New challenge to VIEs | China Accounting Blog | Paul Gillis

New challenge to VIEs

I have learned from some investors that there has been a major challenge against the VIE structure of a U.S. listed Chinese company. The challenge relates to whether the VIE can be consolidated into the financial statements. The SEC has been aggressively examining VIE arrangements, but I have been unable to learn whether this challenge is a result of an SEC investigation, or who the company or auditor are.

Bear with me; this discussion has to get technical.

Under the VIE accounting rules, consolidation of the VIE is allowed if the public company is considered to be the primary beneficiary of the VIE (ASC 810-25-20). In a typical VIE arrangement, there are two potential beneficiaries of the VIE: 1) the Chinese individual who owns the shares in the VIE, and 2) the public company that has contracts with both that individual and the VIE that transfer control and economic interests to the public company. VIE arrangements are structured to make it clear that all of the control and economic interest flows to the public company.

Clear until now, anyway.

In many VIEs the founder of the company is the owner of the VIE. The founder also usually has voting control over the public company, which is often retained after the IPO by use of two classes of shares. Founders typically retain voting control even if their share holdings are reduced to a minority position. The two class of shares approach to retaining control by founders is common in technology offerings, most famously in Facebook. Two classes of stock are not allowed on the Hong Kong exchange, and that presents a challenge for U.S. listed companies that may want to move onto the Hong Kong exchange if they get kicked out of the U.S., but that is another story.

Under typical VIE agreements, the founder agrees to transfer his VIE shares to another VIE shareholder at the public company's request, and to otherwise vote those shares and select VIE management at the public company’s direction. Since the public company can remove the VIE owner at will, it has been thought that the VIE owner has no rights, and accordingly no interest in the VIE. Therefore the public company is the only beneficiary of the VIE and can consolidate it into their financial statements.

The founder, however, could stop any attempt to remove him as the owner of the VIE since he has voting control over the public company. With voting control, the founder has the power to elect the board that selects, terminates and sets the compensation of management, and establishes operating and capital decisions of the company. Do these powers mean that the founder is actually the primary beneficiary of the VIE? If the founder is the primary beneficiary, the public company cannot consolidate the VIE and instead will report its share of earnings as it receives them.

What happens if the SEC or auditors decide that this is the correct approach? Companies with this fact pattern will be forced to deconsolidate their VIEs, and restate prior financial statements. The VIE will drop out of the financial statements, possibly turning income into losses in some companies, while having a minor effect on some others.

Companies affected by this are likely to restructure their VIEs to be allowed to consolidate in the future. The easy solution seems to be to pick someone other than the founder to own the VIE. While that may fix the accounting problem, it introduces a huge amount of risk. One reason that the VIE is usually held by the founder is to align the interests of the VIE shareholder with the interests of the public shareholders. The idea is that the founder will not steal the VIE since doing so would destroy the value of his shares in the public company.

If the SEC is making this position clear to the accounting firms, we could see some real surprises when companies file their Form 20F over the next few weeks.

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