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Unwind the VIE and go home

There is a interesting editorial in Caixin today. It was written by Wang Rao, CEO of Chinese investment bank e-Capital. Wang argues it is time for overseas listed Chinese companies to unwind their VIE structures and seek listing at home. The editorial comes on the heels of an announcement that Chinese investment manager Shengjing had launched an investment fund dedicated to helping overseas-listed Chinese to delist and list instead on China’s stock exchanges. I have long argued that Chinese markets are the appropriate place for Chinese companies to list, since Chinese investors and regulators are better able to understand the companies. The Chinese stock markets, however, have not developed sufficiently for this to happen, I had forecast it would take 5-10 for the necessary reforms to make domestication possible. It appears that things may be moving faster than I expected.

The main factor driving this thinking is the rapid development of China’s own stock markets. The China Stock Market (SSE Composite) has more than doubled in the last year. Perhaps even more important is the success of China’s new third board, the National Equities Exchange and Quotations (NEEQ). NEEQ listed an average of 193 companies a month for the last four months, and now lists 2,343 companies with a total market cap of over US$180 billion. These are mostly small companies with an average market cap of only $77 million. Regulators have promised to tighten supervision of this lightly regulated market, and time will tell whether this market will be plagued with the rash of frauds that were seen with US reverse mergers on the US OTCBB.

Vipshop - gross vs. net

Two research reports came out recently against Vipshop Holdings (VIPS), a Chinese e-commerce company listed on NYSE. One report, from Beijing based J Capital, apparently focuses on differences between US regulatory filings and Chinese statutory filings. The J Capital report has not been made public, and my observations are based on the press reports. The company has pushed back on this report saying J Capital read the wrong statutory filings. I don’t put much faith in these types of analyses, since there are many reasons why those filings might be different that don’t point to fraud in the US filings.

The other reportis from heretofore unknown research firm Mithra Forensic Research (Mithra). Mithra has taken the more traditional short selling research methodology so effectively used by the likes of Muddy Waters that involves throwing the kitchen sink at the company. At the heart of Mithra’s allegations is that VIPS is improperly recording revenue.

While it is disappointing to see another billion dollar plus market-cap Chinese company come under short attack, I am slightly encouraged because this attack may be different than many of the earlier attacks. Carson Block has said that frauds in the US typically are a result of overly aggressive application of ac-counting standards, but in China, frauds have typically been exposed as situations where large parts of the company simply do not exist.

VIEs are dead, long live the WFOE

The State Council, China’s cabinet, last week promised policies to boost e-commerce in China. Included in the proposed reforms is a promise to reduce shareholding restrictions on foreign investments.Premier Li Keqiang appears to be leading the effort.

Nearly all of China’s larger internet companies have Cayman Islands incorp-orated parent companies that were used to facilitate taking foreign capital and listing in overseas markets. Because current Chinese regulations severely re-strict foreign companies from participating in the internet sector, the much maligned variable interest entity (VIE) structure was created to circumvent the rules by operating E-commerce businesses in Chinese companies controlled through contracts instead of through ownership. Investors soon learned thepainful lesson that contractual control is inferior to actual ownership.

In January, the Ministry of Commerce issued a proposed foreign investment law for public comment. The new foreign investment law makes it clear that the VIE structure does not circumvent the foreign investment restrictions. In other words, it doesn’t work. The proposed law has a twist – if the foreign company is Chinese controlled, then investment from that foreign company would be treated like domestic investment, and would not be subject to foreign investment res-trictions. The proposed solution works perfectly for many of China’s largest internet companies, like Alibaba and Baidu, which are controlled through corp-orate governance structures that leave voting control in the hands of minority Chinese shareholders (management).

Regulatory reforms stalled

A number of regulatory reforms related to auditing in China appear to have stalled, creating risk for investors.

The most significant change was proposed in Hong Kong, where the regulation of listed company auditors would be taken away from the Hong Kong Institute of CPAs (HKICPAs) and given to the Financial Regulatory Commission. Hong Kong had faced the embarrassment of having its regulatory equivalency with the European Union revoked because of the lack of an independent audit regulator. The HKICPA has proven to be an ineffective regulator. Public consultations were held in Autumn 2014 and then everyone went silent. In March, HK Secretary for Financial Services and the Treasury, Professor KC Chan, reported that the government had completed the public consultation and found majority support for the direction of the reforms. The consultation conclusions are to be published in the middle of this year.

