Beware Investing in China
Posted by Douglas Lawson on 26/Jun/2015
It's all Wong
"Chop" is a word that I have had little use for until recently. Since entering my lexicon around 12 months ago I have been using it with increasing frequency. In China, "chop" refers to a physical device, containing a company's seal, that is used to transact official business. Each chop must be approved by the Public Security Bureau (a Government office that acts as the provincial police) and a company may have various chops for different purposes, for example opening bank accounts, authorising invoices and paying suppliers. In the UK the signature of a legal representative of a company is normally legally binding but not in China. In China, it is possession of the chops that matter. I was to find this out the hard way.
I first heard of Sorbic International plc ("Sorbic") in May 2010 when John McLean, the Chairman, came into our office in Edinburgh. We knew John through an investment in China Food Company plc, a manufacturer of animal feeds, soya sauce and other condiments. Five years ago, the UK, like much of the western world, was in the depths of the biggest recession since the Great Depression of the 1930s and the prognosis was bleak. On the contrary, China was continuing its breakneck rate of growth and overtaking Japan as the world's second largest economy. Consumer spending was soaring and Sorbic offered us a means of exposing our funds to this trend. Sorbic's business is the manufacture of sorbates, namely sorbic acid and potassium sorbate which are used as food preservatives. Sorbic had listed on AIM in September 2008, raising £6 million through Finncap, the small cap London broker. Sorbic operated through a wholly-owned subsidiary called Linyi Van Science and Technique Company Limited ("LVST"), based in Linyi, Shangdong Province.
Increasing demand for sorbates led the company to look for a new factory site where new capacity could be installed. This search led to Ulanqab in Inner Mongolia, over 1,000 miles from Linyi, where LVST would have better access to export markets and could take advantage of cheap land and financial incentives to build a factory that would double the existing capacity and feed burgeoning global demand. This new factory would be funded by the combination of a loan from Mr Wang Yan Ting ("Wang", pronounced 'Wong'), the CEO of Sorbic and founder of LVST, and a £3.5m placing of convertible loan notes (the "Loan Note(s)"). The Loan Notes would pay a coupon of 10% and would convert (at the option of the Loan Note holder) at 32p, a modest premium to the share price at the time. As an investor, this opportunity ticked lots of boxes. Here was a chance to access the fast growing, Far Eastern consumer economy in a protected instrument that was secured on hard assets and paid a generous coupon. What's more, if Sorbic delivered on its plans, we could convert into equity and benefit from capital upside. If not, we would be repaid at maturity by a company with solid fundamentals - in 2010, Sorbic reported EBITDA in excess of £1 million after sales growth of 10%. With the only constraint on growth (apparently) capital, profits and operating cashflows looked set for very strong progess and the covenant looked strong. We completed our Loan Note investment on 25 August 2010. What wasn't to like?
Quite a lot, as it turns out. But not initially. Initially, everything was very encouraging. In February 2011, Sorbic announced to the market that the new factory building in Inner Mongolia was "largely complete and construction remains on track in terms of timeline". Then, in September 2011, Sorbic announced the completion of construction work and expected commissioning of production in November 2011. The market could barely contain its excitement and the shares, which had steadily declined since the convertible issue in May 2010, soared from 10p to 22p. However, the first signs that all was not well came in December 2011 when Sorbic quietly announced, in its preliminary results to September 2011, that the targeted production date was being extended to spring 2012. An equity placing followed shortly afterwards. The warning signs were, admittedly, already there. Why was a company that had just reported £3.5 million of cash raising equity? The new factory was supposed to be fully funded through the original Loan Note raise in which we participated in May 2010 and LVST, the operating company, was profitable and generating cash.
Then the first bombshell. Just as production was about to begin in March 2012, LVST received official notification from the Ulanqab, Inner Mongolia local authority that the industrial zone in which the new facility was situated has been identified as an area that may be rezoned as a city zone for urban planning. What did this actually mean? We had to wait until June to find out but the upshot was that LVST was forced to cease the final stages of construction and move elsewhere. In short, despite the factory being substantially complete, and a significant investment of capital and resource having been invested by Sorbic/LVST in the project, the local authority simply knocked on the door and said: "find somewhere else to operate". Could they really do this? Apparently, yes.
