Investor risk lurks in legal structure of China IPOs -lawyers

Sun Jun 23, 2013 12:59pm EDT

* Investor losses, court ruling highlight risks of VIEs

* Structure used by half of Chinese listings on NYSE, Nasdaq

* Legal questions cloud prospects for Chinese IPOs in U.S.

By Dena Aubin

NEW YORK, June 23 (Reuters) - As the U.S. market for Chinese stock offerings revives, some experts are warning that American investors could be left out in the cold if a company faces problems, due to an unusual business structure employed by many Chinese companies.

The structure, known as a variable interest entity, or VIE, is designed to let companies bypass Chinese government bans on foreign ownership in some business sectors.

A popular corporate form in Chinese IPOs, the VIE structure was used in this month's successful, $91 million flotation of Light-in-the-Box Holding Co Ltd, for instance. That IPO has richly rewarded investors, with the shares up 57 percent from their IPO price of $9.50, even after a steep decline recently amid a broad market selloff.

VIEs include several components: a Chinese business with a license to operate in a restricted sector; a foreign holding company; and a web of contracts meant to give outside investors control and access to profits, but not actual corporate ownership.

In practice, if things go wrong, foreign investors in a VIE may have few legal rights, a risk underscored by a ruling in October by China's highest court that has triggered fresh concerns among legal experts.

"These are extremely high-risk structures. ... Your lay investor has no idea that this is what they're invested in," said Jason Flemmons, a former U.S. Securities and Exchange Commission enforcement official.

"Even though you have agreements ... that are supposedly protecting investors, actually exercising those purported rights in the Chinese legal system would be virtually impossible," said Flemmons, now a senior managing director at FTI Consulting.

COURT RULING CAUSES CONCERN

China's Supreme People's Court ruled in October that certain contracts meant to "conceal illegal intentions" were invalid. The ruling involved the late Nina Wang, head of privately held Hong Kong property firm Chinachem, and contracts she used to invest in China Minsheng Bank.

The October ruling went largely unnoticed until recent weeks when concerns emerged that the decision could impact VIEs.

"To the extent a VIE contract structure is designed to circumvent the requirements of Chinese law, such contracts are void," said Steven Dickinson, a lawyer at Seattle-based law firm Harris & Moure and co-manager of the firm's China practice.

"Not voidable, void. It is as if they did not exist," he said.

Dozens of Chinese companies have come to the U.S. market as VIEs. VIEs are also used for Chinese listings in Canada, Hong Kong and Britain, and by some multinational companies for their Chinese operations, according to Paul Gillis, an accounting professor at Peking University in Beijing.

Investors have mostly brushed off VIE risks because China for years allowed major Internet companies such as Baidu and Sina Corp to operate with VIEs.

About half of China-based companies listed on the Nasdaq and New York Stock Exchange use VIEs, according to Fredrik Oqvist, an independent investment analyst based in China.

Their murky legal status reflects China's confusing mix of state control and market economy, experts said.

By leaving the issue in a legal gray area, China can attract foreign investment to bolster key sectors of the economy, while keeping the right to clamp down when it desires, experts said.

Lawyers said they do not expect a rash of legal challenges to VIEs. But on the rare occasions when VIEs are challenged, U.S. investors nearly always lose.

"I've yet to see a situation where shareholders have gotten their hands on Chinese assets in an adversarial situation," said Drew Bernstein, co-managing partner at accounting firm Marcum Bernstein & Pinchuk who works with China-based companies.

STRING OF TROUBLES

Ambow Education Holding, a Chinese education company using a VIE, was forced into liquidation earlier this month by investors who said its Chinese executive had blocked an investigation into alleged financial wrongdoing.

The Chinese founder denied the allegations and remains in control of the VIE. Liquidators "are in for a Herculean task in trying to liquidate and gain access to the assets," Oqvist, the independent analyst, said in a recent blog.

In 2010, investors lost control of the VIEs at online gaming company GigaMedia when its Chinese executive refused to give up the licenses and corporate seals.

In anther situation, Internet group Yahoo's shares tumbled in early 2011 after it learned that Alibaba, a Chinese e-commerce company in which it was a major shareholder, had terminated its VIE contracts and transferred a valuable asset to Alibaba's Chinese chief executive, Jack Ma. He defended the move and later settled his dispute with Yahoo over the matter.

The U.S. Securities and Exchange Commission has stepped up scrutiny of VIEs, raising questions in at least 140 letters to China-based companies since 2010, according to data from Audit Analytics.

ACCOUNTING ISSUE

VIE accounting is a concern, too. Under U.S. accounting rules, companies typically consolidate subsidiaries' results on the parent company's financial statements.

In a VIE structure, the Chinese business's results go on the financial statements of the U.S.-listed holding company. The argument is that VIE contracts are nearly the equivalent of ownership of the Chinese business by the U.S.-listed company.

But if the SEC were to decide a company's VIE contracts were a sham, it would likely demand that the Chinese business be taken out of the U.S.-listed company's results, lawyers said.

"That is the nightmare scenario," said Thomas Shoesmith, a partner at law firm Pillsbury who works on China transactions. Without the Chinese firm's assets, the balance sheet of the U.S.-listed company could essentially be zeroed out, he said.

Companies going public now are detailing the risks. Light-in-the-Box, for example, disclosed in its IPO documents that it could lose its license and be shut down if the government decides it does not comply with Chinese law.