关于VIE的详细解释

博主注：此文转自并整理自http://www.chinaaccountingblog.com/。这是个意外的收获，没想到目前看到的关于VIE的最详细解释居然在这里出现！

PaulGillis(PhD & CPA, gillis@gsm.pku.edu.cn)isProfessor of Practice and co-director of the IMBA program at PekingUniversity's Guanghua School of Management. Dr. Gillis is a memberof the PCAOB's Standing Advisory Group. The views expressed in thisblog are his own and do not necessarily reflect the views of theBoard, individual board members, or the staff of thePCAOB.

Index

The emperor's new suit: VIEs in China

Explaining VIE structures

Are VIEs a going concern?

PRC challenge to VIE structures

Cleaning up the VIE sector

Statistics on VIE usage

First VIE IPO after Buddha Steel

The emperor's new suit: VIEs in China

Mar 9, 2011 6:15AM

“But hehas nothing on at all,” said a little child at last. “Good heavens!Listen to the voice of an innocent child,” said the father, and onewhispered to the other what the child had said. “But he has nothingon at all,” cried at last the whole people. That made a deepimpression upon the emperor, for it seemed to him that they wereright; but he thought to himself, “Now I must bear up to the end.”And the chamberlains walked with still greater dignity, as if theycarried the train, which did not exist.

Hans Christian Andersen,The Emperor’s NewSuit,1837.

Ever since China opened upto the world in 1978, investors have fallen into the trap oftreating China like a fairy tale. “China isdifferent”, they say as they proceed to check their experience andlogic at the border and accept claims that the normal rules thatoperate everywhere else in the world do not apply in China. Manyhave left China with their tail between their legs, having taken aterrible beating for making fundamental businessmistakes.

Over the next couple ofmonths, I intend to write a series of blog posts about a Chinaphenomenon that I believe falls in that category.Based on data collected by Fredrik Oqvist, one ofmy star exchange students from Sweden, 77 out of 177 Chinesecompanies listed on the NYSE or NASDAQ use a unusual corporatestructure known as a Variable Interest Entity, or VIE.

The term ‘variable interestentity’ (VIE) comes from FASB Interpretation No. 46R: Consolidationof Variable Interest Entities (FIN 46R). FASB Interpretations are part of US GAAP, andthe VIE is a creation of accounting rules. FIN46R was the anti-Enron rule – designed to stop the use of offbalance sheet entities that had led to the corporate crises of theearly 2000s. FIN46R established new rules for when a company shouldbe 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 offbalance sheet debt. For Chinese companies,however, the rules opened up a whole new range ofpossibilities.

The accounting rules forwhen a company can be consolidated have been around a long time.Accounting Research Bulletin (ARB) No. 51 setforth the basic rule that a company is consolidated when ownershipexceeds 50%; equity accounting requires picking up a share ofearnings or losses when ownership is between 20% and 50%; and theinvestment is recorded at cost when ownership is below 20%. Therules focused on percentage of shares owned. Therules were tightened up in 1988 to force most the consolidation ofmost financing companies. Back in the 1980s and1990s, companies found a way around these rules by routinely set upspecial purpose vehicles as a means to keep debt off the balancesheet. The idea was to avoid consolidation byhaving special purpose vehicles owned by corporate insiders(remember Andy Fastow?) or banks. This method ofoff-balance sheet financing came under significant attack after thecollapse of Enron and the FASB responded in 2003 with FIN 46R whichshifted the focus of the test for consolidation away from shareownership to the substance of who bore the risk and rewards of thecompany.

When private Chinesecompanies in the internet sector began to look to list early in the2000s they quickly faced a big problem. Foreigninvestment in the internet sector was prohibited so the companiescould not sell shares overseas. The Shanghai andShenzhen exchanges were not an alternative because China was not atthe time letting private companies list in China. So theentrepreneurs set up offshore companies, typically in the CaymanIslands, and made plans to list the offshore companies on NASDAQ.But in order to list overseas, the offshore holding company neededto be able to include the revenues and assets of the Chinesecompanies that actually ran the business in their financialstatements. But since the offshore holdingcompany did not (and could not) own the shares in those companies,accounting rules appeared to make this impossible.

