New Oriental

This case was prepared by Professor Paul Gilis of the Guanghua School of Management based on publicly available
information. Karen Wong, Jack Smith, John Carter, Global Capital Funds and Asia Stars are fictitious characters.
© 2012 Paul Gillis

New
Oriental’s
Variable
Interest
Entity

“So,
Karen,
what
do
you
propose
we
do?”
said
Jack
Smith.

Jack
was
the
Chief
Investment
Officer
for
Global
Capital
Funds
(GCF),
one
of
the
top

five
mutual
fund
groups
in
the
United
States.
GCF
had
$1
trillion
under
management

in
a
family
of
mutual
funds.

Karen
Wong,
31,
had
joined
GCF
right
after
she
earned
her
MBA
degree.
She
had

started
as
an
analyst,
but
Jack
quickly
saw
her
talents
and
promoted
her
to
portfolio

manager.

She
was
managing
the
Asia
Stars
fund,
which
had
been
a
top
performer
in

its
group.
She
had
developed
a
track
record
of
picking
solid
Asian
companies
that

had
outperformed
their
peers.
Today,
however,
she
had
a
problem.

Jack
had
come
to
Karen’s
office
shortly
after
the
market
opened
on
July
17,
2012.

John
Carter,
GCF’s
chief
risk
officer
was
at
his
side.
Carter
had
a
scowl
on
his
face,

but
that
was
normal.

The
portfolio
managers
had
a
natural
dislike
for
the
risk

officer.
After
all,
it
was
his
job
to
second-‐guess
their
decisions,
but
Karen
had
to

admit
he
was
usually
right.

Today’s
visit
was
about
the
largest
position
in
the
Asia
Stars
fund,
a
Chinese

company
listed
on
the
New
York
Stock
Exchange
called
New
Oriental
Education
&

Technology
Group
(NYSE:
EDU).
The
company
had
announced
its
4th
quarter

earnings
before
the
market
opened.
The
earnings
were
good;
revenues
for
the

quarter
were
up
40.7%
and
net
income
for
the
year
was
up
30.4%.
The
stock,

however,
was
falling
like
a
rock,
down
20%
in
the
first
hour
of
trading.
The
reason

was
that
Louis
Hsieh,
President
and
CFO
of
New
Oriental,
had
announced
in
the

earnings
call
that
the
SEC
had
launched
a
formal
investigation
of
the
company.

Louis
said
that
the
Company
believed
that
the
investigation
concerns
whether
there

is
a
sufficient
basis
for
the
consolidation
of
Beijing
New
Oriental
Education
and

Technology
(Group)
Co.
Ltd.,
a
variable
interest
entity
of
the
Company,
and
its

wholly
owned
subsidiaries,
into
the
Company’s
consolidated
financial
statements.

Asia
Stars
held
10
million
shares
of
New
Oriental
that
had
been
worth
$225
million

the
day
before.
The
fund
had
lost
$45
million
already
today.

While
Asia
Stars
had

less
than
5%
of
its
capital
invested
in
New
Oriental,
the
loss
was
going
to
be
painful

and
it
would
leave
a
black
mark
on
Karen’s
record
as
a
portfolio
manager.

About
New
Oriental

As
the
largest
provider
of
private
educational
services
in
China,
New
Oriental
offers

education
for
a
lifetime,
teaching
skills
that
give
students
a
crucial
competitive

advantage
in
the
workplace
and
help
improve
their
quality
of
life.
New
Oriental

2
offers
a
wide
range
of
educational
programs,
services
and
products
that
include

English
and
other
foreign
language
training,
overseas
and
domestic
test
preparation

courses,
all-‐subjects
after
school
tutoring,
primary
and
secondary
school
education,

educational
content
and
software
as
well
as
online
education.

New
Oriental
has
become
the
most
recognized
brand
in
Chinese
private

education.
Based
on
founder
Michael
Yu's
groundbreaking
vision,
New
Oriental’s

innovative
and
inspirational
instruction
combines
humorous,
interactive
teaching

techniques
with
traditional
Chinese
educational
values.

Since
its
founding
in
1993,
New
Oriental
has
had
over
13
million
student

enrollments,
including
approximately
2.4
million
enrollments
in
fiscal
year
2012.
In

2012
New
Oriental
has
a
network
of
55
schools,
664
learning
centers,
32
New

Oriental
bookstores
and
over
5,000
third-‐party
bookstores
and
over
17,600

teachers
in
49
cities,
as
well
as
an
online
network
with
over
7.8
million
registered

users.

Variable
interest
entities

New
Oriental
commenced
operations
in
China
in
1993..
In
2004,
the
Company
set
up

a
holding
company
in
the
British
Virgin
Islands
(which
later
changed
its
domicile
to

the
Cayman
Islands).
The
reason
for
setting
up
the
offshore
company
was
to

circumvent
Chinese
regulations
that
prohibit
foreign
ownership
of
primary
and

middle
schools
for
students
in
grades
one
to
nine.

New
Oriental
wished
to
raise

foreign
capital
for
expansion,
and
the
offshore
company
facilitated
it
raising
funds

from
Tiger
Global
Private
Investment
Partners
II,
L.P.

The
restrictions
on
foreign
investment
in
the
education
sector
were
problematic.
A

work-‐around
had
been
developed
to
allow
foreign
investment
in
restricted
sectors.

The
solution
would
have
the
restricted
operations
held
in
a
corporation
that
was

owned
by
a
Chinese
individual.
That
would
make
the
operations
domestically

owned
and
avoid
the
restrictions
on
foreign
ownership.

The
problem
was
that
if
the
operations
were
actually
owned
by
a
Chinese
individual,

how
could
foreigners
be
convinced
to
invest
in
a
company
that
actually
did
not

conduct
the
business?
The
solution
that
was
found
was
to
put
in
place
a
series
of

contracts
that
gave
the
foreign
company
control
over
the
Chinese
company
that

actually
operated
the
business.
While
this
left
the
ownership
of
operations
in

Chinese
hands,
it
gave
control
to
foreigners.

In
order
to
sell
investors
on
this
idea
it
was
critical
that
the
foreign
company
be

allowed
to
consolidate
the
operations
of
the
individually
owned
Chinese
company
in

its
consolidated
financial
statements.
The
accounting
rules
for
consolidation
had

long
focused
on
stock
ownership,
requiring
consolidation
when
more
than
50%
of

the
shares
were
owned,
requiring
equity
accounting
for
ownership
between
20%

and
50%,
and
portfolio
accounting
for
ownership
below
20%.
Enron
famously

abused
these
rules
and
set
up
special
purpose
entities
that
were
owned
by
Andy

Fastow,
Enron’s
treasurer
(who
would
later
go
to
prison).
Enron
would
put
large

amounts
of
debt
in
these
entities,
and
because
Enron
owned
no
shares
in
the

companies,
it
was
not
required
to
consolidate
the
entities
and
put
the
debt
on
its

3
balance
sheet,
even
though
it
was
essentially
on
the
hook
for
it.
When
Enron

imploded
the
Financial
Accounting
Standards
Board
(FASB)
decided
that
accounting

rules
had
to
change
to
prevent
reoccurrence
of
the
Enron
off-‐balance
sheet
financing

scandals.
The
FASB
issued
FASB
Interpretation
No.
46
(FIN
46)
which
was
later

reissued
as
FIN46R
which
changed
the
consolidation
rules.

FIN46
requires
an
entity

to
consolidate
a
variable
interest
entity
(VIE)
if
it
is
the
primary
beneficiary
of
the

VIE.
Under
FIN46R,
a
variable
interest
is
one
that
increases
or
decreases
in
value

based
on
the
increases
or
decreases
in
the
expected
cash
flows
from
the
entity’s

assets
or
liabilities.
The
primary
beneficiary
of
the
varlable
interest
entity
is

required
to
consolidate
that
entity
in
its
financial
statements.
Said
another
way,
if
a

company
has
the
upside
and
downside
in
another
entity
it
must
consolidate
it.

The

main
effect
of
FIN46
and
FIN
46R
was
to
require
many
companies
to
consolidate

special
purpose
entities
that
were
set
up
to
keep
debt
off
the
balance
sheet.

FIN46
and
FIN46R
were
not
limited
to
off
balance
sheet
financing
situations.

Chinese
companies
had
found
a
way
to
use
the
VIE
to
allow
consolidation
of

companies
that
were
off
limits
to
foreign
investment.

The
operations
that
did
not

permit
foreign
investment
would
be
held
in
a
Chinese
company
owned
by
a
Chinese

individual.
The
public
company
would
control
this
company
through
legal

agreements,
rather
than
through
ownership.
See
Appendix
1
for
a
description
of
the

use
of
VIEs
in
China.

The
Confrontation

“So,
I
understand
that
New
Oriental
has
all
its
operations
in
a
variable
interest
entity.

Does
that
mean
we
have
invested
a
quarter
of
a
billion
dollars
in
an
entity
that
does

not
actually
own
the
business?”
asked
John
Carter.

“Yes”,
answered
Karen
Wong.
“New
Oriental
uses
the
VIE
structure.
It
allows
the

public
company
to
control
businesses
where
China
restricts
foreign
ownership.
The

VIE
structure
is
very
common
–
half
of
U.S.
listed
Chinese
companies
use
it.”

