Muddy Waters - NQ Mobile

8/13/2019 Muddy Waters - NQ Mobile

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Mr. Dennis M. NallyChairmanPricewaterhouseCoopers International Ltd.

Mr. Robert E. Moritz

Chairman and Senior PartnerPricewaterhouseCoopers LLP330 Madison Avenue, 24th Floor

New York, NY 10017

Mr. Raymund ChaoAudit and Assurance Leader, BeijingPricewaterhouseCoopers Zhong Tian LLP26/F Office Tower A, Beijing Fortune Plaza7 Dongsanhuan Zhong RoadChaoyang District

Beijing, 100020China, People's Republic of

January 13, 2014

Re: NQ Mobile Inc.

Dear Messrs. Nally, Moritz and Chao:

I am writing to bring to your attention serious accounting and disclosure issues at your client NQMobile Inc. I believe these allegations deserve the immediate attention of PwC’s GlobalChairman, U.S. CEO and the PricewaterhouseCoopers Zhong Tian (“PwC China”) auditengagement partner for the company.

PwC is the brand under which the member firms of PricewaterhouseCoopers InternationalLimited (“PwCIL”) operate and provide professional services. Together, these firms form thePwC network. NQ Mobile is a China-headquartered company, with American Depositary Shares(ADSs) listed on the New York Stock Exchange. NQ Mobile Inc.’s most recent audit opinion issigned by PwC member firm PricewaterhouseCoopers Zhong Tian CPAs Limited Company inBeijing, the People’s Republic of China.

As has been widely reported in the press, Muddy Waters Research issued a report entitled

“Initiating Coverage on NQ Mobile Inc. (NYSE: NQ) – Strong Sell” on October 24, 2013. In thisreport we detailed evidence supporting our belief that:

• NQ is a massive fraud. We believe it is a “Zero” because the majority of NQ’s purported2012 China security revenue is fictitious.

• NQ’s Antivirus 7.0 is unsafe for sale to consumers, and we consider it to be spyware thatmakes users’ phones vulnerable to cyber attack.


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• NQ’s purported 2012 international revenue of $36.5 million, which includes revenuefrom the United States, is likely less real than its PRC revenue.

• The recent pivot to advertising and gaming is merely an attempt to change to a fraud that NQ hopes will be less obvious.

• NQ’s acquisitions are highly likely to be corrupt and part of the fraud.•

NQ’s cash balances are very likely non-existent at the level reported. In NQ’s 2012 20-F,PwC classified all cash and term deposits as Level 2 assets. NQ’s purported movementsof cash from its IPO almost certainly did not occur due to PRC FX controls. We believe

NQ’s term deposits are likely fraudulent.

Before our report was published on October 24, the stock had risen about 280 percent in 2013. NQ’s stock dropped by nearly 50 percent after we issued this report, wiping out $500 million ofmarket value. The shares continued to slide the next day.

On October 25, the company held a conference call to respond to our allegations, and Dallas- based NQ Co-CEO Omar Khan held television interviews with Fox Business and Bloomberg.

On October 29, 2013, we published “NQ’s Top Ten Lies Since Friday” to highlight thecompany’s and Mr. Khan’s lack of veracity while attempting to stem the severe share slide. On

November 1, NQ announced that the Independent Special Committee of its Board of Directorsretained the global law firm of Shearman & Sterling LLP to advise it in connection with itsindependent review of the allegations raised in our report. Shearman & Sterling engaged Deloitte& Touche Financial Advisory Services Limited (FAS) as forensic accountants to assist in thematter.

Deloitte FAS is the same firm that was recently sanctioned and fined $10 million by the NewYork Department of Financial Services for its lack of independence and objectivity while

conducting compliance monitoring activities on behalf of the regulator for Standard CharteredBank to correct money laundering violations. Deloitte is at the center of the Chinese reversemerger fraud scandals and is the original defendant in the dispute between the Chinese auditfirms and the U.S. Securities and Exchange Commission over access to auditor work papers inChina. Deloitte China has the most clients named in fraud lawsuits of all the global audit firms inChina.

We also published a report entitled “Chinese Media Views on NQ” on November 1, as well astwo more detailed analyses of our claims: “If You Believe in Yidatong, You’ll Believe in SantaClaus” on November 6 and “NQ’s US Veneer: Withholding Facts, Conned Men, and aConvicted Racketeer” on November 12. (We have attached a copy of all of these reports asExhibits A, B, C, D, E F, and G and encourage you to visit www.mudywatersresearch to viewmedia appearances and other commentary by our firm about NQ Mobile.)

On December 19, 2013, Muddy Waters Research made an Offer to NQ’s IndependentCommittee to engage, at our own expense, an independent and qualified accounting firm toevaluate the independent committee’s investigation of our allegations made on and followingOctober 24. It is necessary and reasonable for the independent committee to have a qualified

party evaluate the credibility of the investigation. Our offer cites eight examples of independent


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committees’ apparent dysfunction and the resulting flawed investigations of fraud allegationsmade against China companies. Each of these independent committee reports exonerated thecompanies of wrongdoing, but they were followed later by substantial investor losses and (oftenserious) regulatory action.

Our choice of a firm to evaluate the independent committees investigation, Plante Moran, hashad an office in Shanghai for more than 15 years and employs accountants and managementconsultants who are experienced in helping western companies make deals in China. Theyunderstand the culture and the complexities of doing business in a country with unique businessetiquette, intense competition and corruption. Most importantly, they do not audit any of theChinese companies recently accused of fraud. Unlike Deloitte, Plante Moran and our proposedlead partner, Martin Terpstra, are independent and objective with regard to NQ and these issues.

The following information is intended to bring to your attention concerns that we and ouraccounting advisors have identified in the Company’s financial statements as critical to PwC’saudits of the Company’s past, present, and future financial statements and accompanying

disclosures. In particular, we are very concerned about the scope of the audit soon to begin inearnest. We want to make sure it is sufficient to provide an appropriate opinion on thecompany’s financial statements as of December 31, 2013.

Under U.S. auditing standards established and enforced by the industry regulator the PCAOB,PwC is required to plan and perform the audit of the NQ financial statements to obtain“reasonable” assurance—a high level of assurance—about whether the financial statements arematerially misstated due to error or fraud. 1 As this wording suggests, auditor responsibilities arefocused on fraud and other illegal acts that result in material inaccuracies in, or omissions from,the financial statements. 2

The auditor applies procedures for the purpose of forming an opinion on the financial statements.Performing those activities may bring illegal acts such as fraud to the auditor's attention. Forexample, AU 317, a relevant auditing standard, describes such procedures as reading minutes of

board meetings (including those of a special investigative committee of the board); inquiring ofthe client's management and legal counsel concerning litigation, claims and assessments; and

performing detailed and broader substantive tests of transactions or balances. The auditor shouldmake inquiries into NQ management, the audit committee and any special investigativecommittees concerning compliance with laws and regulations, as well as knowledge of violationsor possible violations of laws or regulations.

1 See paragraph .02 of AU sec. 110, Responsibilities and Functions of the Independent Auditor. 2 Under Sections 10A(a)-(f) of the Securities Exchange Act of 1934 (15 U.S.C. § 78j-1(a)-(f)), the auditor of an

issuer’s financial statements generally is required, among other things: (1) to perform procedures designed to obtainreasonable assurance of detecting illegal acts, including fraud, that would have a direct and material effect on thefinancial statements, (2) when becoming aware of information indicating an illegal act has or may have occurred, todetermine whether it is likely that an illegal act has occurred and, if so, its possible effects on the financialstatements, and (3) to report illegal acts that come to the auditors attention to various parties based on criteria in thestatute, unless the act is clearly inconsequential. Also, the auditor's responsibilities under PCAOB standardsregarding illegal acts generally are set forth in AU sec. 317, Illegal Acts. And Auditing Standard No. 16,Communications with Audit Committees, requires the auditor to make certain inquiries of the audit committee aboutviolations or possible violations of laws and regulations.


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PwC U.S., and possibly other non-China PwC entities, face significant liability for the auditopinions issued by PwC China because of the significant revenue and expenses NQ purports togenerate outside of China. By claiming significant non-PRC revenue and expenses, NQ is unlikemost other recent China frauds. (PwC’s U.S. entity performs more than Appendix K review of

SEC filings because NQ has significant activity in the U.S. by virtue of its Dallas, TX co-headquarters.) Just as Deloitte U.S. is a defendant in the civil litigation surrounding anotherChina fraud, ChinaCast Education, PwC U.S. cannot distance itself from the NQ audits nor avoidcivil and regulatory liability for fraud and other illegal acts.

With NQ, according to ChinaRAI, PwC is now the auditor for seven China companies suspectedof being frauds. 3 This puts PwC in a tie for third place with Friedman LLP and MaloneBaileyLLP, and behind Frazer Frost LLP (nine) and Deloitte China (17). Friedman, MaloneBailey, andFrazer Frost are generally not regarded as industry leaders. Deloitte China has become a

particular lightning rod for the SEC, PCAOB and short-sellers.

