There’s a small wave of rogue stocks sweeping through the market, with one aim in mind: To destroy your portfolio.
And don’t expect much help from the authorities. Despite the SEC launching an official taskforce last month to root out fraud in foreign companies listing on U.S. exchanges, every week or two, another company gets exposed for fudging its figures, or fabricating its operations.
Top of the SEC’s hit list: Chinese stocks.
But here’s the scariest part…
Until recently, these scam stocks wiggled onto U.S. exchanges through “reverse mergers” – essentially, a way of dodging the scrutiny that comes with being a legitimate U.S. stock. (That’s why we wrote a special report, warning against reverse-merger companies and provided a list of the most likely scams. You can read it for free here.)
But recently, two companies that weren’t reverse-mergers and would have qualified as “safe” investments in China have come under investigation, as shareholders have suffered a beating.
So it seems the problems may be more widespread…
How Chinese Shenanigans Smacked American Investors
I’ll bet that average Yahoo! Inc. (Nasdaq: YHOO) shareholders across America didn’t think that some shady moves on the other side of the world would cost them $3.7 billion.
But that’s exactly what happened recently when the company announced that its Chinese division, Alibaba Group, had transferred a major asset to a separate company. A company owned by its CEO.
Yahoo shares fell 15% over the following few days.
Here’s the whole story…
In 2005, Yahoo felt its strategy for gaining traction in China wasn’t working, so it purchased 39% of leading Chinese internet firm, Alibaba Group (the investment was later raised to 43%).
Analysts estimate that Yahoo’s original $1 billion investment is worth as much as $10 billion today, making up a huge chunk of Yahoo’s $20 billion market cap.
As part of its operations, Alibaba owned the highly popular Alipay, an online payment system that processes 8.5 million transactions per day. (Consider it the PayPal of China.)
Trouble is, the People’s Bank of China issued new regulations last year that may prevent foreign investors from holding stakes in Chinese internet-payment services. As a result, Alibaba decided to transfer ownership of Alipay.
Here’s where it gets strange…
In August 2010, Alibaba transferred Alipay to a different company, controlled by Alibaba CEO, Jack Ma.
As if that weren’t murky enough, Alibaba won’t release any information on what compensation it received, or how income from Alipay will flow back to Alibaba and Yahoo.
Even more outrageous, Yahoo claims it wasn’t notified of this transfer until March 31 – seven months after the multi-billion-dollar transfer!
Yet the Alibaba team claims the Yahoo board was informed the whole time – a classic “he said… she said” story that leaves investors confused and angry when it’s their money that is ultimately lost.
On June 1, sources indicated that Yahoo and Alibaba reached a preliminary agreement that would work this out. Supposedly, Jack Ma’s company will retain control of the Alipay subsidiary and compensate Yahoo to some degree.
Also, Chinese authorities made it clear that it would allow Yahoo to own Alipay, despite being a foreign company.
But the damage was already done. Yahoo shares fell on the announcement and investors have investors lost a substantial amount of money. Moreover, trust in Yahoo has eroded, since this “safe” American company appeared to have no control over its lucrative Chinese assets.
But this isn’t the only case of Chinese monkey business…
A Simple Scam… A Disastrous Result
A more cut-and-dried case of fraud has crushed investors in Beijing-based Longtop Financial Technologies (NYSE: LFT).
Trading on the stock was suspended at $18.93 on May 17 – a mere two months after it hit $34.79. And investors are now stuck with shares that may end up being worthless.
Of the nine Wall Street analysts covering the stock, seven ranked it a “buy,” while two rated it a “hold.”
And Longtop’s investors included some of the biggest and smartest hedge funds, including SAC Capital, Renaissance Holdings, DE Shaw and Tiger Management, along with top banks like JPMorgan Chase (NYSE: JPM) and UBS (NYSE: UBS).
But in old-fashioned “too good to be true” style, investors began to question Longtop’s profits and it didn’t take long for the house to crumble. And after the Longtop’s shares were suspended, the company’s auditor, Deloitte Touche Tohmatsu, resigned on May 23 after it identified false financial records and potentially fake sales.
When the stock does trade again, it’s likely that the company will have sunk from one with a $1 billion-plus market cap, to near zero.
The lesson is this: If you’re going to chase profits in China, make sure you know what you’re risking and keep your investment manageable in case disaster strikes.
And check out our Chinese scam stock guide. It’s essential reading if you’re thinking about investing in Chinese companies. Not only that, it’s free and you can access it right here.