“But
haven’t
there
been
a
lot
of
problems
with
VIE’s?”
asked
Jack
Smith.
“Didn’t
we

get
burned
last
year
when
Yahoo
lost
its
interest
in
Alipay
when
the
VIE

mysteriously
disappeared
into
the
hands
of
the
Chinese
shareholder?
“

“Yahoo
was
not
in
any
of
my
funds”,
answered
Karen
Wong,
“But
I
don’t
think
that
is

going
to
happen
in
this
situation.
Michael
Yu,
the
owner
of
the
VIE,
has
an
interest
in

keeping
it
in
New
Oriental,
and
the
lawyers
say
the
contracts
that
make
him
do
so

are
enforceable.
“

“Lawyers!”
snorted
John
Carter,
“Aren’t
these
the
same
lawyers
who
say
that
the
VIE

actually
works
to
get
around
Chinese
restrictions
on
foreign
investment?
Did
you

hear
about
the
Buddha
Steel
case?
A
lot
of
other
lawyers
say
there
is
no
way
these

deal
hold
up
if
the
end
up
in
court.”

“I
am
worried
about
this
SEC
investigation”,
said
Jack
Smith.
Why
is
the
SEC
now

challenging
whether
these
VIEs
can
be
consolidated?
What
if
the
SEC
is
right
and

they
cannot
consolidate?
What
do
we
have
left?

4
“Karen,
you
have
to
take
us
through
your
thinking
on
why
we
should
be
holding
this

investment,
and
the
way
the
market
is
moving,
you
better
make
it
quick”
said
John

Carter
as
he
settled
into
his
chair.

The
other
shoe
drops

By
the
time
John
Carter
left
Karen’s
office,
New
Oriental
shares
had
dropped
38%

although
they
did
rally
slightly
to
close
at
14.62,
down
35%
for
the
day.
John
had

told
Karen
to
spend
the
night
preparing
for
a
meeting
the
next
morning
with
Jack

and
himself,
where
they
would
decide
what
to
do
with
the
New
Oriental
position.

Karen
reviewed
all
of
her
prior
analytic
work
on
New
Oriental,
and
she
was

prepared
to
defend
her
decision
to
maintain
the
position
in
the
stock.
The
meeting

was
scheduled
at
10
am,
and
she
watched
her
computer
cautiously
as
the
market

opened
at
9:30.
She
was
relieved
to
see
that
New
Oriental
opened
at
$15
“Maybe
we

have
seen
the
worst
of
it”
she
muttered
to
herself
as
she
grabbed
her
Starbucks
and

headed
for
the
conference
room.

Jack
was
already
there
when
Karen
arrived.
He
smiled
warmly
“this
happens
to
the

best
of
them,
you
know.
It
is
a
tough
business”.
Karen
wondered
why
John
Carter

was
not
present
–
he
was
always
early
to
meetings.
Suddenly
John
Carter
burst
into

the
room
–
“it
is
dropping
like
rock!”
he
shouted.
Jack
jumped
out
of
his
chair
and

headed
for
the
Bloomberg
terminal
in
the
corner.
Karen
beat
him
there
and
punched

in
the
code
for
New
Oriental
–
EDU.
The
stock
had
just
fallen
through
$11
and
was

still
dropping.

The
screen
flashed
the
news
on
the
stock
–
Muddy
Waters
Research

initiating
coverage
on
EDU
–
strong
sell.

Muddy
Waters
Research
was
notorious
in
China
investment
circles.
Muddy
Waters

was
one
of
several
short
selling
research
firms
that
specialized
in
finding
fraudulent

Chinese
companies.
It
had
brought
down
many.
It
was
a
highly
controversial

business
model,
and
the
founder,
Carson
Block
was
despised
by
many
investors.

Block
was
not
always
right,
but
he
always
hurt
companies
when
he
focused
on
them.

The
investigation

The
Board
of
Directors
of
EDU
formed
a
Special
Committee
of
independent
directors,

including
Baidu
Chairman
Robin
Lee
and
BIMBA
Dean
John
Yang.

The
Special

Committee
hired
law
firm
Simpson,
Thacher
and
Bartlett
and
accounting
firm
Ernst

&
Young
to
conduct
an
investigation.

EDU
issued
a
press
release
on
September
30
announcing
that
the
Special
Committee

had
completed
its
review
of
Muddy
Water’s
allegations
and
had
found
no
significant

evidence
to
support
them.
The
Company
indiated
that
the
investigation
into
the
VIE

structure
continued,
and
that
the
company
would
miss
the
filing
date
for
its
annual

report
on
Form
20F.

EDU’s
stock
had
jumped
from
a
low
of
$14
to
$17
in
the
week

prior
to
the
announcement,
suggesting
someone
had
leaked
the
news.
On
October
1,

the
first
trading
day
after
the
announcement,
the
stock
fell
$0.06.
Muddy
Waters

announced
it
was
“more
convinced
than
ever”
that
EDU
was
misleading
investors.

5
On
October
12,
2012
EDU
announced
that
it
was
filing
its
annual
report
on
Form
20F.

I
staid
that
it
was
informed
by
the
staff
of
the
SEC’s
Division
of
Corporation
Finance

that
the
staff
has
no
objection
to
the
consolidation
of
its
schools.

EDU
stock
jumped
14%
in
premarket
trading
the
next
trading
day,
but
quickly
fell

back
after
a
Chinese
accounting
blog
pointed
out
that
the
company
was
making

inconsistent
disclosures
about
the
SEC
investigation.

Questions

Should
EDU’s
VIE
be
consolidated?

What
would
happen
to
EDU’s
financial
statements
if
the
VIE
cannot
be
consolidated?

6
Consolidating
EDU’s
VIE

Paul
Gillis
PhD
CPA

http://www.chinaaccountingblog.com/weblog/consolidating-‐edus-‐vie.html

New
Oriental
Education
&
Technology
Group
(NYSE:
EDU)
has
filed
its
delayed

annual
report
on
Form
20-‐F.
EDU
claims
that
the
SEC
has
no
objection
to
the

consolidation
of
its
VIE.
However,
the
SEC
has
indicated
it
will
continue
to
review

EDU’s
disclosure
documents,
including
the
2012
Form
20-‐F,
which
would
not
have

been
provided
to
the
SEC
until
now.
In
the
Form
20-‐F
the
company
says
the
SEC

investigation
is
ongoing,
so
I
don’t
understand
what
is
going
on.

If
the
SEC
has
blessed
the
consolidation
of
EDU’s
VIE,
this
is
big
news
for
VIEs,
and
I

am
a
bit
surprised
by
the
result.
The
investigation
into
EDU
likely
was
a

consequence
of
Muddy
Water’s
allegations
against
the
company;
allegations
that

appear
to
have
been
discredited.
There
is
an
issue
present
in
EDU
that
Muddy

Waters
did
not
raise,
but
I
thought
that
the
SEC
would.
EDU
has
an
asset-‐heavy
VIE,

that
is,
most
of
the
business
at
EDU
is
in
the
VIE.
Consolidation
requires
that
the

parent
company
have
a
right
to
the
residual
profits
of
the
VIE.
EDU
claims
a
right
to

these
residual
profits
because
of
a
series
of
service
agreements
between
EDU
and

the
VIE.
It
is
apparent
that
EDU
is
not
distributing
all
of
the
profits
through
these

agreements.
The
question
that
the
SEC
should
have
addressed
is
whether
all
that
is

necessary
to
consolidate
a
VIE
is
a
agreement,
or
whether
those
agreements
have
to

give
access
to
the
residual
profits
in
practice.
This
is
not
just
a
technical
accounting

question;
it
also
gets
to
the
substance
of
the
arrangements
and
what
the

shareholders
actually
own.
If
you
do
not
take
the
profits
out
as
you
are
entitled
to

them,
will
you
ever
be
able
to
take
them
out
and
do
you
really
own
them?

EDU
says
it
obtains
a
right
to
receive
substantially
all
of
the
economic
benefits
of
the

VIE
in
consideration
for
the
services
provided
by
EDU’s
wholly
owned
subsidiaries

(WFOEs).
The
service
fees
are
set
at
a
percentage
of
revenue.
I
do
not
understand

how
a
fee
that
is
a
percentage
of
revenue
is
considered
to
be
an
interest
in
the

residual
profits
of
the
company.
Residual
profits
are
what
remain
after
the
revenue-‐
based
fees.
Most
VIE
agreements
get
around
this
by
allowing
the
public
company
to

unilaterally
set
the
fees
so
that
they
can
be
made
equal
to
net
income.
While
those

kinds
of
arrangements
are
more
easily
argued
to
result
in
an
interest
in
residual

profits,
they
are
likely
to
be
challenged
by
tax
authorities
as
violating
transfer-‐
pricing
rules.

EDU
reports
that
the
VIE
earned
$159
million
in
2012.
Retained
earnings
of
the
VIE

increased
by
$49
million,
suggesting
that
the
VIE
only
made
payments
to
the
parent

of
$110
million.
EDU’s
VIE
has
retained
earnings
of
$308
million,
which
is
the

accumulated
earnings
that
have
not
been
paid
out.
The
accounting
question
is

whether
EDU
has
an
interest
in
those
retained
earnings.

