Buddha Steel, VIEs and Legal Ethics: Part II, Man Discovers the WFOE

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Two initial comments to start off with. First, I’ll try to make this post shorter than Part I; second, I suggest you read Part I before this one — it will make a lot more sense that way.

Right. Well, last time I talked about how some canny lawyers and their venture capital overlords came up with a sneaky way to get around China’s foreign investment restrictions during the Internet boom years. The structure involved an offshore company and a series of dubious contracts between that foreign company and the Chinese entity that held various Internet-related licenses.

But time marches on, and wily attorneys adapt to changing circumstances. Let’s rejoin our heroes, Everyman Wang and Generic Zhang. When last we saw our intrepid entrepreneurs, they were busy pissing away 12 million dollars of investment on the dubious venture ‘EZ Cheez,’ a PRC-based cheese straightening company. It’s now 2006, and the boys have called up CEO Capital with a new pitch:

Wang & Zhang: Hi, Mr. CEO. We feel really bad that EZ Cheez went under, but that’s how the cookie crumbles.

CEO: Yeah, that’s life. We lost a ton of money on shitty deals, but lucky for us, we were bought out of some others and even managed to ride a couple to public listings.

Wang & Zhang: Congrats. We have a new company that needs investment.

CEO: Great. We invested once, so you guys must be OK. Gimme the pitch.

Wang & Zhang: Through our government contacts, we’ve once again secured a monopoly position in a highly restricted industry in China: sneeze insurance.

CEO: Come again?

Wang & Zhang: You know, when you sneeze, you involuntarily close your eyes and several different muscles can contract. This leads to a lot of accidents. Consider what happens if you’re operating heavy machinery and you sneeze at just the wrong time.

CEO: Never worried about it before.

Wang & Zhang: And with sneeze insurance, you won’t have to.

CEO: You guys never cease to amaze me in your ability to create new markets.

Wang & Zhang: Our new company, iSneeze, has been promised the only license to underwrite sneeze insurance policies in the PRC, but we need 50 million dollars to capitalize.

CEO: Consider it done, but let me talk to my lawyer first.

Since the EZ Cheez deal, CEO has fired its previous lawyer, Merc, for being too old (32). This is a young man’s game, and they now get their advice from Tyro, a 28-year-old VC lawyer with several years experience “in the Valley.”

CEO: Well, young Tyro, what can you tell me about iSneeze?

Tyro: Yep, it’s in a restricted area, but don’t worry, I’ve got you covered.

CEO: You’re not going to set me up with one of those offshore company/service contract setups, are you?

Tyro: Well, yes, what’s wrong with that?

CEO: It’s just so six years ago. Can’t you give me something a bit more fresh?

Tyro: Sure, I have a fresh option for you that will make it even easier for you to get profits offshore.

CEO (laughing): ‘Profits.’ You lawyers, always with the strange jargon. Just tell me what the structure looks like.

Tyro: OK, well, as usual, we set up an offshore company somewhere like the Cayman Islands or BVI – the shareholders will be Wang, Zhang and CEO Capital.

CEO: Sounds familiar.

Tyro: Here’s where it’s different. Instead of all those contracts between the offshore company and Wang & Zhang’s Chinese company, iSneeze Insurance PRC Ltd., we do something else. The Cayman company sets up its own PRC entity, a wholly-foreign owned entity, or WFOE–

CEO: Gesundheit.

Tyro: –which provides services to iSneeze Insurance PRC Ltd.

CEO: But iSneeze Insurance is the one that has the insurance license and makes all the money, right?

Tyro: Yes.

CEO: And we don’t own any of that company?

Tyro: No. You own a WFOE, iSneeze Services Ltd., the exclusive service provider to iSneeze Insurance Ltd. The insurance company collects premiums but the WFOE will suck up all the profits and send them offshore to the parent company. The great part is that since the service agreements are between two PRC-based companies, we won’t have to get an approval from the foreign exchange authority!

CEO: Wow, that’s clever! But if it doesn’t really own anything, will that affect the listing of the Cayman company?

Tyro: Not at all. It will own the WFOE, which will have an exclusive deal with the insurance company. Moreover, in addition to service agreements between these two onshore companies, other contracts will bind Wang & Zhang, and iSneeze PRC to the Cayman company.

CEO: Such as?

Tyro: Such as: a Power of Attorney, giving the Cayman company the ability to control certain actions of the founders; an Option Agreement, which allows the Cayman Company to buy equity in iSneeze PRC; a Loan Agreement, whereby the founders state that they have borrowed money from the Cayman company to establish iSneeze PRC.

CEO: Wow, that sounds very technical. What does all that get us?

Tyro: If something goes wrong, you’ll be able to exert control over the PRC company and even purchase shares if need be.

CEO: And these agreements are enforceable?

Tyro: I’ve never had a judge strike them down, not once!

CEO: Great! Let’s do it!