Any PwC partner who believes the value of the PwC brand is worth preserving should take heedof the experience of other firms operating in China. Further unqualified opinions for NQ willlikely end in embarrassment and litigation against the firm and its partners. As of January 3, NQis currently trading at more than 35% below its 52-week-high, which was set in October. Thedamages to investors are already sufficient to justify multiple class action lawsuits.

If PwC concludes, after expanding its audit scope and performing additional tests and proceduresin response to clear heightened fraud risk, that fraud at NQ Mobile has a material effect on thefinancial statements—and that the illegal act or acts have not been properly accounted for ordisclosed—PwC should express a qualified opinion or an adverse opinion on the financialstatements taken as a whole. If NQ Mobile prevents PwC from obtaining sufficient appropriate

evidence to evaluate whether illegal acts material to the financial statements have (or are likelyto have) occurred, PwC should probably disclaim an opinion on the NQ financial statements.

If NQ management refuses to accept a modified a PwC report, PwC should resign from theengagement, possibly withdraw its opinions on prior financial statements and warn investors onmanagement’s representations. PwC must communicate the reasons for withdrawal in writing tothe audit committee of the board of directors. If PwC is unable to determine whether the acts areillegal because NQ imposes limitations on its work or because PwC is unable to interpretapplicable laws, regulations or surrounding facts, PwC may have to resign the NQ audit.

PwC China may soon have no choice but to resign as NQ’s auditor rather than issuing aninappropriate, and unsubstantiated, unqualified opinion on the 2013 financial statements. PwCChina, PwC’s U.S. firm and possibly other PwC entities outside of China will face significantregulatory and civil liability if the firm supports a fraudulent charade.

We request that you and your audit teams carefully study the issues we have raised in the body ofthis letter and be prepared to make the hard decisions we believe you must make on behalf ofinvestors and the integrity of the global capital markets. If we are correct that NQ is a fraud and

3 http://www.tradingfloor.com/posts/china-finance-updated-data-auditors-linked-issues-606252080


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PwC fails to inform investors and regulators of this risk, PwC will also be held liable in courts oflaw and in the court of global public opinion in the event of the Company’s failure.

We look forward to hearing from you and are available to respond to any questions you mayhave.

Sincerely,

Carson Block, Esq.Muddy Waters, LLC


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Table of Contents

Desktop research alone raises serious concerns about NQ being a fraud................................8

Majority of NQ’s 2012 China mobile security revenue is fictitious......................................8 NQ’s 2012 international revenue is fictitious........................................................................14 Lack of investment in websites inconsistent with revenue numbers in emerging markets...................................................................................................................................................15 Lack of investment in long-lived assets outside China inconsistent with internationalrevenue figures.........................................................................................................................17 Ease of emerging market success makes NQ an outlier.......................................................17 Distimo data for Google Play store results inconsistent with NQ claims ...........................17 NQ revenue appears overstated given lack of investment in technology and employees .18

Deep-dive due diligence leaves no doubt NQ is a substantial fraud .......................................22NQ’s largest purported revenue source, Yidatong (“YDT”), is a sham counterparty .....22

YDT has no physical operations whatsoever.........................................................................22 NQ secretly controls YDT.....................................................................................................24YDT’s majority (75%) owner Ms. Xu Rong is not an arms-length party.............................25

NQ’s cash balances are fraudulent ........................................................................................27 NQ’s purported VIE funds transfer would violate Chinese law............................................27 NQ presented PwC with forged term deposit documents......................................................28

NQ’s Chairman’s lies about top customers further support our conclusion that NQ is afraud..........................................................................................................................................32 NQ prepaid card sales numbers are fabricated....................................................................33 NQ Accounts Receivable balance is fraudulent because of revenue fraud ........................36 NQ has made a number of mistakes with respect to its purported tax treatments, whichis clear evidence of fraudulent accounts ................................................................................37

NQ Beijing claimed that in 2011 that it paid a sales tax called “Business Tax”, rather thanVAT. ......................................................................................................................................37

NQ Beijing’s SAIC financials fail to recognize as Non-Operating Income any VAT creditsor refunds received. ...............................................................................................................38

NQ’s acquisitions highly likely to have fraudulent intent and accounting ........................40 Domain name purchase price is absurd ................................................................................40

PricewaterhouseCoopers Member Firms’ Professional and Legal Obligations And LiabilityIf NQ Is A Fraud..........................................................................................................................41

PwC’s legal and professional obligations with regard to reports of fraud at NQ .............41

PwC’s legal and professional obligations with regard to the NQ Board’s “independent”investigation of our allegations...............................................................................................43 More PwC China clients accused of fraud............................................................................44 We recommend PwC China resign the NQ engagement .....................................................44

Our NQ reports............................................................................................................................45

Appendix A – YDT SAIC ownership record.............................................................................47


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NQ’s growth in China-ba sed paying users is a function of the growth of China’s overall mobileinternet market. The chart below shows China Mobile’s 3G users and two sets of estimates forthe number of mobile internet users in China. Note that the trajectories are similar to that of

NQ’s China paying users.

NQ, like some other companies in the mobile security application field, uses a “freemium” business model. NQ gives its security applications away for free, but charges users to upgrade tothe premium version, which has an updated virus library. The graph below shows therelationship between cumulative registered users (roughly defined as the cumulative number ofuser accounts ever associated with the activation of a NQ security app), active users (users whohave utilized an app in the prior 30 days), and paying users.

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NQ Security App Paying Users - China (Millions)

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China Mobile 3G Users (20F) Imedia: Nationwide Mobile Internet Users CNNIC: Nationwide Mobile Internet Users


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NQ’s reported paying users to active users ratio of ~10% is in line with the industry. We spokewith people who were familiar with the details of the mobile security app businesses of NQ’ssignificant competitors that also use the freemium model: AVG, Lookout, McAfee. (NQ’sclaimed ratio of active users to cumulative registered users of ~40% is 1.5x to 2.0x that of theother companies, which have active user bases of 20% to 30% of their cumulative registeredusers.)

In order for NQ to have six million paying customers in China at the end of 2012, it needed tohave 57 million people who had used its applications in the prior 30 days, and 164 millioncumulative activations of its security apps in China. NQ therefore claimed market share ofapproximately 60% of the China security app market at the end of 2012. NQ’s 2012 20-F stated:

“We have captured a dominant market share in China’s mobile security market. Anindependent study conducted by SinoMR Research during the fourth quarter of 2012indicated that our market share, in terms of registered user accounts in China, wasapproximately 60% as of December 31, 2012.” 4

4 NQ 2012 20-F, p. 45.

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NQ China User Composition 2009-2012 (millions)

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NQ had a major problem though. Its claims of registered users, active users, and market sharedid not pass the laugh test. Qihoo 360 (QIHU) and Tencent each offer mobile security apps thatinclude all of NQ’s premium features in a free version. QIHU’s security software is ubiquitouson PCs in China, which give it a massive distribution channel. Likewise, Tencent has enormousdistribution through its incredible user base. QIHU claimed to have a 70% market share of

mobile security apps in China, which utterly contradicted NQ:

“360 Mobile Safe, the No. 1 mobile security product in China, was used by over 200million smartphone users in China as of December 2012. 360 Mobile Safe had anapproximately 70% share of the mobile security market as of December 2012, accordingto iResearch.” 5

Independent research analysts supported QIHU’s claims:

It is important to understand that the mobile security apps market is almost exclusively forAndroid devices. Because Apple’s iOS platform is a closed system – i.e., Apple is the exclusivedistribution platform for iOS apps – iOS has far fewer security threats than does Android.

5 QIHU 2012 20-F, p. 27.


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Our own extensive surveying confirmed that NQ’s market share claims are grossly overstated.Our surveys of over 800 respondents from five cities show that NQ’s share of the China mobilesecurity app market is only 1.4%. In contrast, QIHU has 73.5% market share in our survey,followed by Tencent at 15.7%, Kingsoft at 4.9%, and “other” at 3.8%. Our data includessamples from Tier 3 and 4 cities, and includes three cities in two of NQ’s top four provincial

markets of Guangdong, Zhejiang, Jiangsu, and Henan.6

China’s two leading Android app stores confirm that QIHU and Tencent are the major players inmobile security. NQ’s respective share of downloads in each store is 0.42% and 1.0%,completely undermining its claims to have had 164 million cumulative registered users, 57million active users, and six million paying users. (Note that Baidu, which does not have a goodrelationship with QIHU, owns 91 Zhu Shou. Thus, QIHU’s app is not available in the store.)

6 NQ disclosed its top four markets on the October 25, 2013 conference call. If this disclosure differs from the data NQ has provided to PwC, it is yet another instance of management lying.


