“Journey to the West”: Tim Clissold on Corporate Governance of Chinese Firms
Based on Tim Clissold's lecture “Journey to the West: Root Causes of Corporate Governance Failure in Chinese Stocks”, 22 October 2018, Oxford
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Tim Clissold starts with a basic observation: the past decade has witnessed significant value destruction in China’s stock market. At the same time, he notes that there is significant misinformation about China in Western media. To address these problems, Clissold argues that we (in the West) should not try to demand China to change, but to make China intelligible to Western investors.
He argues that the value destruction of Chinese companies comes from two things: one is failure of Chinese managers, while the other is the failure of foreign investors to fully understand and appreciate the environment that these actors are operating. In Clissold's view, we actually have tools within our own systems to predict when a market failure will take place. This idea has driven a research project that Clissold is involved in, supported by Janus Henderson (an asset management group in London). The project draws on a number of objective indicators to understand aspects of Chinese corporate governance which allows these failures to take place and also to construct tools for investors to predict the risk of potential failure in the future.
The project, which is called "China Investing: Signals and Smokescreens", examines more than 60 Chinese companies that had endured periods of intense financial stress, such as a short attack. What short sellers want is the price of the stock to take a nosedive, so they usually attack by spreading bad rumours about the company. Clissold uses several high-profile failures in the corporate governance of Chinese domestic stocks as illustrations. For example, Muddy Waters, a short seller, produced a report on a Chinese steel company, declaring that the company had overstated its revenues in the US and its management had used tens of millions of dollars for personal use. The stock of the said company immediately collapsed after Muddy Waters' release of the report. In another case, a Chinese fishery company blamed ‘missing’ scallops for its loss of up to 114 million US dollars.
You can't make this stuff up.
Failures like these are pervasive. And these failures do matter for foreign investors. This is because China is internationalising. It has become more and more integrated with western financial systems. For example, the MSCI's Emerging Markets index includes 200 A-shares, shares of mainland China-based companies that are traded in the Shanghai Stock Exchange and the Shenzhen Stock Exchange. The London-Shanghai Connect will allow global investors more opportunities to buy stocks of Chinese companies through depositary receipts. There are also other activities taking place, such as the largest IPO in history by Alibaba. These developments are important for China. China’s stage of development, its relatively high levels of corporate debt and global ambitions mean that China needs capital from the world to fund its future growth.
Foreign investors have lost billions of money in this process. Clissold asks: "What can be done?"
One option is to lobby China, but Clissold thinks it is unreasonable to change the way that China operate. On the contrary, he suggests that we should develop tools to better understand the risks and corporate culture in China.
This leads to the research project with Janus Henderson. The project analysed publicly available information from companies that underwent periods of intense financial stress in recent years. Some of these companies failed while others survived. From this study, certain red flags emerged as indicators of potential risk; and also green flags that could indicate a certain robustness that enables a company to weather the storm.
The key factors identified in this research include:
- Financial ratios
- Board oversight
- Material transactions
- External oversight
- Variable interest entities
An important characteristic regarding Chinese companies is the role of the original founders in its operations. Due to the historical development of China’s economy (all private businesses were established in the last 25 years), these companies tend to be dominated by their founders, who are often highly entrepreneurial risk-takers. It is therefore useful for investors to consider the abovementioned factors to "get into the mind" of the Chinese CEOs.
Clissold argues that an investor should first test the internal consistency within the documents to identify potentially falsified information. For example, a Chinese chemicals company claimed in its financial report that its success was due to its significant spending on R&D. Turn another few pages in the same report, it says that the company actually spent 0.2% of its revenue on its R&D department, which had 100 people. If you do the math, each one of those 100 people would only receive a nominal wage. Such internal consistencies are warning signals.
Another approach that Clissold proposes is to evaluate external comparatives. For example, a metal company claimed that its monthly import is larger than the quota from the Chinese Ministry of Environmental Protection for the entire country for the whole year. In another case, a manufacturer of capital equipment for the production of photovoltaic cells claimed margins of 57%. Compared with other companies which produce such equipment, such margins are extremely unreasonable.
The second factor is board oversight, which is quite critical to whether a company survives or not. Quite often the boards of Chinese companies are composed of people with quite close relationships, including those deemed "independent directors". For example, in a tobacco company in Clissold's study, the chairwoman appointed her 21-year old son as an independent director. Other companies appointed “vase-directors”. In one particularly high-profile case of fraud by management of a company, one of the non-executive directors was fined by government authorities for his failure to intervene. The said director protested publicly that he should not be punished because he “knew nothing about the operation of the company” and “did not have the ability to understand the accounting sheets”.
Another example concerns “musical chairpersons”. One company, for instance, saw five chairpersons replaced within three years. There may also be impulsive behaviours on the part of CEOs. Clissold gives a few examples, such as a business that manufactured LED lighting that suddenly acquired a second-tier French football club. The underlying reason for the purchase, according to the chairperson of the LED lighting company, was that President Xi wanted to promote football in China.
Clissold points out that the presence of a diversified board is incredibly helpful for dealing with financial disturbances. One Chinese anti-virus software company suffered a sustained short attack, but eventually emerged from the ordeal with its stock price intact. The board consisted not only of the core controlling management team, but also highly experienced corporate veterans from a variety of business backgrounds.
The third indicator is related to material and related-party transactions. The first example concerns the "partial listing” of a company. One company that makes solar cells is actually part of a larger corporate group, and only part of the group is listed. Both buyers and sellers of the business of the listed company are controlled by the larger group. This could be ascertained from the Chairman’s Statement that "38% of our sales over the pat year were transactions to independent third parties”. By implication, the remaining 62% of sales were not.
Another question that an investor should ask is "who is doing the valuing?" In one case, a forest company's financial statements revealed that almost all of its previous three years’ profits had resulted from large revaluations of forestry assets rather than the revenue derived from the sale of timber. If you look at the valuer, you will find that it is a small company based in a small town of New Zealand, with no website.
The third example Clissold provides is about potential “personal gains”. Here, he spoke about a series of discounted equity placements made by a Hong Kong-quoted company to outside companies owned by its chairman.
The final example is about mutual shareholdings, where two companies own each other’s stocks. Such arrangements can create opportunities for various forms of market manipulation, including more subtle forms.
The fourth indicator is external oversight. The credential of auditors can be a problem. For example, one Chinese company hired an auditor in Florida that only had six employees and no capabilities in China. In another case, a company had a revenue of 130 million dollars while its audit fee was only 16,500 dollars. In another example, a company had fired the external auditors half way through the audit because they had asked to see the bank statements, a request that was deemed to be “overly broad”. The last example concerned the collusion of major counterparties, namely, the banks/financiers colluded with the firm's management to provide fake confirmation letters to the auditors.
The last issue Clissold addressed in his lecture was about variable interest entities (VIEs). Chinese Internet companies, for example, construct VIEs to circumvent certain regulations (for example, prohibitions against foreign equity ownership in certain industries in China). Section 52 of Chinese Contract Law would render contracts that breach mandatory laws and regulations of the state void. Yet, these VIE arrangements, the legality of which is currently in a grey-zone, allow Chinese companies to get access to foreign capital without violating the law. Nevertheless, as Clissold points out, these VIEs suffer from considerable imperfections.
To conclude, Clissold argues that there are no completely un-flagged failures and that we can use our existing techniques to analyse complicated systems and to mitigate their risks in China. This is also an important learning opportunity for anybody interested in China.