Do you still think SAIC filings do not matter? How about the SAT documents that are not accessible to independent third parties such as auditors?
It is a Game Changer! SAIC and SAT filings matter: Deloitte finally chose to reference SAIC and SAT documents in its probe into China Mediaexpress Holdin (NASDAQ:CCME) operations:
- Issue raised: Information on file with the State Administration of Industry and Commerce as to certain subsidiaries appearing to be inconsistent with comparable financial information provided to DTT
- Issue raised: the verification of certain subsidiary tax payments with the local office of the State Administration of Taxation
If auditors start to reference SAIC filings during audits, isn’t it prudent that investors should begin to acknowledge their importance? In fact, investors who do not are just plain ignorant and will find out that their diamond in the rough portfolios with glorious P/Es of five or less are just piles of worthless paper. (Investors also need to be aware that companies that amend past filings are likely not alerting SAT agencies of changes).
I will even go a step further and say that investing in companies that downplay the significance of SAIC filings and/or have not included auditor comments attesting to the independent viewing of SAT documents (mainly when SAIC filings do not match) will expose your portfolio to meaningful risks.
One more question: Think it can’t get any worse for investors who desire to go long the Chinese RTO space?
Well it just did! By now, anyone who follows the China space should be aware of VIE and FIE corporate structures. Simply put, an FIE structure is dictated by a direct ownership of a PRC operating company by an offshore entity (U.S. B.V.I, and/or Hong Kong, etc), while a VIE structure is enforced by management/consulting contracts between PRC operating subs and a PRC intermediary directly owned by an off shore entity. VIE arrangements were crafted by ambitious lawyers to enable Chinese companies to go public in the U.S., circumventing PRC laws that prohibit foreign ownership in PRC companies operating in certain industries. Keep in mind that the PRC government bodies have not clearly commented on the legality of VIE arrangements.
Related to this topic, let’s reference a passage out of the ‘Risk Factors‘ section of a typical ChineseHybrid 10K:
Buddha Steel Inc (OTCCB:AGVO)
“There are risks involved with the operation of our business in reliance on the VIE Agreements, including the risk that the VIE Agreements may be determined by PRC regulators or courts to be unenforceable. Our PRC counsel, AllBright Law Offices, has provided a legal opinion that the VIE Agreements are binding and enforceable under PRC law, but has further advised that if the VIE Agreements were for any reason determined to be in breach of any existing or future PRC laws or regulations, the relevant regulatory authorities would have broad discretion in dealing with such breach, including:
- Imposing economic penalties;
- discontinuing or restricting the operations of HAIC or Baosheng Steel;
- imposing conditions or requirements with respect to the VIE Agreements with which HAIC or Baosheng Steel may not be able to comply;
- requiring our company to restructure the relevant ownership or operations;
- taking other regulatory or enforcement actions that could adversely affect our company’s business; and
- revoking the business licenses and/or the licenses or certificates of HAIC, and/or voiding the VIE Agreements.
Any of these actions could adversely affect our ability to manage, operate and gain the financial benefits of Baosheng Steel, which would have a material adverse impact on our business, financial condition and results of operations. If we are unable to restructure our relationship with Baosheng Steel in such circumstances, our resulting corporate structure (Buddha, Gold Promise and HAIC) would have essentially no operations or means of operating a steel business.”
Most players in the ChinaHybrid space assumed that VIE structures would not be challenged. That would jeopardize companies like Baidu Adr (NASDAQ:BIDU)…Well, a VIE structure has finally been challenged in the case of AGVO, leading to the termination of its recent reverser merger transaction:
“On March 22, 2011, Buddha Steel, Inc., a Delaware corporation; the majority shareholder of Buddha; Gold Promise (Hong Kong) Group Co., Limited, a Hong Kong Corporation (“Gold Promise”); Hebei Anbang Investment Consultation Co., Ltd., a Chinese company (“HAIC”); and Dachang Hui Autonomous County Baosheng Steel Products Co., Ltd., a Chinese company (“Baosheng Steel”) entered into a Termination Agreement pursuant to which the parties terminated the Consulting Services Agreement; Operating Agreement; Voting Rights Proxy Agreement; Option Agreement and Equity Pledge Agreement all dated as of April 2, 2010.
In March 2011, Baosheng Steel was advised by local governmental authorities in Hebei Province of the People’s Republic of China that the Control Agreements contravene current Chinese management policies related to foreign-invested enterprises and, as a result, are against public policy.”
Realistically, I do not think Companies like BIDU are at risk here. But we at Geoinvesting are postulating that China may be finally taking measures to regulate companies that choose to go public via reverse mergers. I do not want to illicit undue panic yet, but investors need to be aware of another risk thrown into the “beloved cesspool” of Chinese RTO companies that embody VIE structures. A difference between FIE and VIE structures is that FIEs are required to undergo a joint inspection by SAIC and SAT agencies, VIEs are not. Therefore, the analysis of SAIC filings for VIEs cannot automatically be used in the same way they are used for FIEs. It is very plausible that if this “VIE” risk morphs into a bigger ordeal, RTO VIE’s will be lucky to experience significant P/E expansions.
On a related topic, we think that there could be equally large problems for companies that embody FIE structures that operate in industries in which the PRC does not allow direct ownership. China Education Alliance (NYSE:CEU) and Subaye (NASDAQ:SBAY) come to mind. Both of these companies portray an FIE structure even though, according to our findings, foreign direct ownership is strictly prohibited in their respective industries. Stay tuned, as the GeoTeam has come across another company with a broken ownership structure that we feel could send shares tumbling by at least 50%.
See more on our SBAY findings here…
See more on the relevance of SAIC filings here.
To see a circumstance where SAIC can be relevant in the analysis of VIE, such as CBEH, please go here.
Disclosures: Short CBEH stock; Position in CBEH Puts; Short SBAY, Short CCME after the exercise of CCME puts.