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Semiconductor fraud in China highlights lack of accountability

Push for homegrown chipmakers leads to multimillion-dollar investment swindle

A desire by Beijing to development domestic chip companies has led to a series of reckless investments in poorly planned projects, many of which went bankrupt.   © Reuters

BEIJING -- The Chinese government has ambition to create a "national champion" in the semiconductor industry. With a clear target in place, local governments have been eager to support private enterprises that make chips -- even those with dubious credentials.

The desire to groom homegrown chip companies has led to a series of reckless investments in poorly planned projects, many of which went bankrupt within a couple of years after swiping multimillion-dollar investments from government organs.

This situation caught the eye of the Chinese National Development and Reform Commission (NDRC). During a press briefing held in October 2020, spokeswoman Meng Wei said that some companies "with insufficient knowledge of integrated circuit development have blindly entered into projects."

The NDRC is stepping in to work with other governmental departments and put in place tighter supervision over semiconductor projects, as Beijing continues its push to boost domestic chip development and manufacturing. This is a matter of survival: Geopolitical tensions between China and the U.S. are unlikely to be resolved soon, and Chinese manufacturers' access to U.S.-produced chips and other key components has been severely restricted.

"The semiconductor manufacturing industry is extremely complicated, with many stakeholders. It is difficult to pinpoint responsibility and hold anyone accountable when something goes wrong during the process. Besides, when actual fraud is found, local governments will swallow their pride, absorb the losses and stop talking about it," a veteran investor based in the Yangtze River Delta industrial region told 36Kr.

Wuhan Hongxin Semiconductor Manufacturing "founder" Bao Enbao falsely claimed to be Cao Shan, a non-existent vice president at Taiwan Semiconductor Manufacturing Co.   © Reuters

To date, the most high-profile case involves Wuhan Hongxin Semiconductor Manufacturing Co. (HSMC), whose project received immense support from the government of Wuhan's Dongxihu district. On July 30, 2020, local officials announced that HSMC's project could not continue due to irreconcilable gaps in funding. The authorities have since taken over the botched project, with no clear plans for the next step. The status of the billions of yuan of public money that were sunk into HSMC remains unaddressed.

As part of 36Kr's probe into the matter, industry experts, as well as HSMC's former employees and contractors, provided insight into what happened. The investigation, also based on company documents, exposes HSMC's malpractice over the last three years.

HSMC was jointly formed in November 2017 by the Wuhan Dongxihu District Government and Beijing Guangliang Lantu Technology, a company registered by an individual named Cao Shan.

Cao promised an investment to the tune of 1.8 billion yuan ($279.1 million) for a 90% stake in HSMC, while the Wuhan government channeled 200 million yuan for the rest.

Whenever Cao met with potential investors, he introduced himself as the vice president of Taiwan Semiconductor Manufacturing Co. (TSMC), or as the vice president of Acer's New York office. He also boasted of personal "connections" with high-ranking Chinese government officials, people with knowledge of the matter told 36Kr.

Cao was responsible for bringing on board Long Wei, who was a "very capable" man and instrumental in securing the investment from the Wuhan government, according to insiders at HSMC. Long would later install Li Xueyan -- a rookie in semiconductor manufacturing -- in the management team. With Long Wei as chairman, Cao Shan as director, and Li Xueyan as director and general manager, HSMC's founding team was complete.

Cao's promised 1.8 billion yuan never materialized. Meanwhile, HSMC received an additional 8-billion-yuan investment from the Wuhan Dongxihu district government after two capital injections received in January and March 2019.

The absent investment was only the tip of the iceberg. 36Kr found that Cao Shan was not even the real name of the HSMC founder. Cao was in fact Bao Enbao, who borrowed the name of his family's driver. Naturally, the credentials Bao presented as Cao were false -- TSMC did not have a VP named Cao Shan, and Acer did not even have an office in New York. In reality, Bao had only completed primary school and lacked the technical expertise required to make semiconductor wafers.

These shortcomings did not prevent HSMC from being recognized as a star project for Wuhan and Hubei Province. HSMC branded itself as a project that took on $20 billion in investments. How HSMC, led by Bao Enbao's alter ego, managed to pull the wool over the eyes of suppliers, industry veterans and government backers remains a mystery.

With plenty of cash flowing into its coffers, HSMC announced ambitious plans to manufacture chips with 90-micrometer to 7-nanometer process technology. "Cao" proclaimed that HSMC would "become second only to TSMC and Samsung in chip technology."

All they needed was a technical team to carry out the vision.

Bao's plan to recruit engineers and technicians was simple: He would identify a company with good connections in the industry and pay a handsome fee to hire top talent. HSMC enlisted the services of recruitment company Shanghai Jingtai to poach up to 100 senior technicians. The higher their level, the more commission HSMC was willing to pay.

To speed up the planning process in building a plant, Bao Enbao acquired old Semiconductor Manufacturing International Corp. factory drawings from a design institute.   © Reuters

Shanghai Jingtai's first big catch was Chiang Shang-Yi, a well-respected leader in the industry and former TSMC executive, who had just ended a three-year tenure as an independent director of Semiconductor Manufacturing International Corp. (SMIC). Reportedly, HSMC paid as much as 1 million yuan as the commission fee for Chiang's recruitment.

Within a short time, HSMC managed to build a highly qualified team of engineers who joined for the attractive remuneration and a chance to work under Chiang as CEO of the company.

