There was an interesting article by Dune Lawrence and Belinda Cao of Bloomberg looking at the status of Muddy Water’s attack on NQ Mobile. The article reaches a mixed conclusion on the accounting.
Several experts interviewed by Bloomberg said the high days sales outstanding (DSO) was a red flag. High DSO usually is a red flag, but a fraud perpetrated in this way would be quite small compared to what Muddy Water’s alleges. Muddy Water’s says that over 90% of the business is fake, and you can’t cover that up by edging up DSO.
The second issue is whether the cash is there. I consider that the true test of whether the company is a fraud. If the cash is there, I see no way that any fraud could be of the scale alleged by Muddy Waters. The company is taking some extraordinary steps to clear this issue up. The Level 1/Level 2 controversy is meaningless.
The movement of funds is more interesting. Muddy Water’s alleged that it was impossible for NQ Mobile to transfer the proceeds of the offering to the VIE without violating Chinese law. A couple of experts disagreed with that.
Accountant Drew Bernstein said well-connected people can work around the rules. Carson Block says these people don’t have that kind of clout. I side with Block on this. I seriously doubt that the company could have convinced a Chinese bank to simply ignore the law and allow them to exchange dollars into renminbi and then transfer the funds to a privately held company.
Lawyer Rocky Lee suggests another possibility. NQ deposits the funds with a Chinese bank offshore as security for an onshore loan to the VIE owner, who inserts the funds as capital. It is clear from the financial statements that is not what happened. First, such a transaction would require substantial disclosures that are not present. Second, the balance sheets of the company and the VIE make it clear that is not what happened.
The VIE reports total liabilities of US$161,761,000. NQ Mobile reports total liabilities of US$34,369,000 of which $16,871,000 are said to be liabilities of the VIE. So, why the difference of $144,890,000? The only explanation that makes sense to me is that the difference is an intercompany receivable from the VIE to NQ Mobile’s WFOE that is eliminated in consolidation. But that means that the VIE owes NQ Mobile $145 million. If the money had been contributed as capital in the manner suggested by Rocky Lee there would not be debt in the VIE. If the bank had loaned the money to the VIE the loan would not have been eliminated in consolidation.
So, how did that $145 million get there? Given China’s exchange controls I see only one way to get dollars into a VIE. That is to find someone inside China who has a big pile of RMB and who wants to exchange it for dollars. So, you find Mr. Wang who has 650 million renminbi. We won’t ask how he got it. Mr. Wang could go to the bank and exchange $50,000 per year. If he had 2,097 friends help him, each taking out $50,000, he could get the money out in one year. Or, to do it all at once you could offer to deposit $100 million in Mr. Wang’s Hong Kong account if he will deposit his 650 million renminbi in your China account. (You can get a great exchange rate this way as well). There are a number of variations on this approach (Rocky Lee suggested one in the article that has also been used by public companies). There are middlemen who do these transactions. A lot of wealth has left China in this fashion, all in violations of China’s exchange controls.
But perhaps NQ Mobile found a better, legal way to do it. I am all ears.