China’s Ministry of Finance issued draft regulations on cross-border audit services on April 21, 2014. The proposed regulations would ban foreign auditors from working in China, requiring them to work with affiliates on the mainland. While the proposed regulations had no meaningful effect on the Big Four, since they all have huge practices on the mainland. I believe the regulation was targeted at the many small US CPA firms that had been traveling to the mainland to audit reverse mergers. Chinese regulators felt that shoddy work by some of these foreign firms had unfairly tarnished the reputation of Chinese accountants. Perhaps unexpectedly, the proposed regulation caused uproar among smaller Hong Kong CPA firms that had significant practices serving mainland companies with listings in Hong Kong. As far as I can tell, nothing has been done since April.

Short selling campaigns in China

China has been a major focus in recent years for short selling research firms. Short sellers make money by borrowing stock, selling it, and hoping to repurchase and return the borrowed stock at lower prices. Short selling campaigns put short positions into place, and then publish reports about the companies that often allege fraud or overvaluation. The campaigns often lead to a sharp decline in stock prices, investigations, and even delistings, giving the short sellers significant profits.

I am planning to teach a course this fall at Peking University that will focus on short selling campaigns against Chinese companies. I want to share some interesting data about the history of short selling campaigns against Chinese companies. I obtained this data from the excellent database offered by Activist Shorts Research. Founder Adam Kommel kindly gave me access to this database. I highly recommend that any fund investing in Chinese equities subscribe to it.

Here is a table I extracted from the data:

Regulation Fair Disclosure

One of the best rules that the SEC ever put in place was Regulation Fair Disclosure, or Reg FD, which was promulgated in 2000. Reg FD mandates that public companies must disclose material information to all investors at the same time.

Prior to Reg FD, companies would often disclose market-moving information to certain investors before others, allowing them to profit by placing trades before the information became widely known.

Unfortunately, Reg FD does not apply to foreign private issuers. Most US listed Chinese companies are classified as foreign private issuers. As foreign private issuers, the companies are also not required to file quarterly reports on Form 10Q nor get auditor review of the quarters. Most US listed Chinese companies do provide quarterly results anyway, although they usually do not include an auditor review report. For foreign private issuers, the annual report is filed on Form 20F instead of Form 10K, and is due a month later.

I think the logic behind not applying Reg FD to foreign private issuers is based on an assumption that the companies are also listed on a foreign exchange, and the SEC is reluctant to add on additional requirements beyond what the regulators and exchanges in local markets require. That logic is invalid with respect to most U.S. listed Chinese companies, since they are not typically listed on any other stock exchange.

SEC settles with China Big Four

The SEC has announced a settlement with the Chinese member firms of the Big Four over their failure to give the SEC auditing working papers when requested to do so. The firms argued that they were unable to do so because of Chinese laws, but after the suit was filed the firms worked with Chinese regulators to release the working papers. An administrative trial judge banned the firms from practice for six months, and the settlement is a result of the firm’s appeal of the judge’s decision.

The settlement falls far short of what is needed to protect investors. What is needed is a comprehensive deal between China and the US to allow the SEC unfettered access to documents necessary to enforce US securities laws on Chinese companies that have elected to list in the United States. Instead the settlement lets the accounting firms and their clients off the hook, providing only a mechanism to restart the proceedings if the firms fail to cooperate in the future.

It appears that the SEC decided to kick the can down the road, rather than use the leverage of these cases to push China into greater cooperation on securities fraud by US listed Chinese companies. There have been many instances of fraud committed by US listed Chinese companies, and most perpetrators have escaped justice when China blocked the SEC from getting China documents. As far as I know, no Chinese person has faced prosecution in China for crimes associated with US listed companies, even when the purported acts – theft, kidnapping of auditors, fake bank confirmations, etc. are all crimes in China.

Big Four settlement imminent?

The Wall Street Journal, citing unnamed inside sources, reported that the SEC is close to reaching a deal with the China’s member firms of the Big Four over the lawsuit over audit working papers. The firms would be sanctioned, pay fines of $500,000 each, and have the suspension from practice that was ordered by an administrative trial judge removed. The Journal reports the SEC Commission could vote on the settlement as soon as February 5, 2015.

The article says that the settlement includes a strong framework for the firms to cooperate with the SEC and for the agency to obtain audit documents in the future. The problem is that the firms and the SEC have no ability to do that. China has refused to allow the firms to turn over working papers to the SEC or PCAOB, and any deal to do so has to be with Chinese regulators and not with the accounting firms.

