Cleaning up the VIE sector | China Accounting Blog | Paul Gillis

Cleaning up the VIE sector

Buddha Steel, Inc. (OTCBB:AGVO) filed an 8k on March 28, 2011 reporting that it had terminated the agreements with its variable interest entities (VIE) because local government officials in Hebei Province had informed them that the agreements contravene current Chinese management processes related to foreign invested enterprises and, as a result, are against public policy. Buddha Steel was in the process of doing a $38 million underwritten public offering that was pulled.   The company announced that its financial statements should not be relied upon and announced it would not file its 10K on time. 

Buddha Steel was organized like many U.S. listed Chinese companies, particularly those that operate in markets (like steel, internet, and education), that are off limits to foreign investment.  Buddha Steel was a U.S. company that did a reverse merger with Gold Promise, a Hong Kong company. The actual operating assets of Buddha Steel, however, were in a Chinese company, Baosheng Steel.  Because Chinese law prohibits foreign ownership of Baosheng Steel, it remained owned primarly by Buddha Steel’s Chinese CEO and his family.   Similar to many other deals in industries restricted to foreign investment (and increasingly in unrestricted industries) Baoshen Steel and the CEO entered into a series of agreements to effectively transfer control of Baoshen Steel to Buddha Steel.   These agreements allowed Buddha Steel to consolidate Baosheng Steel in its financial statements as a VIE. 

This has become the archetypal form for U.S. listed Chinese companies.  This time, however, Chinese authorities in Hebei Province stepped forward and stopped the deal.  According to the company, the authorities said the agreements contravene current Chinese management processes related for foreign-invested enterprises and, as a result, are against public policy. When the government said the agreements were illegal, Baosheng Steel can no longer be considered a VIE and cannot be consolidated in the financial statements.    I speculate that the Hebei officials were not acting on their own, but rather with some coaching from Beijing.   I think this may be one of the early Chinese reactions to the reverse merger scandals that have been getting increased attention. 

Chinese authorities looked the other way when the VIE structure was created to allow China’s internet sector to develop with companies like Baidu, Sina, Sohu and DangDang, all of which use the VIE structure.   It is doubtful that this sector could have developed as successfully as it has if the rules restricting foreign investment in these sectors were strictly followed.  But now, scandals involving Chinese companies that have done reverse mergers to get on U.S. exchanges are embarrassing China.  Embarrassing China rarely ends well for the offending party.

So where do we go from here?  While this may be a case of “killing a chicken to scare the monkeys”, I would  not be surprised if any future attempts to put together VIE deals meet a similar fate. Companies have not usually asked permission before setting up VIE structures – in fact the whole purpose of many of these structures is to avoid the need to ask permission to set up offshore structures.   I expect Chinese officials will become more aggressive at killing these deals before they get going. 

But what about the many existing U.S. listed Chinese companies that rely on the VIE structure, including Baidu, Sohu, Sina, CNInsure, DangDang, Youku, Ctrip?   When commentators have pointed out the risks of the VIE structures, investors have pointed out that if these structures are used by giants like Baidu, the risks must be minimal.  Certainly China is not going to put Baidu, a critical component of China’s internet infrastructure (and with a market cap of US$47 billion), out of business?    

That is the type of contradiction that is so typical of China.  Can China use the rules to shut down embarrassing reverse merger companies without also taking down powerful companies like Baidu?   The big internet companies have the same agreements that were used by Buddha Steel.  If the agreements violate public policy in the Buddha Steel case, why don’t Baidu’s VIE agreements also violate public policy? 

I don’t think China will shut down most of the VIE companies anytime soon.  The officials are too pragmatic to do that.  But we have entered into a period of great uncertainty.  I am looking forward to reading how lawyers and accountants explain themselves out of this hole in the annual filings.   The SEC will undoubtedly be asking some very tough questions.   

How did we get into this mess?  The problem is that China has made it difficult for private companies to obtain capital at home.  While the Shenzhen Exchange has become more friendly to privately owned businesses in recent years, there is a substantial backlog of companies hoping to list, and the listing standards are higher than the U.S.   Entrepreneurs being entrepreneurs, they found ways around this problem by listing overseas, but in order to do so they created the awkward, and now arguably illegal, structure that is called a VIE.   The VIE is only part of the problem.  The whole structure of Cayman Island companies, listed in the U.S., but controlling operations in China, has created a morass that is undermining effective regulatory oversight of the companies.  No wonder we are seeing so many frauds on the market. 

The solution to this problem has to come from China.  For the financial markets to operate properly, companies and investors cannot function under the level of uncertainty that the Buddha Steel case inserts in the system.   While China could just get tough and force all of the companies using VIE structures to restructure into Chinese owned entities, that would cause a great deal of harm to the companies, their shareholders and the Chinese economy.  Instead, I think China should use this as an opportunity to regularize this sector. Here are my suggestions to Chinese regulators:

1. Make it easier for Chinese companies to directly list overseas without using an offshore entity.  Many companies have chosen the VIE approach as a way of getting around cumbersome Chinese regulations.  

2. Recognize the reality that there already is significant foreign investment in prohibited sectors, and find a way to regulate this investment instead of pretending to prohibit it.  Prohibition has not worked, and China needs entrepreneurial companies like Baidu, Dangdang, CTrip and Ambow Education.

3. Bring the offshore structures back onshore. Encourage U.S. listed Chinese companies with offshore parents to merge the offshore company into the Chinese operating company.   This will give China better regulatory control over these companies and it will give the shareholders real ownership of the operations. That is a good tradeoff for investors. China needs to develop rules to make this possible.

4. Develop a regulatory structure that works for these companies, and which coordinates effectively with the SEC and PCAOB.

5. Create opportunities for U.S. listed Chinese companies to obtain a listing on Chinese stock exchanges.  Let the markets decide the best place for a Chinese company to obtain capital, not regulatory barriers or even worse, the opportunity to avoid regulatory oversight.  Think Baidu is hot on NASDAQ? Wait till you see what it does on ChiNext.

6. Use a carrot and a stick.  Make it easy for firms to regularize their operations, and then strictly enforce existing Chinese laws on any companies that do not restructure.  

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