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Archive for July, 2011

I’ve covered GigaMedia previously, pointing out, among other things, that the VIE structure seemed pretty safe as it wasn’t being contested in courts. Well that’s changed now, so a lot of people should start re-examining their risk exposure in this area.

But first, let’s get up to speed with the general progress of the overall situation.

The lawsuit has taken some very interesting turns lately and looks likely to get pretty nasty. Further, the fact that the lawsuits are currently being pursued not only in the PRC, but also in Singapore, Hong Kong, BVI, and California certainly doesn’t make this any easier to follow.

GigaMedia presents the situation in their latest 20-F, although they don’t add much new information, here’s the basics of the case developments in the PRC:

T2 Entertainment, as represented by the newly appointed legal representative Yan Guoming, filed lawsuit against Wang Ji and related persons in the courts of the PRC in August 2010, seeking to recover, among other things, the tangible property of T2 Entertainment, including the company seal, financial chops and business certificate. In August 2010, Wang Ji also filed two lawsuits against T2 Entertainment and Lu Ning, one of shareholders of T2 Entertainment, to invalidate two shareholder resolutions of T2 Entertainment: (i) the shareholders’ resolution dated in February 2010 approving a transfer of the shares of T2 Entertainment held by Wang Ji to a third party (“Wang Ji’s 1st Suit”); and (ii) the August 7 Resolution (“Wang Ji’s 2nd Suit”). Wang Ji’s 1st Suit is temporarily suspended due to the absence of the defendant Lu Ning in the first formal court hearing and pending the court’s decision as to T2 Entertainment’s standing, as represented by Yan Guoming, to join the suit. Wang Ji’s 2nd Suit was withdrawn by Wang Ji in April 2011.

They also give us some insight into how Wangji is proceeding:

Wang Ji (who owned 20 percent of the equity interests of T2 Entertainment) and Lu Ning (who owned 80 percent of the equity interests of T2 Entertainment) appointed their respective representatives to attend such shareholders’ meeting and the August 7 Resolution was duly passed in accordance with the articles of association of T2 Entertainment. In late March, 2011, we were informed by the court that Wang Ji had submitted supplementary documents to the court. The documents included a purported shareholders’ resolution of T2 Entertainment dated February 14, 2011 (“February 14 Resolution”) which stated that the August 7 Resolution was invalid, that Yan Guoming has no authority or right to represent T2 Entertainment, and that Wang Ji is the executive director, legal representative and manager of T2 Entertainment and his acts representing T2 Entertainment are valid. The February 14 Resolution claimed that Lu Ning and Wang Ji attended the shareholder’s meeting in person and passed the February 14 Resolution by mutual agreement.

However, if you’re looking to follow just one of these suits you should make it the california, it might not sound too exciting from what GigaMedia tell us:

On November 10, 2010, the Company filed a lawsuit in the United States District Court for the Central District of California (the “California Action”) asserting a number of claims against the other shareholder of T2 Entertainment and our former head of operations in the PRC, including, among others, tortious interference with contract, tortious interference with prospective economic advantage, fraud, aiding and abetting conversion and breach of oral contract. In these matters, the Company is seeking to recover, among other things, monetary damages. Subsequently, Wang Ji filed a motion to intervene in the California Action on April 26, 2011. The court set Wang Ji’s motion to intervene for hearing on August 22, 2011. On May 24, 2011, Wang Ji filed an ex parte application to shorten the time with respect to the August 22, 2011 hearing date for his motion to intervene. We opposed the ex parte application on May 26, 2011. On May 27, 2011, the court issued a ruling denying Wang Ji’s ex parte application to shorten time. Hearing on the intervenors’ motion will be held on August 22, 2011. On April 18, 2011, Wang Ji also filed a complaint against the Company and T2CN in the United States District Court for the Central District of California. Wang Ji’s complaint was subsequently stricken by the court for failure to follow court rules, though, according to court records, that complaint has now been properly refiled.

But according to Dacheng Law Offices they’ll be coming up against claims that their VIE structure breaks Chinese law, and further, that they knew that it was in violation of the law but presented it to their shareholders as something else.

The complaint seeks $40 million in damages and a court declaration affirming that Gigamedia’s business structure, operating in China as a Variable Interest Entity (VIE), and its attempted direct and indirect involvement in T2-E’s online game activities, is invalid and illegal under the laws of People’s Republic of China (PRC).

In this regard, the complaint also points out that, in its Annual Report to the SEC for the year ending Dec. 31, 2009, GigaMedia reported that the promulgation by Chinese government authorities of Notice 13 on Sept. 28, 2008, if enforced, would render ownership the [VIE] structure in the PRC invalid and illegal.

The complaint alleges the VIE structure was known to be unenforceable when GigaMedia made these representations and that they were misleading.

