china's square peg vs. the west's round hole - wsj

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BUSINESS ASIA JUNE 23, 2011

China's Square Peg vs. The West's RoundHoleThe skills that make for corporate success in China lead to problems whencompanies list abroad.

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By JO SEPH STERNBERG

The uproar over alleged frauds at Chinese companies listed in the West is entering a new

stage as accounting problems mount, higher-profile listings come under suspicion, and bigger-

name investors turn out to have been hit. This is part of a pattern: First China shipped tainted

pet food overseas, then contaminated toys. Now it turns out China also exported toxic listings.

It's an apt comparison. Investors, regulators and commentators so far have focused on the

simple fraud aspect of many of these stories: forged bank statements, falsified inventories,

faked forests and factories. The food- and product-safety scandals likewise featured a heavy

dose of old-fashioned deceit.

But as with those earlier scandals, there's also a structural element to the stock fracas.

Dangerous goods made it to market because China lackedand still doesthe systemic

protections consumers in the West enjoy, from effective regulation to brand identity to a legal

system that metes out damages when problems slip through the cracks. Structural

characteristics of the Chinese economy also lurk beneath the surface of many alleged stock

frauds.

Consider the case of Sino-Forest Corporation. The Toronto-listed shares first came under

attack from short-sellers earlier this month with publication of a report from Hong Kong-based

Muddy Waters Research highlighting what it claimed were serious flaws with the company's

accounting. Many of the company's revenues flow through so-called authorized intermediaries,

companies whose relationships with Sino-Forest are at present poorly understood.

Also poorly understood, and more poorly documented, is Sino-Forest's ownership of its forest

assets. Muddy Waters says such "unnecessary"Muddy Waters' wordcomplexity has been

a cover for fraud. The company says it's all perfectly legitimate.

They could both be right. The real purpose of these intermediaries appears to have been to

make tax payments on behalf of Sino-Forest. Muddy Waters is correct that such an

arrangement in a Western company would raise eyebrows. Not so in China, where executives

face a bewildering array of ever-shifting local, regional and national tax burdens in what a

Deloitte survey found to be Asia's most complex tax system.

The most efficient way to manage tax

liabilities in such a regimesimply to gain

some level of predictabilityis to build a

web of related companies among which

money can be moved in ways to minimize

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the tax burden. Along with this strategy

come a variety of tricks of variable legality,

including under- or over-invoicing and

potentially dodgy accounting for inventories

and the like.

This would count as tax dodging in the

West, where rates and enforcement are predictable. In China it's a survival instinct. This

illustrates the broader point that the skills necessary to stay afloat in the regulatory quicksands

of China's not-nearly-a-market economy are not conducive to satisfying the nit-pickiness of

Western investors.

So too with the other uses of complexity and opacity. Such as self-protection for individual

entrepreneurs, especially at a time when Beijing seems increasingly willing to jail businessmen

who grow a little too successful. Consider Huang Guangyu, founder of Gome Electrical

Appliances Holdings, a well-known retailer. Mr. Huang disappeared for months in late 2009

before surfacing in a jail cell in May 2010, whereupon he was promptly convicted for

supposed white-collar crimes related to another of his companies and sentenced to 14 years.

Gome's corporate complexity allowed Mr. Huang to hold onto his company in the face of this

onslaught. He had wisely vested ownership of one-third of the company's stores, plus

intellectual property such as a well-known former logo, in a company distinct from Gome's

listed unit. Thus, when management and a foreign private-equity firm tried to exploit his legal

troubles to pull the listed Gome out from under him, he had some leverage.

Mr. Huang managed to keep a couple of his proxies on the listed company's board. In the

West it would be absurd to think this was a good outcome. But in the West, a conviction is a

somewhat more reliable indication that wrongdoing occurred. And when you can't trust thefairness of the legal system either in criminal or corporate matters and always sit beneath the

Damocles sword of a corrupt and rapacious state, it pays to be prepared.

All of which offers some perspective on the current spate of scandals. The Chinese corporate

structure can leaves plenty of scope to defraud investorshaving set up a system to deceive

regulators, why not deceive shareholders, too? The bigger problem, though, is that otherwise

legitimate companies often have to resort to such tactics, too.

Some argue that transparency is a Chinese company's best defense to the onslaught of

Western short sellers. Good luck with that when transparency abroad risks corporate suicide

at home. Chinese companies need to improve corporate governance to win and keep the

confidence of Western investors. They won't be able to do it until they operate in an

environment that won't punish them for good behavior. And until China's economy rewards

"good" behavior, the wisdom of listing on stock exchanges designed for Western-stylecompanies will be open to question.

Mr. Sternberg edits the Business Asia column.

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