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It had become obvious that NQ was lying about market share, and therefore its security apprevenue was impossible. NQ thus decided to distract the market by claiming to change itsstrategic focus to more opaque businesses: gaming and advertising. In order to deflect attentionfrom its app business, NQ claimed that China security app revenue growth suddenly fell to zero(actually negative in Q3 2013). The graph below shows NQ’s China paying users from 2009 –Q2 2013, including its implausible flattening in 2013 from high growth in 2012.

While NQ’s China security app paying user numbers suddenly table-topped in 2013, ChinaMobile’s 1H 2013 results indicate that China’s mobile internet market is still growing rapidly.China Mobile announced that its wireless data traffic increased 129% in 1H 2013, and that itshandset sales increased significantly over 1H 2012, with particularly strong 3G handset sales. 7 According to Gartner Research: “In markets such as China and Latin America, demand for

7 China Mobile Ltd. Form 6-K, filed August 15, 2013, p. A-2.

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feature phones fell significantly as users rushed to replace their old models with smartphones,” 8 which shows that the smartphone market in China grew nicely in 2013.

To further obscure the fraud in China security apps, NQ purported to become an overnightadvertising and mobile gaming powerhouse in China. The mobile gaming revenue model, with

in-app selling revenue, advertising revenue, and distribution agreements, is far more opaque –and therefore more conducive to fraud – than is the security app business.

One cannot overstate the speed with which NQ seemingly transformed itself. At the beginningof 2013, NQ had ruled out the possibility of adopting such a model. The following is a quote

NQ chairman Henry Lin gave in an interview for Wharton in January 2013. 9

“Why don’t we take ads? I think the format of ads on mobile phones is not mature yet.Furthermore, there is a fundamental conflict between our safety service, by its verynature, and the advertising model. If you want to target ads accurately, there will be

privacy issues.”

NQ’s 2012 international revenue is fictitious

NQ reported international 2012 security app revenue of $35.7 million, including revenue fromthe United States, which is substantially fraudulent. The graph below shows NQ’s reportedinternational security app revenues from 2009 – 2012.

NQ has been very opaque with investors about the specific markets from which it has generatedthis revenue. You as the auditor will have much more information than we do in this regard.However, NQ has generally stated that it derives most of its international revenue from Southeast

8 http://www.gartner.com/newsroom/id/26234159 http://knowledge.wharton.upenn.edu/article/nq-mobiles-henry-lin-we-have-been-a-global-company-from-day-one/

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Asia and the Middle East. In its response to our initial report, it included the below table ofsome of its international markets and “service providers” (SPs) with which it works:

If NQ’s international revenue were anywhere close to real, then NQ would have cracked the codein marketing to the global emerging markets customer. In other words, NQ claims to generatesignificant revenues in numerous countries with different ethnicities, cultures, and languages.

NQ would not be the first company to experience such success, of course. Procter & Gamble,Coca-Cola, and a handful of other companies come to mind as having succeeded acrossnumerous emerging markets. However, dollar for dollar, NQ appears to have been the mostsuccessful pan-emerging market marketer ever!

Lack of investment in websites inconsistent with revenue numbers in emergingmarkets

NQ appears to invest negligible money in website development and maintenance in thesemarkets in which it dominates the mobile security market. Below is NQ’s home page for SaudiArabia. It appears the last update is close to three years old. It prominently features version 5.6of its anti-virus software while it is currently marketing version 7.0 everywhere else. The lastnews release is from 2011. NQ replaced the logo shown on the website in June 2011.


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The Saudi Arabian website is NQ’s only Arabic website. We used the local versions of Googleto search for NQ websites in the UAE, Qatar, Egypt, Jordan, and Turkey. They don’t exist.

Local Google searches for India, the Philippines, Indonesia, Malaysia, and Thailand also yieldedno local websites. Vietnam is the only country on the list NQ provided that has an up-to-datelocal language website.

Without needing to even invest a few hundred dollars annually in building and maintaining locallanguage websites, NQ appears to employ the most profitable international business model ever.

NQ’s emerging market customers are evidently so well informed about NQ’s products and sodesirous of them that they flock to pay for NQ apps regardless of whether there is a website.

On the other hand, NQ’s 20-F states that its website is an integral part of its “viral” marketing,rendering it unclear as to how NQ could have become so successful overseas (other than byreporting fraudulent revenues):

“Viral Marketing: A significant percentage of our users come from our own useracquisition channel, namely our Internet and mobile Internet website. These users learnof our services through existing user referrals. We expect the viral marketing channel tocontinue to account for a significant portion of our user acquisition in the foreseeablefuture.” 10

Note that NQ claims to have made a seven figure (USD) investment in search engineoptimization for its U.S. website alone. We pointed out that its claim to have paid $1.5 millionfor the domain nq.com was laughable. NQ responded by stating that the price was so high

because it purchased SEO services. With the U.S. market being such an unattractive place to do business compared to the emerging markets, one wonders why NQ went ahead and hired OmarKhan as “Co-CEO.” However, we note Omar does a fantastic job of investor relations.

10 NQ 2012 20-F, p. 45.


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Lack of investment in long-lived assets outside China inconsistent with internationalrevenue figures

NQ has not had to invest in any other way in order to dominate the emerging markets. Despitegenerating approximately 40% of its 2012 revenue outside of China, NQ has zero long-lived

assets outside of China. Just as incredibly, only $5.5 million of its $149.5 million in cash (as ofSeptember 30, 2013) was outside of China. Given that it has a substantial physical presence inthe United States, the cash commitment to emerging markets is incredibly small. Again, NQappears to be the most efficient and profitable emerging market operator ever.

Ease of emerging market success makes NQ an outlier

What makes NQ’s international business even more incredible is that it is able to successfullymarket apps to emerging market customers who have relatively little income with which to payfor them. What’s more, NQ is an outlier in its ability to sell security apps to emerging marketscustomers. McAfee, Lookout, AVG, and Kaspersky are all unable to generate significant

revenues in emerging markets, despite two of these companies having sizable existing user basesof PC antivirus software. None of those companies exceed approximately $10 million in annualmobile security app revenues globally, and each of them generate significantly more money in

North America and Western Europe than they do in emerging markets.

Senior employees from these companies told us that emerging markets consumers are unwillingto pay for security apps, despite having more malware present than developed market consumers.According to these employees, the reason that emerging market Android phones are more likelyto encounter malware is that emerging market consumers frequently download pirated versionsof mobile apps, which is because EM consumers simply do not want to pay for apps.

Emerging market consumers have far less disposable income than do developed marketconsumers, which is reflected in the monthly phone ARPUs of these markets. Thailand, which isone of NQ’s markets, is a good example of this disparity. The monthly mobile phone ARPU inThailand is $7.13, despite 60% of Thais already using their mobile phones to access the internet.If NQ to be believed, its Thai customers are spending approximately 20% of Thai mobile ARPUon NQ apps. Again, NQ has worked this marketing magic in Thailand without a Thai languagewebsite, without long-lived assets, and without a discernable cash committed to the market.

In contrast, the monthly mobile phone ARPU in the United States is $46.50. Yet, NQ’s salesattempts in the U.S. have proven largely futile, while it is a money making machine in emergingmarkets. NQ’s relative futility in the U.S. stems from fact that it’s materially harder for NQ tocommit fraud in the U.S. than in emerging markets.

Distimo data for Google Play store results are inconsistent with NQ claims

NQ primarily distributes its apps through the Google Play store in markets outside of China. Acompany called Distimo provides one of the leading analytics services for Google Play. Itestimates that NQ’s global revenue for all mobile apps is only $800,000 annually. The chart

below is from Disitmo, showing the daily revenue estimates for NQ over the nine months priorto our October 24, 2013 initial report:


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NQ responded by stating that Distimo’s data is flawed, in part because NQ is not a client ofDistimo. However, Distimo insisted to us that NQ has been a client since September 2012. (Aswe will soon explore, lying is a major theme of NQ.)

NQ revenue appears overstated given lack of investment in technology andemployees

NQ also appears to be one of the best businesses ever when looking at its returns on computersand employees, which are the two main inputs that determine revenue. NQ purports to have

generated more revenue per gross dollar of computer equipment than all but one of the 51software companies and internet application development companies to which we compared it.Facebook is the only company to earn a higher return on gross computer equipment than NQ. Itis ridiculous for NQ to claim to generate almost the same returns on computers as Facebook,which is the world’s dominant social network and has over 1.19 billion active users. 11

NQ’s revenue per dollar of gross computer equipment was more than three standard deviationsabove the mean. In 2012, NQ generated $46.09 of revenue per dollar of computer equipment onthe balance sheet. The mean average for the group (ex-NQ) was $13.07 per dollar of computerequipment. The standard deviation of the group was $10.86, meaning that NQ was more thanthree standard deviations above the mean.

