The pitch to investors described a company on the verge of spectacular success: a Chinese firm making sophisticated, high-end chemicals used to fight fires, stain-proof fabrics and toughen touchscreens. Tianhe Chemicals Group Ltd. boasted rock-bottom labor costs, unique manufacturing techniques and net profit margins triple those of competitors such as DuPont Co. and 3M Co.
Tianhe (pronounced TYEN-huh) also had an impressive backer: investment banking giant Morgan Stanley & Co. LLC. In 2012, after spending millions of dollars vetting the firm, a Morgan Stanley investment arm paid $300 million for a stake in Tianhe and a seat on its board.
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To investors, the company touted what it described as its "close partnership" with the American bank's private equity team. It credited the bank with helping it strengthen its internal controls and governance. When Tianhe went public in June, Morgan Stanley was one of three lead banks that helped it raise $654 million from investors, making the deal one of the largest Hong Kong IPOs this year.
Tianhe's stock has since lost much of its luster. A mysterious group, allied with speculators betting against Tianhe's stock, alleged that the company had exaggerated the value of its business. Then Hong Kong regulators froze the $7.9 billion company's stock for more than a month. Since the allegations were made, Tianhe has lost 39 percent of its value.
Morgan Stanley's private equity team and its stock analysts have reaffirmed their confidence in Tianhe's management since the company's reputation came under attack. But a two-month investigation by The Associated Press identified significant discrepancies in publicly accessible financial records and statements Tianhe made to investors, including questions about whether its chairman sold himself Tianhe's main assets while he was running a predecessor company owned by the Chinese government.
The AP's investigation largely confirmed some claims by Anonymous Analytics, the shadowy investment research group that targeted Tianhe. And it uncovered new information the group did not.
The controversy surrounding Tianhe — and Morgan Stanley's role in bringing the company to global investors — carries special significance at a time when China's financial markets are rapidly opening to the world. In September, Alibababa Group Holding Ltd.'s $25 billion New York IPO set the record as the world's largest. And next week, for the first time, foreigners will be allowed to buy shares in the roughly $3.9 trillion of companies traded on the Shanghai Exchange. Even investors who don't seek such companies will likely end up owning shares in them through mutual and pension funds that seek to replicate returns of the broader market.
Amid global enthusiasm for Chinese stocks, Tianhe is a sobering example of Chinese companies' sometimes-murky financial practices and the roles of U.S. firms eager to get a piece of China's lucrative but sometimes risky market.
Among AP's findings:
— Tianhe revenues cited in commercial business data from government and public sources were a fraction of the revenues the company reported to foreign investors, $106 million in 2012, not $684 million. The AP purchased the financial data on Tianhe's subsidiaries from vendors who also perform due-diligence work for the U.S. Commerce Department. Tianhe disputed the idea that was a discrepancy and permitted the AP in Hong Kong and the company's home city of Jinzhou to inspect financial statements audited by Deloitte Touche Tohmatsu Ltd. reflecting the higher revenue figures.
— Commercial business data and records at a state-owned financial institution identify one of Tianhe's predecessor companies as the property of Chinese government organizations, although the company's founders said they own it. The difference is significant because the older company transferred key assets to a current Tianhe subsidiary for "nil consideration" in 2009, and Chinese law requires government property to be sold at a "reasonably determined" price. A case manager for China Great Wall Asset Management Corp., a state-owned financial institution, confirmed that the government's records show the predecessor was state-owned as recently as late 2013. Tianhe said the information was outdated but declined to allow the AP to review regulatory files to settle the question.
— Tianhe said it produces cutting-edge products that sell for up to $18 million per ton, but its research budget is a shoestring compared to competitors. The company's scientists told the AP that they inherited a run-down fluorochemical facility, were forced to design key equipment themselves and had to extensively retrain their Chinese research staff. Yet Tianhe's total R&D expense last year was $1.7 million, or just 0.2 percent of sales. Last year competitor Daikin Industries Ltd. of Osaka, Japan, spent more than $300 million, 2.6 percent of its sales. DuPont spends about 6 percent of sales on research and development.
— Tianhe's financial filings indicate that one principal customer, Shanghai Xidatong International Trading Co. Ltd., has bought as much as $100 million in chemicals each year. Business data purchased by the AP said the company's annual revenues and expenses in 2012 were less than $6 million, and the company's net worth was $900,000 in the red at the end of 2012. Its chief executive, Zhang Silang, declined to answer questions from the AP. Shanghai Xidatong's registered office is an unoccupied room containing broken furniture and old mattresses in a dilapidated apartment building. It conducts its business out of a different office with signs for another chemical company.
— Taxes that Tianhe said one subsidiary paid to local authorities in 2012 exceed the amount the government there reported collecting from all businesses in the county that year. Tianhe said it paid fully $128 million and produced receipts from the county government to support it. The local government's propaganda office declined to let tax officials speak with the AP.
