Variable interest entities under the spotlight
By Ye Zhen |
August 1, 2012, Wednesday
|
Print Edition
Print Edition
NEW York-traded shares in New Oriental Education & Technology Group Inc, the largest provider of private education on the Chinese mainland, plunged 34 percent in mid-July after short seller Muddy Waters alleged dodgy bookkeeping and the US Securities and Exchange Commission said it would investigate the company's structure.
About US$2 billion, or half the market value of the Beijing-based company, was wiped off in just two days.
Muddy Waters, which has made a name for itself ferreting out alleged malpractices among US-listed Chinese companies, said New Oriental's corporate structure was "far more problematic than just a weak VIE."
That once again raised the specter of so-called "variable interest entities," commonly known as VIEs.
These are offshore holding corporate structures popular with Chinese companies listing overseas.
Setting aside their contractual labyrinth, these structures basically allow a listed company owned by foreign investors to control a China-based company and share in its profits without actual ownership.
The structures are a backdoor way of entering some Chinese sectors, such as the Internet, that don't allow foreign investment.
Fears of unraveling
Many Chinese stocks listed in the US have taken a recent beating amid fears that the VIE structure is about to start unraveling.
Sina, operator of the Weibo microblogging service, dropped 7.3 percent on July 17.
Baidu, China's biggest online search engine, fell 2.2 percent.
Video website operator Youku Inc slumped 11 percent.
Concerns about variable interest entities aren't new. The gray area was created when Chinese online giant Sina first used the structure to list in New York in 2000.
A number of high-profile Chinese firms, including Sohu and Baidu, have followed.
As of April 2011, 42 percent of Chinese companies listed in the US used the VIE structure, and thousands of unlisted companies continue to operate through the use of the structure, the law firm Cadwallader said in a note to clients, cited by the Financial Times.
From the perspective of Muddy Waters, the structure poses risks because foreign investors ultimately have no substantial control over the China-based business.
"The contract can be canceled at any time by the executives of the Chinese company, and they would be breaking no Chinese law in doing so," Dan David, vice president at investment fund GeoInvesting LLC, said in an interview with US financial magazine Barron's.
The 2011 dispute involving US Internet giant Yahoo, Japanese mobile carrier Softbank and China's Alibaba Group famously highlighted the problems.
Alibaba, the Chinese e-commerce giant, violated its agreements with Yahoo, which owned 43 percent of Alibaba through a VIE structure, and Softbank, which held 33 percent, by transferring its online payment business Alipay to a local company controlled by Alibaba's chairman, Jack Ma, without seeking approval from the partners.
Ma defended the action as necessary for Alipay to qualify for a government license as a third-party payment system, where foreign investment is expressly banned. Ma said the move didn't breach any laws or regulations.
Compensation agreement
As a result, Yahoo and Softbank lost control over Alipay without any legal recourse. Though the three parties eventually settled their dispute with a compensation agreement, the seeds of distrust were sown.
The last scare spooking the prices of US-listed Chinese companies is predicated on the consequences of the Alipay dispute, Analysys International analyst Huang Meng said earlier this month.
Louis Hsieh, New Oriental Education's president and chief financial officer, was quick to try to reassure investors that his company's plight "isn't another Jack Ma situation."
The elephant in the room where VIEs are concerned is the Chinese government.
The authorities have been vague to date on how they regard these backdoor listings. Some analysts say their patience with this market anomaly may be running thin.
"It would be a disaster if the government decides to clamp down on VIEs," said Li Ding, the chief financial officer of a Shenzhen-based dotcom company preparing to list on the Nasdaq.
"It's like a sword of Damocles hanging over the head, making firms like us very passive."
The lack of supervision over the VIE structure can lead to "accidents" among overseas listed Chinese stocks, Liu Jipeng, a professor at China University of Political Science and Law, told China Economic Times.
Liu said it would be difficult for regulators to intervene immediately, but in the long run, he said he sees a trend toward tighter regulation of the listing structure.
About US$2 billion, or half the market value of the Beijing-based company, was wiped off in just two days.
Muddy Waters, which has made a name for itself ferreting out alleged malpractices among US-listed Chinese companies, said New Oriental's corporate structure was "far more problematic than just a weak VIE."
That once again raised the specter of so-called "variable interest entities," commonly known as VIEs.
These are offshore holding corporate structures popular with Chinese companies listing overseas.
Setting aside their contractual labyrinth, these structures basically allow a listed company owned by foreign investors to control a China-based company and share in its profits without actual ownership.
The structures are a backdoor way of entering some Chinese sectors, such as the Internet, that don't allow foreign investment.
Fears of unraveling
Many Chinese stocks listed in the US have taken a recent beating amid fears that the VIE structure is about to start unraveling.
Sina, operator of the Weibo microblogging service, dropped 7.3 percent on July 17.
Baidu, China's biggest online search engine, fell 2.2 percent.
Video website operator Youku Inc slumped 11 percent.
Concerns about variable interest entities aren't new. The gray area was created when Chinese online giant Sina first used the structure to list in New York in 2000.
A number of high-profile Chinese firms, including Sohu and Baidu, have followed.
As of April 2011, 42 percent of Chinese companies listed in the US used the VIE structure, and thousands of unlisted companies continue to operate through the use of the structure, the law firm Cadwallader said in a note to clients, cited by the Financial Times.
From the perspective of Muddy Waters, the structure poses risks because foreign investors ultimately have no substantial control over the China-based business.
"The contract can be canceled at any time by the executives of the Chinese company, and they would be breaking no Chinese law in doing so," Dan David, vice president at investment fund GeoInvesting LLC, said in an interview with US financial magazine Barron's.
The 2011 dispute involving US Internet giant Yahoo, Japanese mobile carrier Softbank and China's Alibaba Group famously highlighted the problems.
Alibaba, the Chinese e-commerce giant, violated its agreements with Yahoo, which owned 43 percent of Alibaba through a VIE structure, and Softbank, which held 33 percent, by transferring its online payment business Alipay to a local company controlled by Alibaba's chairman, Jack Ma, without seeking approval from the partners.
Ma defended the action as necessary for Alipay to qualify for a government license as a third-party payment system, where foreign investment is expressly banned. Ma said the move didn't breach any laws or regulations.
Compensation agreement
As a result, Yahoo and Softbank lost control over Alipay without any legal recourse. Though the three parties eventually settled their dispute with a compensation agreement, the seeds of distrust were sown.
The last scare spooking the prices of US-listed Chinese companies is predicated on the consequences of the Alipay dispute, Analysys International analyst Huang Meng said earlier this month.
Louis Hsieh, New Oriental Education's president and chief financial officer, was quick to try to reassure investors that his company's plight "isn't another Jack Ma situation."
The elephant in the room where VIEs are concerned is the Chinese government.
The authorities have been vague to date on how they regard these backdoor listings. Some analysts say their patience with this market anomaly may be running thin.
"It would be a disaster if the government decides to clamp down on VIEs," said Li Ding, the chief financial officer of a Shenzhen-based dotcom company preparing to list on the Nasdaq.
"It's like a sword of Damocles hanging over the head, making firms like us very passive."
The lack of supervision over the VIE structure can lead to "accidents" among overseas listed Chinese stocks, Liu Jipeng, a professor at China University of Political Science and Law, told China Economic Times.
Liu said it would be difficult for regulators to intervene immediately, but in the long run, he said he sees a trend toward tighter regulation of the listing structure.
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