11 http://expandedramblings.com/index.php/resource-how-many-people-use-the-top-social-media/#.UrcGRWRDuMA


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AVG Technologies N.V., which is one of the global leaders in mobile internet securityapplications, generated only $15.47 in revenue per dollar of computer equipment. Qihoo 360generated only $4.06 in revenue per dollar of computer equipment. McAfee, Inc., another globalleader in computer and mobile security applications, generated only $5.93 in revenue per dollar

of computer equipment in 2010, which was the year prior to Intel Corp. acquiring it for $7.7 billion.

NQ’s revenue per gross computers ratio is an astounding 4.3 standard deviations above that of itsChina peer group of 18 companies. The following table compares Chinese software and internetapplication developers. 12

12 The figures for PWRD, FENG, GAME, LONG, MOBI, YY, GA, and 700.HK are in RMB.


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NQ’s revenue to gross computer equipment would be more believable if it had an army ofemployees writing code on paper. The only China software company with a revenue to grosscomputers metric that approaches that of NQ is ASIA, which is 3.3 standard deviations above themean (compared to NQ’s 4.3 standard deviations). However, ASIA’s employees are far less

productive than the average, at 1.1 standard deviations below the mean. Another strong

performer in the revenue to gross computers metric (1.3 standard deviations above the mean),PWRD, also has employee productivity far below the average. 13 In other words, the twocompanies with a ratio greater than one standard deviation above the mean return on computerspending have highly manual processes, as evidenced by their relatively low employee

productivity measures.

However, NQ’s revenue per employee tells us that heavy reliance on manual processes is not thereason its return on computer investment is off the charts. NQ’s employees are slightly more

productive than average. In other words, NQ’s massive returns on computer equipment are notdue to having an army of employees undertaking manual work.

Looking at NQ’s computer equipment per employee also suggests that NQ’s purporteddomination of the China and emerging market mobile security app space is ridiculous. As of

2012, NQ had only $3,181 of computer equipment per employee. AVG has $25,153 ofcomputer equipment per employee. Qihoo 360 has $25,575. In 2010, McAfee had $55,289 incomputer equipment per employee.

13 We only compare the Chinese companies in terms of revenue per employee because of sizable differences inemployee productivity between the PRC and US.


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Deep-dive due diligence leaves no doubt NQ is a substantial fraud

NQ’s largest purported revenue source, Yidatong (“YDT”), is a sham counterparty

NQ’s largest purported revenue source, Yidatong (“YDT”), is a sham counterparty and nearly all

of the revenue NQ reported receiving through YDT is fraudulent. YDT’s SAIC incomestatements show that it generated a fraction ($2.9 million in 2012) of the revenue NQ hasclaimed to generate through YDT ($20.2 million in 2012). Importantly, NQ and YDT do notdispute the accuracy or authenticity of the YDT financial statements. However, NQ states thatYDT has booked its revenue on a net, rather than gross, basis.

YDT’s revenue is clearly booked on a gross basis because:

• The business tax YDT paid in 2012, $97,000, which is paid based on gross revenue, iswholly consistent with $2.9 million in gross revenue (3.3%).

• PRC GAAP, which is the basis on which the SAIC financial statements are prepared and

presented, requires YDT to book revenue on a gross basis because NQ is not a party to thecontracts between YDT and the mobile carriers. This treatment is consistent with that of twoPRC-listed SPs: Beijing Bewinner (002148.CH) and OurPalm (300315.CH).

YDT has no physical operations whatsoever

We did extensive research looking for YDT’s operations, and visited 10 locations at which it purportedly has an office.

• In five of the 10 cases, the addresses do not physically exist – i.e., there is no such buildingor office at the purported location. Importantly, the address given on YDT’s “Contact Us”

web page is one such ghost address.• In four of the 10 cases, the addresses at least existed, but nobody had ever heard of YDT, andit is doubtful that YDT had ever been associated with the addresses.

• YDT rents one office in Tianjin, but it never has any employees there. It does not have anysignage on the building and is not listed in the directory. People in the neighboring officeshad never heard of YDT.

• Four of the ten addresses at which we looked for YDT were in Beijing. NQ responded thatthe reason we could not find YDT is that YDT used virtual office addresses in order to fulfillregulatory requirements. 14 This argument does not hold any water. YDT was not usingvirtual offices – it was using non-existent ones.

As detailed in our report, we obtained most of the addresses from YDT’s SAIC files. It is illegalto provide a false address to SAIC. While doing so is not a capital offense, there is absolutely nolegitimate reason that a business would provide false and non-existent addresses to SAIC, as itrisks unnecessary complications. A company would provide a fake address though in order toavoid having people discover that it has no operations.

14 http://www.bloomberg.com/news/2013-11-03/nq-mobile-sales-search-leads-to-suburban-beijing-office.html


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NQ’s response has been that YDT has been cranking away for years in a room in the office of acompany called 9H. 9H is a company founded by YDT’s majority owner Ms. Xu Rong. NQ

board member and co-founder Mr. Zhou Xu is a shareholder of 9H. Ms. Xu and Mr. Zhou areentangled with one another in at least two other companies.

As Bloomberg News recently reported, and we confirmed on multiple occasions, YDT had nosignage in the building. Nobody at the security desk or management office had ever heard ofYDT. Bloomberg wrote: “ The building directory contains no listing for Yidatong, and twoguards at the first-floor security desk said they’d never heard of the company.” 15

9H is in a secure building that requires a security token to activate the elevator. If the downstairs building employees had never heard of YDT, then despite purporting to have five clients inaddition to NQ and processing approximately $35 million annually in transactions, YDT neverreceived a package, visitor, lunch delivery, or mail in its own name. NQ’s contention does notcome close to passing the laugh test.

If YDT had been at the 9H office the entire time, then there is no reason its “Contact Us” page,shown below, would have referenced a non-existent building. Note there is no phone numbergiven either. (Since our report, YDT has substantially upgraded its website in order to appearmore legitimate. Use www.waybackmachine.org to see its prior website.)

An investor who has frequently touted NQ on SeekingAlpha.com took the below picture after

our report. The photo purportedly shows YDT inside the 9H office. According to Bloombergand our own site visits, the single room contains the entirety of YDT’s operation at 9H. Wefound the photo interesting because there are clear signs that it is a Potemkin setup. In otherwords, the “employees” were brought into the room and seated in front of computers specificallyfor the purpose of fooling the investor.

15 http://www.bloomberg.com/news/2013-11-03/nq-mobile-sales-search-leads-to-suburban-beijing-office.html


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Note that a) of the four computer screens visible, two of them are blank – the employees arestaring at computer wallpaper, b) there are no telephones visible on the desks, which is surprisinggiven that this small group of people are processing approximately 40 million transactions peryear and presumably need to speak with mobile carriers and customers fairly frequently, c) wesee no paper files or filing cabinets, which again is surprising given the massive amount of datathe business would generate.

When we visited YDT, which was only three days after NQ provided the 9H address and beforethe above photo was taken, there were only four YDT “employees” in the room.

NQ secretly controls YDT

Because YDT had no operations of its own and was merely a façade, NQ was YDT’s entireinfrastructure. YDT repeatedly used NQ email addresses, phone numbers, fax numbers, andmailing addresses when communicating with China Mobile, SAIC, and China’s Ministry ofIndustry and Information Technology (MIIT).

NQ responded that YDT provided NQ’s information so these parties could contact NQ directly.This is a lie. The NQ contact information was the only information YDT furnished to these

bodies, and was presented as YDT’s own contact information. NQ claims that YDT has severalother customers, which account for about 40% of YDT’s business. YDT never furnished theinformation about those customers (as YDT’s own) to these parties.

YDT, which is purportedly processing approximately 40 million individual transactions per year,was unable to furnish its own email server. In fact, YDT’s email server was NQ’s. This is notcost sharing or efficiency. This is just sloppy fraud tradecraft by NQ. Below is a screenshotshowing them both using NQ’s email server:


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We signed up for carrier billing 22 times, over all three carriers, and from 11 different provinces(including all four of NQ’s largest provincial markets) between September 2013 and shortly afterour report came out. YDT, which purportedly processes at least 72.1% of NQ’s carrier billing inChina, was never the SP.

YDT’s majority (75%) owner Ms. Xu Rong is not an arms-length party

NQ has repeatedly lied about the extent of Ms. Xu’s involvement with NQ. It is incontrovertiblethat NQ has lied about her, and even now, NQ has only admitted to some of its lies regardingMs. Xu. NQ is lying about its relationship with her in order to attempt to conceal that YDT was,and still is, an undisclosed related party.

• In NQ’s prospectus and as recently as August 2013, NQ claimed that Ms. Xu had been aconsultant to the company for approximately six months, and left in mid-2007.

