It’s no secret that the world of banking and finance has consistently submerged itself in corruption and controversy, seemingly coming to a head in the devastating financial crisis of 2008. It’s also no secret that China, with its absence of freedom of information and strict censorship from the governing Communist party, is exceedingly corrupt and controversial. The China Hustle brilliantly ties these corrupt worlds together to illustrate an alarming picture of a potentially imminent bubble burst with huge consequences for the global economy; stemming from China but inflamed by nonchalant regulation within the financial world. A documentary created by Oscar-winning director Jed Rothstein, The China Hustle sheds new light on just how far-reaching the duping and deceit in China, and on Wall Street, really is. It’s simple explanations of important financial jargon echoes the award-winning financial corruption film The Big Short (see our review for this here) and means that it’s an easy watch for those who are just getting to know the financial world. Forbes declared it ‘the most important film of 2018,’ a daring statement in a year full of blockbusters, but if, like myself, you are interested or even directly involved in financial trading and banking, it is a must watch.
It begins, and continuously returns to, Dan David, a short-selling hedge fund manager working in Skippack, Pennsylvania; a far-cry from the Wall Street bustle, but equally as involved. In the wake of the 2008 crisis, he, as well as many other investors, recognised that Chinese companies were becoming the real money-makers of the financial markets; ‘there was virtually no money you could invest in Chinese companies in 2009 that you could lose money on’. David outlines that they were initially very hard to access on U.S. markets, but efforts from boutique investment banks like Roth Capital and Rodman & Renshaw in the 2000s pushed over 400 Chinese companies on to U.S. exchanges, making executives, bankers and lawyers surrounding these deals millions of dollars in the process.
I know what you may be thinking; how could these banks so easily push these Chinese companies on to U.S. capital markets? Surely rigorous audits and checks are required to list a company on an exchange? One would hope this is the case when so many people invest their life savings in these markets, but the documentary illustrates, perhaps frighteningly, that banks can easily get around these checks through what are referred to as ‘reverse mergers.’ The theme of manoeuvring around checks and balances of the market while remaining within the fringes of the law is a recurring one in this documentary.
What is a reverse merger?
According to the bankers, traders and lawyers interviewed in the documentary, a reverse merger involves a foreign company seeking access to the U.S. market and a shell company in the U.S. A shell company is merely a company that no longer operates, but still exists on the stock market. They’re often old mining companies in rural areas, waiting for a partner to merge with, and from the mid-2000s it was Chinese companies that fit the bill. This manoeuvre allowed hundreds of Chinese companies to list on U.S. markets, and they performed remarkably well, with the average Chinese reverse merger stock up several hundred per cent between 2009 and 2010, according to the documentary. So far, so good?
Well, not really. While a vast amount of money was being made by investing in these seemingly unbeatable Chinese stocks, a handful of investors like Dan David were becoming increasingly cynical about the financial performances of some of these companies. Carson Block, founder of the first Chinese self-storage company Love Box, had invested in ‘Orient Paper Inc,’ who had claimed to be doing $100 million in business a year, shipping high quality paper throughout China. Block, a clearly self-assured, seasoned investor, was pessimistic and thus decided to visit one of their manufacturing sites himself in China. What was supposed to be a ‘fast-growing company’ was in fact a near-derelict warehouse with broken machines, rotting garbage and little staff. It was immediately clear that this was a fraudulent company, and for the first time in the documentary it was clear that cynicism from these investors was justified and more fraud was likely to be uncovered. On seeing this, Carson decided to publish a report detailing this fraud and even bet against the company on the market to reinforce his claims. In the days following, Orient Paper’s share price fell 55%. Carson knew this company was fraudulent and destined to go to zero, and thus ‘short’ its stock. The documentary, as mentioned above, nicely defines financial jargon like ‘short-selling,’ which is where investors believe a share price will go down and thus ‘bet’ that it will fall. Investors like Dan David, Carson Block and many others interviewed in the documentary began short-selling Chinese stocks due to concern over fraudulent statements.
At this point of the documentary, the money-motivated nature of the bankers, lawyers and auditors involved becomes increasingly clear. These intermediaries that were supposed to keep the markets clean and secure were merely processing necessary paperwork to get these deals over the line, collecting their fees and moving on, regardless of any potentially fraudulent activity. And this was enabling these Chinese companies to denounce reports like Block’s and David’s on fraud and continue attracting investors; the names of industry giants on their financial statements would instil trust, despite the massive deception that was taking place. These fraudulent companies were merely ensuring that all the boxes that allowed them access to the U.S. markets were ticked.
But what happens if they are caught?
Emphasised in the documentary, the Securities and Exchange Commission (SEC) that regulates U.S. capital markets are astonishingly ill-equipped to deal with fraud like this, and thus are insufficient in protecting the public from potentially losing vast swathes of capital due to a lack of due diligence. It’s pointed out in the documentary that it is not illegal to steal from foreign investors in China, and yet Chinese companies are allowed to trade in foreign markets. The accountability for breaking the law in China ends at the border; there are no consequences in the U.S. from regulators, which is fundamentally why they are getting away with it and continue to get away with it. Dan David makes it abundantly clear that the only defence against fraudulent activity on U.S. capital markets is short-selling. Short sellers like David have taken down forty to fifty of these fraudulent Chinese companies while the SEC haven’t managed more than two or three. But, as David states at the very beginning of the documentary; ‘there are no good guys in this story. Including me,’ highlighting that while his efforts have focused on removing these fraudulent companies from U.S. markets, he has made money at the expense of others.
What I found particularly hard to grasp when watching this documentary was the scale of fraud from Chinese companies that has been exposed, and what has yet to be exposed on U.S. markets. Dan David’s biggest short-sell win was with TechPro, a nearly $2 billion company where Dan believed its CEO was misallocating shareholder money to spend on his own projects. His presentation in front of investors and shareholders led to a 91% decrease in TechPro’s share price. But this is just the tip of the ice-berg; according to the documentary there are over 100 Chinese companies that trade on U.S. exchanges with a combined value of $1.1 trillion. And with billions of dollars of ordinary people’s retirement plans, pensions and life-savings having already been lost to fraudulent Chinese activity, this is clearly a pending crisis that warrants much more attention.
Towards the end, we are truly exposed to the sobering reality of the consequences of fraud like this. Ordinary American citizens whose retirement savings were eviscerated by these fake companies struggle to hold back tears as they talk us through their experience. Ray, 68, lost $150,000 of his retirement plan after being issued a buy recommendation from Roth Capital for what turned out to be a fraudulent Chinese company.
This build-up of credit draws many parallels with the mortgage crisis of 2008; could we see a bubble burst of similar proportions? Jim Chanos, an investment manager, points out that ‘there has never been a credit build-up so large that we are seeing in China today that hasn’t resulted in a major financial crisis.’ And we don’t know which companies could potentially be fraudulent. The documentary interestingly draws focus towards Alibaba at the end of the documentary, detailing that any full investigation into their accounting was disrupted when President Trump appointed a lawyer that was involved in Alibaba’s listing on the NYSE to head the SEC. This uncertainty surrounding even Alibaba, an enormous internet company, shows just how deep-seated this crisis could really be. To quote Jim Chanos, stay tuned.