Tiger Woman on Wall Stree (21 page)

The global recession was not contained in the West: as the factory to the world, China quickly saw its exports slow. But Beijing showed the world the upside to being a command economy: in an adverse environment, it could use its policy tools to boost economic growth far more quickly than could market capitalism’s invisible hand.

Beijing released its 4 trillion RMB stimulus package at the end of 2008, which brought about approximately 10 trillion RMB in bank (and shadow bank) lending, to stave off the ripple effects from the crisis and bolster the economy. People in the West marveled at the resilience of the Chinese economy, and some even argued that the Chinese version of state capitalism was superior to the Western version of free market capitalism. Books like
When China Rules the World
by Martin Jacques (editor of the journal of the British Communist Party for nearly two decades) and
What the
U.S. Can Learn from China
by Ann Lee popped up in bookstores and on Kindle reading lists.

Corporate America continued to buy Chinese companies, some with dubious qualities, even as Muddy Waters was undermining investor confidence in Chinese stocks. Loaded with cash and facing gloomy prospects at home, the multinationals felt the heat from their investors and boards to deliver growth by jumping into emerging markets. When their competitors all rushed into China, they had to follow or risk being blamed for a lack of vision.

Generally speaking, a company can grow either by expanding its business organically or by acquiring or merging with other companies. Organic growth tends to be slower but healthier, because the company has better internal control of its operations. Growth by acquisitions delivers more immediate results but brings more execution risks, such as when cultural or organizational differences between companies complicate the integration process. China presented an additional challenge in that, just as in the public market, companies involved in the M&A chain had a tendency to inflate the value of local acquisitions.

Pearson, the London-based multinational education and publishing company, fell prey to just such a situation. As a public company, it was under constant pressure to deliver growth, even as its core publishing businesses, Penguin and the
Financial Times
, were declining. Meanwhile, China’s English tutoring and test preparation industry was booming. So at the end of 2011, Pearson announced a deal to buy out Global Education and Technology (GET) at a generous price of “four baggers,” the Wall Street term for four times a company’s 30-day average share price (GET’s stock had been hammered prior to the announcement). For each American depositary share trading at $5.37 on the day-of-deal announcement, Pearson would pay $11.01 in cash. When the deal was announced, GET’s stock rose 97 percent.

Since the company’s IPO lunch at the St. Regis, I had watched GET from a distance without getting involved myself—I didn’t long; I didn’t short. I didn’t buy long because I didn’t like the managers—they seemed provincial, and yet they intended to build a nationwide business. A big portion of the company’s business was franchises, as opposed to directly owned schools. Adequately trained staff and management are the key to running franchises, but an industry friend told me that the couple who headed the company hated traveling, and the company’s schools outside Beijing, where the couple lived and worked, were run-down and poorly managed. Even so, I didn’t short. I knew the U.S. market at the time was crazy for Chinese education companies, and I didn’t want to be killed in the rush.

Shortly after the deal was announced, the SEC sued four Chinese citizens affiliated with GET for
insider trading
. It seemed that GET’s management had told the brother-in-law of the CFO (who was also the chairwoman of the board of directors) and his friends about the possibility of a deal before the takeover was announced. They started to accumulate company shares and doubled their money after the announcement. The SEC obtained a court order to freeze their assets only two weeks after the suspicious trading took place, but some of the insiders had already liquidated or transferred their illicit profits.

Despite the SEC investigation and vocal opposition from Pearson’s shareholders, the acquisition proceeded, and the deal closed by the end of 2011. Almost a year later, the SEC brought charges against a new defendant in relation to the case.
By mid-2013
, no further information on the status of its investigation had been released publicly.

GET’s case was an obvious transgression of corporate governance under American standards. The consolidation of power within the company created conflicts of interest and compromised the board’s ability to protect the interest of minority shareholders.
In the case of GET, the CEO and the CFO—the husband and wife team that co-founded the business—also chaired the board. Many Chinese companies appoint a few individuals—sometimes family members and friends—to multiple senior executive positions. What Americans might call corruption, the Chinese call family values.

