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Posts Tagged ‘SEC’

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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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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Deloitte’s China woes have gone from bad to worse.

Latest Muddy Waters target Focus Media (FMCN) is yet another company with serious fraud allegations leveled against them which was audited by Deloitte. Something that has led to serious suspicions against the auditors themselves.

The company was already in trouble with American authorities following the Longtop scandal and its aftermath, where they were unable to help in the on-going investigations against the fraudulent company. Should these latest fraud allegations be proven correct, and yet another client of the company found guilty of fraudulent activities, American authorities and investors will not stay silent.

Being audited by Deloitte is becoming a burden for Chinese companies, as the markets have lost so much confidence in the auditor that all of Deloitte’s clients are suspects by association. Deloitte-audited Chinese companies are traded at a discount by some investors, government authorities are increasing their scrutiny of them, and short sellers are looking at them specifically for potential short cases.

Trying to pitch clients on the idea of trading at a discount and facing extra scrutiny from authorities and shorts will make it exceedingly hard for Deloitte to maintain its current market position. This will be especially true for the IPO market where Chinese companies are already facing increased scrutiny from the SEC, which means companies are unlikely to want to add even more potential issues to their offering.

Deloitte needs to move fast to regain the confidence of the market if they want to stay competitive in China, but this will likely be neither easy nor cheap to accomplish.

In fact, the situation has deteriorated to a point where there might have to be a token leadership change at the top, followed by a purge of the company’s entire China operations to indicate that the company is serious about getting to grips with the situation.

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A lot of people in China are looking to the Lashou IPO for a gauge on the temperature for China IPOs in the US. People were looking forward to seeing an increased US appetite for China concept stocks.

But as the IPO looks evermore likely to fall through, some will be inclined to conclude that interest in new Chinese IPOs is low. I’m not entirely certain we can go that far, but I do think we’ve learned some important lessons from the Lashou IPO process.

Firstly, there seems to be an increase in the amount of information that the SEC requires about VIE structures.

Previous disclosures have varied a lot in detail, and lacked some fundamental information that investors need to make informed decisions about the risks involved in the investment. Something that has arguably led to a mispricing of companies using VIE structures.

It now looks like the SEC wants to clean this up and give investors the information they need to properly judge the internal risks in the VIE structures.

I think this reform is much overdue and hope we will soon see an overhaul of the disclosures on the IFRS dictated exchanges with regards to VIEs as well (Predominantly Hong Kong and Singapore).

Secondly, there has been a very strong reaction to allegations of potential accounting issues at the company. This is hardly surprising when you consider the sheer amount of accounting frauds that have been uncovered in Chinese companies the last year.

We’ll have to see what comes of these allegations but investors have had their fingers burnt before so they will approach any company with rumoured accounting issue carefully.

In short, any Chinese company looking to IPO in the future had better get their act together on these two fronts before they file, as they are likely to face more scrutiny than before.

However, I think the real reason for the IPO issues might be found in the prospectus itself, rather than in the overall sentiment of the investors.

For instance, the company is operating in an industry where it has literally thousands of competitors, and this has forced the company’s margins down to a fraction of what we see in Groupon, for instance. So the financials themselves probably didn’t excite investors too much to begin with.

More alarmingly, the company’s biggest competitive edge over its competitors, its strong brand name, is in question, as the company does not own the trademark rights associated with it.

This could cause the company to loose the rights to its’ brand name as well as the rights to the website lashou.com, which would likely force the company to rebrand and start over from the beginning.

However, as Jiayuan managed an IPO not long ago under similar circumstances (they didn’t own the trademark rights to their brand either), we must conclude that something has changed.

I would argue, however, that what we’re seeing here isn’t a cooling off in the general interest in China concept stocks. Instead, we’re seeing investors becoming significantly less forgiving when it comes to discrepancies and issues in Chinese companies, but this should not be mistaken for a cooling interest in China as a whole.

We’ll have to wait until we see the prospectus for the rumoured Vancl IPO, and how well it is received by investors before we draw any definitive conclusions. But companies seem likely to face unabated, if more demanding, investor interest.

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So the much talked about CSRC paper is finally available for public viewing, albeit through a leak.

Had a quick glance at it and it seems to be pretty much what was reported on. iChinastock has a good run-down of the basics of it, I’ll just be adding some quick comments afterwards:

The report describes Variable Interest Entities (VIEs) as a major threat to China’s national security, but does not suggest that China’s top leaders ban the structure.

iChinaStock has translated four key reforms proposed in CSRC’s report:

1) Chinese companies under the VIE structure must receive approval from by both the Ministry of Commerce (MOC) and CSRC to list overseas.
2) Old rules for old companies (those already listed overseas) and new rules for new companies (those not yet listed overseas). In other words, firms that are already listed overseas would be exempt.
3) Encourage Chinese Internet companies to list on the domestic market.
4) A few companies that have reasons and desires to list overseas, such as the internet companies that are temporarily unable to list domestically, should be able to list directly in foreign markets. Note: the meaning of this “direct listing” is still unclear.

One aspect not mentioned here is that the report also presents foreign ownership as bad for the industry, due to the potential of equity draining from China. The flip side of this is of course that it was foreign investors that helped the companies and the sector grow when it needed capital. One of the biggest issues that still plagues this sector in China is a lack of good financing options available, especially if the VIE window is closed.

Second, you will find an interesting proposal to collaborate with the SEC, and other foreign equivalents, regarding the enforcement of these issues. The basics would likely be that the SEC should check any VIEs being reported on their end with Chinese authorities, this would enable both sides to keep the situation under control.

Apart from these two points the iChinastock article seems pretty bang on to me. So let’s move on to some comments.

There are a couple of things I find rather interesting about this proposal, for instance if we assume that the internet companies allowed to list on foreign markets is likely to be quite few, otherwise why not just declare it an unprotected sector, then there will need to be plenty of action domestically to provide new financing options. If this doesn’t happen the companies which are already listed overseas will have a huge advantage in their access to capital, which would solidify them as the big players for the foreseeable future.

Another interesting thing to consider is what isn’t dealt with in this paper. It doesn’t touch on the current MIIT and GAPP issues, nor does it spell out what should happen regarding the enforceability of the contracts. It seems we could be heading for a rather strange situation where the government will “give the VIEs its blessing”, but still leave the issue of enforceability of the relevant contracts up in the air.

Above all else, the big question seems to be what is meant by allowing some companies to list directly. Allowing some of these companies to list with direct equity ownership would require changing a multitude of laws and edicts, so if this is the plan it’ll certainly be hard to implement.

Let’s not get too carried away here however. We are talking about a leaked research report from the CSRC, not only is it not, as far as we know, officially endorsed by the CSRC, the CSRC is far from the only ministry that would have to sign off on something like this.

It also bears mentioning that even with the government promising to stay out of the listed VIEs, they still aren’t as safe as equity ownership. GigaMedia didn’t need any government intervention to loose its’ China operations.

Other posts on this subject can be found at the China Accounting Blog and China Hearsay.

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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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This post will be a quick comment on some new developments in China, an analysis will follow later in the week.

The CSRC has come up with some basic rules for RTOs in China, and reverse listings. The rules are still out for comment by industry professionals and we’re likely to see some minor changes in them still, but the overall road they wish to take is clear: RTOs and reverse listings will be subject to a similar legal framework as regular listings. This means demands on profitability and stable balance sheets.

What this will mean in reality is that listing overseas will become even more attractive to Chinese companies. Although it also provides an opportunity for the SEC to have a long talk with the CSRC about regulations on reverse listings in the US.

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