Archive for June, 2011

Just a quick update:

according to a China Daily article the PCAOB and CSRC met during the US-China Strategic and Economic Dialogue last month, and decided to increase their efforts to close the regulatory loopholes in accounting between the two countries.

Professor Paul Gillis talked about these issues over at the China Accounting Blog, and I would imagine him to be a strong candidate to consult on the issue.

This bodes well for the future as it should make certain frauds significantly harder to accomplish, however, I have a feeling this collaboration will also have an effect in “outing” a few more companies. It could also speed up the rate at which short sellers are issuing reports on Chinese frauds.

Overall we’re seeing a good amount of growth in the “DD-to-short” sector, I suspect based on the success of Muddy Waters and citron research in bringing down some big guns. But if the regulatory loopholes go away, and we can look forward to overall better quality filings from Chinese companies, now is the time to find the frauds early, short them, and publish your findings.

Will we be seeing a frenzy in this market now before the job likely gets much harder?

All in all exciting times ahead!


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As we have seen in articles and blog posts all over the Internet, the VIE structure comes with very real risks. As such, investors should take care, and when possible apply pressure, for how and when these structures are used to make sure they are not subject to unnecessary risks.

The VIE structure is sometimes seen as a temporary solution while waiting for the Chinese government to further liberalize the market. Once it is possible to legally own the business through a WFOE, the VIEs should be abandoned for its securer counterpart.  Unfortunately, there are still cases in which VIEs are used when there are no legal necessities to do so.

One example of this is Cogo Group [COGO], a reverse listed Chinese company in the Diversified Electronics Industry. The company uses a VIE structure for two of their subsidiaries, Shenzhen Comtech and Shanghai E&T, both are in commodities trading where there is no legal necessity for a VIE structure.

Here’s how the situation was presented in the company’s latest 10-K:

At the time of its incorporation, foreign shareholding in a trading business such as Shenzhen Comtech could not exceed 65%. With subsequent PRC deregulation, foreign ownership of such a trading business can now reach 100%, and approval of foreign ownership of companies in the PRC engaged in commodity trading businesses—which includes agency trade, wholesale, retail and franchise operations – is now delegated to local government agencies of the PRC Ministry of Commerce. In order to exercise control over Shenzhen Comtech (a PRC operating company legally permitted to engage in a commodity trading business), without direct shareholding by us (a U.S.-listed company and therefore a foreign-invested entity), Honghui Li, our vice president, and Huimo Chen, the mother of our principal shareholder and chief executive officer, Jeffrey Kang, hold 99% and 1%, respectively, of the equity interests of Shenzhen Comtech, and through contractual agreements with us hold such equity interests exclusively for the benefit of our 100% directly owned subsidiary, Comtech China.

As you can see from this excerpt, the reasoning for the VIE structure does not hold up. Moreover, they could have held up to 65% of the operations even with the tougher legislation at the time of incorporation, but chose not to do so.

The reason the VIE was not converted into a WFOE seems to be because it requires approval from MOFCOM, as indicated in an earlier 10-K:

However, foreign ownership of companies in the PRC engaged in commodity trading businesses—which includes agency trade, wholesale, retail and franchise operations—is subject to restrictions under PRC laws and regulations, and requires special approval from the PRC Ministry of Commerce, which is time consuming to obtain.

There is no indication, however, that the company has even tried to change its current makeup in this direction, and the question needs to be asked whether something being “time consuming to obtain” is a valid reason for keeping a VIE structure.

The description of the ownership of Shanghai E&T is a rather complicated affair in itself. As far as we know, there is no reason why the company cannot simply own this subsidiary outright: yet not only is the majority ownership held by Shenzhen Comtech, but the same company also holds 35% more equity “through trust agreements” for the benefit of Comtech China (the WFOE).

Shenzhen Comtech, in turn owns a 60% equity interest in another of our PRC operating companies, Shanghai E&T, with the other 40% being held by Comtech China through trust agreements. Under the trust agreements, Shenzhen Comtech owns a 35% equity interest in Shanghai E&T for the benefit of Comtech China and Honghui Li owns a 5% equity interest in Shanghai E&T for the benefit of Comtech China.

This trust agreement arrangement was accomplished by the company’s WFOE paying 16 million RMB for the 40% minority stake. To then give this stake away under a trust agreement, for which there appears to be no good justification, seems a strange move.

There is no further information available about the nature of the VIE contracts.

These issues might not seem very important at first glance, but recent events have taught us just what the risks in a VIE structure are, and as such this is something that warrants investors concerns.

There seems to be no legal for why these entities cannot be converted to WFOEs, other than potential issues with MOFCOM approval. It appears that no effort has been made to gain such approval, and it seems as if the company simply wants to keep its business in a VIE structure.

Investors need to assert pressure on companies to move away from VIEs and towards securer forms of ownership, where possible. While it may not be of much difference for the founder of the company, it is of the utmost importance for foreign investors to make sure that their money is as safe as possible.

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With the current interest shown in the GigaMedia case it seems prudent to offer some sobering reminder of how, at times, big events can change so little.

