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:
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.
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.
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, Sina, and AliBaba 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
Anyone can perform this three factor analysis of a U.S listed
Chinese company in about 30 minutes and ten minutes is usually
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
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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In a criminal trial the charge is the foundation of the accusation & every care must be taken to see that it is not only properly framed but evidence is only tampered with respect to matters put in the charge and not the other matters.
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