Sino-Forest’s Structural Issues

In this post I will turn to a lesser-discussed issue in the Sino-Forest debate, the one relating to its contractual relationships in China. More specifically I will try to elaborate on the argument Professor Paul Gillis has made that these can be viewed as a “primitive version of a VIE structure”, and that they will therefore share similar underlying uncertainties.

The VIE structure is essentially a method of conducting business in China using contractual arrangements rather than equity ownership in order to exert control over an entity. Normally this is used because of legal restrictions to what the company can do in China as a foreign entity.

Similar to this, Sino-Forest have 81.3% of their “timber ownership” under contractual control through a series of agreements with land holders and Authorised Intermediaries (AIs).

The company states that this reliance on contracts instead of outright ownership was put in place in order to comply with local regulations, much in the same way as VIE agreements. However, there appear to be no control agreements, equity pledges or such arrangements made between the parties, and thus there is no outright VIE status achieved.

The entities that are controlled in this way do, however, seem to have a very close relationship between them. The company uses only its AIs and any money made is directly reinvested in a sort of “closed Eco-system” that exists among the contracted parties.

So Sino-forest’s way of conducting the majority of its’ business in China shares the same basic tenets as a VIE structure. And as the basic premise of these relationships bear a close resemblance to a VIE structure, we are also likely to find similar issues with both practices. For instance, the close relationship and business practices in the operations may be subject to transfer-pricing scrutiny, and the reliance on contracts instead of direct ownership puts the legality and enforceability of these contracts on centre stage.

Of these two, the issue of the legality and enforceability of the contracts is likely the most important, and certainly the most pressing one. Similar to what we find in VIEs, if the contracts do not measure up then investors lose any rights they have to the assets held under them, and to the business conducted through them.

Contractual control is a weaker form of control when compared with direct ownership, and should thus be traded at a discount, especially if the legality of these contracts is in question. In the case of Sino-Forest 81.3% of the company’s forest holdings are held in this way, which makes it an issue of exceptional importance.

I will look more closely at the potential legal problems that this way of conducting business can lead to in a later post.

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Deloitte’s Future in China

Deloitte’s China woes have gone from bad to worse.

Latest Muddy Waters target Focus Media (FMCN) is yet another company with serious fraud allegations leveled against them which was audited by Deloitte. Something that has led to serious suspicions against the auditors themselves.

The company was already in trouble with American authorities following the Longtop scandal and its aftermath, where they were unable to help in the on-going investigations against the fraudulent company. Should these latest fraud allegations be proven correct, and yet another client of the company found guilty of fraudulent activities, American authorities and investors will not stay silent.

Being audited by Deloitte is becoming a burden for Chinese companies, as the markets have lost so much confidence in the auditor that all of Deloitte’s clients are suspects by association. Deloitte-audited Chinese companies are traded at a discount by some investors, government authorities are increasing their scrutiny of them, and short sellers are looking at them specifically for potential short cases.

Trying to pitch clients on the idea of trading at a discount and facing extra scrutiny from authorities and shorts will make it exceedingly hard for Deloitte to maintain its current market position. This will be especially true for the IPO market where Chinese companies are already facing increased scrutiny from the SEC, which means companies are unlikely to want to add even more potential issues to their offering.

Deloitte needs to move fast to regain the confidence of the market if they want to stay competitive in China, but this will likely be neither easy nor cheap to accomplish.

In fact, the situation has deteriorated to a point where there might have to be a token leadership change at the top, followed by a purge of the company’s entire China operations to indicate that the company is serious about getting to grips with the situation.

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China Education Resources And the License Question

In this post I want to take a look at China Education Resources [CHN], a Chinese company listed on the TSX-V exchange in Toronto.

I’m choosing to talk about this company for two reasons: firstly, it looks like it has made incorrect filings to Canadian authorities, and secondly, because it speaks to the lack of information available to China concept stock investors in Canada.

