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Regulatory capture in Hong Kong

Again in 2013, Hong Kong placed first in the Heritage Foundation’s Index of Economic Freedom, which measures its view of the economic freeness of various countries. The index focuses on the presence of the rule of law and the absence of government regulation. On the latter point Hong Kong does particularly well, scoring 98.9 in Business Freedom compared to 90.5 for the United States and 48.0 for China. 

Of course, business rarely wants no regulation – after all that might lead to excessive competition. The professions have long sought closure – blocking outsiders from the work of the profession in exchange for regulatory oversight. Milton Friedman in Capitalism and Freedom observed this behavior: “the pressure on the legislature to license an occupation rarely comes from the members of the public . . . On the contrary, the pressure invariably comes from the occupation itself.” 

The accounting profession secured a particularly sweet deal in Hong Kong. They blocked access to their lucrative market to accounting firms from outside Hong Kong while convincing regulators to allow them to regulate themselves through the Hong Kong Institute of CPAs (HKICPAs).  

Favorable regulatory winds

There are signs that there may soon be a regulatory breakthrough on overseas IPOs of Chinese companies.  

The Singapore Exchange (SGX) and the China Securities Regulatory Commission (CSRC) reached a deal to allow Chinese companies to list directly in Singapore, that is, without using an offshore holding company. While there are hundreds of Chinese companies that have listed overseas, only large SOEs tended to get the necessary permission to list directly. The rest used offshore structures, typically with a Cayman Island holding company, to get around Chinese regulations. The offshore structures contributed to the regulatory mess that ensued, where Chinese regulators did not regulate the companies because they were not Chinese, and foreign regulators could not regulate them because China would not let them have access to the people and records in China. 

Now Chinese companies can directly list in Singapore after their applications are approved by both CSRC and SGX. The agreement, however, does not deal with the troublesome variable interest entity (VIE) structure that is used to circumvent Chinese rules restricting foreign investment in certain sectors. 

Deferred taxes and VIEs

Autohome (NYSE:ATHM) had a successful debut on Wednesday with the shares popping 80% above the offering price. That is the seventh IPO in the U.S. this year, ending a drought.  Investors seem less spooked by the VIE structure and risk of regulatory problems with the SEC and PCAOB. None of those issues have been fixed, but investors seem convinced that they will not escalate. Despite recent short seller attacks at Fab Universal (successful) and NQ Mobile (largely unsuccessful) investors seem comfortable that they will not be victims of yet another Chinese accounting fraud. 

Unless sentiment changes, I am thinking that 2014 could be like 2007 with perhaps as many as 30 U.S. IPOs. That will hardly make a dent in the backlog of private equity money waiting for an exit, but it will be a good start. 

Autohome’s filings present a fascinating new issue. Autohome has accrued a deferred tax liability of $75 million for “outside basis difference”. While this issue has been bouncing around for some time, I believe this is the first time that a company has recorded the liability.  

FU shows VIE risk

Investors in Chinese companies have been badly burned by CEOs who seem to forget that they have shareholders. Some CEOs have sold assets out of the company and kept the proceeds. Some have just cleaned out the bank accounts. Others have taken the whole company. The variable interest entity (ViE) structure, where companies are controlled with contracts is a common enabler of these scams. Shareholders have little, if any, legal protection when things go wrong with a ViE.

A recent case highlights the problem. FAB Universal (NYSE:FU) came to market in 2012 through a reverse merger with a Pittsburgh headquartered company. The company was listed on the NYSE. Investors would have been prudent to take the company's ticker symbol as prescient.

FU recently came under attack by short sellers. Jon Carnes (aka Alfred Little) is one of the more lethal predators in the pack of short selling research firms that have circled U.S. listed Chinese companies for the last few years. Carnes alleged the company was a scam, selling pirated videos from nonexistent retail locations. A few days later another short selling research firm, GeoInvesting, disclosed a tip it had received that FU's VIE had issued a $16.4 million bond in China and had not bothered to record it in its financial statements.

Accounting for VIE taxes

An essential component of any VIE structure is a service contract between the wholly foreign owned enterprise (WFOE) and the VIE. The purpose of this contract is to enable the WFOE (which is owned by the public company and its shareholders) to extract the profits from the VIE (which is owned by a Chinese individual). Without this contract the public company has no economic interest in the VIE, and cannot consolidate the VIE in its financial statements. More important than the issue of consolidation is that unless the contract is effective, the public company owns nothing and may be worthless.

The problem with these contracts is that companies selectively apply them, if they apply them at all. The contracts usually provide that the WFOE can charge a fee to the VIE for services rendered that is equal to the entire profits of the VIE. There are a bunch of problems with that. 

First, these companies often need their cash in the VIE, not in the WFOE. So, if the profits are transferred from the VIE to the WFOE, the VIE may be short of cash. While direct loans between Chinese companies are not allowed, it is possible for the WFOE to loan the cash back to the VIE in the form of entrusted loans. Entrusted loans are permissible for the accumulated earnings of a WFOE, but cannot be used for funds that were contributed to capital of the WFOE

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