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Chinese Internet Companies Using VIEs to Consolidate Financial Statements

August 6th, 2012 by · Leave a Comment

If one reads the annual reports filed with the SEC by Chinese internet companies, he will discover that these publically traded companies do not actually own the online businesses directly, as the PRC government restricts foreign investment in internet and online advertising.

In Baidu’s 20-F for 2011, the section describing risks related to their corporate structure on page 19 states the following:

“The PRC government restricts foreign investment in Internet, online advertising and employment agency businesses. We and our PRC subsidiaries are considered foreign persons or foreign-invested enterprises under PRC foreign investment related laws. As a result, we and our PRC subsidiaries are subject to PRC legal restrictions on foreign ownership of Internet, online advertising and employment agency businesses. Accordingly, we operate our websites and conduct online advertising and employment agency businesses in China through our consolidated affiliated entities.”

Similar statements can be found on the annual reports filed by Sohu (10-K for 2011, page 46), Sina (20-F for 2011, page 18), New Oriental (20-F for 2011, page 13) and most other listed Chinese internet or education companies.

Then who actually own and run the online businesses of Baidu, Sohu, and similar Chinese internet and educational services companies? The answer is: the affiliated entities and variable interest entities (VIEs) that are incorporated in the PRC and owned by individual nominee shareholders who are usually company employees or management personnel.

In Baidu’s case, Robin Li, CEO and co-founder, is the principal nominee shareholder of Baidu Netcom, one of Baidu’s consolidated affiliated entities (20-F for 2011, page 21). Similarly, Charles Zhang, CEO and founder of Sohu, and other executive officers and employees of the Sohu Group, directly or indirectly owns all of the VIEs affiliated with Sohu (10-K for 2011, page F-43).

Typically, capital for these affiliated entities and VIEs were funded by the parent company through loans to the nominee shareholders, and the loans are eliminated for accounting purposes against the capital of the VIEs upon consolidation.

As explained in Sohu’s annual report for 2011 (page F-43), “under contractual agreements with the Sohu Group, Dr. Charles Zhang and those other executive officers and employees of the Sohu Group who are shareholders of the VIEs are required to transfer their ownership in these entities to the Sohu Group, if permitted by PRC laws and regulations, or, if not so permitted, to designees of the Sohu Group at any time as requested by Sohu Group to repay the loans outstanding.” Furthermore, “Dr. Charles Zhang and those other executive officers and employees of the Sohu Group who are shareholders of the VIEs have pledged their shares in the VIEs as collateral for the loans.”

Other Chinese internet companies, such as Baidu and Sina, all have similar contractual agreements with their respective nominee shareholders who control the affiliated entities and VIEs.

So what does it mean for a shareholder of these Chinese internet and educational services companies: do they own a piece of the explosive growth of the Chinese internet and educational service sectors?

The answer is: that depends. As long as the Chinese government does not invalidate the legal structures of these corporate arrangements, and eventually allows foreign ownership of the Chinese internet and education sectors, then yes, you are “sort” of owning a piece of the action. But if the Chinese government decides to change course, then maybe you don’t own a piece of anything.

As with many things in China, government policies can be hard to read, and harder to interpret. Business matters can seem murky, and not entirely black and white. But for those who are careful and well-informed, amazing returns have been possible investing in Chinese stocks. Had you bought Sohu back in 2001 for around $1.00, you could have sold it two years later for $35. More recently, Baidu went from $12 (adjusted for splits) in January 2009 to over $140 in April 2011.

So if you are interested in investing in China, proceed with caution, be vigilant, understand the risks, and do not pour all your savings into any particular stock.

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