CHN is in the online education industry in China, where it has the cersp.com portal, which it runs and has developed in collaboration with the curriculum development centre of the Ministry of Education. Coupled to this web portal is a set of online educational services:

a) A school platform, which is a form of online system for sending messages between participants (Teachers, Students, Parents etc.), as well as providing the infrastructure for online tests etc. It has been described as the Facebook of teaching in China.

b) An online tutoring programme, where students sign up for lessons with teachers over the Internet platform. The students prepay the service.

c) Distribution of CD products, containing sample education software for trial purposes. Students can then sign up for the full offering online.

In order to conduct its business the company reports having three WFOEs (CEN Network, China Education International Inc. and CEN China Education Overseas Corporation), as well as two 90% owned subsidiaries (CEN Smart, and TTTC). TTTC also owns 54% of another consolidated entity ZYCY (Or 60%  according to the MD&A filing).

There is no mention of which one of these entities supposedly holds the licenses necessary to operate the business, but with the information we’ve been given, it looks like none of these entities could legally hold them. This is due to the fact that they are operating in restricted areas of the Chinese economy, which don’t allow foreign ownership.

The norm for a company operating in this line of business would be to have a VIE structure, where there is a contractual relationship to a consolidated Chinese company that holds the licenses and conducts the business in the restricted area. These types of structures are very common in China these days, but have a lot of risks attached to them.

However, CHN explicitly states in their latest annual filings that they have no VIEs.

The question then seems to be whether one of the entities consolidated under equity ownership is in fact a VIE (this would likely be TTTC as they seem to be the direct holders of the web portal), or whether the licenses etc. are held by others, which would mean the company doesn’t actually own any of the key assets they’ve presented as their own.

This could be a case of a primitive form of VIE arrangement managing to list overseas without going through the normal steps of solidifying the structure. If this is the case what we’d likely find is that unconsolidated related parties hold the licenses. Think VIE arrangement without any real control agreements, similar to what was found at Sino-Forest.

At present, the lack of information provided by the company makes it very hard to say how it actually operates, but it seems clear that none of the consolidated entities could in fact run the business. So we may assume that there is in fact more to this story than the financials tell us, even if we don’t quite know how much more.

I believe Canadian investors need more detailed disclosure requirements from Chinese companies listed in Canada, in general, and especially where VIE structures are involved. The amount of details available, even regarding disclosed VIE structures, is very limited and sometimes doesn’t even include the nature of the contracts that make up the basis for consolidation. This is nowhere near enough to give investors the information they need to make correct calls about risks in these investments.

There are currently over 50 Chinese companies listed on the stock exchanges in Canada. Not a huge number, but enough to warrant some special attention from the regulators when it comes to disclosures.

Full disclosure: I hold no position in CHN, nor do I intend to take any position in the company. I have alerted relevant authorities in Canada about these issues.

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New Disclosure Requirements Under IFRS

I’ve talked previously about the issue of VIE disclosures under IFRS, and how they are leaving investors clueless as to the nature of VIE “subsidiaries”.

Well it looks like there will be some movement on this front with new rules for consolidation and disclosures under IFRS, although they don’t come into effect until 2013.

The rules in question are IFRS 10, 11, and 12, where IFRS 10 and 11 deal with consolidation and Joint-venture/Joint-operations consolidation, and IFRS 12 deals with new disclosure requirements. The rules can be used before 2013, but must be adopted as a package, apart from the disclosure rules in IFRS 12, which can be adopted on their own.

These new disclosure requirements should mean a company has to account for the control mechanisms for any subsidiary, which is not consolidated based on equity ownership. So it would seem we can expect disclosures on the IFRS exchanges more in line with what is currently available under US GAAP.

Investors will undoubtedly welcome any reform that will bring greater clarity to VIE structures on IFRS exchanges, but the extent to which these disclosures will go in practise is still uncertain. As IFRS is a framework based on principles it is doubtful whether there will be precise enough requirements to ensure all relevant information investors need to have at their disposal is available.

The time leading up to the implementation of these rules is a chance for the relevant authorities for exchanges with a heavy Chinese VIE presence to set up their own more precise rules and guidelines on what information should be included in the new IFRS 12 disclosures.