Two of the first deals donewere Sina and Sohu, both served by highly creative partners fromPricewaterhouseCoopers who figured out how to solve the puzzle.They decided they could use the developing rules that weretargeting off-balance sheet accounting to their advantage.Where their colleagues were carefully structuringfinancing transactions to keep special purpose vehicles off thebalance sheet, they would have their clients deliberately failevery test that had been established to in order to keep companiesoff the balance sheet. The end result would bethat they would be required (allowed) to consolidate the Chineseentities, even though the listed company owned no shares in them.They did this ahead of FIN 46, and its issuancein 2003 gave further support to their conclusions.

Following the Sina and Sohuofferings over 125 Chinese companies have listed on NASDAQ, withabout half of them using a VIE structure. Thegreat risk with the VIE structure is that the public company doesnot actually own the VIE and its operations.Instead it controls the entity throughagreements. The lawyers often indicate that thereis substantial uncertainty as to whether the agreements areenforceable in China. As a consequence, somecommentators have said that “we avoid companieswith VIE structures completely” and “China basedcompanies with VIE structures are the single biggest time bombs inthe U.S. markets”.

I plan to write two moreblog posts about VIEs. In the next post I willexplain how VIEs work and how they are used in China.We are seeing some clever uses of VIEs in recentyears, with increased risk. The following postwill discuss the accounting, tax and legal risks of VIEs.I think these risks are substantial, and I willexplain some risks that have not been observed by othercommentators. I may split these two posts into additional posts,since some of the topics are complicated. I amhoping to provide a more comprehensive analysis of VIEs and theiruse in China than I have been able to find.

In the end, I think you mayagree with me that the Emperor has noclothes.

Explaining VIE structures

Mar 20, 2011 3:00AM

This posting will explainthe use of variable interest entities (VIEs) by U.S. listed Chinesecompanies. I have selected E-Commerce Dangdang,Inc. (NYSE: DANG), which listed on the NYSE late in 2010, as anexample of how the VIE structure is used. I haveselected Dangdang because it follows the archetypal model for VIEstructures, not because it has any higher or lower risks than othercompanies using VIEs.

Offshore holdingcompanies.Like most U.S. listed Chinese companies,the actual listed company of DangDang is a Cayman Islandscorporation. After the IPO, founders Peggy Yu andGuoqing Li controlled 44.1% of the voting power of the company.

Chinese companies that listin the U.S. mostly use a foreign incorporated company as the listedcompany. The exceptions are large former state-owned enterpriseslike PetroChina or China Life, which list the Chinese incorporatedparent company. The foreign parent companies are usuallyincorporated in the Cayman Islands because it is a favored locationfor offshore companies due to its tax-free status and establishedlegal system that is built on English law. Some companies have usedcorporations formed in the British Virgin Islands or the U.S. U.S.holding companies are usually a poor choice, since this brings thecorporate group into the U.S. tax net. Such arrangements areusually an accident of history – the foundershaving started the company in the U.S. or used a reverse mergerwith a U.S. shell company.

The usual way to prepare foran IPO would be to contribute the shares of the Chinese operatingcompany to the Cayman Islands company so that the Chinese companybecomes a wholly owned subsidiary of the Cayman Islands company.The big problem with that was that foreigninvestment is not permitted in the internet sector where Dangdangoperates. There are other problems related to foreign exchange andtaxes that I will cover in another posting. In order to list in theU.S. (or anywhere for that matter), it was necessary for the CaymanIslands corporation to be able to consolidate in its financialstatements the Chinese operations of Dangdang that were held by thefounders. The Cayman company also needed a way to get access to theprofits of the Chinese operations for the benefit of theshareholders. Since they could not simplytransfer the Chinese company to the Cayman Island holding company,they used the VIE rules to consolidate the Chinese operations byputting in place the archetypal VIE structure, as illustrated inthis chart from their registration statement:

VIEentities.Beijing Dangdang KewenE-Commerce Co. Ltd. (Dangdang Kewen) is a Chinese company that isowned by Dangdang’s founders, Peggy Yu Yu and Guoqing Li, who arehusband and wife. Because both shareholders areChinese citizens, Dangdang Kewen is permitted to hold the licensesthat are essential to the operation of Dangdang.Dangdang Kewen has a 100% owned subsidiary inWuxi.