Just for reference the part where they admit that the structure is illegal is the following statement relating to GAPP:

On September 28, 2009, the PRC General Administration of Press and Publication (“GAPP”), National Copyright Administration, and National Office of Combating Pornography and Illegal Publications jointly published a notice, which, among others, (i) provides that GAPP is responsible for pre-examination and approval of Internet games as authorized by the central government and State Council, and that the provision of Internet games either online or on a downloaded basis constitutes Internet game publishing, which is subject to pre-examination and approval by GAPP; and (ii) prohibits foreign investors from participating in Internet game operating businesses via wholly owned, equity joint venture or cooperative joint venture investments in the PRC, and from controlling and participating in such businesses directly or indirectly through contractual or technical support arrangements. If applied literally and uniformly, such notice would render our ownership structure in the PRC invalid and illegal. To date, however, there are substantial uncertainties regarding the interpretation and application of such notice.

All in all this looks like THE case to follow if you’re working with VIEs in China, especially those affected by the GAPP guidelines. Presumably if this case determines that GigaMedia were misleading shareholders then so are all the other companies whose VIE structures fall under GAPP scrutiny.

Maybe GigaMedia should call some of the other Chinese game companies listed overseas to draft in some help, because I doubt many of them would like to see this one go the wrong way!

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The title of this post was taken from an article in the Economist, worth a look if for nothing else than its wonderful cartoon illustration. The title caught my attention because we have dealt a lot with VIE contracts and challenges to its structure, yet there continues to be a gaping hole in the discussion – specifically, around the ownership of a VIE.

Who owns what in a VIE structured company is critical as the incentives of the VIE owners can be completely misaligned from the interest of investors, as often indicated by companies in the risk sections of their annual filings. Yet for all the acknowledgement of risks, we seldom see companies taking actions to mitigate them.

Generally, VIEs fall into at least one of three different categories of ownership: CEO/Founder-owned, Family-owned, and Employee-owned.

CEO/Founder owned VIEs are common if for no other reason than for its relative simplicity.  The founders tend to be PRC nationals who have started a company and then set up a foreign SPV; they can then simply retain ownership of their original company in China and sign the normal VIE contracts with their SPV’s WFOE. This ownership structure is often perceived as the least risky for foreign investors, but certain situations have given foreign investors reason to reflect.

One such situation is exemplified by the divorce proceedings of Tudou’s CEO Gary Wang, where his wife settled to drop the claim of 76% of the equity interest in the company’s operating VIE for cash payments. This led to the now prevalent Tudou clause, which aims to remedy the situation; however, it will be interesting to see if companies that have already listed will also add this to their existing arsenal of VIE agreements.

Another interesting issue that surfaces is the increase of Chinese companies taking a collective beating on the foreign exchanges, causing a misalignment between the incentives for the owner of the VIE with those of shareholders in the public company, as the value of shares in the US is now sometimes even below reported cash balances. The rationale is that there is no reason a company should be listed in the US with a P/E of four, when it could just as easily trade in China at a P/E of 12.

There has been talk about the dangers and difficulties of PE firms delisting a company from a foreign exchange in order to take it public domestically in China instead, but simply cutting the VIE contracts before listing domestically simplifies this process significantly.

Family-owned VIEs work on another level than CEO-held VIEs; there is an overhanging monetary incentive for any member of the family to simply cut the contracts and walk away, as they normally don’t hold equity in the public company. We must then infer that the reason they do not jump ship is because of their bond to the relative who runs the company.

Some observers have pointed out that there are severe unreported risks in the potential deterioration of ties between the VIE owner and their relative within the listed company. For instance, the Tudou situation could have ended worse if the VIE was been owned by the CEO’s ex-wife.

Should family disputes and squabbles be reported in the 20-F annual reports?

It may sound ridiculous, but with some companies, there is the risk that a divorce or a falling out amongst kin could lose the company its entire China operation.

Employee-owned VIEs are another option, and perhaps most interestingly the only viable one for foreign players in the market. Many point to GigaMedia as a prime example of what could happen if there is a falling out between the VIE owner and the company.

The obvious drawback is the amount of power given to a single employee. The employee, as the GigaMedia case showed, becomes impossible to fire. In fact, the employee can hold the company hostage, with the implied threat that the company’s entire operations are under his/her control and could disappear at any point.

Additionally, I question the wisdom of this method of ownership due to historically high employee turnover rates in China.  What would happen if the employee joined a rival company? You could in effect “recruit” an entire business, or business segment, from your competitor.

Now, the above cases discuss the purer forms of VIE structures, as in ones where basically the entire company, or at least an independent part of a company, is in a VIE.

One way to minimise adverse incentives created by this form of ownership is to set up your organisation so that no VIE can operate as a separate entity.

The goal should be to hold as much of the business as possible in WFOEs, preferably limiting the VIE to holding nothing but the necessary licenses. This way, a VIE on its own has no real value; its only value is as part of the whole organisation, the listed company. Then, the value of the VIE bargaining chip is lessened substantially because no one stands to gain from picking the company apart.

