I was very fortunate to have KPMG consulting partner David Frey talk to my MBA class on Multinationals in China last week about the rapidly changing landscape for MNCs. He has some great insights. One of his predictions is that China will make the Yuan freely convertible sooner than people think. I hope he is right; currency restrictions are increasingly causing problems for U.S. listed Chinese companies.
Chukong Holdings Limited filed on last Friday with the SEC for a U.S. IPO. Chukong is an online game company so it uses the variable interest entity (VIE) structure despite a specific MIIT prohibition against using VIEs for game companies. The company also faces a lawsuit alleging they ripped off their game Fishing Joy from an arcade game, report that they have not been paying required employee benefits, never bothered to register their stock option plan, and have an auditor facing suspension by the SEC, but based on past history investors ignore such matters.
Chukong is unprofitable. Its losses have increased over the past three years from 30 million RMB to 91 million RMB. It has burned 84 million RMB of cash in operations over the past three years. It stockpiled that cash by selling preferred stock in its Cayman Island parent company to Sequoia and other investors.
The VIE lost 43 million RMB in 2013, yet Chukong says it had cash flow from operations of 57 million RMB? How can that be? The company discloses that an intercompany payable between the VIE and the Chukong increased from 16 million RMB to 145 million RMB in 2013. I believe that Chukong has treated the intercompany loan as an operating cash flow, rather than the financing cash flow that it is.
I suspect that Chukong is actually burning cash in its VIE. That would make sense, since 89% of revenues and presumably most of the business is in the VIE. It also appears that company got the cash to burn by selling preferred shares in the Cayman Islands parent company, and then somehow transferred that cash to the VIE.
Chukong carefully explains in their filing that they may not be able to convert the proceeds of their offering into RMB and to capitalize PRC operations. That is because China has strict capital controls. With proper approvals, Chukong would have been able to contribute the proceeds from the preferred stock sales as capital (or made a loan) to its Chinese subsidiaries, known as wholly foreign owned enterprises (WFOE). But getting the money from the WFOE to the VIE is where it gets tough. SAFE Circular 142 says that the RMB obtained from a capital contribution cannot be used for an equity investment in China. SAFE Circular No. 45 prohibits converted funds from being loaned to another company through entrust loans. Direct company-to-company loans (commercial paper) are not allowed in China, so entrust loans, with a bank in the middle, get around the prohibition. But entrust loans cannot be made from converted contributed capital. So how did Chukong get the funds into the VIE? Lots of ways have been invented to circumvent China’s capital controls, but all of them have one thing in common – they are illegal.
Chukong dutifully explains that all these rules may continue to limit the use of proceeds of the offering. That gets to the principal accounting issue – Is Chukong a going concern? Auditors have to assess whether a company has the financial wherewithal to survive another year. If they conclude that it is more likely than not that the company won’t make it, they are to issue a going concern opinion and the offering would likely be doomed.
Chukong addresses the going concern issue in the footnotes to the financial statements:
The Group assesses its liquidity by its ability to generate cash to fund its operations, its ability to attract investors and its ability to borrow funds on favorable economic terms. Historically, the Group has relied principally on cash from investors, to fund its operations and capital expansion needs. Management believes that the Group can continue as a going concern in the next twelve months with cash generated from operating activities or financing activities.
Apparently Chukong and its auditors have applied the going concern test at the group level. But is that appropriate when currency restrictions make it impossible to freely move money around the group? Should the test be done separately for each significant operation? I think so. If that is done in this case the company would have to assess whether the VIE will be able to obtain sufficient cash to continue operations for another year. The company has explained all the reasons why the IPO proceeds cannot be used to fund the VIE, but it has provided no other explanation of how the VIE will find the cash it needs to continue to operate for another 12 months. Since most of the business is in the VIE, I don’t think Chukong is a going concern if the VIE is not also a going concern. Presumably Chukong intends to continue to have the WFOE loan money to the VIE, despite the fact they have said it would be illegal to do so. Investors deserve a straight answer to this.
Readers know I have a poor opinion of the VIE structure. This is just another example of the deepening contradictions of it. This problem will be relieved when China relaxes capital controls, but a comprehensive solution to the VIE problem is needed.