Why is Kangmei Pharmaceutical, found to have committed one of China’s biggest financial frauds, rallying?
- Regulator imposes tiny fine, does not signal Kangmei Pharmaceutical will be delisted
- Shows light punishment gives companies ‘great motivation’ to cheat, analyst says
Kangmei Pharmaceutical, found by regulators to have engaged in one of China’s largest financial frauds totalling US$12.6 billion, has seen its shares surge by 17.3 per cent this week, after it got a slap-on-the-wrist fine and may not face delisting.
“This is a perfect example that shows when the cost is too small for a financial fraud, companies will have great motivation to do it,” said Ma Jinghao, a visiting professor to Central University of Finance and Economics in Beijing.
“Investors sold off their holdings of Kangmei earlier, believing the violation should be serious enough to trigger a delisting of the firm. But now many feel Kangmei was oversold, given the hope was kept alive that Kangmei will remain listed,” he added.
Recent fraud scandals, from Kangmei in China to General Electric in the US, highlight how fragile auditing can be, because the relationship formed between the service provider and the client does not necessarily lead to an independent inspection of the books, Ma said.
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The China Securities Regulatory Commission (CSRC) wrapped up an 10-month investigation into Kangmei on August 16. After the markets closed that day, the securities regulator announced Kangmei had been involved in “premeditated and malicious cheating of investors”, with long-term planning.
Specifically, between 2016 and 2018, Kangmei inflated revenue by 29 billion yuan (US$4.1 billion) and its operating profit by 4.1 billion yuan, the regulator said. It also inflated cash positions by a total of 88.7 billion yuan in its 2016 and 2017 annual reports and its 2018 interim report, the regulator said.
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The company apologised to shareholders, and said it would announce later if it will appeal.
Investors shrugged off the eye-popping fraud numbers and harsh wording of the regulator. Since Monday, they have been buying the stock. The share price hit the upside limit of 5 per cent – Kangmei has been moved to a risk-alert board under the Shanghai bourse and its daily movement band has been cut to 5 per cent – for four consecutive days before it slid by 3.5 per cent on Friday.
Trading volume surged from 211,700 shares on Monday, to 2.2 million shares on Wednesday, and subdued to 1.8 million shares on Friday. Average trading volume of the company in the past year stands at around one million shares per day.
Guo Shiliang, a financial columnist based in Guangzhou said investors, including 230,000 individual shareholders and some institutions, are betting on a pickup of the share price, while some are trying to bring down the average of their investment costs by picking up cheaper shares.
China strengthened the delisting rules last year, to deter fraud and clean up zombie companies. But the rules regulating information disclosure remain too soft, Guo and Ma said.
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According to the rules, not all frauds result in delisting. Only the most serious face that punishment. The rules stipulate that if after excluding the inflated part, the financial data is bad enough to reach the bottom line for a listed entity, then the company responsible for the inflation should be delisted.
Luckily for Kangmei, the company had a positive net profit from 2016 to 2018, even after excluding the inflated profit. Meanwhile, some people believe there is real value in the firm, which is said to be in talks with a state firm regarding restructuring after the CSRC announcement.
Based in southeast China’s Guangdong province, Kangmei is a top Chinese medicine producer.
The company made it into Fortune China 500 in 2018, and ranked No. 5 in the medical industry. It was also selected as a MSCI China index constituent in May 2018, though it was kicked out by the index this May, due to the investigation.
A sufficient cash position can help win credit lines, bring down the loan interest, and otherwise help fundraising by the firm, said Andrew Lam, a director with BDO in Hong Kong, who said the fraud should be “at least one of the biggest on record”.
A fraud on such a big scale needs elaborate work to happen, he said.
“But sometimes, it is not that the bigger things are, the easier it is to find the problems. It is the opposite. Because people tend to trust big companies,” he added.