Besides Pearson, construction equipment maker Caterpillar also joined the China rush too quickly. And its executives also found out that they had not bought what they anticipated.

Caterpillar, the world’s largest maker of tractors and excavators, was long held up as one of the biggest success stories for a foreign company in China, a huge market for construction machinery. It was also a highly successful stock, with a market cap of nearly $67 billion in early 2012. That is, until Caterpillar agreed to acquire Zhengzhou Siwei.

In June 2012, Caterpillar purchased ERA Mining Machinery Ltd. and its subsidiary Siwei, China’s fourth-largest maker of hydraulic mine-roof equipment, for
$887 million
.

The Chinese company seemed like an excellent target: it was recording surging sales and offered Caterpillar access to the lucrative mining market. ERA Mining Machinery was also owned by two American entrepreneurs, which conceivably instilled the buyers with a sense of confidence and trust. Including Western faces on the board had become a common practice among Chinese companies seeking to boost their corporate image.

In January 2013, seven months after the deal closed, Caterpillar announced it would write down a noncash charge of $580 million
against its earnings
. The U.S. company had uncovered evidence that Siwei overstated its profit for years by fabricating nonexistent sales.
Caterpillar was alerted
to the possibility of fraud after it noted discrepancies in the company’s routine inventory count, something its auditors should have discovered before the deal went through. Caterpillar’s management defended itself to the
board by saying that its due diligence was “rigorous and robust”—after all, the entire deal team, including the lawyers, auditors, and bankers, missed the blatant fraud as well.

It is my belief that most of the black-and-white frauds that originated in China have been largely flushed from U.S. exchanges. The majority of the Chinese companies left behind, however, still have some issues with corporate ethics and governance. These issues are common to all emerging markets, but they are more pronounced in China.

A story told to me by a former senior executive of Camelot Information Systems, an NYSE-listed provider of IT services for China’s financial industry, shows that this degree of opacity and lack of corporate governance can be as destructive as outright fraud.

The executive found out, after the fact, that Camelot’s CEO had been using the company’s brokerage account, which was secured by its American Depository Receipts (ADRs), to fund his personal investments. When Muddy Waters’ reports triggered a collapse in investor confidence and in the prices of ADRs across the board, the CEO got a margin call from his broker and was forced to sell millions of shares to bring the account back up to the minimum margin. Camelot’s stock price plummeted. Today the stock trades between $1 and $2 per share, down 90 percent from its IPO price of $17 per share and 95 percent off its peak of nearly $27 per share.

The CEO kept the board and other members of the management team, including the CFO, entirely in the dark about his actions, and none of the loans from the company toward his personal investments were disclosed in the SEC filings as they should have been. After trying his best to explain and apologize to angry and confused investors, the CFO decided that he couldn’t work for a boss who had deliberately misled him and the company’s investors, and he resigned soon after. When even the CFO is kept in the dark about the company’s financial situation, investors have no way to know what they are getting involved in.

To a large degree, China’s weak corporate governance can be attributed to a lack of common values and moral standards. In the United States, education, religion, and social norms instill in most people some sense of ethical obligation and responsibility. Chinese business executives, on the other hand, seem to only respond to the prospect of punishment. And thanks to the structural loopholes, the U.S.-listed Chinese companies operating in two jurisdictions have little to fear in terms of reprisal. Corporate governance also has to be legislated and enforced by a strong, independent legislature and judiciary—neither of which is present in China. Securities litigation for Chinese capital markets did not even exist until 2001, when the Supreme People’s Court of China began developing a framework for investors to sue listed companies for losses incurred through financial fraud.
Today, the process
is still slow and cumbersome, and the court can be bribed. It is not uncommon for Chinese lawyers to work out a “revenue-sharing scheme” with the judge to secure a ruling in their favor. Chinese investors have filed more than 1,000 cases against 14 domestically listed companies, but most remain in legal limbo and are unlikely to be settled
in favor of investors
.

