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Posts Tagged ‘GigaMedia’

I’ve covered GigaMedia previously, pointing out, among other things, that the VIE structure seemed pretty safe as it wasn’t being contested in courts. Well that’s changed now, so a lot of people should start re-examining their risk exposure in this area.

But first, let’s get up to speed with the general progress of the overall situation.

The lawsuit has taken some very interesting turns lately and looks likely to get pretty nasty. Further, the fact that the lawsuits are currently being pursued not only in the PRC, but also in Singapore, Hong Kong, BVI, and California certainly doesn’t make this any easier to follow.

GigaMedia presents the situation in their latest 20-F, although they don’t add much new information, here’s the basics of the case developments in the PRC:

T2 Entertainment, as represented by the newly appointed legal representative Yan Guoming, filed lawsuit against Wang Ji and related persons in the courts of the PRC in August 2010, seeking to recover, among other things, the tangible property of T2 Entertainment, including the company seal, financial chops and business certificate. In August 2010, Wang Ji also filed two lawsuits against T2 Entertainment and Lu Ning, one of shareholders of T2 Entertainment, to invalidate two shareholder resolutions of T2 Entertainment: (i) the shareholders’ resolution dated in February 2010 approving a transfer of the shares of T2 Entertainment held by Wang Ji to a third party (“Wang Ji’s 1st Suit”); and (ii) the August 7 Resolution (“Wang Ji’s 2nd Suit”). Wang Ji’s 1st Suit is temporarily suspended due to the absence of the defendant Lu Ning in the first formal court hearing and pending the court’s decision as to T2 Entertainment’s standing, as represented by Yan Guoming, to join the suit. Wang Ji’s 2nd Suit was withdrawn by Wang Ji in April 2011.

They also give us some insight into how Wangji is proceeding:

Wang Ji (who owned 20 percent of the equity interests of T2 Entertainment) and Lu Ning (who owned 80 percent of the equity interests of T2 Entertainment) appointed their respective representatives to attend such shareholders’ meeting and the August 7 Resolution was duly passed in accordance with the articles of association of T2 Entertainment. In late March, 2011, we were informed by the court that Wang Ji had submitted supplementary documents to the court. The documents included a purported shareholders’ resolution of T2 Entertainment dated February 14, 2011 (“February 14 Resolution”) which stated that the August 7 Resolution was invalid, that Yan Guoming has no authority or right to represent T2 Entertainment, and that Wang Ji is the executive director, legal representative and manager of T2 Entertainment and his acts representing T2 Entertainment are valid. The February 14 Resolution claimed that Lu Ning and Wang Ji attended the shareholder’s meeting in person and passed the February 14 Resolution by mutual agreement.

However, if you’re looking to follow just one of these suits you should make it the california, it might not sound too exciting from what GigaMedia tell us:

On November 10, 2010, the Company filed a lawsuit in the United States District Court for the Central District of California (the “California Action”) asserting a number of claims against the other shareholder of T2 Entertainment and our former head of operations in the PRC, including, among others, tortious interference with contract, tortious interference with prospective economic advantage, fraud, aiding and abetting conversion and breach of oral contract. In these matters, the Company is seeking to recover, among other things, monetary damages. Subsequently, Wang Ji filed a motion to intervene in the California Action on April 26, 2011. The court set Wang Ji’s motion to intervene for hearing on August 22, 2011. On May 24, 2011, Wang Ji filed an ex parte application to shorten the time with respect to the August 22, 2011 hearing date for his motion to intervene. We opposed the ex parte application on May 26, 2011. On May 27, 2011, the court issued a ruling denying Wang Ji’s ex parte application to shorten time. Hearing on the intervenors’ motion will be held on August 22, 2011. On April 18, 2011, Wang Ji also filed a complaint against the Company and T2CN in the United States District Court for the Central District of California. Wang Ji’s complaint was subsequently stricken by the court for failure to follow court rules, though, according to court records, that complaint has now been properly refiled.

But according to Dacheng Law Offices they’ll be coming up against claims that their VIE structure breaks Chinese law, and further, that they knew that it was in violation of the law but presented it to their shareholders as something else.

The complaint seeks $40 million in damages and a court declaration affirming that Gigamedia’s business structure, operating in China as a Variable Interest Entity (VIE), and its attempted direct and indirect involvement in T2-E’s online game activities, is invalid and illegal under the laws of People’s Republic of China (PRC).

In this regard, the complaint also points out that, in its Annual Report to the SEC for the year ending Dec. 31, 2009, GigaMedia reported that the promulgation by Chinese government authorities of Notice 13 on Sept. 28, 2008, if enforced, would render ownership the [VIE] structure in the PRC invalid and illegal.