WFOEentities.The Cayman Islandscorporation established a Chinese subsidiary, Beijing DangdangInformation Technology Co. Ltd. (Dangdang Information).Because this entity is 100% owned by a foreigncorporation, it is known in China as a whollyforeign owned enterprise (WFOE). DangdangInformation is not permitted to hold the necessary licenses tooperate the business, and is not permitted to sell audio and videoproducts in China. It does, however, conduct asignificant portion of Dangdang’s business in China, including ,for example, handling product procurement and fulfillmentoperations and operating warehouses. Ideally,Dangdang Kewen would also be a WFOE, but this is not permitted inthe internet sector. Dangdang Information has a99% owned subsidiary in Wuxi.

Agreements.The concept that underpins a VIE structure is that control isobtained through legal agreements rather than through shareownership. Taken together, the agreements areintended to provide Dangdang Information with substantially all ofthe economic benefits from Dangdang Kewen and the obligation toabsorb all of its losses. Dangdang uses five agreements to achievethis. These agreements are typical of most VIEstructures:

Loanagreement.The founders borrowed funds from DangdangInformation in order to capitalize Dangdang Kewen.By using Dangdang Information instead of theCayman Island parent to make the loan, the agreement is between twoChinese companies, avoiding the need to deal with the StateAdministration of Foreign Exchange.

Equity pledgeagreement. Thefounders executed an equity pledge agreement with DangdangInformation which pledges their shares in Dangdang Kewen ascollateral under the loan agreement and the other agreements.

Call optionagreement.The founders agree to sell Dangdang Kewento Dangdang Information at any time for the original capitalcontribution. The payment price can be offset against the loan.From a practical viewpoint, the option cannot beexercised unless at some point in the future China allows foreigninvestment in companies like Dangdang Kewen.

Technical supportagreement.Dangdang Kewen agrees to use DangdangInformation as its exclusive technical service provider includingplatform and technical support, maintenance and other services. Itis through this agreement that Dangdang extracts the profits ofDangdang Kewen. The transfer price that determines the amount ofthe charge for technical services creates tax risk, which I willdiscuss further in a later post.

Power ofattorney.The founders give a power of attorney toDangdang Information that gives it all the normal shareholderrights, including voting, attending shareholder meetings andfulfilling the call option agreement.

Operations.The registration statement of Dangdang does not provide details onhow it will operate, but there are some clues.The objective in any VIE structure will be tominimize the profits in the VIE. Residual profitsin the VIE cause problems because the ultimate transfer of theseprofits to the public shareholders is difficult and expensive.While VIE agreements typically require the VIE shareholders to turnany dividends over to the public company, any distributions to theVIE shareholders would be subject to individual income tax inChina, layered on top of corporate taxes already paid.

Companies with VIEoperations in China typically try to conduct as much of thebusiness as they can justify in the WFOE. InDangdang’s case, it appears that they intend to conductprocurement, fulfillment and warehousing activities in the WFOE(except for audio and video products that the WFOE is prohibited bylaw from handling). On top of that, the WFOE willcharge the VIE for a technical service charge to compensate fordeveloping and maintaining the internet trading platform. The idealsituation will zero out the profit of the VIE, resulting in all ofthe profits residing in the WFOE.

This posting has outlinedthe basic structure of VIEs using a typical example. There are somevariations on this structure that I will explain in futurepostings. In these postings I intend to present some of my researchon how VIEs are actually being used in China, and outline some ofthe more significant risks.

Are VIEs a going concern?

Mar 25, 2011 12:39AM

One of the cornerstones ofaccounting is the concept that a business is agoing concern.Financial statements are premised on theassumption that a business will continue to operate for theforeseeable future. That is important becausethe recovery of the value of the assets on the balance sheetusually is premised on their being used in the business and notsold at liquidation value.

Auditors are required toassess whether there is substantial doubt about a companies abilityto continue as a going concern. Ordinarily thisassessment centers around the issue of whether a company hassufficient resources to meet its obligations as they come duewithout a major restructuring. Auditors are tolook forward one year from the date of the financial statements inmaking this assessment.

When auditors conclude thatthere is substantial doubt about a companies ability to continue asa going concern, they are required to include an explanatorycomment in their opinion on the financial statements.That opinion is commonly referred to as a goingconcern opinion, and the issuance of such an opinion usually setsoff an alarm in the financial markets. Abankruptcy filing often happens withindays.

