Buddha Steel, VIEs and Legal Ethics: Part I, the Internet Years

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This is Part I of maybe two or three posts that is ostensibly about the recent Buddha Steel case, in which a Chinese company with a US listing announced that part of its corporate structure was found to be unacceptable to Chinese regulators.

If you don’t plan on reading this series, my conclusion with Buddha Steel is that I don’t see a wave of similar actions from the PRC government for companies with variable interest equity (VIE) structures.

That being said, I’m going to use this an excuse to thoroughly explain exactly what these corporate structures are, why they are important to the practice of foreign investment law in China, and why I’ve been railing against these things for the past 12 years. In the meantime, if you want the quick and dirty on Buddha Steel, etc., you can to go China Accounting Blog (the author and another reader of mine clued me in to Buddha Steel in the first place), Pillsbury Winthrop law firm, and China Law Blog.

OK, so let’s get started. Let’s go back to the China mini Internet boom, which lasted about nine months or so in ’99/’00. I teach this every year to my FDI students, and it’s a bit dry, so instead of the usual lawyer-speak, I’ll give you a short excerpt from the screenplay I wrote back in 2003 (was never picked up for some reason) about a couple of entrepreneurial Chinese kids making waves in a fast-paced new industry:

Narrator: In the beginning . . . [cue music][camera pans down from overhead shot – we see a small group of apes sitting on a bluff in a primeval setting looking down into a valley where a large black monolith has just appeared].

Well, in retrospect, that opening sequence was a bit overdone. In the interests of time, let’s fast forward to 1999.

We are now in Beijing, and our two heroes, Everyman Wang and his best friend Generic Zhang, have just graduated from the prestigious Tsinghua University. For 14 months now, they have struggled to get their Internet business off the ground, but they realize that they need capital to expand and have approached a Venture Capital firm from California called CEO Capital. We join the meeting in progress:

Wang & Zhang: So we’re very interested in bringing you on as an investor.

CEO: I’m sure you are. Tell me again about your company.

W&Z: We are currently the only company in China that offers cheese straightening services, and we do so through an online booking portal.

CEO: Wow, the only one?

W&Z: Correct. We were granted a monopoly license because of connections that we have with the Ministry of Silly Gadgets.

CEO: Amazing. So that means–

W&Z: Yep, if you are in China and need your cheese straightened, you have to come to www.ezcheez.cn.

CEO: Incredible. I mean, I know I’m just a Cock-Eyed Optimist, but if just half of the people in China need their cheese straightened on a regular basis . . .

W&Z: Yeah, we’re pumped. But we calculate we need 12 million dollars to expand.

CEO: With a monopoly position like that, I don’t think that will be a problem, guys. I’ll go talk to my lawyer.

W&Z (sotto voce, to each other): We just made 12 million bucks!

The meeting adjourns, and the rep from CEO Capital goes back to California, where he meets with his legal advisor, a venture capital expert named Merc who has, he points out, extensive experience with Chinese start-ups.

CEO: So you did some research on EZ Cheez. What can you tell me?

Merc: Looks awesome, but there is one wrinkle.

CEO: I don’t like the sound of that.

Merc: Not to worry. The wrinkle is that foreign investors are barred from the cheese straightening business in China.

CEO: So I can’t buy any equity? That’s not going to work. Woe is me!

Merc: It does sound bad. I thought about it for days and couldn’t come up with a solution. Then last night I visited some friends up north and ate some Blondie’s Pizza with some suspicious mushrooms on it. I had the most interesting dream.

In the dream, I was flying high above China, looking down. I could see the Great Wall and a huge army of barbarians on the outside. The invading army attacked the wall again and again again but could not break through. All of a sudden, a wizard appeared to the barbarians and tapped the commanding general on the head with a gnarly old stick — seriously, that stick was really cool. Anyway, immediately the barbarian army turned intangible, and they moved forward and walked right through the Great Wall! They were about ready to rape, pillage and so on when I woke up.

