I will be writing a few posts in relation to a study Professor Gillis and I have recently concluded into the disclosures of Chinese companies using VIE structures listed on the NYSE and NASDAQ. This first one will deal with the issue of equity pledges.
In collecting the data for our study we came across several numbers that make for interesting reading for investors, and people in the industry. Professor Gillis has already discussed two of these over on the China Accounting Blog, I strongly suggest you have a look at his analysis.
I have chosen to focus in on the equity pledge agreements because it is one of the more important of the VIE agreements. In the classic VIE structure the equity pledge is used to secure the loan to monetise the VIE, and sometimes also compliance with the other VIE agreements.
The basic premise is that if the owner of the VIE, who has pledged his shares acts contrary to the company’s wishes, they can call on his pledged equity and place it in the ownership of another nominee holder.
However, these pledges have to be registered with the Chinese authorities before they become valid. Before this registration the pledges have no legal value whatsoever and are entirely unenforceable.
Interestingly, when we examined the disclosures of these companies we found that only 11% of them stated that they had registered their equity pledges. Which means that, as far as we know, only 11% of companies with VIEs have any legal basis for the agreement put in place to secure compliance with the other contracts.
The equity pledge is potentially one of the most useful of the VIE contracts. Companies, and foreign shareholders can ill afford to leave this agreement unenforceable because they didn’t take the necessary steps to make the agreement admissible in court.
[...] he will have additional posts on this issue, so stay tuned, and Fredrik already has another post up on VIEs and equity pledges, which I may or may not address in a future post. Tagged as: business scope, contract law, [...]
[...] he will have additional posts on this issue, so stay tuned, and Fredrik already has another post up on VIEs and equity pledges, which I may or may not address in a future [...]
Frederik,
What if the equity is pledged to a non-PRC party? Since foreign ownership is prevented, is it still possible to register the equity pledge with the local authorities? If this agreement isn’t enforceable, why is it even necessary?
All of these equity pledges are always made to one of the company’s WFOEs, which is prevented from owning the shares, as you say. The theory of the practice is that the WFOE can call in the shares in accordance with the pledge and force the original owner to hand them over to a new designated PRC owner. The contracts should be formulated to say the company can claim the shares for itself or hand them over to a third party.