I will be writing a few posts in relation to a study Professor Gillis and I have recently concluded into the disclosures of Chinese companies using VIE structures listed on the NYSE and NASDAQ. This first one will deal with the issue of equity pledges.
In collecting the data for our study we came across several numbers that make for interesting reading for investors, and people in the industry. Professor Gillis has already discussed two of these over on the China Accounting Blog, I strongly suggest you have a look at his analysis.
I have chosen to focus in on the equity pledge agreements because it is one of the more important of the VIE agreements. In the classic VIE structure the equity pledge is used to secure the loan to monetise the VIE, and sometimes also compliance with the other VIE agreements.
The basic premise is that if the owner of the VIE, who has pledged his shares acts contrary to the company’s wishes, they can call on his pledged equity and place it in the ownership of another nominee holder.
However, these pledges have to be registered with the Chinese authorities before they become valid. Before this registration the pledges have no legal value whatsoever and are entirely unenforceable.
Interestingly, when we examined the disclosures of these companies we found that only 11% of them stated that they had registered their equity pledges. Which means that, as far as we know, only 11% of companies with VIEs have any legal basis for the agreement put in place to secure compliance with the other contracts.
The equity pledge is potentially one of the most useful of the VIE contracts. Companies, and foreign shareholders can ill afford to leave this agreement unenforceable because they didn’t take the necessary steps to make the agreement admissible in court.