CEO: That’s a bitchin’ dream, dude.

Merc: Absolutely. It also solves your problem.

CEO: How’s that?

Merc: The army is your investment. When it was solid, in this case an equity purchase, the Great Wall (i.e. China) wouldn’t let you in. But when it was intangible, there was no problem.

CEO: So how can I turn myself invisible?

Merc: Intangible. Whatever. Here’s my idea. Instead of buying into the PRC company, we set up a new one in the Cayman Islands, with Wang, Zhang and CEO as the investors.

CEO: But that company would have no assets!

Merc: Doesn’t matter. That company, call it EZ Cheez Ltd., signs a series of contracts with the Chinese company, call it EZ Cheez PRC, to provide exclusive management services, license the EZ Cheez trademark, etc. Using the same name and having this relationship, everyone will just see these companies as part of a greater enterprise.

CEO: So we don’t need assets, just these contracts? Remember that the plan is to list in three years.

Merc: Nothing to worry about. We’ll bury some language in your disclosure documents about some of the risks of this structure, but no one will understand it anyway. The important thing is that the Cayman company will be sucking all the profits from the PRC company.

CEO: I’m not sure what you mean by ‘profits’. Is that some sort of legal jargon?

Merc: Don’t worry. You can list with this structure.

CEO: Awesome! Um, by the way, what happens if we have a problem with Wang and Zhang? Are these contracts safe?

Merc: {laughing} Of course! We’ll make ’em enforceable in a safe place, like Hong Kong. Anything happens, and you can grab those shares away from those kids.

CEO: I’m sold! Where do I send the 12 million dollars, directly to EZ Cheez PRC?

Merc: No. Remember that you won’t have any direct relationship with EZ Cheez PRC, so you can’t fund their activities.

CEO: But they need operational capital to expand!

Merc: Calm down, nothing to worry about. You put the money into EZ Cheez Ltd. Wang and Zhang will fly down to Hong Kong, withdraw cash as they need it, and carry it across the border into China.

CEO: Like in a suitcase?

Merc: A suitcase, cardboard box, whatever receptacle they feel comfortable with. This is a business custom in China, or so I’ve been told.

Editorial Note: This was the very first sort of corporate structure I saw, back in 1999, that attempted to get around China’s ban on investment in the Internet sector. A company was set up in the Caymans, BVI, or Hong Kong, money was thrown in, and it was off to the races.

I knew companies that were carrying money in from Hong Kong in suitcases. I had some start-up clients who conflated the terms “revenue” and “investment”. That being said, please note that not everyone was doing it this way; I am not trying to paint the entire venture capital industry with this brush (just most of them).

What about all those service contracts? Did they work? To be honest, it didn’t really matter in the early days. These start-ups were years away from making any money, so there were no profits to distribute.

What about the VC guys, did they make out OK? Some of them were bought out, others rode out on a listing. Mr. VC made his money, the founders got filthy rich, etc. For firms that went sideways, though, the VCs (and other investors) were left high and dry, with no assets to go after. In the end, they had nothing but some worthless equity in an offshore holding company. Sometimes this was just normal business risk, but other times the investors had the rug pulled out from under them just when the start-up starting making money.

You might be thinking, wait a minute, that Cayman Island company had no assets, nothing of value except these service agreements that were questionable when it came to enforcement. How would a company like that get listed?

Good question. That was the problem I had back then as a young(er) lawyer, and it’s the same one I have today with so-called VIE structures, an issue I’ll get into next time. Suffice it to say that a lot of these companies were not only built with money from Sand Hill Road, but their corporate structures were built on sand also.

Part II: in which Wang & Zhang’s lawyer discovers the WFOE, a VC lawyer comes up with new worthless contracts, and foreign investors continue playing fast and loose with risk management.

One response on “Buddha Steel, VIEs and Legal Ethics: Part I, the Internet Years

  1. pug_ster

    Lol, I love the schnick that you wrote. Then again, that’s what happens to many of these startups, most of them fail, but some of them do succeed.