Whilst this was a set-back, surely Sorbic/LVST would be compensated for loss, not just of capital in terms of the infrastructure that had been built and would have to be abandoned, but also the business disruption, quantifiable as loss of profits? Sorbic announced the signing of a compensation agreement totalling £5 million. Shortly afterwards, this compensation agreement, where part of the deal was a new site in Inner Mongolia, was "put on hold" as Sorbic explored an alternative option for new capacity close to the existing facility in Linyi. Sorbic had decided that, after all, Inner Mongolia was not the best location for a new factory and that, actually, the best place was next door to the existing factory in Linyi. This struck us as an enormous waste of capital and resources.
Meanwhile Sorbic had announced its results for the year to 30 September 2012. Revenue was up 14% but, due to margin pressure, this translated into little more than a breakeven result at operating profit level. After a similar result the previous year, the investment was not panning out as we had hoped but, never mind, we were earning a 10% coupon, Sorbic had £4.1m of cash and the loan matured in February 2013.
However, these same results warned that "due to the difficulties in transferring funds out of China, it is unlikely that the Company (Sorbic International plc) will be able to make the interest payment on the December loan stock". Our probings of this issue were batted away by the company. The cash was all in China, in bank accounts in the name of LVST. But Sorbic owns 100% of LVST so it does not matter if the cash is at 'topco' or 'opco' level, does it? Apparently it did - Sorbic was blaming insurmountable regulatory and bureaucratic hurdles that were prohibiting fund flows out of China. The redemption date on our loan came and went and we had little choice but to renegotiate the terms and extend the maturity date out from February 2013 to 31 August 2014 with interest now rolling up.
Over the next year (2013) trading improved and Sorbic's cash balance grew. Negotiations with the Inner Mongolian government also continued and Sorbic eventually plucked up the courage to tell them that they did not wish to relocate within Inner Mongolia and instead would expand capacity locally in Linyi City. An impairment provision of £6.7 million of the £9.1 million total investment in Inner Mongolia was made. The results were peppered with platitudes such as: "the Board is keen to act in the best interests of shareholders" (very kind of them) and "the compensation agreement will be fair and reasonable to both parties". We are now over two years further down the road from the original order to cease manufacturing of the new plant in Inner Mongolia and not one renminbi in compensation has been paid by the Inner Mongolian government. Will it ever arrive? I am not holding my breath.
We decided to appoint Jay Newman, an experienced Far Eastern investor, fluent in Chinese, to the board of Sorbic to find out exactly what was going on. His results were enlightening and depressing in equal measure and we now had an ally who could speak the native language and help us to decipher what was really going on.
In an update to the market on 25 February 2014, Sorbic announced that: "results are significantly ahead of the same period last year, as well as management expectations". Furthermore, encouraging noises were made about the construction of a new facility at Linyi, which would be funded by the local authorities, as well as existing cash resources, whilst the Inner Mongolia compensation negotiations were recommencing (nearly a year after they had started).
When the interim results were released on 23 June 2014, the company reported consolidated cash balances of £6.6 million at 31 March 2014. All this cash remained 'locked' in China. Also, discussions to expand Linyi had slowed and Inner Mongolia compensation looked set to remain outstanding until "an internal rearrangement of responsibilities" had completed. What this meant was that the board was now trying to oust Wang, the CEO and Legal Representative of LVST, the operating company. This was the first time that the market had been told that Wang was the impediment to allowing funds out of LVST to flow up to Sorbic in order to repay the overdue loan notes. Blaming 'the Chinese system' had been a smoke-screen. Thus, despite all this cash in LVST, the operating company, another equity raise into Sorbic was necessary. These funds would finance Sorbic until Wang could be replaced as the legal representative.
