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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