I have been doing a lot of consulting lately for investment professionals concerned about the issues recently raised by Muddy Waters LLC about Sino-Forest and other Chinese companies listed on North American stock exchanges through reverse mergers. I have found that most of these investment professionals are confused about what is going on with Chinese companies listed on foreign stock exchanges and their confusion is causing them to improperly evaluate the true risks of investing in Chinese companies.

The fact is that there are risks concerning every Chinese company that lists outside of China. China is a developing country based on socialist market principles that are unclear even to the Chinese. It is a certainty that even the best managed and most profitable Chinese company will not be managed and operated in a manner that would be typical of a well-managed U.S., Canadian or Western European company. This is going to be true of pretty much any company from the developing world. However, it is also important to account for major distinctions concerning Chinese companies that have listed outside China.

There are basically three kinds of companies that list their shares outside China:

The first group is made up of well established Chinese companies that form the heart of the Chinese industrial and service economy. These companies are typically state owned enterprises already listed within China on the Shanghai and Shenzhen stock exchanges. Examples of such companies that have listed on the New York Stock Exchange are:

  • Aluminum Corporation of China Ltd
  • China Eastern Airlines Corporation Limited
  • China Life Insurance Company Limited
  • China Mobile (Hong Kong) Limited
  • China Netcom Group Corporation (Hong Kong) Limited
  • China Petroleum and Chemical Corporation
  • China Southern Airlines Company Limited
  • China Telecom Corporation Limited
  • China Unicom
  • Guangshen Railway Company Limited
  • Huaneng Power International Incorporated
  • Jilin Chemical Industrial Company Limited
  • Petro China Company Limited
  • Semiconductor Manufacturing International Corporation
  • Sinopec Shanghai Petrochemical Company Limited
  • Suntech Power Holdings Company Limited
  • Yanzhou Coal Mining Company Limited (ACH)

It makes sense to ask whether or not these companies are actually profitable. It may also make sense to ask whether these companies are working on behalf of their investors, both Chinese and foreign. However, it is absurd to even consider whether these are “real” companies, with real assets, real operations and real cash flow.

The same is true of many other lesser known privately held Chinese companies that have listed in the United States. Whatever an investor may think about how they run their business, there is no question that they are in business and are working actively to make money for someone.

The next group are typified by companies that operate in China under unique structures such as the VIE (variable interest entity) structure that is common in the Internet sector. Many people are surprised to learn that Alibaba, Baidu, Sina, Tudou and other foreign listed Internet companies do not actually have any direct Internet operations in China. This is because, as foreign companies, they are not permitted to operate directly in China’s Internet sector. They therefore operate through Chinese companies that they create and then “control” through elaborate contractual arrangements. Though one can certainly raise many questions about the security of these contractual relationships in terms of calculating the real worth of these companies, there is no question about whether or not these are “real” companies. Alibaba and Baidu and their related companies dominate the Internet sector in China and operate vast numbers of businesses. Since they operate on the Internet, these businesses are relatively easy to monitor to determine whether or not they really exist. In addition, in their public filings in the U.S. and Hong Kong, these companies clearly describe every detail about the structure of their business and clearly state the possible risks arising from their unusual business structures. This means that while the VIE approach to doing business in China raises unusual risks, it would be difficult to claim that their structures are not well described and that their risks have not been exposed. More importantly, one cannot say that their business structures are designed to conceal a business that does not really exist or that operates on a scale far small than reported.

Muddy Waters and its followers are not claiming that their target companies fall into either of the above two categories. Muddy Waters states quite clearly that it believes that Sino-Forest and others are absolute frauds. The claim is that these companies have used complex structures and claims about the unique nature of doing business in China to hide the fact that they are complete frauds. The claim is that they are not doing any real business in China at all. The claim is that they have no income, no employees, no factories, no nothing. They are empty shells, created to take money from naive foreign investors.

I do not know whether these claims are true and I am not personally aware of any proof that any of the Chinese companies listed in the U.S. and Canada are complete frauds. I have found, however, that many investment professionals are confused about the accusations against Sino-Forest and others. In an attempt to make a case that they have not been completely duped by the fraudsters, the investment community seems to want to argue that Sino-Forest and others should be treated as though they were members of the two groups of companies I describe above. In this way, they can excuse their analysis by claiming that the company practices of Sino-Forest and its ilk can be “excused” by the unique characteristics of the Chinese business environment and regulatory system.

