by Xinhua writers Zhang Yi, Wang Zichen
BEIJING, July 23 (Xinhua) -- A probe by the U.S. stock regulator and attacks from a business research group have created trouble for a well-known Chinese education agency and provoked debate about a type of ownership structure widely employed by U.S.-listed Chinese companies.
Shares of the NYSE-listed New Oriental Education & Technology Group plummeted by more than one third on July 18 because of an investigation notice from the U.S. Securities and Exchange Commission and an accusation from Muddy Waters, a research group specializing in risks analyses of Chinese companies, stirring controversy about the firm's ownership structure.
Muddy Waters said in a report that the variable interest entity (VIE) ownership structure "creates the illusion that the shareholders own the underlying business. In reality, management or their designees are the shareholders of the operating business."
In this particular case, Muddy Waters alleged that New Oriental's VIE structure "was -- and still is -- dangerous for shareholders" and "deviates widely from best practices and is among the most troubling" ones.
One day before Muddy Waters issued its report, New Oriental issued a public notice stating that "the U.S. Securities and Exchange Commission has issued a formal investigation order." The company believes the investigation concern the consolidation of its VIE into its financial statements.
Although the company has tried to mollify market sentiment since the news broke, investors remain nervous about the ownership structure, despite the fact that it has been used by many Chinese companies.
VIE was first adopted by Chinese Internet giant Sina in 2000 when the company was trying to go public in the U.S. It has since been used by dozens of Chinese enterprises that have sought presence on the U.S. stock exchange.
Generally, the structure allows U.S.-listed firms to control -- but not legally own -- companies that are actually operating in China, or VIEs.
Public companies have contracts with operating businesses that are supposed to provide cash back to them, and controls that act as management checks.
Although the VIE structure has involved market capitalization of hundreds of billions of U.S. dollars and served shareholders for a decade, the stock turbulence last week has spawned doubts about legitimacy of such a practice.
"The very idea of VIE and its ilk is to let private enterprises raise money overseas while getting around Chinese regulations and restrictions," said Kevin Wang, a Beijing-based partner with Allbright Law Offices, a firm known for corporate and commercial practices.
Under government provisions, Chinese companies must be scrutinized by a series of regulators before they may be listed in foreign countries.
But few private companies ever bother to go through the process, as they assume they will not receive a permit in the end, said Paul Gillis, a member of the standing advisory group of the U.S. Public Company Accounting Oversight Board (PCAOB).
Chinese entrepreneurs often choose to register new companies in foreign countries as listing vehicles in order to avoid the permit application, industry insiders said.
However, since some of the listed companies are foreign-registered, they are subject to China's limitations on foreign investment, which restrict or exclude foreign companies from multiple sectors, including those related to education and the Internet, even though the management is in Chinese hands.
To circumvent the restrictions, Chinese business people have employed a complex combination of contracts which transfer all rights, obligations and decision-making from operating entities in China to openly-traded companies owned by investors.
In essence, investors hold interest in Chinese companies not based on voting rights, but on a series of contracted agreements.
The VIE structure first faced intense scrutiny last year when a spar between Chinese company Alibaba and its shareholder Yahoo highlighted the structure's flaws.
Alibaba was accused of transferring Alipay, a key asset, to another Chinese company controlled by Jack Ma, Alibaba's founder, allegedly without the knowledge of Yahoo and Softbank, two of the company's biggest shareholders.
Alibaba was seeking a license from the Chinese financial regulator, but the central bank asked Alipay to submit a statement proving it had no contractual ties to foreign investors.
Although Ma later dismissed claims that he sidestepped investors' oversight, the dispute battered the market's confidence in Chinese companies listed in the U.S., as it brought public attention to the gap between global investors and local administrators.
"The VIE structure poses significant risks to shareholders," said Gary Liu, deputy director of the Lujiazui International Finance Research Center under the China Europe International Business School.
"Legally, shareholders in America don't actually own the Chinese entity that operates on the ground and generates profits. What binds the parties is just part of a contract," Liu said.
In addition to doubts about the binding power of these contracts, Gillis warned that investors could be exposed to another hidden risk.
Regulatory authorities in China may one day deem the practice illegal, as VIE was created to circumvent certain government regulations and public policy, Gillis wrote in his China Accounting Blog.
"Nobody would willingly pick this ownership structure as the first choice," Liu said. "It's the last resort."
Analysts have argued that uncertainties created by the VIE structure must be mitigated in order to maintain financial stability and boost investors' confidence.
"Investors have become skeptical of companies that use the VIE structure and there is a discount in the valuation of these companies," Gillis said.
Liu urged administrative bodies to allow more flexibility in foreign investment.
"If the government is concerned about foreign-registered companies investing in certain industries, it can examine specific requests based on clear and detailed criteria instead of restricting the whole industry," Liu said, referring to a practice that the U.S. has adopted to check Chinese investment.
Wang argued as long as founding, management, operation and clients are all very much Chinese, the country should have no fear of "industry invasions," even though the companies in question might be registered overseas.
Gillis suggested that the Chinese government relax regulations on foreign financing and widen private companies' access to capital.
"The private enterprises need to be given the same deal that state-owned companies have -- the ability to directly list on foreign exchanges as long as they are regulated by the China Securities Regulatory Commission," Gillis said.
China might also ask the companies to put voting power in the hands of Chinese citizens, which could easily be done by using two classes of shares, the same structure Facebook recently used, Gillis said.
Analysts have generally predicted that Chinese companies have easier access to capital if the VIE structure is replaced by actual ownership.