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 — 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 — 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.