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Nisha Gopalan is a Bloomberg Gadfly columnist covering deals and banking. She previously worked for the Wall Street Journal and Dow Jones as an editor and a reporter.

There are many questions in the complex tale of China Huishan Dairy Holdings Co., the milk producer whose Hong Kong-traded shares plunged 86 percent last week, but the way its chairman managed to pledge most of the company to banks and brokerages has to be the most vexing.

Huishan on Tuesday confirmed it had met with creditors and asked the Liaoning provincial government to help mediate a rollover. It added an extra bombshell: The company's treasury and cash operations manager, Ge Kun, couldn't be contacted, having sent a letter saying "recent work stress had taken a toll on her health" and she planned to take a leave of absence.

Those were issues that should have been disclosed sooner. But it was also the extensive borrowing of Chairman Yang Kai that caused Huishan to join the growing list of Chinese firms whose opaque workings have burned many mom and pop investors.

Yang controls 90 percent of a vehicle called Champ Harvest Ltd., which is Huishan Dairy's largest shareholder. According to company filings, Yang pledged almost all of his 71 percent interest in Huishan as collateral either to borrow from banks or get margin finance to trade stocks. Much of it was pledged to Ping An Bank Co. That Yang owed Ping An a lot of money first came to light back in December, but that practically all his Huishan Dairy stake was on the hook was a surprise.

Milking It
The bulk of Champ Harvest's interest in Huishan Dairy was used as collateral to secure loans
Sources: Filings, Bloomberg calculations
Note: Rest of shares denotes stock that hasn't been pledged against loans.

It's not as if Huishan is a stranger to deals involving unusual collateral. At one point it used its cows to secure cash. And Yang was within the letter of the law in borrowing so much against his shares.

Hong Kong exchange rules state that a controlling shareholder can borrow against stock and not disclose that so long as it's for personal finance reasons and not for loans, guarantees or other forms of support for the company.

The city's other main regulator, the Securities and Futures Commission, puts the onus of disclosure on the lender, so in this case, Ping An. A lender has to disclose an interest in listed shares that have been pledged to it when those shares total more than 5 percent of a company. But according to activist investor David Webb, that rule doesn't apply if the "qualified lender" is a bank, brokerage or insurance company.

Before last Friday's plunge, Huishan had been one of the most stable stocks in Hong Kong, despite allegations by Muddy Waters Capital LLC in December that it had been overstating its spending on cow farms to support profits. That prompted speculation someone must have been buying to prop up the stock.

In Deep
China Huishan Dairy's debt levels have been rising
Source: Bloomberg

Yang's personal diversification out of milking is also curious. Champ Harvest in January became the biggest holder of the Hong Kong-listed shares of Jilin Jiutai Rural Commercial Bank Corp., a lender that was among the Huishan creditors that expressed confidence in the company during an emergency meeting last Thursday. Jilin Jiutai Rural has quite a big exposure to shadow banking.

Warning bells should ring when any one person pledges so much of their stake in a company as collateral for loans.

Authorities in India were forced to grapple with a similar issue several years ago when the founder of a technology outfit called Satyam Computer Services Ltd. cooked the books, inflated profits and pledged almost all his stock to buy land. Now, all shares pledged for loans have to be disclosed.

With Yang's stake worth so much less than a week ago and margin calls coming in, Huishan Dairy's chairman can't rest easy. Until Hong Kong tightens its disclosure rules, neither can minority investors.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nisha Gopalan in Hong Kong at ngopalan3@bloomberg.net

To contact the editor responsible for this story:
Katrina Nicholas at knicholas2@bloomberg.net