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
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
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.
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)