China's Forbidden Investment
Emerging Legal Risks for Investors Who Deal with Chinese Variable Interest Entity (VIE) Structures
Copyright 2012. All rights reserved.
Over the last decade, the number of Chinese companies listed on American stock exchanges has exploded. In 2010 alone, 38 Chinese companies went public in the U.S.—nearly a quarter of the IPOs in the U.S. that year. American stock exchanges are now home to some of the most influential companies in China today, especially tech- and Internet-based powerhouses like: Baidu (NASDAQ: BIDU), a Chinese language search engine that currently outranks Google as the most popular website in China; Youku (NYSE: YOKU), a leading Chinese Internet video provider, attracting 200 million unique visitors each month; and RenRen (NASDAQ: RENN), hailed as the “Facebook of China” among Chinese teens, with over 30 million registered users. Investors worldwide have embraced these U.S.-listed Chinese companies as a critical gateway into China’s rapidly developing economy and untapped market of more than 1.4 billion consumers.
This gateway owes its existence to an unusual legal structure forged under U.S. accounting rules called a “variable interest entity,” or VIE. Under the VIE structure, Chinese companies like Baidu are able to merge their financial “on the books” existence with U.S.-listed offshore holding corporations or shell corporations owned by foreign investors. Approximately 42% of the Chinese companies listed in the U.S. use the VIE structure. But this arrangement comes with a big catch: it violates Chinese law, putting foreign investors at great financial and legal risk. Investors are thus increasingly turning to the courts for relief from this risk. Of the 188 federal securities class actions filed in 2011, 33 involved lawsuits against U.S.-listed Chinese companies. American companies like Yahoo are also facing lawsuits over failed China-related investments based on the VIE structure. This litigation in turn has become another legal risk that investors must face when dealing with China’s “forbidden investment.”
This article provides a brief overview of: (1) the VIE structure and its pervasive use among Chinese companies to secure billions of dollars in foreign investment; (2) recent developments that indicate the doubtful legal viability of the VIE structure; and (3) the litigation strategies that investors are now adopting to redress this reality.
The VIE Structure and How It Enables Foreign Investment in Chinese Companies
The “variable interest entity” (VIE) structure officially came into existence under U.S. accounting rules in January 2003, when the Financial Accounting Standards Board (FASB) issued accounting guideline FIN 46R. The purpose of FIN 46R was to end the kind of fraud that Enron committed during the early 2000s by using off-“balance sheet” legal entities to hide its many financial liabilities. FIN 46R therefore required American companies to consolidate into their financial statements the net assets, liabilities, and activities of all their “variable interest entities”—that is, any legal entity whose business conduct put most of its returns or most of its risk-of-loss into the hands of an American company, even if the American company did not control the entity through a majority voting interest. In short, under FIN 46R, American companies could no longer pretend they did not own the financial liabilities of their VIEs. However, FIN 46R also meant American companies could take financial credit for VIE assets they did not actually own.
This rule opened the door to a flood of Chinese companies that wanted to list on American stock exchanges but could not without violating the strict ban imposed by China on foreign ownership in certain economic sectors such as telecommunications and the Internet. Indeed, the VIE structure let companies like Baidu enter U.S. exchanges as the sum of: (1) a wholly Chinese-owned operating company licensed to do business in China (“OpCo”); and (2) an offshore holding company or shell company (“HoldCo”) subsidized by foreign investors. While Chinese law prohibits the HoldCo from directly owning shares of the OpCo, the HoldCo can nevertheless contract with the OpCo in a way that gives the HoldCo near total control over the OpCo. Such virtual ownership may be conveyed in particular through loan agreements, equity pledge agreements, call option agreements, technical support agreements, and power-of-attorney agreements between the OpCo and either the HoldCo or a “Wholly Foreign Owned Enterprise” (WFOE) created by the HoldCo under Chinese law. Then, since these legal agreements put a majority of the OpCo’s revenues and losses into the HoldCo’s hands, the HoldCo can treat the OpCo as a VIE and consolidate the OpCo’s assets (e.g., licenses, facilities, etc.) onto the HoldCo’s balance sheets. The HoldCo can also effect a “reverse merger” with the VIE for IPO purposes (i.e., a shell company consuming its parent).