There was another surprise in these results. Wang had misrepresented a 'loan' that he had purported to have made to LVST for the purchase of land for the new factory in Inner Mongolia. Following a meeting between the Inner Mongolian authorities and John McLean, it became apparent that the land was 'given' to LVST for a nominal sum, in line with the industrial zone policy which provided grants for the full amount to cover the purchase. This was the first tangible evidence of the type of person we were dealing with. Wang was claiming to have paid for a tranche of land that had in fact been given to LVST for free! He was holding himself out as a creditor of the company, claiming that he was entitled to be reimbursed for a £1.65 million purchase he had made on behalf of LVST. I am no legal expert, but this strikes me as theft and why this was not adequate justification for his arrest and interrogation by police is strange. However, at the very least, it was fortunate that this crime had been indentified and the board could now make the necessary steps for his removal, take control of the business and put in place the process of transferring cash to the UK to repay loan note holders. Easy.
We gave Sorbic some more leeway by extending the redemption date again to 31 December 2014. The quid pro quo was a redemption premium of 10% if the loan was redeemed prior to 31 October 2014, ratcheting to 20% if redeemed thereafter. Then an olive branch. In an announcement on 10 November 2014, we were told that Wang had agreed for the LVST's funds to be used for the repayment of the Loan Stock and discussions were taking place to initiate the process. Following this outcome, the board decided to defer the proposed legal representation changes. We should have known better........
Sorbic was propped up by another small fundraising. The preliminary results to 30 September 2014 were released on 19 January 2015. Revenues were down and Sorbic made a loss, however, cash balances were higher than ever at £6.9 million. A new framework agreement for Inner Mongolian compensation had been agreed "to cover sufficient carrying costs", which were disclosed as £2.5 million. There was no mention of business disruption compensation and this offer was a 50% haircut to the previously agreed £5 million. However, the new site at Linyi would be paid for by the local authorities through the substitution of the old plant for a new one so 'net net' we would be no worse off. The timing for the conclusion of negotiations of Linyi and the start of building was scheduled for the first half of 2015. We were also informed that the necessary actions to redeem the outstanding loan stock were being put in place. eCFO, a business consultancy based in China with experience of these issues, were appointed to advise and implement the funds transfer.
Sorbic then went silent on the newswires. Wang was clearly not cooperating. Behind the scenes plans were being put in place to restart the process of removing Wang as Legal Representative. On 22 April, this became a fait accompli, with Wang removed from office as a board director of Sorbic and as legal representative of LVST. A new legal representative of LVST was installed - Mr Cai Lun, the managing partner of Guolan, a Beijing law firm. The remaining two directors of LVST were also replaced with Jay Boyle and Matt Winter, directors of eCFO, the company's advisers. This had to be great news. My Wang, the impediment to the repayment of outstanding loan stock due to us and others, had been removed. Again, we should have known better. Wang was not going without a fight. He removed the cash from LVST's bank accounts and declined to hand over the chops, which he had removed from the premises before he was dismissed. Surely this is illegal. Apparently not. The police were called but decided that Mr Wang's non-cooperation was a "commercial matter". This conclusion seemed astonishing to us. A minority shareholder who had created a fictitious loan, removed over £7 million of cash from the LVST's known bank accounts, refused to pay creditors, and removed the chops and company seals from the premises and refused to disclose their whereabouts was not deemed to be acting illegally! Furthermore, he was still on the premises running the company!
The nub of the issues appears to be this - the most obvious crime to Western observers is the removal of the cash from the LVST bank accounts that are known to the board. The cash may have been transferred into a personal account of Wang (clearly illegal) or into a new account in LVST's name known only to Wang (legal). Can he not be forced to disclose the location of the cash? Apparently not. What about the bank? Must the bank not disclose to the new Legal Representative of LVST, with the authority of the new LVST board, the details of the cash transfers? Apparently not. The bank feels restricted in what it can disclose to the new legal representative because it is not convinced the legal representative has been changed because the new legal representative cannot provide the chops and company seals as evidence of his status! In other words, it does not matter who owns the company. It does not matter who runs the company. It does not matter what legal documents say. All that matters is who holds the chops. Whoever holds the chops calls the shots.
This is a painful lesson for us but puts into context Chinese valuations. It may look cheap, it may be profitable, it may have cash, but if a lunatic, a crook, a fraudster (or a combination of the three) alone holds the chops, it is probably worth nothing.
D Lawson May 2015