Fishy business

In late 2001 Liu Shuwei was writing a book about how to identify fake financial accounts. The scholar from the Central Finance University stumbled across the fish and lotus root farmer Lantian Stock, a Shenzhen-listed firm with a return on equity that had averaged higher than 20% over five years.

But Liu spotted something fishy and wrote a report for Finance Insider, a restricted publication for banking regulators and executives at state-owned firms. She advised the state banks to stop lending to Lantian.

Liu got death threats and a defamation lawsuit for her whistleblowing. Instead of backing down, she sent her report to more than 100 media outlets. Investors began to wake up to the reality that there were hardly any fish in Lantian’s ponds and that its lotus juice products were nowhere to be found in retail outlets.

Eventually regulators exposed the truth: Lantian had cooked its financial statements. The food firm became the textbook case for studies in Chinese accounting fraud.

Since then market watchdogs have imposed stricter rules on audit and disclosure. But lately, investors have started wondering if there could be a repeat of the Lantian scandal after trading in Shenzhen-listed Zhangzidao Group was unexpectedly suspended in mid-October pending the result of an inventory inspection at its sea farm.

Last Friday, the aquaculture company sent a disturbing signal to its shareholders with a statement that they should expect a Rmb812 million ($132 million) loss in the third quarter. Why? Zhangzidao claimed to have invested heavily in Japanese scallop seeds in 2011. These were cultivated at a sea farm covering 70,000 hectares of seabed off northeastern China. But the company claimed that higher-than-normal volatility in water temperature brought about by a “cold water current” in the Yellow Sea had wiped out the harvest.

The revelation came as a shock – the quarterly loss is nine times Zhangzidao’s 2013 net profit – and Southern Metropolis Daily was soon noting that the company had never mentioned “cold water currents” as a risk factor, despite operating in the Yellow Sea for more than a decade.

Other sea farmers in the region have not reported production disruption due to adverse sea conditions, Beijing News reported.

Just like Lantian in the late 1990s, Zhangzidao had been an investor darling, and was viewed as a high-growth agricultural play. The company is named after an island in Bohai Bay and was previously dubbed “the undersea bank” for producing high quality seafood in big quantities. Controlled by the county-level local government, Zhangzidao carries a current market capitalisation of Rmb11 billion, and its shareholders include domestic institutions like the National Social Security Fund – China’s Rmb1.2 trillion pension reserve – as well as the insurer China Life.

The Global Times noted that there have been market rumours that Zhangzidao has ventured into real estate projects but suffered heavy losses. To camouflage this misadventure, “the cold water disaster is being made up as a cover story”. Citing a former Zhangzidao staffer, Beijing News went further, reporting that the expensive scallop seeds the company claimed to have placed in its sea farm were, in fact, “a mixture of stones and rotten vegetables”.

Xinhua also weighed in with “10 questions to Zhangzidao”, demanding that shareholder concerns are addressed.

Investors are now asking Zhangzidao to show them whatever remains of the shellfish harvest. Zhangzidao chairman Wu Hougang has apologised for the losses but denied the accusations of a cover up. He insists that the company only discovered the catastrophe recently, although Zhangzidao had claimed in 2012 that it would check on the health of its Japanese scallops on a monthly basis.

Speaking to Xinhua, Wu welcomed investors to carry out their own on-site checks. But he warned that inspections would be difficult, as the scallop beds lie in water 20 to 40 metres deep across a huge area.

Both the Shenzhen Stock Exchange and the China Securities Regulatory Commission have now announced their own investigations, and trading in Zhangzidao will remain suspended pending the regulatory probes. Legal experts told the Global Times that if fraudulent behaviour comes to light, the company risks delisting.

In the meantime Undercurrent News has noted that Zhangzidao is embarking on “a major public relations offensive”. Last week it announced that it had acquired Japan’s Toyomi Trading in a deal that offers access to Hokkaido scallops. Earlier this month, it unveiled a new logo and a new brand for its international trading unit.

These efforts don’t appear to have satisfied the local audience, with Beijing News also warning that China’s agricultural sector has been a “complete disaster zone” when it comes to accounting fraud.

Malpractices are not confined to the A-share market. Sino-Forest, a Canadian-listed timber firm operating in China, collapsed in 2012 under fraud allegations (see WiC111). In September, Canadian regulators laid out a civil case against five former executives at the firm. Trading in vegetable grower Chaoda Modern, which had reported double digit earnings growth for more than a decade after going public in Hong Kong in 2000, has also been suspended from trading since September 2011, after the territory’s financial authorities initiated proceedings against the company. And for those with longer memories, there’s also Yang Bin, founder of flower grower Euro-Asia, who was sentenced to 18 years in jail in 2003 for fraud and corruption. Intriguingly enough, the Chinese-Dutch tycoon’s arrest came just two weeks after he was picked by Kim Jong-il to run an experimental special administrative zone between North Korea and China.

So why are the country’s agricultural firms so scandal-prone?

“Profit margins for the agricultural sector are typically low. On the other hand it is difficult for regulators to impose effective oversight on the production processes. These factors explain why fraudulent practices have been so common among agricultural firms,” Beijing News suggests.

The newspaper also warns that retail investors can find it difficult to understand the business models of some of the agricultural firms, while Beijing Business Today has noted that the problems at Lantian and Zhangzidao both relate to “underwater fixed assets”, where fair value is difficult to audit.

“This industry is deeply submerged beneath the water. Hopefully as the water recedes, the stones will appear,” the newspaper suggested, referring to the Chinese idiom that uncertainty cannot disguise the truth forever.

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