I often receive calls from U.S. investors in Chinese companies listed on the U.S. stock exchanges. The investors are concerned with questions about the value of their investment and they want me to assist them in analyzing the legal status of the Chinese entity. My 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, then there is no value in China to protect and further analysis of the company is a waste of time.
I have done this research so many times that I have developed a three step test to determine whether a Chinese company is a fraud. I take a 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 is very low and legitimate Chinese companies do not usually keeps large amounts of their cash in interest bearing bank accounts.
Usually the supposed large cash account is accompanied by bogus explanations explaining why the Chinese entity is unable to repatriate the funds to its investors as dividends. Later investigation usually reveals that these funds were never actually deposited in the bank. That is, these large deposit accounts are simply falsified. The odd thing is that auditors will normally verify that the accounts are real. Once the fraud has been exposed, I have asked auditors what they did to verify the account. They usually state that 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 that 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 very 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.
It is certain that Chinese companies located in rural Fujian, Shaansi or Heilongjiang do not generate margins at this level. These high margins are then the explanation for why the company has so much free cash; they are so profitable they are printing money. The claim is that they have some unique product or some technical monopoly. In my experience, these claims are never true, as just a few minutes of careful thought would reveal.
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, and Sina are organized as VIEs.
But most Chinese business sectors are open to foreign investment. When a company that operates in manufacturing or retail sales chooses to organize as a VIE, there is typically only one reason: the organizers are planning to commit fraud against the 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 China lawyers are usually contacted by investors long after this analysis should have been conducted. We are usually called on when the investors begin realizing that something is wrong and the Chinese company has ceased even to pretend and is now no longer returning investor calls. Don’t let this happen to you. If a Chinese company fails to meet the above three factor test, your answer is clear: don’t invest.