- points to a still-robust appetite for loans.

"Lower growth in loans is caused by monetary policy tightening as of now, not by demand weakening," said Helen Qiao, an economist at Goldman Sachs.

ECLIPSING BANK LOANS

For China's central bankers, however, ample credit is not entirely good news. Policy makers have made inflation their top goal, and the extra cash from creative lending could help keep inflation -- already at a 34-month high -- elevated.

To better track the explosion of non-traditional lending, the central bank proposed in February that China's true monetary conditions be measured using "social financing," a broad group of credit that includes on- and off-balance-sheet loans and bond and equity issuance.

By this measure, China's monetary conditions are only a little tighter than in 2010, despite four interest rate rises and nine increases in reserve requirements over the past year. The central bank's 2011 target for total social financing is 14 trillion yuan, not far off last year's 14.3 trillion yuan.

That figure will stay high despite Beijing's efforts to restrain bank lending, bankers said.

Lenders have strong incentives to cash in on demand for credit by making off-balance sheet loans, including designated loans, bank acceptance bills and trust loans.

In the first quarter, designated loans, or loans lent from one firm to another but facilitated by banks, leapt to 320.4 billion yuan ($49.6 billion), more than doubling from the same period last year. Bank acceptance bills hit 761.1 billion yuan, or a third of all that was issued in 2010.

Most popular are trust loans, which are dressed up by banks as a variety of higher-yielding wealth management products to attract deposits from savers looking for better returns.

Chinese banks sold 8.25 trillion yuan ($1.28 trillion) worth of wealth management products in the first six months, topping last year's total of 7.05 trillion yuan, local media reported.

"The sales of such products keep surging in our bank and I cannot see any sign of cooling in months ahead," said a banker at a small city bank in China's southwest Sichuan province, who declined to be named.

HOW RISKY?

China's bank regulator has made plain its dislike for nebulous "shadow loans." It has a long-standing order to banks to move trust loans back on their books by the year-end.

It made its latest move this week by telling banks to check all bill financing deals [ID:nL3E7I40A7], just days after tightening control on wealth management products.

But some analysts say shadow loans could help avert a cash crunch if China overtightens policy in its fight against inflation.

"Credit created outside the banking system can work as a cushion against excessive monetary tightening," said Goldman's Qiao.

Others are uneasy that so much lending and borrowing is happening out of sight, since it is hard to gauge if the loans were made sensibly and to what end.

Indeed, some economists say some of the off-balance sheet loans are funneled into properties and stocks, fuelling China's asset inflation, a point officials tacitly acknowledge.

"The risks of such off-balance-sheet activities outweigh the benefits, because 40-50 percent of the shadow lending goes to the property sector," said Nie Wen, an analyst at Hwabao Trust in Shanghai. ($1 = 6.463 Chinese Renminbi)

(Editing by Don Durfee)

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Analysis: Sino saga shows flaws in Canada's regulatory regime (Reuters)

TORONTO (Reuters) – Canadian regulators are under fire for their disappearing act as shares of Chinese forestry company Sino-Forest melted down, raising new questions about a regulatory regime that's long been criticized for lacking teeth.

Sino-Forest, which three weeks ago had a market capitalization of about C$4.7 billion, is now worth just C$700 million, after accusations of fraud leveled by Hong Kong-based short-seller Carson Block and his one-man firm Muddy Waters sent its shares and bonds into a downward spiral.

Regulators said they had launched an investigation, but then stayed silent, doing nothing to quell the speculation, halt the stock or drill down into the problems.

There were similar complaints of inaction during the huge Bre-X stock fraud of the 1990s, while shareholder activists noted bitterly that press baron Conrad Black was successfully prosecuted in the United States and not in Canada.

"We have a system in Canada that is 80 years behind the times," said Al Rosen, a forensic accountant with Rosen & Associates, who said Canada's current reporting standards serve the interests of auditors more than investors.

He said Ontario regulators, responsible for Mississauga, Ontario-based Sino-Forest under Canada's patchwork of provincial regulators, have let investors down, and Canada would be better served by a single securities regulator, with separate prosecution and regulation arms.

"If you don't have these people with proper supervision and leadership and guts and courage you've got nothing," he said.

