A wake-up call for corporate China

PUBLISHED : Friday, 02 April, 2004, 12:00am
UPDATED : Friday, 02 April, 2004, 12:00am

If life is not as it used to be for former executives of Martha Stewart, Tyco and Worldcom, so China Life Insurance, too, is in deep trouble. China's biggest insurance company is facing a class-action lawsuit in New York for financial fraud. The plaintiffs are a group of US investors who allege that, according to a Chinese government audit report released in February, the company engaged in a series of illegal, fraudulent practices to artificially inflate its revenue and earnings, and misappropriated US$654 million of company resources.

The lawsuit claims that it failed to disclose this fraud in its initial public offering in December on the New York Stock Exchange, thereby causing financial losses to the class-action members. Considering that the company hit the headlines with last year's biggest IPO - US$3.5 billion - the proceedings are a blow to China's efforts to tap overseas capital to fuel its rapid economic growth.

However, the scandal is really nothing new to Chinese firms which operate or raise capital in the United States, the world's financial centre. In 2002, the Bank of China's New York branch had to pay US$10 million in penalties to the US Treasury Department over shady loan practices. Last year, it paid another US$5.25 million to settle a civil lawsuit that charged the bank with underwriting illegal transactions aimed at tax evasion.

Last month,, a Chinese internet stock listed on Nasdaq, received a notice from the Securities and Exchange Commission, saying that it was considering civil enforcement proceedings for possible violations of federal security laws. The company had restated its 2000 revenue, from US$7.9 million to US$3.7 million. Trading of shares was suspended for four months from September 4, 2001. In addition, US$4.35 million was paid to settle a class-action lawsuit by US investors.

These scandals once again bring to international attention the risks associated with widespread corporate fraud in China. One incident reported in the China Life audit involved a subsidiary firm that borrowed four million yuan from a local savings institution, then recorded the money as premium income in its books before returning the loan two days later, and paying the lender 100,000 yuan for the favour. Such flagrant violations of rules and regulations not only give the perpetrators a false clean bill of health, they also aggravate the threat to the stability of China's financial system as a whole, not to mention cheating a few investors in the process.

This also highlights the incompetence of China's domestic regulatory watchdogs and raise questions about the government's credibility, because the offending companies are either state-owned, or showcases of China's economic achievements. Yet, the government has merely removed a chief executive or imprisoned a president. No fines have been imposed and there is no sign of a better corporate governance mechanism.

Foreign investors are not as willing to suffer in silence. If the past record is a guide, China Life will have a tough time ahead. Although the company has said that all the irregularities occurred before it was reorganised last June - that is, prior to its IPO in New York and Hong Kong - and that it will pursue its defence vigorously, there is no escaping the embarrassment that two-thirds of its management were in place throughout the periods of alleged fraud. Besides, the lawsuit is represented by Milberg Weiss, which specialises in securities litigation. One of its most recent successes was a negotiated settlement of US$517 million on behalf of investors with Lucent Technologies. The complaint was also falsification of accounts.

Elsewhere, China also paid a price for its less-than-admirable record. Two Chinese companies have already been delisted in Singapore's stock exchange for failing to meet the disclosure requirements. To Chinese firms that look outward for capital, these lessons are the dues they must pay before they fully learn to obey the rules of the game - so different from what they are used to on the mainland. The overseas securities laws and accounting principles are both more transparent and strictly enforced. Penalties and fines are swift and steady, unlike the paper tigers that pretend to police the corporate behaviour in China. If any of the 40-odd Chinese companies that are listed on the US stock exchanges really plans to avoid legal trouble, it had better shed the state-owned enterprise mentality of 'my government never gives me more than a slap on the wrist and then a kiss on the cheek'. Foreign laws bite.

It is understandable that overseas investors would want to ride one of the world's fastest-growing economies. But to some, the credibility risks far outweigh the potential rewards, especially when China's judiciary system fails to inspire much confidence. As a safer alternative, more people, fund managers in particular, choose to invest in Chinese companies listed on overseas stock markets. These firms, at least, are subject to a degree of regulation and overseeing which leaves investors feeling comfortable.

The outcome of the China Life case is, thus, doubly significant. The market is watching with great interest. In the long run, improved compliance with the law serves China's interests, too. If a company is seen to get away with fraud, the market will lose confidence and will dump China en masse.

Li Yong-yan is a China business analyst