China Finance: Will SEC probe of New Oriental include other VIEs?
During the past week or so I've been kept pretty busy dealing with the aftermath of New Oriental Education's (NASDAQ: EDU) annual filing. It has caused some raised eyebrows to say the least, and a lot of people have questions about what exactly this means for VIEs in general, and New Oriental Education's VIEs in particular.
While the situation we currently have is one where VIEs are stuck in a kind of no-mans-land without any clear decision from the SEC, we should still have enough information to take steps towards limiting any potential downside exposure.
As I wrote in a previous China Finance piece, the investigation into New Oriental was initiated by the SEC after a tip from short sellers Muddy Waters, by all accounts the investigation is related to whether or not there is sufficient reason for the company to consolidate its VIE. While some statements have made it seem like this investigation is all but over, the company's annual filings paint a different picture:
On July 13, 2012, we were informed that the SEC had issued a formal order of investigation captioned “In the Matter of New Oriental Education & Technology Group Inc.” In that investigation the SEC’s enforcement staff has requested documents and information concerning the basis for the consolidation of New Oriental China, a variable interest entity of our company, and its schools and subsidiaries, into our consolidated financial statements and other issues related to certain allegations about us contained in a report issued on July 18, 2012 by Muddy Waters LLC. We are cooperating fully with the SEC in its investigation. We cannot predict the timing, outcome or consequences of the SEC investigation.
However, we still don't know the exact details of the investigation, which creates a bit of a problem when we try to decide what the potential spread of these issues could be. But there are a few things we can say to help us narrow the field, and considering the last count had 48% of Chinese companies listed on the major US exchanges using VIEs, narrowing the field is important.
SEC does not seem to be looking at all VIEs
The investigation does not appear to be general and it has not been expanded to include any other companies apart from New Oriental, so it's highly unlikely to be about the VIEs as a whole. This means that the companies at risk will have structures that resemble New Oriental's in some way. The most striking aspects of the New Oriental VIE is that it's fairly asset-heavy and retains a lot of its earnings in the VIE rather than transferring them to the Wholly Foreign Owned Entity (commonly known as WFOE), as their contracts would suggest they should.
If we look for VIEs with these characteristics, we come up with a few candidates who could also have trouble if the SEC takes a negative view on one of these issues. One is Ambow Education (NYSE: AMBO) is an obvious candidate as it's in the same industry as New Oriental, but is even more asset-heavy. Another interesting example here is Soufun (NYSE: SFUN), which, as an Internet company, appears to hold undue amounts of assets in its VIE (62.8% according to their latest annual filings). ChinaNet (NASDAQ: CNET) is another Internet company that is not only incredibly asset-heavy, but also retains it's earnings in the VIE.
Here's a list of some other asset-heavy VIEs to keep an eye on:
Looking through the portfolio to identify companies with these characteristics should be a good first step when assessing your potential exposure to the ongoing situation, but what does it mean overall for VIEs?
Well, if we put the event in context, than I'd say it plays into an overall theme of trying to eliminate the practice of using VIEs from both the Chinese and American sides. The latest move from the Chinese side was to limit the use of the VIE Walmart acquired when they snapped up Yihaodian, which I wrote at the time could be seen as a way to gradually limit the use of VIEs.
I think what we're seeing here is the first step from the US side to limit the use, and useleness, of VIEs. The US will likely start by tightening up the consolidation requirements and then gradually move towards a stricter application of the rules. This means it's more important than ever for companies to look over how they have structured their VIEs and move to rectify shortcomings before they become a problem. I think we're seeing the end of accepting the empty WFOE consolidating a VIE where the entire business assets are held, and as such there is a short case for asset-heavy VIEs in general until they restructure.