From
what
EDU
is
saying,
the
SEC
appears
to
have
decided
that
EDU
has
a
right
to

the
residual
earnings
of
the
VIE,
despite
the
disclosure
that
the
VIE
is
not
paying

7
these
profits
to
the
public
company
through
the
service
agreements.
Perhaps
the

fees
required
under
the
agreements
are
equal
to
or
greater
than
the
net
income,
yet

the
company
has
decided
against
paying
them.
Payments
from
a
VIE
to
a
WFOE
are

inherently
tax
ineffective,
and
once
the
profits
are
in
the
WFOE
it
is
very
difficult
to

get
the
cash
back
to
the
VIE.
Perhaps
EDU
was
able
to
convince
the
SEC
that
it
met

the
letter
of
the
law
by
having
the
contractual
right
to
these
profits,
even
if
in

practice
it
did
not
actually
collect
the
payments
it
was
entitled
to.

Getting
the
residual
profits
through
service
contracts
is
the
usual
method
for
VIEs,

even
though
it
is
tax
inefficient.
There
is
another,
even
more
tax
inefficient
way,
to

get
the
profits
out.
That
would
be
through
a
dividend
from
the
VIE
to
the
VIE’s

individual
shareholder,
who
would
then
turn
it
over
to
WFOE.
Most
VIE
agreements

provide
for
that
possibility,
although
I
see
no
disclosure
of
such
provisions
by
EDU.

There
are
layers
of
additional
taxes
in
this
approach
that
can
drive
the
effective
tax

rate
up
substantially.
EDU
addresses
this
issue
in
its
tax
footnotes:

Aggregate
undistributed
earnings
of
the
Company’s
PRC
subsidiaries
and
VIE
that
are

available
for
distribution
was
US$395,534
and
US$483,100
as
of
May
31,
2011
and

May
31,
2012,
respectively.
Upon
distribution
of
such
earnings,
the
Company
will
be

subject
to
PRC
EIT
taxes,
the
amount
of
which
is
impractical
to
estimate.
The
Company

did
not
record
any
tax
on
any
of
the
aforementioned
undistributed
earnings
because

the
relevant
subsidiaries
and
VIE
does
not
intend
to
declare
dividends
and
the

Company
intends
to
permanently
reinvest
it
within
the
PRC.

Of
the
$483
million
of
undistributed
earnings,
$308
million
are
in
the
VIE.
The

remainder
is
in
the
WFOEs
and
would
not
be
subject
to
enterprise
income
tax
(EIT)

on
distribution.
It
would
be
subject
to
withholding
tax,
at
10%,
an
amount
that
is
not

impractical
to
estimate.
(EDU
does
not
appear
to
use
a
Hong
Kong
holding
company

to
reduce
the
withholding
rate
to
5%,
a
technique
that
probably
does
not
work

because
of
treaty
shopping
restrictions).
The
distribution
of
VIE
earnings
would
be

subject
to
individual
income
tax
when
distributed
to
the
individual
VIE
shareholder,

and
then
to
EIT
when
the
individual
gives
the
money
to
the
WFOE,
and
then
to

withholding
tax
when
distributed
by
the
WFOE
to
the
Cayman
Islands
parent.
Here

is
what
would
happen:

Amount
of
retained
earnings
of
VIE
=
$308
million.
Individual
income
tax
on

dividend
to
Michael
Yu
(20%
X
$308)
=
$61.6
million.
Amount
paid
to
WFOE
$308-‐
$61.6
=
246.4
X
EIT
of
25%
=$61.6
million.
Total
tax
liability
on
VIE
retained

earnings
is
$123.2
million.
Add
to
that
a
10%
withholding
tax
to
get
the
money
out

of
China
to
the
Cayman
Islands.

Does
EDU
provide
for
that
deferred
tax
liability?
No,
the
company
waves
it
off
by

saying
they
do
not
intend
to
distribute
dividends
and
plan
to
leave
the
money
in
the

PRC.
Accordingly,
the
taxes
that
would
be
payable
on
distribution
are
not
recorded.

The
company
indicates
it
never
plans
to
pay
the
public
company
any
of
the
retained

8
earnings
of
the
VIE.
Not
providing
tax
on
income
that
the
company
never
expects
to

distribute
is
allowed
under
GAAP.

What
troubles
me
about
EDU’s
accounting
is
the
combination
of
claiming
an
interest

in
the
profits
of
the
VIE
despite
the
lack
of
ownership
but
also
arguing
that
EDU
will

never
get
those
profits.
When
you
start
layering
on
aggressive
accounting
policies,

even
if
individually
each
is
GAAP,
the
final
picture
does
not
fairly
present
the

situation.

If,
as
EDU
appears
to
say,
the
SEC
has
signed
off
on
this,
we
can
stop
worrying
about

accounting
challenges
to
the
VIE
structure.

9
EDU:
Is
the
SEC
investigation
really
over?

Paul
Gillis
PhD
CPA

http://www.chinaaccountingblog.com/weblog/edu-‐is-‐the-‐sec-‐investigatio.html

New
Oriental
Education
&
Technology
Group
(NYSE:EDU)
filed
its
delayed
2012
20F

on
October
12,
2012.
In
a
press
release,
the
company
says
this:

…New
Oriental
was
informed
by
the
staff
of
the
SEC's
Division
of
Corporation
Finance

that,
based
on
the
Company's
representations
made
in
response
to
the
SEC's
inquiries,

the
staff
has
no
objection
to
the
Company's
consolidation
of
its
variable
interest
entity,

Beijing
New
Oriental
Education
&
Technology
(Group)
Co.,
Ltd.
("New
Oriental

China")…

However,
EDU
also
makes
this
curious
statement
in
the
press
release:

The
SEC
staff
has
indicated
that
it
will
continue
to
review
New
Oriental's
disclosure

documents,
including
the
2012
Form
20-‐F.

So,
is
the
investigation
over,
or
not?

The
actual
filing
raises
more
issues:

On
July
13,
2012,
we
were
informed
that
the
SEC
had
issued
a
formal
order
of

investigation
captioned
“In
the
Matter
of
New
Oriental
Education
&
Technology
Group

Inc.”
In
that
investigation
the
SEC’s
enforcement
staff
has
requested
documents
and

information
concerning
the
basis
for
the
consolidation
of
New
Oriental
China,
a

variable
interest
entity
of
our
company,
and
its
schools
and
subsidiaries,
into
our

consolidated
financial
statements
and
other
issues
related
to
certain
allegations
about

us
contained
in
a
report
issued
on
July
18,
2012
by
Muddy
Waters
LLC.
We
are

cooperating
fully
with
the
SEC
in
its
investigation.
We
cannot
predict
the
timing,

outcome
or
consequences
of
the
SEC
investigation.

That
is
a
different
story.
First
of
all,
they
say
it
is
the
enforcement
staff,
a
term
that

customarily
refers
to
people
working
for
the
SEC’s
Division
of
Enforcement
(people

who
may
send
you
to
jail),
not
the
SEC’s
Division
of
Corporation
Finance,
(people

who
may
make
you
change
disclosures).

Then
they
say
they
cannot
predict
the
timing,
outcome,
or
consequences?

I
am
skeptical
about
whether
we
are
getting
the
straight
scoop.

Post
script:

This
is
what
the
special
committee
said
on
September
30:

10
The
Special
Committee
understands
that
the
SEC’s
Division
of
Corporation
Finance
is

engaged
in
a
review
of
the
Company’s
consolidation
of
the
financial
results
of
the
VIE

into
the
Company’s
consolidated
financial
statements.
Accordingly,
the
Special

Committee’s
work
on
that
issue
is
likewise
continuing.

Note
they
say
the
Divison
of
Corporation
Finance.
EDU
needs
to
get
its
story
straight.

11
SEC
v.
EDU
–
the
end
of
VIEs?

Paul
Gillis
PhD

July
18,
2012

http://www.chinaaccountingblog.com/weblog/sec-‐v-‐edu-‐-‐-‐the-‐end-‐of-‐vies.html

New
Oriental
Education
and
Technology
Group
(NYSE:
EDU)
dropped
a
bombshell

in
its
fourth
quarter
earnings
release
this
morning.
The
company
reported
that
the

SEC
has
issued
a
formal
order
of
investigation
captioned
"In
the
Matter
of
New

Oriental
Education
&
Technology
Group
Inc."
The
Company
believes
that
the

investigation
concerns
whether
there
is
a
sufficient
basis
for
the
consolidation
of

Beijing
New
Oriental
Education
&
Technology
(Group)
Co.,
Ltd.,
a
variable
interest

entity
of
the
Company,
and
its
wholly-‐owned
subsidiaries,
into
the
Company's

consolidated
financial
statements.

Investors
are
appropriately
concerned.
The
stock
is
off
37%
as
I
write
this,
with

other
companies
with
VIEs
off
by
single
digits.
A
formal
investigation
is
far
more

serious
than
the
normal
comment
letter
process
that
usually
deals
with
these
kinds

of
issues.
It
means
the
Division
of
Enforcement
of
the
SEC,
rather
than
the
Division

of
Corporate
Finance
is
dealing
with
the
issue.

On
July
11
EDU
announced
it
had
restructured
its
VIE
ownership.
The
VIE
had
been

owned
by
a
number
of
shareholders,
some
of
whom
are
no
longer
active
in
the

company.

It
is
now
held
by
an
entity
owned
by
Chairman
Michael
Yu.
I
don’t
see

anything
wrong
with
that
restructuring.
The
SEC
investigation
was
launched
on
July

13.

