Op-Ed Commentary: Chris Devonshire-Ellis
Feb. 11 – Among all the furor in the United States concerning China listing deals being uncovered as fraudulent reverse mergers, it seems that an estimated US$38 billion of value may have just gone up in smoke. A number of Chinese companies have been found to have misled dealmakers in bids to become listed on Nasdaq and related markets, and it appears the toxicity of these discoveries may spread to other markets in Toronto, London and even Hong Kong.
As we reported earlier in the week, a sharp-eyed American small investor spotted that a Chinese, Nasdaq-listed company, reported sales turnover of its entire inventory every week. Further investigation revealed a huge documentary fraud – the original entity, based in Harbin, had apparently managed to inflate its annual sales from its Chinese audit of US$1 million in 2008 to almost 60 times its original figure, reporting annual sales of US$59.7 million to the SEC.Ongoing commentary on the popular web site, “The Street,” outlines other cases of Chinese fraud, all of which have chilling comparisons to the various frauds perpetrated in the late 1980s and early 1990s, including those documented in the book Mr. China.
Lessons appear not to have been learned. All too often, the same mistakes have been made: too much emphasis on US regulations over listing, the involvement of too many US based law firms and VC funds with little practical China experience, and actions based only on the desire to earn big success fees. While much of the commentary and anger concerning these issues appears directed at China, the reality is that U.S. dollar signs of potential fee earnings – combined with an inherent misunderstanding of Chinese law, a lack of knowledge of what constitutes appropriate due diligence, and a mixed lax regulatory environment – have permitted a number of Chinese companies to make monkeys out of Wall Street. This phenomenon may also spread to other markets where Chinese companies are listed.
Over the years, I’ve met with plenty of VC funds and dealmakers from the U.S. looking to find appropriate Chinese businesses to take to market. In all cases, their emphasis was not so much on quality, but on turnover, and such funds and dealmakers had little or no knowledge of China’s reporting systems, nor the variety of ways in which these systems can easily be abused.
It seems no one wants to turn down a potential deal and once the fees are paid, it’s the American stock investor (not the firms or dealmakers involved) who has to pick up the tab. Unfortunately, scams and instances of under-reporting are common and can bypass listing regulations. In just one example, I recall our practice being asked to conduct financial due diligence into a Chinese retailer that had approached one of the Big Four to apply for a listing in Hong Kong. Conducting a check on four of the 17 businesses branches, we uncovered in all cases that the mandatory welfare payments due to the Chinese employees had not been met in full and that in all cases these payments had only been met to between 30 and 50 percent of the required mandatory payment. Given the business employed several thousand staff, this was a potentially huge liability. We were then asked to check all remaining branches of the target business. Every single one had underpaid the required mandatory welfare and created a potential liability equivalent to several million US dollars in unpaid mandatory welfare. For obvious reasons, this was a sticking point when preparing the company listing prospectus.
At this juncture, matters took an interesting turn. The Big Four firm involved suggested that if the unpaid amount could be legally regarded as “negotiable” this amount need not be identified in the prospectus. We were asked to conduct sensitive research on the subject (essentially discretely asking the provincial governments concerned with the welfare collection if they would be prepared to accept lower mandatory welfare payments in settlement on behalf of the businesses employees). The result was positive: the local governments were prepared to negotiate and settle for lower amounts than legally prescribed.
A third party legal opinion was then sought over the question as to whether the local government had the legal right to negotiate and settle what appeared to be State directives. That opinion also turned out to be positive: mandatory welfare payments, it transpired, are not mandatory at all and can be negotiated. As a result, the unpaid welfare deficit and potential liability never appeared on the listing prospectus, because, under Hong Kong’s regulatory regime, liabilities subject to interpretation do not have to be included in a listing prospectus. The company subsequently raised tens of millions of dollars from its IPO. I don’t know whether or not the company used any of that to pay off its mandatory welfare debt.
As can be seen, the lessons from the situation concerning Chinese companies listed in the US and elsewhere are not necessarily the fault of the Chinese. Rather, the Chinese have merely exploited situations to their advantage, taking advantage of loopholes and others’ poor understanding of how rules and regulations can be subverted in China. This behavior is certainly corrupt, and misleading to the extreme, but blame for much of the fraud, in my view, lies with the dealmakers and lawyers unaware of how Chinese laws and reporting can be misused, the inherent contradictions within the application of China’s regulations, and the poor legislation governing listing requirements and prospectus data inclusion.
At the end of the day, it seems no one is prepared to throw cold water on any deal that promises a result. The consequence of this behavior will be bankrupt stocks and angry investors, and ultimately the only question remaining is the extent of the financial damage. The lessons of Mr. China, it appears, have been and continue to be completely ignored. With the existence of advice and expertise that can prevent such negative consequences, the onus is then on professional negligence. The pointing finger should be directed at the service providers that permitted these listings to take place and allowed themselves to be duped.
Chris Devonshire-Ellis is the founding partner of Dezan Shira & Associates, a foreign direct investment firm with 19 years of China experience. The firm maintains 10 offices in China and provides due diligence services in addition to advisory work concerning China legal and tax issues. The firm may be contacted at firstname.lastname@example.org, and their brochure downloaded here.
The China Due Diligence Series
Part One: China Due Diligence You Can Conduct Yourself
Part Two: China Operational Due Diligence
Part Three: Analyzing Chinese Financial Reporting
Part Four: Kicking a China Business’ Tires – The Checklist