Fraud tends to increase when the economy is good, but revealed when the economy is bad. Or as Warren Buffet once, said, “Only when the tide goes out do you discover who’s been swimming naked.”
I mention all this because in the last few months our China lawyers have been called in to help on more suspected fraud cases than maybe any time in our law firm’s history. I wish I could discuss those cases, even elliptically, but I cannot, for fear of tipping off those who are suspected. So I will instead re-hash old blog posts on this issue with — when necessary updated information. The point of today’s posts and those that follow is to help arm you with information so you can better discern China-related frauds (really frauds anywhere) on your own, or at least get you to the point where you realize you need to do something to act on your suspicions.
But I would first like like to discuss a company called Sino-Forest and start out doing so with a giant WE TOLD YOU SO, obliquely on here but not so obliquely to our clients. There, now that that’s out of the way, let me tell you about Sino-Forest. Sino-Forest was at one time a high-flying Chinese company that traded publicly in the United States. We first hinted at our suspicions of Sino-Forest back in 2011 in a post entitled, How To Really Really Investigate A Chinese Company. Another reason for my writing this post today is because the Ontario Securities Commission hearing panel just “found that Sino-Forest Corp. and four individuals, among them former CEO Allen Chan, engaged in ‘deceitful or dishonest conduct’ that constituted fraud, according to a decision released Friday.” One of the ways we as China attorneys spot China company frauds is when a company claims to own something or be engaging in some sort of business that cannot legally be true in China. This leads us to conclude the company is either lying or operating illegally, neither of which makes for a good investment or business partner.
I feel compelled to warn you that this is going to be a fairly long and fairly technical post and more posts on China fraud will follow. But if you even have an inkling that you are in any way dealing with a fraud, I will tell you — with all the humility I can conjure — that this post and those that follow it (starting tomorrow) are must reads.
I will start out by talking about some of the main issues to consider when looking at Chinese companies that trade publicly overseas, by quoting liberally from Thinking Clearly About Chinese Companies Listed On US Stock Exchanges. Or, If A Tree Falls In A Sino-Forest…., a post my fellow blogger Steve Dickinson wrote way back in 2011. I note that what reeks of fraud in publicly traded companies generally holds true for private companies as well. Steve’s post provides good background on risk assessment:
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.
In tomorrow’s post, I will discuss some due diligence you can and must do to avoid becoming a victim.