GigaMedia: the Answer to the ‘What If?’ VIE Question

June 10, 2011

Mess with an equity owner, this is what happens.

Sorry to spring this on you late in the week. It’s a bit technical, but the topic is important for anyone doing China foreign investment and/or China IT work. Before I get started, thanks to Fredrik at the excellent China Finance blog for his post on the subject (and giving me the heads-up on this one).

I’ve talked about VIEs in the past. The term, which stands for Variable Interest Entities, refers to a specific corporate structure used in China, primarily to get around foreign investment restrictions. In the legal biz, we often refer to this as the “Sina Structure” since the Net firm Sina used it many moons ago.

The structure is relatively simple. The core business in China, in which foreign firms are not allowed to operate subsidiaries, is a domestically-owned company, owned by one or more Chinese nationals. That entity holds the valuable operational licenses, for example a license to operate an online game. This domestic firm is the VIE and treated as part of the overall business.

The rest of the operation is the foreign invested part. An offshore company is set up somewhere like in the Caymans or BVI, and that holding company then sets up a subsidiary in China, called a WFOE. The WFOE provides services to the Chinese firm described above, sucking revenue out of it, money which is then remitted offshore to the holding company.

If all goes well, the offshore holding company goes for a public listing somewhere, like the NASDAQ.

As I’ve discussed before, the problem here is that the listed company doesn’t own the VIE. Yes, there are lots of contracts between the foreign entity and the VIE, but the enforceability of those agreements is questionable.

What’s the risk? A very useful post on Seeking Alpha describes the two possibilities:

There appear to be two ways that a VIE structure might collapse. The first would be an outright attack by the Chinese government. Many of the VIEs were constructed to circumvent government restriction on foreign investment in certain sectors. The government could simply prohibit any agreement that transfers control, directly or indirectly, of any company in prohibited industries to foreigners. Such an attack would follow the Western concept of voiding contracts that are contrary to public policy.

The other way a VIE structure might collapse is if the legal owner of the VIE decides to take his company back and breach the VIE agreements. This is the case with GigaMedia’s majority owned subsidiary T2CN.

So what happened with GigaMedia? Essentially, the local guy walked away with not only the VIEs, but the WFOE as well. How did that happen? Easy. This fellow, Wang Ji, had complete ownership control of the VIEs, plus as head of the WFOE, he also had legal control of that entity as well.

Oops. Yes, this is the kind of thing I’ve been warning about for over a decade. We’ve seen this sort of thing many times with Representative Offices, and occasionally (and temporarily) a WFOE, but the scale of Wang Ji’s power grab is quite impressive.

What can GigaMedia do to get out of this mess? They have several lawsuits pending against Wang Ji. With respect to the China-based suits dealing with the VIEs, I say good luck. Wang Ji was the legal owner and, despite all those contracts, I would be very surprised if a judge here forced him to relinquish control, particularly to a foreign company that is legally not able to operate that sort of business in China anyway.

What about the WFOE? Well, different story there. Theoretically, GigaMedia merely has to file a letter of dismissal with the government, and Wang Ji is history. On the other hand, since Wang Ji is not going to cooperate (with respect to signatures, use of the WFOE seal, etc.), the entire process becomes that much more difficult and time consuming. Will GigaMedia get its WFOE back? Legally speaking, yes, it’s just a matter of time.

However, without the VIEs, who gives a shit about the WFOE? Remember, the WFOE is just a pass-through vehicle for VIE profits. If there are no VIEs, there are no operating licenses, and without those, GigaMedia will not be able to collect revenue. Pardon the expression, but the WFOE staff will be left sitting there with their collective thumbs up their useless asses.

Okay, that’s enough of that. This is a great example of what can go wrong. It would be nice to think that this dispute will serve as a wake-up call in the Net community, with foreign firms taking a fresh look at their legal structures.

But you know me, I’m not going to hold my breath.

For a lot more detail on this, including a look at GigaMedia’s SEC filing documents, I really encourage you to take a look at Fredrik’s post on this at the China Finance blog.