November 11, 2011 12:27 am
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There is rising concern that a complex corporate structure investors use to own Chinese companies listed overseas may contain more risk than previously thought, according to lawyers, analysts and scholars interviewed by dealReporter.
A Variable Interest Entity (VIE) structure has been used for years primarily to circumvent China’s rules that ban foreigners from investing in certain sectors such as internet and telecommunication. The structure is essentially a series of contract agreements that allow foreign investors control over companies operating in China that they do not actually own.
Most of China’s well established internet companies – Sina (NASDAQ: SINA), Baidu.com (NASDAQ: BIDU), Tudou (NASDAQ: TUDO), Sohu.com (NASDAQ: SOHU) among them – are listed in the US using this structure. Fredrik Öqvist, CEO of Chi-Eco Consulting, estimated that about half of the more than 200 Chinese companies listed in the US use VIE structures.
The structure came under intense scrutiny recently partly because a rather public spat earlier this year between Alibaba Group and Yahoo (NASDAQ: YHOO), which holds around 43% of the Chinese internet giant through a VIE arrangement. Alibaba transferred the online payment system Alipay to a Chinese domestic company held by Alibaba Chief Executive Jack Ma. Yahoo claimed it was blindsided by Ma’s move that came without Alibaba board’s approval, but Alibaba defended itself, saying Yahoo had known about the planned transfer for years.
The incidence spooked foreign investors because it set a high-profile example that a Chinese company can walk away from its VIE contract with foreign partners, analysts and attorneys said.
MOFCOM review power debate
More importantly, the Chinese government has signaled its intent to more closely regulate VIE, sparking fears that the structure could be outlawed. The Ministry of Commerce’s [MOFCOM] national security review process, notice no.53 unveiled on 26 August, stipulates that foreign investors are not allowed to evade a national security review in M&A through any means, including indirect ownership and “contractual controls” or offshore dealings.
Some lawyers interpret that to mean MOFCOM has the jurisdiction to regulate VIEs and the government may assert the right to instruct a Chinese entity that is indirectly held by foreign investors via a VIE to either terminate the control or risk having their operating license revoked.
Despite the rule and internal discussions among various governmental agencies including MOFCOM, the China Securities Regulatory Commission and the Ministry of Industry and Information Technology [MIIT] on the subject, Chinese regulators have not agreed as to how to regulate VIE, and some officials even credit the structure for fostering China’s internet boom.
“My point of view is that VIE is very good and without the VIE structure, China’s internet industry would not develop so fast,” said a MOFCOM source involved in the ministry’s internal VIE discussion. “There are no security concerns as these companies are all based in China.”
Another MOFCOM source said: “Currently MOFCOM still doesn’t require all the VIE companies to notify their ongoing M&A deals with MOFCOM under the foreign investment policy. But VIE companies should be aware that MOFCOM has the right to retrospectively (investigate) historical deals.”
A source involved in MIIT’s internal discussion over VIE told this news service that the regulator that grants license to internet companies in China is quite tolerant to companies with VIE structure.
Lawyers and scholars said it is unclear whether MOFCOM intends to look into a VIE only when it involves cross-border M&A when a national security review arises, or whether it will investigate the validity of all VIEs in general.
The lack of consensus on VIE partly reflects ongoing power struggles among various regulatory agencies, which all seek to expand regulatory authority, the first MOFCOM source said, adding there may also be difficulties in regulating VIE companies that are already in place.
Risks create trading discount
While the Chinese regulatory picture on this issue is still murky, foreign investors and their attorneys do not take the risks lightly. Foreign private-equity investors of Chinese internet start-ups, in particular, are “in a panic,” scrambling to find alternative exit strategies to an IPO in the US, a preferred strategy to pocket their investments in the past, analysts said.
Mayuresh Masurekar, an analyst at Collins Stewart, said institutional investors in the US have been avoiding or giving substantial discounts to China-concept stocks with a VIE structure to limit their risk exposure. For example, Chinese search engine Baidu has been given a 30%-35% discount to the fair value Masurekar assigns the company at USD 215, Masurekar said. Baidu was last traded at USD 142.43 Monday morning. The discount is partly attributable to investors’ concerns over the VIE structure and partly a potential slowdown of China’s economy, he said.
“There have been regulatory, or at least potential regulatory, uncertainties (in companies with a VIE structure) to a very large extent for a long time,” Öqvist said on a recent conference call. “At some point you have to ask at what point does this uncertainty become so large that you can’t say it’s controlled by listed companies any more? That depends on how much the company is in a VIE, something that’s currently not disclosed” in SEC statements of these companies.
Many analysts are quick to say investors’ fears for the risks of regulatory uncertainties over VIE and a potential breach of VIE contracts by a Chinese company are overblown.
“I think obviously this structure is less than ideal, because it weakens the internal control of the company ... but this is the prevailing model that has been working for the last 10 years. It’s in (China’s) best interest to maintain this model,” said Dan Su, an analyst at Morningstar.
VIEs rooted in Enron scandal
But Steve Dickinson, a partner at litigation firm Harris & Moure, said on the same conference call as Öqvist that potential risks in VIE structures are so substantial that he thinks “this is one of the greatest investment frauds ever perpetrated in the US market.”
The elaborate VIE arrangement was inspired by the so-called Enron Killer, a Financial Accounting Standards Board rule implemented following the implosion of Enron in 2001. FIN46 requires a reporting entity to consolidate balance sheets of companies that it does not own but does indeed control to close the loophole of escalating off-balance-sheet losses that can go undetected for a long time, such as in the case of Enron, experts said.
Lawyers said companies in VIE structure use the Enron Killer logic in reverse, where a Cayman Island-registered company would report consolidated financial statements to include assets of the companies in China they don’t own but merely control through a set of agreements.
“The only way that works is if you believe those contracts will be enforced by Chinese courts,” Dickinson said. But he said he doubts a Chinese court would take the side of foreign companies in a potential VIE contract dispute, because those contracts carry little legal weight, if any, in China.
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