China Aviation Oil appeared to be a savvy investment. The Singapore-listed company boasted Western-style management, strong ties to Beijing, and most important, a near monopoly on the sale of imported jet fuel to China.
Now, after some disastrous trades in the futures markets - betting the price of oil would drop, not rise - the company is bankrupt and facing allegations of misconduct. International investors have been left with a harsh reminder: China may be a rising economic star with a potentially huge domestic market, but investing in Chinese companies carries a unique set of risks due in part to the legacy of a state-run economy.
China Aviation Oil (CAO) is one of hundreds of Chinese companies to raise funds on overseas markets, like Hong Kong, London, New York and Singapore. For a while, investors reaped rewards. After going public in 2001, CAO's share price tripled in less than three years. But then, with the price of oil rising to record levels, the company's management made some bad choices. They lost $550 million trading oil futures - 20 times what the company makes in a year and three times more than the value of all its assets.
To make matters worse, company officials didn't own up to the losses until it was too late - except, it appears, with their directors back in China.
"It's fairly clear that there was insider dealing by the controlling shareholder who had been advised of the trading losses," says Hong Kong-based retail investor and shareholder rights activist David Webb. "They sold 15 percent of a company that was basically insolvent, took the proceeds and lent it [back] to the company to keep it going."
The $100 million loan from China Aviation Oil Holding Company, which is owned by the Chinese government, was used to cover losses. At the time, though, company officials in Singapore said it was earmarked for new investments.
"There was absolutely no transparency," says David Gerald, the head of the Securities Investors Association of Singapore (SIAS), a local advocate for small investors. "They exercised judgment wrongly and when the losses ballooned, instead of being open about it, they hid it."
Not long ago, Mr. Gerald's organization and others hailed CAO as a model Chinese business adhering to strict corporate governance standards. CAO executives even responded to investor questions in online forums (though it now appears that the answers were not always truthful). On paper, CAO also had good risk management procedures in place, including a manual reviewed by auditor Ernst & Young. Ultimately, there wasn't any oversight.
"Despite the gloss in the annual report, there wasn't any effective compliance check," says Mr. Webb. "There's no point in having a rule book, if you don't have people making sure the rules are followed."
China Aviation Oil is not the only China-backed company to break the rules. Some financial market observers - drawing parallels to Enron and WorldComm - believe greed in the midst of an investment boom has gotten the better of too many Chinese executives.
• China Life Insurance's shareholders have filed a class-action lawsuit in New York. The complaint accuses its parent company of embezzlement and depositing money in illegal bank accounts. China Life's initial public offering on the New York Stock Exchange was the biggest IPO of 2003.
• Shanghai Land's top executives have been jailed and charged with stock market fraud, share price manipulation and embezzlement. The Hong Kong-listed company admits making nearly $80 million in "unorthodox loans."
• Several officials at Hong Kong-listed Bank of China, including a former CEO, have been arrested and charged with bribe taking and embezzlement.
Sometimes Chinese companies do not need to break any rules in order to transfer funds to the detriment of investors. Shenzhen Expressway and Beijing Enterprises - both listed in Hong Kong - transferred key assets or cash back to their parent companies in China. But shareholders had no say in the pricing. Unlike other large transactions, these deals were not put to a shareholder vote because the Hong Kong stock exchange grants an exemption for mainland Chinese government bodies.
The loophole is part and parcel of a continuing competition between major financial markets to attract Chinese companies. Just last week, the London Stock Exchange argued that it is up to 50 percent cheaper for a Chinese company to list in London than New York. But officials went out of their way to argue that lower costs don't mean lower standards.
International ratings agency Standard & Poor's has a different message. Feeling misled by China Aviation Oil, S&P warns that "complex corporate structures and unreliable accounting practices" make it difficult to evaluate Chinese companies and the CAO scandal "highlight[s] the risks surrounding many China-based and China-related corporates."