A common corporate structure that has allowed dozens of Chinese companies to get listed on U.S. exchanges is drawing increased scrutiny from American audit regulators.
Chinese Internet companies such as Sina Corp. and Baidu Inc. have used so-called variable interest entities, or VIEs, to work around Chinese restrictions and seek foreign investors since 2000. Now, the Securities and Exchange Commission is also asking questions about the structure, said Paul Boltz, a Hong Kong-based partner at Ropes & Gray LLP, who cited comment letters the agency sent to six companies since December. Judith Burns, an SEC spokeswoman, declined to comment.
The heightened attention may add to investors’ caution regarding Chinese stocks trading in North America. Sino-Forest Corp. (TRE) among other companies has been buffeted this year by allegations of accounting abuses and fraud, burning investors including John Paulson, the billionaire whose hedge fund said in June it lost $468 million on Sino-Forest. The company, which doesn’t use a VIE, has denied the allegations.
The VIE structure, which allows firms to set up contractual relationships that mimic equity ownership, may carry its own risks, according to Joseph St. Denis, director of research and analysis at the Public Company Accounting Oversight Board. The PCAOB, which oversees auditors of U.S. public companies, has begun to look at VIEs’ audit implications.
“China has blocked our inspections of firms in their region, but we think VIEs are a risk area,” St. Denis said. “We can’t know, without going to inspect, how much risk they represent.”
Yahoo! Inc. shareholders learned about some of the VIE- related risks this year. The Sunnyvale, California-based Internet media company, which owns more than 40 percent of Hong Kong-based Alibaba Group Holding Ltd., disclosed in May that the Chinese company had transferred its online payment business, Alipay, to a company controlled by Alibaba founder Jack Ma. Yahoo, which said in a news release that the move hadn’t been approved by Alibaba’s board, declined 15 percent in four days amid concern that its Alibaba stake would lose value.
Alibaba responded that the change was in the best interest of the company and its shareholders and said its directors were told about the change in July 2009. The companies settled their dispute in July.
Last month, the Chinese government signaled it may create new rules for VIEs, which have helped enable the boom in overseas listings of Chinese stocks.
PCAOB has begun to look at the audit implications of VIEs because of their common use in reverse mergers, sometimes called reverse takeovers or RTOs, according to St. Denis. More than 400 Chinese businesses have used the maneuver -- buying public shell companies to gain stock market listings in North America while avoiding the scrutiny of an initial public offering. The SEC in June cautioned investors about buying stakes in such companies, saying they may be prone to “fraud and other abuses.”
Under a VIE arrangement, a Chinese company that wants to sell shares in the U.S. usually sets up a holding company, often in the Cayman Islands, for that purpose. Then, through a wholly owned onshore firm in China, the new company creates contracts with a VIE owned by the founders or their designees.
While the holding company extracts profit from the VIE through agreements to provide services such as consulting and technical support, its U.S. shareholders don’t own any part of the VIE. The structure avoids Chinese restrictions on direct investment by foreigners in sectors including telecommunications, steelmaking, education and agriculture.
‘Variable Interest Entity’
The risk in the setup is twofold -- first, VIE structures have been tolerated, but never openly approved by Chinese authorities, said Paul Gillis, a visiting professor at the Guanghua School of Management at Peking University in Beijing. Second, a VIE’s ownership differs from the publicly listed holding company’s, he said. Most often, VIEs are owned by the founders of the Chinese company, and in other instances by family members or employees, he said.
“Will the regulators shut them down?” says Gillis. “Will shareholders steal them? We’ve seen cases of both.” He estimates that at least 42 percent of Chinese businesses listed on the New York Stock Exchange or Nasdaq as of 2009 used VIE arrangements. Gillis said he made a presentation on the subject to the PCAOB last month.
In many Internet businesses, the VIE holds operating licenses and other parts of the firm that cannot be foreign owned, Gillis said. Functions such as advertising, warehousing and fulfillment operations can be done by other units owned by the holding company. In other cases, the entire Chinese operating company is a VIE, he said.
“The less risky ones try to minimize what’s in the VIE, the riskiest ones put the entire business in the VIE,” Gillis said.
In comment letters since December, the SEC asked for more explanation of the VIE structures at Shanda Interactive Entertainment Ltd. (SNDA), a gaming company; Kongzhong Corp. (KONG), which provides games and content for wireless devices; Fushi Copperweld Inc. (FSIN), a wire maker; and Sino Assurance Inc. (SNAS), a seller of project guarantees. Boltz of Ropes & Gray said his firm is handling two more such requests to Chinese firms that have not yet been made public.
Taking More Time
Sino Assurance is not aware of any outstanding questions from the SEC regarding its VIE structure, attorney Gary Joiner of Frascona, Joiner, Goodman & Greenstein P.C. wrote in an e- mail. Lawyers listed as contacts on the SEC comment letters for Shanda and Fushi declined to comment. The lawyer listed for Kongzhong did not respond to an e-mail and a telephone message requesting comment.
