What went wrong?:
- Same bed different Dreams. In early 2011, U.S.-listed shares in several Chinese companies started falling on reports of financial fraud, especially firms like ChinaCast which legally dodged U.S. disclosure rules by listing through reverse mergers. U.S. investors thought the company's performance in the face of this falling share price signaled it was time for ChinaCast to launch a share buyback. Investors were then pleased when Chen announced a plan to repurchase US$ 50 million worth of common shares over 12 months. Shareholders waited for the buyback to begin, but nothing happened. Frustration ensued and soon the two sides were fighting. Chen was offered but refused two years compensation in exchange for a voluntary resignation. Chen was then removed by the seven-member board, four of whom backed Sherwood, and replaced Chen with Feng.
- In 2011, American shareholders, the 10 largest of which controlled 55% after the listing, initiated a shakeup of the company's management, ousting then CEO and chairman Hong Konger Chen ZiAng. Derek Feng Yiyi was installed as the new chairman.
- In February 2012, Deloitte attempts to check the books at the company's Shanghai office were blocked by the company's employees.
- In the weeks prior to Derek Feng's appointment as Chen's replacement as Chairman in March 2012, Chen looted the company before shareholders or the Board could do anything to stop him.
- In December 2012, ChinaCast announced all quarterly and annual financial statements from the beginning of 2009 to the end of September 2011 could not be trusted - despite being audited by a Big 4 firm. The announcement also revealed other problems at the firm, including loss of control of equity in subsidiaries and a great amount of assets that did not exist.
What was Chen able to do:
- Several hundred million yuan was transferred from company accounts without the approval of the board of directors.
- In September 2011, ChinaCast subsidiaries Shuangwei Co. and Yupei Co. each had 100 million yuan in Shanghai's Bund Branch of Huaxia Bank. The money was used as collateral in September 2011, for loans issued to three other companies unrelated to ChinaCast.
- Company's business license vanished.
- Company's registration seals vanished.
- Company's computer records vanished.
- Company's paper files and accounting were shredded.
- Loss of control of equity in key subsidiaries. Ownership of ChinaCast's colleges – Hubei Polytechnic University School of Business, Guangxi Normal University Lijiang College, and Chongqing Normal University's College of Foreign Trade and Business – had been transferred to several people including a former company president Jiang Xiangyuan without board approval.
- Large amount of assets did not actually exist despite being audited by Big 4 firm.
Ned Sherwood, who held 800,000 shares, was the leader of the management reorganization. He says he never authorized the asset transfers and was later stunned by the financial maneuvering that eventually hollowed out the company. No disrespect intended, but I am guessing he is not very experienced at doing business in China. If he was, he would have known a foreigner cannot make any changes to the leadership of a Chinese company without having many trusted people physically on the ground and in key positions such as holding the company chops, controlling bank accounts and having authorized bank signatories, the heads of HR and finance.
Sherwood said he conducted due diligence before buying ChinaCast stock on the Nasdaq exchange. Really.
Due Diligence should be 'Do' Diligence and not just rolling the dice:
- ChinaCast's former president Jiang Xiangyuan, who was also removed in the shakeup and, according to records obtained by Caixin, may have played a role in the disappearance of funds. A probe by Feng's management team found Jiang had been convicted in 2001 by the Shanghai Hongkou District Court for misappropriating public funds and given an 18-month suspended sentence. Jiang's conviction had gone undetected during due diligence long before ChinaCast crumbled.
The key lesson for investors is due diligence can do very little when the shell is in the U.S. and the business is in China. Overseas investors and regulatory agencies will always be at a disadvantage trying to understand what really goes on on the ground in China, or any market for that matter.
- "Shareholders of Looted Firm Sue Auditor in NY Court", Caixin Online, February 20, 2013.
- "Hard Lesson for China-Concept Stock Investors" Caixin Online, May 16, 2012.
CKB Solutions is all about real solutions for the real world. To learn how we can help your business, contact Greg Kovacic in Hong Kong.