The complaint alleges the VIE structure was known to be unenforceable when GigaMedia made these representations and that they were misleading.

Just for reference the part where they admit that the structure is illegal is the following statement relating to GAPP:

On September 28, 2009, the PRC General Administration of Press and Publication (“GAPP”), National Copyright Administration, and National Office of Combating Pornography and Illegal Publications jointly published a notice, which, among others, (i) provides that GAPP is responsible for pre-examination and approval of Internet games as authorized by the central government and State Council, and that the provision of Internet games either online or on a downloaded basis constitutes Internet game publishing, which is subject to pre-examination and approval by GAPP; and (ii) prohibits foreign investors from participating in Internet game operating businesses via wholly owned, equity joint venture or cooperative joint venture investments in the PRC, and from controlling and participating in such businesses directly or indirectly through contractual or technical support arrangements. If applied literally and uniformly, such notice would render our ownership structure in the PRC invalid and illegal. To date, however, there are substantial uncertainties regarding the interpretation and application of such notice.

All in all this looks like THE case to follow if you’re working with VIEs in China, especially those affected by the GAPP guidelines. Presumably if this case determines that GigaMedia were misleading shareholders then so are all the other companies whose VIE structures fall under GAPP scrutiny.

Maybe GigaMedia should call some of the other Chinese game companies listed overseas to draft in some help, because I doubt many of them would like to see this one go the wrong way!

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The title of this post was taken from an article in the Economist, worth a look if for nothing else than its wonderful cartoon illustration. The title caught my attention because we have dealt a lot with VIE contracts and challenges to its structure, yet there continues to be a gaping hole in the discussion – specifically, around the ownership of a VIE.

Who owns what in a VIE structured company is critical as the incentives of the VIE owners can be completely misaligned from the interest of investors, as often indicated by companies in the risk sections of their annual filings. Yet for all the acknowledgement of risks, we seldom see companies taking actions to mitigate them.

Generally, VIEs fall into at least one of three different categories of ownership: CEO/Founder-owned, Family-owned, and Employee-owned.

CEO/Founder owned VIEs are common if for no other reason than for its relative simplicity.  The founders tend to be PRC nationals who have started a company and then set up a foreign SPV; they can then simply retain ownership of their original company in China and sign the normal VIE contracts with their SPV’s WFOE. This ownership structure is often perceived as the least risky for foreign investors, but certain situations have given foreign investors reason to reflect.

One such situation is exemplified by the divorce proceedings of Tudou’s CEO Gary Wang, where his wife settled to drop the claim of 76% of the equity interest in the company’s operating VIE for cash payments. This led to the now prevalent Tudou clause, which aims to remedy the situation; however, it will be interesting to see if companies that have already listed will also add this to their existing arsenal of VIE agreements.

Another interesting issue that surfaces is the increase of Chinese companies taking a collective beating on the foreign exchanges, causing a misalignment between the incentives for the owner of the VIE with those of shareholders in the public company, as the value of shares in the US is now sometimes even below reported cash balances. The rationale is that there is no reason a company should be listed in the US with a P/E of four, when it could just as easily trade in China at a P/E of 12.

There has been talk about the dangers and difficulties of PE firms delisting a company from a foreign exchange in order to take it public domestically in China instead, but simply cutting the VIE contracts before listing domestically simplifies this process significantly.

Family-owned VIEs work on another level than CEO-held VIEs; there is an overhanging monetary incentive for any member of the family to simply cut the contracts and walk away, as they normally don’t hold equity in the public company. We must then infer that the reason they do not jump ship is because of their bond to the relative who runs the company.

Some observers have pointed out that there are severe unreported risks in the potential deterioration of ties between the VIE owner and their relative within the listed company. For instance, the Tudou situation could have ended worse if the VIE was been owned by the CEO’s ex-wife.

Should family disputes and squabbles be reported in the 20-F annual reports?

It may sound ridiculous, but with some companies, there is the risk that a divorce or a falling out amongst kin could lose the company its entire China operation.

Employee-owned VIEs are another option, and perhaps most interestingly the only viable one for foreign players in the market. Many point to GigaMedia as a prime example of what could happen if there is a falling out between the VIE owner and the company.

The obvious drawback is the amount of power given to a single employee. The employee, as the GigaMedia case showed, becomes impossible to fire. In fact, the employee can hold the company hostage, with the implied threat that the company’s entire operations are under his/her control and could disappear at any point.

Additionally, I question the wisdom of this method of ownership due to historically high employee turnover rates in China.  What would happen if the employee joined a rival company? You could in effect “recruit” an entire business, or business segment, from your competitor.

