FU shows VIE risk | China Accounting Blog | Paul Gillis

FU shows VIE risk

Investors in Chinese companies have been badly burned by CEOs who seem to forget that they have shareholders. Some CEOs have sold assets out of the company and kept the proceeds. Some have just cleaned out the bank accounts. Others have taken the whole company. The variable interest entity (ViE) structure, where companies are controlled with contracts is a common enabler of these scams. Shareholders have little, if any, legal protection when things go wrong with a ViE.

A recent case highlights the problem. FAB Universal (NYSE:FU) came to market in 2012 through a reverse merger with a Pittsburgh headquartered company. The company was listed on the NYSE. Investors would have been prudent to take the company's ticker symbol as prescient.

FU recently came under attack by short sellers. Jon Carnes (aka Alfred Little) is one of the more lethal predators in the pack of short selling research firms that have circled U.S. listed Chinese companies for the last few years. Carnes alleged the company was a scam, selling pirated videos from nonexistent retail locations. A few days later another short selling research firm, GeoInvesting, disclosed a tip it had received that FU's VIE had issued a $16.4 million bond in China and had not bothered to record it in its financial statements.

The company issued a blanket denial to the short seller’s reports and then went silent. The NYSE suspended trading pending the release of information. After three weeks, the company issued an extraordinary press release. The allegation related to the bond issue was true; the company indicated it would have to amend the past two quarterly reports to include the bond liability, proceeds and related interest expense. The company implied "hey, no harm, no foul, the cash is still there". And the company continues to deny the other allegations by Alfred Little. 

Not so quick. There is incredible harm here. Any trust between the shareholders and management has been irreparably damaged. How could Chairman Zhang think he had the right to do a bond offering without apparently even telling his board, much the less his shareholders? Management cannot recover from this kind of failure. I expect the NYSE delists this stock very soon, and it will soon be near worthless after the shorts cover their positions when it opens on the Pink Sheets. $238 million of market cap will have been destroyed.

There is no evidence so far that the Chairman intended to rip off his shareholders. In fact, he probably suffers the worst from the destruction of market value. Instead, this is further evidence of the attitude some Chinese CEOs have towards shareholders. Too many Chinese CEOs think the company, especially if it is a VIE, is their own private company and they will do with it what they wish.

I was talking with a partner from a major investment bank the other day who said that she thought investors had become comfortable with the ViE structure. I observed that the structure works just fine until there is an issue, and then it always fails and the shareholders are wiped out. She told me that is the case with any Chinese company, whether there is a VIE or not. Investing in Chinese companies is all about whether you trust the executives. Fair enough.

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