Risk Governance and Control: Financial Markets & Institutions/ Volume 7, Issue 4, Fall 2017, Continued - 1

THE ROLE OF RISK MANAGEMENT IN

CORPORATE GOVERNANCE:
GUIDELINES AND APPLICATIONS
Hugh Grove *, Mac Clouse **
* Accounting Professor, respectively, Daniels College of Business, University of Denver, the USA
** Corresponding author. Finance Professor, respectively, Daniels College of Business, University of Denver, the USA

Abstract

How to cite this paper: Risk management should be a key concern of board members to
Grove, H., & Clouse, M. (2017). The role
of risk management in corporate
enhance corporate governance in any organization. Eleven key
governance: Guidelines and numbers, ratios, and models were advocated in this paper for risk
applications. Risk Governance and management analyses, including an analysis of their variability with
Control: Financial Markets & Institutions,
graphs. They are applied to Kaisa, a Chinese property developer,
7(4-1), 92-99.
http://doi.org/10.22495/rgc7i4c1art1 located in Shenzhen but incorporated with limited liability in the
Cayman Islands. The importance of such risk management analyses
Copyright © 2017 The Authors was demonstrated in this paper as Kaisa destroyed $12.9 billion in
This work is licensed under the Creative four different types of investments: $2.2 billion in stock market
Commons Attribution-NonCommercial value, $0.3 billion in private equity investments, $2.5 billion in
4.0 International License (CC BY-NC global bonds, and $7.9 billion in Chinese short-term and long-term
4.0).
http://creativecommons.org/licenses/b
debt. Thus, the use of key financial statement metrics, including
y-nc/4.0/ fraud models and ratios, has been shown here to provide enhanced
corporate governance with risk management guidelines and
ISSN Online: 2077-4303 applications. Boards of Directors need to pay attention to key
ISSN Print: 2077-429X
financial statement metrics, which have been shown to work over
Received: 07.01.2017 and over again, as with Kaisa in this paper. These key metrics
Accepted: 28.10.2017 usually start with operating cash flows which then may indicate
JEL Classification: G32, G34
problems with debt service (the fixed charge coverage ratio) which
DOI: 10.22495/rgc7i4c1art1 then may lead to bankruptcy predictions by the Altman bankruptcy
model. To cover up such survival problems, companies often resort
to earnings management and even fraudulent financial reporting
which are typically red flagged by the quality of earnings, the
quality of revenues, the new fraud model and the old fraud model.

Keywords: Risk Management, Corporate Governance, Fraud Models

1. INTRODUCTION backed securities, and collaterized debt obligations.

Other Lehman Brothers risk committee members
Risk management should be a key concern of board were a retired CEO of IBM, a Broadway show
members to enhance corporate governance in any producer, a former CEO of a Spanish television
organization. Unfortunately, such concern is often network, and a retired rear admiral of the U.S. Navy!
not the case. The tipping point for the financial A similar competence issue was raised by
crisis was generally acknowledged to be the Fall, Richard Breeden, former head of the Securities and
2008 bankruptcy of Lehman Brothers. Risk Exchange Commission (SEC), about the board of
management was very weak at Lehman Brothers as American International Group (AIG) which included
indicated by its ineffective risk management diplomats and admirals: “AIG, as far as I know,
committee (Grove and Patelli, 2013). Lehman didn’t own any aircraft carriers and didn’t have a
Brothers’ risk committee only ever had two seat in the United Nations” (Das, 2011). The SEC
meetings, one in 2006 and one in 2007 before the attempted to alleviate this problem in March 2010
company went bankrupt in 2008. The lack of by mandating board risk oversight and related
expertise was noteworthy with Lehman Brothers’ disclosures for enterprise risk management of U.S.
risk management committee. The chair was an 80 publicly-held companies (Walker et al., 2015). The
year-old banker who had little experience in the 2010 Dodd-Frank Act requires that major banks
newer banking practices concerning financial have a risk management committee with at least one
instruments, such as credit default swaps, mortgage- member being an expert in risk management. There

