The “Big Boys’ Market” VIEs—The “Myth” of Foreign “Ownership” of PRC Stocks

"Choose Your Investment Wisely
Not All Chips are Blue"

 

If I'm not mistaken (and as Madame Arqala could tell you, I often am), in his seminal work, Benjamin Graham made the observation above.  Along with the advice to carefully analyze a proposed investment before you commit funds. 

If you’ve been following recent financial news about the PRC government’s clampdown on private educational companies, you’ve probably seen comments about the Variable Interest Entity (VIE) structure which is typically used by companies in the PRC to access equity from foreign investors.

The VIE is used because under PRC law foreigners may NOT own stock in some sectors within the PRC.  Lots to be exact.

How does the VIE work or more accurately claim to work?

1. A PRC company wishing to access foreign equity markets establishes an offshore company with the same name as its own. The Cayman Islands is a “favorite” location.

2. The offshore company and the PRC-based company sign contracts that ostensibly (note that word) grant the offshore company legally enforceable rights to a share of profits of and a measure of control over the PRC company. These are portrayed as providing “the equivalent to ownership”. If you’re interested you’ll find a detailed discussion of the structure and the agreements in the two “warning” articles cited below.

3. The offshore company then issues shares to investors. Note these are shares in the offshore company not in the PRC company.

4. Net proceeds from the issue are upstreamed to the PRC company typically as loans in consideration for the contracts and agreements in point #2 above.

What are the issues with the structure?

1. As with other structures based on complex legal agreements that attempt to “work around” (or perhaps more accurately circumvent) law, they are inherently fragile.

2. The investors’ ownership rights are in the assets of the offshore company – those are solely the contracts and agreements with the PRC company—not in the assets of the PRC company. That is, the investors have no direct claim against the assets of the PRC company.

3. To enforce their constructive (or more accurately imaginary) ownership rights in the PRC company, the investors have to enforce the underlying contracts against the assets of the PRC company.

4. That legal action has to take place in the courts and under the laws of the jurisdiction where the PRC company holds assets. In both cases that is in the PRC.

5. “Small” problem with that. Under PRC law, foreign ownership of PRC companies is illegal.

6. Therefore, mechanisms that attempt to “get around” PRC law—the VIE and the various contracts and agreements that purport to give the rights of ownership-- are illegal.

7. And, thus, are not enforceable in the PRC.

This legal situation is analogous to the Peking University Founders Group offshore bonds debacle, chronicled here for Part 1 and here for Part 2

While for some time, the PRC authorities have turned a “blind” eye to the use of VIEs, that does not change the fact that these structures are illegal.

Whenever the authorities choose, they can enforce the law.

This month the PRC turned its “good” eye toward education companies. They will no longer be able to use VIEs.

That lead to a substantial drop in PRC “equities” listed on non Chinese markets.

As well as much angst among investors, some of them charter members of the “big boys” club that frankly should have known better.

The 31 July FT article Equities Watchdogs Bite. Investors Rethink China Stocks Strategy After Regulatory Shock (Harriet Agnew, Tabby Kinder and Hudson Lockett) contains a rather chilling quote.

“The VIE structure, which allows global investors to get around controls on foreign ownership in some Chinese sectors, has never been legally recognised in China, despite underpinning about $2tn of investments in companies like Alibaba and Pinduoduo on US markets.” 

First, you will note that there are some US$ 2 trillion in stock investments on US markets that use the VIE structure.

Second, that suggests that the FT journalists’ reference to a “rethink” is wrong because clearly there was no “thinking” at the time of investment.

Rather it was “faith-based” investment.

To be fair, some of this amount is via passive investing by funds seeking to track various global indexes that include these companies.

I’ve always thought it was a good idea for an index to only include investable stocks.

What is distressing about all of this is the simple fact that neither the FT article nor this post constitute an “overdue wake-up call” nor a “sobering fact”.

There have been many warnings about VIEs.

Here are just two:

• 2012 King and Wood Mallesons – A PRC/Australian law firm which described the structure as a “Sword of Damocles over their [foreign investors’] heads”.

• 2017 Council of Institutional Investors – a “buyer beware” alert.

If you look within these two articles, you will see further warnings in the form of prior actions taken by PRC authorities against VIE structures as well as some rogue activities, e.g., T2CN and GigaMedia. Or perhaps (?) more benign – Alipay and Alibaba.

All of these “wake-up calls” and “sobering facts” were clearly ignored.

• Over a prolonged period.

• To the tune of US $2 trillion.

Remind me again about the efficient market theory.

Don’t forget to also mention the role of the “sophisticated” investor in the markets.

I do really love a good laugh

“Foreign Investors Face Critical Test Over Chinese Bonds” Peking University Founder Group Part 1

Failure is Most Often Preceded by Failure to Prepare Adequately 

The 9 April edition of the FT had an article about the “critical” test facing foreign holders of USD bonds supported by a “keepwell” from Peking University Founder Group and by extension other similar "Chinese" bonds.

It is indeed a sad story.