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Lessons From the Lashou IPO Process

A lot of people in China are looking to the Lashou IPO for a gauge on the temperature for China IPOs in the US. People were looking forward to seeing an increased US appetite for China concept stocks.

But as the IPO looks evermore likely to fall through, some will be inclined to conclude that interest in new Chinese IPOs is low. I’m not entirely certain we can go that far, but I do think we’ve learned some important lessons from the Lashou IPO process.

Firstly, there seems to be an increase in the amount of information that the SEC requires about VIE structures.

Previous disclosures have varied a lot in detail, and lacked some fundamental information that investors need to make informed decisions about the risks involved in the investment. Something that has arguably led to a mispricing of companies using VIE structures.

It now looks like the SEC wants to clean this up and give investors the information they need to properly judge the internal risks in the VIE structures.

I think this reform is much overdue and hope we will soon see an overhaul of the disclosures on the IFRS dictated exchanges with regards to VIEs as well (Predominantly Hong Kong and Singapore).

Secondly, there has been a very strong reaction to allegations of potential accounting issues at the company. This is hardly surprising when you consider the sheer amount of accounting frauds that have been uncovered in Chinese companies the last year.

We’ll have to see what comes of these allegations but investors have had their fingers burnt before so they will approach any company with rumoured accounting issue carefully.

In short, any Chinese company looking to IPO in the future had better get their act together on these two fronts before they file, as they are likely to face more scrutiny than before.

However, I think the real reason for the IPO issues might be found in the prospectus itself, rather than in the overall sentiment of the investors.

For instance, the company is operating in an industry where it has literally thousands of competitors, and this has forced the company’s margins down to a fraction of what we see in Groupon, for instance. So the financials themselves probably didn’t excite investors too much to begin with.

More alarmingly, the company’s biggest competitive edge over its competitors, its strong brand name, is in question, as the company does not own the trademark rights associated with it.

This could cause the company to loose the rights to its’ brand name as well as the rights to the website lashou.com, which would likely force the company to rebrand and start over from the beginning.

However, as Jiayuan managed an IPO not long ago under similar circumstances (they didn’t own the trademark rights to their brand either), we must conclude that something has changed.

I would argue, however, that what we’re seeing here isn’t a cooling off in the general interest in China concept stocks. Instead, we’re seeing investors becoming significantly less forgiving when it comes to discrepancies and issues in Chinese companies, but this should not be mistaken for a cooling interest in China as a whole.

We’ll have to wait until we see the prospectus for the rumoured Vancl IPO, and how well it is received by investors before we draw any definitive conclusions. But companies seem likely to face unabated, if more demanding, investor interest.

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Why Canada-Listed Chinese VIEs Are Interesting

In this post I’ll outline why I think Chinese stocks listed on TSX and TSXV are potentially very interesting for international investors. I might also follow up this post with some more specific examples of interesting features I’ve found whilst looking through these companies.

The businesses are obviously interesting in themselves, but at this moment there is a more encompassing reason to look at Canada-listed VIEs, namely that the accounting standards are transitioning from Canadian GAAP to IFRS.

As I’ve stated in a previous post, finding a VIE under IFRS is significantly harder than under, say US GAAP. This is because VIEs have to be declared under US and Canadian GAAP, but can be counted as a “Subsidiary” under IFRS without any further clarification. What’s interesting now is to see how the change in accounting standards in Canada will affect the disclosures of VIEs.

It has to be said that the disclosures in Canada are not quite up to par with their US equivalents, even at this stage. For instance the risk sections are nowhere near as exhaustive, and the details of the VIE agreements are non-existent in many cases.

This switch will give investors a good way to understand how disclosures differ between the systems in regards to VIEs, and as such perhaps provide some insight into what to look for to find VIEs under IFRS. At the very least it might provide incentives to push for more disclosure on the matter under IFRS, perhaps similar to what we saw on the Lashou IPO filings.

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