Archive for the ‘VIE structures’ Category

As the accounting issues between the US and China escalates investors in China concept stocks aren’t the only ones scratching their heads. Equally troubled are the country’s VC and PE firms who were just starting to see a light at the end of the tunnel with YY’s recent IPO.

People may be underestimating the potential losses for China if the US markets were to be closed off, in particular when it comes to the technology sector. There are currently many young promising Chinese tech companies, but most of them have at some point taken in foreign capital to grow, which means they will have a VIE structure in place.

A VIE structure and foreign shareholders will automatically rule out a domestic listing, so the only possibility is to go abroad for an IPO exit or try to find M&A options in China, something that has been very slow moving so far. A foreign exit has traditionally meant one of two places for up and coming Chinese tech companies: US or HK.

The problem we could face now is that the US exchanges will close completely for Chinese companies, and HK’s new VIE regulations means it should be all but impossible to list the company their either. At that point we’re left with the “secondary exchanges” for Chinese companies, most likely London or Singapore.

However, these exchanges don’t have the same history of taking in Chinese companies, much less the soon-to-be-big tech companies and their disclosure rules for VIEs are relatively lacking. These factors combined mean that the ambiguity and risk both for investors and the company that wants to IPO increases, and if there’s one thing Chinese companies and investors in them don’t need right now it’s more ambiguity and risk.

This development poses very real problems for the country’s VC and PE firms, and in turn for innovation and new company creation in some vital Chinese industries.

A lot of the debate seems centred around the issues this will raise for investors and the US role as central capital market, but China does not walk away scot-free from this either. And decreased private investment in key innovation industries is not what China needs right now.

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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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While there are some fairly varying opinions regarding exactly what happened when walmart got conditioned approval for their acquisition of Niu Hai Holdings, one thing at least seems clear: MOFCOM is not overly fond of VIEs.

This certainly won’t be welcomed by foreign investors using VIEs, but its hardly news either. MOFCOM have been the most vocal department when it comes to issues relating to VIEs, for instance in their recent M&A regulations, so a continues negative stance is hardly shocking. What is interesting is how they express their negative views.

They haven’t banned the VIE structure as such, if anything they are acknowledging its existence, but they are limiting the scope under which they will allow it to operate. So far I don’t think this will cause any major issues for Walmart, so from their point of view this is probably a pretty good result.

Other VIEs might want to take notice of the restrictions, however. just in case this turns out to be the start of a trend. While MOFCOM can’t really declare VIEs illegal, they may find a simpler solution in simply restricting their business scope until they are basically useless.

Seasoned watchers of the VIE space will know to take any such hints of future regulatory enforcement with caution though, as we have seen similar things before, with Buddha Steele for instance. What we can say is that MOFCOM certainly doesn’t seem to like VIEs, and if you cannot ban them limiting them is probably your next best option.

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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.

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A report in the Chinese press has outlined yet another instance of the government criticising VIEs and foreign influence in sensitive sectors.

While this might not sound as news it has two features that sets it apart from the average criticism. It is supposedly the opinions of some fairly senior people in the central government, and it outlines a potential course of action to bring current business practices more in line with official law and policy.

Although generally vague there are two features relating to the scrutiny of VIEs that offer some interesting insights into how enforcement around the issue could look. Something that should be of interest to investors seeking to understand risk exposure in the area.

  1. Talks about scrutinising all contracts between domestic and foreign companies in these restricted industries.
  2. Examining the suitability of the foreign partner in these contracts

The reason this is interesting is that it sets out a potential focus of enforcement that is different from what some thought it would be. For instance there’s no direct attack on the VIE concept, but rather a slower approach that starts with scrutinising the contracts involved and the companies that have signed them.

This is important as it shifts the focus from the structure as a whole into its individual parts, and as such opens up for treating different VIEs differently. This type of action looks a lot like trying to pick off some low hanging fruit in the industry, which in this case would likely mean some of the poorer constructed VIEs.

As I have mentioned before there are big differences between one VIE structure and another, ranging from how much of the assets are kept in the VIE to how they have formulated the contracts used to extract the money into the WFOE. These factors will take on a new importance if this type of action is implemented.

For instance, if the government was to start scrutinising the contracts used in VIE structures they will find that some of the technical services agreements have terms that can by no means be referred to as “at arms length”. Some of these agreements stipulate that the VIE is to pay all of its revenues as fees for services rendered by the WFOE, as well as any residual profit at the end of the year. While this contract might be good from a consolidation standpoint it is an absolute nightmare from a transfer pricing point of view, and leaves the company open to some very serious tax liabilities.

Increased scrutiny of the WFOE used in the deal offers another set of potential problems. With some of these companies holding virtually their entire operations in the VIE it could be hard to argue how the WFOE is providing services of enough value to receive all the profits from the VIE. Another potential issue that could arise is questions of whether the WFOE is acting outside its business scope, for instance when it provides loans to capitalise the VIE.

This type of enforcement, if enacted, is not so much an attack on VIEs as a tightening of the screws surrounding the structure. While well-constructed VIEs may walk away unscathed some lower quality arrangements could get in very real and costly trouble. Investing on this information will be all about being able to tell a good VIE from a bad one, which will require looking over the details of your investment structure before the Chinese government does.

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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.

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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.

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