Spinoffs - Chinese style | China Accounting Blog | Paul Gillis

Spinoffs - Chinese style

Spinoffs are situations where a corporation disposes of part of its business by giving shares in the business to shareholders. When they work, the value of the parts is greater than the value of the whole. “Spinoffs” of US listed Chinese companies work differently.

A favorite transaction of US listed Chinese companies is to "spin off" parts of the business in a new entity in an IPO transaction. Shareholders of the parent company are not distributed shares of the company that does an IPO although they may benefit if the value of the underlying shares is recognized in the stock price. There have been a number of these transactions and several in the pipeline.

I have observed, however, that the biggest winners in these transactions appear to be members of management. Management typically ends up with a big chunk of these deals which are structured in a way that does not report as expense the value transferred to them.

Rather than point to a specific transaction, I am going to examine these transactions through a straw man. When I look at specific transactions, I find the public documents obscure what is going on and add bells and whistles that do not alter the essence of the transaction while providing arguments to counter any attacks on the structure. So, the transaction I describe below is fictitious, although I think fairly represents what is going on. I leave it to others to apply this to specific transactions. I apologize, but this simplified example is still complicated as hell.

Big Data Inc. is a US listed Chinese company. Big Data Inc. is a Cayman Islands incorporated company with two wholly owned Chinese subsidiaries (WFOEs), Blockchain Corporation and Big Data Corporation. Blockchain Corporation (a WFOE) controls through contracts Blockchain Inc., a Chinese corporation owned by Chinese individuals. Big Data Corporation (a WFOE) controls through contracts Big Data Inc., a Chinese corporation owned by Chinese individuals. The contractually controlled businesses are consolidated into the financial statements as variable interest entities (VIEs). Pre-spinoff the business looks like this:

Big Data has a market capitalization of $10 billion. In 2017 management formed a new Cayman Island corporation (Blockchain China Inc) and received all of the shares in exchange for a capital contribution of $1 million. Big Data Inc. then contributes Blockchain Corporation (WFOE) to Blockchain China Inc in exchange for a controlling shareholding with management as a minority shareholder. At this point an investor group, either one of the big Chinese e-commerce companies or a PE investor contributes cash to Blockchain Corporation diluting the interests of Big Data and management and often leading to the deconsolidation of Blockchain China Inc from Big Data. Immediately after the "spin off" the structure looks like this:

Finally, Blockchain China Inc. does an IPO in the US receiving $200 million for 10% of the outstanding shares (market capitalization of $2 billion). Management continues to hold 10% of the shares, now valued at $200 million.

The question is whether management should obtain this windfall and whether compensation expense should be recorded. I am concerned that there is a significant transfer of value away from the shareholders of Big Data to management without consent by the shareholders or even adequate disclosure. Big Data, like most US listed Chinese companies, has a weighted voting rights structure that gives management voting control. Shareholders don’t get to vote and based on my reading of the disclosures of many of these transactions shareholders and regulators could not easily figure out what is happening anyway.

When management is given shares in a company, accounting standards require that the value of those shares be expensed as share based compensation. I do not see material share based compensation for the shares obtained by management in these transactions, likely because management argues they are buying shares in the Cayman Island shell company (Blockchain China Inc) for full value because it has no business at that point in time. However, if you look at the transaction as a whole, you might collapse the steps and reach a different conclusion. As far I as I can tell, auditors and the SEC have never raised this issue. We have a transfer of value from the existing shareholders of Big Data to management of $200 million without recording compensation expense or obtaining minority shareholder consent. That might technically follow the rules, but I think it is poor corporate governance.

There is a good research project here for a young academic. Do Chinese spinoffs create shareholder value and if so, for who?

Copyright 2018 Paul L. Gillis all rights reserved