Let’s get straight to it, this post supposes some prior knowledge of VIE structures, available at other blogs. But suffice to say that it’s a method of controlling, and consolidating companies in China without actually holding any equity ownership in them.
One of the issues with this is that no one knows whether or not these contracts are enforceable, something which is normally disclosed in the risk sections of the annual filings. It’s the one where the company’s lawyers state that the contracts are enforceable, only to use the very next statement to say that there’s so much uncertainty on the issue that they really don’t know.
Now this is all fine and dandy as long as there is disclosure on the issue, and investors know how to evaluate the risks properly. However, some companies seem intent on trying to seem much more solid than their VIE structures make them, and then we get into trouble.Investors might misunderstand the situation, and thereby not take the risks into account. But the biggest question is why a company would be so intent on hiding this structure when it has become more or less industry standard in certain areas.
Imagine if you were to find a company in a heavily regulated industry in China, say a full-blown IT company with online services and the whole shabang, claiming to have complete ownership of their entire operations. What if they even state that their ICP-license is under a wholly-owned entity (In China an ICP license can only be granted to a foreign-domestic JV, with the domestic player holding the majority, and in practice even the JV is nigh impossible as you need to get it passed government authorities)? You’d expect any such company to be called out even before listing on these strange practices.
Well, as it turns out there is a company like this currently being sued on other grounds, but for some reason it appears like they won’t get into this blatant misleading of their investors.
The company is Subaye Inc. and they are in the cloud computer services business. Here’s what their latest 10-K states as their corporate structure:
For a company that cannot possibly legally own every part of their business there’s an awful amount of 100% ownership going around!
On to there risk section where the attempts to illuminate the reader as to their actual structure could be described as lackluster at best [emphasis added]:
In order to comply with Chinese laws limiting foreign ownership of Internet and advertising businesses, we conduct our ICP (independent content provider) and online advertising businesses through our subsidiary, Guangzhou Subaye Computer Tech Limited. If the Chinese government determines that these contractual arrangements do not comply with applicable regulations, our ability to operate could be significantly reduced resulting in loss of customers and revenue.
The Chinese government restricts foreign investment in Internet and advertising businesses. Accordingly, we operate our websites and our online advertising business in China through Guangzhou Subaye Computer Tech Limited ”GZ Subaye,” our wholly-owned subsidiary. GZ Subaye holds the licenses and approvals necessary to operate our website and our online advertising business in China. We cannot assure you, however, that we will be able to enforce these contracts. Although we believe we comply with current Chinese regulations, we cannot assure you that the Chinese government would agree that these operating arrangements comply with Chinese licensing, registration or other regulatory requirements, with existing policies or with requirements or policies that may be adopted in the future. If the Chinese government determines that we do not comply with applicable law, it could revoke our business and operating licenses, require us to discontinue or restrict our operations, restrict our right to collect revenues, block our website, require us to restructure our operations, impose additional conditions or requirements with which we may not be able to comply, impose restrictions on our business operations or on our customers, or take other regulatory or enforcement actions against us that could be harmful to our business.
without getting into too much detail, they first state that the industry is restricts foreign investment, and then that in order to comply with these restrictions they operate in it through a wholly-owned subsidiary. I don’t really know quite where to start with this one, so I’ll just let it speak for itself. But the authors duly go on to show an amazing grasp of the English language when they all of a sudden say that they’re not sure if “these contracts” can be enforced, without any contracts mentioned that they could be referring back to.
This looks like a bad cut-and-paste job to me, and I think it should be added onto any lawsuit being brought against the company.
Perhaps the reason it is not brought up is that the PRC council involved actually signed off on the report, stating that the structure presented complied with current PRC legislation. This in itself is worthy of a blog post on how to judge legal opinions in Chinese statements.