Tea Leaf Nation

A Glitch in the Cash Machine

There's a wrinkle to those hot Chinese tech IPOs. 

Investors, ready your wallets. In the past week, Sina Weibo, China's massive microblogging platform with 280 million users, and Alibaba, the operator of China's largest online marketplace which generated $1.84 billion in revenue in the fourth quarter of 2013 alone, have respectively filed for, and announced plans to file for, initial public offerings (IPOs) in the United States. The Weibo IPO is expected to raise as much as $500 million, while Alibaba's might top $15 billion, making it one of the biggest stock offerings in history. But as investment bankers busy themselves with counting zeros and investors lick their chops, few will pay much mind to a fundamental oddity in the companies' corporate structures with the potential to haunt their stock prices for years to come.

At first glance, Chinese tech IPOs look like win-win propositions: Global investors get to profit from China's incredible growth story -- particularly in the Internet sector, where total user have reached a stratospheric 618 million as of January 2014 -- while the firms get the money they need to fuel further growth. Indeed, Chinese companies listed in the United States have collectively outperformed the U.S. market lately. According to one index that tracks such companies, their share prices have gone up almost 70 percent in the past year, compared to 12 percent of the benchmark Dow Jones industrial average. But a problem is being swept under the rug: Their corporate structures are likely illegal under Chinese law, though the day of reckoning has yet to come.

It all starts with the fact that Chinese laws and regulations by and large prohibit foreign ownership in the Internet sector, one of many industries deemed sensitive or strategic to China's national interest, along with others like education, fisheries, gambling, and air traffic control. In order to have their cake and eat it too, the companies have to perform a legal abracadabra of sorts. Weibo's filing with the U.S. Securities and Exchange Commission (SEC) discloses a variable interest entity structure, or VIE, typical among Chinese companies listed in the United States. Chinese citizens form a VIE, but the VIE then signs multiple contracts with another company wholly owned by a foreign holding company, giving the latter full de facto control. Ideally, under this arrangement, the Chinese regulators treat the VIE as Chinese, while international investors feel comfortable that the VIE company will turn over most of its profits to the holding company. Presto.

This wasn't the purpose for which VIEs were intended. Paul Gillis, a professor at the Guanghua School of Management at the prestigious Peking University in Beijing, explained to Foreign Policy that a VIE is an accounting concept introduced after the October 2001 exposure of accounting tricks obfuscating U.S. energy company Enron's financial decay. VIEs were intended to ensure a company's financial statements accurately reflect debts incurred by entities that it controls. But Chinese companies have "flipped the rule on its ear," according to Gillis, by using the VIE structure to place assets of Chinese domestic entities onto the balance sheets of their overseas holding companies.

Fredrik Oqvist, the founder and CEO of consulting company ChinaRAI, which has built a database of Chinese VIE companies listed in the U.S., estimates that approximately half of the Chinese companies listed on the New York Stock Exchange and Nasdaq use this structure. But the switcheroo has fooled no one. Although Chinese regulators have mostly tolerated the transgressions, high profile snafus involving VIE companies have sometimes popped up to shake the markets. In May 2011, it was confirmed that Alibaba founder and Chairman Jack Ma, the owner of such a VIE entity, transferred assets out without informing Yahoo or Softbank, two major shareholders in Alibaba that also sit on its board. (Shortly after this revelation, Yahoo's share price took a huge hit, losing $2 billion in market value.) In August 2011, filings revealed that founder-owned shares of the VIE for Tudou, one of China's top online video sites, had became entangled in an ugly divorce, causing significant delays to the IPO and making plain that the Chinese courts had the final say on who owns the VIE, not foreigners.

If those signs are not clear enough, in June 2013, the Chinese Supreme Court ruled on a 10-year-old case, in the process invalidating a set of VIE contracts because they "circumvented Chinese laws and regulations." The Chinese Supreme Court's decision did not void or prohibit all VIE contracts, but the decision has prompted the SEC to require some companies with VIE structures, like Chinese search giant Baidu, to make more detailed disclosures in its filings.

If the enforceability of the VIE contracts is highly questionable, should the holding companies be allowed to claim that they exercise effective control over these operating entities? Sina Corp., which operates Weibo, did not respond to an emailed request for comment, while a spokesperson for Alibaba declined to comment. But Gillis believes that the SEC is "in a tough position," because it has to rely on Chinese lawyers for listed companies, who deem the contracts enforceable. Gillis describes the Chinese legal community as split on the issue, but adds that "the ones questioning enforceability are not the ones signing the opinions" that declare them enforceable. Oqvist agrees that a regulator like the SEC should perhaps request further disclosure by the companies' Chinese lawyers to give a better explanation of why they think the contracts are enforceable, "given the circumstantial evidence that they are not." Even Weibo's own IPO offering document notes, "There are very few precedents and little official guidance as to how contractual arrangements in the context of a variable interest entity should be interpreted or enforced."