Accordingly, the VIE structure has bestowed considerable benefits on U.S.-listed Chinese companies—and not just in terms of providing access to billions of dollars of once inaccessible foreign capital. IPOs that involve “reverse mergers” do not require a formal underwriting process and the prospectuses for such IPOs are not reviewed by the SEC. Hence, the time and expense of a reverse merger IPO is significantly less than that of a traditional IPO. According to industry estimates, a U.S. “reverse merger” can occur in three months and cost just $1 million in fees. By contrast, Chinese companies trying to get listed on Chinese or Hong Kong stock exchanges must contend with long waiting periods and major financial hurdles (e.g., cash flow thresholds, profitability requirements, etc.). As a result, in 2010, more than 42% of Chinese companies listed in the U.S. were using the VIE structure, and between January 2007 and March 2010, 159 of the 215 Chinese companies that listed in the U.S. did so through reverse mergers. These companies included Chinese technology and Internet giants such as Baidu and Youku, whose IPOs respectively rose 354% and 161% on their first day of trading alone.
Recent Developments Indicate the Doubtful Legal Viability of Chinese VIEs
While U.S.-listed Chinese companies have benefited significantly from their use of the VIE structure in recent years, they have also exposed investors to considerable (and often undisclosed) legal and financial risks. These risks derive from the basic reality that when investors buy shares of U.S.-listed Chinese companies like Baidu and Youku, they are not assuming direct ownership of a value-generating Chinese operating company—instead, they only control an offshore holding company or shell company whose entire viability hinges on the soundness of its contracts with its Chinese operating company counterpart under the VIE structure. As the following recent developments indicate, however, these VIE contracts may not even be worth the paper they are written on.
1. Unenforceable Contracts. At first glance, the VIE structure might seem like a perfect way to bypass China’s ban on foreign investment in certain economic sectors: it allows foreign investors to profit from a Chinese company without ever owning a single share of it. Yet, this presumes that the legal agreements that underlie the VIE structure are valid under Chinese law—an assumption severely undercut by Article 52 of China’s Contract Law, which states a contract is void when “a lawful form is used to conceal an unlawful purpose.” The whole VIE structure thus appears to violate Chinese law to the extent its main purpose is to conceal foreign investment in forbidden sectors. This exposes foreign investors to the risk that Chinese VIEs may readily breach their contracts with their U.S.-listed counterparts if this serves the VIE’s interests, because Chinese courts will not enforce these contracts against the VIE anyway. This scenario is what happened to Gigamedia, a U.S.-listed Taiwanese video game company that acquired control of an online game company, T2CN, that in turn controlled two Chinese VIEs. In early 2010, Gigamedia fired the Chinese executive who ran T2CN, but the executive refused to surrender his personal ownership of the Chinese operating licenses for the VIEs—licenses essential to Gigamedia’s business in China. Gigamedia has yet to recover the licenses despite suing the executive in multiple jurisdictions including China.
2. Chinese Clampdown. Even if a Chinese VIE faithfully honors all of the legal agreements it has made with its U.S.-listed counterpart, foreign investors are not off the hook. Given the essential invalidity of the VIE structure under Chinese law, foreign investors are still faced with the reality that Chinese regulators can at any time decide to shut down a particular VIE or ban all VIEs. Of course, China has generally acquiesced to the proliferation of the VIE structure within its economy over the last decade, with Chinese authorities not reviewing or requiring approval of VIE arrangements. Several recent government actions, however, indicate that foreign investors can no longer take such acquiescence for granted. In March 2011, local authorities in the Heibei Province scuttled Buddha Steel’s plans to go public in the U.S. through a “reverse merger” with its Chinese VIE, a steel plant in the province. The local officials told Buddha Steel that its VIE contracts with the plant violated Chinese law on foreign investments, leading Buddha Steel to terminate the contracts and the IPO. China’s Ministry of Commerce (MOFCOM) recently voiced the same conclusion through its adoption of a new national security review policy on mergers and acquisitions effective September 1, 2011. Article 9 of this policy bans the use of “contractual controls” as a way to bypass China’s bar on foreign investment in certain sectors. MOFCOM has also announced it is considering other potential limits on VIEs, and a leaked memo from the China Securities Regulatory Commission (CSRC) indicates this agency’s desire to mandate Chinese companies first get MOFCOM and CSRC approval before using the VIE structure to list overseas.