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is also an ISO 31000 Risk Management standard thinking probabilistically. He argued that such an
which has processes for risk identification, risk approach requires quantitative analysis for
analysis, and risk evaluation (McNally and Tophoff, understanding and dealing with uncertainty,
2015). especially to inform, guide, and correct intuition.
Recent problems in risk management include Thus, risk managers should be asking how good the
JPMorgan Chase where there was a $6 billion trading quantitative tools are and how useful the
loss by the company’s chief international investment quantitative analysis is, rather than focusing upon
office, i.e., the “London Whale” loss, and the intuition (Coleman, 2011).
liquidation of UBS’s $500 million Willow Fund, a Coleman further argued that financial risk is all
closed-end investment fund. The portfolio manager about money - P&L and the variability of P&L. Future
changed his investment strategy from distressed outcomes can be summarized by P&L and the
corporate debt instruments to derivatives with risky uncertainty in P&L can be described by the
bets against the debt of European nations. The distribution or density function which can map
fund’s independent directors did nothing and many possible outcomes of the profits or losses. For
investors learned the hard way that a fund’s managing risk, the major contribution of a P&L
directors cannot be relied upon to protect investors distribution is an understanding of how variable the
from a fund manager’s risky bets (Morgenson, 2013). P&L can be. “When the P&L distribution is known,
Thus, board directors often disappoint by what they i.e., the possibilities of gains versus losses, when the
do not do, especially concerning risk management generation of this distribution is known and what
(Morgenson, 2013). causes the gains and losses, then, virtually
There should be effective monitoring of risk everything about financial risk is understood”
without dependence on any corporate bailout (Coleman, 2011). The most important distribution
financing which happened for the largest 19 U.S. aspect is the variability or the spread of the
banks with the U.S. Taxpayers Assistance Relief Act distribution. A common, well-known measure used
of $700 billion in 2009. “The CEO of any large to summarize the variability or the dispersion of the
financial organization must be the Chief Risk Officer distribution is volatility, also known as the standard
and must not delegate risk control to a Risk deviation. For most normal, well-behaved
Committee or a Chief Risk Officer. Risk control is distributions, one standard deviation above and
simply too important” (Buffett, 2008). Buffett further below the expected outcome indicates the result will
commented on risk control: “I believe a CEO must be outside the range approximately 32% of the time.
not delegate risk control. It’s simply too important. Two standard deviations above and below the
If Berkshire Hathaway ever gets in trouble, it will be expected outcome indicates the result will be
my fault. It will not be because of misjudgments outside the range approximately 5% of the time
made by a Risk Committee or a Chief Risk Officer. (Coleman, 2012).
In my view, a board of directors of a huge financial One of the major goals of risk management is
institution is derelict if it does not insist that its CEO the avoidance of a significant surprise or an
bear full responsibility for risk control. If he’s outcome other than what is expected. While
incapable of handling that job, he should look for surprises do happen, it is a large surprise, whether
other employment. And if he fails at it – with the good or bad, that provides risk management
government thereupon required to step in with problems. If the standard deviation of the
funds or guarantees – the financial consequences for distribution is known, then management can predict
him and his board should be severe” (Buffett, 2009). the range of the outcomes with the best and worst
For example, both the CEOs of Volkswagen and possible values for both 68% and 95% confidence
Wells Fargo Bank “resigned” in 2016 without any ranges. Knowing the end points of these ranges
golden parachute pay when lack of risk management shows how good or how bad the outcome can be. An
procedures became public at their companies. The outcome outside of the 68% confidence range would
Wells Fargo CEO even had to claw-back $41 million be a surprise that could happen 32% of the time. An
of his compensation. outcome outside of the 95% confidence range can
only happen 5% of the time, but these surprises will
2. RISK MANAGEMENT OVERVIEW be much better, or much worse, than the expected
outcome. Management must know how much better
A definition of risk management is provided by or how much worse the outcome can be in order to
Coleman (2011): “Risk management is the art of plan responses to these large surprises.
using lessons from the past to mitigate misfortune Managing risk should be a core strategic
and exploit future opportunities - in other words, competency for any international company as
the art of avoiding the stupid mistakes of yesterday Coleman (2011) emphasized: “The ability to
while recognizing that nature can always create new effectively manage risk is the single most important
ways for things to go wrong. Thus, risk management characteristic separating financial firms that are
is about much more than numbers; it is the art of successful and survive over the long run from firms
using numbers and quantitative tools to actually that are not successful. At successful firms,
manage risk. Risk is a central, maybe the central, managing risk always has been and continues to be
component of managing a financial organization.” the responsibility of managers - from the board
In assessing the overall risk of a company, Coleman through the CEO and down to individual line
focused on the variability of profits and losses (P&L) managers.” Volatility risk measures are backward
which provides a risk framework for levels of the looking, based upon historical performances but as
firm from individual managers up through the board Coleman (2011) observed: “Understanding the past
if calculated and reported on a consistent basis. He is terribly important because understanding current
observed that managing risk requires being exposures, and how they would have behaved in the
comfortable with uncertainty and randomness and past, is the first step toward managing the future.”