Now, the above cases discuss the purer forms of VIE structures, as in ones where basically the entire company, or at least an independent part of a company, is in a VIE.

One way to minimise adverse incentives created by this form of ownership is to set up your organisation so that no VIE can operate as a separate entity.

The goal should be to hold as much of the business as possible in WFOEs, preferably limiting the VIE to holding nothing but the necessary licenses. This way, a VIE on its own has no real value; its only value is as part of the whole organisation, the listed company. Then, the value of the VIE bargaining chip is lessened substantially because no one stands to gain from picking the company apart.

We do see that companies set up this way better aligned between shareholders and the owners of the VIE; Baidu is one example of this.  Not all companies have taken these steps however, and in some cases, it’s difficult to tell to what extent these steps have been implemented at all.

The question of adverse incentives in VIE structures, and how to mitigate them by aligning the interests of investors and VIE owners, deserves attention. PE and VC firms that come into these companies likely have a better chance at instigating real change than shareholders of publicly traded companies, but the issue is a pressing one for any investor who is not the owner of the VIE.

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With the current interest shown in the GigaMedia case it seems prudent to offer some sobering reminder of how, at times, big events can change so little.

First a very quick look at what has happened so far according to the company filings. For a more elaborate description please look here.

After Mr. Wang usurped the company’s China operations, by holding onto the official chops and other documents, the company proceeded to file suits in various courts with a number of claims against the former head of China operations.

After initially forecasting quick resolution, litigation seemed to have hit on problems and the references became increasingly bleak in their outlook, referring in part to the complexity of the procedure. This culminated in the company basically admitting defeat on the issue by setting up a new China organisation from scratch.

From what we know of the process, however, it appears that the question of the VIE contracts were not tried at any stage. In fact the only real mention of them is to conclude that the equity pledges are unenforceable due to not being registered.

Although we may speculate that the reason for GigaMedia to suddenly give up its attempt to enforce control over the WFOE and the VIEs was that the contracts would not have been enforceable. There is actually no legal judgement to say that it is so, and therefore nothing has actually changed when it comes to clarifying the gray area in which VIEs operate.

As this is the case, the fact that GigaMedia has just lost their entire China operations will not result in any change to the current risk disclosures associated with SEC filings for VIEs. There are still substantial uncertainties as to the enforceability of the contracts, and so far there’s still only the possibility that courts will find them unenforceable.

The lasting effects of the case will more likely be in how investors read the statements, rather than the statements themselves. Rather than just being empty words, the “substantial uncertainty” can now be said to be so great that a company gave up trying to regain control over its operations. Further, the statement that contracts “may not be as effective as equity ownership” might well do with being read as “will not be as effective as equity ownership”.

More than anything this case shows us what can happen when disputes arise within companies with VIE structures. They may be solid as long as no one within the organisation rocks the boat, but the question of who exactly owns the VIEs is now clearly more pressing than before. Yet here, again, we might in fact not see any change in the corporate filings presented.

As there is no change in disclosures to guide the reader as to how the VIE situation is progressing, more and more pressure is being put on investors to stay a jour with developments to be able to adjust their risk evaluations.

Fredrik Öqvist

Shoushuang Li

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In today’s post I’d like to have a quick look at GigaMedia, which is having some issues in China which on the face of it appear to be VIE related. The head of their Chinese operations has run off with the Chinese company, supposedly because he’s not a shareholder in the parent company and they wished to replace him. But let’s have a look at the situation as presented by the company’s SEC filings.

GigaMedia is a company registered in Singapore involved in online gaming and gambling, their main business areas seem to be SE Asia and China, with a JV in Europe focusing mainly on gambling.

In China the company conducts its business in the normal manner with a WFOE (T2CN Information Technology (Shanghai) Co., Ltd. (T2 Technology)) and three VIEs (Shanghai T2 Entertainment Co., Ltd. (T2 Entertainment), Shanghai T2 Advertisement Co., Ltd. (T2 Advertisement), Shanghai Jinyou Network & Technology Co., Ltd. (Jinyou)) holding the permits. All of these companies are managed through a BVI holding company (T2CN Holding Limited (T2CN)which the company owns about 67% of).

The precise ownership of the VIEs remains unclear as the company does not disclose this information. However, all the normal contracts appear to be in place according to the latest 20-F form: Shareholder Voting Rights Proxy Agreements, Exclusive Equity Transfer Call Agreements, Exclusive Technical Service and Consultancy Agreement, and Equity Pledge Agreements.

The filing also includes the normal reservations about the effectiveness of contractual control and the legal uncertainties surrounding VIEs, mentioning both MIIT and GAPP rules.

