Is New Oriental Education's Management Telling the Truth?

NEW YORK (TheStreet) --

New Oriental Education's (EDU) shares fell through the floor for the second day in a row.

Falling in sympathy were Apollo Group ( APOL), Bridgepoint Education ( BPI),   Corinthian Colleges ( COCO) and Devry ( DV).

EDU Chart EDU data by YCharts

Shareholders were already reeling from the pain of watching their shares lose half their value in a month. The situation took a turn for the worse when allegations of management fraud circled through the Internet.

Muddy Waters Research claims New Oriental presented fraudulent financial statements. New Oriental shares, which earlier in the day were trading higher, dropped another 30% Wednesday.

Support fell from under the shares of New Oriental comparable to a trap door on a gallows, leaving investors twisting in the wind. The Muddy Waters Research report concerning New Oriental is profoundly disparaging. MWR claims encompass the reported quantity of schools owned, manipulation of financial reports, value of assets, and a host of other impropriety by management.

This is my second article about New Oriental. In the first, I advised readers to avoid Chinese stocks due to the added risk of fraud. Well-known international auditor Deloitte Touche Tohmatsu Shanghai (Deloitte) is the current New Oriental auditor. I have also written about the perils of Chinese stocks for about a year.

Deloitte already has issues with the Securities and Exchange Commission. The SEC is asking for documents on another company, and Deloitte is refusing to turn them over. Deloitte claims Chinese law forbids the auditor from fully cooperating with the SEC demands.

Deloitte has resigned from at least one other Chinese company after company fraud allegations surfaced. ChinaMedia Express ( CCME) is a company I wrote about several times last year.

China MediaExpress was one of several Chinese firms to hail down in a rain of controversy over several Chinese companies. China MediaExpress went from trading over $10 per share to the current price of 3 cents a share. You don't need to break out a calculator to know how injurious of a return that is.

In fairness to Deloitte, if MWR's allegations are correct, there is no way to know for the average investor if Deloitte is a conspirator or a victim. For the average investor, knowing who to trust can make all the difference in the world.

Investors depend on a three-legged stool to prevent and root out financial fraud with public companies.

The first leg consists of fellow investors. Short-sellers are always on the look for financial fraud or anything that doesn't pass the smell test. When the short interest in a stock is climbing, it's a sign something isn't right. The problem may be a general economic slowdown, or something less virtuous on the part of management.

The second leg consists of law enforcement. This includes the FBI and SEC along with other law enforcement agencies. The fear of prison and or a ruined career keeps a lot of people honest. Because law enforcement is able to pursue management and auditors, the level of criminal activity is a relatively small amount.

The third leg consists of auditors public companies hire to confirm financial documents presented by a company's management team are genuine. Sure, it's true that domestic companies cook the books on occasion (Enron comes to mind), but fear of the second leg, law enforcement, tends to keep auditors from losing their way.

Chinese companies traded on U.S. exchanges only have one leg from the fraud prevention stool. With two legs missing, the number of Chinese stock blowups is only surprising because so few have crashed into the floor.

The SEC has not been able to hold Chinese nationals responsible for securities fraud. It's a no-lose situation for would-be criminals. If you're successful and don't get caught, you keep making money. If you do get caught and shares crash, you still make money but don't face prison time. Without the capacity to send people to prison, the main deterrent is removed.

Auditor opinions can't be trusted for the same reason -- no prison time for cooking the books. Additionally, in spite of a given auditor trying to do the right thing and build a reputation for honesty, a company's documents are effortlessly contrived, placing an auditor in a situation of not knowing for sure what is and is not real.

MWR has a solid reputation for correctly rooting out issues within companies. After adding up the additional risk, liquidating shares should be considered. Receiving less than $10 a share is no fun, but I am willing to wager CCME shareholders wish they could find a buyer near $10.

At the time of publication the author did not hold a position in any stock mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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