• Our initial report showed the Ms. Xu was an executive employee of NQ, rather than aconsultant, and that she was with NQ well into 2008 at least.

• NQ has since admitted that it had lied about Ms. Xu. It now accurately characterizes her asan employee, and states that she resigned from NQ in December 2008.

• NQ continues to lie about the other material aspect of its relationship with YDT and Ms. Xu:The timing of when Ms. Xu became involved with YDT. NQ continues to insist that at notime was YDT a related party. It is incontrovertible that NQ is lying.

• YDT’s SAIC file makes clear that Ms. Xu became the Executive Director of YDT inFebruary 2006. Per NQ’s admitted timeline of Ms. Xu’s employment, YDT was anundisclosed related party through 2008, thus infecting the historical audited financials in

NQ’s prospectus. Below is the screenshot of the Tianjin online SAIC portal, which showsthe date on which Ms. Xu became the Executive Director:


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• YDT’s SAIC files show that Ms. Xu became the 75% owner of YDT in February of 2007,making clear that NQ is even today lying when it insists that she did not own any of YDTuntil after she purportedly left NQ in December 2008. See Appendix A for the SAICownership record.

• Ms. Xu is entangled with NQ “co-founder” Mr. Zhou Xu. Ms. Xu and Mr. Zhou co-own 9H(which is YDT’s purported landlord) and Jing Xiu. Ms. Xu is a Supervisor of Yiteng, which

became a shareholder in NQ’s VIE in 2006. (Ms. Xu and Mr. Zhou were the foundingshareholders of Yiteng, and she was the supervisor at the time Yiteng owned its share of theVIE.)

• Prior to joining NQ, Ms. Xu was an executive at two other companies Mr. Zhou led. Therelationship map below shows the present entanglement of Ms. Xu and Mr. Zhou:

On November 3, 2013, Phoenix New Media ran an article titled “Getting to the Bottom of NQ’sBizarre Road to Riches,” which concluded that Mr. Zhou is the power behind the throne at NQand YDT, and that he secretly controls YDT. The article is available at:http://finance.ifeng.com/business/special/ruigongsi11/index.shtml.

The table below shows the various people involved with Yiteng, which appears to contain theinner circle of the NQ fraud:


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The SP for every China Mobile registration was UM Pay, which is an SP that China Mobile jointly owns. The SP for every China Unicom registration was Unisk, which is an SP that ChinaUnicom jointly owns. NQ itself was the SP for every China Telecom registration.

NQ initially responded that its proprietary “BOSS” system chooses the SP for each transaction based on numerous factors. This does not pass the laugh test. First, it is almost impossible thatwe would have never had a transaction processed by YDT were YDT really processing asignificant portion of NQ’s carrier billing. Second, it is entirely logical for a company to use thesame, carrier owned, SP for every transaction on that carrier.

NQ’s cash balances are fraudulent

We believe NQ’s term deposits are likely fraudulent. PwC approved classification of all cash andterm deposits as Level 2 assets in NQ’s 2012 20-F. NQ’s purported movements of cash from itsIPO almost certainly did not occur due to PRC FX controls.

NQ’s cash balance as of December 31, 2012 is, therefore, overstated by at least approximately$47 million by virtue of it having been legally impermissible for NQ to have injected ~$47million in IPO proceeds into its Variable Interest Entity (“VIE”). NQ has not responded to thisconclusion in our report. We believe they can find no counterargument.

NQ’s purported VIE funds transfer would violate Chinese law

PwC clearly erred by failing to note that NQ’s contention, from 2011 onward, that its offshoreentities loaned ~$47 million to the VIE is inconsistent with PRC law. PwC’s error is clearer

because it also failed to note that this contention is inconsistent with NQ’s disclosures containedin its F-1, and 20-Fs for both 2011 and 2012. NQ’s disclosure reads in relevant part:

“Due to the restrictions imposed on loans in foreign currencies extended to any PRCdomestic companies, we are not likely to make such loans to our consolidated affiliated


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entities, Beijing Technology, NationSky, Beijing Feiliu, and QingYun (Tianjin) FinancialManagement Co., Ltd., or Tianjin QingYun, each a PRC domestic company. However, ifsuch loans become necessary for the operations of our PRC subsidiary or consolidatedaffiliated entities, these statutory limits and other restrictions may materially andadversely affect our liquidity and ability to fund operations in the PRC by limiting a

source of cash for these PRC entities. Meanwhile, we are also not likely to finance theactivities of our consolidated affiliated entities by means of capital contributions due toregulatory restrictions relating to foreign investment in PRC domestic enterprisesengaged in our line of business.” 16

NQ’s strategy to deflect attention from this problem has been to purportedly liquidate its termdeposits and transfer funds into a new bank account. (We address problems with the purportedterm deposits infra.) We do not dispute that the new account came to hold $103 million.However, we note that it took almost two weeks to complete the transfers, despite managementhaving repeatedly insisted to investors on the October 25 th conference call that NQ could receiveimmediate liquidity from its term deposits.

We also note that the imposition of another bank account – particularly one with the purpose ofreceiving lumpy inflows – adds an additional layer of complexity, should PwC seek to confirmwhether the cash ultimately came from operations. We also note that on November 29 th, NQ

proposed amendments to its Articles of Association that clarify the mechanics for founders pledging shares. (The amendment was approved on December 23 rd.) Above and beyond all elsethough, NQ could not have legally had the funds it claims in its VIE.

NQ presented PwC with forged term deposit documents

Even though NQ claimed to be effectively cash flow neutral since inception (and thus rendering

cash confirmations irrelevant to supporting the existence of NQ’s revenue), its historical cash balances are substantially overstated by virtue of NQ having had no legal means (or legitimate purpose) to move approximately $47 million of IPO proceeds into its VIE without passingthrough its WFOE. NQ’s method of gaming the cash confirmation process has been to presentterm deposits from smaller Chinese banks, which is similar to how Satyam defrauded investorsand PwC.

NQ’s VIE cash balance is per se overstated by at least $47 million. As discussed supra, NQ hadno legal means of lending approximately $47 million of IPO proceeds directly to the VIE. NQfraudulently claimed to have flowed funds in this manner presumably in order to divert IPO

proceeds without detection. (It would have been more obvious if NQ had claimed to contribute

these funds to its WFOE, but did not do so.)PwC is now on notice that NQ has presented its auditors with fraudulent term depositdocumentation. In response to our initial report, NQ released a table listing 14 of its purportedterm deposits. From the table alone, we can tell that five of the term deposits are forged becausethe interest rates do not accord with the effective interest rates as of the dates of the deposits –

16 NQ 2012 20-F, p. 24. See also NQ F-1, p. 27.


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than customer – copy), it means that NQ has undisclosed debt, and thus the “cash” isencumbered.

NQ’s term deposits are all purportedly held at smaller Chinese banks, which is likely significantto how NQ commits this aspect of its fraud. NQ’s CFO, KB Teo, told us before we published ourreport that NQ’s term deposits were all held at China’s top tier banks, specifically at ChinaMerchants Bank and Bank of China. While it is well established that China-based issuers havecommitted cash confirmation fraud at China’s Tier 1 banks with the complicity of branch staff, itis even easier to gain the complicity of the branch staff and management at non-Tier 1 banks.

PwC, of course, has been defrauded through term deposits in emerging markets before. PwC

was Satyam’s auditor when Satyam passed off forged term deposits as real. It should be notedthat Satyam’s management faced criminal punishment in India. China has never attempted to

punish management of a US-listed fraud, thus making fraud even more likely to occur in China(and in NQ’s case) than in India and Satyam.

NQ has routinely presented auditors with forged documents. We obtained various receipts andinvoices purportedly issued to and by NQ for historical periods. These invoices almost certainlyhave been incorporated in PwC’s audits of NQ. Some of the invoices are clearly fraudulent

because they are issued on vouchers that by law went out of use on January 1, 2011.

On June 13, 2010, SAT issued a notice changing the uniform general tax invoices. 18,19 Under the

notice, SAT canceled 12 types of general invoices, including the Beijing CommercialCorporation Invoice ( ). However, NQ repeatedly received these canceledCommercial Corporation Invoices from its vendors after this format went out of use.

18 http://www.bjtax.gov.cn/bjsat/zwgk/zcfg/gsgb/201012/201104/t20110417_17330.html19 The Beijing tax bureau issued the notice as part of implementing a national policy.


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The invoices that replaced the Commercial Corporation Invoice were available beginning August1, 2010, and SAT ceased being provided to businesses on October 1, 2010. Beginning January 1,2011, companies were prohibited from issuing the Commercial Corporation Invoice. We haveobtained numerous non-compliant invoices issued to NQ. PwC should have realized that theseinvoices were non-compliant, and thus were likely to be forged.

Below is an image of one such non-compliant invoice dated June 27, 2011 – well after theseinvoices stopped circulating.