The first mentions of any issues surrounding the structure came in the company’s 2Q 2010 (6-K 2010-08-30), where it is mentioned briefly as:

“GigaMedia is now in a dispute with its former China head over his ongoing attempts to usurp company assets in China, including local company bank accounts and company operations. GigaMedia has filed legal action and is working aggressively with local police, courts and government officials to bring about a rapid resolution. GigaMedia’s China operations may be adversely affected by these illegal actions.”

This was followed by a more in-depth discussion about the issues in two separate 6-K filings (filed 2010-11-15, and 2010-11-26).

Gigamedia had felt the need to change leadership in China, there’s no mention of why they felt this need, but their former China head, Wang Ji, would be offered a senior consulting role or possibly be chairman of the board for the Chinese company. While he at first went along with the plans he suddenly changed his mind and starting from July 2010 he categorically refused to step down from any of his current posts.

The specifics of the situation were described as follow:

“GigaMedia believes that Wang Ji currently has in his possession, among other things, the company seals, financial chops and business registration certificates of T2 Technology and GigaMedia’s VIEs.  Wang Ji also has in his possession all documents, records and data and tangible property, including license agreements, trademark and domain name documentation, held in the offices of T2CN’s wholly-owned subsidiary, T2 Technology.  The company seals, financial chops and business registration certificates of T2 Technology and GigaMedia’s VIEs are necessary for the respective entities to declare dividends and approve service fee payments to GigaMedia, among other things. These documents are necessary for GigaMedia to run its online games business in the PRC.  Under PRC law, the company seals, financial chops and business registration certificates are essential for entering into contracts, conducting banking business, or taking official corporate action of any sort.  Consequently, GigaMedia has not been able to register the resolutions removing Wang Ji from his position as a director of T2 Technology and as the legal representative, executive director and manager of T2 Entertainment.  In short, Wang Ji has effectively usurped control over T2 Technology and T2 Entertainment’s operations and accounts.”

The company further stated that any adverse resolution in this case would likely have “a serious material adverse effect” on the company. Hence they had proceeded to file lawsuits against Mr. Wang in the PRC, Hong Kong, Singapore and the British Virgin Islands.

The filing finished off by stating that the company had not registered its equity pledge, and as such felt that they were highly unlikely to be able to get these contracts enforced in court.

The second statement further clarified the importance of the situation by stating that:

  • GigaMedia’s revenues attributable to its online games business in the PRC totaled approximately US$10 million, which represented approximately 20% of GigaMedia’s total consolidated revenues for the six months ended June 30, 2010.
  • GigaMedia’s proportionate share of the total assets of the entities held by T2CN was approximately US$32 million, which represented approximately 11% of GigaMedia’s total consolidated assets as of June 30, 2010.
  • GigaMedia’s equity in the income from continuing operations before income taxes of the entities held by T2CN (exclusive of amounts attributable to the non-controlling interest) was approximately US$0.6 million, which represented approximately 1% of GigaMedia’s total income from continuing operations before income taxes for the six months ended June 30, 2010.

The company also disclosed that they were considering writing off the entire investment in the entities held by T2CN since they had lost control of the company and were unable to gain access to any financial information regarding the entities.

When the 4Q 2010 results were filed (6-K 2011-05-06), the company had deconsolidated T2CN and completely written off the entire investment. Where they had previously seemed confident of a reasonably swift conclusion to the dispute, they now admitted to a bleaker outlook:

“While management continues to believe that its general legal position is sound, as a result of recent setbacks that have delayed the progress of the litigation against Wang Ji and the increasing complexity of the ongoing litigation, it is now impractical for the company to estimate with any degree of certainty the timeline for the eventual resolution of the dispute or the likelihood of a successful outcome.”

The latest mention of the dispute is in the 1Q 2011 report (6-K 2011-05-26), where new developments are briefly referred to:

“Investments ongoing in new China platform while continuing to pursue all means to resolve the dispute in connection with the China-based business T2CN.”

Well to be honest I’m a bit shocked, I was expecting to find a case revolving around the legality of a VIE structure, albeit one without properly registered documents and such. But what’s interesting to note here is that the conflict really seems to be one step higher than should be possible. The VIE contracts aren’t actually coming into it because somehow the former China head has managed to gain control of the WFOE, which is the entity to which all the VIE’s are supposedly contractually tied to.

This matter should be quite easy to deal with through normal procedures, as there should be no question who has authority over the WFOE, thus GigaMedia should be able to at least regain control over this entity. I’m not quite certain how the company has gone about things but it seems oddly suspicious that they’re unable to regain control over a WFOE.

I’m not quite sure what to make of a company that’s apparently unable to regain access even to its WFOE after many months and quite a lot of money spent on lawyers. I get the feeling there might be more to this story than the SEC filings suggest.

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