Related party rules miss the mark | China Accounting Blog | Paul Gillis

Related party rules miss the mark

A recent activist short selling report on Hong Kong listed China Zhongwang Holdings (1333 HK) alleges an elaborate scheme the heart of which is the alleged sale of billions of dollars of aluminum to companies controlled by the Chairman’s family and proxies. I have no opinion as to whether the allegations are correct, but they do illustrate a problem I see as a major obstacle to corporate governance in Asia.

The report lays out what are alleged to be undisclosed related parties. Hong Kong has strict rules about related party disclosures, probably because Asians seem to have a preference in doing business with the family. That is, of course, of great concern to investors, since profits can easily be tunneled out to insiders by mispricing related party transactions. 

From what I can tell, however, most of the alleged undisclosed related parties may not be related parties under the rules, or it may be impossible to prove that they are. The rules that define a related party are set forth in Hong Kong Standard on Auditing 550 and define a related party as one of these situations:

(a)  Direct or indirect equity holdings or other financial interests in the entity. 

(b)  The entity's holdings of direct or indirect equity or other financial interests in other entities. 

(c)  Being part of those charged with governance or key management (that is, those members of management who have the authority and responsibility for planning, directing and controlling the activities of the entity). 

(d)  Being a close family member of any person referred to in subparagraph (c). 

(e)  Having a significant business relationship with any person referred to in subparagraph (c). 

The key to getting around these rules is to use a person who is not related to chairman and who does not have a significant business relationship with management (not the company). So chairmen who want to do transactions that will not be treated as related party transactions do so with companies controlled by individuals to whom they are not related by blood. 

Therein lies the problem, and the reason why related party rules fail so miserably in Asian cultures. A person who on paper appears to be unrelated may in fact be completely under the control of the chairman. 

Crony capitalism is a worldwide problem, but it almost an art form in Asia.  Asian culture is based heavily on Confucian principles that define human relations. In general, Confucian principles follow a patriarchal model, where the father is owed complete obedience from the son, with a corresponding requirement for the father to show benevolence to the son. In many relationships, the Chairman takes the father role and the counterparty takes the son role. 

In China, the problem has been compounded by the one-child policy. While the one-child policy may have eliminated siblings, it did not replace the human need for sibling-type relationships. Siblings (who may be considered close family members under HK rules) are replaced in Chinese personal relationships by close friends – often classmates or other childhood friends, and the bond between these individuals is as strong, or stronger, than most sibling relationships. But as long as the parties are careful not to have a  significant" business relationship between them they may remain unrelated parties for purposes of the disclosure rules. Consequentially, their transactions may not be examined by auditors under the related party rules and will not be disclosed. 

We will see how the Zhongwang allegations play out. But if the Dupré Analytics allegations are substantiated, accountants need to look hard at whether the related party rules really work in Asia. 

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