In other cases, the invoices show that NQ is purchasing products from companies that are outsidethe vendors’ scopes of business. Confirming that purchase invoices conform to vendors’ scopesof business is easy to do via the SAIC website.

The above invoice is one such example. It is an invoice for mobile phones NQ purportedly purchased. However, as shown below, that vendor’s scope of business is selling stationery.


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NQ’s Chairman’s lies about top customers further support our conclusion that NQis a fraud

Chairman Henry Lin lied about the identities of NQ’s second and third largest revenue sourceson NQ’s conference call held in response to our initial report. Disclosures in NQ’s 2012 20-Fmake it clear that Chairman Lin was lying. Chairman Lin lied on the call because (as an old

proverb holds) one lie requires 1,000 to cover up – it becomes hard to keep all of the lies straight.

On the call, an investor asked the following question: “Just on the revenues, we had some debateabout, what is your true revenue number? And given Yidatong's had some allegations as well,would you be able to provide some verification from your number 2 and number 3 customer? Ithink in the 20-F you've got an 11% and an 8% customer. Could you name them, and could they

provide verification of those revenues?..And who are the number 2 and number 3 customers?”

Chairman Lin answered that UM Pay and Info2Cell were numbers 2 and 3. This is clearly a lie because both are SPs, and are, therefore, part of the carrier billing channel. If either UM Pay orInfo2Cell were the second or third largest revenue sources (at 11% and 8% of total net revenue,or $10.1 million and $7.3 million, respectively), then NQ’s carrier billing channel would haveaccounted for more than $27.9 million in 2012. (Recall that YDT was $20.2 million and ChinaMobile was $1.8 million.)

Shortly after we publicly exposed the lie, Bloomberg television interviewed NQ Co-CEO OmarKhan, and specifically asked him who the second and third largest revenue sources are. Herefused to answer.

Obviously if the records NQ provided to PwC show that UM Pay and Info2Cell (or any othercarrier or SP) were in fact the second and third largest 2012 revenue sources, there is a major

problem because that would contradict the disclosures in the 20-F.

If, as we expect, the records show that the second and third largest revenue sources wereinternational prepaid card distributors, then the PwC offices responsible for confirming thoserevenues must use extra diligence in confirming the 2013 revenues from these sources. Theserevenue sources are outside of China, and unlike with China-source revenue, the SEC is quitelikely to be able to investigate the veracity of these records.

2010-04-28

( )

2011


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NQ prepaid card sales numbers are fabricated

In response to our initial report, NQ disclosed that it sells 600,000 prepaid cards per month at anaverage net monthly revenue of $0.60 (RMB 3.67). This is a lie – NQ sells nothing approachingits claimed 7.2 million cards per year.

After speaking with customer service multiple times and searching the internet, we found onlytwo stores in China selling NQ prepaid cards. One “store” was a computer mall basement kioskin Beijing, and the other was a kiosk in a computer mall in Guangzhou. Customer service told usthat the Beijing kiosk is the only store in Beijing that sells the cards. Both stores reported thatthey sell an immaterial number of prepaid cards. The one-year prepaid cards they carried had

NQ’s old logo, which was replaced over 2 ! years earlier in June 2011.

There are only three stores on Taobao selling NQ cards. The Beijing kiosk operates two of thestores, and the Guangzhou kiosk operates the other Taobao store. The table below shows thetotal revenue of these Taobao stores – for all products. Clearly these stores sell very few NQ

cards online or in the real world.


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NQ responded that it sells its cards in over 5,000 stores, at a rate of approximately 600,000 cards per month. NQ provided the below list of some of its “leading retailers” as “evidence” of this. 20 In addition to only listing 15 locations, the Beijing and Guangzhou locations are all kiosks in thesame mall in their respective cities.

Phoenix New Media visited one of the Beijing kiosks and noted that the placement and sales ofthose cards were suspicious. More importantly, providing a sampling of stores rather than thelist of 5,000 is a clear fraud tactic. China MediaExpress (CCME) did the same thing when weexposed that its largest purported contract with Ba Shi bus company in Shanghai was a lie.CCME gave a partial list of three of the purported 1,000+ buses it had under contract through BaShi. (We showed the three buses were fakes because the license plate numbers belonged to

passenger vehicles.)

Just as CCME’s attempt to cover up was incompetent, NQ’s initial cover up with respect to thecards was incompetent. The photos below come from NQ’s October 26, 2013 response to ourreport. NQ’s photos, which purport to prove that it sells approximately seven million prepaidcards per year in China, show that it was quickly trying to create a façade of significant prepaidcard sales.

20 NQ Response Presentation dated October 26, 2013.


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The above picture seems to be trying to show that there is a kiosk that prominently advertises the NQ cards by hanging a large sign in the background. We tend to think that if the store, which isa Hosin hardware retailer, really did want to hang a NQ sign up, it would first turn off the light

boxes in back of the banner.

This photo shows NQ prepaid cards in a “Hot Buy” counter at a store. We wonder how hot thecards are. They show NQ’s old logo, which was replaced in June 2011.


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Here’s another store selling NQ cards. The cards in the middle once again show NQ’s old logo.If this were not a ruse, then it would mean NQ ordered several years of prepaid cards in early2011, and is still working its way through that inventory.

NQ also responded to our point about the lack of prepaid card sales by stating that it does not sellits cards online. This sleight of hand is designed to distract from the point: If NQ were reallyselling anywhere close to seven million cards per year, they would be fungible, in demand, andselling in volume on Taobao.

NQ Accounts Receivable balance is fraudulent because of revenue fraud

A review of NQ’s days sales outstanding shows that NQ’s reported revenues were always highlysuspect:

0

50

100

150

200

250

020406080

100120140160180

Q410

Q1 11 Q2 11 Q3 11 Q4 11 Q112

Q212

Q312

Q412

Q113

Q213

Q313

Days $ MillionNQ DSO and LTM Revenue Q4 2010-Q3 2013

LTM Rev DSO


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NQ’s competitors advised us that they receive payment within 45 days from the date of invoice,even in emerging markets. NQ is a true outlier in having such high DSO. Note that NQ’s DSOhas ticked down in recent quarters. We believe NQ has been able to decrease its DSOs because

NQ is round-tripping money from acquisitions it makes (we discuss how NQ appears to bemassively overpaying for its acquisitions infra), and NQ has recently been on an acquisition tear.

NQ’s fraudulent ARs must occasionally be paid down, which requires real cash. The massiveoverpayments would easily allow for that, while leaving ample cash to put in the pockets of NQmanagement and the selling shareholders. (NQ’s outsize share compensation to unnamedmanagement and consultants further enables the round tripping.)

As we previously noted, NQ is fairly unique in that it claims to have a sizable amount of non-PRC revenue. Using share issuance to pay for acquisitions is also unusual for US-listed PRCcompanies. Such companies usually pay for acquisitions (legitimate and corrupt) with cash.However, it is not a coincidence that both of these unique conditions co-exist.

NQ needs to provide its offshore sham counterparties with cash to pay down the ARs. It is mucheasier to get cash into the PRC, legally and illegally, than out of it. By buying PRC businesseswith offshore currency (shares), NQ is able to facilitate the fraudulent pay down of offshoreARs. This conclusion is all the more obvious when considering NQ’s substantial reported PRCcash balances, which would indicate that it does not need to primarily issue shares to buy thesecompanies.

NQ has made a number of mistakes with respect to its purported tax treatments,which is clear evidence of fraudulent accounts

These numerous tax mistakes are proof of book cooking. NQ’s book cookers made thefollowing tax-related errors in producing fraudulent financials for its various entities.

NQ Beijing claimed that in 2011 it paid a sales tax called “Business Tax,” ratherthan VAT.

NQ claims that NQ Beijing began paying VAT in lieu of Business Tax in 2012 due to theexpansion of a VAT pilot program to Beijing. 21 Software sales have been subject to VAT since2001. 22 The VIE and WFOE obtained their software developer VAT certificates in 2006 and2008, respectively. In order to maintain the VAT certificates, the companies would have neededto pay VAT on prior years software sales. The expansion of the pilot program to Beijing appliedto industries other than software sales, 23 and thus would not have necessitated a sudden shift to

VAT in 2012.The likely explanation is that the book cooker realized that, because VAT is administered moreclosely than Business Tax, it was advantageous to claim NQ is a Business Tax payer; however,the 2012 VAT reform gave NQ less room to maneuver with its auditor.