I
doubt
that
the
restructuring
led
to
the
investigation.
I
suspect
that
the

company
has
been
responding
to
the
normal
comment
letters
that
the
SEC
Division

of
Corporate
Finance
issues
to
all
companies
periodically.
Something
may
have
gone

terribly
wrong
in
this
process
and
the
issue
was
referred
to
the
Division
of

Enforcement,
which
launched
a
formal
investigation.
That
is
all
my
speculation,

however.

I
have
written
about
my
concerns
over
consolidation
of
VIES.
I
had
planned
to
do
a

post
using
EDU
as
a
case
study
to
explain
some
of
the
major
concerns
I
have
about

VIEs,
but
was
waiting
for
EDU’s
current
financial
statements.
The
SEC
has
beaten
me

to
the
punch.

I
suspect
that
there
are
three
issues
that
the
SEC
will
focus
on.
First,
EDU
has
legal

opinions
that
say
that
the
VIE
agreements
are
in
compliance
with
Chinese
law
and

are
enforceable.
So
does
every
other
VIE,
yet
the
opinions
uniformly
come
with

caveats
that
the
Chinese
courts
might
not
agree
and
everything
might
fall
apart.

Some
lawyers
say
these
agreements
are
clearly
not
enforceable
and
violate
Chinese

laws
and
there
has
been
some
noise
that
Chinese
regulators
are
unhappy
with
some

of
the
lawyers
who
have
issued
opinions.
This
could
be
an
area
where
the
SEC
and

Chinese
regulators
are
cooperating.

12
Second,
EDU
is
an
asset
heavy
VIE.
In
its
last
published
financial
statements,
EDU

reported
that
it
had
62%
of
its
assets
and
97%
of
its
revenue
in
the
VIE.
One
of
the

requirements
for
consolidation
is
that
the
public
company
has
an
interest
in
the

residual
profits
of
the
VIE.
In
the
case
of
EDU,
as
is
the
case
for
most
VIEs,
the

interest
in
residual
profits
is
obtained
through
technical
service
agreements
that

allow
the
public
company
to
extract
the
profits
from
the
VIE
through
fees.
Many

VIEs
do
not
appear
to
be
making
those
fee
payments,
leaving
all
of
the
profits
to

accumulate
in
the
VIE.
That
raises
the
question
of
whether
the
public
company

actually
has
an
interest
in
those
profits.
If
it
does
not
take
them
out
by
following
the

VIE
agreements,
how
does
it
plan
to
ever
get
those
profits
to
the
shareholders?

Third,
the
company
may
not
have
accrued
taxes
that
would
be
payable
if
the

payments
from
the
VIE
to
the
public
company
were
made.
The
major
reason
for
not

making
the
payments
in
the
first
place
is
the
adverse
tax
consequences.
Any

payments
are
subject
to
business
tax
at
5%.
In
addition,
it
is
likely
that
tax

authorities
would
disallow
a
deduction
to
the
VIE
for
the
payments
on
the
basis
that

the
value
of
services
was
not
worth
the
amount
of
the
payment.
Nevertheless,
the

payment
would
remain
taxable
in
the
WFOE.
This
transfer-‐pricing
problem
could

raise
the
effective
tax
rate
to
over
60%.
The
argument
companies
make
for
not

accruing
the
tax
is
that
they
never
expect
to
make
the
payments.

The
problem
with

that
argument
is
that
it
undermines
the
basis
for
consolidation
in
the
first
place.
I

have
a
student
who
wrote
his
thesis
on
this
topic
and
we
plan
to
post
a
detailed

analysis
of
this
issue
in
the
near
future.

EDU
announced
the
investigation
in
the
same
call
as
it
announced
its
fourth
quarter

earnings.
It
said
that
Deloitte
had
not
finished
its
audit
of
the
accounts
for
the
year

ended
May
31,
2012.
Deloitte
is
in
a
real
pickle
here.
They
are
already
up
to
their

eyeballs
in
trouble
with
the
SEC,
and
if
they
sign
off
on
these
accounts
they
could
be

setting
themselves
up
for
more.
Deloitte’s
signoff,
or
refusal
to
do
so,
will
be
the
first

indication
as
to
the
seriousness
of
the
SEC's
challenge
to
consolidation.

What
are
the
risks
that
this
spreads
to
other
companies?
It
is
tough
to
say,
since
we

do
not
know
specifically
what
the
SEC
is
focused
upon.
If
Deloitte
refuses
to
sign
off

on
the
May
31
numbers,
then
I
expect
it
spreads
very
quickly.
If
instead,
it
is
a

company
specific
issue
(such
as
an
allegation
of
lying
to
the
SEC)
then
the
problem

may
be
contained
to
EDU.

13

This
is
a
fast
moving
story
so
you
should
do
an
Internet
search
on
New
Oriental
and

read
the
financial
websites
such
as
Yahoo
Finance.

Useful
links:

http:///www.chinaaccountingblog.com
http://zhongguojinrongblog.wordpress.com/2012/07/18/edus-‐sec-‐troubles/

http://www.chinahearsay.com/gigamedia-‐the-‐answer-‐to-‐the-‐what-‐if-‐vie-‐question/

http://www.chinalawblog.com/2011/10/vies_in_china_the_end_of_a_flawed_strate
gy.html

http://www.chinalawblog.com/2011/10/china_vies_the_end_of_a_flawed_strategy_
an_updaterebuttal.html

Accounting Matters
Variable Interest Entities in China
Guest Series
18 September 2012
This report is exclusively for Forensic Asia Limited's clients. Please help us protect the exclusivity of this service by not forwarding it to
others. For independent research to survive, the integrity of its products has to be maintained. All products/correspondences should only
be received by paying clients. If you have received this report in error, please delete it or contact us about how to become a client.
There is a growing feeling that VIEs are becoming unworkable – hardly
surprising for a structure which is trying to tell Chinese regulators that
the business is owned by Chinese and to foreign investors that it is
owned by foreigners. That’s a concern given that half of all overseas
listed Chinese companies use it. So, why don’t the Chinese simply allow
private companies to list overseas with a dual share structure to
preserve control? Well, maybe there’s a desire for them to list at home.
Why are VIE’s used?
Private companies in China have had difficulty in getting access to capital
and have looked to foreign investors as a source of funds. Unfortunately,
Chinese companies need permission to list overseas and foreign
companies are restricted from operating in certain domestic sectors.
How are they structured?
The solution has been to create a domestic vehicle that contains the
restricted businesses and is owned by a Chinese individual. However,
through a series of legal agreements, as opposed to share ownership, the
economic interest is transferred to a domestic vehicle which, in turn, is
owned by a foreign listed company. As the economic interest ultimately
lies with the foreign company, it is able to consolidate the VIE.
Challenges to the VIE structure
Chinese regulations are designed to keep certain sectors out of foreign
hands so a structure that puts them back in to those hands will come
under scrutiny. There are many regulatory, shareholder and operational
risks that have surfaced in scandals such as Alibaba, Sina.com and New
Oriental Education. It is felt that VIEs are becoming unworkable,
particularly for assets heavy businesses.
Where to now and how to fix it?
If China allows private companies to directly list abroad in the same
manner as state-owned enterprises, VIEs are no longer necessary. Control
could be maintained through a dual class share structure. One major
beneficiary would be the elimination of the regulatory problems that have
been so conducive to fraud.
Forensic Asia
1801-02, Wing On House
71 Des Voeux Road
Central, Hong Kong
Regulated by the SECURITIES
AND FUTURES COMMISSION
of Hong Kong
Paul L. Gillis, PhD, CPA
Guanghua School of
Management
Peking University
Beijing, China
gillis@gsm.pku.edu.cn
Largest US-listed Chinese Companies with VIE Structures
Follow us on Bloomberg
(FRSC), twitter or
facebook
Visit our sister companies:
Asianomics
ChartAsia
Companies BBG Industry Mkt Cap (US$m) YTD US$ (%)
Baidu BIDU Internet 40,314 -1
Netease NTES Internet 6,764 15
Sina Corp SINA Internet 4,587 33
Youku Tudou YOKU Internet 3,357 32
Focus Media FMCN Advertising 3,126 25
Qihoo 360 QIHU Internet 2,953 58
Ctrip.Com CTRP Internet 2,653 -21
New Oriental EDU Commercial 2,347 -37
Sohu.Com SOHU Internet 1,666 -12
Renren RENN Internet 1,562 14
Source: Forensic Asia Limited

