Look for suspicious claims

Journalists can dig beneath the surface and go beyond paper filings to uncover irregularities.

Reporters from Canada’s The Globe and Mail and research firm Muddy Waters alleged in the fall of 2011 that Chinese company Sino-Forest Corp. — Canada’s largest publicly traded timber company — overstated the size and value of its timber holdings in China’s Yunnan Province. (For a look at how reporters verified the discrepancies, see Reporter’s Notebook, this chapter.)

Sino-Forest denied the allegations, but after doubts were raised, the Ontario Securities Commission accused the company of misrepresenting its revenues and exaggerating its timber holdings. The OSC temporarily halted trading in the company’s shares and also asked that the chairman/CEO and several company directors resign. The Royal Canadian Mounted Police also got involved, launching a criminal probe into fraud allegations.

For an opinion column on the conflict that sometimes occurs between auditors’ opinions and investment research firms, see: http://nyti.ms/HAEPZC

In most countries, failure to disclose information that has a “material” or significant effect on the company’s value incurs penalties. In addition, such disclosures must be timely. If they’re not, it’s a red flag for journalists and regulators. How can journalists find stories by monitoring company disclosures?

Here are some tips:

1. Become familiar with regulatory requirements

The role of stock exchanges and security regulators in making sure companies operate legally and in the best interests of shareholders is especially important in emerging markets, where regulation and enforcement tend to be weak. However, such requirements vary widely, and so does enforcement.

Journalists should become familiar with listing and delisting regulations for the exchanges they cover, and then monitor enforcement diligently. This includes paying attention even to the basics, such as whether companies file financial statements on time. Listing and delisting regulations are published by the exchanges themselves or by the securities regulatory agency, often on their websites.

Filing delays often indicate that something is amiss. Trans-mile Group, a Malaysian freight operator, delayed filing its annual report in 2007 for several months. When it finally filed, the company showed a new loss of $36.05 million. The late filings followed the disclosure that the company had overstated its revenues in 2004 and 2005.

As a result of this scandal, two independent directors of Transmile’s audit committee were later sentenced to prison and fined for making misleading statements in the company’s quarterly report to Bursa Malaysia.

Even if there are no losses or false statements connected with filing delays, such delays can indicate that the company’s financial functions do not have sufficient resources or are incompetent.

In contrast, improvements in governance and compliance with regulations can have a positive impact on a company’s reputation. In 2012, ratings agencies Standard & Poor’s (S&P) and Renaissance Capital (RenCap) noted the improvement of the Nigerian banking industry, especially in the areas of risk management and governance.

“Nigeria now has fewer, but larger, banks with better corporate governance and regulatory oversight,” S&P said in a statement.

Journalists who are knowledgeable about the regulations in the sectors they cover, whether banking, commodities, manufacturing or other areas, are in good position to recognize an important news development in press releases issued by regulators or, as in this case, reports from rating agencies, reported in This Day, Lagos.

Read the story at: http://bit.ly/Hxh6Lg

What can regulators do? Depending on the country’s legislative, legal and regulatory framework, they can:

  • Withdraw a company’s license to operate

  • Halt trading in its shares

  • Censure a company by so-called “name and shame” statements

  • Levy financial penalties

  • Seek court injunctions

  • Apply to the court to freeze company assets

  • Censure, fine, prosecute and seek court injunctions against directors

Reporter's Notebook

Sometimes probing into the truthfulness of a company’s disclosures requires a lot more than simply poring over paper filings and examining the numbers.

In fall of 2011, reporters at Canada’s The Globe and Mail traveled to China and spent two weeks on the ground there, investigating Sino-Forest Corp., the timber giant that is listed on the Canadian exchange.

Researchers at Muddy Waters LLC initially had raised alarms about the company, alleging that the company was perpetrating a fraud by inflating the value of its timber holdings.

Reporters spent two weeks in Yunnan Province, conducting interviews with local government officials, forestry experts, local business operators and brokers to break the story that essentially backed up Muddy Waters’ claims. The company continues to deny the allegations.

Read The Globe and Mail story: http://bit.ly/HAF1rW

2. Pay attention to share trading by insiders

Some lay people associate the term “insider trading” with illegal activity, but company executives and board members may buy and sell shares in the company as long as they observe the disclosure regulations and strictly observe the company’s own internal policies on trading.

It is illegal for any insider to use non-public information — special knowledge — for any share-trading purpose, including tipping off friends or relatives to news that could cause shares to rise or fall sharply, so called “material news.”

On most exchanges, corporate insiders — including management and directors, along with any individual who has a significant stake in a company — must report their holdings and transactions in the company’s shares.

Insiders are not only the company’s top management and directors, but can also include brokers, friends, family, stakeholders and consultants who may have access to inside information that is not public.

Such disclosure requirements for share trading by insiders vary widely by exchange, and may be minimal in emerging markets. But where such disclosures are required, journalists should keep track of any trades, changes in ownership and trading patterns. They are worth a regular monthly story on trades by directors and managers at top companies.

The biggest insider trading criminal conviction to date involved Raj Rajaratnam, an investor who once ran Galleon Group, one of the world’s largest hedge funds. He received the stiffest prison sentence so far — 11 years — and a $10 million fine in 2011 for trading on information provided by company insiders to rack up more than $50 million in profits. The SEC later assessed a $92.8 million penalty on Rajaratnam, the largest ever imposed for insider trading.

Even when not criminal, insiders’ decisions to buy or sell shares often send signals to shareholders and would-be investors, making the information newsworthy.