SEC attention may increase the time it takes for companies to get U.S. listings, according to Rocky Lee, Hong Kong-based Asia managing partner for Cadwalader Wickersham & Taft LLP.
“The SEC is now more concerned about VIE structures and are asking more questions,” said Lee. “This can mean that the U.S. listing process will take more time, subject to more extensive review from the SEC. It’s plausible that existing listed VIE companies will be required to provide further disclosure.”
The dispute between Alibaba Group and Yahoo reflects some of the uncertainty surrounding VIEs. Ma, Alibaba’s founder, said the company had to restructure its Alipay unit to get a needed permit and Chinese regulators would not accept foreign ownership, according to an Aug. 10 memo published by Cadwalader.
Alibaba and Yahoo settled their differences in July, with an agreement giving Alibaba, and Yahoo through its stake, a share of Alipay revenue and as much as $6 billion if Alipay sells shares to the public.
As a result of the episode, “the validity of the use of the VIE structure in the online payment sector has been brought into question,” the memo said.
Financial software maker Longtop Financial Technologies Ltd., which disclosed that it may face SEC civil claims related to accounting abuses and whose U.S. shares have lost more than 99 percent of their value this year, used a VIE structure. The company is conducting an independent investigation into allegations made by its auditor, Deloitte Touche Tohmatsu CPA Ltd. The auditor resigned in May, saying Longtop’s chairman had admitted there was fake revenue and cash on the company’s books.
China MediaExpress Holdings Inc. (CCME), a provider of advertising on buses in China that is being sued for fraud by Starr International Co., used the structure as well. The company has denied allegations of fraud. The structure is also used by Rino International Corp., which makes pollution-control equipment and in November disclosed that some of its previous financial statements “should no longer be relied on.”
“U.S. markets were seen as the paradise for VIEs, that was the place to go because the U.S. regulators didn’t scrutinize the VIE too hard,” said Boltz. “The driver of the SEC’s interest is perhaps the meltdowns that have happened in some of these companies. It’s embarrassing for the SEC, so that makes them scan the horizon to look for where are the other sensitivities.”
In March, Buddha Steel Inc. (AGVO), a company incorporated in Delaware, withdrew a public offering registration after officials in Hebei province said its VIE structure conflicted with policies on foreign-invested enterprises.
Battling for Control
GigaMedia Ltd. (GIGM), which makes online gaming software, has battled for more than a year to regain control of a VIE. When GigaMedia tried to replace its China head last year, he refused to step down or turn over the VIE documents and assets necessary for GigaMedia to run its business in China, according to SEC filings. Parts of GigaMedia’s VIE agreements weren’t properly registered with the Chinese government, making it unlikely the company will be able to enforce them through a Chinese court, according to Cadwalader’s August memo.
The U.S. listing of Tudou Holdings Ltd., a Chinese online video company, was delayed by a dispute over the ownership of the VIE that accounts for almost all its revenue. The company filed a registration statement in November. In April, it disclosed a lawsuit in which the ex-wife of founder Gary Wei Wang claimed a share in 76 percent of the VIE’s equity.
In June, Tudou said the lawsuit had been settled. The prospectus for its August listing cautioned prospective buyers that “the shareholders of our VIEs may be involved in personal disputes with third parties that may have an adverse effect on their respective equity interests in the relevant VIE and the validity or enforceability of our contractual arrangements with the relevant VIE and its shareholders.”
While companies already disclose risks associated with VIEs in SEC filings, Boltz says the recent cases should make investors and lawyers write VIE contracts with more details to handle such things as family disputes.
“The VIE structure in fact depends on individuals, so real-life issues which happen every day -- like death, divorce, family disputes, can impact listed companies with large market caps,” he said. “It’s a reminder to think ahead when using VIEs.”
In a flawed VIE structure, the owners’ interests may not be aligned with the shareholders of the listed company, according to Lee. Low share valuations, which mean Chinese entrepreneurs aren’t getting much benefit from their U.S. listings, bring that difference to the fore.
‘Tempted to Walk’
“One concern some of the legal practitioners have is that with very low public company valuation, entrepreneurs might be tempted to walk away from the VIE structure,” Lee said.
China’s Ministry of Commerce, or Mofcom, is considering new rules for VIEs, spokesman Shen Danyang said last month.
“There are currently no laws or regulations to regulate VIE,” he said at a regular briefing in Beijing on Sept. 20. “Mofcom and other related government agencies are studying ways to regulate such investment.”
While Chinese regulators are unlikely to disrupt companies that have already made the jump to the U.S., the uncertainty affects the market, according to Lester Ross, a Beijing-based partner at Wilmer Cutler Pickering Hale & Dorr LLP.
“Unless the authorities take steps to disavow those who want to do away with it, skepticism in the market about VIE structures will increase,” said Ross. “In other words, the legal fragility of the structure risks hampering capital formation.”
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