3. American Clampdown. Chinese officials are not alone in their doubts about the legal viability of the VIE structure. In September 2011, SEC Enforcement Director Robert Khuzami announced that the U.S. Justice Department was actively investigating financial irregularities at several U.S.-listed Chinese companies. This announcement follows a series of fraud accusations against and auditor resignations from dozens of U.S.-listed Chinese companies since early 2011. Consider China MediaExpress (“CME”), China’s largest television mobile-advertising operator whose listing on NASDAQ in 2009 occurred through a “reverse merger” that received no formal underwriting or SEC review. In January 2011, Forbes China ranked CME the #1 small-to-mid-sized company in China with “the most potential.” In February 2011, allegations surfaced that CME was fraudulently inflating its revenues. On this news and a later securities class action lawsuit, CME’s stock price dropped 48%. Then, in March 2011, CME’s independent auditor Deloitte Touche Tohmatsu resigned, with Deloitte publicly declaring “it was no longer able to rely on the representations of management.” NASDAQ suspended CME from trading in April 2011 and decided to fully delist CME in December 2011.
Unfortunately, the story of CME is not unique: since February 2011, more than 40 U.S.-listed Chinese companies have reported accounting irregularities or have been forced to halt trading because of suspected irregularities. This has led the SEC in turn to become more involved in the lifecycle of U.S.-listed Chinese companies. Thus, in June 2011, the SEC issued a bulletin to investors about “instances of fraud and other abuses involving reverse merger companies.” The SEC has also sent comment letters over the last two years to several major U.S.-listed Chinese companies (e.g., Shanda Interactive Entertainment Ltd., Konzhong Corp., Sino Assurance, Inc.), attempting to learn more about these companies’ VIE structures. The Public Company Accounting Oversight Board (PCAOB) has further built on this initiative through its own reports exposing the poor auditing standards that surround Chinese VIEs. Taken together, these efforts tend to reflect SEC Commissioner Luis Aguilar’s recent declaration that “[w]hile the vast majority of [U.S.-listed Chinese companies] may be legitimate businesses, a growing number of them have accounting deficiencies or are outright vessels of fraud.”
Litigation Strategies Enabling Investors to Redress the Risks of Chinese VIEs
Given the multitude of frequently undisclosed—if not financially devastating—risks proliferating among U.S.-listed Chinese companies of late, investors are increasingly turning to the courts for relief. Of the 188 federal securities class action lawsuits filed in 2011, 33 involved lawsuits against U.S.-listed Chinese companies. American companies like Yahoo are facing similar suits due to their loss-producing entanglements with Chinese VIEs. But since most U.S.-listed Chinese companies have little or no assets in the United States, the scope of recovery afforded by lawsuits against these companies is generally limited to these companies’ directors and officers (D&O) insurance policies. This has led some investors to engage a new target: the global financial firms whose auditing or underwriting allowed U.S.-listed Chinese companies to obtain their listings in the first place. Hence, in one of the first securities class actions filed this year, a shareholder of Camelot Information Systems—a U.S.-listed Chinese IT firm—sued not only Camelot, Camelot’s officers, and Camelot’s directors, but also the underwriters behind Camelot’s IPO, including Goldman Sachs, Barclays Capital, and Oppenheimer & Co. Although it is far too early to predict how successful these auditor and underwriter-targeted suits will be, investors are proving they can advance suits and obtain relief against U.S.-listed Chinese companies in federal district courts.
1. Bringing Suit. As the number of securities class actions against U.S.-listed Chinese companies in American courts continues to rise, investors are generally relying on Section 10(b)—and its implementing regulation, SEC Rule 10b-5—under the Securities Exchange Act of 1934, Sections 11 and Section 12(a)(2) of the Securities Act of 1933, and their corresponding “control person” liability sections (Section 15 or Section 20(a)).