I suspect that a deal is imminent between the US and China over audit and securities regulation. Given China’s recent proposal to clean up the VIE structure, I think China has decided it wants access to US capital markets and has decided to cooperate with US regulators and remove obstacles to US listings. Consequentially, I expect we will see a deal between Chinese regulators and the SEC and PCAOB before the settlement with the Big Four is finalized. US regulators would be foolish to let the Big Four off the hook before they get such a deal.

A contrarian view on VIEs

The proposed Chinese foreign investment laws have received a great deal of attention because they propose to create rules to deal with the VIE structure.

Most analysts, including foreign and Chinese law firms, are saying the new rules propose to treat VIEs that are controlled by foreign firms as foreign invested enterprises, subjecting them to full regulation and possible exclusion if they operate in restricted sectors. But they also point out that the intent is to look at the ultimate control of the VIE, and if the foreign company is controlled by Chinese companies or individuals (and many are), then the VIE would not be treated as foreign controlled. This proposal is said to have come from Robin Li of Baidu.

Steve Dickinson at the China Law Blog is taking a contrary view. In his post, China VIEs are Dead. Done. Over. Stick a Fork in Them, Dickenson argues that the State Council has rejected the Robin Li proposal and the concept of Chinese controlled foreign companies is not going to be used. Instead the State Council is punting the decision to the various regulators. Dickenson points out the problems created if regulators selectively approve certain VIEs.

Chinese VIEs - winners and losers

China has proposed revising its approach to regulating foreign investment. A good summary is here. Investments in most sectors will be treated the same for foreigners and locals. A negative list will restrict foreign investment in certain sectors. China has published proposed rules for this new approach, but it does not include the negative list. A good working assumption is that the negative list will include most of the industries that are in restricted or prohibited categories on the current foreign investment catalog. The proposed law is here (in Chinese). The Ministry of Commerce will accept comments until February 17.

One of the important changes is that variable interest entity (VIE) arrangements are specifically covered. A VIE will be treated as foreign invested if it is foreign controlled. In the common Chinese use, VIEs sign a series of contracts with a Cayman Islands incorporated, publicly listed company or its wholly foreign owned enterprise (WFOE) subsidiary. Those contracts give control of the VIE to the public company and under the new rules make the VIE a foreign invested enterprise. That means the VIE cannot operate in sectors on the negative list.

Actual control and VIEs

Yesterday I wrote about the proposed new foreign investment law for China. The new law appears to change the way China will look at variable interest entities, focusing on who actually controls the entity vs. who is the owner of record. That could create problems for many VIE structures that would be found to have prohibited foreign investment.

There is another way to look at this proposal, which is well explained in this article just released by Chinese law firm Haiwen(in Chinese). The proposal introduces a concept of actual control. That concept could be applied to the VIE, and the actual control of the VIE would be found to be with the foreign, typically Cayman Islands incorporated, public company. That would cause a problem if foreign investment continues to be banned in internet companies.

The other way the concept could be applied is to look at the listed, typically Cayman Islands company. If this company is controlled by Chinese, perhaps that means that the VIE is actually controlled, indirectly, by Chinese, and can continue to operate legally. What it means is that China will look to ultimate control, rather than legal ownership to apply its foreign investment restrictions, and if Chinese are ultimately in control, then no restrictions will apply.

The end of VIEs?

There is a potential development with variable interest entities (VIEs) that could threaten many US listed Chinese companies that use this structure. It has been reported in Chinese forums. The documents are all in Chinese and I may have misinterpreted them. I am sure lawyers are going to be pouring over this in the coming days – I will add links to their analysis when they publish.

Today, January 19, 2015, the Ministry of Commerce (MOFCOM) released a draft of a new foreign investment law for public comments. What is notable about this new law is that it appears to introduce an actual control rule for determining when an enterprise has foreign investment and is thus subject to regulation as such. What that appears to mean is that a VIE that is controlled by an offshore company will be treated as a foreign invested enterprise (FIE).

The nature of VIE arrangements in China is that they give control to an offshore company (typically the listed Cayman Islands company or its Chinese subsidiary (WFOE)), yet argue to Chinese regulators that the VIE is a local company owned by locals, and therefore not subject to foreign investment restrictions. The proposed law appears to change that interpretation. Instead, a VIE controlled by a foreign company will be treated as a foreign invested enterprise.

