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Posts Tagged ‘VIE risk’

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 Wang Ji’s 2nd Suit was withdrawn by Wang Ji in April 2011.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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As we have seen in articles and blog posts all over the Internet, the VIE structure comes with very real risks. As such, investors should take care, and when possible apply pressure, for how and when these structures are used to make sure they are not subject to unnecessary risks.

The VIE structure is sometimes seen as a temporary solution while waiting for the Chinese government to further liberalize the market. Once it is possible to legally own the business through a WFOE, the VIEs should be abandoned for its securer counterpart.  Unfortunately, there are still cases in which VIEs are used when there are no legal necessities to do so.

One example of this is Cogo Group [COGO], a reverse listed Chinese company in the Diversified Electronics Industry. The company uses a VIE structure for two of their subsidiaries, Shenzhen Comtech and Shanghai E&T, both are in commodities trading where there is no legal necessity for a VIE structure.

Here’s how the situation was presented in the company’s latest 10-K:

At the time of its incorporation, foreign shareholding in a trading business such as Shenzhen Comtech could not exceed 65%. With subsequent PRC deregulation, foreign ownership of such a trading business can now reach 100%, and approval of foreign ownership of companies in the PRC engaged in commodity trading businesses—which includes agency trade, wholesale, retail and franchise operations – is now delegated to local government agencies of the PRC Ministry of Commerce. In order to exercise control over Shenzhen Comtech (a PRC operating company legally permitted to engage in a commodity trading business), without direct shareholding by us (a U.S.-listed company and therefore a foreign-invested entity), Honghui Li, our vice president, and Huimo Chen, the mother of our principal shareholder and chief executive officer, Jeffrey Kang, hold 99% and 1%, respectively, of the equity interests of Shenzhen Comtech, and through contractual agreements with us hold such equity interests exclusively for the benefit of our 100% directly owned subsidiary, Comtech China.

As you can see from this excerpt, the reasoning for the VIE structure does not hold up. Moreover, they could have held up to 65% of the operations even with the tougher legislation at the time of incorporation, but chose not to do so.

The reason the VIE was not converted into a WFOE seems to be because it requires approval from MOFCOM, as indicated in an earlier 10-K:

However, foreign ownership of companies in the PRC engaged in commodity trading businesses—which includes agency trade, wholesale, retail and franchise operations—is subject to restrictions under PRC laws and regulations, and requires special approval from the PRC Ministry of Commerce, which is time consuming to obtain.

There is no indication, however, that the company has even tried to change its current makeup in this direction, and the question needs to be asked whether something being “time consuming to obtain” is a valid reason for keeping a VIE structure.

The description of the ownership of Shanghai E&T is a rather complicated affair in itself. As far as we know, there is no reason why the company cannot simply own this subsidiary outright: yet not only is the majority ownership held by Shenzhen Comtech, but the same company also holds 35% more equity “through trust agreements” for the benefit of Comtech China (the WFOE).

Shenzhen Comtech, in turn owns a 60% equity interest in another of our PRC operating companies, Shanghai E&T, with the other 40% being held by Comtech China through trust agreements. Under the trust agreements, Shenzhen Comtech owns a 35% equity interest in Shanghai E&T for the benefit of Comtech China and Honghui Li owns a 5% equity interest in Shanghai E&T for the benefit of Comtech China.

This trust agreement arrangement was accomplished by the company’s WFOE paying 16 million RMB for the 40% minority stake. To then give this stake away under a trust agreement, for which there appears to be no good justification, seems a strange move.

There is no further information available about the nature of the VIE contracts.

These issues might not seem very important at first glance, but recent events have taught us just what the risks in a VIE structure are, and as such this is something that warrants investors concerns.

There seems to be no legal for why these entities cannot be converted to WFOEs, other than potential issues with MOFCOM approval. It appears that no effort has been made to gain such approval, and it seems as if the company simply wants to keep its business in a VIE structure.

Investors need to assert pressure on companies to move away from VIEs and towards securer forms of ownership, where possible. While it may not be of much difference for the founder of the company, it is of the utmost importance for foreign investors to make sure that their money is as safe as possible.

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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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Recently trading stopped on shares of Jiangbo Pharma, because the SEC wants some more information from the company. I have yet to see a good report on exactly what information has been requested, however.

This in itself is no great surprise, the company is reverse listed and used to be audited by the shorters favourite Frazer Frost, which is by now almost synonymous with fraud allegations and delistings.

What is more interesting is that on the face of it, the investment in the company still doesn’t seem so bad, as the market cap of the company was around 42 million while it held cash of 146 million (assuming we can trust the books on this). Thisseems like an odd thing to have happen until you look through their corporate structure and find that basically all of the company’s assets is sitting in the VIE for no apparent reason.

I doubt that this is what the market has been pricing the company for, however, it seems more likely that the market assumed fraudulent books and overstated profits/cash positions. But nevertheless investors could quickly learn just how much 146 million in a VIE could be worth if the owner decides to pack it up.

JGBO’s structure is a very simple VIE arrangement with the entire operating part of the company in the VIE. It should be noted that there is no legal reason for the entire company to be run as a VIE, some areas are restricted but much of it could reasonably be run through a WFOE.

Even though all of the normal contracts are in place the company appears unwilling to transfer any of their assets out of the VIE, even to the extent that they failed to make their interest payments/penalties on convertible notes in the US due to an inability to transfer money out of the VIE.

If the contracts that they claim to have are in place the money should, at the very least, be able to travel to the WFOE without much hassle or expense. Even if transferring it out of China does require SAFE approval, SAFE approval is not a valid excuse for holding all of the company’s assets in a legally questionable VIE arrangement without any security for the investors.

The company seems to be making up excuses for why the money should stay in the VIE, where the investors have questionable control over it. If this turns into a legal case involving fraud my guess is that investors will come to the stark realisation that 146 million in cash stashed in a VIE might well be worth nothing at all.

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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 Zhejiang 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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