‘Trust nothing, verify everything’

Last updated on July 2nd, 2019 at 09:08 pm

It seems there is no way to put a stake in the issue of trust vs. verification. Caterpillar Inc.’s recent $580 million writedown on a Chinese company it acquired in June for $700 million is an example of the principle.

It is also a reminder of how difficult it is to penetrate an unfamiliar market. Keep in mind this applies equally to anyone from any country investing in another.

According to Caterpillar, ERA Mining Machinery Ltd. deliberately engaged in “accounting misconduct,” which was designed to overstate profitability before the acquisition. It was apparently a “deliberate, multi-year, coordinated accounting (effort)” by several senior managers at ERA. The accounting problems surfaced in November when Caterpillar found discrepancies between ERA’s actual vs. book inventory and went on from there.

Tell me it isn’t so!

Given they were advised by Citigroup and the Freshfields Bruckhaus Deringer LLP, how is it possible they missed 84 percent of the acquisition’s value? (Maybe they only charged 84 percent of their normal fee. On second thought, not possible). Hopefully, the flurry of lawsuits to follow will enlighten us.

Just to make it clear, ERA was represented on the deal by Blackstone and DLA Piper. Note, not a Chinese mainland legal or accounting firm was mentioned. This all took place in Hong Kong, which has one of the highest business and transactions transparency ratings in the world.

Just to make sure that I had not entered a parallel universe, I checked with some well-known financial and legal firms doing business in China and Hong Kong. They said “trust nothing, verify everything.” I then checked with some people in the Chinese government. They said, very diplomatically: verify everything, as the government is not responsible for transactions between businesses (they apparently give the same advice to Chinese companies/investors going overseas). Finally, I checked with some people who have worked at the various embassies in China, they also said, “Trust nothing verify everything.”

I’m still trying to figure out how, when conventional wisdom is that everything must be verified, you can miss $580 million out of $700 million in value.

ERA Mining was listed on the Hong Kong Growth Enterprise Market (GEM) exchange. The GEM is “designated to accommodate companies to which a higher investment risk may be attached,” according to the offering circular filed by Caterpillar in 2011. The company was previously known as ERA Holdings Global Ltd., a corporate secretarial services company, before it was acquired by Siwei in September 2010, through a reverse takeover. Siwei was the original name of ERA in China before the reverse merger.

So let’s just go over the cast of characters one more time. On one side you have a few “senior Chinese managers” who, according to the allegations, engaged in fraud by misstating inventories and earnings over a number of years, and then did a reverse merger into a secretarial firm listed on a dodgy Hong Kong index. On the other side you have some of the supposedly best and most sophisticated international corporate, financial and legal minds in the world.

Unless things have changed in the post economic meltdown world, when you do due diligence you go over everything with a fine-tooth comb, you match the physical inventory with sales and bank statements. The idea is to verify everything. When the transaction involves a recent reverse merger on a “high risk” stock list, it’s a red flag, which means you go over everything twice.

So, how does 84 percent of the value of a company that has been thoroughly checked disappear?

Even given Caterpillars’ statement that this was just a little less than 1 percent of the firm’s $63 billion value, it still seems incredible to believe that an elephant of this size could be missed.

While the exact details have yet to emerge, some heads seem to be rolling. It appears that following the discovery in November, Luis de Leon, vice president responsible for mining products, is leaving Caterpillar “to pursue other opportunities.” Given the timing and his responsibilities, the speculation is the two events are connected.

Those who appear to be blameless include the CEO and the board, who were apparently taken by surprise, and I assume “shocked” that things were not handled better. Everyone is sure they would never have approved the acquisition, if they had thought it was going to turn out like this.

One wonders if they realize that, given the amount involved; if these “senior Chinese managers” are convicted of fraud, they could be executed or face life imprisonment.

It’s not something which seems to cross the minds of our corporate boards, but maybe it’s something we could consider learning from China. In the meantime, one wonders what happened to the $700 million.

I know it’s only a minor issue for Caterpillar, but it sounds like real money to me, or maybe that’s the problem.

Sarcasm aside, it seems like with Madoff, Enron, Health South, any mega bank, accounting, law or consulting firm that you care to mention, greed and deceit are human characteristics, rather than national ones.

So, if your business or investing future involves foreign places (or the United States, for that matter), please forget trust and verify everything. Firms with more resources and supposedly smarts than you have apparently been taken in.

This is not to suggest you avoid China or overseas investments, but just that you need to take precautions no matter where you invest.

As far as China goes, as Rich Lavin, a Caterpillar group president whose responsibilities included China, said at the 2011 Las Vegas Mining Expo, “We (Caterpillar) have got to win in China,” because the market is so huge, that over the long term, “If we don’t lead in China we’re not going to be the global industry leader.”

That’s a sentiment that, despite its recent stumble, Caterpillar and many other companies understand. But as per usual, the devil is in the details.

Einar Tangen, formerly from Milwaukee, now lives and works in Beijing, China. He is an adviser to Heilongjiang Province, Hebei Province QEDTZ, China.org.cn, China International Publishing Group, Beijing Baotong and DGI DESIGN. He is also a weekly public affairs commentator for CCTV News’ Dialogue and the author of “The Kunshan Way,” an economic development history of China’s leading county level city. While in Milwaukee, he was a partner at Jackson, Morgan and Tangen, president of E-Tech and a senior vice president at Stifel Nicolaus. He chaired various boards in Milwaukee and was a member of the Federal Home Loan Bank of Chicago. Readers who would like to submit questions or suggest areas of interest can send an e-mail to steve.jagler@biztimes.com.

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