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puda - Why China RTOs should not be bought
To start off, this is all conjecture and personal opinion so should be taken as such...
OK let's think over a few things with PUDA to understand some general risk with China RTOs and PUDA specifically as an example.
Here were the allegations:
http://alfredlittle.co...
Read this part again:
"Zhao then recklessly leveraged Shanxi Coal by borrowing RMB3.5 billion ($530.3 million) from CITIC at an incredibly high 14.5% annual interest rate (including fees) to finance the development of its coal mines. PUDA shareholders are completely unaware of these transactions that decimate the value of its U.S. listed shares."
OK so Zhao according to the allegations (that apparently have enough merit to cause a halt and immediate investigation that the company itself recognizes and have Zhao immediately step down) recklessly leveraged Shanxi (the operating subsidiary of PUDA) with $500+ million in debt at 14%+.
Now look what happens potentially to shareholders of PUDA per the annual report:
"Because virtually all of our assets are held by our operating subsidiaries, the claims of our shareholders will be structurally subordinate to all existing and future liabilities and obligations, and trade payables of such subsidiaries. In the event of a bankruptcy, liquidation or reorganization of the Company, our assets and those of our subsidiaries will be available to satisfy the claims of our shareholders only after all of Putai and its subsidiaries’ liabilities and obligations have been paid in full."
OK so in this case it looks like the China private equity firm is now owed $500+ million by Shanxi directly and therefore PUDA indirectly and all of that money has to be paid back one way or another BEFORE investors in PUDA recognize any other value? Do PUDA longs think the company is a great value with over $500 million in debt and much of the PIPE cash just spent?
Oh, and in the meantime that $500+ million is costing over 14% interest to PUDA's operating subsidiary (Shanxi)?
And all investors in the US can do is wait in line behind CITIC and the $500+ million owed before having anything of value if the debt crushes the operating subsidiary? Does anybody think Shanxi (and indirectly PUDA) is worth anything with $500+ million in debt to service? And has to fund it at 14%+ interest on that debt?
One guess is CITIC gets to foreclose on all the Shanxi assets assuming the half billion dollar loan plus 14%+ interest can't get serviced/paid back on time.
IF that's the case, it IMO is likely US investors would be left with next to nothing after forking over about $100 million just in December 2010 to PUDA with the PIPE. Then PUDA handed the money to Shanxi to buy up the mines? Ugh.
On a conspiracy theory side-
Makes me wonder if there might be some China govt collusion involved on some level. I find it hard to believe CITIC would have no clue Shanxi was supposed to be mostly owned by PUDA that traded on a major US exchange.
Continuing the conspiracy idea- considering the overwhelming size of the purported loan it makes sense to me at least that this was strategically done to give CITIC overwhelming financial pressure on Shanxi so the assets could be eventually claimed by CITIC and not PUDA since CITIC has rights/claims first before any PUDA shareholders. Maybe CITIC would even forgive the rest of the loan if all the assets were handed over. Maybe let Zhao keep the $30+ million earlier loan? Ugh.
So what happens to Zhao if all this were true? In the US likely nothing. US investors as mentioned in the annual are basically last in line. Maybe US investors could point their anger at the auditors or the PIPE placement people. Who knows. Likely they won't place the blame on their own shoulders where maybe the blame should rest (after all, the risks are spelled out in the annual report).
In China who knows what might happen to Zhao but he might be reveared as a hero for managing to transfer China's coal assets to a Chinese state run Private Equity fund and at the same time take a good chunk of US investor money to help fund the projects and infrastructure. US investors are 'rich' anyways I guess compared to most Chinese citizens, so maybe he gets a Robin Hood image in China? No idea but it is one possibility worth thinking about and would make sense why someone would do something seemingly (in US investor's eyes) so reckless...
The PUDA longs will need to start praying Zhao/Shanxi has not done much with the CITIC loan money so that it can be paid back to CITIC immediately and try to reverse what potential huge damage has already been done. Somehow I think that is an unlikely outcome though but who knows.
