Connected dealings and other sinkholes

The typical listed company is a well-oiled funding machine: it can borrow from banks, it can sell shares, it can issue bonds, it can seek advances from suppliers, and so on. Usually there are only a handful of people at the top who control such funding levers and have much of a clue about what is going on.

In the eyes of the unscrupulous, the listed company is a giant piggy bank: it can raise vast amounts of capital and, because its internal workings are so complex, this cash can be easily, and covertly, redirected to inside parties.

And the absolutely No 1 preferred way of achieving this is via connected transactions, or dealings by controlling shareholders and top-level management with listed firms.

This kind of governance abuse is common. It is a highly effectively means of stripping cash from listed entities. It is easy to implement and easy to conceal, and the main parties who are supposed to watch out for such malfeasance (auditors and independent directors) are poorly equipped and poorly motivated to do the job.

Real Gold failed to promptly disclose or obtain independent shareholder approvals when it used its assets to support the loans of its controlling shareholder, and lent money to and bought assets from him.

Connected transactions could also be disguised by using seemingly unrelated companies as intermediaries.

While such transactions are usually disclosed as required, they are governed by different provisions of the listing rules under which the thresholds for shareholder approvals are higher than those for connected transactions, and connected shareholders are allowed to vote on the transactions to which they appear to be not connected.

For instance, Ho Chin-hou - the former chairman and executive director of Extrawell Pharmaceutical, a company listed in Hong Kong - used Smart Ascent Limited (SAL), which was controlled by him and equally owned by his son-in-law and daughter-in-law, to buy a 51 per cent stake in Fosse Bio-Engineering Development (FBE) for about HK$39 million in early 2001.

A 51 per cent interest in SAL was then sold for around HK$73 million in March 2004 to Extrawell Pharmaceutical, which was not told of Ho's connection with SAL. Ho was sentenced to two years' imprisonment (suspended for two years) in July 2009 for his role in this transaction.

Concealed connected transactions are usually very difficult to detect, but there are several warning signs that investors should look out for.

Companies making acquisitions or purchases of goods and services from obscure offshore companies that do not seem to make sense (either in terms of size, frequency, rationale or pricing) bear scrutiny. Such companies will typically also need to raise funds regularly as their cash reserves dry up.

For companies that do not disclose such transactions, the decrease in cash may show up as an unexplained increase in other assets. Fictitious cash balances may be created to cover up the transactions. Therefore, investors ought to beware when a company raises funds despite purporting to have lots of cash. Warren Buffett once said price is what you pay, value is what you get. As such, connected persons, like any other investors, will buy more shares when they believe their companies are undervalued. Indeed, during the recent market meltdowns, the controlling shareholders of many of Hong Kong's largest companies were busily mopping up their shares, which was a sign of confidence in their companies.

On the other hand, if a controlling shareholder has been steadily cutting his stake, whether by way of selling shares or being diluted through the company issuing new shares, it might indicate that something is amiss (although it could also mean that markets are running ahead of fundamentals or that the controlling shareholder has financing issues).

Independent non-executive directors are usually appointed because they know the directors or controlling shareholders of the company. As management controls the flow of information to the board, these independent directors are often unaware of any wrongdoings in which management or the controlling shareholder is involved until the news breaks.

As such, in the rare circumstances when they feel uncomfortable enough to resign on their own accord despite their ties with the controlling shareholders and limited involvement with the company, something might really be brewing.

Auditors are appointed and paid by management. When they do come across something suspicious, unless the wrongdoings are very clear cut (in which case they are obliged to report to the relevant authorities), they usually try to resolve the issues with management. In light of the very tough competition in the industry, auditors are loath to resign and give up their fees unless they are dealing with very serious issues with implied reputational risks.

Resignations of key professional managers could be another indicator. As mere employees, they have less to gain and more to lose if something blows up. Association with a major scandal could sink their careers.

Altogether, this is a lot to track. But if you think this task is too troublesome, perhaps you should just stick to Hong Kong blue chips.

Khor Un Hun is a former investment banker with extensive experience in advising on mergers and acquisitions and fund-raising in Asia