China needs an audit regulator

Xiao Gang, Chairman of the Chinese Securities Regulatory Commission (CSRC), said last week that during 2015 the CSRC would phase out the current approval based system for Chinese IPOs and implement a registration-based system. A registration-based system will be more like the process used by the U.S. Sec-urities and Exchange Commission. Regulators will let the market judge offerings, focusing instead on compliance.

Most high profile IPOs from China are not listed on China’s stock exchanges but rather on US or Hong Kong exchanges, and the changes will not apply to those companies.

This is a good step forward for China’s stock markets, in large part because it has the potential to create a more efficient market less subject to corruption and political favoritism.

As regulators step back, it is critical that other institutional players, particularly auditors, lawyers, and investment bankers step up. They will become the prin-cipal gatekeepers to the market. Without increased professionalism by these players, the Chinese stock markets could become increasingly dangerous for investors.

Regulatory impasse

The SEC extended the time for briefings to be filed in the appeal of the Chinese affiliates of the Big Four firms against the January 2014 decision by an Admin-istrative Trial Judge to ban them for six months. The final brief is now due on May 29, 2015, meaning that a final decision is unlikely before late summer.

Both the SEC and the Big Four indicate that substantial progress has been made towards a settlement, “however, the multi-party nature of the negotiations, the importance, complexity and sensitivity of the matters under discussion, and the legal and cross-border regulatory issues presented have continued to require significant time and care to discuss.” The negotiations, of course, are not be-tween the SEC and the Big Four, they are between the SEC and China, since the Big Four have no means to negotiate a settlement. It is all up to China to deter-mine the extent to which it is willing to cooperate with U.S. securities regulators on Chinese companies listed in the U.S.

In a closely related matter, U.S. Public Company Accounting Oversight Board (PCAOB) negotiations for regulatory access to China have been going on for a decade. PCAOB Chairman James Doty recently said that those negotiations were in a “difficult and frustrating place”. Shaswat Das, Associate Director of the PCAOB’s office of International Affairs and Alan Lo Re, Assistant Director Attorn-ey of the PCAOB’s Division of Enforcement and Investigations are scheduled to speak at a conference in Beijing on Thursday, and perhaps have meetings scheduled with Chinese regulators.

A difficult and frustrating place

According to a Reuter’s report by Soyoung Ho that is currently behind Reuter’s paywall, PCAOB chairman James Doty said some discouraging things at the recent meeting of thePCAOB’s Standing Advisory Groupabout the prospects for an inspection agreement with China.

Doty is quoted to have said that the PCAOB’s effort to inspect auditors in China is “in a difficult and frustrating place”. Doty indicated that he was still hopeful that an agreement could be reached. However, according to the report he said: “It’s getting late to plan an inspection for 2015. That’s what’s discouraging about this. It’s not impossible, but it’s getting late to plan for the 2015 cycle.

According to the Reuters report, proposed agreements “are now in the hands of more senior Beijing officials, and it’s not clear what decision they’ll reach, or when. If PCAOB inspectors are allowed to review audit documents in the People’s Republic, it may not happen before 2016 at the earliest.”

In addition to the PCAOB inspection issue, theSEC decisionagainst the Big Four firms has yet to be resolved. Filings in the appeal have been extended to the end of the year to allow time for settlement, and perhaps Chinese officials want to settle both issues simultaneously.

Who audits Alibaba - update

Back in May I raised the question of whether PwC Hong Kong is the principal auditor of Alibaba given that most operations are on the mainland. The SEC has now released its correspondence with Alibaba and I found that they raised this issue with Alibaba. Here is the SEC’s question (italics) and Alibaba’s response (bold).

We note that your audit report is signed by PricewaterhouseCoopers - Hong Kong, although the majority of your operations appear to be in mainland China. We also note your risk factor disclosure that “[i]f the affiliate of [your] independent registered public accounting firm were denied, temporarily, the ability to practice before the SEC, [you] would need to consider with [your] Hong Kong based auditor the alternate support arrangements they would need in their audit of [your] operations in mainland China.” Please tell us how you concluded that it isappropriate to have an audit report issued by an auditor in Hong Kong, in light of the location of your corporate offices, your principal operations, and your principal assets. Please also tell us your understanding of the nature and extent of the work conducted by each firm, including the participation of your Hong Kong based audit firm with respect to the work of its affiliated firm in mainland China.

