I was scheduled to testify before the U.S. China Economic and Security Commission last Thursday. Unfortunately my flight was cancelled due to the storm called Snoquester. I did watch the hearing, which is webcast here. The Commissioners did often reference my written testimony.
One of the more interesting lines of questioning came from Commissioner Jeffrey Fiedler. He noted that U.S. companies have said to U.S. courts that they cannot provide information to the courts, because that information is either a state secret or is private under the law of the other country. That “raises serious questions as to whether the boards of directors, the U.S citizen members of boards of directors of U.S. multinationals, are able in fact to perform their duties when companies have invested in China.”
Caterpillar recently was forced to write off $580 million after accounting irregularities were found at a recent acquisition in China. Reuter’s reported that a former Caterpillar board member said that the board was distracted and paid relatively little attention to the transaction.
Puda Coal, Inc. was a U.S. listed Chinese company that came to market through a reverse merger with a Delaware company. The SEC has charged Puda Coal’s chairman and CEO with stealing the assets of the company, leaving it as a shell. Recently a Delaware Chancery Court Chancellor issued a bench ruling refusing to dismiss a breach of fiduciary duties claim against the independent directors of Puda Coal. The following was included in his ruling:
If you’re going to have a company domiciled for purposes of its relations with its investors in Delaware and the assets and operations of that company are situated in China that, in order for you to meet your obligation of good faith, you better have your physical body in China an awful lot. You better have in place a system of controls to make sure that you know that you actually own the assets. You better have the language skills to navigate the environment in which the company is operating. You better have retained accountants and lawyers who are fit to the task of maintaining a system of controls over a public company.
Independent directors who step into these situations involving essentially the fiduciary oversight of assets in other parts of the world have a duty not to be dummy directors. I’m not mixing up care in the sense of negligence with loyalty here, in the sense of your duty of loyalty. I’m talking about the loyalty issue of understanding that if the assets are in Russia, if they’re in Nigeria, if they’re in the Middle East, if they’re in China, that you’re not going to be able to sit in your home in the U.S. and do a conference call four times a year and discharge your duty of loyalty. That won’t cut it. That there will be special challenges that deal with linguistic, cultural and others in terms of the effort that you have to put in to discharge your duty of loyalty. There’s no such thing as being a dummy director in Delaware, a shill, someone who just puts themselves up and represents to the investing public that they’re a monitor. Because the only reason to have independent directors – remember, you don’t pick them for their industry expertise. You pick them because of their independence and their ability to monitor the people who are managing the company. . .
If it’s a situation where, frankly, all the flow of information is in the language that I don’t understand, in a culture where there’s, frankly, not legal strictures or structures or ethical mores yet that may be advanced to the level where I’m comfortable? It would be very difficult if I didn’t know the language, the tools. You better be careful there. You have a duty to think. You can’t just go on this [board] and act like this was an S&L regulated by the federal government in Iowa and you live in Iowa.
These recent developments ought to have every independent director of a company with significant Chinese operations asking themselves and the company some tough questions. Here are a few of those questions:
1. Does the company have significant operations in China?
2. Have you personally visited those operations and looked management in the eye? How frequently do you visit?
3. Do you have the language and cultural skills to understand the business in China? Is there another board member that you can rely on for this?
4. Does the audit firm have sufficient expertise and a good reputation in China? Does it have all required licenses to operate in China? Does the audit firm outsource any of its audit work to other firms?
5. Does the audit partner who looks after Chinese operations meet with the audit committee periodically?
6. Does the audit committee understand and approve the scope of audit work in China?
7. Are any of the company’s business activities considered state secrets in China?
8. Are there any restrictions on giving access to corporate information in China to the auditors or the board?