Accounting Matters
Page 2 of 15 18 September 2012 Forensic Asia
Investors in Chinese companies soon encounter an obscure accounting term –
the variable interest entity, or VIE. A VIE is a company that is included in
consolidated financial statements because it is controlled through contracts,
rather than the more conventional control that is obtained through ownership.
The contracts attempt, often imperfectly, to mimic the control and economic
interest of direct ownership.
VIEs are widely used in China. Of the 225 Chinese companies listed on the
NYSE and NASDAQ, 108 (48%) use the VIE structure (see Figure 2). Chinese
companies traded on other exchanges, including the OTCBB in the U.S., the
Hong Kong Stock Exchange, the Toronto Stock Exchange, the London Stock
Exchange, and others, also use VIEs. Some multinational companies use VIEs to
hold their part or all of their China operations.
Why are VIEs used?
After the Communists took power in China in 1949, private business
disappeared and all economic activity was conducted by state-owned
enterprises. Following the disastrous Cultural Revolution and the death of Mao
Zedong, Deng Xiaoping, in December of 1978, set China on a path of reform
and opening up that led to the China becoming the second largest global
economy.
China’s stock markets reopened in 1990 after having been closed in the early
1950s. Initially the stock markets were used to reform state-owned enterprises
by providing capital and instituting corporate governance.
Private enterprise emerged as the opening up process began and
entrepreneurs prospered in the new environment. By 2002, the share of GDP
produced by the non-state sector exceeded two-thirds. Private companies,
however, had great difficulty accessing capital. As late as 2006, a study found
that 98% of Chinese companies could not access bank loans. In 2000, only 1%
of companies listed on China’s stock exchanges were privately owned. That
began to change in 2001 when Jiang Zemin invited businessmen to join the
Communist Party, signalling the beginning of reforms that would lead to the
establishment of Chinese venture capital and private equity firms, the SME
board on the Shenzhen Stock Exchange, and ChiNext, China’s answer to
NASDAQ. These new institutions would increasingly meet the capital needs of
China’s entrepreneurial sector.
These new capital institutions would lag the development of the private sector
in China. Starved for capital locally, privately owned firms looked to overseas
markets. Foreign investors were keen to participate in China’s economic
miracle. Yet, as companies prepared for public listings in overseas markets,
obstacles loomed in their way. China required its companies that wanted to
list overseas to obtain permission from the State Council, China’s highest
executive organ. The big state-owned enterprises like PetroChina that listed in
the U.S. had no difficulty obtaining this permission, but it was viewed unlikely
that a privately controlled business would be able to do the same. Instead the
private companies formed offshore companies, typically in the Cayman
Islands, to serve as the company that would actually list on the foreign
exchange.
A VIE is a company that is
included in consolidated
financial statements
because it is controlled
through contracts
China required its
companies that wanted to
list overseas to obtain
permission from the State
Council but only SOEs were
likely to get approval

Accounting Matters
Using offshore companies as the listing vehicle created a new problem for
these companies. China controls foreign investment through an investment
catalogue that classifies industries as encouraged, restricted, or prohibited for
foreign investment. Many of the sectors in which entrepreneurs were active
are restricted, including the Internet sector. The Internet entrepreneurs faced
a problem. By using offshore companies they had made their company foreign,
yet foreign companies could not operate their business because it was in a
restricted sector. The entrepreneurs could have gone to Chinese regulators
and asked permission to have foreign investors, but they thought it unlikely
they would be successful in doing so.
Necessity being the mother of invention, this is when the VIE concept was
created. The VIE structure is commonly called the Sina structure, named after
Sina.com which listed on NASDAQ in 2000. Actually the structure was
developed for two Chinese Internet companies, Sina and Sohu, which both
listed in 2000 and Price Waterhouse (PW) audited both. The solution to the
restricted sector problem was to separate the business into two parts – the
parts of the business that were open to foreign ownership were put into a
wholly foreign owned enterprise (WFOE) that was owned by the Cayman
Islands public company. The parts of the business that were restricted to
foreign ownership were put into a Chinese company that was owned by
Chinese individuals (the VIE). The challenge was to include the restricted part
in the consolidated financial statements, which was considered to be an
essential requirement for going public. The accounting rules at the time
focused on stock ownership; if a company was more than 50% owned it was to
be consolidated. Many companies were abusing these rules by creating special
purpose vehicles to hold debt. Since these companies did not own more than
50% of the shares of the special purpose vehicle they did not consolidate it,
keeping the debt off their balance sheet. Enron made extensive use of this
technique, and its collapse led to the establishment of VIE rules.
In the Sina and Sohu cases, PW accountants convinced the U.S. Securities and
Exchange Commission (SEC) that the Chinese company that held the Internet
content provider license and was owned by Chinese individuals should be
consolidated into the financial statements of the offshore parent company.
They argued that a series of agreements between the public company and the
VIE sufficiently mimicked ownership so that the VIE should be consolidated.
The accounting rules were formally changed in 2002 after Enron collapsed, and
Financial Accounting Standards Board (FASB) Interpretation No. 46:
Consolidation of Variable Interest Entities established rules that require
consolidation of entities when the parent company has the risks and rewards
normally associated with ownership, but the accountants at PW had convinced
the SEC to apply the concepts to the Sina and Sohu offerings at an earlier date.
Many of the sectors in
which entrepreneurs were
active are restricted and
could not be owned by
foreigners
Separate the business into
two parts: that which
operates in restricted
businesses (VIE) and that
which does not (WFOE)
Auditors persuaded the SEC
that VIE be consolidated
into the financial
statements of the offshore
parent company
The VIE was owned by
Chinese individuals but
controlled through legal
agreements by the listed
vehicle

Accounting Matters
How are VIEs structured?
While there is some variation in VIE structures, an archetypal model has
developed. Here is a diagram of the archetypal structure:
Figure 1: Structure of a Variable Interest Entity
Source: Paul Gillis
Some structures have Hong Kong companies between the Cayman Islands
company and the WFOE. The objective of these intermediary companies is to
minimize withholding taxes on dividends paid from China, but China’s treaty
shopping rules generally make this practice ineffective.
Starting at the top of the structure there are shareholders in the public
company. The VIE structure is only used on overseas listed Chinese private
companies. It is not used for State controlled companies like PetroChina or
China Life, even when they are listed overseas. It is also not used with private
companies listed on Chinese stock exchanges. While the VIE structure is most
common on the NYSE and NASDAQ, it can also be found in companies listed on
other foreign exchanges, including Hong Kong and Toronto. Because the VIE is
an American accounting term, entities controlled through contracts are not
called VIEs in those markets, but operate in the same manner.
The listed company for non-state controlled companies listing abroad is always
an offshore company. The most popular location for incorporating these
companies is the Cayman Islands, although the British Virgin Islands, the
United States, and other jurisdictions are sometimes used. The listed company
typically has no operations and serves only as a holding company.
The WFOE is a Chinese subsidiary that is wholly owned by the offshore listed
company. A WFOE is the conventional entity used by multinational
corporations to conduct business in China. Most overseas listed Chinese
companies that do not use the VIE structure will conduct all of their China
business in a WFOE. WFOEs are heavily regulated by Chinese authorities and
must conduct their business within the scope of a business license that is
granted to them. Companies using the VIE structure tend to conduct any part
While the VIE structure is
most common on the NYSE
and NASDAQ, it can also be
found in companies listed
on other foreign
exchanges, including Hong
Kong and Toronto
The WFOE is a Chinese
subsidiary that is wholly
owned by the offshore
listed company

Accounting Matters
of the business that can be done by foreign invested enterprises in their
WFOE. Often the WFOE obtains a business license that allows it to conduct a
consulting business, and its only customer is the VIE.
The VIE is a Chinese company that is owned by an individual who holds
Chinese nationality. The Chinese individual is typically the founder and
chairman of the public company. In situations where the founder is not a
Chinese citizen, another trusted employee is usually selected to own the VIE.
This allows the VIE to claim it is domestically owned when it applies for
permits to operate a business in a sector that is restricted for foreign investors.
However, in order to consolidate the VIE in the financial statements of the
public company, the VIE must meet certain accounting requirements.
FASB Interpretation No. 46: Consolidation of Variable Interest Entities (FIN 46)
contains the accounting rules for VIEs. It has been amended and is now known
as FIN 46R, and is included in the FASB Codification of Accounting Standards in
Section 810. The rules as presently written require an entity to be consolidated
where the parent company has the power to direct the activities of the entity
which most significantly impact economic performance, has the obligation to
absorb the expected losses of the entity, and has the right to receive the
expected residual returns of the entity. When the VIE is initially formed, none
of those conditions are met. In order to consolidate the VIE, a series of
agreements are put in place to meet those requirements. These VIE
agreements vary somewhat between companies, but most follow what has
become a standard protocol.
What are the standard VIE agreements?
The concept that underpins a VIE structure is that control is obtained through
legal agreements rather than through share ownership. Taken together, the
agreements are intended to provide the WFOE with substantially all of the
economic benefits from the VIE and the obligation to absorb all of its losses.
The typical VIE will use five agreements to achieve this:
Loan agreement
The first two agreements deal with capitalizing the VIE, and attaining some
sort of collateral for the loan given to provide funds for the capitalization. To
achieve this, a loan agreement is set up and the equity in the VIE is pledged as
collateral in the event of any failure to comply with the agreement.
The loan is normally given to the owners of a VIE by the WFOE and is typically
in the form of an RMB denominated, interest free loan running for a number
of years with the potential for extension. A loan from the offshore public
company would face regulatory problems with the State Administration of
Foreign Exchange. Regulatory problems remain, however. The authorized
business scope of the WFOE is unlikely to include making loans to Chinese
individuals, although no companies appear to have been challenged on this
issue.
The loan agreement typically transfers most shareholder rights from the
Chinese shareholder of the VIE to the WFOE, giving the WFOE the power to
vote shares in the VIE, collect dividends, and make other important corporate
decisions.
The VIE is a Chinese
company that is owned by
an individual who holds
Chinese nationality
The rules as presently
written require an entity to
be consolidated where the
parent company has the
power to direct the
activities of the entity
Control is obtained through
legal agreements rather
than through share
ownership
The loan is normally given
to the owners of a VIE by
the WFOE
The loan agreement
transfers most shareholder
rights from the Chinese
shareholder of the VIE to
the WFOE