First a very quick look at what has happened so far according to the company filings. For a more elaborate description please look here.

After Mr. Wang usurped the company’s China operations, by holding onto the official chops and other documents, the company proceeded to file suits in various courts with a number of claims against the former head of China operations.

After initially forecasting quick resolution, litigation seemed to have hit on problems and the references became increasingly bleak in their outlook, referring in part to the complexity of the procedure. This culminated in the company basically admitting defeat on the issue by setting up a new China organisation from scratch.

From what we know of the process, however, it appears that the question of the VIE contracts were not tried at any stage. In fact the only real mention of them is to conclude that the equity pledges are unenforceable due to not being registered.

Although we may speculate that the reason for GigaMedia to suddenly give up its attempt to enforce control over the WFOE and the VIEs was that the contracts would not have been enforceable. There is actually no legal judgement to say that it is so, and therefore nothing has actually changed when it comes to clarifying the gray area in which VIEs operate.

As this is the case, the fact that GigaMedia has just lost their entire China operations will not result in any change to the current risk disclosures associated with SEC filings for VIEs. There are still substantial uncertainties as to the enforceability of the contracts, and so far there’s still only the possibility that courts will find them unenforceable.

The lasting effects of the case will more likely be in how investors read the statements, rather than the statements themselves. Rather than just being empty words, the “substantial uncertainty” can now be said to be so great that a company gave up trying to regain control over its operations. Further, the statement that contracts “may not be as effective as equity ownership” might well do with being read as “will not be as effective as equity ownership”.

More than anything this case shows us what can happen when disputes arise within companies with VIE structures. They may be solid as long as no one within the organisation rocks the boat, but the question of who exactly owns the VIEs is now clearly more pressing than before. Yet here, again, we might in fact not see any change in the corporate filings presented.

As there is no change in disclosures to guide the reader as to how the VIE situation is progressing, more and more pressure is being put on investors to stay a jour with developments to be able to adjust their risk evaluations.

Fredrik Öqvist

Shoushuang Li

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In today’s post I’d like to have a quick look at GigaMedia, which is having some issues in China which on the face of it appear to be VIE related. The head of their Chinese operations has run off with the Chinese company, supposedly because he’s not a shareholder in the parent company and they wished to replace him. But let’s have a look at the situation as presented by the company’s SEC filings.

GigaMedia is a company registered in Singapore involved in online gaming and gambling, their main business areas seem to be SE Asia and China, with a JV in Europe focusing mainly on gambling.

In China the company conducts its business in the normal manner with a WFOE (T2CN Information Technology (Shanghai) Co., Ltd. (T2 Technology)) and three VIEs (Shanghai T2 Entertainment Co., Ltd. (T2 Entertainment), Shanghai T2 Advertisement Co., Ltd. (T2 Advertisement), Shanghai Jinyou Network & Technology Co., Ltd. (Jinyou)) holding the permits. All of these companies are managed through a BVI holding company (T2CN Holding Limited (T2CN)which the company owns about 67% of).

The precise ownership of the VIEs remains unclear as the company does not disclose this information. However, all the normal contracts appear to be in place according to the latest 20-F form: Shareholder Voting Rights Proxy Agreements, Exclusive Equity Transfer Call Agreements, Exclusive Technical Service and Consultancy Agreement, and Equity Pledge Agreements.

The filing also includes the normal reservations about the effectiveness of contractual control and the legal uncertainties surrounding VIEs, mentioning both MIIT and GAPP rules.

The first mentions of any issues surrounding the structure came in the company’s 2Q 2010 (6-K 2010-08-30), where it is mentioned briefly as:

“GigaMedia is now in a dispute with its former China head over his ongoing attempts to usurp company assets in China, including local company bank accounts and company operations. GigaMedia has filed legal action and is working aggressively with local police, courts and government officials to bring about a rapid resolution. GigaMedia’s China operations may be adversely affected by these illegal actions.”

This was followed by a more in-depth discussion about the issues in two separate 6-K filings (filed 2010-11-15, and 2010-11-26).

Gigamedia had felt the need to change leadership in China, there’s no mention of why they felt this need, but their former China head, Wang Ji, would be offered a senior consulting role or possibly be chairman of the board for the Chinese company. While he at first went along with the plans he suddenly changed his mind and starting from July 2010 he categorically refused to step down from any of his current posts.

The specifics of the situation were described as follow:

“GigaMedia believes that Wang Ji currently has in his possession, among other things, the company seals, financial chops and business registration certificates of T2 Technology and GigaMedia’s VIEs.  Wang Ji also has in his possession all documents, records and data and tangible property, including license agreements, trademark and domain name documentation, held in the offices of T2CN’s wholly-owned subsidiary, T2 Technology.  The company seals, financial chops and business registration certificates of T2 Technology and GigaMedia’s VIEs are necessary for the respective entities to declare dividends and approve service fee payments to GigaMedia, among other things. These documents are necessary for GigaMedia to run its online games business in the PRC.  Under PRC law, the company seals, financial chops and business registration certificates are essential for entering into contracts, conducting banking business, or taking official corporate action of any sort.  Consequently, GigaMedia has not been able to register the resolutions removing Wang Ji from his position as a director of T2 Technology and as the legal representative, executive director and manager of T2 Entertainment.  In short, Wang Ji has effectively usurped control over T2 Technology and T2 Entertainment’s operations and accounts.”

