U.S. and Hong Kong stock market regulators are demanding that Chinese companies provide investors more warnings about the risks of a legal structure commonly used to list those shares overseas.
The scrutiny follows some little noticed legal developments in China over the past 18 months that show the contracts behind the foreign listings may not hold up in court. It also casts a spotlight on the risks inherent in some of the world’s most sought-after investments just as Alibaba Group Holding Ltd. prepares for what could be the biggest foreign listing of a Chinese Internet company.
The U.S. Securities and Exchange Commission has pressed Beijing-based Baidu Inc. (BIDU:US), China’s No. 1 search engine, to make additional disclosures about its corporate structure, citing the potential for foreign owners to lose control.
Separately, the Hong Kong Stock Exchange added a requirement last month for companies that seek to list using the structure to obtain a legal opinion stating that their contracts don’t break rules or laws, and won’t be invalidated.
At issue are “variable interest entities,” or VIEs, which are used to circumvent the Chinese government’s restriction on foreign ownership of key industries. The VIEs give overseas investors both the economic gains and losses of the business through contracts rather than direct ownership. About half the Chinese firms listed in the U.S. use the structure, and Internet and financial companies are among those that have virtually no other way to comply with Chinese law.
Investors such as Gary Black, global co-Chief Investment Officer for Calamos Investments, said they have grown more cautious about such stocks.
“We continue to invest in VIEs selectively where there is a high return opportunity, where we’ve done our homework, and where we feel confident about management,” said Black, whose firm manages $27.8 billion in Naperville, Illinois. “Our level of scrutiny has increased. For example, we recently sent three members of our global investment team to China, where they met with several managements with VIEs we were considering.”
Even investors with a clear sense of the risks are in a bind, said Arthur Kroeber, Beijing-based managing director of GaveKal Dragonomics, who advises mutual funds and hedge fund managers on investing in China.
“On the one hand the structure is obviously risky, but on the other hand the best-performing stocks in the world this year have been the Chinese Internet stocks, all of which are VIEs,” Kroeber said. “So if you invest in them you take on more risk than you’d like, but if you don’t invest in them your returns will fall well short of your benchmark. Plus, investors are looking for ways to play the ‘rising Chinese consumer,’ and Internet stocks are really the only way to do it.”
The CSI Overseas China Internet Index has gained 76 percent this year, compared with a 24 percent return in the Standard & Poor’s 500 index. That performance is helping fuel a wave of offerings from Chinese companies to attract foreign investors, many of whom may not realize they are buying something other than a direct stake in the operation.
Among the most anticipated is Alibaba, which is considering a listing in New York and Hong Kong and says it doesn’t anticipate any problem meeting exchange requirements. Investors’ appetite for that deal won’t be damped by concerns over the structure, said Jim Oberweis, co-manager of the $188 million China Opportunities Fund, adding that an Alibaba listing would be the offering of the year.
Supreme Court Ruling
In two letters in June and August, the SEC pressed Baidu to discuss the impact of recent People’s Republic of China court and arbitration rulings on its business and its formal or informal talks with the Chinese government about the structure. The company was also asked to specify who owns its various VIEs.
The SEC’s initial letter, dated June 18, makes reference to two cases. In the first, China’s Supreme Court in October 2012 invalidated similar contracts meant to give control over a mainland holding company and an effective stake in Minsheng Banking Corp. to a foreign company, Hong Kong-based Chinachem Financial Services. The court ruled that the setup was improperly circumventing the law, saying it amounted to “concealing illegal intentions with a lawful form.”
In the other case, Shanghai’s arbitration board invalidated VIE agreements for an online gaming company over the same issue of “concealing illegal intentions with a lawful form,” according to Baidu’s response to the SEC dated July 2.
In its letter, Baidu said that Chinachem’s VIE structure was different and that neither the court ruling nor the arbitration panel’s decision created binding precedent under Chinese law.
After the second letter from the SEC in August, Baidu agreed to change its disclosure and add that it could lose control over the assets in its VIEs, including the right to use the well-known name baidu.com. The result would be a material adverse impact on its earnings and reputation, Baidu said.