— Overseas facilities and construction described by G.S. Ravi, a Tianhe executive, in a published interview before the company's IPO do not exist. Tianhe is merely in the process of renting warehouses and plans to build a plant in Singapore, it told the AP.
"It's one thing for a company's executive to make optimistic statements about growing revenue, but it's a real warning sign when management is making statements that don't appear to be consistent with reality," said Jay Ritter, a professor at the University of Florida's business school who studies global initial public offerings.
Morgan Stanley declined to answer the AP's questions, but one of its managing directors, Homer Sun, said in September that the $65 billion investment bank's Asian private equity unit stands behind Tiahne. In their most recent publicly available research note, Morgan Stanley's investment analysts continue to recommend that investors bulk up on the stock, which they predict will double within a year.
In response to AP inquiries, Tianhe executives provided the AP limited access to confidential documents in Hong Kong and Jinzhou. In Hong Kong, the company twice allowed an AP reporter to inspect its Deloitte-audited financial statements and other records on the condition that she could not take notes or communicate with co-workers over an unmonitored phone line while viewing the files. It videotaped her the entire time. In Jinzhou, the company persuaded local government officials over their objections to allow AP to inspect and copy some of its own corporate records but not others.
Doubts about Tianhe could have consequences broader than market losses for the pension funds and retail investors who owned shares worth hundreds of millions of dollars through Morgan Stanley's private equity arm and mutual funds managed by firms including Blackrock Inc. and The Vanguard Group Inc. Funds owned by both companies held Tianhe's stock as of the end of September.
Trouble could be costly for the banks that took Tianhe to market: Morgan Stanley, Bank of America Merrill Lynch and UBS AG. Problems would embarrass Hong Kong regulators, who have recently threatened to impose criminal penalties on banks that fail to prevent IPO clients from misrepresenting matters to the public.
Also, challenges in resolving basic information about Tianhe's earnings, customers and corporate history illustrate some of the difficulties for China's transition from its opaque, state-run past into a modern market powerhouse. Though concerns about fraud exist around the globe, China's patchwork of local regulators, its relatively weak legal system and its reliance on paper records leave investors especially vulnerable.
"Accounting fraud in the U.S. is usually from the overly aggressive application of an accounting principle," said Paul Gillis, a professor at Peking University's Guanghua School of Management. "Accounting fraud in China has usually been situations where large portions of the business simply do not exist."
For decades, China's chemical industry has been playing catch-up with foreign competitors.
"The product range they're able to provide is increasingly sophisticated, and the global chemistry majors are concerned," said Norbert Meyring, head of KPMG International's chemical industry consulting practice in China, speaking of domestic Chinese producers in general. "But they are not technology leaders, so to speak. They are not there yet."
Tianhe's story began in 1992, when a local transportation official founded a lubricants factory in a city a few hours from the North Korean border. In 2004, the company bought a shuttered state-owned fluorochemical factory near the town of Fuxin and hired three American chemists to guide it.
The company's rapid rise paralleled Morgan Stanley's own in China. The bank set up shop there in 1993, winning the government's approval two years later to begin a joint venture with a state-owned bank and launching its Asian private equity arm in 1999. After raising $1.5 billion from investors in 2007, Morgan Stanley's Homer Sun first watched and then courted Tianhe.
Morgan Stanley's relationship with Tianhe runs deep. Sun, who is the chief investment officer for Morgan Stanley's Asian private equity arm, is on Tianhe's board, its audit committee and the respective boards of both its main subsidiaries. In February, as Tianhe prepared for a Hong Kong IPO, the company hired Morgan Stanley banker Joseph Lee to be its chief financial officer.
Morgan Stanley, UBS and Bank of America took Tianhe public on June 12 of this year — raising $654 million and boosting the value of Morgan Stanley's stake to more than $500 million. Over the next few months, Tianhe's value surged by 35 percent. Morgan Stanley stock analysts announced in a research note in August that "major positive catalysts" should drive shares of Tianhe even higher.
The stock's run ended in early September, when Anonymous Analytics challenged whether Tianhe had overstated its size and value. The group said its affiliates bet against the stock of the companies it targets. It alleged misleading claims in Tianhe's IPO and raised questions about its financial statements, customers and products. Hong Kong officials halted trading at Tianhe's request, reviewing the company's proposed rebuttal to its critics before allowing trading to resume on Oct. 9.
Though fraud allegations against overseas-listed Chinese firms have been common in recent years, short-sellers have rarely targeted a Chinese company Tianhe's size — much less one that had just come to market and was so closely tied to a brand-name bank like Morgan Stanley.