The use of Section 10(b) may be seen in cases like Henning v. Orient Paper, Inc., No. 2:10-cv-06887-VBF-AJW (C.D. Cal. 2011), where shareholders sued a Chinese paper products company, Orient Paper, that obtained its NYSE listing through a reverse merger with a previously listed shell corporation. The Section 10(b) claim raised in this case encompasses a broad number of “false and misleading statements” that Orient Paper allegedly made in its SEC 10-K Reports--statements that hid extensive self-dealing by the company’s CEO, inflated revenues based on non-existent customers, and the retention of an independent auditor that had already been disbarred by the PCAOB. But this Section 10(b) claim also takes direct aim at Orient Paper’s use of the VIE structure itself in terms of alleging that Orient Paper used its 2008 10-K Statement to mislead investors into believing that Orient Paper owned its Chinese VIE counterpart, when the Chinese VIE was actually owned by Orient Paper’s CEO and Orient Paper only had a contractual right to 80% of the VIE’s profits. The claim does acknowledge that Orient Paper mentions this VIE contractual arrangement in its 10-K, but emphasizes that this disclosure was “buried . . . in the bowels of [the] 10-K” while Orient Paper continued to assert to public investors through press releases and SEC filings that it was a “holding company” for the Chinese VIE and the Chinese VIE was an entity that Orient Paper had “acquired.”
Section 11 and 12(a)(2) claims are found in In re Agria Corp. Securities Litigation, No. 1:08-cv-03536-WHP (S.D.N.Y. 2009), which involved claims against Agria, a U.S.-listed Chinese holding company (NYSE: GRO) that developed agricultural products for sale in China through a Chinese VIE called Primalights III Agricultural Development Co. (“P3A”). Agria conducted its IPO in November 2007, raising over $282 million. But in April 2008, Agria reported to that it likely would not be able to file its 10-K Annual Report on time, due in part to the sudden resignation of its COO—an event precipitated by a protracted compensation dispute between Agria’s CEO and COO. Agria’s share price collapsed and Agria’s shareholders sued, alleging that Agria’s IPO Registration Statement mislead investors by representing that Agria’s VIE structure allowed Agria to “exercise effective control over P3A.” Agria’s control over P3A, however, rested entirely on the goodwill of P3A’s four shareholders, one of whom was Agria’s COO—and Agria never disclosed in its registration statement that Agria’s CEO and COO were fighting over executive pay issues, thus gutting Agria’s ability to effectively control P3A.
Finally, the control person liability claims are primarily asserted against the directors and officers of failed U.S.-listed Chinese companies. But given that many of these directors and officers are Chinese citizens—and Chinese courts are generally unwilling to enforce U.S. judgments against Chinese citizens—investors are also suing the auditors and underwriters that enabled the proliferation of the VIE structure and U.S.-listed Chinese companies in the first place. For instance, in Munoz v. China Expert Technology, Inc., No. 1:07-cv-10531-AKH (S.D.N.Y. 2007), the shareholder-plaintiffs amended their Section 10(b) claims four times against a U.S.-listed Chinese company’s outside auditors—PKF New York and BDO McCabe—before a federal district court finally found these claims were plausible enough to survive the auditors’ motion-to-dismiss. Investors are also hoping to recover from American companies like Yahoo that failed to fully disclose their close association with U.S.-listed Chinese companies with risky VIE structures. Indeed, in a securities class action filed in 2011, Yahoo shareholders allege that Yahoo failed to disclose and to mitigate the risks posed by Yahoo’s $1 billion stake in Alibaba Group Holdings—a Chinese investment holding company whose extensive use of the VIE structure enabled Alibaba’s CEO to transfer Alibaba’s most valuable asset, online payment processor Alipay, out of Yahoo’s control, thus devaluing Yahoo’s stake in Alibaba along with Yahoo’s share price.