Accounting Matters
Equity pledge agreement
In order to establish security for this loan the owners of the VIE pledge their
equity as collateral. Because an equity pledge is a form of security interest, it
needs to be registered with the relevant Chinese authorities before it is
perfected. If there is no registration, the equity pledge agreement may be
unenforceable. In the past, companies have had difficulty getting these equity
pledges properly registered. Pressure from the SEC has led to greater
compliance by companies in seeking the registration of equity pledge
agreements.
Call option agreement
The call option gives the WFOE the legal right to purchase the VIE at a set
price. This price is typically the amount of the loan granted to the founders to
capitalize the VIE, or the “lowest permissible price under PRC law”. However,
because the VIE is usually in an industry that is restricted to foreign
investment, the call option cannot be exercised by the WFOE and would
instead need to be transferred to another Chinese individual.
Technical service agreement
The major challenge with VIE arrangements is the requirement that the parent
company have a right to the residual profits of the VIE. This is typically
accomplished through an agreement or series of agreements that name the
WFOE as the exclusive provider of technical services to the VIE. The services
provided by the WFOE to the VIE vary by company and industry, but often
include website maintenance, programming, sales support, fulfilment services,
curriculum development, etc. The agreements give the power to set the
pricing for these services to the WFOE, and often explicitly provide that the
WFOE can extract all of the profits of the VIE through these service
agreements. In practice, however, many companies do not extract all of the
profits through service agreements. Some companies also use an asset
licensing agreement, under which the WFOE licenses certain assets, typically
including intellectual property, to the VIE in exchange for royalty fees.
Power of attorney
The founders of the VIE typically give a power of attorney to the WFOE that
assigns to it all of the normal shareholder rights, including voting, attending
shareholder meetings, and acts necessary to execute the call option
agreement.
Challenges to the VIE structure
Despite its widespread use for privately held Chinese companies listing abroad,
the VIE structure has come under considerable attack in recent years. These
risks fall into three broad categories: regulatory risks, shareholder
misappropriation risks, and operational risks.
Regulatory Risks – Will the government shut down my company?
The raison d’être for VIEs is to avoid the effect of regulation. Companies that
use the VIE structure tell two inconsistent stories. To Chinese regulators they
say that the business is owned by Chinese and not by foreigners. Yet, to
foreign investors they claim that foreigners own the business. It is unsurprising
that VIEs face regulatory challenges.
Owners of the VIE pledge
their equity as collateral
Gives the WFOE the legal
right to purchase the VIE at
a set price
WFOE can extract all of the
profits of the VIE through
service agreements
Give a power of attorney to
the WFOE
To Chinese regulators they
say that the business is
owned by Chinese and not
by foreigners. Yet, to
foreign investors they
claim that foreigners own
the business

Accounting Matters
Chinese regulators initially ignored the growing use of VIE structures, even as
most of China’s Internet sector was developed under this model.
No PRC regulatory body has officially approved a VIE structure, yet many
investors and advisors believe that they have tacit approval to use the
structure. There have been several challenges to VIE structures by regulators
in recent years.
The first regulatory attack on VIEs came in 2009 when the General
Administration of Press and Publication (GAAP), and two other regulators
published Xin Chu Lian [2009] No. 13, (Notice 13). Notice 13 specifically
prohibited the use of contractual arrangements to control Chinese Internet
game operators. No action, however, has been taken against companies in this
sector that use the VIE structure and the rules have essentially been ignored.
A more serious attack on the VIE structure occurred in late 2010 when Jack Ma
of Alibaba Group attempted to obtain a license for Alipay from the People’s
Bank of China (PBOC). The PBOC had decided to regulate online payment
processors and as a first step required them to obtain a license. Alipay is the
market leader among online payment processors in China. It operated as a
WFOE that was wholly owned by the Alibaba Group, a Cayman Islands
company owned in turn by Yahoo!, Softbank and Jack Ma, a Chinese individual
and CEO of Alibaba Group. Jack Ma was apparently told by regulators that
Alipay could not obtain the required license if it was a WFOE, so the entity was
converted to a VIE with Jack Ma as shareholder. Jack Ma was then informed by
regulators that the license would not be granted to a VIE, so the VIE was
unwound and Jack Ma ended up owning Alipay entirely by himself. Yahoo!
and its shareholders were obviously outraged at the loss of Alipay, and
negotiations ultimately lead to a deal for Alibaba to buy out Yahoo!.
Buddha Steel, Inc. pulled its planned IPO in March of 2011 after local
regulators in Hebei province told the company that its VIE structure
contravened current Chinese management practices related to foreign
invested enterprises and, as a result, was against public policy. Steel is a
restricted industry for foreign investment.
In August 2011, the Ministry of Commerce issued regulations requiring a
national security review when foreigners acquire domestic companies. These
regulations specifically provide that the required review could not be avoided
through use of VIE or similar structures.
In September 2011, a report surfaced in the Chinese press that was purported
to come from the China Securities Regulatory Commission (CSRC). The report
advocated greater regulation of the VIE structure (particularly in sensitive
areas such as the internet), and suggested that Chinese companies should be
encouraged to list at home. The report was widely reported and lead to a
significant decline in the price of companies using the VIE structure. Over the
next year, however, no significant changes in the regulation of VIEs transpired.
Shareholder misappropriation risks – Will someone steal my VIE?
The nightmare scenario for investors in companies using the VIE structure is
that the Chinese shareholder of the VIE will one day take the VIE and refuse to
acknowledge the VIE agreements. The VIE structure is dependent on the
enforceability of the contracts between the WFOE and the VIE. If those
Chinese regulators initially
ignored the growing use of
VIE structures
The first regulatory attack
on VIEs came in 2009...
...and then a more serious
attack in 2010...
...and let’s not forget
Buddha Steel
National Security review
needed
Greater regulation of the
VIE structure
The Chinese shareholder of
the VIE will one day take
the VIE and refuse to
acknowledge the VIE
agreements

Accounting Matters
contracts can be breached, not only does the accounting treatment fail, but
also the public shareholders lose the business that is in the VIE.
Lawyers have given opinions that VIE structures are legal under Chinese law,
often using remarkable legal gymnastics to explain why specific rules such as
GAPP’s specific prohibition on the use of VIEs for online games does not apply
to their Internet game company. The opinions are consistently caveated with a
statement that Chinese law is unclear and that authorities might disagree. The
opinions point out that if authorities disagree, the consequences could be
disastrous, leading possibly to the business being shuttered. What they do not
usually point out is that the shareholder of the VIE might take the position that
the contracts are not enforceable and will simply decide to ignore them and
take the VIE. Like most countries, China has a rule that says that contracts that
frustrate public policy are not enforceable, and as we saw in the Buddha Steel
case, local regulators and judges might decide that VIE contracts frustrate
public policy.
The first case challenging VIE contracts came up with the company that started
the VIE trend – Sina. In 2001, not long after Sina’s IPO, its board removed a
founder who was also the controlling shareholder of its VIE. In the end the
founder agreed to sell his shares in the VIE to another insider, and a crisis was
averted.
Nasdaq listed Agria Corporation nearly lost its VIE in 2008 when its COO, who
also owned the VIE, resigned in a compensation dispute. The COO had no
share interest in the public company. The dispute was settled through a
significant payment of cash and shares to the COO and to management of the
VIE, and Agria was able to retain control of its VIE.
Gigamedia, a Nasdaq listed, Taiwan based, online game company lost its VIE
when it tried to replace the VIE owner as head of its China operations. The VIE
owner took the company chops, registrations and other key documents for
both the VIE and the WOFE. The company and the VIE owner are fighting it out
in court, but Gigamedia had to start over in China.
The most serious case related to loss of the VIE to the VIE shareholder was
that of Alipay and Jack Ma. As previously discussed, Jack Ma ended up with
sole ownership of Alipay after the PBOC said that Alipay could not get an
online payment processor license if it was controlled by foreigners either as a
WFOE or through VIE agreements.
Operational Risks – Will the VIE actually work?
VIE structures have been in use in China for a little more than a decade. While
the regulatory risks and risks of VIE shareholder misappropriation have gotten
most of the headlines, there is growing concern that the VIE structure is
unworkable for some companies. When most of the business in the company
is conducted in the VIE, China’s tax and business laws make it difficult and
expensive to operate a VIE.
The problems arise in asset-heavy VIEs; those where most of the assets and
most of the business is conducted in the VIE. Internet companies are examples
of asset-light VIEs. They usually have a small proportion of the assets and
business in the VIE, operating most of the business in their WFOE. An Internet
company will typically put only the Internet content provider license and the
servers necessary to host the site into the VIE, retaining all of the
Lawyers have given
opinions that VIE structures
are legal under Chinese
law...
...but the opinions are
consistently caveated with
a statement that Chinese
law is unclear and that
authorities might disagree
The first case challenging
VIE contracts came up with
the company that started
the VIE trend – Sina
The most serious case
related to loss of the VIE to
the VIE shareholder was
that of Alipay and Jack Ma
There is growing concern
that the VIE structure is
unworkable for some
companies
The problems arise in
asset-heavy VIEs

