The VIE world certainly got a big shakeup yesterday by the SEC investigation of EDU. It has caused all manner of questions, both new and old to start flying through the air, and another shift in the risk assessment of the structure has ensued.
Essential reading about the issue can be found, as ever, on the China Accounting Blog, that lays out what happened:
New Oriental Education and Technology Group (NYSE: EDU) dropped a bombshell in its fourth quarter earnings release this morning. The company reported that the SEC has issued a formal order of investigation captioned “In the Matter of New Oriental Education & Technology Group Inc.” The Company believes that the investigation concerns whether there is a sufficient basis for the consolidation of Beijing New Oriental Education & Technology (Group) Co., Ltd., a variable interest entity of the Company, and its wholly-owned subsidiaries, into the Company’s consolidated financial statements.
Investors are appropriately concerned. The stock is off 37% as I write this, with other companies with VIEs off by single digits. A formal investigation is far more serious than the normal comment letter process that usually deals with these kinds of issues. It means the Division of Enforcement of the SEC, rather than the Division of Corporate Finance is dealing with the issue.
On July 11 EDU announced it had restructured its VIE ownership. The VIE had been owned by a number of shareholders, some of whom are no longer active in the company. It is now held by an entity owned by Chairman Michael Yu. I don’t see anything wrong with that restructuring. The SEC investigation was launched on July 13. I doubt that the restructuring led to the investigation. I suspect that the company has been responding to the normal comment letters that the SEC Division of Corporate Finance issues to all companies periodically. Something may have gone terribly wrong in this process and the issue was referred to the Division of Enforcement, which launched a formal investigation. That is all my speculation, however
Like Professor Gillis I am of the opinion that the restructuring of the company was nothing to get too riled up about, if anything it actually made the structure more stable. Even though there would need to be a reapplication to register the equity pledge because of the change in ownership. But, and this is fairly wild speculation, it’s entirely possible the SEC asked some questions regarding this shift and didn’t quite like the answers it got back.
The real impact of this move by the SEC is unclear at the moment, as we have no information about what exactly they are unhappy about. But it is fair to say that any concerns about consolidation of VIEs certainly has the potential to impact other companies that use the structure. Although SEC probes like this tend to be quite specific so the potential impact may indeed differ between companies. Not all VIEs are the same.
The key items at present for investors in other VIE companies are to assess their own situation. How much of the company is actually in the VIE (or: how much of the investment will just disappear from the balance sheet if consolidation is impossible), and then whether or not the potential issues the SEC has identified in EDU are likely to exist here as well. The last point will only become clear when we know the exact nature of the SEC investigation, but taking stock early will mean investors can move quickly on any new information supplied.