William K. Black, December 18, 2018 Bloomington, MN
On December 13, 2018, the Wall Street Journal published an interesting op ed by Jesse M. Fried, a famous law professor in multiple areas of corporate law, and Matthew Schoenfeld, who works at a hedge fund that is the leading funder of civil lawsuits, primarily fraud and tort suits. The title is “Will China Cheat American Investors? The answer, of course, is yes – it will continue to cheat American (and non-American) investors. Fried also has a strong background in economics, which is relevant to his op ed and my blog article.
The op ed is interesting in part because it was published just after a documentary on Chinese stock fraud (“The China Hustle”) had its general video release. The China Hustle explores the pervasive defrauding of primarily U.S. investors by those that control Chinese corporations. Though the documentary does not make the point, it is describing “accounting control fraud.” A ‘control fraud’ is a seemingly legitimate entity used by the person that controls it as a “weapon” to defraud or predate. For the sake of brevity, I use “CEO” rather than “the person that controls the corporation.”
Accounting control frauds target creditors and shareholders as their primary intended victims. Their primary weapon of fraud and predation is accounting. The art is to inflate assets and understate liabilities, which overstates capital and income. White-collar criminologists, economists, accounting academics, and regulators have explained the ease with which the CEOs running control frauds are able to suborn supposed “controls” (auditors, appraisers, attorneys, and credit rating agencies). The art is to suborn, not destroy, supposed ‘controls’ so that they will “bless” the CEO’s frauds, lending their reputation as supposedly independent professionals to aid the CEO in defrauding creditors and defrauding and predating on shareholders. The CEOs leading the fraud and predation can even use their ability to hire and fire the key officers at these supposed independent professional controls to generate a “Gresham’s” dynamic within their profession. George Akerlof, in his famous 1970 “lemons” article that led to award to him of the Nobel Prize in Economics in 2001, first named that perverse dynamic. Akerlof explained how it worked.
[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.
What all of these factors mean, plus a host of other factors that make controlling a seemingly legitimate firm uniquely valuable to CEOs running sophisticated, massive fraud and predation schemes, is that control frauds and predation cause vast harm and can become epidemic. When I say that the control frauds are “seemingly legitimate” and that the supposed ‘controls’ are seemingly legitimate I mean that they both actually function frequently as ‘criminal enterprises.’
The “China Hustle” documentary is deeply flawed in its apparent belief that endemic fraud can only occur in places like China that have no effective rule of law. The GFC, the three most destructive financial fraud epidemics in history that drove the GFC, the astonishing level of elite financial predation in the United Kingdom, the U.S., and Australia, and the complete failure to prosecute the financial elites that led those fraud epidemics combined to prove that the United States does not have an effective rule of law.
I now routinely use the phrase “control fraud and predation” because Bastiat’s warning has proven true. Frederic Bastiat is the patron saint of economists that worship laissez faire, so it is ironic that his famous warning has revealed why laissez faire ideology creates an intensely criminogenic and predatory environment. Laissez faire ideology ignores the ability of elite frauds and predators to use their exceptional power to corrupt the rule of law. Vigorous regulation, supervision, and prosecution of elite crimes and predation is essential to the effective rule of law. Laissez faire proponents wage a continuous, unholy war in favor of the three “de’s” – deregulation, desupervision, and de facto decriminalization and “glorify[y]” elite white-collar criminals as their heroes.
When plunder becomes a way of life for a group of men living together in society, they create for themselves in the course of time a legal system that authorizes it and a moral code that glorifies it.
Predatory acts (“plunder[ing]”) are not criminal. Predatory acts, however, are so deeply unethical that if the poor committed those acts the wealthy, with dominant political power, would make those acts crimes. This point is similar to one that the media has been describing considerably in recent weeks – the fact that campaign finance crimes require the prosecution to prove that the defendant “knowingly and willfully” committed the crime. This means that ignorance of the law can be a defense for people like President Trump unless the prosecution can prove he knew he was violating the law. Laws that criminalize behavior undertaken primarily by elites are far more likely to require the prosecution to demonstrate that the defendant willfully violated the law. The President and members of the Congress share a common interest in protecting their political contributors from prosecution, so they drafted the statutes governing contributions (and bribery) to make it exceptionally difficult to prosecute the elites that enrich them and help them win elections. Our greatest ability to predict judicial decisions by conservative jurists is when the case involves business interests. Conservative jurists are most likely to vote to advance business interests (as opposed to factors such as national security or views on federalism). Conservative jurists, over the last 30 years, have recurrently made it more difficult to prosecute elite white-collar crimes and corruption and to gut regulatory actions essential to prevent a criminogenic and predatory environment.
I emphasize predation for two other reasons. First, two Nobel Laureates in economics, George Akerlof and Bob Shiller have written a book to try to get economists to take predation seriously. The standard neoclassical assumption channels the false laissez faire claim that predation cannot occur, or, in the alternative, cannot be serious. Second, the WSJ op ed that prompted this article focuses on a classic example of predation frequently observed – and then ignored – by bad economists. The predation is by controlling shareholders that loot minority shareholders. This is a common pattern for hundreds of years all over the world.
