New Oriental Education & Technology Group Inc. (NYSE: EDU) filed an amended Form 20F for the fiscal year ended May 31, 2012 on February 22, 2013. The amended 20F has been reported in the Chinese press as having been filed on April 3, but I think that is the day they discovered it. The stock was hammered yesterday, but I doubt that relates to the discovery of the filing.
The amended filing was a consequence of continued SEC attention to EDU’s VIE structure. EDU says the document “does not reflect events after the filing of the original report” but then immediately discusses the reorganization of Deloitte into an LLP, which happened on January 1, 2013. From my review of the document, the most significant change is the signing of a new power of attorney on December 3, 2012 (also after the original report). The power of attorney is between EDU’s WFOE and Century Friendship, Chairman Michael Yu’s private company. The power of attorney allows the WFOE to unilaterally act for Century Friendship on New Oriental China, EDU’s master VIE. The new power of attorney replaces one signed on April 23, 2012, which was presumably not strong enough for the SEC.
There have been significant changes in the 20F document and the financial statement footnotes, although the numbers on the financial statements did not change. Most of the changes relate to expanding discussions of control issues and the risks present if control is lost. The company now states that if it is unable to control the VIE it may be forced to deconsolidate, but deconsolidation would not force the company to liquidate.
Deconsolidation could happen if Chinese regulators successfully challenge the use of VIEs to control Chinese schools. It could also happen if Michael Yu chooses to disregard the VIE agreements and the company is unable to enforce them to regain control. On that later point investors are told to trust Michael Yu:
We rely on Century Friendship and Mr. Yu to comply with the laws of China, which protect contracts, including the contractual arrangements New Oriental China and its schools and subsidiaries and its shareholder have entered into with us, which provide that directors and executive officers owe a duty of loyalty to our company and require them to avoid conflicts of interest and not to take advantage of their positions for personal gains. We also rely on Mr. Yu to abide by the laws of the Cayman Islands, which provide that directors have a duty of care and a duty of loyalty to act honestly in good faith with a view to our best interests.
If Mr. Yu does not respect the contracts the company may have to litigate, and the document says that litigation would have “substantial uncertainty as to outcome”. That is the case in all VIE arrangements. They will work fine until they don’t work fine – which is when the VIE shareholder decides to change the deal. You can ask Yahoo shareholders about that.
The financial statements are not restated, although the footnotes are significantly changed. Three footnotes were substantially rewritten, increasing their word count by 15%, 45% and 93% respectively. Accountants usually resist changing financial statements after they are issued, since the changes are usually considered a restatement. Instead, they often convince the SEC to allow them to make the changes prospectively. Deloitte apparently concluded these changes were not material enough to be considered a restatement and it appears the SEC agreed.