Although the VIE structure is highly problematic, that doesn't necessarily impugn the Chinese companies that use it. Some of the most respected companies in China, serviced by major U.S. accounting firms, use the VIE structure. They do so to wrangle with China's sometimes-draconian foreign ownership restrictions in their sectors, not to dodge the financial or corporate governance requirements set out by the U.S. exchanges on which they list. And the VIE arrangements are clearly disclosed in the companies' public documents. In fact, Oqvist believes that if an investor avoided all Chinese companies with VIE structures, that person would not be left with "very many growth companies" to choose from.

Collectively, the companies that employ the structure may have become "too big to fail" anyway. But individually, each is vulnerable to the whims of the Chinese courts, regulators, or shareholders. Gillis believes Chinese authorities should "regularize" a system by which a Chinese company would receive foreign investment. "It is not in China's interest to have so much of its economy built on a potentially illegal structure," he said. 

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Tea Leaf Nation

China, We Fear You

A viral essay explains why many Taiwanese think their government is selling out to China.

On March 18, thousands of students began a sit-in of Taiwan's Legislative Yuan in the capital, Taipei, a historic first that has paralyzed the island's lawmaking body. Students have amassed to protest an attempt by the Kuomintang, the island's ruling party, to push through a trade pact with China. The Taiwanese government negotiated the pact, known as the Cross-Strait Service Trade Agreement (CSSTA), with its mainland counterparts and tried to push it through the legislature without debating the pact item by item. Sentiment against the CSSTA immediately reached a boiling point among many Taiwanese already anxious about the increasing influence of China, its neighbor, cultural cousin, and closest trade partner -- one that claims to have sovereignty over Taiwan. The essay below was written by a Taiwanese attorney, Richard Chiou-yuan Lu, and has gone viral on Facebook, Taiwan's social network of choice. Foreign Policy translates an edited excerpt, with permission.

Many people don't understand what the CSSTA says, so some protesters don't even know why they oppose it. No one in Taiwan dares to write in support of the pact because sentiment here has almost reached the point where anyone who dares to support the CSSTA is seen as a traitor. But could Taiwanese President Ma Ying-jeou really have been that flagrant in selling us out? If everyone believes that the agreement is bad for Taiwan, why did Ma insist on signing it?

Put simply, the CSSTA opens up cross-strait investment in the service sector. In the future, Taiwanese investors will have far more latitude in China to go into sectors like hospitals, publishing, tutoring, and banking. The same will be true of Chinese investors here. For Taiwanese financiers, the benefits absolutely outweigh the drawbacks. For average Taiwanese people, if they don't mind having a Chinese boss, there will be more jobs because increased investment in Taiwan will bring about more employment opportunities. 

In fact, according to the pact, China will open up more sectors to us (80) than we to them (64). If our legislature had voted on the agreement one provision at a time, it would not have been favorable for us, because the whole negotiation would need to be reopened. In renegotiation, it's unreasonable to expect China to let us insert yet more provisions that work for us but not demand something in return.

If the CSSTA were with any other country, it would be acceptable. If Japan's economy opened up to Taiwanese capital and Japanese companies were to set up branches here, and there ended up being Japanese people all over our streets, would that be so bad? Not for Japanophiles like me. But Japan would not give us these favorable terms because it would insist on equal exchange and not give an inch in negotiations. As economists say, there's no free lunch. Why should China act any differently?

Kids, we all know China "loves" us. They want us to return to the "motherland" as soon as possible. But first they have to seize our economy by its lifeline. If one day our convenience stores and supermarkets become Chinese-owned, the Taiwan Taxi company is renamed Chinese Taiwan Taxi, our bank and credit card records are sent to headquarters in Beijing, and directors of our top hospitals are replaced by Chinese, can we accept that?

The truth is, the Taiwanese companies that can afford to set up branches in China are large conglomerates, and those Taiwanese profiting the most from the CSSTA are tycoons and their families, not your family or mine. As far as Chinese companies are concerned, their investment in Taiwan is a drop in the bucket that won't affect their overall operations. And those Chinese companies are deeply influenced by their political system. If Taiwan were to hold a referendum on independence, the Chinese government might order its companies to cease operations in Taiwan. For example, our convenience stores would close and our taxi service would stop, assuming they had Chinese investment, and Beijing would have our credit card records and hospital records in hand. With such a scenario staring us in the face, could we still hold the referendum? 

This is not as far-fetched as it may sound. Something like this has already happened to our media when the Want Want Group, which has significant business in China, acquired the China Times, one of Taiwan's largest newspapers, in November 2008. People's Daily, China's widely reviled Communist Party mouthpiece, is probably better than what the China Times has become today.

The truth is that if the counterparty to the agreement were a country other than China -- or a democratized China that would treat Taiwan as an equal and stop trying to achieve its political agenda through business, and didn't want to swallow us up -- we'd happily accept the pact. Take the words from the above paragraphs and insert "Japan" or "the United States" in place of China -- there would be no issue. When Taiwan signed a free trade agreement with New Zealand in June 2013, the public wasn't out for blood then.

But why is it that when it comes to China, we won't give an inch? It's because we're afraid of you, China. Really. We're very afraid.

Translated by David Wertime and Rachel Lu

Photo: AFP/Getty Images