Most of the time, goingconcern issues arise when there is a question of whether thecompany will be able to raise enough cash during the succeedingyear to pay its bills when they come due. But therules go further than that. AU Section341The Auditor’s Consideration ofan Entity’s Ability to Continue as a GoingConcernsays that the auditor needs toconsider legal proceedings, legislation, or similar matters thatmight jeopardize an entity’s ability to operate. In other words, if the government might put you out of business,then you might not be a going concern.

That brings us back to VIEs.As explained in earlierpostings,U.S. listed Chinese companies frequently use VIEs to operate inChina. A VIE is an entity that is not owned bythe public company, but is allowed to be consolidated in thefinancial statements because it is controlled through agreements.The assumption that the U.S. listed company is agoing concern may rest on whether those agreements areenforceable.

Let’s look at this issue indetail, using the case of CNINSURE (NASDAQ:CISG).I am not picking on CISG – the language here istypical of most VIEs in China. When we go tothe20Ffiling for CISG,we find the following opinion of legal counsel about the viabilityof the legal arrangements surrounding the VIE structure:

“In the opinion ofCommerce & Finance Law Offices, our PRC legalcounsel:

• the ownershipstructures of Meidiya Investment and Yihe Investment, theirsubsidiaries and our subsidiaries in China comply with all existingPRC laws and regulations;

• the contractualarrangements among our PRC subsidiaries, Meidiya Investment, YiheInvestment, their shareholders and their subsidiaries governed byPRC law are valid, binding and enforceable, and will not result inany violation of PRC laws or regulations currently in effect;and

• the business operationsof our PRC subsidiaries, Meidiya Investment and Yihe Investment andtheir subsidiaries comply in all material respects with existingPRC laws and regulations.”

All fine so far.The agreements are valid, binding and enforceableand do not violate any laws or regulations. Thereis no going concern issue evident here. But then,CISG, like most companies using VIEs, adds thisqualification:

“We have been advised byour PRC legal counsel, however, that there are substantialuncertainties regarding the interpretation and application ofcurrent and future PRC laws and regulations. Accordingly, the PRCregulatory authorities may in the future take a view that iscontrary to the above opinion of our PRC legal counsel. We havebeen further advised by our PRC counsel that if the PRC governmentfinds that the agreements that establish the structure foroperating our PRC insurance intermediary businesses do not complywith PRC government restrictions on foreign investment in theinsurance intermediary industry, we could be subject to severepenalties including being prohibited from continuingoperation.”

Yikes! To paraphrase,“despite what they said, our lawyers have told us there issubstantial uncertainty about what they said and they might bewrong. If they are wrong we might be put out ofbusiness.”

I have not found a singleinstance of an auditor issuing a going concern opinion because ofthe substantial uncertainty surrounding the enforceability of theVIE agreements. Does substantial uncertaintyabout the enforceability of an agreement lead to substantial doubtabout a companies ability to continue as a going concern? It certainly has not in practice.They are not called ‘generally accepted auditingstandards’ for no reason. The approach ofignoring the ‘substantial uncertainty’ related to the VIEagreements in assessing ‘substantial doubt’ about the companycontinuing as a going concern has become ‘generallyaccepted’.

There appear to be two waysthat a VIE structure might collapse. The firstwould be an outright attack by the Chinese government.Many of the VIEs were constructed to circumventgovernment restriction on foreign investment in certain sectors.The government could simply prohibit anyagreement that transfers control, directly or indirectly of anycompany in prohibited industries to foreigners. Such an attackwould follow the Western concept of voiding contracts that arecontrary to public policy. I don’t think they are going to do that.Many of these companies bring significant benefitto China. Baidu, which uses a VIE structure, isconsidered China’s Google even though it is actually a CaymanIslands company. China has known about Baidu’sVIE structure for a long time, and if they wanted to shut this downthey could have already done so. In reality, theuncertainty of the VIE structure probably gives Chinese regulatorsextra leverage over these companies.