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Since risk measurement techniques require expertise companies indicated a 20% possibility of earnings
and experience to use properly, managers, board management up to a possible 10% distortion of
members, and investors have a responsibility to earnings per share (Whitehouse, 2012). A McKinsey
understand their complex businesses and & Company report (2013) found that 100 small
investments. Risk management techniques can try to Chinese companies, mainly using reverse take-overs
put estimates around, but cannot properly (RTO) to get listed on U.S. stock exchanges in 2005-
represent, extreme or “black swan” surprise events. 2010, had then been delisted in 2011-2012 and
Managers, board members, and investors have to destroyed over $40 billion in stock market value.
learn to live with such uncertainty and avoid a false Also, major frauds of the 21st Century had destroyed
sense of security. $490 billion in stock market value (Grove and
Basilico, 2011). Thus, two fraudulent financial
3. RISK MANAGEMENT PROCEDURES reporting prediction models are advocated for risk
management. An “old fraud model” (Beneish, 1999)
Coleman’s risk focus is on the variability of profits analyzed SEC investigations of U.S. public companies
and losses from the income statement. However, this from 1982-1992 and has a -1.99 cutoff; a larger
narrow profitability focus is expanded in this paper result is a red flag for fraudulent financial reporting
to include a liquidity focus with the variability of (smaller negative or positive numbers). A “new fraud
operating cash flows from the statement of cash model” (Dechow et. al., 2007) analyzed SEC
flows and a solvency focus with the variability of investigations from 1982-2006 and has a 1.00 cutoff;
cash from the balance sheet. Thus, all three major a larger result is a fraud prediction.
financial statements can contribute to risk
management procedures. 4. RISK MANAGEMENT APPLICATIONS
Then, these three initial risk management
focuses are each expanded to assess additional These eleven numbers, ratios, and models,
volatility as follows. The net income profitably focus advocated in this paper for risk management
is expanded to consider the profit margin ratio. The analyses, are applied to Kaisa, a Chinese property
operating cash flow liquidity focus is expanded to developer, located in Shenzhen but incorporated
consider the quality of earnings ratio and the quality with limited liability in the Cayman Islands. In 2007,
of revenues ratio. The quality of earnings is Credit Suisse brokered a $300 million equity
computed by dividing operating cash flows by net investment deal with two international private
income. The quality of revenues is computed by equity funds, the Carlyle Group and the Temasek
dividing the cash collected from customers by Holdings. In 2009, Kaisa raised $450 million with an
revenues. The cutoff for a good result for both ratios initial public offering (IPO) on the Hong Kong stock
is one or better, assessing whether accountants’ exchange, led by the Bank of China International and
accrual measures are being converted into cash Credit Suisse with an unqualified audit opinion by
(Schilit, 2010). This financial analyst also PWC Hong Kong, its ongoing auditor. From 2009-
commented: “A common element in major frauds is 2013, Kaisa also raised $2.5 billion in debt
that their warning signs were not hard to find; in investments from over two dozen foreign fund
fact, they were hard to miss” (Schilit, 2010). These investors, including BlackRock, Fidelity Investments,
cutoffs follow the observation of many investment Lion Global Investors, and JPMorgan Asset
bankers: GAAP is CRAP, CASH is KING (Miller, 2015). Management (Barboza, 2015). These global bond
The cash solvency focus is expanded to offerings were led by Citigroup, JPMorgan Chase and
consider the fixed charge coverage ratio, the Sloan Credit Suisse. Thus, there should have been plenty
accrual ratio, and the Altman bankruptcy model. of due diligence investigations of Kaisa by all these
The numerator in the fixed charge coverage ratio investment banks, private equity funds, auditors,
emphasizes free cash flow: Earnings Before Interest, IPO stock investors, and international debt investors.
Taxes, Depreciation and Amortization (EBITDA) less However, by April, 2015, Kaisa was on the verge of
capital expenditures less cash income taxes paid. bankruptcy and all these investments were in danger
The denominator emphasizes debt service: interest of being lost. A lawyer representing some of the
payments and debt repayments. The cutoff for Kaisa bondholders commented: “Many investors are
adequate debt service is 1.15 per a private equity shocked at what happened. It’s troubling that in a
partner who looks at over one hundred possible market as sophisticated as this, no one knew what
acquisitions each year (Miller, 2015). Often, a typical was going on” (Barboza, 2015). One has to ask:
bank loan covenant for such debt service is a more where was the risk management analysis by all these
conservative 2.0. The Sloan accrual ratio numerator sophisticated entities?
is net income less free cash flows which is computed A key contribution to risk management analysis
as operating cash flows less capital expenditures. could have been a Moody’s Investment Service
The Sloan denominator is average total assets and Report, “Red Flags for Emerging-Market Companies:
the cutoff is 0.10 where a result over this cutoff is a A Focus on China,” published July 11, 2011
red flag (Robinson, 2007). The Altman bankruptcy (Moody’s, 2011). It analyzed 20 potential red flags,
model has the following overall cutoffs: below 1.8 is grouped into five categories, for non-financial
a bankruptcy prediction; 1.8 to 3.0 is a possible Chinese companies issuing corporate debt:
bankruptcy prediction and over 3.0 is a non- 1. Possible weaknesses in corporate governance
bankruptcy prediction (Altman and Hotchkiss, 2. Riskier or more opaque business models
2005). 3. Fast-growing-business strategies
An additional focus for possible earnings 4. Poor quality of earnings or cash flow, and
management or fraudulent financial reporting which 5. Concerns over auditors and quality of financial
can distort risk management procedures is still statements.
needed. A 2012 survey of 170 CFOs of U.S. public