So sad that I'll have to discuss it in two posts.

A few quotes to set the stage for my commentary.

A “person” quoted in the article made two comments worthy of note.

Will a Chinese parent recognise its contractual obligations under a keep-well deed, which literally gave the impression to offshore bond holders the deeds are equivalent to a guarantee?

The person added:

The Chinese parent actually took the majority of subscription proceeds back to China for its own use.

And Simmons and Simmons:

The administrator’s decision has cast significant doubts concerning the validity and enforceability of keepwell agreements, at least under [mainland China’s] restructuring process,” the law firm said in a January report

Now to my commentary.

I think the real issue here is that the bondholders failed an earlier “critical thinking test” that got them into this fix.

This is similar to the case of not knowing “insurance” from a “guarantee”. Or a “promise” from a legally binding “obligation”. Or consolidated from legal entity financials. 

The equivalent of running with scissors and wondering why you got hurt.

What in the investment world might be characterized as a “rookie” mistakes, though sadly it’s not just rookies who make this mistake. At least as they are typically defined. 

If they are looking for someone to blame, a mirror would be handy

Background

I found six outstanding bonds issued by subsidiaries of PUFG listed on the HK Exchange.

As you will notice, four of them are guaranteed by PUFG (indicated by “G” in the table below).

Only two have the keepwell and deed of equity interest purchase undertaking (indicated by “K”).

If you had looked at this time last year, most of PUFG’s outstanding bonds were ‘”supported” by keepwells / deeds of equity interest purchase undertaking.

We turn now to AA’s elder wiser brother, expert in many things Asian, for an explanation.

As is often the case, regulatory avoidance “influences” PRC financing and investing structures. There are many regulators in the PRC, but usually avoidance of SAFE (State Administration of Foreign Exchange) requirements is the primary driver. Cross border foreign currency guarantees must be registered with SAFE. A process that can be time consuming, result in requests for disclosure of all sorts of information that one would prefer not to disclose, as well as refusal to register the guarantee. Keepwells do not fall under this regulation

According to press reports, this structure is used with only 16% of outstanding Chinese offshore bonds. But note that represents some US$96 billion. 

The FT article above refers to bondholder concerns about those with keepwell structures.

This is the group of bonds that I focus on this commentary.

It’s a sad but common fact that most investment problems begin prior to the actual purchase of the investment. 

That is, before the “wise” investor plunks down his or her cash.

The first mistake so often made is a failure to read the offering documents.

Here’s a link to the Offering Circular (prospectus) for the Nuoxi Capital US$400 million 5.35% 24 Jan 2023. To which I'll refer in this and a following post. 

I am presuming that the prospectuses for other keepwell issues are similar.

The first thing to notice is that this issue is for “professional” investors.

There’s a reason for that.

The issue contains risks beyond those considered normally acceptable for retail investors.

Even if you are a professional investor (or more likely imagine you are), that should cause you to think very very carefully.

Structure

The Issuer: Nuoxi Capital, is a special purpose company set up for the “special purpose” of borrowing money.

It has no assets of its own. It conducts no operation other than borrowing funds and upstreaming them to its parent.

The Guarantor: HK JHC Company, is an actual company with assets and operations.

According to the prospectus page 17, as of June 2017 the Guarantor had (drum roll) US$28.5 million in equity capital and US$856.2 million in total assets.

You may also have noticed and I certainly hope you did that the Guarantor has some rather “large” gearing (leverage) and some rather “small” equity.

At this point you should be wondering about the capacity of the Guarantor to guarantee some US$600 million in bonds. The Offering Circular is for two bond issues: US$200 million and US$400 million..

And perhaps what it is going to use the $600 million for.

Not to worry we learn on page 55, it is going to use the funds for “general corporate purposes”.

Well actually to worry.

First, this is a rather “large” amount. One might be forgiven for wanting a bit more detail as to what "good works" this money might be put to.

One might also think that the borrower would have concrete plans and be able to supply some details. 

After all, if you borrow money, you generally borrow only as much as you need. So before you borrow, you need to know the amount so you don't wind up with too little or too much money.  

Unless of course your borrowing is motivated by negative cashflow in your business.  

Second, if you know your PRC company behaviour, you know there is classic PRC MO: borrow money outside the PRC (HK is a favorite) and funnel it to China.

If you’re a serious international investor, you should know this.

If you don’t, you probably should stay in your home marker where you could buy today's Carillon, Thomas Cook, Tesla or Gamestock.

The Parent Company: PUFG, a PRC company, was founded in 1986. Its consolidated financials as of 30 September 2017 are prepared according to Chinese GAAP. 

If you’re not familiar with Chinese GAAP, you might want to pause to ask yourself if you should proceed with this investment. Can you evaluate PUFG's financial position?

The financials shows some CNY 56.7 billion in shareholders equity composed of NCI of CNY 35.8 billion (!) and CNY 20.8 billion to shareholders of PUFG.

If you’re wondering, the fine banks that prepared the prospectus had a very high opinion of readers’ ability to convert CNY to USD. 