The other way a VIEstructure might collapse is if the legal owner of the VIE decidesto take his company back and breach the VIE agreements. This is unlikely to happen in most cases, sincethe legal owner of the VIE is also the majority shareholder, andtypically the CEO, of the listed company. But ifthe VIE owner were forced out of the public company, it is possiblethat he or she may choose to take the VIE with him/her. The publiccompany would then have to sue in Chinese courts to enforce theagreements. We will then learn how substantial the substantialuncertainty might be. I would not want to be in the shoes of aforeigner trying to sue a politically connected local businessmanin a provincial court for enforcement of an agreement that arguablycircumvented public policy. Several of the recentaccounting frauds of U.S. listed Chinese companies have used theVIE structure and we may soon get a chance to see how this scenarioplays out. Suppose the public company loses theclass action lawsuit that was filed against it after the disclosureof the fraud. The CEO might just decide toabandon the public company, particularly if he is facing furtheractions by the SEC. So he just takes theoperating company and goes off on his own, challenging theshareholders to sue him to enforce the VIE agreements. One caselike this would undermine confidence in any company using the VIEstructure.

Back to accounting.All of the disclosures about the risk of VIEs areincluded in the annual filing on Form 20F in the risk section. The filings also include the financialstatements, which appear on the “F” pages. Thefinancial statements are supposed to stand alone.Yet, I find no discussion in any financialstatements about the risks of VIEs. I encouragecompanies to expand the discussion of the VIE arrangements infinancial statement footnotes and include an assessment ofrisk.

PRC challenge to VIE structures

Apr 2, 2011 8:28AM

There is a significantdevelopment with respect to the use of variable interest entitiesin China. Buddha Steel, Inc. (OTCBB:AGVO) filedan8kon March 28, 2011reporting that it had terminated the agreements with its VIEsbecause local government officials in Hebei Province had informedthem that the agreements contravene current Chinese managementprocesses related to foreign invested enterprises and, as a result,are against public policy. Readers ofthisblogwill be awarethat the government holding VIE agreements invalid was one of thetwo ways I saw VIE arrangements blowing up. I wasnot aware of this case when I wrotethat.

The company also advisedthat their previously filed financial statements should not berelied upon. The company was in the process ofdoing a $38 million underwritten public offering that has now beenpulled. Obviously, the company is no longeragoingconcern.

Thomas M. Shoesmith ofPillsbury Winthorp Shaw Pittman LLP has an analysis of thissituation on the Pillsburywebsite.He speculates this might be a one-off eventdriven by local facts and circumstances. If not,investors in U.S. listed Chinese companies are in for quite aride.

Cleaning up the VIE sector

Apr 7, 2011 3:02AM

Buddha Steel, Inc.(OTCBB:AGVO) filed an8kon March 28, 2011reporting that it had terminated the agreements with its variableinterest entities (VIE) because local government officials in HebeiProvince had informed them that the agreements contravene currentChinese management processes related to foreign investedenterprises and, as a result, are against public policy. BuddhaSteel was in the process of doing a $38 million underwritten publicoffering that was pulled. The company announcedthat its financial statements should not be relied upon andannounced it would not file its 10K ontime.

Buddha Steel was organizedlike many U.S. listed Chinese companies, particularly those thatoperate in markets (like steel, internet, and education), that areoff limits to foreign investment. Buddha Steelwas a U.S. company that did a reverse merger with Gold Promise, aHong Kong company. The actual operating assets of Buddha Steel,however, were in a Chinese company, Baosheng Steel.Because Chinese law prohibits foreign ownershipof Baosheng Steel, it remained owned primarly by Buddha Steel’sChinese CEO and his family. Similar to manyother deals in industries restricted to foreign investment (andincreasingly in unrestricted industries) Baoshen Steel and the CEOentered into a series of agreements to effectively transfer controlof Baoshen Steel to Buddha Steel. Theseagreements allowed Buddha Steel to consolidate Baosheng Steel inits financial statements as a VIE.

This has becomethearchetypalformfor U.S. listed Chinese companies.This time, however, Chinese authorities in HebeiProvince stepped forward and stopped the deal.According to the company, the authorities saidthe agreements contravene current Chinese management processesrelated for foreign-invested enterprises and, as a result, areagainst public policy. When the government said the agreements wereillegal, Baosheng Steel can no longer be considered a VIE andcannot be consolidated in the financial statements. I speculate that the Hebeiofficials were not acting on their own, but rather with somecoaching from Beijing. I think this may be oneof the early Chinese reactions to the reverse merger scandals thathave been getting increased attention.

