Caveat emptor: China Commission’s Robinson cautions investors on Chinese stock and bond offerings

(Washington, D.C.): The front page of todays Wall Street Journal, features a lengthy, above-the-fold expos of the initial public offering by China Life, a state-owned insurance company, that last December raised some $3.5 billion on the New York Stock Exchange. Only thereafter was it disclosed that the China National Audit Office had been poring over China Lifes books for much of 2003. It turns out that the auditors had detected numerous accounting irregularities and violations of law, including fraudulent handling of some policies.

Not surprisingly, in the wake of these revelations, the stock price fell significantly as American and other unwitting international investors who had hugely oversubscribed this IPO finally learned the truth about these “widespread irregularities.”

Unfortunately, China Life is hardly the only example of financially challenged state-owned Chinese enterprises that are restructured and supposedly “scrubbed” of liabilities and problems in order to attract billions of dollars on U.S. exchanges for a Chinese government that relinquishes none of its control of these enterprises to outside shareholders. The Journal quoted, the Chairman of the U.S.-China Economic and Security Review Commission, Roger W. Robinson, Jr. as saying: “In the post-Enron era, these black boxes are becoming a real concern. As corporate governance gains prominence, Chinese issues will receive more scrutiny.”

The U.S.-China Commission will be addressing the governance-, financial- and security-related risks associated with Chinas rapidly growing presence in the U.S. capital markets in its upcoming annual report to the Congress, presently scheduled for release on 10 June 2004.

When China Life Insurance Co. listed shares on the New York Stock Exchange last December, it boasted of its “leading market position” and “high growth opportunities.”

It didn’t mention that the Chinese government’s powerful audit arm was poring over its books. And in mid-January, when the auditors delivered to China Life’s parent a draft report detailing widespread irregularities, China Life told the public nothing. It first acknowledged that something was up on Feb. 3, the day after the auditors announced some of their findings. By that time the stock price already had been dropping. Now regulators in the U.S. and Hong Kong are investigating.

China Life’s debut as a public company presents a lesson for investors lured by the rapid economic growth of China. Many investors have rushed to buy chunks of former state monopolies, believing these companies are leading the race to profit from the Chinese boom. But companies dressed up for an overseas stock-market listing often have yet to grasp Western standards of disclosure. And the listed companies typically retain hard-to-understand ties to unlisted state-owned parents.

“In the post-Enron era, these black boxes are becoming a real concern,” says Roger Robinson, chairman of a commission that advises the U.S. Congress on Chinese economic and security matters. “As corporate governance gains prominence, Chinese issues will receive more scrutiny.”

Already controversies over China Life and other companies have damped investor mania, although the shares of many big Chinese companies listed in the past few years remain well above their offering price. Shanghai-based Semiconductor Manufacturing International Corp. announced just before its March listing in the U.S. and Hong Kong that, contrary to earlier statements, it would need additional financing for working capital through 2005. The company’s share price fell below its offering price. China Minsheng Banking Corp. admitted it fabricated a 2000 shareholders meeting at which a name change was supposedly approved. The Shanghai-listed bank has postponed a $1 billion stock offering in Hong Kong.

When China Life offered shares, demand outstripped the number of available shares by a factor of 25. Within two weeks, the price on the New York Stock Exchange zoomed to nearly double the offering price. Today, the shares have lost most of those gains.

China Life calls the government audit a “routine review” and says it disclosed the results promptly after it received them in final form in April. It says a contract requires its parent to pay $8.15 million in back taxes and fines resulting from the violations, so China Life shareholders won’t suffer. Although it has reported an “informal inquiry” by the U.S. Securities and Exchange Commission, China Life says it was told by the SEC that the inquiry isn’t meant to suggest that any laws were violated. A spokesman for the SEC declined to comment.

In response to a Wall Street Journal query, China Life has for the first time acknowledged another audit investigation in 2002 by the Ministry of Finance that covered the company’s operations in several provinces and cities. The ministry’s probe, which hasn’t been reported outside China, criticized China Life for its lack of “management controls” and violations of “standard accounting procedures,” according to a ministry official who participated.

Positive Sign?

Some China watchers think the disclosure disputes and audit reports are actually a positive sign that China is transforming itself into a capitalist economy in tune with Western standards. Chinese companies were first allowed to sell shares to the public just 20 years ago, compared with the centuries that Western stock markets have had to develop. The notion of full disclosure is even newer. The Chinese government says it hopes the attention of foreign investors will transform sleepy state enterprises into globally minded corporations.

