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.