The company further stated that any adverse resolution in this case would likely have “a serious material adverse effect” on the company. Hence they had proceeded to file lawsuits against Mr. Wang in the PRC, Hong Kong, Singapore and the British Virgin Islands.

The filing finished off by stating that the company had not registered its equity pledge, and as such felt that they were highly unlikely to be able to get these contracts enforced in court.

The second statement further clarified the importance of the situation by stating that:

  • GigaMedia’s revenues attributable to its online games business in the PRC totaled approximately US$10 million, which represented approximately 20% of GigaMedia’s total consolidated revenues for the six months ended June 30, 2010.
  • GigaMedia’s proportionate share of the total assets of the entities held by T2CN was approximately US$32 million, which represented approximately 11% of GigaMedia’s total consolidated assets as of June 30, 2010.
  • GigaMedia’s equity in the income from continuing operations before income taxes of the entities held by T2CN (exclusive of amounts attributable to the non-controlling interest) was approximately US$0.6 million, which represented approximately 1% of GigaMedia’s total income from continuing operations before income taxes for the six months ended June 30, 2010.

The company also disclosed that they were considering writing off the entire investment in the entities held by T2CN since they had lost control of the company and were unable to gain access to any financial information regarding the entities.

When the 4Q 2010 results were filed (6-K 2011-05-06), the company had deconsolidated T2CN and completely written off the entire investment. Where they had previously seemed confident of a reasonably swift conclusion to the dispute, they now admitted to a bleaker outlook:

“While management continues to believe that its general legal position is sound, as a result of recent setbacks that have delayed the progress of the litigation against Wang Ji and the increasing complexity of the ongoing litigation, it is now impractical for the company to estimate with any degree of certainty the timeline for the eventual resolution of the dispute or the likelihood of a successful outcome.”

The latest mention of the dispute is in the 1Q 2011 report (6-K 2011-05-26), where new developments are briefly referred to:

“Investments ongoing in new China platform while continuing to pursue all means to resolve the dispute in connection with the China-based business T2CN.”

Well to be honest I’m a bit shocked, I was expecting to find a case revolving around the legality of a VIE structure, albeit one without properly registered documents and such. But what’s interesting to note here is that the conflict really seems to be one step higher than should be possible. The VIE contracts aren’t actually coming into it because somehow the former China head has managed to gain control of the WFOE, which is the entity to which all the VIE’s are supposedly contractually tied to.

This matter should be quite easy to deal with through normal procedures, as there should be no question who has authority over the WFOE, thus GigaMedia should be able to at least regain control over this entity. I’m not quite certain how the company has gone about things but it seems oddly suspicious that they’re unable to regain control over a WFOE.

I’m not quite sure what to make of a company that’s apparently unable to regain access even to its WFOE after many months and quite a lot of money spent on lawyers. I get the feeling there might be more to this story than the SEC filings suggest.

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Recently trading stopped on shares of Jiangbo Pharma, because the SEC wants some more information from the company. I have yet to see a good report on exactly what information has been requested, however.

This in itself is no great surprise, the company is reverse listed and used to be audited by the shorters favourite Frazer Frost, which is by now almost synonymous with fraud allegations and delistings.

What is more interesting is that on the face of it, the investment in the company still doesn’t seem so bad, as the market cap of the company was around 42 million while it held cash of 146 million (assuming we can trust the books on this). Thisseems like an odd thing to have happen until you look through their corporate structure and find that basically all of the company’s assets is sitting in the VIE for no apparent reason.

I doubt that this is what the market has been pricing the company for, however, it seems more likely that the market assumed fraudulent books and overstated profits/cash positions. But nevertheless investors could quickly learn just how much 146 million in a VIE could be worth if the owner decides to pack it up.

JGBO’s structure is a very simple VIE arrangement with the entire operating part of the company in the VIE. It should be noted that there is no legal reason for the entire company to be run as a VIE, some areas are restricted but much of it could reasonably be run through a WFOE.

Even though all of the normal contracts are in place the company appears unwilling to transfer any of their assets out of the VIE, even to the extent that they failed to make their interest payments/penalties on convertible notes in the US due to an inability to transfer money out of the VIE.

If the contracts that they claim to have are in place the money should, at the very least, be able to travel to the WFOE without much hassle or expense. Even if transferring it out of China does require SAFE approval, SAFE approval is not a valid excuse for holding all of the company’s assets in a legally questionable VIE arrangement without any security for the investors.

The company seems to be making up excuses for why the money should stay in the VIE, where the investors have questionable control over it. If this turns into a legal case involving fraud my guess is that investors will come to the stark realisation that 146 million in cash stashed in a VIE might well be worth nothing at all.

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