Published January 24, 2013
HONG KONG – A Chinese mining equipment company at the centre of an alleged accounting fraud was also involved in a web of insider loans and asset transfers prior to its purchase by Caterpillar Inc., public filings show.
The transactions, while not illegal, should have sounded warnings about the company's finances when the U.S. firm came calling last year, corporate governance experts said.
The world's largest maker of tractors and excavators said last week it was writing off most of the $654 million value of its purchase of ERA Mining Machinery Ltd after uncovering "deliberate, multi-year, coordinated accounting misconduct" at its subsidiary Zhengzhou Siwei.
Caterpillar said an internal investigation had uncovered improper accounting of inventories, revenue recognition and cost allocation at Siwei, designed to overstate the profitability of the business in the years before it bought it.
Corporate disclosures from ERA filed prior to the takeover show some unusual transactions, including directors lending the company cash at relatively high interest rates and asset-shuffling between Siwei and related parties.
Investors and corporate governance experts say these were potential red flags that should have prompted Caterpillar and its team of lawyers, accountants and bankers to ask some searching questions before pulling the trigger on the deal.
"Every time there's a horror story like this, it acts as a damn good wake-up call that you need to look carefully before you do a deal," said David Holloway, senior managing director at FTI consulting and an expert in investigation of business fraud.
Caterpillar declined to comment on the ERA directors' loans and did not respond to a request for comment on Siwei's operations. ERA directors could not be reached for comment.
A source directly involved with the Caterpillar deal said RSM Nelson Wheeler was ERA's auditor, while Deloitte and Ernst & Young acted on Caterpillar's side. RSM did not respond to calls and emails and Deloitte and E&Y declined to comment.
One of the directors who lent the company money was Beijing-based U.S. businessman Emory Williams Jr, a former chairman of the American Chamber of Commerce in China and son of a former Sears Bank and Trust Co. chairman and chief executive.
A second was Li Rubo, a graduate of the South Dakota School of Mines and former Chinese government official. There are no allegations of illegality against any of ERA's directors.
A security guard at Siwei's six-storey, glass-fronted headquarters on the outskirts of Zhengzhou, eastern China, stopped a Reuters reporter from entering the campus, saying senior managers were all in Beijing for meetings.
Reuters' efforts to contact ERA chairman Williams, Li and other directors and major shareholders at listed addresses in Hong Kong, Beijing, Shanghai and Zhengzhou and by telephone and email were also unsuccessful.
One concern about ERA should have been why the Hong Kong-listed company needed to borrow more than $9.5 million from four directors -- who earned nearly $500,000 in interest -- at loan rates that were among the most expensive on its balance sheet.
"It wouldn't necessarily mean there are cash flow problems but it would be a massive red flag", because it would call into question whether the financing was in the company's best interests, a U.S. lawyer experienced with China transactions, commenting on condition of anonymity, wrote in an email.
The personal loans are detailed in regulatory filings made to the U.S. Securities and Exchange Commission prior to ERA's takeover by Caterpillar in June last year.
"While company loans to directors are a governance no-no, the opposite is more of a grey area," said Jamie Allen, secretary general of the Asian Corporate Governance Association, in an emailed response to a Reuters' question.
"Is the interest rate fair and at arm's length? Why didn't the company go to a bank?" Allen said he had not studied the ERA deal in detail, but these would have been important questions to ask.
David Webb, a shareholder activist and member of the Hong Kong Securities and Futures Commission's Takeover and Mergers Panel, said local listing rules allowed directors to lend money to companies at normal commercial terms, provided the loan was not securitized, although it was not a common practice.
"Presumably the board would have looked at alternative sources of funding," he said.
In one example, in April 2010, Williams and Li lent $6.4 million to pay down loans of nearly $20 million, mostly funded by a U.S. private equity firm, that were used to acquire Siwei, and for working capital, according to the filings.
Williams and Li made the loan at an interest rate of 8 percent per year, compounded annually. In a letter from the board at the time of ERA's reverse merger, the directors, who did not yet include Williams and Li, called the loans "fair and reasonable" and "justifiable".
ERA's loans with commercial banks at the time were at interest rates ranging from 4.9 percent to 7.4 percent.
At the time of the Caterpillar takeover, ERA was listed in the Growth Enterprise Market (GEM) of the Hong Kong stock exchange, which is designed to accommodate companies with a higher risk profile.
ERA had absorbed Siwei through a reverse takeover in 2010, a corporate maneuver that has become controversial in the United States following a series of accounting scandals involving small Chinese companies listed there.
Caterpillar said it found discrepancies in November between the inventory on the books of Siwei, which makes hydraulic supports for coal mines, and its actual physical inventory, triggering the probe.
The company blamed "several senior managers" whose misconduct it said began some years before it acquired Siwei. Caterpillar did not identify the senior managers.
Corporate filings show that the amount of money Siwei was owed by its customers had grown 58 percent a year since 2008, overtaking total sales in 2011, and that some 90 percent of those debts were overdue when Caterpillar launched its bid.
John Hempton, a prominent hedge fund manager with Sydney-based Bronte Capital, said 20 minutes research into ERA was enough to convince him to short Caterpillar's shares after he heard it was buying the Chinese company.
Hempton found what he considered a problem with ERA's receivables -- it often took 180 days to collect payment, twice the industry average. "This was something that should have been spotted in only a few minutes," he said.
Caterpillar declined to comment further on whether its examination of ERA's accounts had been sufficiently thorough, although last week it said it believed its due diligence process was "rigorous and robust".
Williams and Li also helped finance the 2007 purchase of Zhengzhou Siwei with a $2.95 million interest-free loan, according to ERA's reverse takeover prospectus. Li helped fund his part of the loan by borrowing $2.565 million from another company where both he and Williams were directors.
Records from around that time show some unusual transfers of company assets at Zhengzhou Siwei.
In one instance, Siwei disposed of an industrial tank-making business valued at nearly $5 million at "nil consideration" to a company in which a Siwei director and former substantial shareholder had taken a majority stake four months earlier.
The company said the assets were loss-making, but continued to purchase millions of dollars worth of equipment and services from the same firm between 2007 and 2009, paying an average of 2 percent to 4 percent above the market rate for the "better quality services provided", according to regulatory filings.
Efforts to contact those involved were unsuccessful.
In another case, Siwei transferred a 7.5 percent stake in a mining equipment firm to one of its partners -- a company linked to one of China's biggest weapons manufacturers -- to offset "trade payables", an accounting term that usually refers to liabilities owed to suppliers and could suggest Siwei was having trouble paying its bills.
A director surnamed Wang reached by telephone at the head office of the former partner, Shaanxi Dynamic, said her company had severed ties with Siwei a few years ago.
David Smith, head of corporate governance for Asia at fund manger Aberdeen, said shuffling of assets between related entities was not uncommon in China and could be legitimate.
"It's not necessarily a red flag, but it's a catalyst that would have us look into the matter in quite a lot of detail to understand why it is happening," he said. "Our concern would be value leaving the company as a result of the swapping."
(Additional reporting by John Ruwitch in Zhengzhou, China, Michael Flaherty, Denny Thomas, Stephen Aldred and Lawrence White in Hong Kong, Lucy Hornby and Michael Martina in Beijing and Ernest Scheyder and Jennifer Ablan in New York; Writing by Alex Richardson; Editing by Ian Geoghegan)