For example, a prominent Thai family sold its remaining 49.6 percent stake in a leading Thai telecommunications company, Shin Corp., just three days after a new telecommunications act took effect in 2006. The families netted about $1.88 billion from the deal. Certainly other investors and shareholders would have found such information worth knowing.

The media reported on Nov. 3, 2011, that Sergey Brin, co-founder and a director of Google Inc., sold 83,334 shares of Google Inc., or almost $48.5 million, on Nov. 1. This was part of a planned strategy by Brin and co-founder Larry Page to sell off some of their holdings over a period of time and give up majority control of the company. For the insider transaction page where this was reported, see: http://yhoo.it/L0IC8P

For more on how to track insider trading, see: http://bit.ly/ISulrE

3. Be alert for share manipulation

Share manipulation can be difficult for journalists to detect unless they are tipped off by regulators, brokers or analysts who notice unusual changes in share purchases and price fluctuations.

There have been occasions when journalists were accused by companies of influencing share prices by printing negative news, but as long as the news is accurate and factual, journalists bear no responsibility for the effect of their reporting on share prices.

A case of share manipulation led to a criminal investigation in February 2012 in South Korea, where a former senior government official was accused of hyping the operations of a South Korean developer, CNK International, in a diamond mining project in Cameroon.

The former vice foreign minister, who was serving as an adviser to the mining company, issued a press release claiming that that CNK had secured a project to mine about 420 million carets of diamonds in Cameroon.

The foreign ministry issued its own press release, which led to an immediate and sharp hike in the company’s share price. The former minister, Cho Jung-pyo, allegedly made more than $1 billion from the scheme. Prosecutors said other government officials could be implicated as well.

4. Examine auditors’ report

In almost all the corporate scandals mentioned in this Guide, auditing firms have been castigated for failing to spot fraud, and some have even been criminally charged.

The principal role of an auditor is to determine if financial reports were prepared in accordance with accounting rules and principles. Auditors note that they relied solely on the information provided by the company’s management. Their opinions are limited to stating whether the company has complied with accounting rules and principles.

In the United States, Arthur Andersen, which signed off on all Enron transactions and received large fees from the company, was ultimately destroyed by such failures and a criminal indictment from the U.S. Justice Department, even though it was never convicted of wrongdoing in its audits. In Italy, the reputations of bankrupt Parmalat SpA’s auditors, Grant Thornton and Deloitte Touche Tohmatsu, were battered by their failure to detect fraud in the dairy company’s books. They eventually agreed to pay a $15 million settlement to shareholders.

In fact, all of the Big Four accounting firms have featured in criminal cases involving clients at one time or other. Two PricewaterhouseCoopers partners were criminally charged in connection with the Satyam Computer Systems Ltd. fraud in India. KPMG was charged by the SEC with permitting Xerox Corp. to manipulate accounts. KPMG settled the complaint in 2005 without admitting wrongdoing.

Questions reporters should ask about a company’s auditors and their audits include:

  • Is the external auditor qualified, credible, independent and free of regulatory or legal problems?

  • What are the limitations of the auditors’ opinion?

  • What process was used to verify and audit the financial statements?

  • What does the audit report say about the company’s financial statements?

  • What kind of business relationship does the auditing firm have with the company, aside from its audit services? Any conflicts of interest?

  • Is the audit team knowledgeable in the client’s business?

  • Did management cooperate with the auditors?

Corporate scandals often produce tougher regulation and more rigorous enforcement. After the Enron and WorldCom debacles, the Sarbanes-Oxley Act of 2002 contained new provisions governing audits, auditing firms, audit committees and disclosure requirements for off-balance-sheet transactions, among many other new rules. The new law also held chairmen, CEOs and CFOs personally accountable for the financial reports, compelling them to be more diligent in their oversight of the auditor’s work.

Journalists writing about annual reports and financial statements need to understand the various types of audit opinions. In the audit report, the independent auditing firm expresses its unbiased opinion on the company’s financial statements. Audit opinion provides “reasonable assurance” that statements are free of “material” misstatements, but are not a guarantee.

Unqualified Opinion — No reservations about the financial statements.

Qualified Opinion — The auditor takes exception to certain current-period accounting applications or cannot establish the potential outcome of a material uncertainty.

Disclaimer of Opinion — Auditor does not have enough information to obtain sufficient evidence, and cannot provide an opinion on the financial statements.

Adverse Opinion — Auditor asserts that financial statements do not present the financial position, results of operations and changes in financial position in conformity with generally accepted accounting principles.

Journalists should be alert for another paragraph that might be part of an auditor’s report, called “emphasis of matter.” These are used by the auditor to draw the reader’s attention to certain disclosures in the directors’ report, and are becoming more common, according to some experts.

Emphasis of matter statements are typically issued when there’s uncertainty about the company’s ability to survive as a “going concern.” “Going concern” means that there is a reasonable expectation that the company will continue in business for the next period and that there are no significant doubts that the company can pay its debts for that period.

5. Develop multiple sources in the financial world

Hedge-fund managers, short sellers, analysts and researchers can be valuable sources for journalists because they delve deeply into the company financial and non-financial information and perform extensive due diligence for their clients.

Throughout 2011, Muddy Waters LLC, a short-selling research firm, criticized Chinese companies listed in the United States for allegedly overstating assets and revenues. (A warning to journalists, however: In a number of cases, internal investigations by the companies them-selves disputed those allegations.)

However, Muddy Waters continued to fault the Big Four accounting firms — PricewaterhouseCoopers, Deloitte Touche Tohmatsu, KPMG and Ernst & Young — for poor oversight of the Chinese firms. Regulators in a company’s industry or sector also may be good sources.

(See Chapter 7 for more on potential sources for journalists.)