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Chinese authorities are sensitive to criticism of Tohmatsu warned Kaisa’s offshore bondholders that
corporate governance and these other issues, which they would be effectively wiped out if Kaisa was
could reduce the appeal of Chinese companies to forced into liquidation (Whitfield, 2015).
offshore debt investors. Moody’s was fined $3 To demonstrate a methodology for risk
million by the government watchdog agency for management analysis, the eleven numbers, ratios,
Hong Kong markets in 2011 after this report was and models in this paper are now applied to Kaisa.
published. Kaisa raised 7 of Moody’s 20 red flags Eight years of income statements and balance sheets
(35%), compared to the average of 5.7 red flags were available for Kaisa from 2006 to 2013. The
(28.5%) for the 26 Chinese property developers in 2014 financial statements have not yet been filed,
Moody’s report (Whitfield, 2015). pending resolution of negotiations with debt
A further risk for offshore debt investors is a investors since a $23 million payment was missed in
lack of investment security, due to Chinese January 2015 (Law, 2015). Only six years of
restrictions on foreign currency borrowing which statements of cash flows were available from 2008-
prevent private companies from borrowing directly 2013 and no common stock prices existed before the
from foreigners. To work around this restriction, 2009 IPO. Thus, there were only five years of data to
Chinese companies create offshore subsidiaries that run various fraud models or ratios or the
issue debt, then invest these funds in their domestic bankruptcy model. The volatility of all eleven
parent as equity. Thus, offshore bondholders are numbers, ratios, and models are provided in Table 1
subordinate to onshore lenders, trade creditors, and for risk management of Kaisa. However, the only
potentially mainland equity holders. They would three absolute numbers (net income, operating cash
also be excluded from any onshore bankruptcy flows, and cash) in Table 1 were converted from
proceedings. They may be able to take control of an millions of Chinese renminbi to millions of U.S.
offshore holding company, but they have no direct dollars at an average foreign exchange rate of $1 for
security over the underlying onshore assets. 6 renminbi for ease of discussion.
Accordingly in early 2015, Deloitte Touche