Chinese authorities lookedthe other way when the VIE structure was created to allow China’sinternet sector to develop with companies like Baidu, Sina, Sohuand DangDang, all of which use the VIE structure. It is doubtful that this sector could havedeveloped as successfully as it has if the rules restrictingforeign investment in these sectors were strictly followed.But now, scandals involving Chinese companiesthat have done reverse mergers to get on U.S. exchanges areembarrassing China. Embarrassing China rarelyends well for the offending party.

So where do we go from here?While this may be a case of “killing a chicken toscare the monkeys”, I would not be surprised ifany future attempts to put together VIE deals meet a similar fate.Companies have not usually asked permission before setting up VIEstructures – in fact the whole purpose of many of these structuresis to avoid the need to ask permission to set up offshorestructures. I expect Chinese officials willbecome more aggressive at killing these deals before they getgoing.

But what about the manyexisting U.S. listed Chinese companies that rely on the VIEstructure, including Baidu, Sohu, Sina, CNInsure, DangDang, Youku,Ctrip? When commentators have pointed out therisks of the VIE structures, investors have pointed out that ifthese structures are used by giants like Baidu, the risks must beminimal. Certainly China is not going to putBaidu, a critical component of China’s internet infrastructure (andwith a market cap of US$47 billion), out of business?

That is the type ofcontradiction that is so typical of China. CanChina use the rules to shut down embarrassing reverse mergercompanies without also taking down powerful companies like Baidu? The big internet companies have the sameagreements that were used by Buddha Steel. If theagreements violate public policy in the Buddha Steel case, whydon’t Baidu’s VIE agreements also violate publicpolicy?

I don’t think China willshut down most of the VIE companies anytime soon.The officials are too pragmatic to do that.But we have entered into a period of greatuncertainty. I am looking forward to reading howlawyers and accountants explain themselves out of this hole in theannual filings. The SEC will undoubtedly beasking some very tough questions.

How did we get into thismess? The problem is that China has made itdifficult for private companies to obtain capital at home.While the Shenzhen Exchange has become morefriendly to privately owned businesses in recent years, there is asubstantial backlog of companies hoping to list, and the listingstandards are higher than the U.S. Entrepreneursbeing entrepreneurs, they found ways around this problem by listingoverseas, but in order to do so they created the awkward, and nowarguably illegal, structure that is called a VIE. The VIE is only part of the problem.The whole structure of Cayman Island companies,listed in the U.S., but controlling operations in China, hascreated a morass that is undermining effective regulatory oversightof the companies. No wonder we are seeing so manyfrauds on the market.

The solution to this problemhas to come from China. For the financial marketsto operate properly, companies and investors cannot function underthe level of uncertainty that the Buddha Steel case inserts in thesystem. While China could just get tough andforce all of the companies using VIE structures to restructure intoChinese owned entities, that would cause a great deal of harm tothe companies, their shareholders and the Chinese economy.Instead, I think China should use this as anopportunity to regularize this sector. Here are my suggestions toChinese regulators:

1.Make it easier for Chinese companies to directly list overseaswithout using an offshore entity. Many companieshave chosen the VIE approach as a way of getting around cumbersomeChinese regulations.

2.Recognize the reality that there already is significant foreigninvestment in prohibited sectors, and find a way to regulate thisinvestment instead of pretending to prohibit it.Prohibition has not worked, and China needsentrepreneurial companies like Baidu, Dangdang, CTrip and AmbowEducation.

3.Bring the offshore structures back onshore. Encourage U.S. listedChinese companies with offshore parents to merge the offshorecompany into the Chinese operating company. Thiswill give China better regulatory control over these companies andit will give the shareholders real ownership of the operations.That is a good tradeoff for investors. China needs to develop rulesto make this possible.

4.Develop a regulatory structure that works for these companies, andwhich coordinates effectively with the SEC and PCAOB.

5.Create opportunities for U.S. listed Chinese companies to obtain alisting on Chinese stock exchanges. Let themarkets decide the best place for a Chinese company to obtaincapital, not regulatory barriers or even worse, the opportunity toavoid regulatory oversight. Think Baidu is hot onNASDAQ? Wait till you see what it does on ChiNext.

6.Use a carrot and a stick. Make it easy for firmsto regularize their operations, and then strictly enforce existingChinese laws on any companies that do not restructure.

