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China Valves (OTC:CVVT) is a manufacturer based in China. In the 10K filed November 21, it noted in the risks section that a

failure to comply with the United States Foreign Corrupt Practices Act ["FCPA"] and Chinese anti-corruption laws could subject [the company] to penalties and other adverse consequences.

The company had never discussed FCPA risks in its previous filings with the SEC.

The reason for the new risk disclosure is not stated in the filing, but it must be related to the February 2010 acquisition of Changsha Valve, a former wholly-owned Chinese subsidiary of Watts Water Technologies (WTS). Last month the Securities and Exchange Commission ("SEC") issued a Cease-and-Desist Order (.pdf) ("Order") asserting violations of the Foreign Corrupt Practices Act (“FCPA”). The SEC found that Changsha Valve sales personnel had been making improper payments to state-owned entities in order to win business for years until WTS management discovered the conduct and reported it to the SEC and investors in July 2009.

A review of disclosures, including correspondence between CVVT and the SEC made public in late September, indicates that CVVT management may have reinstated Changsha Valve's practice of paying bribes as soon as the acquisition was complete, while actively trying to conceal it from investors and regulators. The clues come from CVVT flipflopping on the reasons for the acquisition, repeated denials that any violations have occurred, and Changsha Valve's sales commissions since the acquisition.

Conflicting reasons for the unusual acquisition process

CVVT acquired Changsha Valves through an intermediary shell company set up by the wife of CVVT's largest shareholder, making it difficult for investors (and regulators) to establish the link to WTS disclosures about the FCPA violations until an 8K/A was filed in November 2010. Moreover, CVVT changed its story about the reasons for the unusual shell-company arrangement three times in the span of the nine months following the initial disclosure.

Initially, it stated that it was WTS that required, as a condition of the sale of Changsha Valves, that the purchasing party be a company whose registered owner was not CVVT or any of its affiliates. But then in a January 2011 press release it insisted that WTS actually preferred (rather than required) not to transact with a public company buyer (not just CVVT). In June 2011, in its response to an inquiry by the SEC, CVVT flipflopped back to the November explanation, with a twist: WTS again required (rather than preferred) that the purchasing party be a company whose registered owner was not CVVT, but now the "affiliates" were gone, and, in fact, the requirement against CVVT was now against any "direct competitor" of WTS.

By August, in another response to the SEC, CVVT was thoroughly confused and was mixing and matching "preferred" and a "requirement," and it had reverted to the publicly traded company "reason." That confused August explanation is now in the 10K.

Illegal activity at Changsha Valve

According to CVVT 10K, Changsha Valve is "one of the main valve suppliers of China’s hydropower and fossil power industries," and has "established the Chinese industrial standard for metal seated butterfly valves and power plant butterfly valves." But CVVT has a good reason to be less than upfront about the acquisition: SEC's findings reveal that Changsha Valves' success has been achieved through an illegal practice. The summary section of the Order states that the company's products are used in infrastructure projects in China and those projects are mostly developed, constructed, and owned by state-owned entities.

Those entities routinely retain state-owned design institutes to assist in the design and construction of their projects. Employees of Changsha Valve have been making improper payments to employees of certain design institutes to 1) influence the design institutes to recommend that state-owned entities purchase the company's products, and 2) create design specifications favoring the company's products.

The improper payments were facilitated by Changsha Valve sales policy (established prior to WTS acquisition of the company in 2006). It stated that all sales-related expenses, including travel, meals, entertainment, and payment of “consulting fees” to design institutes, were to be borne by Changsha Valve's sales employees out of their commissions, which were equal to 7% to 7.5% of the contract price, depending on the size of the contract. The sales personnel could utilize their commissions to make payments to design institutes of up to 3% of the total contract amount (that is, up to 40% of their commissions). The payments to design institutes were improperly recorded on Changsha Valve’s books as sales commissions.

The sales policy was never translated into English or submitted to WTS management in the United States. In July 2009, WTS China’s in-house corporate counsel became aware of the FCPA violations at Changsha Valve through conversations with sales personnel who were participating in an FCPA training. Shortly thereafter the lawyer notified WTS headquarters.

On August 6, 2009, WTS self-reported the violations to the SEC. On the next day, WTS filed its 10Q and informed investors that WTS has "received information regarding possible improper payments to foreign government officials by employees of [Changsha Valve]," and that such "payments may violate the Foreign Corrupt Practices Act." In September 2009, WTS Board of Directors approved the sale of Changsha Valve after management determined that its "business no longer fit strategically" (WTS 2009 10K).

