“But he has nothing on at all,” said a little child at last. “Good heavens! Listen to the voice of an innocent child,” said the father, and one whispered to the other what the child had said. “But he has nothing on at all,” cried at last the whole people. That made a deep impression upon the emperor, for it seemed to him that they were right; but he thought to himself, “Now I must bear up to the end.” And the chamberlains walked with still greater dignity, as if they carried the train, which did not exist.
Hans Christian Andersen, The Emperor’s New Suit, 1837.
Ever since China opened up to the world in 1978, investors have fallen into the trap of treating China like a fairy tale. “China is different”, they say as they proceed to check their experience and logic at the border and accept claims that the normal rules that operate everywhere else in the world do not apply in China. Many have left China with their tail between their legs, having taken a terrible beating for making fundamental business mistakes.
Over the next couple of months, I intend to write a series of blog posts about a China phenomenon that I believe falls in that category. Based on data collected by Fredrik Oqvist, one of my star exchange students from Sweden, 77 out of 177 Chinese companies listed on the NYSE or NASDAQ use a unusual corporate structure known as a Variable Interest Entity, or VIE.
The term ‘variable interest entity’ (VIE) comes from FASB Interpretation No. 46R: Consolidation of Variable Interest Entities (FIN 46R). FASB Interpretations are part of US GAAP, and the VIE is a creation of accounting rules. FIN46R was the anti-Enron rule – designed to stop the use of off balance sheet entities that had led to the corporate crises of the early 2000s. FIN46R established new rules for when a company should be included in the consolidated financial statements of a group. For most companies, FIN46R was bad news, requiring them to bring back on the balance sheet certain off balance sheet debt. For Chinese companies, however, the rules opened up a whole new range of possibilities.
The accounting rules for when a company can be consolidated have been around a long time. Accounting Research Bulletin (ARB) No. 51 set forth the basic rule that a company is consolidated when ownership exceeds 50%; equity accounting requires picking up a share of earnings or losses when ownership is between 20% and 50%; and the investment is recorded at cost when ownership is below 20%. The rules focused on percentage of shares owned. The rules were tightened up in 1988 to force most the consolidation of most financing companies. Back in the 1980s and 1990s, companies found a way around these rules by routinely set up special purpose vehicles as a means to keep debt off the balance sheet. The idea was to avoid consolidation by having special purpose vehicles owned by corporate insiders (remember Andy Fastow?) or banks. This method of off-balance sheet financing came under significant attack after the collapse of Enron and the FASB responded in 2003 with FIN 46R which shifted the focus of the test for consolidation away from share ownership to the substance of who bore the risk and rewards of the company.
When private Chinese companies in the internet sector began to look to list early in the 2000s they quickly faced a big problem. Foreign investment in the internet sector was prohibited so the companies could not sell shares overseas. The Shanghai and Shenzhen exchanges were not an alternative because China was not at the time letting private companies list in China. So the entrepreneurs set up offshore companies, typically in the Cayman Islands, and made plans to list the offshore companies on NASDAQ. But in order to list overseas, the offshore holding company needed to be able to include the revenues and assets of the Chinese companies that actually ran the business in their financial statements. But since the offshore holding company did not (and could not) own the shares in those companies, accounting rules appeared to make this impossible.
Two of the first deals done were Sina and Sohu, both served by highly creative partners from PricewaterhouseCoopers who figured out how to solve the puzzle. They decided they could use the developing rules that were targeting off-balance sheet accounting to their advantage. Where their colleagues were carefully structuring financing transactions to keep special purpose vehicles off the balance sheet, they would have their clients deliberately fail every test that had been established to in order to keep companies off the balance sheet. The end result would be that they would be required (allowed) to consolidate the Chinese entities, even though the listed company owned no shares in them. They did this ahead of FIN 46, and its issuance in 2003 gave further support to their conclusions.
Following the Sina and Sohu offerings over 125 Chinese companies have listed on NASDAQ, with about half of them using a VIE structure. The great risk with the VIE structure is that the public company does not actually own the VIE and its operations. Instead it controls the entity through agreements. The lawyers often indicate that there is substantial uncertainty as to whether the agreements are enforceable in China. As a consequence, some commentators have said that “we avoid companies with VIE structures completely” and “China based companies with VIE structures are the single biggest time bombs in the U.S. markets”.
I plan to write two more blog posts about VIEs. In the next post I will explain how VIEs work and how they are used in China. We are seeing some clever uses of VIEs in recent years, with increased risk. The following post will discuss the accounting, tax and legal risks of VIEs. I think these risks are substantial, and I will explain some risks that have not been observed by other commentators. I may split these two posts into additional posts, since some of the topics are complicated. I am hoping to provide a more comprehensive analysis of VIEs and their use in China than I have been able to find.
In the end, I think you may agree with me that the Emperor has no clothes.