There are two semi-remarkable facts about this form of predation in China that the op ed discusses. The first is remarkable only to bad economists. The op ed explains:
Americans now collectively own most of the public equity of China’s biggest tech companies, including Alibaba, Baidu and Weibo. This relationship is strange (imagine if the Chinese owned most of Amazon, Facebook and Google). It’s also extremely risky, at least for American investors.
China’s tech darlings began tapping U.S. investors in the early 2000s, when mainland capital markets were unsophisticated and strict profitability requirements shut out most fast-growing tech firms. Dozens of Chinese unicorns and near-unicorns went to New York to raise capital from Americans eager for exposure to China’s explosive growth.
American investors became dispensable, and thus vulnerable to expropriation.
It started around 2014 with a wave of confiscatory “take private” transactions led by Chinese controlling shareholders. The objective was to delist U.S. shares at low buyout prices and later relist them in China at a much higher valuation.
Consider the July 2016 take-private of Qihoo 360, an internet security firm. The founders squeezed out U.S. shareholders at $77 a share, reflecting a value of $9.3 billion. In February 2018, they relisted Qihoo on the Shanghai Stock Exchange at a valuation north of $60 billion. That’s a 550% return. Qihoo’s chairman personally made $12 billion upon relisting, more than he claimed the entire company was worth 18 months earlier.
Public investors in a firm with a controlling shareholder always face the risk of an unfair take-private. But investors in U.S.-listed Chinese companies are particularly vulnerable. Most incorporate in the Cayman Islands. This jurisdiction affords investors much less protection than Delaware, home to most U.S. companies. Neither U.S. nor Cayman court judgments can be enforced in China, where insiders and assets are based. Chinese controllers can thus squeeze out the minority on terms that would make American controllers blush. More than 60 U.S.-listed Chinese companies have been taken private since 2013.
Despite the warning signs, American investors continue lining up for Chinese initial public offerings. In fact, Chinese companies have raised more than $8.5 billion in U.S. markets this year, the most since 2014. This week, Tencent Music Entertainment went public in the U.S., raising about $1 billion at a valuation exceeding $20 billion.
This form of predation allows the controlling shareholders to transfer to themselves the great bulk of the market value of the minority owners’ shares. The China Hustle fraud works by massively overvaluing the firms’ assets, capital, and profits. The predation scheme does the opposite. (Though the explanation it is beyond the scope of this article, shareholders need to know that the controlling person can use both the fraud and predation schemes at the same company at different times.)
“Unicorn” is investor jargon for an initial public offering (IPO) with $1 billion or more in capitalization. The op ed indicates the extraordinary scale and success of the predation. Bad economists’ dogma is that material predation is a fiction. The op ed shows that after literally tens of thousands of cases of predation by controlling shareholders against minority shareholders conducted over hundreds of years in hundreds of countries – it proved to be child’s play for none-to-sophisticated Chinese predators to fleece American shareholders out of billions of dollars. (As I often explain, the key to successful fraud is audacity, not genius.) Worse, the American investors were often purportedly sophisticated institutional investors. Still worse, the Chinese controlling shareholders’ predation scheme has been in successful action for over 15 years. To top it all off, the Chinese are still attracting record amounts of new money successfully from American investors despite having repeated the predation scheme 60 times in the last five years. Only laissez faire ideologues would believe this was impossible because predation was impossible.
The second remarkable fact is probably remarkable only to people like me, who spent a decade working with thousands of effective regulators. What the China Hustle accounting control fraud schemes and the predation schemes described have in common is that neither would be possible if the SEC and either the Bush, Obama, or Trump administration were not so utterly spineless for at least 15 years as to allow the fraud and predation schemes to persist. The Chinese context should have been the easiest context for the U.S. to deny the ability of Chinese corporations to list on the U.S. markets unless the SEC had the power to prevent fraud and contract provisions in the U.S. that China agreed in a binding fashion were enforceable in China. The SEC has not required such a grant of power as a condition of approving Chinese stock listings in the U.S. and has not insisted on enforceable contract terms to prevent predation. The SEC is not even asking for such powers, warning Americans not to invest in Chinese stocks, or seeking to ban such listings.
The Trump administration is making a great deal of noise about China being the great threat to the U.S., but it is refusing to act to prevent endemic fraud and predation against U.S. citizens by Chinese elites. The Chinese government is deeply complicit in these fraud and predation schemes. In January, the new House of Representatives should introduce a bipartisan bill to stop the Chinese fraud and predation schemes and hold oversight hearings on the SEC’s bipartisan failure to protect American investors.
The op ed, presumably due to space limitations, calls for no action. It ends with a wish that the authors know to be false. “Let’s hope investors price in the risk.” That ‘hope’ makes sense only if you believe in laissez fairey tales.