Denial by CVVT

Unlike WTS, CVVT did not tell investors about the FCPA violations at Changsha Valve until almost a year after it had completed the acquisition, and when it did, it actually denied they had occurred. On an investor update call in January 2011, in response to questions, management stated that they "know the industry very well" and that they "are not aware of any evidence indicating that FCPA violations" when Changsha Valve was part of WTS. However, CVVT must have been aware of the illegal practice no later than August 2009 (when WTS disclosed it publicly), even if WTS somehow failed to share that fact during the acquisition negotiations.

Management emphasized on the same call that CVVT "doesn't have any responsibility" for the FCPA violations. Only later, in July, it admitted to the SEC that

the purchase agreement [with WTS] did not cover indemnification for liability associated with the disclosure regarding the possible improper payments to foreign government officials by employees of Changsha Valve [and CVVT] will have successor liability to assume full responsibility for any potential liabilities.

Meanwhile, CVVT has continued to deny the FCPA violations. For example, in the June letter to the SEC, CVVT claimed that it had "investigated Changsha Valve and found no evidence that any employee made improper payments to foreign government officials." In the July letter, it reiterated it had "not found any evidence of possible improper payments."

CVVT also misrepresented the reason WTS did not want to keep Changsha Valve. On the investor update call it blamed the Americans' "culture shock" and management philosophy, and the "difference in opinions" between the local (Chinese) management and the overseas management, and insisted that the "Changsha factory [was] very profitable and famous in [the] industry." Apparently, CVVT did not find the illegal local practice shocking and only saw a "good opportunity" to acquire a competitor on the cheap.

In its June letter to the SEC, CVVT further claimed that WTS "had no localized management to manage Changsha Valve, and the US management encountered challenges when managing Chinese employees" and that WTS "lacked local market knowledge in China." The SEC, on the other hand, found that "WTS had significant operations in China prior to [the] purchase of Changsha Valve," even though it was WTS' "first experience with a Chinese subsidiary that conducted business predominantly with [state owned enterprises]."

Reinstated commissions

When WTS discovered the FCPA violations in July 2009, it immediately directed all of its sales and finance employees at Changsha Valve to stop all payments of any kind to state-owned enterprises. While the internal investigation was ongoing, WTS eliminated commission-based compensation at Changsha Valve to ensure that no further improper payments were made.

According to the June CVVT letter to the SEC, the "disappointed and angry employees at Changsha Valve went on strike." So, the first order of business of CVVT after acquiring Changsha Valve was to make a payment of approximately $2.20 million to "Changsha Valves sales personnel for unpaid sales commission" (see November 2010 8K/A) At the 7.0-7.5% commission rate, that translates to about $30 million in contract value. Sure enough, CVVT reported $31 million in revenues for Changsha Valve in 2010 (CVVT 10K), while under WTS the subsidiary had just $12 million of revenues in (the first half of) 2009 (WTS 10K).

According to CVVT 10K (pages 37 and 40), selling expenses (commissions and other items) for Changsha Valve were 8.3% of revenues in 2010 (and 8.5% in January 2011), in line with the 7.0-7.5% "old" commissions policy numbers (roughly assuming a contract is fulfilled within a year), and measurably higher than the percentage for CVVT overall company-wide selling expense which was only about 6%.

So, does it matter?

WTS had to pay about $3.8 million to settle with the SEC. But Changsha Valve's revenues accounted for only about 1% of WTS revenues, and WTS selfreported the illegal conduct immediately after it was discovered and spent considerable resources in remediation. Changsha Valve accounted for 17% of CVVT revenues (and 21% of net income) in 2010 and CVVT still denies that any violations have occurred or are occurring.

The illegal payments generated profits for WTS of more than $2.7 million. While it is not clear from the Order how the SEC arrived at that number, the US citizen who was signing on the illegal payments was employed in management positions at WTS China for a bit over a year. Changsha Valve has been part of CVVT for almost two years now. CVVT reported cash and cash equivalents balance of $28 million at September 2011 end and about $5 million of negative cash flow from operations for the nine months. Any regulatory and/or legal action against CVVT concerning the FCPA violations is bound to be material.

And Changsha Valve may just be the tip of the iceberg since CVVT admits in the 10K that it "lacks qualified resources to perform the internal audit function properly, which renders ineffective the ability to prevent and detect control lapses of certain areas in accordance with the Company’s internal control design." Will the newly appointed auditors, BDO China Shu Lun Pan CPAs LLP, turn a blind eye too?

Disclosure: I am short OTC:CVVT.

Source: Does China Valves Comply With The Anti-Corruption Laws?