In my previous post I discussed how the contractual structure used by Sino-forest in China has many similarities to a VIE structure, and that it also shares many of the same risks.
I’m going to use this post to map out the major issues I will be discussing in coming posts. Think of it as a kind of roadmap for where coming posts are heading.
The Sino-Forest case can be used to illustrate many issues and potential issues with a VIE-type arrangement.
The contractual relationships themselves are, as with any VIE-type arrangement, of central importance due to the lack of any outright equity ownership in the operations. There are some potential problems with the enforceability of these contracts discussed in the Independent Commission (IC) report, which should be a cause for concern with investors.
In general, the IC appears to have had trouble gaining access to legally enforceable evidence to corroborate the company’s claims on the forest assets. This, coupled with generally poor disclosure of the exact nature of the contracts being used makes for a lot of uncertainty relating to their enforceability.
As with a traditional VIE structure we find potential issues both with the overall contractual business model, and with the contracts themselves. These problems also seem to be worsened by the overall structure the company is using to conduct its’ business in China.
However, the corporate structure issues are not contained to the contractual relationships. The company has also taken the unorthodox step of having a VIE-like structure in place without a WFOE to tie it together.
Company’s that choose not to set up a WFOE in China are not allowed to conduct any “business activities” in the country. There seems to be a contradiction in that Sino-Forest claims not to have any business activities in China, yet in Canada they consolidate the contractually controlled businesses on their balance sheet. This contradiction could have large ramifications for the company, as an adverse ruling in the matter could force it to shut down its’ contractually controlled operations in China.
Another issue arising from the lack of a WFOE is complications with transferring money offshore. One of the main reasons for VIEs to use a WFOE is in order to facilitate the transfer of cash out of China. There are complications involved with making transfers directly from a contractually controlled entity in China to a foreign company. It is possible to do, but the fact that we’re not seeing any money flowing out of the contractual eco-system suggests that Sino-Forest does not have these arrangements in place.
With this in mind it’s easier to understand one reason why the company hasn’t been transferring money out of their closed eco-system in China. However, it also raises concerns over their ability to do this in the future.
With these issues in mind the question whether there is sufficient reason to allow consolidation of the contractually controlled assets could be raised. Especially considering there are some similar concerns surrounding the more established VIE structures.