Are Chinese VIEs More Illegal Today Than They Were Yesterday, And What Might That Mean For Accounting?

• Posted by bbishop
• on October 11th, 2011

Yesterday’s post on variable interest entities (VIEs) generated an excellent discussion on China Hearsay and China Law Blog, two terrific blogs written by China lawyers. The China Law Blog combined their arguments with China Hearsay’s, so I will point readers to China VIEs. The End Of A Flawed Strategy. An Update/Rebuttal at the China Law Blog.

One of the commenters on the China Law Blog post is Peter Schloss, former CFO of Tom Online when it was listed on NASDAQ, now a director of NYSE-listed Giant Interactive ($GA). Schloss has a lot of experience with VIEs in China. He points out that while it is unlikely the government will negate existing VIEs, the worst case scenario for the listed China stocks that use a VIE structure would be that the underlying contracts are deemed invalid and those listed vehicles can no longer consolidate the revenue flowing through the VIEs, resulting in material declines to their revenues and profits. As Schloss writes:

One thing I have not seen you or any of your commentators discussing with regard to VIEs is the accounting issue that investors face, which is equally important as the legal issue. As you know, the VIE structure is not only a mechanism by which foreign ownership restrictions are avoided, but also a mechanism which has allowed entities that are not subsidiaries under PRC law (and US, Cayman and BVI Law for that matter) to be consolidated under US GAAP for income statement purposes pursuant to Fin. 46. Accordingly, there are really two issues at hand here: (1) the legality of the VIE structure under PRC law and whether the lack of a “clean” PRC legal opinion will impede VIEs from being listed on foreign stock exchanges, and (2) whether the SEC will continue to allow consolidation of VIE financials under Fin. 46 if the VIE structure continues to be questioned under PRC law. Without the ability to consolidate the financial performance of the operating entity that is actually controlled by PRC citizens (because of the VIE structure) the VIE structure is meaningless.

I have written that the VIE issue is overstated because the government will not negate existing deals, for several reasons including the fact that powerful interests have financial stakes in many firms using the VIE structure. What Schloss points out–that if US accountants and regulators now believe these deals are illegal then the firms can no longer consolidate the revenue–is a nuclear risk.

It would be be very ironic if that risk becomes reality, as the VIE structure, at least when it applies to the China Internet firms, has NEVER been technically legal. What some are saying has changed is that VIEs have now been officially deemed illegal, though no one seems to be able to provide definitive evidence of an official pronouncement of the illegality, or at least that this time the are more illegal than they used to be. My understanding is that the issue is still “being researched” by the Chinese government, likely because so many interests would be harmed by a more definitive judgement. As I wrote yesterday, it would be career suicide or worse for a Chinese bureaucrat to destroy this structure (or the economic benefits accrued through this structure) on a wholesale basis.

The professional services ecosystem–the lawyers, both Chinese and foreign, the accountants, and the bankers–have all worked together to perform legal and accounting gymnastics to give comfort to investors that the VIE structures were legitimate. And of course the US regulators like the SEC and industry watchdogs like the PCAOB have approved, at least tacitly, the use of VIEs, when anyone not playing the “wink wink nod nod” game knew that they were illegal and specifically designed to get around Chinese law. So the substance of what is going on has not changed, but now the regulators and the professional service providers are going to either drop the hammer on these firms or continue to allow them operate as is, with the likely addition of much scarier risk disclosures.

My bet is that the nuclear option of no longer allowing consolidation will not be triggered. Chinese Internet stocks such as Baidu ($BIDU), Tencent, Sina ($SINA), Netease ($NTES), Sohu ($SOHU) et al account for over $100B of market capitalization between the US and Hong Kong listed firms, all supported by the opinions of some of the top law firms and accounting firms in the world. The Chinese government is going to be wary of destroying so much domestic wealth embedded in these firms, the SEC does not want such a large market disruption, and the professional services firms have no interest in yet another massive and expensive China embarrassment.

So I am sticking with my argument that the VIE issue is overstated, and that if you are short China stocks because of it you should remember the adage that “pigs get slaughtered”.

If you still want more on this issue, I urge you to visit imeigu.com on Wednesday for an interview with Paul Gillis, one of the foremost experts on VIEs in China and the author of the very informative China Accounting Blog.

You can follow me @Niubi on Twitter, @Bill on Stocktwits and @Billbishop on Sina Weibo.

Related posts:

1. VIE Fears For China Internet Stocks Look Unwarranted
2. China VIEs. The End Of A Flawed Strategy. An Update/Rebuttal. : China Law Blog
3. Bloomberg Keeps VIE Fears Alive: China Companies Evading Rule With U.S. Listings Stump Regulators
4. China VIE Issue Overblown, Vice Premier Issues Directive To Recognize Existing Ones?
5. Reuters: China VIE Company Structure Under Threat

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

blog comments powered by Disqus