Lee, the company's chief financial officer and a former Morgan Stanley banker, said the private equity team had closely scrutinized Tianhe.
"They took a long time and also spent quite a bit of money," Lee told the AP of Morgan Stanley's work to check legal documents, get to know Tianhe's customers and scour its financials. "This is their largest investment in Asia."
Obtaining even basic business legal and regulatory filings in China can sometimes be difficult. In recent years, China's central government has championed the development of a reliable credit and business data reporting industry to stimulate lending and commerce. Former Chinese Premier Wen Jiabao approved regulations last year codifying the rules of the industry. A few months later China's central bank invited leading business data vendors including Sinotrust International Information & Consulting Co. Ltd., a Chinese credit-rating agency owned by international advertising and research company WPP plc, to a forum celebrating the industry's legitimization.
The AP purchased Sinotrust business credit reports on Tianhe's component companies from Global Business Information Services Inc. of Chicago (GloBIS), which is used by the U.S. Commerce Department to vet business partners for American exporters. Data in the Sinotrust reports include ownership information, management details and even basic financial statements that Sinotrust draws from government sources and public records.
The data GloBIS produced are slightly different in some places than the disputed 2011 and 2012 financial regulatory filings cited by Anonymous Analytics. But the Tianhe revenue figures in the information ordered by the AP — about one-sixth what the company reported in its prospectus — are identical to what Anonymous Analytics said it found in Tianhe's regulatory filings. Sinotrust's figures were gathered in August, the month before Anonymous Analytics publicized its allegations against Tianhe.
In an interview, Tianhe chief executive Wei Xuan said only local regulatory files that Tianhe authorized the AP to view should be trusted.
Louise Kern, the owner of GloBIS, said this would be unprecedented in her experience and inconsistent with the Beijing's focus on supporting the integrity of credit information.
"The national-level data is sometimes not as up-to-date as the local stuff," she said. "But whatever is there is accurate as to what the company submitted to the government."
Tianhe's private-sector corporate history is notable given China's past emphasis on state-owned businesses. Tianhe told investors that its founder, Wei Qi, got the money for his first chemical factory in 1992 by selling his house, and Wei's family bought out the three fellow shareholders in a second company, Liaoning Tianhe Fine Chemicals Co. Ltd., sometime after its founding in 1998.
Liaoning Tianhe built up much of Tianhe's existing business, acquiring fluorochemical plants, hiring its American research team and branching into new products. Eventually it transferred many of its production facilities and assets to the Wei family-owned entities that became Tianhe. One major transaction in 2009 occurred for "nil consideration," the prospectus said.
Records identified the company as the property of local Chinese government organizations. That would be significant because current shareholders would wonder whether the company had a clean, clear chain of ownership for its own business. No history of state ownership is mentioned anywhere in Tianhe's prospectus.
"Absolutely, knowing the provenance of the asset does make a difference," says Jonathan Brookfield, a Tufts University professor who has studied the sometimes unclear line between public and private ownership in China. "Around the world, you see that when a state asset gets privatized, sometimes it gets nationalized again."
Tianhe declined to discuss its predecessor's unpaid debt but said the information the AP found was "very outdated."
"That statement is not plausible," said Steve Dickinson, an attorney for Seattle-based Harris Moure PLLC who has worked for foreign companies in China for decades.
Listings by China Great Wall Asset Management, as well as business data obtained through GloBIS and Sinotrust, said Liaoning Tianhe was owned by government entities long after it disposed of key assets, not sold to Wei's family years ago as Tianhe described. In the data, which reflect registration changes by the company as recently as January 2014, Liaoning Tianhe was listed as state-owned but managed by Wei Qi and registered at the same address as Tianhe's main offices.
The line distinguishing Tianhe from its customers can be blurry as well.
Financial regulators in Hong Kong require companies to meticulously disclose transactions with "related parties," entities owned, connected with or significantly influenced by the company and key executives. Companies must reveal these ties because business deals involving related parties can be fraught with conflicts of interest or sham transactions.
Tianhe's filings with the Hong Kong Exchange provoke few such concerns. One customer, Shanghai Top Fluoro, is described by Tianhe as a trading company that buys as much as $100 million in high-priced chemicals from Tianhe every year.
Yet Shanghai Top Fluoro's own websites, in both English and Chinese, conflate Shanghai Top and Tianhe. Shanghai Top said it sells chemicals "manufactured by our own plant," a facility that almost perfectly matches Tianhe's Fuxin operation. Shanghai Top also said it employs a team of American scientists with the same chemistry qualifications as those working for Tianhe.
"This is common practice in China," said Tianhe's David Flanigan, a Colorado-based former DuPont scientist who nevertheless said such misrepresentation has caused Tianhe regular trouble over the years.
Tianhe's Joseph Lee said the company recently told Shanghai Top to stop.
