Variable Interest En..es. Paul Gillis. Peking University

Transcription

1 Variable Interest En..es Paul Gillis Peking University 1

2 Our investors ask why we are shor.ng China, the fastest growing sector. It s the accoun.ng. Hedge fund manager 2

3 China s Capital Markets China s stock markets operated from 1891 to 1952 Reopened in Shanghai and Shenzhen in 1990 Ideological shiqs in 1993 and 1997 separated most SOEs from government By 1996 over half of small SOEs were private By 2002 private enterprise produced over half of GDP Entrepreneurs admiwed to Communist party in

4 China s Capital Markets Large SOEs began lis.ng in 1993 H- share in Hong Kong N- share on NYSE A- share + B share on Shanghai and Shenzhen Exchanges Medium and smaller SOEs Red chips in Hong Kong A- share on Shanghai and Shenzhen Exchanges 4

5 China s Capital Markets Private enterprises Generally blocked from China s capital markets un.l SME Board in Shenzhen 2009 ChiNext Growth Enterprises Board By 2009 private companies are 16% of market capitaliza.on Most private companies went overseas to list NASDAQ and NYSE most popular Hong Kong, Singapore, London and other exchanges less so Large number of small companies come to market through reverse mergers in the U.S. in late 00s. 5

6 VIEs in China Variable interest en..es refer to control of a corpora.on through contracts rather than ownership Term VIE comes from U.S. accoun.ng literature FIN 46 Consolida.on of Variable Interest En..es VIE was the an.- Enron rule, requiring consolida.on of off balance sheet financing en..es Chinese companies use the rules to allow consolida.on of companies that they do not own 6

7 Why are VIEs used? Avoid Chinese rules restric.ng foreign ownership in certain sectors Mainly internet, telecom, educa.on Avoid Chinese rules that require approval of overseas lis.ngs of Chinese companies Avoid Chinese foreign exchange controls Avoid tax on transfer of Chinese company to foreign lis.ng vehicle 7

8 Typical VIE structure in China Public Private Equity Founders Equity ownership Contractual relationship Public Cayman Holding International PRC Hong Kong Holding WFOE VIE 8

9 VIE agreements Five standard components Loan agreement Equity pledge agreement Exclusive consul.ng agreement Proxy vo.ng agreement Call op.on Meant to collec.vely mimic equity ownership 9

10 VIE agreements Loan agreement Normally between WFOE and founders/owners of VIE Used to capitalize the VIE Normal terms: personal loan, interest free, can be recalled Issues From foreign en.ty: SAFE regula.ons From WFOE: Business scope won t allow transfer Use of personal accounts: What happens if one of the account holders decides not to transfer the money? 10

11 VIE agreements Equity pledge agreement VIE owners pledge their shares as security for the loan agreement (some.mes also security against breaking the other VIE agreements) Meant to make sure the VIE owners cannot break the contracts without losing the business Establishes security for the investors Issues In regulated industries the agreement cannot be enforced without subs.tu.ng a permiwed en.ty Needs to be registered in order to be valid Historically very few allowed to register If company doesn t specifically state that they are registered assume unenforceable 11

12 VIE agreements Exclusive consul.ng agreement Establishes exclusive channel to extract money to the WFOE Can establish mul.ple channels such as: consul.ng, maintenance, technical services etc. Meant to mimic normal internal transfers Issues Transfer pricing What is market price? Can all profits be transferred? Tax inefficiency Fees extracted through agreement subject to addi.onal 5% business tax 12

13 VIE agreements Proxy vo.ng agreement Transfers the vo.ng rights to WFOE (or designated individuals) Allows the WFOE to effec.vely control appointments and decisions in the company Mimics control element of equity ownership Issues Are the decisions taken valid? Perhaps the most controversial part of the agreement Concern regarding foreign influence and control over internet industry 13

14 VIE agreements Call op.on Allows the WFOE to purchase the equity in the VIE Normally states this may be invoked at any point provided it s legal under PRC law Nominal purchase price, could be offset against the loan agreement Issues Impossible to invoke unless law changes Or op.on is transferred to local Need M&A approval? Probably denied if intent is to con.nue using VIE structure 14

15 VIE Risk Regulatory risk Shareholder alignment risk Tax risk 15

16 VIE Risk Regulatory risk PRC law declares contracts void if an illegi.mate purpose is concealed under the guise of legi.mate acts MIIT bans transfer of control or benefits from websites etc. to foreign interest (Baidu, Sina, Youku, Tencent ) GAPP specifically declares VIE- like contracts illegal in online gaming (Shanda, GigaMedia ) Contracts found unenforceable in ChinaChem (Supreme Court) and Gigamedia (Shanghai Arbitra.on) Debate about foreign influence in internet sector Alipay Buddha stee 16

17 VIE Risk Buddha Steel Set for IPO Used a VIE structure (restricted industry) Blocked by local government (Hebei province) What does it mean? Appears to be a one- off event Local governments can take a different view on enforcement from Beijing 17

18 VIE Risk Alipay Alipay was a WFOE, sold to Jack Ma and made a VIE Banking regulators banned Alipay s VIE structure (claimed) Jack Ma terminated the VIE agreements SeWlement for % of profit and cash in case of IPO What does it mean? Both Tencent and Baidu s.ll have the same service in a VIE Specific regulators can take a different view on enforcement from Beijing Very difficult to do an IPO for Alipay now. 18

19 VIE Risk Shareholder alignment risk VIE ownership Do the VIE owners interests align with investors? How much of the business is in the VIE? Incen.ves to align interests Issues What happens when the stock trades below cash? 19

20 VIE Risk GigaMedia The case Taiwanese online games company Operates with 3 VIEs.ed to one WFOE Removes former head of Chinese opera.ons Wang Ji Wang Ji refuses to give up control of the company and claims GigaMedia has no legal right to operate in the industry Holds on to official papers and stamps for VIEs and WFOE Equity pledge not registered Outcome GigaMedia suing Wang Ji in the PRC, Hong Kong, Singapore and the US Set up a completely new China opera.on from scratch (appears to be same setup) Wang Ji files a countersuit in the US claiming GigaMedia knowingly conducted their business in China illegally and mislead shareholders Shanghai arbitra.on panel rules against Gigamedia (contracts unenforceable) 20

21 VIE Risk Tax risk Some VIEs established to avoid tax on transferring opera.ng en.ty offshore Some U.S. listed Chinese companies have large con.ngent tax liabili.es for transferring the en.ty offshore. Transfer pricing between VIEs and WFOE Individual income tax and double taxa.on risk. VIE structure tends to be tax inefficient Services by WFOE which extract profits subject to 5% business tax on gross. Near impossible to extract profits from VIE other than through services. 21

22 VIE Sta.s.cs US- listed Chinese companies 97 companies, represen.ng 42% of total popula.on, use VIEs (survey in 2009) NASDAQ 53% of popula.on NYSE 29% of popula.on ASE 6% of popula.on Most are in business services (37), electronic and electric equipment (12), and educa.on (8) Reason for VIE 76 cited industry restric.on 5 cited lis.ng issues (MOFCOM/SAFE approval) 16 gave no valid jus.fica.on 22