SEC Investigates New Oriental VIE Structure. Let the Chatter Begin.

July 18, 2012

Chinese education company New Oriental, which is listed in the U.S. on the New York Stock Exchange (NYSE: EDU), included this little bomblet in a July 17 earnings press release:

On July 13, 2012, the Company was informed that the U.S. Securities & Exchange Commission (the “SEC”) had issued a formal order of investigation captioned “In the Matter of New Oriental Education & Technology Group Inc.”  The Company believes that the investigation concerns whether there is a sufficient basis for the consolidation of Beijing New Oriental Education & Technology (Group) Co., Ltd., a variable interest entity of the Company, and its wholly-owned subsidiaries, into the Company’s consolidated financial statements.

Oh my. Grab a cup of coffee and strap in. This will take a few minutes to unpack.

It’s been a while since we talked VIEs. If you recall, the VIE structure refers to a corporate structure used by many Chinese companies that list overseas. The pieces of the puzzle include the Chinese domestic operating company (the VIE), an offshore entity that has wholly foreign owned subsidiaries (WFOEs) in China, and legal agreements between the VIE and the WFOE(s).

EDU is in a business sector restricted to foreign investment, so the VIE structure allows foreign investors to put their money into the company via the NYSE listing as opposed to directly into the operating entity. As I’ve written many times before, I consider this to be an obvious end-run around China’s foreign investment laws and therefore problematic from a legal perspective.

First question: what is the SEC concerned about here? Answer: I have no idea, and I doubt that many other commentators out there know for sure either.

The obvious candidate is the corporate restructuring that EDU announced on July 11, but there is a problem with that interpretation. The move made by EDU was simple: it was an equity buyback between the current CEO Michael Yu and several shareholders of the VIE that no longer work for the company.

The consolidation had zero effect on the VIE structure itself, nor are there any legal issues I can spot offhand regarding the equity purchase. Therefore, I can see no reason why the SEC would be interested in this restructuring, unless there is something else going on regarding those purchase and sale deals that we don’t know about. The equity consolidation, into the hands of the CEO, is not exactly positive from a risk-management point of view, but that is separate from the legal considerations.

Second question: if it isn’t the restructuring, what else could it be? Answer: the SEC might finally be questioning the VIE structure.

OK, don’t panic. I do not know whether the SEC has decided, after all this time, that the VIE structure is actually not as robust as it might appear to be. But you never know. Here are a few possibilities, including a couple suggested by VIE guru Paul Gillis who posted on this last night on the China Accounting Blog with the provocative title “SEC v EDU: the end of VIEs?“:

1. The general legality of the VIE structure under China law — the possibility exists that the PRC government will regulate in this area and declare that some or all of these structures are illegal. It’s not at all likely, but it could happen, and this represents a real risk for investors. However, unless SEC and the Ministry of Commerce are working together on this, the PRC regulatory threat seems way too vague a possibility to bother the SEC at this point.

2. Specific enforceability of VIE/WFOE contracts — because the purpose of these agreements is, arguably in the case of companies like EDU, to bypass China foreign investment restrictions, the validity of the agreements can be called into question. But is this enough to get the attention of the SEC? I doubt it. Lawyers here do not even agree on this issue, so it would be exceedingly odd for SEC to jump in the middle of the debate, unless the issue is simply better/more risk disclosure.

3. Specific provisions of the VIE/WFOE contracts — this would vary depending on the agreements, but there are some common problems here. For example, some VIE contracts include pledge agreements, whereby equity of a VIE reverts to an investor under certain circumstances. In my opinion, if that investor is foreign, then the shareholding becomes problematic if the company is in a restricted industry. Another example is a service agreement between the VIE and WFOE, whereby the WFOE provides services to the VIE in exchange for cash; this is the way that revenue is siphoned off from the operating entity to the offshore structure. If the terms are not reasonable (some agreements attempt to siphon off essentially 100% of the revenue, which is a poor choice), the service contract might not be enforceable.

(These next two were pointed out by Paul Gillis)

4. Attorney letters and disclosure — every time one of these companies lists with a VIE, they need a PRC attorney to sign off on the legality of the structure. Some of this language is acceptable, but in some cases, I find it wholly lacking in terms of adequate disclosure of risk.

5. Lack of revenue flow-through — as I mentioned above, revenue is supposed to flow from the VIE to the WFOE, up to the parent. You know, actual value that investors might care about. But in some cases, that revenue gets stuck with the VIE. Could be a legal issue like I described above, or it could be tax avoidance. Every time that money goes from VIE to WFOE under a service agreement, we’ve got a taxable event (usually 5%, sometimes higher). If the money never gets to the WFOE, what does that tell us about the value of the listed entity? And if the argument is that the revenue will move there at some point in the future, then there’s a big ass tax liability hanging out there.

Third question: what does this mean for EDU, whose stock has tanked as a result of the announcement? Answer: the news ain’t good, but it’s hard to speculate on results until we know what SEC is looking at. As I already mentioned, it’s hard to see why SEC would open a formal investigation on account of what appears to be a legal corporate restructuring. Aside from that, EDU is using a structure that is identical to that used by numerous other PRC companies. Why is EDU being singled out?

In other words, I get a feeling that we do not yet have all the facts of this story.

Fourth question: what does this mean for other U.S.-listed Chinese companies using VIE structures? Answer: It depends. If we ultimately find out that the SEC is investigating EDU on account of a general VIE risk (such as one of those I itemized above), then other similarly situated companies need to lawyer up immediately. On the other hand, if SEC has singled out EDU because of something it did or failed to disclose, perhaps something related to its recent restructuring we don’t know about, then that might very well end with EDU and not effect other listed firms at all.

Another long post with the inevitable “we don’t know anything yet” conclusion.