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Investments in
Chinese companies may be riskier than you think
Shares in Chinese firms listed on US stock exchanges turn out to be worthless
if the Chinese owners or executives run off with the company seals, and the
authorities are often powerless to prosecute
By Steven Davidoff / NY Times News Service, NEW YORK
Illustration: Lance Liu
You might think that if you bought shares
of a Chinese company that was listed on a US stock market you would actually own
a piece of that company.
Unfortunately, it is not that simple. The recent cases of the ChinaCast
Education Corp and the Sino-Forest Corp show that in many instances, foreign
investors in Chinese companies might have bought shares that do not really
represent much. It is a problem that has the potential to extend to even the
soundest Chinese company listed in the US.
The ChinaCast case is not the most egregious, but it is certainly the most
scandalous. In March, its chief executive, Ron Chan, was ousted in a battle for
shareholder control of the company. An American investor succeeded not only in
replacing Chan, but also in obtaining control of the ChinaCast board.
Yet that turned out to be only the beginning of the battle.
Last week, ChinaCast disclosed that it could not find its company seals, or
authorized signatures, for its Chinese subsidiary. Seals are necessary for
ChinaCast¡¦s Chinese subsidiary to undertake any business in China. Without them,
ChinaCast can¡¦t sign contracts or even pay employees.
In other words, China appears to have Lord of the Rings corporate governance ¡X
one seal to rule them all.
Chan was believed to have possession of them, but now claims to know nothing.
Two of the universities owned by ChinaCast appear to have been transferred to
ChinaCast¡¦s former chief investment officer and president of its Chinese
operations. And last week, according to the board, about a dozen people broke
into the company¡¦s Shanghai office and stole a number of documents and
computers.
ChinaCast has a revolt on its hands that it is finding difficult to quell.
One reason that ChinaCast is having a problem is that shareholders did not
actually buy an interest in its operations. Instead, to avoid Chinese
restrictions on foreign investment, ChinaCast¡¦s shareholders invested in a US
company that has contractual arrangements with a Chinese company ¡X but the
Chinese company remains in the ownership of Chinese citizens.
The problem with this structure, known as a variable interest entity, is that it
may be illegal under Chinese law and has been criticized by Chinese regulators.
Even if it is legal, if the Chinese owners decide to go rogue, the US-listed
entity must sue and obtain a judgement from a Chinese court to enforce these
dubious contracts. Good luck with that. Such a litigation can take a long time
to resolve, if ever.
In ChinaCast¡¦s case, it cannot do anything until it has control of the corporate
seals, but under Chinese law it needs them to sue to recover them. In the
meantime, the operators of the Chinese subsidiary can take full advantage of the
situation.
Unfortunately, ChinaCast is not the only Chinese company with dubious claims to
its assets.
Sino-Forest, listed on the Toronto Stock Exchange, is the most prominent Chinese
company to experience this problem. Last summer, Sino-Forest was accused by
Muddy Waters Research of fraudulent accounting with respect to timber lands. At
the time of the report, SinoForest had a US$4 billion market capitalization.
A subsequent report by an independent committee of directors denied that there
was a practice of fraud at the company, but also acknowledged that much of
Sino-Forest¡¦s property was held through a variable interest entity, or otherwise
under contractual rights without an actual title.
Sino-Forest has filed for bankruptcy in Canada. Its assets far exceed its
liabilities, but shareholders are likely to end up with nothing, in part because
Sino-Forest¡¦s rights to its assets are tenuous at best.
The variable interest entity structure may be the root of the problem when
foreign investors own shares in Chinese companies, but it is only part of it.
The norms for business are different in China, and enforcing legal contracts or
rights is sometimes impossible. Legal title to assets is often not formalized,
and even when it is, Chinese executives can use the lack of rule of law to take
advantage of foreign shareholders.
Other disputes show that ownership of assets in China can be fleeting.
Yahoo got into a tussle with Jack Ma (°¨¶³), the chairman and chief executive of
the Alibaba Group, in which Yahoo has a substantial interest, when he
transferred Alibaba¡¦s online payment platform, Alipay, to a private company
controlled by him.
Ma and Yahoo eventually resolved their disputes, but the transfer was a warning
sign that Ma was willing to take all steps to ensure that the only buyers for
Yahoo¡¦s Chinese assets were Ma and his co-investors.
In the case of NASDAQ-listed GigaMedia, a Singapore-based online gaming company,
it wasn¡¦t the variable interest entity structure that did the company in.
Instead, the head of its Chinese business simply made off with the seals for
GigaMedia¡¦s Chinese company and transferred ownership of the assets. GigaMedia
appears to have given up on getting the business back.
And it is not just a few bad apples. At least 105 Chinese companies listed in
the US have been delisted, are under investigation or have financial problems,
according to the Pittsburgh Tribune-Review.
Even when there is no suggestion of fraud, the wide use of the variable interest
entity structure by Chinese companies listed on US stock markets should trouble
investors.
The structure is used by a number of prominent Chinese Internet companies
including Ren-Ren, Baidu.com and Sohu.com. In most cases, the actual Chinese
assets are held by the company¡¦s executives. Ren-Ren¡¦s Chinese assets, for
example, are 99 percent owned by Ren-Ren¡¦s founder and his wife. This puts these
executives in prime position to fend off any challenges by foreign shareholders.
Investors seem to heed the warning signs only half-heartedly. The recent Chinese
initial public offering (IPO) of VIPshop and the pending IPO of AdChina both use
the variable interest entity structure.
AdChina disclosed that if the parties controlling its Chinese operations ¡§fail
to perform their obligations under their agreements with us, we may have to rely
on legal remedies¡¨ under People¡¦s Republic of China law ¡§which may not be
effective.¡¨
VIPshop¡¦s IPO had top-tier underwriters, including Goldman Sachs. However, do
not depend on the underwriters to stick around to make sure that US shareholders
can enforce their rights. After an IPO, the underwriters tend to disappear.
This is not just a problem of a questionable legal structure, but Wall Street¡¦s
apparent willingness to ignore the fact that investors in the US have tenuous
claims when they buy shares in Chinese companies. Underwriters and Chinese
issuers have taken advantage of the hunger for Chinese stocks.
The US Securities and Exchange Commission (SEC) and Washington seem to be almost
as absent. The SEC just brought charges against one Chinese issuer, SinoTech
Energy, claiming it overstated its assets. The regulator has issued a warning
about investing in Chinese companies listed on US stock exchanges, but the
conduct in the ChinaCast case appears to be outright fraud.
The agency simply has not followed up aggressively in most of these cases, most
likely because it is overwhelmed with other tasks. The US government has also
not pressed China to vigorously and quickly enforce its own laws to help US
shareholders.
Here lies the ultimate lesson. An investment in Chinese companies is really an
investment in the people who run these companies.
While some, if not most, of these executives are well-intentioned, there seems
be a lot of suspicious activity out there. Even more so, when those executives
are threatened, they can use the weak legal structures and rule of law to
maintain control of their companies. And heaven forbid they should steal the
seals.
For US investors, it may be that the risks are worth the potential gains in
investing in China, but do not say you have not been warned.
Steven Davidoff, a former corporate lawyer, is a professor of law and finance
at Ohio State University.
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