In this post I will turn to a lesser-discussed issue in the Sino-Forest debate, the one relating to its contractual relationships in China. More specifically I will try to elaborate on the argument Professor Paul Gillis has made that these can be viewed as a “primitive version of a VIE structure”, and that they will therefore share similar underlying uncertainties.
The VIE structure is essentially a method of conducting business in China using contractual arrangements rather than equity ownership in order to exert control over an entity. Normally this is used because of legal restrictions to what the company can do in China as a foreign entity.
Similar to this, Sino-Forest have 81.3% of their “timber ownership” under contractual control through a series of agreements with land holders and Authorised Intermediaries (AIs).
The company states that this reliance on contracts instead of outright ownership was put in place in order to comply with local regulations, much in the same way as VIE agreements. However, there appear to be no control agreements, equity pledges or such arrangements made between the parties, and thus there is no outright VIE status achieved.
The entities that are controlled in this way do, however, seem to have a very close relationship between them. The company uses only its AIs and any money made is directly reinvested in a sort of “closed Eco-system” that exists among the contracted parties.
So Sino-forest’s way of conducting the majority of its’ business in China shares the same basic tenets as a VIE structure. And as the basic premise of these relationships bear a close resemblance to a VIE structure, we are also likely to find similar issues with both practices. For instance, the close relationship and business practices in the operations may be subject to transfer-pricing scrutiny, and the reliance on contracts instead of direct ownership puts the legality and enforceability of these contracts on centre stage.
Of these two, the issue of the legality and enforceability of the contracts is likely the most important, and certainly the most pressing one. Similar to what we find in VIEs, if the contracts do not measure up then investors lose any rights they have to the assets held under them, and to the business conducted through them.
Contractual control is a weaker form of control when compared with direct ownership, and should thus be traded at a discount, especially if the legality of these contracts is in question. In the case of Sino-Forest 81.3% of the company’s forest holdings are held in this way, which makes it an issue of exceptional importance.
I will look more closely at the potential legal problems that this way of conducting business can lead to in a later post.