We do see that companies set up this way better aligned between shareholders and the owners of the VIE; Baidu is one example of this.  Not all companies have taken these steps however, and in some cases, it’s difficult to tell to what extent these steps have been implemented at all.

The question of adverse incentives in VIE structures, and how to mitigate them by aligning the interests of investors and VIE owners, deserves attention. PE and VC firms that come into these companies likely have a better chance at instigating real change than shareholders of publicly traded companies, but the issue is a pressing one for any investor who is not the owner of the VIE.

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Yesterday the Communist Party School paper Study Times issued an article criticising the influence foreign capital has gained within the country’s sensitive IT sector. I think it’s fair to say that this situation should not come as a revelation to the party, as VIE structures are commonplace and increasing numbers of IT companies are filing to list on foreign exchanges.

But the fact that the issue is now openly discussed is of interest, as it could signal the Party’s wish to start dealing with it. So what information might we glean from this particular article then, bearing in mind that it’s just one article, and likely just the starting point of the debate?

I will reference an old post by Professor Paul Gillis of the China Accounting blog, where he discussed how to clean up the sector a while back and suggested the following:

2. Recognize the reality that there already is significant foreign investment in prohibited sectors, and find a way to regulate this investment instead of pretending to prohibit it.  Prohibition has not worked, and China needs entrepreneurial companies like Baidu, Dangdang, CTrip and Ambow Education.

To my mind this article fits rather neatly in as a first step in Professor Gillis’  suggestion above. If we break down the article, the majority of the space is actually used to call attention to the VIE practice and how commonplace it is in the industry. Furthermore, the article doesn’t actually talk about banning and closing these companies outright, instead it talks of increased scrutiny into every aspect. Although some will disagree and argue that this article is in fact a call to ban foreign investment, I think we have to wait a while before we know how the debate will go.

While the main point of the article is about the purchase of influence by foreign capital in the IT sector, which is deemed dangerous for future political reasons, it makes no mention of different classes of shares – only of % of shares held. This oversight seems to overstate the actual influence of foreign capital. The fact is that many Chinese companies, and many western companies as well, issue and list with different classes of shares, sometimes with widely differing voting rights. Thus, the amount of shares does not necessarily represent the amount of influence an investor has. This should be a ready argument to put against their results, as I believe the actual voting power that is controlled by foreign capital to be far less than the % of stock held.

Allowing Chinese companies to list with non voting stock overseas could be one step for the Chinese government to take, should they wish to keep the door open for the country’s IT industry to seek foreign capital whilst limiting any actual influence over the industry.

But overall, I think it’s fair to assume that more debate will lead to more scrutiny, and quite possibly tighter regulations. Exactly how it will all play out is still hard to say, but it will be an exciting debate to follow.

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Those who thought investing in Chinese IT-stocks was risky yesterday will put on the Beatles as they long for the trouble-free environment of yesterday.

I saw a Tweet from Bill (@niubi) over at DigiCha that just sent me into a frenzy of reading and emailing to try to get on top of this new development. I’ll update this and subsequent posts as we get more information.

The Chinese Academy of Social Sciences have released an article pointing to the dangers of foreign controlled companies in the Chinese internet sector, and seems to be pushing for much more of a hard-line stance against the practice.

WSJ (English)

Study Times (Original Chinese)

The piece doesn’t just brand the obviously foreign companies as being controlled by foreign capital, but includes almost every Chinese internet company in this group. As such the risk of increased scrutiny of VIE structures (explained at lengths in the article), and any dealings between foreign and domestic players in the sensitive IT market has gone up significantly.

“If we judge by the indicator that a foreign control of over 20% stake is relatively controlled, and over 50% is majority-owned, then most Chinese Internet companies that are listed offshore are controlled by international capital,” the authors wrote. “International capital thus controls our Internet industry.”

Translation from WSJ article

The report also comes at a time of increased nationalism and an overall lauding of the communist party and “red values”, which should give political forces inclined to act on the article a good base of support. Protecting China from foreign influence is a good line of argument even in moderate times, which could well bode for some public outrage, claims of entrepreneurs selling out the country etc. in the weeks to come.

The report itself is basically a description of the current situation of the IT-industry in China with foreign listings, and VIE-structures. This is followed by recommendations to increase the domestic abilities to finance growth in the Industry (PE, VC etc.), increase the legal scrutiny of both the capital structure and the actual business operations in the industry, and also take very seriously the threat of foreign capital in the industry as it’s a power that can grow.

Although I think the report misses the mark on some issues, the details are unlikely to matter too much, the bigger picture will sell it.

One of my disagreements with the article lies for instance in that the Alipay case to some extent demonstrates the power that VIE structures can give the Chinese government over the IT-companies, rather than highlight the dangers of foreign investment.

That this issue is being discussed in this detail, at this level, at this point in time, should give everyone reason to take this quite seriously, indeed.

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