Did you know that LIXIL suffered enormous losses when it acquired a Chinese company?
On November 16, 2015, the company released summaries of the findings of its internal investigation committee and special investigation committee. The conclusion of the internal investigation included the following.
The conclusion was reached that the Joyou Group’s founder and his son were the people most deserving of blame for Joyou’s accounting fraud. Our investigation also confirmed the fact that Joyou’s improper accounting went back as far as 2008. Specifically, the investigation revealed that Joyou’s financial documents had been falsified and that there were loans not approved by Joyou’s supervisory board. These loans were not recorded in Joyou’s books. They included extremely high-interest personal loans, secured by the assets of Joyou’s Chinese subsidiaries, taken out by the founder’s son, who was the COO. In addition, the founder and his son reported false amounts of income on tax returns in order to minimize tax payments.
(LIXIL, “Investigation Results Concerning the Joyou Matter,” November 16, 2015 (Japanese))
The conclusion of this internal investigation reads as though it emphasizes that the company had been deceived.
This matter involved Grohe, a major German faucet-fixture company acquired in 2014. Because that company owned Joyou, which was listed on the Frankfurt Stock Exchange in Germany, LIXIL also came to hold Joyou shares indirectly. In the company’s June 2015 announcement, the matter was expected to result in losses of ¥33.2 billion from impairment of Joyou share value and investigation costs, among other items, and up to approximately ¥33.0 billion from other debt guarantees. (LIXIL, Financial Results Presentation Materials for the Fiscal Year Ended March 2015, page 33 (Japanese))
Wow, that is frightening... Acquiring a company created the possibility of losses exceeding ¥60 billion.
Confirming the Relationship Among the Companies
LIXIL (a Japanese company)
↓ (held shares indirectly; made a consolidated subsidiary in April 2015)
Grohe (a German company)
↓ (held shares; subsidiary)
Joyou (a German corporation conducting business in China)
Lessons Viewed from Two Angles
- Insufficient pre-acquisition investigation (due diligence)
- Laxity after the acquisition
Insufficient Pre-Acquisition Investigation (Due Diligence)
The investigation of a business and its finances before acquiring a company is called due diligence.
With owner-managed businesses, a buyer may sometimes make an impulsive “Let’s do it!” decision but normally one purchases only after conducting a proper investigation. Of course an investigation is standard.
In this case, if a proper investigation had been conducted, the acquisition funds allocated to Joyou shares might not have been lost.
Generally, there are limits to investigating Chinese companies. Even so, this was extensive fraud, so the chance of finding initial clues through an investigation was not low.
According to LIXIL’s investigation, Joyou had been committing fraud since 2008, its financial documents had been falsified, and it had substantial off-book borrowings. LIXIL made it a consolidated subsidiary in April 2015, and the following month it filed for bankruptcy. That is a chilling sequence of events.
In fact, another recent case besides LIXIL’s was that of Emori Group Holdings. The investigation results the company announced in March 2015 included the following.
The former general manager, who had been the top executive of the Chinese subsidiary, conducted transactions without company approval with companies in which relatives invested or participated in management. This violated internal rules. In circular transactions with relatives’ companies, it recorded gross sales and purchases as though they were merchandise transactions, when it should have recorded only service-provision fees as sales. In transactions with another customer, it also found “buyback transactions,” in which the ultimate purchaser was the same as the supplier.
In the company’s full-year financial results for the fiscal year ended March 2015, additions to the allowance for doubtful accounts at its Chinese subsidiaries alone came to ¥55.011 billion... Accounts receivable from major customers of the Chinese subsidiaries became difficult to collect, and ultimately the Japanese holding company also filed to commence civil rehabilitation proceedings on April 30, 2015. (The company’s Financial Results Summary for the Fiscal Year Ended March 2015 (Japanese))
Those considering acquiring a Chinese company, and those with subsidiaries in China, must conduct thorough checks. Even if it costs money, it is a necessary cost. In my practical accounting experience, there are times when I feel that Chinese companies’ accounting is rough and careless. Even if accounting standards are in place, that does not necessarily mean the actual figures are sound. Question the figures presented to you.
Laxity After the Acquisition
Shareholders in a stock company have limited liability. In principle, their responsibility as shareholders is limited to the scope of their investment.
I think that if nothing unusual had been done after the acquisition in this case, the losses might have been limited to the impairment of the share value and similar losses. Laxity after the acquisition made the wound deeper. Debt guarantees were provided...
Overseas, one encounters many kinds of fraud schemes. It goes without saying that “if someone asks for money soon after you meet, suspect fraud.” Is this a little different from the Japanese instinct? Japan is peaceful.
In my practical experience, when a listed company borrows money, it first raises funds on the strength of its own creditworthiness. Joyou was listed on the Frankfurt Stock Exchange.
The fact that debt guarantees widened the damage suggests to me that there were some special circumstances.
Do not casually provide debt guarantees for an overseas subsidiary you have just acquired and whose actual condition you do not understand.
It may seem obvious in ordinary times, but when making a decision as a party to the transaction, one may become short-sighted, so let us be careful.
What did you think?
Have you now felt how failing to conduct sufficient investigation of Chinese companies can bring a frighteningly painful backlash? Still, it is a large market, and Japanese companies will likely continue to enter it one after another. I hope you will treat this matter as a negative example and avoid losses like these.
In the LIXIL matter, in addition to the internal investigation committee, a special investigation committee made up of outside directors and external experts was also established. I would like it to examine objectively not only the explanation that the company was deceived, but also the acquisition decision and post-acquisition management. Doing business in China may not be straightforward.
Note: The investigation findings of each company and determinations of criminal responsibility are separate matters. Until a guilty verdict against the people involved becomes final, they are presumed innocent. Please check subsequent legal-procedure developments in each company’s additional announcements and other disclosures.