“The government wants to see these companies subjected to harsh market scrutiny,” says Lin Shoukang, head of capital markets for China International Capital Corp., the joint Chinese-U.S. investment bank that underwrote China Life’s offering.

Among the investors who believe that Chinese companies are worth a gamble is Warren Buffett. The billionaire investor’s company, Berkshire Hathaway Inc., owns 1.3% of petrochemicals giant PetroChina Co., which was listed on the New York Stock Exchange in 2000. Although PetroChina shares have fallen recently, they still trade at more than twice their starting price. Despite recent falls, the six biggest Chinese stocks trading in New York climbed an average of 36% between the time they listed and May 14.

The company now called China Life was born in 1949, the year of the Communist revolution, as the People’s Insurance Company of China. For years, People’s Insurance had a monopoly on all kinds of insurance. In the 1980s, the government let some competitors into the market. In 1999 People’s Insurance was split into four independent units, one of which focused on life insurance and was named China Life.

China Life controlled half of the country’s life-insurance market, which has been growing at more than 35% a year. There was just one problem: Its finances were a mess.

During the 1980s and 1990s it sold many life-insurance policies that were more like annuities, offering customers regular payments after retirement with a guaranteed rate of return on the money they had paid in over the years. When China’s central bank cut interest rates seven times between 1996 and 1999, China Life found itself paying out more to policy holders than it could earn through bank deposits. Although China’s insurance regulator later allowed companies to cut their guaranteed rates, many unprofitable policies festered on China Life’s books.

China Life’s expansion relied on another risky strategy: hiring unlicensed agents to hawk policies. As the company would later acknowledge in its prospectus, 37% of its agents as of June 30, 2003, didn’t hold the proper government license.

Such problems were familiar territory for China International Capital Corp. Known as CICC, it is a joint venture between state-owned China Construction Bank and the New York investment bank Morgan Stanley. CICC’s bread and butter was getting state-owned giants such as China Telecom Corp. and China Petroleum and Chemical Corp. to list overseas.

In 2002, CICC decided to tackle a China Life listing, bankers say. CICC’s head, Levin Zhu, is the son of former Chinese premier Zhu Rongji and once worked for Credit Suisse First Boston. The younger Mr. Zhu, whose Chinese given name means “cloud coming,” is also a weather expert, having written a doctoral thesis on Asia’s summer monsoons at the University of Wisconsin.

Levin Zhu got personally involved in the effort to restructure China Life for a New York listing, according to a CICC colleague and another investment banker involved in the deal. A CICC spokeswoman declined to comment or to make Mr. Zhu available for an interview, saying it was “not convenient at the moment” to discuss his role in the China Life issue.

By March 2003, China Life’s underwriting syndicate expanded to include Citigroup Inc., Credit Suisse Group’s Credit Suisse First Boston and Deutsche Bank AG. CICC needed the global heavyweights to package the company for overseas investors.

The investment bankers knew overseas investors would shun a life insurance company with a portfolio of unprofitable policies. Their solution: Split China Life into two companies, a fully state-owned parent and a subsidiary. The parent would inherit all the liabilities that might scare off investors. It even signed an agreement to pay any fines resulting from violations dating from before the split.

The subsidiary, scrubbed clean, would inherit profitable policies, the sales force and other assets. Although the subsidiary would still have tens of thousands of unlicensed agents, investors were assured that insurance regulators never enforced the license requirement.

“In these massive restructurings, all the historical problems and everything else that doesn’t make economic sense get kicked out of the bucket. And then they list the bucket,” says Carl Walter, chief operating officer of J.P. Morgan Chase & Co.’s China businesses and co-author of the book “Privatizing China.” Mr. Walter wasn’t involved in the China Life listing.

Underwriters raced to get China Life ready, recognizing the feverish demand for shares in promising Chinese concerns. In one sign of the times, a small producer of vegetables called China Green Holdings Ltd. saw investors request 1,600 times as many shares as the company had to offer before it was listed on the Hong Kong exchange. In June 2003, China Life formally split into the parent, called China Life Insurance (Group) Co., and the subsidiary with the almost-identical name of China Life Insurance Co. Some top executives held posts in both companies, including Wang Xianzhang, who serves simultaneously as president of the parent and the subsidiary.

