New Oriental Education and Technology Group (NYSE: EDU) dropped a bombshell in its fourth quarter earnings release this morning. The company reported that the SEC has issued a formal order of investigation captioned "In the Matter of New Oriental Education & Technology Group Inc." The Company believes that the investigation concerns whether there is a sufficient basis for the consolidation of Beijing New Oriental Education & Technology (Group) Co., Ltd., a variable interest entity of the Company, and its wholly-owned subsidiaries, into the Company's consolidated financial statements.
Investors are appropriately concerned. The stock is off 37% as I write this, with other companies with VIEs off by single digits. A formal investigation is far more serious than the normal comment letter process that usually deals with these kinds of issues. It means the Division of Enforcement of the SEC, rather than the Division of Corporate Finance is dealing with the issue.
On July 11 EDU announced it had restructured its VIE ownership. The VIE had been owned by a number of shareholders, some of whom are no longer active in the company. It is now held by an entity owned by Chairman Michael Yu. I don’t see anything wrong with that restructuring. The SEC investigation was launched on July 13. I doubt that the restructuring led to the investigation. I suspect that the company has been responding to the normal comment letters that the SEC Division of Corporate Finance issues to all companies periodically. Something may have gone terribly wrong in this process and the issue was referred to the Division of Enforcement, which launched a formal investigation. That is all my speculation, however.
I have written about my concerns over consolidation of VIES. I had planned to do a post using EDU as a case study to explain some of the major concerns I have about VIEs, but was waiting for EDU’s current financial statements. The SEC has beaten me to the punch.
I suspect that there are three issues that the SEC will focus on. First, EDU has legal opinions that say that the VIE agreements are in compliance with Chinese law and are enforceable. So does every other VIE, yet the opinions uniformly come with caveats that the Chinese courts might not agree and everything might fall apart. Some lawyers say these agreements are clearly not enforceable and violate Chinese laws and there has been some noise that Chinese regulators are unhappy with some of the lawyers who have issued opinions. This could be an area where the SEC and Chinese regulators are cooperating.
Second, EDU is an asset heavy VIE. In its last published financial statements, EDU reported that it had 62% of its assets and 97% of its revenue in the VIE. One of the requirements for consolidation is that the public company has an interest in the residual profits of the VIE. In the case of EDU, as is the case for most VIEs, the interest in residual profits is obtained through technical service agreements that allow the public company to extract the profits from the VIE through fees. Many VIEs do not appear to be making those fee payments, leaving all of the profits to accumulate in the VIE. That raises the question of whether the public company actually has an interest in those profits. If it does not take them out by following the VIE agreements, how does it plan to ever get those profits to the shareholders?
Third, the company may not have accrued taxes that would be payable if the payments from the VIE to the public company were made. The major reason for not making the payments in the first place is the adverse tax consequences. Any payments are subject to business tax at 5%. In addition, it is likely that tax authorities would disallow a deduction to the VIE for the payments on the basis that the value of services was not worth the amount of the payment. Nevertheless, the payment would remain taxable in the WFOE. This transfer-pricing problem could raise the effective tax rate to over 60%. The argument companies make for not accruing the tax is that they never expect to make the payments. The problem with that argument is that it undermines the basis for consolidation in the first place. I have a student who wrote his thesis on this topic and we plan to post a detailed analysis of this issue in the near future.
EDU announced the investigation in the same call as it announced its fourth quarter earnings. It said that Deloitte had not finished its audit of the accounts for the year ended May 31, 2012. Deloitte is in a real pickle here. They are already up to their eyeballs in trouble with the SEC, and if they sign off on these accounts they could be setting themselves up for more. Deloitte’s signoff, or refusal to do so, will be the first indication as to the seriousness of the SEC's challenge to consolidation.
What are the risks that this spreads to other companies? It is tough to say, since we do not know specifically what the SEC is focused upon. If Deloitte refuses to sign off on the May 31 numbers, then I expect it spreads very quickly. If instead, it is a company specific issue (such as an allegation of lying to the SEC) then the problem may be contained to EDU.