Your Investment in China May be Worthless
Danny is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Imagine checking your portfolio one day and finding a sizable portion had become worthless. Headlines of every financial website and publication proclaim “China Stocks Plummet.” Investors everywhere scramble in an attempt to unload their now worthless holdings, but to no avail. Billions are lost, retirements postponed, talking heads drone endlessly on about how this could have happened or how it could have been prevented. Congress convenes special committees to draft new legislation (anyone remember SOX?). While this may be a little over the top, or perhaps far-fetched, every investor in China needs to know that this is a possibility, no matter how remote.
As an investor with a sizable holding in Baidu (NASDAQ: BIDU), the leading Chinese language internet search engine, should I be worried? In a previous blog, I have posted my thoughts on Baidu. This is one of the most widely held Chinese companies traded on US markets and most widely respected, so should I be concerned? This is not one of those fly-by-night operations. This is one of China’s greatest investing success stories. Is it possible that my investment could be one day be worth nothing?
The short answer: Yes.
How is this possible, you ask? According to The Economist “Ownership is rarely straightforward in China.” First, we need to understand a little about the history of a corporate structure known as a Variable Interest Entity (VIE). It is estimated that more than half of the Chinese companies listed on US exchanges use this structure. Chinese rules ban foreign ownership in certain sectors including mining, steel, telecommunications, internet and education. In an effort to bypass these rules, the VIE came into being. The VIE is a complex structure whereby a series of contracts exist that take the place of actual ownership. This structure allows foreigners to invest in Chinese companies in these sectors, without violating Chinese foreign ownership laws. In these contracts, the Chinese company agrees to share profits with their foreign investors. These structures have been referred to as “The SINA Model.” They are named for SINA Corporation (NASDAQ: SINA), after the first Chinese company to be listed on foreign markets. For those interested in the extended legal version, this blog from a law firm in China offers an in-depth analysis. This article from Reuters provides a less complex and easier to understand version. This graphic, courtesy of Reuters, illustrates the process.
This sounds like a reasonable solution to the Chinese rules against foreign ownership, right? What could go wrong? Any company that has done business in China can tell you that the rules there are different. Just ask Apple (NASDAQ: AAPL). Apple paid $55,000 to Proview, a Chinese company, for the rights to the iPad name in China. After the iPad was a phenomenal success, Proview sued Apple claiming the rights to the name had never legally passed to Apple. A Chinese court agreed and after a lengthy court battle and arbitration, Apple agreed to pay Proview an additional $60 million to settle the dispute. While this does not deal with the VIE structure, it goes a long way to illustrate the challenges that face companies that do business in China.
Back to the VIE structure. Investors in Chinese companies have had several scares in recent years. In September of last year, reports surfaced that indicated that the China Securities Regulatory Commission had asked China’s State Council to regulate the VIE corporate structure. In a separate incident, US internet company Yahoo! (NASDAQ: YHOO) cried foul when it learned that minority Chinese holding Alibaba.com had transferred Alipay, (their version of PayPal’s electronic payment system) to a separate company owned by one of Alibaba’s founders. In a US company this would have resulted in arrests, SEC charges, class action lawsuits and property seizures. Alibaba.com however, claimed they were pressured to comply with Chinese rules, fearing that any payments run through their system might otherwise be rejected. This left Yahoo! little recourse.
More recently, New Oriental Education (NYSE: EDU) yesterday reported that the SEC was investigating its accounting practices, specifically the consolidation of a wholly-owned subsidiary and VIE, into New Oriental’s consolidated financial statements.
These news items have a chilling effect on investors in Chinese companies. Many investors have already divested their interest in the wake of numerous reports of accounting scandals and outright fraud among Chinese owned companies. Even the most widely held names in Chinese company stocks like Baidu have not been immune, falling nearly 8% on yesterday’s report.
For holders of Baidu and other well known and well respected Chinese companies that happen to sport this corporate structure, is there any good news? At this point, while there are still many unknowns, the news is not all bad. The Chinese government has never said directly that VIEs are not permissible. According to a report the China Securities Regulatory Commission (CSRC) issued a letter at the time stating that it had "no objection" to how the structure was used in the IPO of Sina Corp, which listed on the NASDAQ in 2000. The CSRC has been pressured to act on the numerous fraud cases involving companies that abused the VIE structure. The CSRC is pushing for the Ministry of Commerce to regulate them by requiring all new VIEs to seek ministry approval prior to being setup. This would allow the Chinese government to regulate VIEs and grandfather in the existing companies using the structure. Attorneys asked for their legal opinion have stated they do not expect that China will force investors to dismantle their existing VIEs.
As an informed investor, while I do not expect the Chinese government to outlaw VIEs entirely and the value of my position in Baidu to go to zero, I need to know that however unlikely this may be, it is possible. Any investor in Chinese stocks must understand that the government is a wildcard. With this understanding, an investor may still choose to invest in well known and respected Chinese companies as part of a diversified portfolio, using well thought out allocations, and be prepared for the roller coaster ride that is sure to follow.
Danny owns shares of Apple and Baidu and enjoys Chinese food. The Motley Fool owns shares of Apple and Baidu. Motley Fool newsletter services recommend Apple, Baidu, New Oriental Education, SINA , and Yahoo!. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.