Table 1. Risk Management Kaisa Applications

Standard Deviation Ranges

Red Flag?
Metric Average One: 68%* Two: 95%
# of Years
261 53 468 -146 668
Net Income
3 of 8
17.1 13.7 20.5 10.4 23.7
Profit Margin
3 of 7
-185 -493 123 -788 418
Operating Cash Flow
2 of 6
-0.42 Yes -1.47 0.62 -2.47 1.63
Quality of Earnings
5 of 5 1 of 5
0.98 Yes 0.78 1.19 0.59 1.38
Quality of Revenues
4 of 5 2 of 5
541 181 900 -164 1255
Cash
3 of 8
0.59 Yes -0.20 1.38 -0.96 2.14
Fixed Charge Cover
7 0f 8 2 of 8
0.09 No 0.04 0.15 -0.02 0.21
Sloan Accrual
3 of 5 1 of 5
0.92 Yes -0.04 1.88 -0.96 2.80
Altman Bankruptcy
4 of 5 1 of 5
-0.94 Yes -2.61 0.73 -4.22 2.34
Old Fraud Model
4 of 5 2 of 5
1.84 Yes 1.26 2.42 0.70 2.98
New Fraud Model
5 of 5 2 of 5
*Number of years outside range

Concerning the prior recommended focus on The two standard deviation confidence range was
the P&L or net income, Kaisa’s average net income of 10.4% to 23.7%, a range of 13.3 from worst to best;
$261 million over eight years had a 68% confidence so 5% of the time, the profit margin would be
range of $53 million to $468 million over the 8 years outside this range. Only 7 years were used since
in Figure 1 of the Appendix. Thus, with a volatility of there was an outlier profit margin of 46.9% in 2010,
$415 million from the worst to the best, a manager one year after the IPO which could hint of earnings
or board member would expect that 32% of the time, management to help retain IPO stock investors and
net income would be outside this range. attract new investors. Such superior profit margins
The corresponding profit margin had an should be investigated with competitor comparisons
average of 17.1%. In Figure 2 of the Appendix, there to see “if the story may be too good to be true,”
was a one standard deviation confidence range of especially the 46.7% outlier, as recommended by
13.7% to 20.5%, a range of 6.8% from worst to best; various short sellers (Left, 2011 and Bases et. al,
so a manager or board member would expect that 2011).
32% of the time, profit margin would be outside this Concerning liquidity as an expanded risk
confidence range. It happened in 3 of the 7 years. management focus, the average operating cash flow