21 2012 20F, p. F-29.22 http://www.xm-n-tax.gov.cn/gswz/jsp/fgkcx/xl.jsp?bm=20050603161744574223 http://www.chinatax.gov.cn/n8136506/n8136593/n8137537/n8138502/11735466.html


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NQ Beijing’s 2011 SAIC financials show that the company essentially paid no Business Tax,despite claiming that NQ Beijing was subject at the time to Business Tax of 3% to 5%. 24 NQBeijing’s 2011 income statement shows NQ Beijing’s purported 2011 domestic revenue as beingRMB 113.6 million. (Business Tax only applies to domestic revenue.) However, the income

statement shows that NQ Beijing paid only RMB 8,000 (eight thousand) in Business Tax andsurcharges in 2011. NQ Beijing should have paid at least RMB 3.4 million (340K, or 0.3% ofrevenue) in 2011 Business Tax. 25

In 2012, NQ Beijing’s book cooker had the opposite problem. While the SEC filings claim that NQ Beijing began paying VAT in 2012, the SAIC income statement shows that NQ Beijing paidRMB 6.3 million in business tax on RMB 154.7 million in domestic sales. NQ Beijing shouldhave paid far less in Business Tax and surcharges because at least 35% of the revenue should betaxed with VAT, in addition to the revenue being taxed with VAT under the pilot reform. UnderPRC GAAP, VAT payments are not recorded in income statement accounts – they are shownonly as taxes payable on the balance sheet. Therefore, the RMB 6.3 million is not mislabeled

VAT. It is just another mistake NQ made because its financials are fraudulent.

NQ Beijing’s SAIC financials fail to recognize as Non-Operating Income anyVAT credits or refunds received.

Once again, NQ’s book cooker struggled with the taxes relevant to revenues. To understand theVAT problem, one first needs to understand NQ’s claim about NQ Beijing’s income taxtreatment. NQ claims that NQ Beijing receives a corporate income tax preference for qualifiedsoftware companies. In order to qualify for this income tax preference, at least 35% of NQBeijing’s revenue would have to come from software sales. At least half of the software soldmust be developed in-house.

The effective VAT for in-house developed software is 3% of sales, which consists of the 17%statutory VAT NQ pays on its software sales, netted against a) VAT it paid on its inputs, whichare generally very low for software companies, and b) a credit or refund from the tax bureausufficient to ensure the effective VAT is 3%. Again, NQ Beijing’s SAIC financials show that itsdomestic revenue was RMB 113.6 million and RMB 154.7 million in 2011 and 2012,respectively.

PRC GAAP mandates that the VAT credit or refund be recognized as Non-Operating Income. 26 However, NQ Beijing had no such income in either 2011 or 2012. If NQ Beijing’s SAICfinancials were not fraudulent, they would show at least a few million RMB in Non-Operating

Income in each year. Per a newsletter posted by the Haidian Tax Bureau (the tax bureau thatreceives taxes from NQ Beijing), cumulative VAT refunds to approximately 2,000 Haidian

24 2012 20F, p. F-29.25 VAT for qualified software companies would be 3% of sales after refund. If all sales are VAT sales, the businesstax and surcharge will be at least sales*3%*10% (10% surcharge rate)26 http://www.tjsat.gov.cn/bd/0200/020002/20120508172346812.html


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software companies in 2011 exceeded RMB 380 million (an average of about RMB 200,000 percompany). 27

NQ omitted a purported income tax preference for NQ Beijing from its 2011prospectus

In the prospectus, NQ stated that NQ Beijing “was subject to the prevailing income tax rate of25% on taxable income for the years ended 2008, 2009, and 2010.” 28 However, in the 2011 20-F filed only 10 months later, NQ stated that NQ Beijing “was qualified as a software enterpriseunder the New CIT Law, which was entitled to enjoy an income tax exemption for the first twoyears when it became profitable, followed by three years of preferential income tax rate of 12.5%up to 2015.

Therefore, NetQin Beijing was not required pay any income tax for the years ended December31, 2009, 2010, and 2011.” 29 Omitting a tax preference from the prospectus is much less likelywhen the company’s financials are genuine.

NQ’s SEC disclosures and SAIC financials show that NQ is shiftingimpermissibly high amounts of income from NQ’s variable interest entity(“VIE”) to NQ Beijing in order to avoid paying income tax

NQ claims that NQ Beijing was exempt from corporate income tax in 2011, while the VIE paidcorporate income tax at 15%. 30 Under NQ’s onshore corporate structure, the vast majority of

NQ Beijing’s 2011 revenue consisted of sales to the VIE. The year before (2010), NQ Beijingonly booked RMB 1.5 million in revenue, so the VIE would not have been shifting revenue to ituntil 2011.

By purporting to shift about two-thirds of the VIE’s revenue to NQ Beijing in 2011, NQ loweredthe VIE’s gross margin from 62% in 2010 to 17% in 2011. Purportedly as a result of this shift,the VIE paid only RMB 106,000 in income taxes in 2011, which was only 27.7% of the VIE’s2010 income taxes, while the VIE’s purported revenue grew 193.2% in 2011.

NQ Beijing and the VIE are located in the same building and pay taxes to the same district taxoffice. PRC tax law requires business between related entities to be conducted at pricesequivalent to those for arms length transactions. 31 It is implausible that the VIE would be

permitted to shift this much profit from an entity that pays income taxes to one that does not.

The reason NQ’s SAIC financials show this revenue shift is because the Company pays minimalPRC taxes because it has far less profit than it claims. The Company’s SAIC and SEC financialsare fraudulent.

27 http://www.bjsat.gov.cn/BJSAT/qxfj/hd/sy/zfxxgk/zfxxgkml/gzdt/201112/t20111209_74408.html28 2012 20F, p. F-30.29 2011 F0F, p. F-28.30 2011 20F, p. F-28.31 http://www.chinatax.gov.cn/n8136506/n8136593/n8137681/n8817331/n8817348/8820018.html.


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NQ claims that Beijing Feiliu (“FL Mobile” or “FL”) paid no income tax in 2012and 2013, and a reduced rate thereafter

This claim is based on the assumption FL Mobile was approved for a software enterprise tax preference under the new tax law . This can't be true. The preference is only available for newly

established software companies. FL was established in 2009, but obtained qualified softwarecompany status only in 2011. 32 (FL would have gone through the qualification process afterestablishment in order to be eligible for VAT refunds.) In order to enjoy the tax holiday, FLwould need to have obtained its qualification in 2010.

FL’s tax preference (forgetting the qualification timing issue) would only be valid for two yearsfrom and including its first profitable year. NQ reported in its 20-F a US GAAP profit of$119,000 in 2011 on sales of $2.1 million (from SAIC). 33 It is unlikely that FL was unprofitablein 2011 for PRC tax accounting purposes. The claim that FL would not have to pay tax in 2013seems to be another example of bungled tax treatment resulting from fraudulent accounting.

NationSky’s balance sheet shows too little tax due as of December 31, 2012

NQ purports that Nation Sky generated $12.6 million of revenue in 2012, although NationSky’sSAIC financials actually show $15.2 million of revenue. (The profit numbers are essentially thesame though.) Chinese companies file monthly tax returns for VAT and Business Tax, whilethey file income tax returns on a quarterly basis. The yearend taxes payable balance should be atleast approximately RMB 600,000. The balance sheet shows only RMB 38,000 payable.

Another suspicious element of NationSky’s income statement is that its 2012 sales andmarketing expenses of only $479,000 seem too low to support a sales, presales, and marketingstaff of over 80 people in 10 offices.

NQ’s acquisitions highly likely to have fraudulent intent and accounting

NQ’s acquisitions are highly likely to be corrupt and part of the fraud. NQ is massivelyoverpaying for its acquisitions, which is integral to committing its fraud. Our desktop, SAICfile, and on-site research makes clear that many of NQ’s acquisitions are of businesses that are

barely – if at all – operating. Yet, NQ pays millions of dollars in shares for these companies.

Domain name purchase price is absurd

NQ must really know its emerging markets well though because when we wrote that its claim to

have paid $1.5 million for the domain www.nq.com was absurd, NQ responded by explainingthat the purchase price was so high because it included search engine optimization. Clearly, theUnited States is an awful market in which to do business if it requires such large expenses, andyet one can become an emerging markets juggernaut without even having a website.

32 http://www.chinasoftware.com.cn/GGDetail3.asp?sID=5897&ssID=233990#23399033 NETC, FY 2011, 20F, F-35


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PricewaterhouseCoopers Member Firms’ Professional and LegalObligations And Liability If NQ Is A Fraud

PwC’s legal and professional obligations with regard to reports of fraud at NQ

PwC is, by virtue of our research and this letter, on notice that NQ is a substantial fraud. The“reasonable assurance” audit standard under US Generally Accepted Audit Standards apply

because NQ is listed on a US stock exchange. NQ is such an egregious fraud that a court willlikely hold PwC entities liable for professional negligence for any additional unqualified auditopinions even though this standard is legally high but relatively low given investors’expectations.

