Congress Report Spotlights China Company Risk
US-listed Chinese companies were in the spotlight last week, after a new congressional report detailed the risks they pose to investors due to the unique structure they use to qualify for trading in New York. Uncertainties created by the variable interest entity (VIE) structure are just the latest in a long list of unusual risks that highlight why Chinese firms are quite different from other companies that trade in New York.
But while their risks may be different and often bigger, the rewards of investing in some of China’s biggest corporate names are also potentially huge, as evidenced by exponential growth for shares of some names.
This latest report serves as an important reminder that investing in any company, be it Chinese or western, always carries risks that should be considered before buying shares. Still, the US and China should try to work more closely to reduce some unique risks now posed by Chinese firms, which would better protect investors and boost the credibility of those companies.
Last week the US-China Economic and Security Review Commission released a report highlighting the “major risks” associated with US-listed Chinese firms due to the VIE structure. (English article) The structure, which paves the way for listing by Chinese firms in New York, was pioneered more than a decade ago to address China’s strict laws prohibiting foreign ownership of firms from the sensitive media sector.
The structure uses a series of contractual relationships to create offshore companies that can be listed in New York or other overseas markets without violating Chinese rules. The company that is ultimately listed owns equity in the Chinese firm, but the VIE structure strips overseas shareholders of their rights to control of the company.
The congressional report pointed out the “high probability” that Chinese courts would not uphold many of the contracts in the VIE structure if a dispute were to occur. Such an outcome would effectively render the value of a company’s US-listed shares as worthless. Most Chinese companies already discuss the risks of the VIE structure as part of IPO prospectuses before they list overseas.
The VIE structure may pose significant risks, but the youth of the Chinese market and its unique regulatory environment also create many other major uncertainties.
One equally large risk lies in accounting, an area where some Chinese firms engage in aggressive and even misleading practices to make their performance appear better than it really is. Such practices came into focus in 2011, when scandals at several listed firms starting with financial services provider Longtop Financial cast a chill over the entire sector, wiping out billions of dollars in shareholder value.
Regulatory uncertainty is also a major risk for many Chinese firms, especially in the sensitive media sector.
That risk came into focus as recently as April, when Beijing launched a campaign to clean up pornography and violent content on the Internet. The campaign saw leading web portal Sina (Nasdaq: SINA) suddenly lose its video license after Beijing regulators found pornographic material on one of its sites. That news hit not only Sina, but also shares of leading online video operator Youku Tudou (NYSE: YOKU), wiping out millions of dollars in shareholder value.
Risks are inherent in any publicly traded company, which is why such investments aren’t insured and can offer huge rewards and big losses for stock buyers. E-commerce firm Vipshop (NYSE: VIPS) exemplifies the potential rewards, as its shares have jumped 27-fold since its listing in 2012. Social networking site Renren (NYSE: RENN) is a good example of the dangers, as its shares have lost three-quarters of their value since it went public in 2011.
While unique risks from regulation, the VIE structure and other sources are part of the China investment landscape, China could and should work more closely with the US and other offshore regulators to reduce some of those uncertainties. The Chinese securities regulator made such a move last year, when it signed an unprecedented information-sharing agreement with its US counterpart to assist in fraud investigations of New York-listed Chinese firms.
China should continue to expand that relationship and forge similar new ones with other regulators, which will reduce a major element of uncertainty and add stability to the shares of its overseas-listed firms. At the same time, the old saying “let the buyer beware” remains a key message for anyone interested in these companies, whose hodgepodge of Chinese and western characteristics makes them truly unique investment option.
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