HSMC was also able to procure a highly coveted lithography machine from Dutch equipment maker ASML. At one point, it seemed like Bao was actually building a functional semiconductor manufacturing facility.

However, it did not take long for the engineers to find fault with HSMC's operations. Bao had awarded the construction contract to Wuhan Torch Construction Group, a company that had no prior experience in building semiconductor plants. To speed up the planning process, Bao acquired old SMIC factory drawings from a design institute. Whether the factory would be functional was never a primary concern for Bao. All he needed were walls and a roof as a means for HSMC to grab more investments from the central or local government.

In order to secure the project, Torch paid hundreds of millions of yuan as a deposit, feeding even more cash into Bao's scam.

On May 30, 2019, Torch transferred 435 million yuan to HSMC. It appears that Torch had agreed to guarantee HSMC's bank loan on the premise that HSMC would pay Torch the excess interest. When HSMC failed to repay the loan, Torch was saddled with 11 million yuan in bank loan interest, wrecking its own cash flow. Torch even had trouble with paying its employees.

A few days before Chinese New Year, on Jan. 22, 2020, angry workers from Torch stormed the Wuhan Dongxihu district government offices to demand 50 million yuan in unpaid wages.

HSMC pledged to pay 8 million yuan upfront, with another 4 million yuan to follow a week later. To appease the workers, the legal representative of Torch, Lu Haitao, offered to be detained for 15 days. He also promised to call the mayor's office to report the incident.

News of the furor soon reached the ears of HSMC employees. To placate her employees, Li Xueyan, who succeeded Long Wei and Cao Shan as the company's chairwoman in May 2019, after they withdrew from the management team, repeatedly emphasized that HSMC was not in financial distress. "HSMC has problems, but money is not one of them," she said. Yet, money was precisely the major problem.

HSMC mortgaged the much-anticipated and much-needed ASML lithography machine to the Wuhan Rural Commercial Bank on Jan. 20, 2020, for 580 million yuan, according to business data aggregator Tianyancha.

Chiang, who was instrumental in the machine's procurement and acted as the public face for HSMC, was not informed of the deal. He became suspicious of HSMC's actions, marking the start of a series of disagreements between himself and the board of directors until he resigned from the company in June 2020. In a response to the South China Morning Post, Chiang said he was unaware of the company's financial problems.

"My time at HSMC was a nightmare," he wrote in a LinkedIn message, as reported by the South China Morning Post.

HSMC procured a lithography machine from Dutch equipment maker ASML. At one point, it seemed like Bao Enbao was actually building a functional semiconductor manufacturing facility.   © Reuters

To understand the reasons behind HSMC's financial problems, 36Kr pieced together the company's major sources of revenue and expenditure between the time of incorporation in November 2017 until Chiang's resignation in June 2020, using information sourced from public corporate records and interviews with relevant personnel.

As of Dec. 31, 2019, based on records obtained from the Wuhan Municipal Development and Reform Commission, HSMC received 15.3 billion yuan in total investment. HSMC also mortgaged a number of assets, including the lithography machine. It had persuaded Torch to obtain a bank loan of 700 million yuan on its behalf. Meanwhile, the company's major expenses seemed to be minimal, covering just factory construction fees and employee salaries. Since the factory was not operational yet, little had been spent on equipment.

Based on these calculations, 36Kr estimated that HSMC should still have a healthy 12.4 billion yuan in cash sitting in its accounts, even after settling all outstanding payments to contractors. However, by the time Wuhan's government made public the disruption of HSMC's operations due to capital shortage in July 2020, the company only had a little more than 10 million yuan to its name.

So where did all the money go?

36Kr's investigations revealed that HSMC had complex financial relationships with a number of entities, which were later found to be inextricably linked to core members of the company's leadership. For instance, Foshan Hanqi, a consulting and training firm for HSMC employees, was run by Li Xueyan's brother. Foshan Hanqi had hired engineers to produce technical documents, which were then sold to HSMC. The monthly salary of these engineers fell in the range of 150,000 yuan to 300,000 yuan ($23,250 to $46,500).

When the district government took over HSMC in November 2020, it dismissed Li Xueyan. Although both Cao Shan and Long Wei had already quit the management team in May 2019, Cao (or Bao) is said to be still actively managing a dozen other unrelated semiconductor projects.

It is unclear whether the contractors and staff who were hired for the HSMC project will eventually be compensated for their work.

"People who went to the Dongxihu district government to clarify the matter were told that HSMC had run off with some of the money," Wang Liyin, an employee of Wuhan Huanyu Engineering, a subcontractor of Torch, told 36Kr.

Despite the financial quagmire rooted in HSMC, the semiconductor industry remains a beacon for China's next industrial revolution.

SMIC's co-founder, Xie Zhifeng once said: "The U.S., Japan and South Korea have reached the peak of their chipmaking development. The future market is in China, and the talents are coming home. The time for a paradigm shift in China's semiconductor industry has arrived."

The only catch is there are no shortcuts, as some stakeholders in the industry have learned the hard way.

KrASIA is a digital media platform focused on technology-driven businesses and trends across the Asia-Pacific region. KrASIA belongs to 36Kr Global, of which 36Kr is a minority investor. Nikkei has a minority stake in 36Kr.

For the Chinese version, click here.

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