Under US auditing standards, established and enforced by the industry regulator, the PCAOB,PwC is required to plan and perform the audit of the NQ financial statements to obtain“reasonable” assurance, which is a high legal level of assurance, about whether the financialstatements are materially misstated due to error or fraud. 34As this wording suggests, auditorresponsibilities are focused on fraud and other illegal acts that result in material inaccuracies in,or omissions from, the financial statements. 35

The auditor applies tests and procedures for the purpose of forming an opinion on whether thefinancial statements are fairly presented according to Generally Accepted Accounting Policies.Performing those activities may bring illegal acts such as fraud to the auditor's attention. Forexample, AU 317 , one relevant auditing standard, describes such procedures as reading minutesof board meetings including those of a special investigative committee of the board, inquiring ofthe client's management and legal counsel concerning litigation, claims, and assessments and

performing detailed and broader substantive tests of details of transactions or balances. Theauditor should make inquiries of NQ management, the audit committee and any special

investigative committees concerning compliance with laws and regulations and knowledge ofviolations or possible violations of laws or regulations.

The audit profession seems to have staved off fatal damages from auditing frauds over the pastcouple of decades by clinging to the ambiguity of what exactly constitutes “reasonable”assurance. Herein lies the major disconnect between investors expectations of how well auditsare performed and the reality. The public believes that “reasonable assurance” means a sufficientlevel of professional skepticism and diligence such that the likelihood of an issuer committingfraud and an auditor failing to detect it are minimized. In reality, public company auditors rarely

34 See paragraph .02 of AU sec. 110, Responsibilities and Functions of the Independent Auditor. 35

Under Sections 10A(a)-(f) of the Securities Exchange Act of 1934 (15 U.S.C. § 78j-1(a)-(f)), the auditor of anissuer’s financial statements generally is required, among other things: (1) to perform procedures designed to obtainreasonable assurance of detecting illegal acts, including fraud, that would have a direct and material effect on thefinancial statements, (2) when becoming aware of information indicating an illegal act has or may have occurred, todetermine whether it is likely that an illegal act has occurred and, if so, its possible effects on the financialstatements, and (3) to report illegal acts that come to the auditors attention to various parties based on criteria in thestatute, unless the act is clearly inconsequential. Also, the auditor's responsibilities under PCAOB standardsregarding illegal acts generally are set forth in AU sec. 317, Illegal Acts. And Auditing Standard No. 16,Communications with Audit Committees, requires the auditor to make certain inquiries of the audit committee aboutviolations or possible violations of laws and regulations.


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detect frauds because of the excuse for ineptitude that a “reasonable assurance” standard provides.

The professional standards auditors must follow unfortunately eventually contradict earlier bestintentions to meet investor expectations that auditors will plan and execute an audit to detect

material misstatement. “Even with good faith and integrity, mistakes and errors in judgment [byauditors] can be made…As a result of these factors, in the great majority of cases, the auditor hasto rely on evidence that is persuasive rather than convincing.” 36

This phrase will not totally exculpate PwC from liability in the NQ case because we have provided convincing evidence that NQ is a fraud. The bar for PwC to issue an unqualifiedopinion is no longer just “persuasive,” and it is not limited to whether NQ’s financial statementsare “reasonably” free from material misstatement. To evade liability for additional auditopinions, PwC must now solicit evidence that is “convincing” that a) NQ’s financial statementsare free of material misstatement; and, b) that Muddy Waters’ evidence, research, and conclusionthat NQ is a fraud are patently wrong. Professional skepticism insists on it.

Professional standards also contradict investors’ expectations when they allow auditors the “wewere duped” excuse. “Because of the characteristics of fraud, a properly planned and performedaudit may not detect a material misstatement…For example, auditing procedures may beineffective for detecting an intentional misstatement that is concealed through collusion among

personnel within the entity and third parties or among management or employees of the entity.Collusion may cause the auditor who has properly performed the audit to conclude that evidence

provided is persuasive when it is, in fact, false…” 37

As the New York State Society of CPAs wrote, in spite of a “reasonable assurance” standard“…[the accounting profession] is still not in a position to assure the public that a GAAS audithas a high likelihood of detecting fraud.” 38

However, by virtue of our research, PwC is now on notice that NQ management and directorshave colluded with third parties – particularly Yidatong. We show that Yidatong is anundisclosed related party and NQ’s largest source of purported revenue. Because this collusion isnow established as a fact, and is no longer just a possibility, PwC must investigate and respondaccordingly.

Auditors that fail to detect fraudulent documentation are given another out by professionalstandards that provide in relevant part “…In addition, an audit conducted in accordance withgenerally accepted auditing standards rarely involves authentication of documentation, nor areauditors trained as or expected to be experts in such authentication...” 39

In general, the vast majority of document review during a financial statement audit is carried out by junior staff. PwC China does not comply with U.S. professional audit standards because many

36 AU 230.1137 AU 230.1238 http://www.nysscpa.org/cpajournal/2005/1105/special_issue/essentials/p28.htm39 AU 230.12


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Chinese junior auditors never obtained degrees in accounting. (Individuals who are licensed toaudit public companies for U.S. stock exchange listed companies must meet stringent educationand experience requirements that always include significant university credits in accountingcoursework. 40) A “wet behind the ears” accounting major is not the best detector of fraudulentdocuments. But it would be even more extraordinary if a recently graduated Chinese non-

business major could detect fraudulent documents in China, the world’s largest market forforgeries.

We cite numerous instances in which NQ has likely forged term deposit slips and invoices. PwCis now on notice that NQ is furnishing examples of potentially forged documentation that was

provided to auditors by management to substantiate balance sheet account amounts.

PwC’s audit of NQ’s 2012 results was clearly sloppy. Additional examples of sloppiness overand above the previously discussed alleged NQ fraud that PC missed or looked the other way oninclude:

• Failure to ensure that disclosures about cash balances by entity are correct. (As we explainsupra, we suspect that much of the cash on NQ’s balance sheet is not really there.)

• Classifying Cash and Equivalents as a Level 2 asset in 2012, and reclassifying 2011 Cash andEquivalents as Level 2. We cannot conceive of a circumstance under which Cash andEquivalents could be Level 2 assets. If this was not a sloppy mistake, then PwC shouldrequire NQ to disclose the special circumstances surrounding its Cash balance.

• Not booking restricted share issuance related to performance issuance.• Failure to ensure that share-based compensation is recorded at the correct entity.• Failure to validate that receivables from NQ’s largest purported trade debtor, Yidatong

(“YDT”), are aged over four months beyond what the contracts permits.• Permitting NQ to reclassify significant costs from Cost of Sales to R&D, which substantially

boosted NQ’s gross margin.

PwC’s legal and professional obligations with regard to the NQ Board’s“independent” investigation of our allegations

On December 19, 2013 Muddy Waters Research made an Offer to NQ’s Independent Committee to engage, at our own expense, an independent and qualified accounting firm to evaluate theindependent committee’s investigation of our October 24 and subsequent allegations. It isnecessary and reasonable for the independent committee to have a qualified party evaluate thecredibility of the investigation. Our offer cites eight examples of independent committees’apparent dysfunction and the resulting flawed investigations of fraud allegations made againstChina companies. Each of these independent committee reports exonerated the companies ofwrongdoing, but they were followed later by substantial investor losses and serious regulatoryaction.

PwC has an obligation under Generally Accepted Auditing Standards (GAAS) to determine ifaudit committee or the board has responded appropriately to our allegations and any others thathave been made, from within or outside the company. Under Sections 10A(a)-(f) of the

40 http://nasba.org/licensure/gettingacpalicense/


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is currently trading at more than 35% below its 52-week-high, which was set in October. Thedamages to investors are already sufficient to justify multiple class action lawsuits.

If PwC concludes, after expanding its audit scope and performing additional tests and proceduresin response to clearly heightened fraud risk, that fraud at NQ Mobile has a material effect on the

financial statements, and the illegal act or acts act have not been properly accounted for ordisclosed, PwC should express a qualified opinion or an adverse opinion on the financialstatements taken as a whole. If NQ Mobile prevents PwC from obtaining sufficient appropriateevidence to evaluate whether illegal acts material to the financial statements have, or are likely tohave, occurred, PwC should probably disclaim an opinion on the NQ financial statements.

If NQ management refuses to accept a modified a PwC report, PwC should resign from theengagement, possibly withdraw its opinions on prior financial statements and warn investors onreliance on management’s representations. PwC must communicate the reasons for withdrawalin writing to the audit committee of the board of directors. If PwC is unable to determine whetherthe acts are illegal because NQ imposes limitations on its work or because PwC is unable to

interpret applicable laws or regulations or the surrounding facts, PwC may have to resign the NQaudit.

PwC China may soon have no choice but to resign as NQ’s auditor rather than issuing aninappropriate, and unsubstantiated, unqualified opinion on the 2013 financial statements. PwCChina, PwC’s US firm, and possibly other PwC entities outsi

Documents

Muddy Waters - NQ Mobile