This position is a mistake. The claim against Sino-Forest is not that it has a complex business structure required for doing business in the Chinese market in wood products. The claim is that Sino-Forest has used this argument as a smoke screen for creating a company that is a complete fraud. The claim is that Sino-Forest owns little or nothing in China. The claim is that Sino-Forest has earned little or nothing in China and has no prospects for any real earnings in the future. This has nothing to do with the nature of the Chinese system. The claim is a simple assertion that Sino-Forest is a hollow shell and a fraud.

I do not know whether this claim against Sino-Forest and other Chinese companies that have listed as reverse mergers is true or false. However, this claim is quite different from the concerns that can be raised against Chinese companies that come within the two categories I enumerate above and two mistakes arise from this confusion.

First, legitimate companies under the first two categories are unfairly questioned and their stock is unfairly attacked. I am not contending that their stock is properly valued. However, the accusations against Sino- Forest and others should have no bearing on evaluating the business of these companies.

Second, Sino-Forest and others are given too much credit because investors assume they must be using legitimate business practices that are employed by the legitimate companies that fall into the first two categories.  Many people who have discussed the Sino Forest matter with me assert that Sino-Forest must be using a VIE structure. They argue that since Alibaba and others use a VIE structure, the Sino-Forest system must be acceptable. Though I do not understand Sino-Forest’s so-called “authorized intermediary” structure, I can say for sure that it is not a VIE structure. Therefore, Sino-Forest should not be assumed to be engaging in an unusual and risk but otherwise well known business practice. This is just an example of wishful thinking common in the investment community.

What do you think?

  • John Bird

    Steve –
    I have more than a small amount of experience as a short seller of Chinese companies. Your explanation of the structural differences is fine…as far as it goes. The short selling community is not partial to any corporate structure. The structure chosen by a Chinese company is merely an indication of whether they strive for transparency or needless opacity. As any businessman would agree, it is easier to maintain fewer corporate entities versus more. The inclusion of multi-tiered holding structures is done for a reason and a very possible explanation is to assist in a deception.
    The issue also is not a matter of locating “hollow shells”, though some of the bad actors are complete shams. The more common scenario starts with an existing core business that grows like magic beans. American capital and no legal recouse is an astonishing tonic that transforms these 90 pound weaklings into dynamos that outpreform Apple. The reported growth is the rotten part of this tree. The common denominator is not structure, it is fraud. Many of the RTO companies are proving to be frauds and the abundant flavors would make Baskin Robbins envious.
    Until the SEC, PCAOB, and the Congress have finished with the China audit issue; I see no way to justify the risk of investing in any Chinese company (Hong Kong A shares excepted – your group one) The VIE structure is potentially at risk with dire potential consequences to them all, no matter how large.
    John

  • Xu Hui

    The real issue here when it comes to the status of Chinese companies listed in the US is the complicity of both US lawyers and their auditors in getting the deal done as opposed to conducting detailed due diligence, and a complete lack of acknowledgement of the importance of financial due diligence and the quality of internal audit. The subject in hand is 10% legal, 90% financial. The hand-in-hand relationships between lawyers acting on behalf of Chinese clients is a key issue as why many of these listings have had problems, “getting the deal done” being more important than investor protection.

  • Heidi Yu

    Den, please allow me disagree with you. Just the opposite to your conclusion, Sino-Forest had in fact much less risk than those companies with VIE structure you mentioned in the article. The reason is that Sino-Forest had the assets confirmations provided by China’s government.

    The risk of VIE lies in the fact that the structure is designed to detour China’s restriction of foreign investments in some area, such as internet. China has been encouraging foreign investing in forestry industry, however, it has a policy (very weird and unreasonable one) that foreign-invested forestry companies can not get certificates. That’s the reason for Sino-Forest’s VIE (BVI).

    Since proofs of assets ownership needed for financing on Canadian market, Sino-Forest requested China’s government forestry bureaus to provide confirmations. In the 16 years listing, those confirmations had been considered legal proofs for Sino-Forest’s forestry assets, until OSC was wakened up by Muddy Waters’ fraud allegation and judged that those confirmations were illegal. OSC also implied that China’s government officials were bribed and tried to cover up for Sino-Forest.

    Now you can see, Sino-Forest has no risk of VIE or other things, the only risk is that Canadian regulator can not trust China’s government any more.