New York Debut

Just six months later, after $100 million in bankers’ fees, China Life made its debut on the New York Stock Exchange. Only 27% of its shares were available to the public; the other 73% stayed in the hands of the parent company. The offering raised $3.5 billion.

“I would compare China Life to a gold mine with rich proven deposits,” said Mr. Wang in an interview with the Chinese-language Caijing Magazine before the listing. “Investors can get handsome returns with relatively little input.”

Those lucky enough to buy China Life shares at the initial offering price paid $18.68 per share. As soon as trading started on Dec. 17, the price jumped to $23.25. By Jan. 2 the price hit a peak of $35.60, 91% above the offer price.

Many eager investors probably hadn’t heard of an agency called the China National Audit Office. Its job is to scrutinize the spending of anything in China that’s part of the government — from the remotest county clerk’s office to the biggest state-owned company. For much of 2003, the National Audit Office’s investigators were poring over the 2002 records of China Life, and they didn’t like what they saw.

Among the auditors’ findings: China Life’s investment in its 32-story headquarters complex broke a Chinese law barring insurance companies from commercial real estate projects. The Beijing complex was designed by American architects and is topped by a spire that resembles the Empire State Building.

An audit official who was involved in the investigation says his office delivered a draft report to China Life’s parent company in mid-January of this year. The draft was secret, but on Jan. 30, a Friday, China’s audit chief delivered a nationally televised speech in which he outlined some of China Life’s violations. China Life’s New York-listed shares slumped 4.6%.

The next Monday, Feb. 2, the National Audit Office posted the speech on its Web site. The violations included using unlicensed agents to sell insurance and fraudulent handling of some policies.

While China Life shares recovered briefly in February, they have taken a battering since then from worried investors. The company disclosed the SEC investigation on April 27. Hong Kong’s Securities and Futures Commission said April 28 that it is inquiring into “the circumstances of the listing of China Life” and “assisting the U.S. SEC in its inquiry.”

Analysts at the same investment banks that underwrote the offering are recommending caution on China Life. Citigroup rates the company a “sell.” Its April 26 report criticizes management for being stingy with information on new premiums and claims, calling China Life’s disclosure in this area “extremely disappointing.”

Credit Suisse rates China Life “underperform” but says it’s “probably unrealistic” to expect excellent disclosure from a newly listed company.

Mark Mobius, president of Templeton Emerging Markets Fund Inc., agrees. “There’s a whole culture that has to change,” says Mr. Mobius, whose fund bought China Life shares and then sold them shortly after trading began. “Until then, it is buyer beware.”

What remains unclear is how much, if anything, China Life’s underwriters knew about the National Audit Office’s investigation when they were preparing its prospectus. Representatives for the four lead underwriters declined to comment. “If you don’t ask a direct question, Chinese executives aren’t going to volunteer information,” says Hao Yansu, a dean at the Central University of Finance and Economics in Beijing and adviser to several Chinese insurance companies.

Meanwhile, there is still a veil of secrecy around the separate Ministry of Finance investigation from 2002 that examined China Life’s books from the year before. It showed that a branch in northeastern Jilin province fraudulently recorded transactions to meet sales targets, an executive of the branch said in an interview. Another branch in southeastern Jiangxi province was cited for recording $800,000 in phony construction costs as a way of getting money from headquarters that could be put aside for other uses, says an executive of that branch.

A Ministry of Finance official in Jilin says the investigation took place from May to September 2002 and was a “routine inspection task.” A ministry spokesman declined to comment on the investigation. A spokesman for China Life confirmed the Ministry of Finance audit report, but said it “related only to … a few branches of the former China Life Insurance Co.”

China Life officials insist the company is still a good investment. A group of executives returned last week from wooing fund managers in Asia, Europe and the U.S. China Life also has hired a London public-relations firm, Citigate Dewe Rogerson. Bruce Shu, a Citigate director, says China Life has “maintained or increased market share in all … target segments.”

China Life shares stood at $20.33 in 4 p.m. composite trading Friday on the New York Stock Exchange.

In announcing earnings last month, Mr. Wang, China Life’s president, said the company is profitable, now that it is no longer responsible for the unprofitable policies that were left with its parent. “All in all, the company fulfilled the promises made to its shareholders and is committed to delivering good corporate governance and increasing transparency,” he said.

But another senior China Life executive calls the brouhaha over disclosure a “painful process” and adds: “I think other Chinese companies will learn from our experience. We have to change old habits.”