How Investors Can Avoid the Corruption Minefield in Asia

 | Jun 07, 2017 | 10:00 AM EDT
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In the past, paying bribes in mainland China and many other Asian nations was a cost of doing business. Corruption is so endemic in China, that President Xi Jinping has made it a mainstay of his "reign" to combat problem members of the government, whether "tigers" or "flies."

But the sentiment is shifting even out here in Asia. How best should investors navigate the corruption minefield? East Asia in particular is seeing some decent progress that Asia-focused investors should track.

A motivating force behind Xi's crackdown is that the Chinese people are simply sick of cadres with their hands out. The Communist Party's hold on power is therefore tenuous, and staying in power is its top priority. When a politician goes down, he takes the tycoons who bribed him with him.

Elsewhere, South Korea's last president, Park Geun-hye, is charged in an influence-peddling scheme that alleges her best friend solicited millions of dollars in bribes from Korea's biggest companies, corporate Korea basically on trial. Park Geun-hye pleaded not guilty at her trial. Barely a Taiwanese president goes without being locked up after office.

Hong Kong's last Chief Executive is now warming a jail cell for, rather prosaically, not declaring an apartment lease on a penthouse owned by someone whose broadcast license he was reviewing. The prime minister of Malaysia is tied up in an investigation that suggests more than $1 billion entered his personal bank accounts, much of it from the state-owned investment fund 1MDB. He denied any wrongdoing.

It's a seismic shift. The free flow of information means scandals are soon uncovered and broadcast. And people are more willing to stand up for their rights, even in nations where they had little say over who governs the country.

"I think things are definitely changing compared to 20 years ago," Pei-li Wong, managing director and the leader of the Asia forensic desk at BDO Consulting, says.

This presents a serious challenge for companies, and particularly their investors. Shareholders are probably the last to know there's something wrong at their investment, given the confidential nature of inter- or intra-company investigations.

"One of the best practices is to know what you're buying," Wong says. "A company that places the importance of meeting earnings expectations over compliance or over ethics is probably is not a company that you want to invest in."

Wong's team helps companies with risk assessments and due diligence when they go into deals or new nations, as well as compliance reviews. But her team also investigates whistleblower complaints and suspect transactions.

"It's not enough to put in a policy and say 'All our employees need to follow it'. You need to assess whether it's working," she says. 

She believes there is less blowback, less of a loss of business, for companies that refuse to pay bribes in countries like China. "In most commercial transactions, it's acceptable now for somebody to say 'My company doesn't allow this. But we're happy to make sure the contract terms are the best we can offer.' "

Most companies now have some code of conduct, ideally publicly displayed on their Web site. Their mission statement should outline their views on local laws and policies. The best among them will even outline the policies they put in place for the vendors that supply them.

Vetting the board is more vital in Asia than it is in the West. Boards have a history of close contact, if not collusion, with management in many parts of the continent. That's true in emerging markets, as you'd almost expect, but even in most-developed economies in East Asia.

It's worth a little background check on the names below those nice little headshots in the annual report. Investors should shy away from companies with boards made up of management and key corporate partners. It goes without saying that a long list of lawsuits or confirmed illegal conduct in the past is a flag that's virtually bleeding crimson.

"It's not so different from any other type of risk that an investor might be looking out for," Wong says. "You want directors who are independent, who have a record of not getting in trouble, and who have a record of asking the tough questions of companies."

Wong also recommends referring to Transparency International's rankings. The organization specializes in national profiles of corruption and its annual Corruption Perception Index ranking of public-sector corruption. For Asia, it notes, the majority of countries unfortunately sit near the bottom. 

Transparency International generally ranks nations, rather than companies. But it does have tools, including a set of business principles and a business-integrity toolkit designed to help companies evade the bribery minefield.

It also has a Bribe Payers Index, ranking 28 major nations by the propensity of their companies to pay bribes. Unfortunately, the latest ranking is from 2011, but it makes for interesting reading. The Netherlands leads the world, and for my part of the world, Japan, Australia and Singapore do well to land in the top 8.

South Korea, Hong Kong and Malaysia are middling. Taiwan, India and Indonesia rank among the worst offenders, with China and Russia right down there at the very bottom.

Its Global Corruption Report from 2009 has a section on corruption in the private sector.

The situation is, however, changing rapidly in developed Asia. Japan has introduced a Corporate Governance Code for companies and a Stewardship Code for investors, since many of Japan's biggest institutional investors have or had cross-holding structures in their investments, making them highly unlikely to push management on any issue.

For the 1,400 companies listed on the Tokyo Stock Exchange, 80% now have two or more independent directors. That's up from just 22% two years ago. Of those 1,400 listings, 350 now also have an audit committee to oversee operations, as opposed to just getting by with the auditor they are mandated to have, although very few have moved to the system of three committees seen in the West.

The benefits of such moves, though, are hard to quantify. Many newly appointed independent directors are academics or former statutory auditors, with little to no commercial experience.

"The lifetime employment culture presents Japan with a real problem in finding suitably qualified individuals ready and willing to become independent directors," Alison Kennedy, the governance and stewardship director at Standard Life Investments, says in a note on the issue. 

Investor engagement and disclosure are reminiscent of the situation in the United Kingdom 10 years ago, she believes.

Investors seeking exposure to parts of Japan Inc. that "get it" can look for members of or funds that track the JPX-Nikkei 400 index, which uses an assessment of corporate governance as one of the yardsticks for inclusion. The iShares JPX-Nikkei 400 ETF (JPXN) offers such exposure.

Its performance so far this year, up 12.2%, is no different than other large Japan-focused ETFs, with the iShares MSCI Japan ETF  (EWJ) up 12.0% and the WisdomTree Japan SmallCap Dividend Fund (DFJ) up 15.1%. But holders of the 400 index product can sleep a little better at night, long-term, and feel good that they're part of the solution, not the problem.

Improving corporate governance is one of Prime Minister Shinzo Abe's main issues in pushing through the structural change that's so hard in Japan. And he has made good progress. 

The Stewardship Code will be revamped with greater disclosure guidelines this November, potentially requiring major investors to disclose how they voted on shareholder issues, something reported only in aggregate now. The Companies Act will also be revised, including a potential change to require the appointment of an independent director. 

Nevertheless, this year much of the outperformance of Japanese companies has come from the yen. Currency-hedged ETFs like the wildly popular WisdomTree Japan Hedged Equity Fund DXJ, up 4.3%, are posting much smaller gains around the 5% range.

Korean companies, even more closed shops and liable to insider back-room deals to the detriment of minority shareholders, may well also start to experience reform.

That's coming from inside for now, with Samsung Electronics (SSNLF) leading the way on share buybacks and the cancellation of treasure shares, as I explained yesterday. But the new president, Moon Jae-in, is highly likely to push further change on the colossal chaebol that operate the country's economic engine.

Emerging Asia has yet to take such great strides. But change will surely come.

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