Tax Break

Problems at ChinaCast highlight issues with VIEs and Deloitte’s China challenge

April 3, 2012

More bad news on Chinese companies trading on U.S. markets came this week as education company ChinaCast announced it faces possible NASDAQ de-listing.

ChinaCast shares some interesting traits with other recent Chinese accounting headline-grabbers: the company is structured as a variable interest entity (VIE), there is a dispute between its (now former) CEO and its auditor, and that auditor is Deloitte.

Deloitte has in the past few weeks resigned from two Hong Kong-traded Chinese clients as well, and remains embroiled in a lawsuit with the Securities and Exchange Commission over the work papers in its audit of software maker Longtop Financial.

The VIE structure is something that worries some investors, as the people that control the entities which own the major business assets  have not always acted in the interest of the public company shareholders.

VIEs are  something that Paul Gillis, a  professor at Peking University’s Guanghua School of Management, and a member of the PCAOB’s Standing Advisory Group,  has been writing about quite a bit, including in his most recent post on ChinaCast:

Today the company reports that it is unable to resume normal operations because (former CEO Ron) Chan has taken the chops, business licenses, and accounting records of its Chinese subsidiaries. The company says Chan showed up at the office trying to assert control. We have seen this movie before – Gigamedia. ChinaCast also has a VIE, which is owned by three employees not including Chan. Will Chan be able to seize control of the VIE as well?  ChinaCast’s VIE had 24% of its revenue in 2010.

An “open letter” sent out by the board of ChinaCast, which replaced  Chan, outlines tensions with the auditors:

Ron Chan and his accomplices have refused to provide the necessary financial information so as to allow the Company’s auditors (Deloitte) access to the Shanghai offices in order to complete their field work and enable the Company to issue its 2011 audited financial statements within the time periods required by the SEC.  Additionally, this group of uncooperative managers has improperly declined to pay outstanding invoices for the services of Deloitte and various other outside advisors and service providers.

Chan has penned his own open letter in which he questions the board’s motives, and questions the company’s replacement of  X.Y. Jiang, who was president, China, for the company.  Mr. Jiang, Chan notes,  has been with the company for 11 years and is ” a partner holding 40% of the VIE company, CCLX. ”

VIEs are hard to find outside of China, but in the country they have been a popular way to take public companies which are in industries deemed to be vital to state interests, and therefore closed to direct foreign investment. Those industries include education and software.

As Gillis explains, VIEs control a company through contracts instead of through share ownership, a structure that is “often inferior” for investors, since it lacks many of the protections share ownership would confer.

The VIE is typically controlled by a small number of Chinese nationals. It transfers profits into the public company that shareholders own through technical service agreements.  Ideally, Gillis says, there is very little going on in the VIE.   “Situations where all of the operations are conducted in the VIE are at a higher risk of losing the entire business if the VIE owner decides to disregard the VIE agreement,” he wrote in a study he did last year with Fredrik Oqvist, a consultant who writes the China Finance blog.

That study found 146 VIEs listed on the NASDAQ and 78 listed on the New York Stock Exchange. A number of education companies had a large percent of  either their assets or profits in the VIE, they found.

Periodically concerns bubble up that the Chinese government may crack down on VIEs.

Despite the potential risks, they have provided a way for foreigners to invest in important demographic trends in China, like the rising demand for education by the swelling middle class, argues Michael Harris, a retired PricewaterhouseCoopers partner who is now a consultant with Beijing’s Gao Fei Consulting.

To Harris the key is that investors understand the structure. “A company may boast 400 centers, 50,000 pupils per year. You have to understand of course that you don’t own those 400 centers or control or even have access to the list of the 50,000 students,” he says. “You can’t own those. You have a contractual agreement with a PRC citizen, or citizens.”

Private equity investors and auditors in general are feeling skittish about VIEs, Gillis says, and he thinks 2012 will be the year they come in for some tough challenges, and not just at ChinaCast.

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