Baidu continues to emphasize its strong management and distance itself from the cases identified by the SEC.
“The investment community has become more discerning,” Kaiser Kuo, Baidu’s director of international communications, said in an interview. “They understand there are good, well-structured companies and there are ones where risks are greater.”
Institutional investors have also tended to make distinctions between small Chinese companies and big ones with demonstrable businesses and a global reach.
‘Comfortable’ With VIE
Alibaba hasn’t chosen a venue or a timetable for a foreign listing, said John Spelich, vice president of international corporate affairs.
“We are comfortable that our VIE structures are and will be compliant with all relevant requirements for a listing in the U.S., H.K. or elsewhere,” he said.
For its new requirement, the Hong Kong Stock Exchange echoes some of the same language used in Baidu’s correspondence with U.S. regulators. Companies need a legal opinion stating that the VIE setup isn’t “concealing illegal intentions with a lawful form” and won’t be deemed invalid.
Concerns about VIEs erupted in 2011, when Alibaba transferred its online-payment business, Alipay, to a company controlled by Alibaba founder, billionaire Jack Ma. At the time, Yahoo! Inc. (YHOO:US) had a 40 percent stake in Alibaba, which in turn had a VIE relationship with Alipay. Alibaba said it made the transfer to comply with restrictions on foreign ownership of payment services. Yahoo’s shares tanked on the lost value.
In May 2012, Alibaba agreed to pay $7.1 billion for half of Yahoo’s stake. Under the deal, Alibaba will need to either buy back a quarter of Yahoo’s current stake or let Yahoo sell the shares at the time of an IPO. That settlement could be completed with an overseas listing by Alibaba.
Though Sunnyvale, California-based Yahoo and its investors are being compensated by Alibaba, other foreign investors have suffered losses in companies with the VIE structure.
In September, the SEC accused the former chairman and chief executive of ChinaCast Education Corp. (CAST:US) of stealing $41 million from investors. The SEC said the executive, Chan Tze Ngon, transferred almost all the money raised from the company’s IPO to a subsidiary he secretly controlled. The market value of the Hong Kong-based company plunged to less than $5 million after Chan’s and a former president’s misconduct was disclosed by the new management, from more than $200 million, the SEC said.
FAB Universal Corp. (FU:US), a media distribution company listed on the New York Stock Exchange, was halted Nov. 22 after the stock dropped 42 percent in four days following allegations it defrauded investors. Faruqi & Faruqi and at least three other law firms have filed suit seeking class-action status, after short sellers said that FAB inflated sales figures and that its VIE had secretly issued 100 million yuan ($16.5 million) in bonds.
A preliminary internal review uncovered “certain deficiencies” in internal controls, FAB said in a Dec. 10 statement in response to the allegations. One of FAB’s VIEs conducted a $16.3 million bond offering in China that wasn’t reflected in the financials, the company said, adding that it was planning to restate its financial statements for the second and third quarters of this year.
ChinaEdu Corp. (CEDU:US), a Beijing-based online education provider listed on Nasdaq, said on Oct. 17 that 28 percent of its VIE was frozen as part of a dispute over a loan with its nominee shareholder. The company said in a statement it doesn’t think the freeze will affect its operations.
“VIEs are doomed,” said Paul Gillis, a professor of accounting at the Guanghua School of Management at Peking University. “They work until you need them to work and then they won’t at any point you need to enforce the agreement because you can’t. There’s no evidence of anyone successfully enforcing a VIE.”
The Chinese courts have only recently begun to address the legality of VIEs -- also known as the “Sina structure” after Shanghai-based Internet portal Sina Corp. pioneered the tactic for a U.S. share offering in 2000. One of the earliest references by Chinese regulators to the structure was in an August 2012 decision by the Ministry of Commerce barring Wal-Mart Stores Inc. (WMT:US) from controlling value-added telecommunications services of online retailer Yihoadian through a VIE.
While remaining on the lookout for more court guidance on the corporate structure, investors such as Oberweis, the China Opportunities Fund (OBCHX:US) co-manager, continue to play down the concerns raised by Gillis.
“It’s part of investing in China,” Oberweis said. “You’re kind of stuck with it.”
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