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was a negative $185 million from 2008 to 2013. In was above this cutoff when the company was still
Figure 3, the one standard deviation confidence privately held. In Figure 7, the one standard
range (for a 68% probability) was a negative $493 deviation confidence range (for a 68% probability)
million to a positive $123 million , a range of $616 was a negative 0.20 to a positive 1.38; so, a manager
million from worst to best; so a manager or board or board member would expect that 32% of the time,
member would expect that 32% of the time, the FCC ratio would be outside this range. 6 of the 8
operating cash flow would be outside this years fell within this range. The two standard
confidence range. In 4 of the 6 years, operating cash deviation confidence range (for a 95% probability)
flow was within this range. The two standard was a negative 0.96 to a positive 2.14; so, a manager
deviation confidence range (for a 95% probability) or board member would expect that 5% of the time,
was a negative $788 million to a positive $418 the FCC ratio would outside this range.
million; so a manager or board member would For the Sloan accrual ratio, the average was
expect that 5% of the time, operating cash flow 0.09 (just below the 0.10 cutoff). Only five years
would be outside this range. could be calculated due to the lack of statements of
This liquidity focus is further expanded with cash flows in the earlier years. In only two years
the quality of earnings and quality of revenues (2010 with 0.13 and 2011 with 0.18) was this ratio
ratios. Their averages of a negative 0.42 and a above the red flag cutoff of 0.10. In Figure 8, the one
positive 0.98, respectively, show red flags for standard deviation confidence range of 0.04 to 0.15
possible earnings management or fraud in all 5 captured four years. The two standard deviation
years and in 4 of 5 years, respectively, falling below confidence range was from a negative 0.02 to a
the 1.0 no-red flag cutoff for both ratios. For quality positive 0.21.
of earnings in Figure 4, the one standard deviation Concerning the Altman bankruptcy model, the
confidence range of a negative 1.47 to a positive average was 0.92 which is a bankruptcy prediction
0.62 captures 4 of the 5 years but the fifth year is a below the 1.8 cutoff for four of the five years that
negative 2.13 so there are fraud predictions for all 5 the necessary financial information was available.
years. For quality of revenues in Figure 5, the one 2009, the IPO year, was just a possible bankruptcy
standard deviation confidence range of 0.78 to 1.19 prediction with a score of 2.51 versus the possible
captures 3 of the 5 years (0.94, 0.96, and 0.98) but a range of 1.8 to 3.0 for this model. Years 2010, 2011,
fourth year is 0.74; so, there are fraud predictions 2012, and 2013, all had progressively stronger
for 4 of the 5 years. The fifth year (1.30) is not a bankruptcy predictions of 1.14, 0.41, 0.30, and 0.25,
fraud prediction but occurred in the same year 2010 respectively. In Figure 9, the one standard deviation
as the profit margin outlier of 46.9% which may confidence range of a negative 0.04 to a positive
again indicate earnings management one year after 1.88 captured four years. The two standard
the IPO. deviation confidence range was a negative 0.96 to a
Concerning solvency as an expanded risk positive 2.80.
management focus, the average cash balance from Finally, two well-known fraudulent financial
2006 to 2013 was $541 million. In Figure 6, the one statement prediction models (Beneish, 1999 and
standard deviation range (or a 68% probability) was Dechow et.al., 2007) are applied to the five years
$181 million to $900 million, a range of $719 million that had all the necessary data for Kaisa. The older
from worst to best; so, a manager or board member Beneish fraud model had an average score of a
would expect that 32% of the time, the cash balance negative 0.94 which was well above the fraud
would be outside this range which occurred in 3 of prediction cutoff of a negative 1.99. Thus, there
the 8 years. The two standard deviation confidence were fraud predictions in four of the five years: -1.36
range (for a 95% probability) was a negative $164 for 2009, the IPO year, 1.85 for 2011, -1.56 for 2012,
million to a positive $1,255 million, a range of and -1.01 for 2013. The only non-fraud prediction
$1,419 million from best to worst; so, a manager or year was 2010 with -2.62, which further indicates the
board member would expect that 5% of the time, the possibility of window dressing or earnings
cash balance would be outside this range and it was management in the year after the IPO to keep
on June 30, 2014. Cash was reported as $1,383 investors interested in the company. In Figure 10,
million which was above the upper limit of $1,255 the one standard deviation confidence range was a
million with a 2.5% probability of being correct. The negative 2.61 to a positive 0.73 which just missed
small possibility was validated by cash being only the fifth year while the two standard deviation
$306 million on March 1, 2015 (Yeoh, 2015) so what confidence range was a negative 4.22 to a positive
happened to $1,077 million or $1.077 billion cash in 2.34.
less than nine months? A huge red flag for risk However, the newer, more comprehensive,
management is indicated, similar to both Parmalat Dechow fraud model did predict fraud in all five
and Satyam where over $1 billion in cash at each years. The average score was 1.84, well above the
company was also missing in their last set of 1.0 fraud prediction cutoff. The five fraud
reported financial statements before the frauds were predictions in chronological order from 2009 to
discovered. Parmalat had made up a major Bank of 2013 were 1.13, 1.96, 2.72, 1.67, and 1.72. In Figure
America cash account and Satyam had falsified cash 11, the one standard deviation confidence range of
confirmations. 1.26 to 2.42 picked up three of the five years. The
This solvency focus is further expanded with two standard deviation confidence range was 0.70 to
the fixed charge coverage (FCC) ratio, the Sloan 2.98.
accrual ratio, and the Altman bankruptcy model. Using the expected outcome and the standard
The average FCC ratio was 0.59, well below the deviation from each distribution, three additional
solvency cutoff of 1.15 for adequate debt service. important probabilities were calculated.
Seven of the eight years were below this 1.15 cutoff. Management and the board are likely to be
Only a 2.0 ratio from the initial 2006 reporting year concerned about the possibility of having negative

