Today we have another guest post from Shoushuang Li and Fredrik Öqvist. This post will discuss some of the legal uncertainties with respect to the capitalization of VIEs in China.
Capitalizing the VIE. A VIE needs to be sufficiently capitalized in order to operate. While some VIEs that function primarily as license holding companies may need little capital, others require substantial funding. Because the public company does not have a direct ownership interest in the VIE, but rather controls it through contracts, it needs to find a way to get cash into the VIEs.
In the archetypal VIE form, the public company, or its wholly foreign owned enterprise (WFOE) subsidiary, loans the necessary capital to the individual shareholders of the VIE. The individual shareholders then contribute these funds to the VIE. The loan agreement between the public company or WFOE and the individual VIE owner is secured by an equity pledge in the shares of the VIE, and provides most of the control mechanisms that allow the VIE to be consolidated.
On May 23, 2011 Longtop Financial Technologies (NYSE:LFT) announced that Deloitte Touche Tohmatsu (DTT) had resigned in a letter dated on Sunday, May 22, 2011. LFT’s CFO had resigned the previous Friday. The company has been under attack by shortsellers and the stock has been suspended from trading for the past week. The company also announced that the SEC has begun an investigation. In its letter of resignation, DTT said it resigned as a result of, including other things (1) the recently identified falsity of the Company's financial records in relation to cash at bank and loan balances (and possibly in sales revenue); (2) the deliberate interference by certain members of LFT management in DTT's audit process; and (3) the unlawful detention of DTT's audit files. DTT further stated that DTT was no longer able to rely on management's representations in relation to prior period financial reports, that continued reliance should no longer be placed on DTT's audit reports on the previous financial statements, and DTT declined to be associated with any of the Company's financial communications in 2010 and 2011. It does not get much uglier than that. It is amazing that we have yet another company with huge cash balances apparently falsifying bank confirmations.
This is another guest post, this time from Fredrik Öqvist and Shoushuang Li. Mr. Li is a senior partner with Dacheng, one of China's largest law firms.
This post is a very basic outline of the legal challenges currently faced by VIE structures in China. This is not a complete list, and to make this post readable, we will stick to discussing the challenges to the practice of VIE’s as a whole. Legal issues relating to parts of the practise will be discussed in a later post.
Although it is often said that Chinese law is one based on written statutes, this is not really the whole truth; it is also based on regulations from law enforcing agencies. These regulations can be statements on how laws may be interpreted, which are important when there are no previous rulings to indicate how those laws are meant to be interpreted.
In order to illustrate the legal issues involved with the VIE phenomenon, we should therefore discuss both written statutes and edicts from agencies to get a more complete picture.
I am pleased to announce that the China Accounting Blog is now available in Chinese. I have received a number of requests to provide this. Several of the most popular posts have been translated and more will come.
The Chinese site will be edited by Liu Bing (Will). Will is finishing his first year in the International MBA Program at Peking University. He will be heading to the University of Texas at Austin for his second year. He is enrolled in a great program where he will get an MBA from both the Guanghua School of Management at Peking University as well as the McCombs School of Business at the University of Texas. Two MBA degrees from two great schools. Will was formerly an auditor at KMPG in Beijing.
There is a link (like this 中文) to the Chinese site on the left.
Alibaba Group Ltd (Alibaba) and its shareholder Yahoo are in a very public spat over Alibaba’s alleged transfer of Alipay to a company controlled by Jack Ma and Xie Shihuang, the founders of Alibaba. It is alleged that Alibaba transferred 70% of the online payment service in June, 2009 for $22.4 million to Zhejiang Alibaba E-commerce Company (Zhejiang Alibaba) which is owned by Ma and Xie. The remaining 30% was transferred in August 2010 for RMB 164.9 million. Yahoo claims it did not learn about the transaction until March 31, 2011, despite having board representation.