The Ontario Securities Commission, the biggest of Canada's provincial regulators, did not return repeated phone calls seeking comment.

"The OSC's policy all the time is to not comment, which is a convenient policy, right?" said Rosen. "So when the OSC say, we're giving it the same treatment we've given everything else, you can read anything you want into that. I read into it that they're doing nothing again."

Joseph Groia, a securities lawyer and former director of enforcement at the OSC, also believes regulators were slow to respond in the Sino-Forest saga.

"As best I can tell, they've done nothing. My view is that the horse is out of the barn and there is probably no point in them doing anything now," he said.

MARKET 1; REGULATORS 0

Block, in his fifth successful assault against the stock of a North American-listed Chinese company, said Sino-Forest had fraudulently overstated its assets in a gigantic Ponzi scheme.

Sino-Forest denies the charges.

But while some experts said the OSC should have halted Sino-Forest shares pending probes into the allegations, others said the market should decide the company's fate.

"With 20/20 hindsight you can always say regulators should have done more. But that doesn't mean that at the time there were any warning signs, or red flags that suggested they should have done more," said Cristie Ford a University of British Columbia professor and an expert on securities regulation.

Ford is less sure that U.S. regulators would have been more proactive in their response than their Canadian counterparts and said the Canadian framework is more "compliance-oriented."

"It's about trying to catch things before they require enforcement action rather than hitting the company with the big stick after they've done the bad thing," she said.

"The Americans are very much outliers when it comes to how much enforcement and how much strong action they take in these kinds of situations, relative to everybody, not just Canada."

Sino-Forest's collapse has prompted parallels with Canada's 1997 Bre-X mining scandal, when rock samples were salted with gold to create the impression of a massive gold strike.

That scandal led to a whole new regulatory framework to govern how miners outline mineral resources, and some said Sino-Forest's woes could prompt new rules on other matters, regardless of whether the accusations turn out to be true.

"It is very likely that once the matter of Sino is fully determined one way or the other, the regulators will take a more proactive role in closing any gaps that might have occurred," said Darryl Levitt, a lawyer with Macleod Dixon.

WHO'S IN CHARGE?

But for now, investors burned by the scandal are left to wonder who is actually in charge.

"There are quite a few regulatory bodies in Canada and it would appear that the buck is being passed," said Levitt.

Federal government officials defer to provincial regulators, while officials at IIROC, which oversees trading activity, and the Toronto Stock Exchange operator TMX Group point to the OSC as the organization that handles cases like this.

"I think they've been lax right across the board," said Rosen, author of the book "Swindlers," which says Canadian regulators who should watch corporations and protect investors are all too often missing in action, or asleep at the wheel.

"It's like having signs on the highway that say it's 50 km/h. But there's never any police, there's never any radar, there's never any helicopters. How many people are going to treat it seriously?"

BLAME THE ANALYSTS

The Sino-Forest case and accounting scandals at other North American-listed Chinese companies have also shone a spotlight on the murky world of reverse takeovers, that let small private entities go public via listed shell companies with far less scrutiny than through an initial public offering.

"For certain types of transactions, even if they are done via RTO's, regulators may ask for a prospectus, as opposed to an information circular and thus up the nature of disclosure required," said a lawyer who asked not to be named due to a conflict of interest.

Even as class action lawsuits pile up against Sino-Forest, its directors, its management and its auditors, some say analysts and short-sellers like Muddy Waters should also be held accountable for their actions.

"There are eight research analysts covering this company, all of whom had a buy or an outperform rating on this stock. It's their job to kick the tires in a way that regulators never do," said UBC's Ford.

"If you're going to lay this at the foot of the regulators for not having put a cease trade on this company it seems a little bit misplaced. What about all those research analysts? Why weren't they doing the job they were meant to be doing?"

Any case against analysts who touted the stock, or others that have slammed the company is unlikely to proceed until the allegations are proven, or quashed by an independent probe.

Groia said regulators should watch short-sellers like Muddy Waters too.

"This ought to be a lesson that the regulators learn from, so that they put more liability on the Muddy Waters of this world," he said. "They are not doing this because they are altruists; they are doing it because they are capitalists."

(Additional reporting by Louise Egan and Randall Palmer; Editing by Janet Guttsman)

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