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Archive for October, 2012

The big talking point last week was undoubtedly the New York Times article that laid out the personal wealth of Wen Jiabao’s family in great detail. It was a piece of reporting very reminiscent of the earlier Bloomberg piece regarding the wealth of Xi Jinping’s immediate family, and the result of both articles has been the same: immediate blocking of the entire site inside China. But there are other potential repercussions because of this as well, and they have the potential to harm investors and Chinese stocks listed overseas.

Both stories used Chinese records to build and confirm the bulk of the data they presented, this is also commonly done when conducting due diligence on Chinese companies. These are the SAIC filings where you can find a lot of data about a company to help guide your due diligence process. It used to be that you could get all manner of economic data from the SAIC files, but access rights were severely restricted earlier this year, which forced due diligence professionals to adapt their processes.

It was widely speculated that the restricting of access to the SAIC files was a response to them often being used as a first stop when the now infamous short sellers were putting together reports on Chinese companies. The theory then went that because these reports were having a negative effect on Chinese stocks overall, as the perceived fraud risk increased, the political class stepped in to try to limit the short reports and decrease the downward pressure on Chinese stocks. It may even have been the case that the reason for the political class to move on the issue was that they were themselves losing too much money because of the stock decline.

The risk we face, now that these reports have been put together, at least to some extent, based on the SAIC filings is that access will be restricted even further. This would cause a multitude of problems for conducting due diligence in China, and it would add uncertainty to the market for China concept stocks as it would become even harder to confirm holdings, or even simple things like ownership.

This is especially problematic for people who trade Chinese stocks on the IFRS exchanges, as disclosures from companies on these exchanges tend to be much less detailed. The classic example for me in this is the fact that you can still report a VIE as a subsidiary under IFRS. The classic check on this would be to pull the SAIC filings to find out who were the actual registered equity owners of the entity in question, if you remove this option then investors truly are flying blind.

What’s more, this will probably also increase the costs of performing due diligence in China, which would harm smaller investors more that institutional players who have enough money involved to warrant the outlay. With the easy option of checking SAIC filings for suspicious discrepancies gone investors will need to find other ways of red flagging potential investments, it will also increase the value of having a good network set up for conducting due diligence.

Further, In my opinion it’s quite the opposite of what the overseas listed Chinese companies, especially the small- and mid-cap companies, need right now. many of them appear to be legitimately undervalued and would benefit greatly from increased transparency to help soothe investors concerns regarding them.

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So there’s been an awful lot of speculation and rumours around VIEs of late. Starting with the continued EDU issues that I discussed at some length in my Tradingfloor column earlier, to some new rumours about issues for MNCs. It’s this latest rumour I find most interesting, and I think it’s a very interesting development if we put it in its proper context.

First of all we have to say that we currently have very few details about this crackdown, for instance we don’t know which AICs or MNCs are involved. We could indeed be looking at a situation similar to what we had with Buddha Steel where enforcement appeared to differ depending on where in the country you conducted your business. As we’re talking about local AICs here it’s entirely possible that we’re currently seeing different enforcements in different areas of the country.

But this is not the whole story, of course. What’s really interesting about this is that it seems to follow something of a pattern. It started off with the article discussing the issue of foreign influence in the restricted industries in China, then all was quiet for a good while before we saw some real movement when MOFCOM approved the Walmart takeover of Yihaodian with some reservations, creating what I called the restricted VIE.

This is now the next step in what appears to be a gradual campaign to limit the use of the structure. As Professor Gillis pointed out in his post they’re apparently staying away from the foreign listed companies as they are too high profile. What they do appear to be doing is targeting MNCs in particular. I think this is likely to be an attempt to rein in the most obvious foreign elements in the restricted industries, as they are very obvious examples of the foreign influence the article warned against.

While there are arguments that can be made about the supposed foreign influence many of the foreign listed VIEs are actually subject to (you’ll find most still have a heavy voting majority of Chinese nationals), it’s much harder to argue the same for an actual foreign company.

This is yet another issue with VIEs that will relate particularly to foreign companies. The structures used by the foreign companies are already less stable, in general, than a Chinese VIE due to the difficulties in aligning incentives when the VIE is held by an employee. You create a lot of potential issues with an employee held VIE, as the employee suddenly has an unreasonably strong negotiating position, and with very limited ownership in the foreign parent there are often strong incentives to take the VIE and run.

While the risk of the owners absconding with the VIE can be mitigated by properly structuring the assets etc. it’ll be very hard to deal with this new issue. It’ll be interesting to see how far authorities take these actions, but MNCs will certainly need to keep on top of the situation. Authorities are unlikely to relax the new restrictions against foreign elements anytime soon.

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