The China MediaExpress Saga: Part II The Litigation

March 24, 2011

Yesterday I bored everyone with some background information on China MediaExpress, a NASDAQ-listed company whose performance sounded too good to be true. When last we left them, they were posting outrageously optimistic numbers.

What happened next? CCME had a very rough start to the year, particularly in February when the research firms started piling on:

Last month [February], Muddy Waters Research accused China MediaExpress of “engaging in a massive “pump-and-dump” scheme in which it significantly inflates revenue and profits in order to enrich management through earn-outs and stock sales.” Citron Research and Bronte Capital also released similarly bearish reports on China MediaExpress on Jan. 31 and Feb. 1, respectively.

Ouch, that’s gotta hurt. On March 11, the drama began as shares of CCME were halted, pending an announcement by the company. The following day it was announced that Deloitte Touche Tohmatsu, CCME’s auditors, were withdrawing, and the company’s Chief Financial Officer, Jacky Lam, was quitting. The subtext here: Deloitte had been fed bullshit by CCME and had to distance itself to minimize liability.

Quite messy. About a week later, more drama from a huge investor of CCME, a firm run by longtime China Hand and former AIG icon Hank Greenberg. Apparently Greenberg was not at all pleased with his investment:

Starr International, a firm run by former American International Group (AIG) CEO Maurice “Hank” Greenberg, has filed a suit against China MediaExpress Holdings and its auditor Deloitte Touch Tohmatsu for fraud, Bloomberg reported. The suit alleges that China MediaExpress misrepresented its business and finances, and dishonestly induced Starr International to invest US$13.5 million, making Greenberg, with investments through Starr International and C.V. Starr & Co, the third-largest shareholder in China MediaExpress.

Greenberg, who has been through quite a lot in the past few years, what with the implosion of AIG and the Great Recession and all, but he made a huge bet with a significant portion of his remaining funds in China MediaExpress.

This was a big deal for CCME, particularly once the Citrons and the Muddy Waters types started closing in. Hey, how bad could the company be if an old savvy China Hand like Hank Greenberg was on board?

So Greenberg now says he was duped by CCME. How could this have happened? After all, Starr reportedly performed a due diligence investigation on CCME before it made its investment.

Well, there’s due diligence and then there’s due diligence:

Starr admits the extent of the diligence behind their 1.5 million+ share (with warrants/etc) investment in CCME was based solely upon information provided by management, either directly and/or through regulatory filings.

Oops. Again, given Greenberg’s China credentials, this is really odd. Moreover, rumors say that part of the attraction of CCME was some sort of exclusive deal it had secured with the Ministry of Transport. If it turned out that Greenberg was suckered in by the old “government relationship” scam, that would be utterly shocking. That’s a complete rookie mistake that you grow out of after your first Chinese banquet.

Anyway, I guess we’ll see how far Starr and other investors get with the “they lied to us” defense.

So according to Greenberg, and I guess Deloitte, CCME’s financials were sexed up just a bit. Not only did this dupe investors like Greenberg into making ill-advised investments, but it also of course had an effect on share prices.

Simply put, a company misleads the public about earnings (through various accounting techniques or just plain lying) and the stock goes up. If the officers of the company have earn-out deals, meaning that their compensation is directly related to revenue, then they benefit from this sort of activity. Moreover, if the officers are also shareholders, then they can also cash out at some point and benefit in this way as well.

So where does that leave Greenberg and other investors, who are now suing CCME? Well, remember yesterday when I complained about CCME’s corporate structure? Basically they have a US-listed shell that is tethered to a Chinese operating entity via contract only — in other words, the listed entity has a contractual right to a stream of income from the PRC company, but it doesn’t really own anything.

Sounds shaky to me. To some financial analysts too:

Starr can sue for all the money in the world (or all the tea in China, as it were) but as I’ve previously discussed, I’d be surprised if there’s much if any money/assets left. I’m not 100% sure how the U.S./PRC (China) subsidiary structure protects the CEO, his mother, and the CFO, but at first glance, it looks like there’s plenty of opportunity, means, and motive for them to have siphoned-off most of whatever value there was from the opco into their pockets, with holders of U.S-listed CCME being none-the-wiser, and certainly none-the-richer.

I’d also be surprised if these US-based lawsuits prove fruitful.

Next question: what does this tell us, if anything, about other Chinese reverse mergers that are hanging around out there with skeletons in their closets? You gotta admit that what the CCME founders got away with here (if all of the allegations are true of course) sounds rather attractive. One commenter on a finance BBS summed it up rather well:

[S]o you can buy a reverse merger, run up the share price, sell your shares without reporting, have someone sue you, declare bankruptcy and keep the underlying business?

[T]hat sounds like a great business model. why didn’t I think of that?

As you might expect, the long knives are already out, and the financial press has published lists of other Chinese reverse mergers that are “suspect.” One good source is Herb Greenberg over at CNBC.

Me, I’m a skeptic and conservative when it comes to this sort of thing, so I see this as a much needed wake-up call. This bubble in overseas-listed Chinese companies needed to be deflated at some point. Some of this is just old-fashioned, hype-induced price inflation (hello, social media stocks?), but it would not surprise me if some other reverse merger guys hanging around out there will find themselves in court on fraud charges within the next couple of years.

Let’s be careful out there.

4 thoughts on “The China MediaExpress Saga: Part II The Litigation

  1. deldallas

    Yea, i’d say unless you’ve got a PE firm with the exclusive opportunity to do about 3+ months of due diligence with hired accountants, lawyers, industry/customer consultants, etc., it’s probably better to just put your money in China-focused ETFs.

    Thorough due diligence or thorough diversification is a must in both developed and developing financial markets.

    1. Stan Post author

      Agreed, although some of Citron’s research does raise questions about just how good the quality of Starr’s due diligence was.

      1. deldallas

        Right. If their due diligence was based “solely upon information provided by management, either directly and/or through regulatory filings”, that’s straight unprofessional. Usually with a $10+ million investment, I would suggest there should be a proprietary ~$50k industry-consultant-prepared due diligence report regarding market share, competitors, customer surveys, etc. that would have killed a deal like this.