2. Avoiding Dismissal. The securities class actions that have been filed against U.S.-listed Chinese companies over the last few years are enjoying mixed success, as federal courts grapple with the difficult legal (and often jurisdictional) issues raised by these suits. These issues range from whether investors have explained their securities fraud claims with enough particularity, to whether certain investors have “standing” to sue for relief at all. Accordingly, investors have been dealt setbacks in recent cases like Katz v. China Century Dragon Media, Inc., No. 2:11-cv-02769-JAK (C.D. Cal. Nov. 30, 2011), where a California federal district court dismissed (without prejudice) Section 11, 12, and 15 claims brought by shareholders against China Dragon, a U.S.-listed Chinese seller of advertising on Chinese television. China Dragon’s profits derived solely from contracts between China Dragon’s “wholly owned foreign enterprise” in China and a Chinese VIE. China Dragon’s American shareholders accused the company of inflating its revenues in its IPO while providing accurate figures to Chinese authorities. The court found the Section 11 and 12(a)(2) claims at issue lacking, since the shareholders failed to explain why the difference in financial results was not simply the result of differences between Chinese and U.S. accounting principles).
But cases like China Century Dragon Media may prove more the exception than the rule, as federal courts begin to green-light greater numbers of class actions against U.S.-listed Chinese companies and their outside auditors. Examples of this emerging trend include Munoz v. China Expert Technology, Inc., No. 1:07-cv-10531-AKH (S.D.N.Y. July 18, 2011), discussed above, and Henning v. Orient Paper, No. 2:10-cv-05887-VBF-AJW (C.D. Cal. July 20, 2011), where a California federal district court found shareholder-plaintiffs’ Section 10(b) fraud claims had been plead with more than enough particularity to defeat a joint motion-to-dismiss filed by defendants Orient Paper, its officers, and its outside auditor. Finally, there is In re China Education Alliance Securities Litigation, No. 2:10-cv-09239-CAS-JC (C.D. Cal. Oct. 11, 2011), where another California federal district court let Section 10(b) claims proceed against a U.S.-listed Chinese company where the shareholder-plaintiffs had “adequately allege[d] that [the company’s] SEC filings are demonstrably higher than its Chinese filings.”
3. Brokering Settlements. A track record of settlement is quickly beginning to develop among securities class actions against U.S.-listed Chinese companies. Consider In re Agria Corp. Securities Litigation, No. 1:08-cv-03536-WHP (S.D.N.Y. 2009), where shareholder-plaintiffs settled both their Section 11 and 12(a)(2) claims for $3.75 million from all defendants. Or consider Murdeshwar v. SearchMedia Holdings Ltd., No. 1:11-cv-20549-KMW (S.D. Fla. 2010), where shareholders-plaintiffs’ raising Section 10(b) claims for accounting misstatements have reached a tentative partial settlement of $2.75 million with SearchMedia Holdings—a U.S.-listed Chinese provider of billboard and in-elevator advertising that originally received its U.S. listing through a reverse merger. Both the Agria and SearchMedia settlements are being paid for almost entirely by each company’s D&O insurance policies. It is still too early to speculate, however, how far this trend will go. As the Financial Times has reported, while American investors have brought several dozen suits against U.S.-listed Chinese companies in recent years, only 13 have settled as of June 2011. It also remains unclear what settlement possibilities exist for investors in their class action suits against the global financial firms responsible for independently underwriting or auditing U.S.-listed Chinese companies.
Although there are procedural difficulties in bringing these claims, some plaintiffs have been successful in overcoming them. In Perry v. Duoyuan Printing, No. 10-cv-07235 (S.D.N.Y. 2011). shareholder-plaintiffs filed suit in New York federal district court against U.S.-listed Chinese company Duoyuan Printing for securities fraud, but they have been unable to serve papers on five of the company’s directors and officers now residing in China because Duoyuan has failed to turn over the personal addresses of these executives. But in the case of In re LDK Solar Securities Litigation, No. 07-cv-05182 (N.D. Cal. 2008), the court permitted shareholder-plaintiffs suing U.S.-listed Chinese company LDK Solar to sue LDK’s China-based officers by serving these officers through LDK’s U.S. office. The lawsuit has since survived a motion to dismiss and produced a $16 million settlement for the shareholder-plaintiffs.
For Chinese companies looking to enter the U.S. economy without running afoul of Chinese bans on foreign investment, the VIE structure has proven a remarkable boon. But investors have since been stuck with the bill for this legal misadventure, and litigation may ultimately constitute their best hope for recovering from the present and ever-burgeoning risks now clearly posed by China’s “forbidden investment.”