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values for net income, cash and operating cash flow. On February 1, 2015, Kasia disclosed its long-
The probability that net income will be less than 0 is term debt was $10.4 bln, twice the debt reported in
only 10.38% and the probability that cash will be the financial statements, and the Kaisa CEO
negative is only 6.68%. However, a significant resigned. An analyst said that Kaisa had been
concern is that the probability of having a negative borrowing through off-the-books affiliated
operating cash flow is a very large 72.57%. companies to cover up this $5 bln missing debt,
similar to the off-balance-sheet debt strategy of
5. RISK MANAGEMENT IMPLICATIONS FOR Enron ($25 bln), Parmalat or “Europe’s Enron” ($20
CORPORATE GOVERNANCE bln), and Satyam or “Asia’s Enron” ($10 bln).
Similarly, Lehman Brothers kept $50 bln debt off its
As shown in Table 1, there were plenty of red flags books by claiming its debt collateral was really a
for further risk management investigations by “repossession” financing sale.
Kaisa’s board of directors and other interested At the start of March, 2015, Kaisa had only
parties. Using the numbers, the ratios, and the $306 million in cash of which only $77 mln was
models advocated in this paper, the board members unrestricted. On March 3, 2015, Kaisa missed two
can increase their understanding of their debt interest payments totaling $52 mln. On March
organization’s risk and can better meet their 21, 2015, Standard & Poor’s Rating Services
fiduciary responsibilities as board members. downgraded Kaisa’s credit rating to “default”, saying
Calculating and understanding the confidence it does not expect Kaisa to be able to restructure
ranges for variables and measures can help to both its onshore and offshore debt anytime soon
mitigate the impact of surprises that occur when (Jim, 2015). On March 31, 2015, Kaisa failed to file
outcomes are outside the confidence ranges. its 2014 financial statements, saying its auditors
It is especially important for boards of needed more time to resolve financial reporting
directors and other interested parties to pay issues (especially the going concern, bankruptcy
attention to the fraud predictions by both the new issue). Accordingly, trading of Kaisa common stock
and old fraud models. The board should not be in a was suspended on March 31, 2015 (and has not
position where they are surprised by fraud within resumed as of 2017).
the organization. Such predictions happened for On June 11, 2015, the Kaisa vice-chairman
Kaisa. All of the results in this paper suggest that resigned and a new CEO was appointed (Yung and
there are plenty of red flags for additional risk Fung, 2015). On June 18, 2015, the Sunac CEO told
management investigations by the board of directors reporters that he had decided to terminate the Kaisa
and other interested parties in the four areas of purchase offer because “the financial report
profitability, liquidity, solvency, and fraudulent provided by Kaisa showed its net asset per share
financial reporting. There are many examples of was HK$4.5 and our offer was for HK$1.8. But after
such investigative procedures, like competitor we started the due diligence on Kaisa, I found out its
comparisons, surprise onsite visits, and net asset per share was only zero” (Clare, 2015). He
comparisons of financial report filings with different said that another reason Sunac dropped its Kaisa bid
legal entities, by various short sellers and financial was the delayed publication of Kaisa’s 2014 annual
analysts who detected fraud in small Chinese financial report and commented: “I don’t think their
companies listing on U.S. stock exchanges (Left, report will ever come out” (Hu and Fung, 2015).
2011; Norris, 2011; Bases et.al, 2011; Bishop, 2011; At the time of its IPO, Kaisa listed six executive
Gillis, 2011). directors, none of whom were independent since all
had top management positions in Kaisa, and three
independent non-executive directors. Thus, there
6. CONCLUSIONS was majority control by insiders who had six of the
nine board positions. Also, the Kaisa company
Boards of Directors need to pay attention to key chairman was the chairman of three of the four
financial statement metrics, which have been shown Kaisa board committees: the general board of
to work over and over again, as with Kaisa in this directors, the remuneration committee, and the
paper. These key metrics usually start with nomination committee. His brother was the vice
operating cash flows which then may indicate chairman of the general board of directors. The two
problems with debt service (the fixed charge brothers and a third brother had formed a Family
coverage ratio) which then may lead to bankruptcy Trust which owned 49% of Kaisa.
predictions by the Altman bankruptcy model. To The Kaisa board only had two meetings in
cover up such survival problems, companies often 2009, the IPO year, and the only two board members
resort to earnings management and even fraudulent who attended both meetings were the two brothers!
financial reporting which are typically red flagged by The board has staggered reelections of one-third of
the quality of earnings, the quality of revenues, the the directors who all serve three year terms. Thus,
new fraud model and the old fraud model. the entire Kaisa board cannot be turned over in one
On December 10, 2014, the Kaisa company year. Kaisa reported that there were no audit
chairman and co-founder resigned, “due to health committee meetings in 2009 because the company’s
reasons.” The Kaisa vice-chairman and the CFO also IPO was December 9, 2009! The audit committee did
resigned in December (White, 2015). By March, 2015, meet on March 10, 2010 to reappoint PWC Hong
170 other senior Kaisa managers had also resigned. Kong which has been Kaisa’s auditor since 2007.
A financial press writer commented: “Make Leaders Kaisa is not an isolated example of an ongoing,
Lead - wouldn’t it be nice if executives acted like troubled Chinese company as of early 2017. The
leaders and accepted responsibility for the actions following four significant Chinese companies, Kaisa
of their companies and their employees?” Group Holdings, Tianhe Chemicals Group, Sihuan
(Morgenson, 2012). Pharmaceutical Holdings, and Superb Summit