Editorial Note: You probably recognize this as the so-called ‘Sina structure’ after the Net portal Sina. They were one of the first to use it, and the name stuck (I still use that name, as opposed to VIE structure).

What’s the problem with a Sina structure? Basically, it’s a fiction. When you list, you’re telling folks that you have a solid legal foundation, when in reality you don’t. The Sina structure gives you the benefits of that restricted China business while hiding the regulatory risk from everyone. Much like wearing dark pants and pissing down your leg, you get a nice warm feeling, but nobody notices.

What’s the risk? The problem here is that that offshore company, despite these contracts, doesn’t really exert control over the PRC entity. Sure, they have these loan agreements and option agreements and so on, but try going into a court in China and enforcing them. Ain’t gonna happen.

My fictional lawyer Tyro claimed that he never had a judge strike down these contracts. Probably true. I once asked a very famous China-based VC lawyer, who had done hundreds of deals, if he had ever tried to enforce any of these agreements in a PRC court. He actually laughed, then paused, then admitted that it had never happened.

The Sina structure is even more sneaky than the one I talked about last time because there is an actual PRC-based company, the WFOE, that exists. When a company lists, there it is for folks to look at. “Hey, look there, that’s what we’re getting, a Chinese company. Let’s toss in a lot of money.” Unless they read all the disclosure docs carefully AND get an expert opinion, they probably have no idea that the WFOE is probably only legally allowed to provide “consulting services” or “software development,” a far cry from the kinds of things the listed company is all about.

Ten years ago, I used to wonder what on earth people were thinking when they bought shares in these companies. Eventually I realized that they were relying on prospectuses and disclosure docs that were far from transparent. Lawyers and accounting firms, and their legislative partners in crime, have gamed the system so that the language given to prospective investors is downright misleading.

Think about it this way. Many of the China-based lawyers I know don’t even understand this stuff, much less know whether a Chinese judge would enforce these agreements. Your average investor/fund/legal counsel (whatever) knows much, much less, and yet they are expected to take that language and make an educated investment decision. This is what the “rigorous” U.S. securities laws give us. It’s kind of a joke, and it makes me wonder (since I’m not a securities lawyer) how often investors get screwed over like this.

In Part III, I will finally mention Buddha Steel and what happened to it. More important, I want to say a few things about lawyers who do this kind of work and the right/wrong way to advise clients about risk from the standpoint of professional responsibility.

6 responses on “Buddha Steel, VIEs and Legal Ethics: Part II, Man Discovers the WFOE

  1. Fredrik

    Great post!

    This is actually a lot clearer than many of the SEC filings you see. I don’t quite agree with you that the language is misleading, but it deliberately requires the reader to have a level of insight and knowledge into the practice, and the business, that the writers know very few people have.If you look at the filings through time you can actually see how the presentation develops into its present form, although actually going about doing this is, I will readily admit, quite boring.

    1. Stan Post author

      I think a lot of the language out there is misleading because of what isn’t there. Taken by itself, it sounds at best quite vague, necessitating, as you said, a level of knowledge that most people do not have. That’s a problem with a lot of types of disclosure rules, and legalese in general. If the language is that convoluted, vague, etc. then what’s the point of having the rule there in the first place? Same goes for things like the fine print on credit card applications and other transactions that involve a wide range of the general public who have zero resources to hire lawyers to review the language. It’s a clear violation of the spirit of consumer-based rules, but not of course the letter of the law.

      1. Fredrik

        I see what you mean, the problem with this disclosure is the cut-off point where it’s just acceptable for them to stop because knowledge is assumed. It’s a tough one to get at I fear, I remember at Uni when a friend of mine was in opposition on a paper where the authors had defined “email” and “the Internet” among other things (about half a page each I believe) so it’s a bit of a balancing act.

        By the way, do you know exactly how the lawyers are allowed to give an expert opinion saying the contracts are legal and enforceable, and then in the next sentence say that really they have absolutely no idea? This, to me, is the weirdest and most comical part of the filings…

        1. Stan Post author

          I don’t know much about the US securities law end of this. I can, however, tell stories about how foreign companies/law firms get “legal opinions” signed off on by local Chinese law firms without the latter really having any input at all on the substance. It used to be “Here, sign this paper, and we’ll pay you X.” Shameful, really.

  2. Robert Park

    Slightly off-topic, but this series has got me wondering what are acceptable and not acceptable ways of raising money in China when mixed in with some recent news.


    Misleading headline from The Economist aside, this was the money quote that made me curious:

    “Ultimately, she was convicted of “illegal fund-raising” for, the court concluded, raising 773m yuan from illicit sources.”

    What’s considered an illicit source? Was she money-laundering? Or was it just pure fraud that made it an illicit source? Chinese law seemed to come down hard on this lady, though who knows if those investors will ever see their money back. But does Chinese law do anything to cover the asses of these VC guys in California too? Etcetera. Confused.