此地无银三百两。 (This place no silver three hundred money).
In ancient times, a man called Zhang San had accumulated three hundred pieces of silver after a year of hard work. He was worried that his money would be stolen, so he put it in a wooden box and buried it in his back yard at the corner of his house. This did not completely ease his mind, so he posted a note on the wall saying: "Three hundred pieces of silver are not buried here."
His neighbour, Wang Er, had noticed the activity in the yard. At midnight he took all the silver. In order to deceive Zhang San, he added a note to the one on the wall saying: "Your neighbour, Wang Er, did not steal the money."
This is one of my favorite Chinese idioms and it has a lot of use in financial reporting. When management loudly claims that there is not a problem, the situation bears close examination and the problem is probably worse than thought.
I was surprised to read the latest financial statements from New Oriental Education & Technology Group (NYSE: EDU) and find a statement that is completely inaccurate. Here is the statement, from Note 1 of the financial statements:
In addition, the current sole shareholder of the New Oriental China is also a beneficial owner of the Company and therefore has no current interest in seeking to act contrary to the contractual arrangements.
The purpose of the statement is to support the consolidation of the VIE by indicating that Michael Yu, sole owner of the VIE, has no economic incentive to abrogate the VIE agreements since he also is an owner of the company. This is the moral hazard problem with VIEs. If there is an economic advantage to the VIE owner to abrogate the VIE agreements, it is perhaps more likely he will do so. If you don’t think this is possible, go ask some Yahoo shareholders what happened to their interest in Alipay.
Is there an economic incentive to Michael Yu, sole shareholder of EDU’s VIE, to abrogate the agreements? Of course there is. EDU earned $133 million in 2012. Michael Yu owns 17.8% of EDU, so his share of those earnings is $24 million. EDU’s VIE earned $159 million (EDU lost money in the public entities) and Michael Yu owns all of that. He would be 6.6 times better off by just taking the VIE and abandoning his stock in the public company.
The reason why this is the case is that EDU has an asset-heavy VIE. The entire business of EDU – at least all the profitable parts – is conducted in the VIE. Companies with asset-light VIEs have an incentive to keep the business together, since the public company cannot be operated without the VIE and the VIE cannot operate without the public company (Baidu is a good example of this). In the case of EDU, however, it would appear that the business could operate quite well, perhaps even better, without the public company and its wholly owned subsidiaries. There is no indication that Michael Yu is contemplating abrogating the VIE agreements, and if he tried to do so the company might convince a Chinese court that the agreements are enforceable. But to say that he has no economic incentive to do so is pure rubbish.