China allows WFOEs for auditing

On November 4, China updated the Catalogue for the Guidance of Foreign Investment Enterprises, which categorizes businesses into encouraged, restrict-ed, or prohibited for foreign investment. Dezan Shira’s China Briefing has a good summary of the changes.

Noteworthy is the inclusion of accounting and auditing as an encouraged in-dustry. Auditors will now be allowed to conduct these services using wholly foreign owned enterprises (WFOEs).

The Big Four currently conduct their auditing practices using limited liability partnerships that originally had 60% locally licensed partners and 40% un-licensed partners. The 40% reduces to 20% over the next few years, and I think it is at 35% for most of the firms right now.

The Big Four conduct their consulting practices (including tax) in wholly foreign owned enterprises that are typically owned by their Hong Kong member firm.

So, will this change result in the Big Four moving their auditing practices to WFOEs? I don’t think so. Under present Chinese rules, a partner in a CPA firm must be licensed as a CPA in China and I expect these rules will also apply to the shareholders of a WFOE. If ownership by unlicensed persons is allowed, then China has just opened the door wider than any other country on earth. Licensing requires the partner to pass the notoriously difficult Chinese CPA examination and meet other not so difficult requirements. The present rules, allowing a per-centage of owners to not have local licenses, is better for the Big Four than al-lowing them to have a WFOE. Additionally, an increasing number of Big Four partners are PRC citizens, and the WFOE alternative does not work for them.

Son of Enron

I have recently published two articles on how the accounting standard developed to prevent another Enron was perverted to create Chinese variable interest entities. Accounting standard setters ought to take a hard look at how this standard is being applied.

The first article, for a general audience, is in Foreign Affairs. The second, more academically oriented, is in the Journal of Applied Corporate Finance.

I remain hopeful that China will, as promised, revise the rules on foreign investment in e-commerce and education and make the VIE structure obsolete.

NQ Mobile still at Level 2

NQ Mobile (NYSE:NQ) filed its annual report on Form 20F on Monday, nearly 6 months late. NQ was the subject of a Muddy Waters report on October 24, 2013 that sent the stock price tumbling. A board initiated special investigation found no evidence of fraud, but reported that certain information had been erased from electronic devices. Auditor PwC demanded that it be allowed to expand the scope of its work, and NQ fired PwC and replaced them with Marcum, Bernstein and Pinchuk (MBP) a U.S. based auditor that specializes in smaller U.S. listed Chinese companies. MBP was ultimately able to complete the audit and issue the report.

PwC refused to consent to the use of its prior reports on 2011 and 2012, so MBP had to reaudit those years. Curiously, PwC did not withdraw its opinions on those years – it simply refused to consent to their use in the current filing.

One of the issues Muddy Waters raised in their initial report related to the classification of bank deposits as Level 2 assets in the financial statements. Muddy Waters suggested that meant the cash balances were highly likely to not be real. I disagreed with Carson Block on that matter, and got into a twitter fight with him and the lovable and reformed convicted felon Sam Antar of Crazy Eddie fame. In my view, Level 2 is just a description of how the asset is valued, and while practice varies, I believe that Level 2 is the right description for these assets. I was amused to see that all of the bank deposits are still classified as Level 2. I guess that is a fitting ending to my coverage of the NQ saga.

Understanding Chinese cash flow statements

A short selling research group called Anonymous Analytics (AA) published a short report on Hong Kong listed Tianhe Chemicals Group Ltd (1619:HK) on September 2. Tianhe, listed only this past June, was the seventh company at-tacked by AA. While the people behind AA are not identified, I am told by a re-liable source that I know all of them, which suggests they are prominent shorts operating under a pen name. There is the usual menagerie of allegations, and AA published a letter to Tianhe’s auditor Deloitte pointing out some matters Deloitte should be looking into, a technique first used in Muddy Water’s attack on China Media Express in 2011. Deloitte has said nothing publicly, and they won’t unless they either prove the fraud or find that management has lied to them, in which case they will resign.

Tianhe asked the Hong Kong Stock Exchange to immediately suspend trading. That can be a smart strategy since it prevents the shorts from covering while they continue to pay for borrowed stock. Trading resumed a month later after the company responded to the 20 page AA allegations with a 55 page response alleging that AA had fabricated documents, forged signatures, and hacked email. Shares dropped 40% on resumed trading. The company and AA have since trad-ed insults but the stock remains down 54% from its high, suggesting investors believe AA over management.


Copyright 2015 Paul L. Gillis all rights reserved