Caterpillar Inc uncovered "deliberate, multiyear, coordinated accounting misconduct" at a subsidiary of a Chinese company it acquired last summer, leading it to write off most of the value of the deal and wiping out more than half its expected earnings for the fourth quarter of 2012.

Caterpillar, the world's largest maker of tractors and excavators, said last month that it would take a non-cash goodwill impairment charge of $580 million, or 87 cents per share, in the quarter, following news of the fraud, which was discovered after problems were found with the Chinese company's inventory.
Caterpillar closed the purchase of ERA Mining Machinery Ltd and its subsidiary Siwei, China's fourth-largest maker of hydraulic roof supports, last June, paying HK$5.06 billion, or $653.4 million. ERA had been publicly traded in Hong Kong, doing business through Siwei, which is known for making equipment to support roofs in mines.

A member of the Caterpillar board during the course of the Siwei deal told Reuters the board was distracted at the time by a larger transaction, and paid relatively little attention to the Siwei acquisition.
"It came as a complete surprise to us," the former board member said of the fraud, speaking on condition of anonymity because of the sensitivity of the situation. "It was presented to us as a pretty straightforward transaction. It's a shame. It should have been investigated further."

The source said the driving force behind the deal was Ed Rapp, the former Caterpillar chief financial officer who now serves as a group president with responsibility for China, among other operations. The source said it was Rapp who presented the deal to the board, and pushed for its completion.

A Caterpillar spokesman declined to comment on Rapp's role in the deal. Rapp could not be immediately located for comment.

Reverse takeover

At the time of the Caterpillar purchase, ERA Mining was listed in the Growth Enterprise Market (GEM) of the Hong Kong Stock Exchange, which is "designed to accommodate companies to which a higher investment risk may be attached," according to the offering circular filed by Caterpillar last year in Hong Kong.

The company was previously known as ERA Holdings Global Ltd and provided "corporate secretarial services" before being acquired by Siwei in September 2010 through a reverse takeover.

Caterpillar's write-off could revive concerns over accounting scandals and corporate governance issues of Chinese companies voiced by investors including Muddy Waters founder Carson Block.

Reverse takeovers have been of particular concern, since most of the recent accounting scandals in the United States have come from small Chinese companies who went public via a reverse takeover, including China MediaExpress Holdings Inc. A Hong Kong arbitration panel last month ruled China MediaExpress as a "fraudulent enterprise."

'Completely unacceptable'

In a statement, Caterpillar said an ongoing investigation launched after the deal closed "determined several Siwei senior managers engaged in deliberate misconduct beginning several years prior to Caterpillar's acquisition of Siwei."

According to a question-and-answer dialog Caterpillar included in its statement, the company found discrepancies in November last year between the inventory in Siwei's books and its actual physical inventory, triggering the probe.

The company also said it had replaced several senior managers at Siwei, adding that their conduct was "offensive and completely unacceptable."

Representatives for Siwei didn't respond to calls and requests for comment on the Caterpillar announcement. The company employs about 4,000 people in Zhengzhou, and produces hydraulic roof supports used to prevent rocks from falling into a coal mine's working area.

Siwei competes with market leader Zhengzhou Coal Mining Machinery, according to Zhengzhou Coal's IPO prospectus filed in November 2012.

Citigroup and law firm Freshfields Bruckhaus Deringer LLP served as financial and legal advisers to Caterpillar on the transaction. Blackstone and DLA Piper, meanwhile, acted as ERA's financial and legal advisers.

Freshfields said in an e-mailed statement that it wouldn't be able to comment on client matters. Representatives for Blackstone, Citigroup, and DLA Piper also didn't respond to requests for comments.

China ambitions

The Siwei deal came as part of Caterpillar's larger ambitions in China. In early 2012, it added Jon Huntsman, the former U.S. ambassador to China, to its board of directors.

The company, which already has 23 manufacturing facilities in China and four more under construction, said the Siwei episode would not change its strategy in the country.

Caterpillar's experience with Siwei may also renew focus on the standoff between the U.S. Securities and Exchange Commission and audit firms over access to accounting documents of U.S.-listed Chinese companies suspected of fraud.

Dig below the top line

As a company that makes excavators, Caterpillar should have known the importance of digging, says John Foley of Reuters Breakingviews

U.S. machine maker Caterpillar has taken a $580 million write-down on a Chinese mining equipment producer it bought less than a year ago, erasing three quarters of that deal’s value. The accounting fraud that Caterpillar claims to have found at ERA Mining may not have been visible at the time of the purchase. But the low quality of its target’s rapid growth was.

Caterpillar thought ERA, whose subsidiary Siwei makes supports that hold up coal mines, was a sound bet on China’s infrastructure boom. The company’s 21 percent yearly growth in revenue since 2008 must have been enticing – enough, even, to allay concerns over the complex reverse merger Siwei had been through in 2010. Caterpillar’s offer price showed no signs of doubt: it paid three times Siwei’s prior year sales – trebling the multiple the market attached to the business when it listed.

