Thursday, February 19, 2015

Will China Inc. Fall Victim to Accounting Fraud?

                                                  Caterpillar digs its own hole

Corporate structures bear a troubling resemblance to the famed US Enron collapse.

In 2013, Xiao Gang, the chairman of the China Securities Regulatory Commission, conceded that civil, administrative, and criminal laws lack provisions that would allow securities regulation to actually function.

The system, he said, lacks a judicial underpinning for sound capital markets. In the existing provisions of the law and their enforcement applications, even the most basic disclosure requirements essential to the healthy functioning of financial markets are absent.

However, for any meaningful institutional overhaul to take shape in China’s markets and businesses, the existing system has to be changed. It is characterized by opacity and a culture of secrecy that offers unscrupulous corporates or traders camouflage to cover fraud. But changing a regulatory, legislative, and judicial system that fosters these shortcomings will be hard for Beijing to stomach. 

This lack of transparency, made necessary by China’s anachronistic, murky institutions, is the institutional fault-line. It is a system rife with accounting fraud. Caterpillar, the world’s top maker of tractors and excavators, was victimized by a massive accounting fraud in 2013, something that is certainly not rare in China’s corporate realm.

The case  illustrates the kind of catastrophic losses that are possible if a foreign entity is not vigilant about the pervasive deceptive practices in Corporate China. Caterpillar lost 86 percent of what it paid for its China investment in the course of just months. In this particular case, US$580 million disappeared.

Caterpillar’s case shows how a foreign company with decades of experience can still flounder unless investors really understand how what might be called “Enron-ism” prevails in China. Massive accounting fraud culminated in the 2002 bankruptcy of the Texas-based energy trading company, lost investors US$63.4 billion and resulted in the destruction of Arthur Andersen, once one of the world’s biggest accounting firms.

Caterpillar had been doing business in China for more than 30 years. Its CEO Doug Oberhelman in 2011 was one of the guests invited to dine with former Chinese president Hu Jintao together with a group of other American businessmen.

Great connections, but these do not make you immune. An insider later pointed out that Caterpillar was so bullish on China that it was willing to overlook many of the grave revenue problems of the target subsidiary Zhengzhou Siwei. Caterpillar’s board of directors was immersed in euphoria and blindsided by delusions.  Its board dwelt in euphoria, believing things simply could not go wrong to any significant extent, as the acquisition had been mediated and assisted by three old-China-hand American businessmen who had been operating in China for decades.

All that was just exactly the kind of high-profile defalcations that can be mapped straight to what happened with Enron’s collapse. The essence of its accounting fraud was that it had been moving debts off the corporate balance sheet to shell entities to create a delusional face-lift in financial reporting.

This kind of mentality is widespread in both corporate China and in officialdom despite the massive crackdown on graft ordered more than a year ago by President Xi Jinping. In past decades, China’s officially pronounced consumer price index, the banks’ bad debt ratios, and the local governments’ gross domestic production figures were being systematically fudged. And, in 2013 when statistics showed that ultra-high tax burdens for doing business in China – about 40 percent of corporate revenues were consumed by taxes and levies – the statistic was deleted from the Ministry of Finance’s official website two days after it was announced.

Whistleblowers brought down Enron. In China, the whistle-blowers have been sent to jail instead. Further, in China, the fundamental ineffectiveness of the court system means that impunity is common, creating a general perception in the market that wrongdoing is not going to be deterred. Here is a system where perversity is perpetuated and insider-trading thrives. Lack of a sophisticated and rigorous judicial system often results in impunity for illicit conduct in the markets. Murky cronyism is the name of the game.

Collusive auditing practices to varying degrees are commonplace with the existing accounting profession. Usually the larger the corporate client is, the higher the probability of the outside accounting firms’ willingness to collude in questionable auditing practices – just as Arthur Andersen did.

Behind the September 2014 dazzling IPO of Alibaba at the New York Stock Exchange is an untoward attribute of the corporate structure, and Alibabi’s propensity to entail disproportionate risk for investors.

Paul Gillis, an American accounting professor at Peking (Beijing) University’s Guanghua School of Management wrote in Foreign Affairs last October that Alibaba’s unusual corporate structure is “structurally unsound” and is “putting investors at considerable risk.” The article, titled “Son of Enron, Alibaba’s Risky Corporate Structure.” pointed to startling facts that are perhaps too sensitive for mainstream financial journalism to cover.

Alibaba’s listing was enabled by what is called a variable interest entity (VIE) structure, the corporate structure used by Enron prior to its 2002 collapse. The implication in this, according to Gillis, is that there could be a similar downfall awaiting investors in Alibaba and other Chinese stocks listed on the NYSE.

Why is it that the variable interest entity structure used by China’s US-listed internet companies necessitates “considerable risks” to investors who purchase their shares in the US? The main reason is that US-based investors do not actually have equity ownership in the actual onshore Alibaba corporation in China. What they own is an off-shore company listed on the NYSE.

This Alibaba-US entity exercises control only through contracts signed with privately-owned corporations in China. These entities are owned by the Alibaba chairman Jack Ma, and a handful of close-knit people who actually run China Alibaba. The US-based investors do not have equity ownership in the “real” Alibaba Company, which is privately owned only by Ma and others closd to him.

What the US-based investors bought as shares last September is a separate entity, the Alibaba that is listed in NYSE. Let’s call this public-owned company in the US the Virtual Alibaba. Similar to what is in Virtual Reality in computing, this Virtual Alibaba may function like a real thing, but it is not the “real” Alibaba. Whether or not this virtual Alibaba functions like a real thing hinges on how enforceable is the contract between the Virtual US Alibaba and the Real China  Alibaba.

One indication for the VIE structure to be a potential problem is that control of the VIEs rests on the enforceability of the contracts. In practice this type of contract has not held up when challenged in China’s courts. VIE-related jurisprudence is an area that is likely beyond the competency of China’s existing judiciary.

Second of two adaptations from “China’s Faustian Bargains: China’s Economy Seen in the Undercurrent of Organized Unaccountability”published by Praxia and available on Amazon in paperback and Kindle. The author, trained in economics, accounting, and business law, has for 25 years worked in international business/finance relating to Asia and China.

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