"They should not make that kind of reference anymore," he said.
Shanghai Top declined to comment.
One of Tianhe's leading scientists also overlapped with Shanghai Top and separately started a previously undisclosed California business that was a Tianhe customer.
Tianhe said one of its two chief technical officers, David Offord, provided technical advice to customers of Shanghai Top and appeared in its marketing materials. Offord said he was never an employee of that company.
"I was working at Tianhe. I never worked for Top Fluoro," Offord said. "I never did any sales."
But the AP found additional links between Offord and the company. An archived version of Shanghai Top's website from 2008 lists him as the primary contact for all Shanghai Top's sales outside Asia and as the person to contact regarding matters related to Shanghai Top's website.
Offord also sold Tianhe's products personally. Shanghai Top's English language website invited customers in the U.S. to buy chemicals through Fluoryx Inc., a California-based company that Offord founded in 2009, according to state business filings. Archived versions of Fluoryx's website listed Offord as its president and owner and cited his fellow American scientists at Tianhe as among the company's consultants available for hire. Current versions of the website do not mention Offord or his colleagues.
Offord said he launched Fluoryx to sell test-quantities of Tianhe's products. Asked why he didn't open an outpost for Tianhe in the U.S., Offord said Fluoryx was small-scale and he preferred his independence.
"If I want to buy something or do something, I don't want to have to ask permission from the chairman," he said.
Accounting experts said they would have expected such a business arrangement to require disclosure to investors.
"That's very weird," said Charles Lee, a Stanford University accounting professor whose academic research has covered IPOs and overseas-listed Chinese stocks. "They don't even have to have a significant amount of volume. That certainly should be declared."
Tianhe said that under Hong Kong's rules, Offord did not qualify as a connected person, meaning that there was nothing to require disclosure.
In the two months since Anonymous Analytics targeted Tianhe, the company's stock has fallen 39 percent, wiping more than $3 billion from the company's market value.
Even that steep drop may not be the end of it. Over the past month, executives of the company have bought tens of millions of dollars of its shares and approved an additional $150 million stock buyback by the company, moves that helped support Tianhe's price.
All the banks that led Tianhe's public offering — Morgan Stanley, UBS and Bank of America Merrill Lynch — declined to discuss Tianhe with the AP.
For Morgan Stanley and its Asian private equity chief investment officer, however, the fallout from potential trouble at Tianhe could be especially difficult.
Morgan Stanley's private equity team spent more than $2 million on due diligence before it acquired a stake in Tianhe, according to Tianhe officials, and investigating Tianhe's corporate history and customer relationships would have been a standard part of such a process. By pouring $300 million of private equity investors' money into the chemical company and publicly promoting it, Morgan Stanley played a central role in Tianhe's rise.
Because Morgan Stanley's investment came with a seat on Tianhe's board, bank employees would have had unparalleled access to both Tianhe's private financial information and its operations. Morgan Stanley's Sun would have been in a position to speak with Tianhe's accountants, customers and scientists.
Aside from Sun's public support for Tianhe, other parts of the bank have come to the company's defense. Following the initial allegations by Anonymous Analytics, Bank of America and UBS both suspended their coverage although Bank of America has since resumed it. Morgan Stanley's stock analysts continue to recommend Tianhe, saying there is "convincing evidence that the company has not falsified its accounts, and we do not believe the allegations are credible." The analysts added the standard disclaimer that the firm "may have a conflict of interest that could affect the objectivity of Morgan Stanley Research."
The Hong Kong Stock Exchange and the Securities and Futures Commission, known as the SFC, declined to discuss Tianhe. On the broader topic of how major banks have conducted IPO diligence, however, regulators have begun speaking in aggressive terms.
"Have there been gaps in the (our) oversight of corporate conduct? Probably," Ashley Alder, CEO of the Securities and Futures Commission, Hong Kong's securities regulator, said in a Sept. 19 speech declaring that both banks and the city's regulator had fallen short. After a two-year debate over what penalties banks should face for allowing fraudulent companies to sell shares in Hong Kong, the SFC declared in August it will use criminal laws to go after guilty banks.
"The expectation on the part of banks before was that you really took responsibility for nothing but the way your name appeared" in the prospectus, said Philippe Espinasse, a former investment banker in Hong Kong for banks including UBS. He is the author of several books on IPOs.
Before a public offering occurs, each sentence in an IPO prospectus must be reviewed for accuracy, Espinasse said. The system relies on banks and the lawyers and accountants they hire to protect investors.
"The one document you should rely on is the prospectus," he said, "because that's been vetted by a whole bunch of parties that supposedly know what they're doing."
Associated Press writers Erika Kinetz in Shanghai, Joe McDonald in Beijing, and Bernard Condon and Jon Fahey in New York contributed to this report.