We have had several Chinese companies file for IPOs in the US recently. 500.com is an online sports lottery company.58.com is China’s copy of Craigslist. Sungy Mobile is mobile internet, mostly games.Qunar Cayman Islands is similar to Kayak.
Auditors of these companies are:
Sungy Mobile KPMG
Deloitte won none of these engagements although it previously had the largest market share by number of companies. Some private equity people have told me that they have been avoiding Deloitte for fear that their SEC problems might get in the way of a timely offering. The problems that the Big Four are having with the SEC get extensive coverage in the risk factors, with three of them saying that if the SEC acts against the China Big Four, they will not be able to file financial statements and may be delisted. I was pleased to see that KPMG signed Sungy’s report using its mainland affiliate, breaking from its former practice of signing these reports in Hong Kong. The mainland affiliate does the audits; it needs to sign the reports.
All of these companies use the VIE structure, and I have been analyzing the filings to see what is happening in VIE structuring and disclosures since the fireworks this year in the Gigamedia and Nina Wang cases (spoiler alert: they are not mentioned). I will be putting up a post on this in the next few days.
This post focuses on the use of proceeds. All of these companies have large deficits, which is not surprising since they are startups. Three are still losing money. The filings explain that it is impossible to get the IPO proceeds into the VIE. While the company can contribute or loan the funds to its WFOE, the WFOE cannot contribute to the capital of a Chinese company and it is not permitted to loan funds to a Chinese company. The WFOE is also not permitted to use capital contributions or loans to make an entrust loan. Entrust loans involve a Chinese bank serving as an intermediary between a lender and borrower and have developed as a way for Chinese companies to get around the rule that forbids them from issuing commercial paper. WFOEs cannot make entrust loans with funds that have been converted into RMB, so the WFOE cannot make a loan of IPO proceeds to the VIE in this way.
This, of course, is a huge risk factor. If companies cannot use the IPO proceeds to fund losses in the VIE, how is the business going to survive? Qunar does not appear to have big losses in the VIE (apparently its losses are in its WFOE), and 500.com is profitable, but there is no explanation in the filings on how Sungy Mobile and 58.com expect to get RMB into their VIEs to fund operating losses.
Furthermore, none of the companies explain how they got funds into the VIEs to fund the prior losses. Qunar has investment from Baidu. The others all got big investments from foreign private equity to fund their startup. How did these private equity funds get to the VIE? The private equity fund buys preferred stock in the Cayman Islands parent company. It is possible to then transfer those funds to the WFOE through capital contributions and loans and to convert them into RMB. But the WFOE cannot make a loan to the VIE, and it cannot make a capital contribution to the VIE, so how did the funds get into the VIE? It is quite clear that they were loaned to the VIE, since each of these companies show a loan payable by the VIE to a related company that is eliminated in consolidation. How was this loan legal? And if it is not legal, why isn’t it explained in the document?
I can think of a number of ways to get RMB into a VIE, although none of them are legal. Certainly companies planning to list in the U.S. have not been involved in money laundering. I hope the SEC asks enough questions to get to the bottom of this.