Interesting days for sure. And this is all just a total wild guess as to one possible logical way of understanding why something like this could happen. It certainly is hard to fathom if the allegations prove true. For now, think I'll grab some popcorn and sit and watch the show to see how it all plays out. I would recommend others putting money into China RTOs to think similarly unless they understand their investment could disappear almost immediately with little recourse even if fraud (by a Chinese national) occurs.
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From the latest PUDA 10K:
"Our principal stockholders have significant control over the Company and may have conflicts of interest with the Company.
Mr. Ming Zhao and Mr. Yao Zhao may have, or may develop in the future, conflicts of interest with us. First, the loan used to finance our facility expansions is held by Resources Group, a company which is owned by the Zhaos. It could be in their economic interest to cause us to default on the payment of the loan with Resources Group since Resources Group could acquire the assets which are subject to the lien as a result of enforcement of the lien after a default. In addition, Putai owes Mr. Ming Zhao a principal amount of RMB240 million (US$36.4 million) plus quarterly interest pursuant to a loan agreement dated May 7, 2010, which loan proceeds were used to increase Shanxi Coal’s registered capital to the level required by the Shanxi government to be a coal mine consolidator. It could be in Mr. Ming Zhao’s economic interest to cause us to default on the loan as Mr. Ming Zhao would be entitled to an additional 5% penalty interest on top of the 6% regular interest under the loan. With the combined ownership of us by Mr. Ming Zhao and his brother Mr. Yao Zhao, and the position of Mr. Ming Zhao as our Chairman of the Board, he can to a large extent control the actions which we take. Second, Mr. Ming Zhao is a party to the Investment Cooperation Agreement and Supplementary Investment Cooperation Agreement we entered into on August 1, 2010 and January 10, 2011, respectively, in which Mr. Ming Zhao will contribute 30% of the equity investment needed for acquiring and developing seven mines under the Pinglu Project, and will be entitled to economic benefits and will bear losses that are proportionate to his equity contribution. If Mr. Ming Zhao does not make the required contribution or otherwise does not perform according to the agreement, our coal mining project could be materially impacted, and our recourse against Mr. Ming Zhao may be limited given Mr. Ming Zhao’s control over our Company."
This part too from 10K, Shanxi Coal sole source of revenues:
"We are primarily a holding company and depend on distributions from our subsidiaries to meet our financial obligations.
Our Company has an offshore holding structure commonly used by foreign investors with operations in China. We are a corporation which owns BVI, and BVI owns Putai. Our operations are conducted exclusively through Shanxi Coal, in which we own 90% of the equity interest. The operations of Shanxi Coal are our sole source of revenues."
A couple other risky pieces in 10K:
"Significant assets are subject to a lien held by a company controlled by the Zhaos and their family. If we default on the payment of the obligations secured by the lien we could lose title to assets which are necessary for the operation of our business.
We financed the acquisition of the Shanxi Liulin Jucai Plant and the Zhongyang Plant through Resources Group, an entity owned 80% by Mr. Ming Zhao, 10% by Mr. Yao Zhao, 5% by Xue Ning, Ming Zhao’s wife, and 5% by Xue Yue, a second-generation cousin of Xue Ning, for an aggregate cost of $13 million paid through a 6% secured facilities loan amortized over 10 years. The note is secured by the assets purchased. If we default on the loan, the security could be enforced and title to the assets could be lost, having a significant negative impact on our ability to produce our products."
and this:
"It will be difficult for any shareholder of our Company to commence a legal action against our executives. Other than the stock of our subsidiaries, we have minimal assets in the United States.
We conduct substantially all of our operations through our control of Shanxi Coal. Shanxi Coal and substantially all of Shanxi Coal’s assets are located in Shanxi Province, China. Other than our stock in our direct subsidiary, Puda Investments Holding Limited, an International Business Company incorporated in the British Virgin Islands, we have very minimal assets in the United States. In addition, all of our executive officers reside within China. As a result, it may not be possible to effect service of process within the United States or elsewhere outside of China upon our senior executive officers, including with respect to matters arising under U.S. federal securities laws or applicable state securities laws. Moreover, our Chinese counsel has advised us that China does not have treaties with the United States or many other countries providing for the reciprocal recognition and enforcement of judgments of courts."