Seeing Red in China

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It's basically every day that someone will ask me what investing sources I find to be absolutely essential reading. One source that I open immediately when it hits my inbox is the intermittent email that comes from David Webb at Webb-site.com. Webb's a reformed investment banker who covers the Hong Kong stock market and has served as a one-man corporate governance advocate for the Hong Kong market.

I read Webb religiously even though I have no money invested in Hong Kong-based companies. Webb's most recent dispatch, which uncovered some loans made by Chinese oil company CNOOC (NYSE: CEO), reminded me exactly why I do so. Webb details how CNOOC bought into a subsidiary of its corporate parent called CNOOC Finance, claiming 31% of it for US$54 million in cash. But buried in the footnotes, Webb found something else -- "deposits" that CNOOC had provided CNOOC Finance that exceeded US$800 million. Of course, what these "deposits" actually amount to are loans, completely unsecured. Webb acidly notes, "It is a golden rule of good governance that listed companies should not lend money to their controlling shareholders."

He's right. It's a massive conflict of interest and can lead to disaster. Note what took place with all of the money the Rigas family borrowed from the corporate coffers at Adelphia, or note what has happened with the collapsed Italian company Parmalat. If somehow the controlling shareholder cannot pay the amounts back, the company is helpless.

But there's more than just simple good/bad governance here. These are connected transactions, and they fall far beyond the point of materiality under Hong Kong listing rules. All of these loans should have been put up for shareholder approval. The Hong Kong Stock Exchange is investigating the transactions, but CNOOC's CFO, Mark Qiu Zilei, insists that the company has done nothing wrong. Interestingly, though, CNOOC is putting a similar transaction with CNOOC Finance up for shareholder vote. So, either the company did not require approval before, or it does now.

Mr. Qiu yesterday denied any wrongdoing. "The management believes that we did not breach any listing rules," he said, adding that it would be up to legal experts to determine whether it did or not. Mr. Qiu also noted that CNOOC's parent was financially strong, with a credit rating that was "the highest possible attained by any mainland firm." Shenanigans. It's the old "we didn't do anything wrong, but nobody got hurt anyway" argument.

American investors in CNOOC have some rights to vote under the current shareholder election, so there is some remedy to just say no to their company handing out unsecured loans to its corporate parent. But shareholders also need to understand that if this sort of thing goes wrong, even in a minor way, they're the next best thing to powerless to recoup any losses.

I read Webb's site because it helps me keep track of regulatory issues that surround Chinese companies, and some of his reports make me look at our own securities system in the U.S. and thank my lucky stars. I also follow to ensure that I'm not taking undue risk with the Asian companies that I do hold, Stocks 2004 selection Guangshen Railway (NYSE: GSH) and Taiwanese telecom carrier Chunghwa Telecom (NYSE: CHT). For while what we are witnessing with CNOOC may be specific to the company, anyone who reads Webb for a period of time will recognize that this is, unfortunately, a common thread.

Bill Mann owns shares of Guangshen Railway and Chunghwa Telecom. Stocks 2004 is no longer for sale, but come see what income-generating stocks Mathew Emmert's digging up! Consider a free trial to Motley Fool Income Investor.