That growth, though, rested on the company rapidly increasing the credit it gives to buyers. Siwei’s receivables – the amount it is owed by customers – had snowballed at an alarming 58 percent a year since 2008, and actually overtook total sales in 2011. Some 90 percent of those debts were overdue when Caterpillar launched its bid. ERA said in filings that some debts were collected once its products were installed, but that customers often didn’t tell it when that had happened.

Unsold goods raised another red flag. For businesses that make bespoke machinery, it’s normal for products to sit on the books for a while. But Siwei’s stocks were increasing at an alarming rate. At the end of 2010, the average number of days its products and materials sat in storage was 414. That’s twice what they were during China’s dramatic slowdown of 2009.

None of those factors alone offered evidence of misdeeds. Issues like when to recognize revenues, or how to treat unpaid debts, can be complicated in China, where verbal agreements often take the place of contracts. But there was enough to suggest Siwei’s growth was probably unsustainable, and undeserving of such a generous price. Caterpillar may have fallen foul of fraud, but it also looks like a victim of exuberance.

‘Fraud is always a distinct possibility’

Q&A with Walker J. Wallace, Shanghai-based partner at O’Melveny & Myers

In cases like this, who would be held responsible?

Responsibility would turn on a number of things. For instance, the terms of the contract entered into by the parties, and the nature of the accounting misconduct. Typically, the acquisition agreement would contain various representations regarding the accuracy of the financial statements of the company being acquired, or the target, including a representation that the financial statements were “fair.” Contractual liability for breach of this representation would turn on who gave the representation. This is often a heavily negotiated issue. A buyer will typically insist on getting this representation from any sellers in the transaction, including founders of the company who may be selling their interest in the company. However, sellers will often push back. For example, a private equity fund that is selling its stake in the target would argue that it does not manage the business and cannot take responsibility for this type of rep. The bottom line, though, is that anyone giving the representation under the contract would generally be liable if the accounts were incorrect.

Putting aside the contents of the contract, there can also be liability for anyone who might be said to have fraudulently induced the buyer to buy the target by providing false information, whether or not the person committing such fraud was party to the contract. This might cover management members who prepared the accounts knowing that the buyer would rely on them, or sellers who knew that accounts were incorrect (even if they did not technically sign onto the representations given in the contract).
There might also be a case for negligence against the accounting firm that audited the accounts. To the extent that they were negligent in the conduct of their audit and could be said to owe a duty to a buyer who relied on those accounts, the buyer might sue them.

Finally, there might be a case of criminal fraud. However, criminal fraud would mostly be pursued by the police, and would not be something that the buyer could prosecute (although they could bring it to the attention of the police).

In the case of a loss like this, I would be very surprised if the buyer did not pursue all of these angles.

Could legal action be taken to recover some of the loss?

Although the buyer could typically sue under a variety of theories to recover its losses in a case like this, such a suit is not easy. First, it has historically been difficult for foreign litigants to collect against defendants in China. This situation has improved markedly over the past 10 years, but continues to be a problem. Second, regardless of the location of a defendant, once the money is out the door from buyer to seller, it can be very hard to track down again. For example, if a buyer bought the target from a fund that was a limited liability partnership and the fund was subsequently wound down after distributing proceeds from the sale to its partners, it would not be clear who could be sued to recover the funds.
Sometimes, a buyer will insist that management members keep a stake in a company, like the target, until several years after the sale. This is to tie management to the continuing success of the company, and give some redress in the case of problems. However, management’s stake typically would only represent a fraction of the total purchase price for the target.

Similarly, sometimes a buyer will insist that part of the purchase proceeds should be “held back” for some period after the purchase. If no problems are discovered within an agreed period after the purchase, this holdback amount would be paid to the sellers. However, if problems crop up, the buyer could refuse to pay the holdback amount, though the holdback amount is typically only a fraction of the total purchase price.

How could future cases like this be prevented?

Whether fraudulent accounts can be prevented in the first instance may depend on the nature of the fraud. For example, it is not uncommon to discover that companies have been underpaying their taxes, regardless of the accounts they have put forward. This is relatively straightforward in many cases because it is largely a matter of comparing the types of income earned, and the nature of the taxes that should have been paid. The discrepancy between what should have been paid and what was actually paid is usually pretty noticeable.

However, to the extent the diligence process turns on documents and data provided by a company, if sellers are determined enough, they can certainly provide fraudulent documents that seem to corroborate their accounts. This type of fraud can be hard to discover.

In the case of doing diligence on financial accounts, lawyers do not typically have primary responsibility for the process. The responsibility typically falls on an accounting firm working for the buyer.

Is acquiring a Chinese target generally risky? How would you advise clients looking to purchase a Chinese company?

I would not draw the conclusion from one fraud that buying a Chinese target is generally of higher risk. Fraud happens everywhere that there is a lot of money, and between cases like Enron and Worldcom, places like the U.S. have certainly had problems with fraud in the past. However, there are some pretty typical areas where Chinese companies run into regular problems. For example, underpayment of taxes and social benefits is a recurring problem with most Chinese companies. However, in my experience, a bigger issue in Chinese acquisitions has been questions around the enforceability of contracts and the ability to secure redress in the case of a breach.

I would not be surprised if the main lesson to be drawn from the case is that fraud is always a distinct possibility. Unfortunately, people get complacent because of a variety of pressures.

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