Alibaba is a private company (not to be confused with Alibaba.com, the Hong Kong traded B2B company it also controls), so financial statements are not available. I have attempted to piece together the structure and the issues presented from press reports and from public filings of Alibaba.com. There is no assurance I have figured out the structure correctly.
It appears Alipay was operated through Zhejiang Alipay Network Technology Co. Ltd and Alipay Software (Shanghai) Co. Ltd., both second or third tier wholly owned subsidiaries of Alibaba, and wholly foreign owned enterprises (WFOE) in China.
These are sure exciting times to be an auditor in China. While the signing of a clean audit opinion is always an important milestone in a company’s annual reporting cycle, I have never seen it take on the importance that it has in China. Lately, the life or death of many U.S. listed Chinese companies has come down to whether the auditors are going to sign off, and that decision is often resting on whether they can confirm the bank balances to their satisfaction. If the auditors sign off, the price should increase significantly, but if they don’t, the stock is likely to be delisted before it trades again. We seem to have a new type of investment strategy - the cash confirmation play, where you wager whether the auditors successfully confirm cash.
China Media Express Holdings (NASDAQ: CCME) lost its auditor and its NASDAQ listing when the auditors were unable to confirm cash to their satisfaction. In their most recent financial statements, CCME reported cash of $170 million, or 76% of its total assets. That amounted to $4.82 of cash per share, and the company last traded at $11.88 before it was delisted upon the resignation of its auditor, Deloitte. As I discussed in an earlier post, there were several other similar situations as the U.S. listed Chinese companies with calendar year ends prepared to file their annual report on Form 10K in March.
There has been considerable noise coming from the SEC recently about China. Emily Chasan has an excellent article over at the China Realtime Report summarizing what has been going on. The article states that since March 2011 24 U.S. listed Chinese companies have reported accounting problems, resignation of their auditors, or both. Particularly amusing is how the SEC is confronting companies about whether they are really ready for a U.S. listing and apparently talking some out of it. SEC Chief Accountant Wayne Carnell said "As a result of these questions, we have seen some registrants elect to deregister, to go home, and basically delist from the U.S."
Representative Patrick McHenry of the House Subcommittee on TARP, Financial Services and Bailouts. The letter outlines the steps the SEC is taking to protect investors in U.S. listed Chinese companies. It is worth a read if you follow this space.
Renren had a very successful IPO this week. I had previously written that Renren would be a key test of whether Chinese regulators were serious about cracking down on VIEs after Buddha Steel. Certainly there is no more sensitive an industry than social networking, and the fact that Chinese regulators let this one go indicates to me that Buddha Steel was likely a victim of a crackdown on reverse mergers. Renren did have extensive discussions of VIE risk in the financial statements – the most extensive I have seen and I commend them for that.
Renren also disclosed a material weakness in its internal controls; a disclosure that is becoming commonplace with U.S. listed Chinese companies. In Renren’s case the material weakness identified related to insufficient accounting personnel with appropriate U.S. GAAP knowledge. That is no surprise; there are simply not enough people in China with U.S. GAAP knowledge to go around.
Last Friday, the SEC asked for comments on a proposal from NASDAQ to change the rules for listing reverse mergers. Under the proposed rules, a reverse merger could apply for a NASDAQ listing if it meets two conditions:
1) Traded for at least six months (OTC or another U.S. or foreign exchange) following the filing of audited financial statements for the combined entity.
2) Maintain a bid price of at least $4 per share for 30 of the 60 preceding days.
NASDAQ calls these “seasoning” requirements. NASDAQ indicates that the requirements should discourage inappropriate behavior on the part of companies, promoters, and others. The six-month delay after the audit is done makes certain that at least one report following the annual report is filed prior to listing, giving the auditors two bites at the apple. If a company does a traditional IPO, however, the rules do not apply. Traditional IPOs are audited before they are listed and receive considerable SEC scrutiny. Reverse mergers exist to avoid that scrutiny.