Fabricating financial reports has become a serious problem among Chinese companies. In addition to a business culture that has long tolerated corruption, the problem stems from weaknesses in the accounting profession and lack of independent media. Recently, the Chinese media has made more progress than before in exposing corporate fraud, often after being prompted by vocal, outraged local investors on social media. However, red envelopes containing kickbacks still too often influence reporters and editors. Chinese accountants, meanwhile, have little independence from management, and the industry as a whole suffers from a severe shortage of qualified auditors. A CFO friend once shared a stunning story she experienced when interviewing someone for a controller position in her firm. She asked the interviewee,
“In a situation where you disagree with your boss, what would you do?” The interviewee answered with no hesitation, “I’m very flexible. I’ll do the books however I’m told to.” In many Chinese companies, this attitude is a prerequisite for a job.

Another common corporate governance issue relates to the lack of independence among boards of directors. This has been a heated topic in corporate America as well: Some say Enron’s spectacular fraud resulted from the company being a one-man show under Ken Lay, in his dual role as CEO and chairman of the board. More recently, some blame J.P. Morgan’s $6 billion loss in the London Whale trading scandal on the (potentially too) powerful Jamie Dimon serving as both CEO and chairman of the board. This type of arrangement is common in China, where many companies in private sectors are young and inexperienced when it comes to governance and shareholders’ rights. Corporate boardrooms are supposed to protect shareholders by providing checks and balances on managers, but this safeguard is nearly absent from Chinese corporate boardrooms. In the end, it is usually the minority shareholders who suffer the consequences.

Corporate governance goes beyond the relationship between management and the board. It also includes the company’s relationships with customers, suppliers, and the community. Problems with this kind of corporate governance are common even among China’s biggest listed companies.

  *  *  *  

No discussion of U.S.-listed Chinese stocks would be complete without taking a close look at Chinese Internet plays, the most traded and volatile names on Nasdaq. Half the market capitalization of all U.S.-listed Chinese private issuers is concentrated among a few leading Internet names: Baidu (“the Chinese Google”), Youku (“the Chinese YouTube”), and Sina, a unique combination of Facebook and Twitter. But although these Chinese companies
are often compared to Google, YouTube and Twitter, their business ethics differ significantly from those of their American counterparts. They tend to be so aggressive in monetization—the process of converting user traffic on a website into revenues—that it ultimately compromises users’ experiences, driving them away to competitors and eventually undermining the companies’ own future success. As such, these stocks tend to be volatile and can make for risky investments. They often sink or rise by a few percentage points within one trading day, indicating a distinct lack of conviction among investors.

The largest Internet name by far is Baidu, which was one of 2005’s largest and hottest IPOs. Compared with Google’s more moderate first-day pop of 18 percent in 2004, Baidu’s stock soared 354 percent on its first day of trading, generating quick profits for investors like Knucklehedgie. Baidu had a market capitalization of $44 billion in July 2013, making it one of the largest Chinese ADRs.

Like Google, Baidu is a search engine based on keyword-matching algorithms. But Baidu is way “ahead” of Google in monetizing China’s more than 550 million Internet users by utilizing an opaque bidding process and reportedly ranking its results based on the advertisers’ bid price, rather than the relevancy of the information. China Central Television (CCTV), the country’s largest and most influential state-owned broadcaster, shed light on the company’s weak corporate governance in two major televised exposés in 2008 and 2011. In both instances, CCTV targeted unlicensed medical products, one of Baidu’s most lucrative ad revenue sources, and revealed step by step how the ads sneaked into search results.

Ads for medicines, supplements, and body care products were a fast-growing and highly profitable portion of Baidu’s business, accounting for an estimated 30 to 40 percent of its revenue. Drugs have become disproportionately expensive in China relative to average household incomes, and China is also an aging society
with a weak and underfunded healthcare system. A long supply chain connects manufacturers to hospitals, with kickbacks paid each step along the way, the cost of which is passed on, either entirely or partly, to patients who may not have medical insurance. The invasion of American fast food such as fried chicken, pizza, and Häagen-Dazs into the Chinese diet means the demand for certain medicines, such as diabetes drugs and weight-loss supplements, has skyrocketed, and the ever-worsening pollution also makes certain respiratory conditions like asthma more acute. All these factors make purchasing medicines online for lower prices a compelling option, as more Chinese now have Internet access.