Bill Bishop over at Digicha has a post up: Chinese Groupon Clone Lashou Files for US IPO. Lashou's preliminary F-1 is interesting to me because of its expanded disclosures regarding its VIE arrangements. It is preliminary and could still change, but by the time they get to this stage they are pretty much done. This was the first public filing, but there were likely several confidential filings before this. It looks like it might have been a rocky process. The company was forced to restate all of its prior financial statements due to errors that were discovered, which is embarrassing to the accountants. James Zhang, CFO, was the audit committee chairman of alleged fraud Duoyuan Printing. Ernst & Young are the auditors for Lashou.
Many have wondered what the SEC was going to do after all the recent concerns over the VIE structure that have been raised. It is important to understand that the SEC is not responsible for approving the VIE structure. The SEC is responsible for making sure the risks of the offering are properly disclosed - not to evaluate the appropriateness of investors taking those risks. That is different than the role of Chinese regulators, who require lower levels of disclosure and tend to consider the appropriateness of the security as a prudent investment. I have been guilty of saying that U.S. listing requirements are looser than Chinese requirements. That is only true with respect to reverse mergers - otherwise they are just different.
Lashou even discusses the recent memo leaked from the CSRC about VIEs. It is dismissed because it is unclear whether the memo was actually submitted to the State Council (I doubt it was) and whether the State Council will actually do anything.
In the Lashou filing, we see the standard disclosures regarding overall VIE risk. That is, the lawyers first say that the VIE contracts are not illegal, and that they are valid and legally binding. Then they qualify that by saying there is substantial uncertainty and that the PRC regulators might not agree. That has been standard language for some time. Substantial uncertainty is a bad thing for investors, but the SEC has done its job making sure investors know that - if of course they read it.
Lashou also points out that Chinese laws prohibit foreign companies from investing in ISP or other value-added telecom businesses, so they control those businesses through a VIE. They then admit that MIIT rules prohibit a domestic company from transferring the ICP license to a foreigner in any form, or from providing any assistance, including providing resources, sites or facilities to foreign investors that conduct value-added telecom businesses illegally in China. Lashou waves off the issue by saying that "due to a lack of interpretive materials from the regulator, it is unclear what impact the MIIT circular might have on us or other Chinese Internet companies that have adopted the same or similar corporate and contractual structures as ours." That is the "everyone else is doing it" defense. Lashou points out that if the VIE agreements fall apart, a long list of bad things happen that would "materially and adversely affect our business, financial condition and results of operations." In other words, we would be dead.
Lashou refers to the recent MOFCOM M&A rules that say that the required security review of transactions cannot be avoided through the use of contractual arrangements (like VIEs). Lashou's defense against this rule is twofold. First the rules don't specifically say that online social commerce business falls in its scope and they did their deal before these rules came out so they should not apply to them anyway. The lawyers said that these rules are new and there is no assurance that MOFCOM would agree with the company's view. No kidding.
The list of potential problems goes on and on. The company says the transfer of shares by certain shareholders in 2010 and 2011 may be taxed under Circular 698, which taxes offshore transfers by PRC citizens. They could have transfer pricing problems with the VIE. The required SAFE registrations may not have all been done. The company failed to register its employee stock ownership plan. The company says it may have been required to get CSRC approval for the U.S. listing, which it didn't. I complained about this tendency of Chinese IPOs to ignore Chinese laws in my recent Wall Street Journal editorial.
The lawyers are doing their job even if their behavior seems more like the world's first profession than the second. The SEC is not responsible for evaluating these risks, rather only to make sure they are disclosed. The accountants, however, are in the tough spot. I see two problems with this offering. The first is whether the "substantial uncertainty" with respect to the legal risks rises to the level of "substantial doubt" as to whether the business is a going concern. The PCAOB pointed to this issue in their recent guidance on auditing in emerging markets.
The second issue relates to a more conventional use of going concern. Will Lashou actually have enough cash to continue operations? That seems like a silly question, given that the company has US$116 million in cash at June 30, 2011 and hopes to raise another $100 million. Its burn rate was $22 million for the six months to June 30, so they would appear to be safe here. Or are they? Lashou discloses that because of SAFE rules it may not be able to transfer any of the IPO proceeds to its operating companies in China. If that is a problem, how did they transfer the early PE funded rounds to China? The disclosures about where the cash is located and whether the company can freely use it within the group are woefully inadequate. On a positive note, Lashou discloses summary financial information about the VIE, something that I have been calling for.