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International Group, all have five factors in common: just destroyed common stock investments, but Kaisa
1) they did IPOs on the Hong Kong stock exchange in destroyed four types of investments: $2.2 bln in
2009, 2014, 2010, and 2001, respectively, 2) they market cap, $0.3 bln in private equity investments,
failed to file their 2014 financial statements on time $2.5 billion in global bonds, and $7.9 billion in
by March 31, 2015, 3) their auditors have yet to sign Chinese short-term and long-term debt. As in other
off on these financial statements, 4) they now have cases of possible fraudulent financial reporting,
had their shares suspended from trading on the unethical behavior, and investment losses, one must
Hong Kong stock exchange, and 5) their chairman or ask: where were the company managers, the boards
CEO resigned in 2014 after negative financial news of directors, and sophisticated investors with risk
was reported on their companies. management procedures for their various strategies?
As of 2017, these four Chinese companies have Unfortunately, we have seen this movie many times
destroyed $68.7 bln (US dollars) in international before, both in China and in the U.S.! Once again,
equity and debt investments as follows: Kaisa $12.9 these people disappointed by what they did not do,
bln, Tianhe $8.1 bln, Sihuan $45.1 bln, and Superb especially concerning risk management (Morgenson,
Summit $2.6 bln. The other three Chinese companies 2013).

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APPENDIX

Variability of Key Metrics

Figure 1. Net Income Figure 2. Profit Margin

Figure 3. Operating Cash Flow Figure 4. Quality of Earning

Figure 5. Quality of Revenues Figure 6. Cash

Figure 7. Fixed Charge Coverage Figure 8. Sloan Accrual Measure

Figure 9. Altman Bankruptcy Figure 10. Old Fraud Model

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