Accounting Matters
programming, advertising sales, and fulfilment activities in the WFOE.
Consequentially there is minimal profit in the VIE, and this profit can be easily
extracted through the service agreements.
Education companies are good examples of asset-heavy VIEs. In this industry it
is necessary to put the entire school into the VIE because of restrictions on
foreign ownership. Because the school has to collect the tuition, all of the
profit of education companies tends to end up in the VIE. That creates
problems.
Under the typical VIE structure, the profits of a VIE are extracted to the public
company through service contracts. Chinese tax laws impose a 5% business tax
on service payments. The business tax is similar to a sales tax or value added
tax (VAT); in fact, China is in the process of turning the business tax into VAT.
This tax is a cost of using a VIE since it would not be payable (because there
would be no service charge) if the operations were in the WFOE.
There is also concern that Chinese tax authorities might question why a
company would pay 100% of its earnings to another company for services.
That is especially likely when those services are of dubious value. The
authorities might make a transfer pricing adjustment, disallowing a deduction
to the VIE for part or all of the service fee. That would significantly increase the
tax liability of the VIE (which usually pays tax at 25%). If the tax authorities
adjusted the transfer price, they might also allow the WFOE to reduce the
income it reports, resulting in a tax refund to the WFOE. But they might not.
After all, the cash found its way to the WFOE, so the tax authorities might
instead characterize the payment as a dividend to the individual shareholder
of the VIE (which is taxed at 20%), followed by a payment from the individual
shareholder to the WFOE (which might be characterized as interest on the
loan, and taxed to the WFOE at 25%). The end result would be a disaster –
raising the effective tax rate above 60%.
Because of this risk, many asset-heavy VIEs have not been making the
payments on the service contracts. Another reason for not making the
payments is that the companies typically need the cash in the VIE, not the
WFOE. It is usually not in the authorized business scope of the WFOE to be
making loans or capital contributions to the VIE, so if the cash is transferred to
the WFOE it is difficult to get it back to the VIE where it is needed for
operations or capital improvements.
Companies have not typically been accruing the taxes that would result if they
made the service payments under the VIE agreements. They argue that they
do not intend to ever make these payments. The problem with that argument
is that it undermines the basis for treating the company as a VIE in the first
place. One of the key requirements for consolidating a company as a VIE is that
the parent company has a right to the residual profits of the VIE. If it has no
intent to ever distribute the profits of the VIE to the public company, should
the public company be considered to have a right to those residual profits?
The most recent scandal with respect to VIEs broke when New Oriental
Education (NYSE: EDU) “EDU”, announced that it was under SEC investigation
as to whether it should be consolidating its VIEs. Shortly after this
announcement Muddy Waters, a short-selling research firm, released a report
alleging that EDU was improperly consolidating certain operations that were
Tax is a problem
Why would a company pay
100% of its earnings to
another company for
services?
Many asset-heavy VIEs
have not been making the
payments on the service
contracts
Companies have not
typically been accruing the
taxes
A scandal with New
Oriental Education

Accounting Matters
actually franchise operations, not-for-profits, or state-owned. A special
committee of the board was formed to conduct an investigation.
Where to now?
The problems with VIEs have led many investors to conclude that the structure
is unsustainable. The problems are unsurprising because the structure is based
on inconsistent statements. To investors, the company says that it owns its
operations, yet to Chinese regulators it claims it does not control them.
Neither statement is true and a structure built on lies is not likely to work for
long.
The reasons why the VIE structure is needed are related to Chinese regulations
restricting foreign investment in certain sectors, or which make it difficult for
Chinese companies to directly list abroad. The solution to the problem can be
found by addressing those regulations.
A number of state-owned enterprises have listed abroad without using
offshore structures or VIEs. China’s major telecommunications companies,
China Mobile, China Unicom, and China Telecom are all listed on the New York
Stock Exchange yet do not use either an offshore holding company or a VIE.
Like the Internet industry, the telecommunications industry is restricted for
foreign investment. These state-owned enterprises had the political power to
obtain permission to directly list ADSs abroad and to have foreign investment.
Private companies have not had that level of political clout and as a
consequence were forced into offshore holding companies and VIE structures.
The problem with VIEs and offshore companies could be eliminated if
permission were given to private companies to directly list abroad. No change
in law or regulations appears to be necessary, rather the government simply
needs to give the same permission to privately owned companies to directly
list abroad that it has given to the large SOEs.
Allowing private Chinese companies to directly list abroad would eliminate the
only justification for using a VIE structure – to avoid Chinese regulations that
prohibit foreign investment in certain sectors. It has the additional benefit of
closing the regulatory hole that these companies have fallen into. Chinese
regulators have been unable to effectively regulate overseas listed Chinese
companies because the listing entity is usually a Cayman Islands company that
is outside of their jurisdiction. U.S. regulators like the SEC and the Public
Company Accounting Oversight Board (PCAOB) have likewise been unable to
effectively regulate these companies because, despite being Cayman Islands
companies, the officers and records are located in China and Chinese
regulators will not grant them access. These regulatory holes have been a
major factor in creating an environment conducive to fraud. While allowing
private companies to directly list abroad does not solve the access issues for
U.S. regulators, it would allow Chinese regulators to more effectively supervise
the companies.
How to fix the VIE structures
If China decides to allow private companies to directly list abroad in the same
manner as SOEs, the Cayman Islands and VIE structures are no longer
necessary. If Chinese regulators decide to go in this direction, I expect they will
The VIE structure is
unsustainable
SOEs can list overseas
Why not allow private
companies?
It would help closing the
regulatory hole
Ask US-listed Chinese
companies to restructure

Accounting Matters
approach several leading U.S. listed Chinese companies and ask them to
restructure. The companies will be allowed to directly list ADSs of a Chinese
company on U.S. exchanges, but first they will be asked to merge the offshore
parent company and the WFOE into the VIE. At that point the operating
company in China would become the listed company. That is a big win for
investors since they now have direct ownership in the entity that actually
operates the business. The restructuring solves the regulatory problems, the
shareholder moral hazard problems and the operational problems that have
plagued the VIE structure. Investors can also hope that Chinese regulators take
a more active role in supervising the company, perhaps heading off some of
the frauds that have so damaged the market for U.S. listed Chinese companies.
The original concern of Chinese regulators in restricting foreign investment in
certain sectors was to make certain that Chinese, and not foreigners, were
making the decisions that impact sensitive sectors. Those concerns remain,
even though the offshore structures and VIEs have substantially undermined
the policy. I expect that Chinese regulators will want to make certain that
Chinese remain in control of critical decisions that may impact social stability
or state secrecy. The easiest way to accomplish this would be through a
multiple share structure. A shares, with full voting rights, would be issued to
Chinese nationals. B shares, with limited voting rights would be traded as ADSs
on U.S. exchanges. This structure would also facilitate the listing of A shares on
Chinese exchanges, which I expect the companies will be encouraged to do.
Chinese regulators have indicated they would prefer that the overseas listed
companies come home to list, and this could be the first step in making that
happen.
Another advantage of allowing Chinese companies to directly list abroad is
that the CSRC could be made the first gatekeeper for access to foreign capital
markets. Companies that wish to list overseas would need to seek the
permission of the CSRC, which could stop listings of companies with state
security issues or disreputable management. By making the CSRC the primary
regulatory of overseas listed companies, it should be easier for overseas
regulators such as the SEC and PCAOB to negotiate workable arrangements for
obtaining the information needed to enforce foreign securities laws.
Investors would actually
own the operating
company
Use a multiple share
structure to retain control

Accounting Matters
Figure 2: US Listed Companies With VIE Structure, in Descending Order of Market Capitalisation
Company BBG Industry IPO/RTO Market
Capitalisation
(US$m)
YTD
US$
(%)
Baidu Inc-Sp Adr BIDU Internet IPO 40,314 -1
Netease Inc-Adr NTES Internet IPO 6,764 15
Sina Corp SINA Internet IPO 4,587 33
Youku Tudou Inc YOKU Internet IPO 3,357 32
Focus Media-Adr FMCN Advertising IPO 3,126 25
Qihoo 360 Te-Adr QIHU Internet IPO 2,953 58
Ctrip.Com-Adr CTRP Internet IPO 2,653 -21
New Oriental-Adr EDU Commercial Services IPO 2,347 -37
Sohu.Com Inc SOHU Internet IPO 1,666 -12
Renren Inc-Adr RENN Internet IPO 1,562 14
Changyou.Com-Adr CYOU Software IPO 1,416 38
51job Inc-Adr JOBS Commercial Services IPO 1,260 4
Giant Intera-Adr GA Internet IPO 1,219 34
Home Inns & -Adr HMIN Lodging IPO 1,163 -1
Shanda Games-Adr GAME Software IPO 1,073 24
Soufun Holdi-Adr SFUN Internet IPO 1,090 7
Spreadtrum-Adr SPRD Semiconductors IPO 985 2
Asiainfo-Linkage ASIA Internet IPO 880 57
Tal Educatio-Adr XRS Commercial Services IPO 662 -14
E-House Chin-Ads EJ Real Estate IPO 661 34
21vianet-Adr VNET Internet IPO 619 21
Autonavi Hol-Adr AMAP Software IPO 608 22
Elong Inc-Sp Adr LONG Internet IPO 567 10
Perfect Worl-Adr PWRD Internet IPO 546 23
E-Commerce C-Adr DANG Internet IPO 435 24
Nq Mobile Inc- A NQ Software IPO 381 52
Hisoft Techn-Adr HSFT Software IPO 358 24
Fushi Copperweld FSIN Electrical Compo&Equip RTO 349 21
Cninsure Inc-Adr CISG Insurance IPO 324 -7
Synutra Internat SYUT Pharmaceuticals RTO 309 7
Bona Film Gr-Adr BONA Entertainment IPO 308 33
Isoftstone -Ads ISS Commercial Services IPO 298 -39
3sbio Inc-Adr SSRX Biotechnology IPO 299 32
Yingli Green-Adr YGE Electrical Compo&Equip IPO 295 -51
Kongzhong-Adr KONG Telecommunications IPO 284 65
Phoenix New -Adr FENG Media IPO 275 -37
Noah Holding-Ads NOAH Diversified Finan Serv IPO 264 -22
Xueda Edu Gp-Adr XUE Commercial Services IPO 231 -4
Ambow Educat-Adr AMBO Commercial Services IPO 209 -60
Charm Commun-Adr CHRM Advertising IPO 200 -39
Bitauto Hold-Adr BITA Internet IPO 180 8
China Nepsta-Adr NPD Retail IPO 181 46
Cdc Corp-Cl A CDCAQ Software IPO 180 3,088
Chindex Intl Inc CHDX Healthcare-Products RTO 177 22
China Digita-Adr STV Electronics IPO 173 -8
Jiayuan.Com Inte DATE Internet IPO 172 -6
Utstarcom Holdin UTSI Telecommunications IPO 170 -21

