Because of my law firm’s reputation for conducting due diligence on foreign companies, we get a ton of calls from investors in Chinese companies listed on U.S. stock exchanges. The investors are concerned with the value of their investment and they want us to assist them in analyzing the legal status of the Chinese entity. Our initial response is that the first step is to determine whether or not the Chinese entity is an empty shell. If the Chinese entity is an empty shell, there is no value in China to protect and further analysis of the company is a waste of time.
Our lawyers have done this research so many times that we have developed a three step test to determine whether a publicly traded Chinese company is a fraud. We first look at the annual or quarterly report of the Chinese company and if it meets these three tests, it is virtually certain to be a complete fraud, with no operations, no assets and no funds in the bank.
The three indicia of fraud are as follows:
1. The company has a large amount of cash in the bank. I often see supposed cash holdings greater than 50% of the company’s annual gross revenues. Interest rates at Chinese banks are very low and legitimate Chinese companies do not usually keep large amounts of cash in interest bearing bank accounts. Usually the supposed large cash account is accompanied by bogus explanations as to why the Chinese entity is unable to repatriate the funds to its investors as dividends. Later investigation usually reveals these funds were never actually deposited in the bank even though auditors will verify the accounts are real. Once the fraud has been exposed, I have asked auditors what they did to verify the account and they usually say they relied on reports from the management of the company. In China, the only way to verify the authenticity of a bank account is to arrive at the bank unannounced and look at the computer screen while standing BEHIND the counter as the clerk makes an unplanned query. Virtually no bank in China will allow this, which means audit verifications of Chinese bank accounts are typically of no value.
2. The company reports profit margins in excess of 30%. I often see fake companies report profit margins of 50%. China is a difficult country in which to do business and I have never seen a legitimate Chinese company with profit margins even approaching this level, not even state owned monopoly companies and there is just no way a Chinese company in rural Fujian, Shaansi or Heilongjiang is generating these margins. These high margins are then used to explain why the company has so much free cash; they are so profitable they are printing money. They will claim they have some unique product or some technical monopoly. In our experience, these claims are almost never true.
3. The company is formed as a VIE (variable interest entity) when it is operating in a business sector where foreign investment is not restricted and the VIE structure is not required. A VIE is required only when a foreign invested company intends to operate in a restricted sector such as the Internet. This is why Baidu, Sina, and AliBaba are organized as VIEs. But most Chinese business sectors are open to foreign investment. When a company operating in manufacturing or retail sales chooses to organize as a VIE, they typically do so for one reason: their organizers are planning to commit fraud against foreign investors.
Anyone can perform this three factor analysis of a U.S listed Chinese company in about 30 minutes and ten minutes is usually enough.
Unfortunately, our due diligence lawyers are usually contacted by investors long after this analysis should have been conducted. We are usually called on when the investors begin realizing something is wrong. Don’t let this happen to you. If a Chinese company fails to meet the above three-factor test, don’t invest.