POSTSCRIPT -- 5/9/2012
The financial and legal risks of U.S.-listed Chinese companies using the VIE structure continue to resound in American markets with the recent announcement that ChinaCast Education Corporation (NASDAQ: CAST) has been suspended from trading on the NASDAQ exchange. A $200-million-dollar provider of post-secondary educational and e-Learning services throughout China, ChinaCast first listed on the Singapore Stock Exchange in 2004 and then obtained its NASDAQ listing in 2007 through a reverse merger transaction with a U.S.-listed special purpose acquisition company.
ChinaCast's corporate structure constitutes a dizzying array of relationships between companies located in Delaware, Bermuda, the British Virgin Islands, Hong Kong, and mainland China. Yet, the true heart of ChinaCast appears to lie in its contractual arrangements (through a wholly-foreign-owned Shanghai subsidiary) with a single VIE entity: ChinaCast Li Xiang Co. ("CCLX"). This VIE structure has enabled ChinaCast to profit from the Chinese satellite communications market -- a market otherwise closed to foreign investment under Chinese law. In 2010 alone, CCLX was responsible for 24% of ChinaCast's overall revenue.
ChinaCast's suspension from trading on NASDAQ was ultimately precipitated by ChinaCast's own announcement in March 2012 that it would not be able to file its SEC Form 10K Annual Report for 2011 on time. This delay appears to be the result of a protracted dispute between ChinaCast and Ron Chan, one of ChinaCast's former Shanghai-based executives. Chan was ousted from his position as ChinaCast's Chairman and CEO in January 2012 after American shareholder Ned Sherwood led a successful proxy battle to obtain control of the ChinaCast Board.
Through dueling open letters to shareholders, both ChinaCast and Chan describe a pattern of events that unfortunately has become all too common in recent years among U.S.-listed Chinese companies using the VIE structure. In particular, much like the Gigamedia case (described above), ChinaCast has accused Chan of sabotaging the company following his ouster by stealing the licenses and seals (or "chops") of ChinaCast's wholly-foreign-owned subsidiaries in Shanghai. Chan in turn has denied these allegations and claimed that it is actually ChinaCast's new board that has jeopardized the company's integrity by firing not only Chan but also ChinaCast's president, Jiang Xiangyuan -- one of three Chinese nationals who together own ChinaCast's revenue-generating VIE. Chan's allegations thus echo the troubling facts behind the Agria case (described above).
Caught in the middle, of course, are ChinaCast's NASDAQ shareholders, whose financial fate now rests on the increasingly doubtful ability of ChinaCast to continue profiting from VIE assets these shareholders do not own. Indeed, if what ChinaCast has alleged is true, then ChinaCast (in the form of its Shanghai subsidiaries) no longer has the ability to contract with ChinaCast's VIE under Chinese law -- at least, not until Chan has returned the relevant seals and licenses. On the other hand, if Chan's allegations are true, then ChinaCast has likely given one of the actual owners of ChinaCast's VIE more than enough reason to abandon his voluntary observance of the otherwise unenforceable VIE contracts upon which ChinaCast's profitability depends.
ChinaCast has since reported that because of Chan's alleged conduct, the company is unable to resume normal operations. Even before Chan's removal, however, ChinaCast was not running normally; instead, it was grappling with SEC inquiries that led to a restatement of its financial statements for 2010. ChinaCast has since accused Chan of obstructing the company's independent auditor, Deloitte, in its preparation of ChinaCast's financial statements for 2011. These inter-personal conflicts thus reveal yet another rapid route to collapse for U.S.-listed Chinese companies using the VIE structure. And with 146 such companies still listed on NASDAQ and another 78 listed on NYSE, it appears investors will be facing these kinds of problems for some time to come.
The articles on our Web site include some of the publications and papers authored by our attorneys, both before and after they joined our firm. The content of these articles should not be taken as legal advice or as an expression of the views of the firm, its attorneys or any of its clients. We hope the articles spur discussion in the legal community with insight into the experience of the authors. We expressly reserve the right in the future to become wiser or simply change our mind.