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Posts Tagged ‘China risk’

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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After a couple more days, with some added information on this topic we can now start to guess at an outline of what actually happened when Yahoo lost its’ Alipay investment.

There’s been some mud-slinging between the companies involved and the crux seems to be whether or not Alibaba’s board, and thereby Yahoo, was informed of the transfer of Alipay or not. The Chinese side are claiming the duly informed the board, while Yahoo are claiming they got no word about this.

I think they’re both telling the truth, although they’re missing each others points.

Due to restrictions of foreign investment in certain relevant areas of its’ business areas, Alibaba has to conduct parts of its business through VIEs. A VIE is in reality a series of contracts that aim to create ownership of a company without actually holding any equity interest in it. As Chinese laws strictly speaking only ban equity ownership, this type of structure “allows” foreign investment in restricted areas. However, there are quite substantial doubts as to the legitimacy and enforceability of these contracts.

As I mentioned in a previous post the transfer of Alipay was actually made in two stages, the first one transferred 70% of the company, the second one transferred the remaining 30%. Hence we can safely say it was transferred into a VIE, or it would have de-consolidated at the first stage.

Here’s the sequence of events that I think brought about the de-consolidation of Alipay, and the subsequent misunderstanding regarding the information. It should be noted that this is my best guess, I’ve had no way of truly confirming this.

  1. Alibaba wants to transfers 70% of the Alipay into┬áZhejiang Alibaba E-commerce Company (Zhejiang Alibaba) its’ VIE, in order to facilitate approval from banking authorities.
  2. The board are duly notified that Alipay is being transferred to Zhejiang Alibaba, which looks and acts like just another subsidiary unless you know what you’re looking for.
  3. The regulators still will not approve the company for a banking license, most likely because they still consider it a foreign investment, so Alibaba want to transfer the remaining Alipay equity to Zhejiang Alibaba, which would then be a wholly-domestic company on paper.
  4. The board are notified that the rest of Alipay should be transferred into this subsidiary-looking VIE thing. As it will still be consolidated this does not appear to be a big deal.

This is the bit the Chinese side are talking about, because they informed the board of all of these transfers, Yahoo clearly knew what was going on. Alipay had been transferred to Zhejiang Alibaba, a VIE entity technically separate from the company but consolidated in the financial statements. Thus, Alibaba’s management had fulfilled its duty.

However, from Yahoo’s point of view this was simply an internal transfer to comply with some pesky regulations, they didn’t see the entity as separate until it de-consolidated. The last two steps are what they weren’t informed of, and this was the important bit from their perspective:

  1. The banking authorities take the VIE hardline, saying that this type of legal construction circumvents the law and is therefore not allowed. If Alipay is to get its’ license it needs to desist from this activity.
  2. In order to finally obtain the license and not hurt its’ business too much Alipay cuts the contracts, and disappears from the Alibaba financial statements. The board is not notified.

Thus, Alibaba’s management failed to fulfill its duty.

My guess is that Yahoo’s board representation simply didn’t realise the risks involved in a VIE-structure, or the current legal pressure being asserted on them, and took the decision to allow the transfer of the equity under the view that this was a very solid system of control.

Now Yahoo is pushing to be compensated for what is being called a spin-off, and in reality this might be the only road still open for them. Consolidating Alipay again seems like an impossible task, given what appears to be a hardline approach by the authorities on the matter.

The trend for legal landscape for VIEs is one of increased enforcement of the laws against them, however, this enforcement is not coming from Beijing. Instead we’ve seen regional enforcement, as in the Buddha Steel case, and now also industry specific enforcement with Alipay. Navigating the VIE field is becoming more and more like a maze, and Beijing seem likely to allow local and industry regulators to continue to police the VIE question as they see fit.

Investors should duly take note of this situation and see if their own companies have any system in place to compensate for potentially forced termination of the VIE contracts. Further, is this high-profile case perhaps the final proof needed of just how substantial the uncertainty of enforcing VIE contracts truly is?

Update: Good article which seems to confirm at least some of the guesses I made earlier

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