Accounting Matters
Capitalisation
(US$m)
YTD
US$
(%)
China Transinfo CTFO Software RTO 144 63
Taomee Holdi-Adr TAOM Internet IPO 135 -20
Airmedia-Adr AMCN Advertising IPO 122 -49
The9 Ltd-Adr NCTY Software IPO 121 -31
Chinacache-Adr CCIH Internet IPO 113 24
China Distan-Adr DL Commercial Services IPO 108 56
Chinaedu Cor-Adr CEDU Commercial Services IPO 105 0
Linktone Ltd-Adr LTON Internet IPO 93 94
Ata Inc-Adr ATAI Software IPO 98 -39
Syswin Inc-Ads SYSW Real Estate IPO 94 111
China Nuok-Adr NKBP Pharmaceuticals IPO 92 69
Acorn Intern-Adr ATV Advertising IPO 81 -33
Kingold Jewelry KGJI Retail RTO 79 30
L&L Energy Inc LLEN Coal RTO 74 -24
Sky-Mobi Ltd-Adr MOBI Retail IPO 70 -30
Cogo Group Inc COGO Computers RTO 60 0
China Techfa-Adr CNTF Telecommunications IPO 55 -42
Lentuo Inter-Adr LAS Retail IPO 56 -24
Noah Educati-Adr NED Software IPO 54 -33
Ku6 Media-Adr KUTV Internet IPO 50 -17
Ninetowns In-Ads NINE Software IPO 43 -15
Agria Corp - Adr GRO Agriculture IPO 41 -29
Mecox Lane-Adr MCOX Internet IPO 37 -45
Sinocoking Coal SCOK Coal RTO 38 -21
Origin Agritech SEED Biotechnology RTO 33 -39
Tri-Tech Holding TRIT Environmental Control IPO 32 -15
China Informatio CNIT Telecommunications RTO 27 -21
Daqo New Ene-Adr DQ Chemicals IPO 30 -49
Vimicro Inte-Adr VIMC Semiconductors IPO 31 -38
Trunkbow Interna TBOW Telecommunications RTO 29 -58
China Financ-Adr JRJC Internet IPO 28 -22
Visionchina -Adr VISN Advertising IPO 27 -79
Advanced Battery ABAT Electrical Compo&Equip RTO 24 -26
Chinacast Educat CAST Commercial Services RTO 24 -92
China Natural Ga CHNG Pipelines RTO 21 na
Telestone Techno TSTC Telecommunications RTO 18 -64
China Hgs Real E HGSH Real Estate RTO 15 -45
Efuture Informat EFUT Software IPO 15 -14
Skystar Bio-Phar SKBI Pharmaceuticals RTO 13 -40
Shengkai Innovat VALV Miscellaneous Manufactur RTO 12 -43
Andatee China AMCF Transportation IPO 12 -61
Biostar Pharmace BSPM Pharmaceuticals Other 11 -38
Chinanet Online CNET Advertising RTO 11 -55
Tianli Agritech OINK Agriculture IPO 10 -19
China Jo-Jo Drug CJJD Retail RTO 10 -38
China Yida Holdi CNYD Media RTO 9 -77
Dehaier Med Sys DHRM Healthcare-Products IPO 9 32
Euro Tech Hldgs CLWT Distribution/Wholesale IPO 8 56
Qkl Stores Inc QKLS Food RTO 8 -64

Accounting Matters
Capitalisation
(US$m)
YTD
US$
(%)
Cleantech Soluti CLNT Metal Fabricate/Hardware RTO 7 -13
China Advanced C CADC Building Materials RTO 8 -81
Sino-Global Ship SINO Transportation IPO 6 0
Recon Technology RCON Oil&Gas Services IPO 7 465
Kingtone Wir-Adr KONE Software IPO 4 -15
Jingwei Internat JNGW Software RTO 3 na
Tibet Pharma TBET Pharmaceuticals IPO 1 -95
China Cgame Inc CCGM Internet RTO 1 -81

Accounting Matters
Figure 3: Past Forensic Asia Research
Date Author Title Hyperlink
13 Sep 12 Quincy Sell Chinese Banks Download...
11 Sep 12 Gillem Tulloch Asian Financial Stress: A north-south divide Download...
05 Sep 12 Keith Neruda China Telcos: Time to put the Mobile/Unicom pair trade back on Download...
03 Sep 12 Gillem Tulloch Summer’s Over: China Prop/Everbright/Jain/Country Visits Download...
13 Aug 12 Gillem Tulloch Worldwide Financial Stress: BRICing apart? Download...
09 Aug 12 Keith Neruda Bharti Airtel (Sell): Time for Plan B Download…
03 Aug 12 Gillem Tulloch Thailand Visit (O/W): A crowded trade Download…
25 July 12 Forensic Asia Angels & Demons: Introducing ChartAsia Download…
24 July 12 Keith Neruda China Unicom (Sell): Not yet a fundamental buy signal Download…
20 July 12 Gillem Tulloch China Property: Making sense of it all Download…
09 July 12 Chris Roberts Asian Equities: Unfinished bear Download…
07 July 12 Gillem Tulloch Day 6: Boom town Download…
06 July 12 Gillem Tulloch Day 5: Bullet train to Beijing Download…
05 July 12 Gillem Tulloch Day 4: Shanghai frustration Download…
04 July 12 Gillem Tulloch Day 3: Wenzhou deteriorating Download…
03 July 12 Gillem Tulloch Day 1&2: Zhenzhou powering ahead Download…
28 June 12 Gillem Tulloch China Corporate Solvency: Accrued interested expenses rising Download…
24 June 12 Gillem Tulloch Greentown China (Sell): Dead man walking? Download...
20 June 12 Gillem Tulloch Suspicious Behaviour: China’s deteriorating working capital Download...
12 June 12 Forensic Asia Angels & Demons: It’s all about China Download…
11 June 12 Gillem Tulloch Greentown China (Sell): Mad or desperate Download…
05 June 20 Gillem Tulloch China (U/W): Corporate balance sheets at breaking point Download…
29 May 12 Gillem Tulloch A balance sheet goes missing Download…
25 May 12 Keith Neruda China Unicom (Sell): Lower rates don’t address core concerns Download…
22 May 12 Gillem Tulloch China Property: Are presales real? Download…
15 May 12 Forensic Asia Angels & Demons – Potpourri Download…
09 May 12 Gillem & Keith Indian Company Visits: Be greedy… Download…
03 May 12 Keith Neruda Bharti: Trading at 50x balance sheet adjusted PE Download…
26 Apr 12 Forensic Asia Angels & Demons: Mad & bad Download…
26 Apr 12 Keith Neruda China Unicom: Financing costs make themselves felt Download…
23 Apr 12 Keith Neruda China Mobile 1Q12 results Download…
18 Apr 12 Gillem Tulloch China Property: Just a bad dream? Download…
16 Apr 12 Gillem Tulloch Bo Xilai and China Everbright (Sell) Download…
11 Apr 12 Gillem & Keith China Mobile: A short debate on the pros and cons Download…
04 Apr 12 Gillem Tulloch Greentown China results: Going, going... Download…
02 Apr 12 Gillem Tulloch Shimao results: Don't buy the hype Download…
30 Mar 12 Gillem Tulloch Indian corporate overview Download…
23 Mar 12 Keith Neruda China Unicom (Sell): Valuation levers worsening Download…
21 Mar 12 Gillem Tulloch Philippine corporate overview Download…
15 Mar 12 Keith Neruda Profiting from mispriced balance sheets Download…
07 Mar 12 Gillem Tulloch Asia 2011 reporting season/Shimao Property presales fall 31% Download…
24 Feb 12 Gillem Tulloch US road show/China 2011 earnings disappoint Download…
17 Feb 12 Gillem & Keith Indian company visits – First thoughts Download…
16 Feb 12 Gillem & Keith Indonesian company visits Download…
09 Feb 12 Keith Neruda Bharti (SELL): Overvalued, illiquid balance sheet Download…
03 Feb 12 Gillem Tulloch China earnings disappoint Download…
27 Jan 12 Gillem Tulloch Reliance Communication: Under-Reporting Liabilities Download…
13 Jan 12 Gillem Tulloch India’s foreign debt problem Download…
Source: Forensic Asia

New Oriental

More Related Content

What's hot

Similar to New Oriental

More from asianextractor

Recently uploaded

New Oriental