Statistics on VIE usage

Apr 11, 2011 4:20 AM

I am pleased to turn theblog over to Fredrik Öqvist for this post.Fredrik was an exchange student from Sweden atPeking University last year and, like many exchange students (andmore than a few readers I bet), he has stayed on in Beijing. Anyonewho needs a good VIE analyst can drop Fredrik a noteat:freppas@gmail.com.

PaulGillis

In this post I will presentstatistics about the usage of variable interest entities (VIEs) byUS-listed Chinese companies. In preparing thisinformation, I have reviewed the annual SEC filings of 230 Chinesecompanies listed on the NYSE, NASDAQ and the ASE.I have not included any OTCBB companies in thisanalysis, although many of these companies also use the VIEstructure.

Table 1 illustrates that 42%of U.S. listed Chinese companies use the VIE structure.The VIE structure is used by more than half ofNASDAQ listed companies, with fewer companies on the NYSE and ASEusing this structure.

A separate analysis of 2010listings indicates that the use of VIEs is increasing.47% of 2010 NYSE listings (9 of 19) used VIEs,while 65% (10 of 16) of 2010 NASDAQ listings used VIEs.

Table 2 breaks down theusage of VIEs by industry, using two digit Standard IndustryClassification (SIC) codes. VIEs are used in abroad range of industries, yet they are highlyconcentrated in Business Services, hardly surprising since thiscode includes internet companies.

The use of the VIE structureis most apparent in industries that have restricted foreigninvestment. This makes sense, since the VIEstructure was invented to address the restrictions on foreigninvestment in the internet sector, but its use has spread toinclude companies in other industries that are restricted toforeign investment, such as education, financial services and realestate.

I examined the annualfilings for the companies using a VIE structure to determinewhether they explained why the VIE was used.Chinese prohibition against foreign investment inthe sector is the primary reason given. Fivecompanies, including four listed in 2010, cited restrictions onChinese companies listing abroad as a reason for the use of VIEs. This indicates that Chinese companies areincreasingly using the VIE structure to get around recent rulesrestricting offshore listings. Also, asurprisingly large number of companies failed to give any reasonfor their structure in the annual reports.

I also examined howcompanies using the VIE structure disclosed the risk that isassociated with the structure. Of companies withVIE structures, 81% (79 of 97) refer to a legalopinion that concludes that the VIE agreements are enforceableunder Chinese law. Of those reporting a legalopinion, 71% (56 of 79) report that there is substantialuncertainty about how Chinese courts and regulators might view theagreements. None have a going concernqualification related to this uncertainty in the auditors opinionon their financial statements.

Fredrik Öqvist

p.s.Over at theChinaHearsayblog, lawyer Stan Abrams haswritten an amusing and informative screen play aboutVIEs.

First VIE IPO after Buddha Steel

Apr 18, 2011 5:35AM

We may get a clue this weekas to what China really thinks about VIE structures. On March 28,2011,BuddhaSteelpulled a $38 million offeringthat was to land the RTO company on Nasdaq and also advisedinvestors not to rely on its financial statements after Hebeiofficials found its VIE agreements invalid.

Internet data centeroperator21Vianetisscheduled to debut on NASDAQ on Thursday, April 21, 2011.The company hopes to raise $138 million.The company uses thearchetypalVIE structurefor all of its operations- substantially the same structure that was used by BuddhaSteel.

What we will learn onThursday is whether the Buddha Steel case was a harbinger of thedemise of VIE structures or just an aberration.If the deal is allowed to go forward ( andassuming that Chinese officials are paying attention) it wouldappear that the Buddha Steel case may have been a local decision,or perhaps instead an initiative that was targeted atthescandalpronereverse takeovercompanies.

The risk disclosures on theVIE structure in the 21Vianetregistrationstatementare standard.There is no reference to the Buddha Steelsituation.

21Vianet is a good testcase. It has bulge bracket investment banks, white shoe law firms,and Ernst & Young. It is definitely not inthe same class as the RTO companies. So, if alast minute problem pops up on thislisting,Katy bar thedoor.

UPDATE:

21Vianet Group Inc. raised$195 million in itsIPOon Wednesday,selling more shares than planned at a price $2 higher thanoriginally proposed. There was no last minutesurprise from regulators about the VIE structure, despite thecompany being in the sensitive, and off limits to foreigninvestors, data center services business.

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