Or perhaps thought we should all getting used to thinking in terms of CNY. 

So they didn’t provide conversion to USD.

As per my calculation using IMF data as of the financial statement date, those numbers are in sequence US$8.5 billion, US$5.4 billion, and US$3.1 billion.

Usually in consolidated financials the NCI have a smaller share of total equity than the shareholders of the Group.  That's why they are typically called "minority interests".

That might be another sign to take a deep breath and close the prospectus unless of course you are already sleep walking your way to a “wise” investment.

What the financial position of the three above parties indicates is that the “credit” rests on PUFG, assuming of course that we assess that PUFG is sufficient credit support. 

Otherwise, you should find another “prime” asset to invest in.

What’s key then is the ability to go after PUFG in their jurisdiction with a reasonable chance of prevailing in court.

That’s a matter of structure and the law. PRC law.

So let’s look at how the transaction has been designed to “achieve” that.

Governing Law and Jurisdiction: Laws of England and Hong Kong Courts.

Hmm. But we want to go after a PRC entity in the PRC unless of course PUFG has many cash rich subsidiaries in jurisdictions where we can get a HK court judgement enforced.

This structure is probably going to work as "well" as that in Golden Belt Sukuk did.

The Parent Company Undertakings

The Keepwell Deed (Page 78) tells us that

The Keepwell Deed is not, and nothing therein contained and nothing done pursuant thereto by the Company shall be deemed to constitute, or shall be construed as, or shall be deemed an evidence of, a guarantee by or any legal binding obligation of the Company of the payment of any obligation, responsibilities, indebtedness or liability, of any kind or character whatsoever, of the Issuer or the Guarantor under the laws of any jurisdiction, including the PRC.

And

The parties to the Keepwell Deed will acknowledge that in order for the Company to comply with its obligations under the Keepwell Deed, the Company may require approvals, registrations, filings, clearance or other authorisation of PRC government authorities. The Company will undertake to use its best efforts to obtain such approvals, registrations, filings, clearance or other authorisation. The Keepwell Deed and any non-contractual obligations arising out of or in connection with it will be governed by and construed in accordance with English law.

In “little words” not a guarantee. 

May require PRC government approvals which Company will use its “best efforts” to obtain. 

Oh, and they will do that at perhaps the least convenient time to learn whether there is an obligation--after payment default occurs.

A keepwell is best written on soft paper, either Charmin tough and soft or Kleenex soft, so that one will be able to obtain the maximum benefit from it. Because it’s likely to be a limited use in getting your money.

The Deed of Equity Interest Purchase Undertaking (Page 82) also repeats that same bit of information

The Deed of Equity Interest Purchase Undertaking is not, and nothing therein contained and nothing done pursuant thereto by the Company shall be deemed to constitute, or shall be construed as, or shall be deemed an evidence of, a guarantee by or any legal binding obligation of the Company of the payment of any obligation, responsibilities, indebtedness or liability, of any kind or character whatsoever, of the Issuer or the Guarantor under the laws of any jurisdiction, including the PRC.

This disclosure appears several times in the prospectus as early as page 6.

If as the unnamed person above says you got the “impression” you had a guarantee, I suppose you can similarly conjure up the “impression” that you were repaid. 

One delusion is as good as the other.

But wait there’s more!

See Post 2.

Update on CIPS China – Impressive Progress But .

 

Back some four years ago there was a great deal of ideologically-driven hysteria from the usual sources that the creation of China’s Cross-Border Interbank Payment System (CIPS) sounded the death knell for the US dollar.

I wrote a post then that “put a finger in that optic”.

Four years later it’s time for an update.

Summary

CIPS has come a long way since 2015, but still lags US dollar cross-border payment systems. Also it lags the existing cross border RMB payment system CHATS in Hong Kong, as a forthcoming post will demonstrate.

Analysis

From 2016 through 2019 CIPS has grown remarkably both in terms of value (648%) and number (678%) of transactions.

In 1Q2020, CIPS processed 444,000 payments equivalent to US$ 1.37 trillion. It seems poised to post a 12% increase over 2019.

Over its “life” there has been an equally impressive growth in number of participants.

There are two types of participants: Direct and Indirect.

What is a Direct Participant (DP)?

It is a bank located with Mainland China that has an account with CIPS and the Chinese National Payment System (CNAPS) aka HVPS. Think of HVPS as the Chinese equivalent of the US Fedwire. These are the only banks that may directly input payments into and receive payments the CIPS system.

The DPs include foreign owned banks in the PRC. These are called "FMIs" in the CIPS “literature”

What is an Indirect Participant (IDP)?

It is a bank located in Mainland China or overseas that has a correspondent account with one of more of the Direct Participants. Note that an IDP is not restricted to working with a single DP.

The IDP sends its payment orders to its Direct Participant correspondent for input into CIPS. The DP sends the payment order into CIPS, the DP's account with CIPS is debited for the payment.  The DP debits the IDP's account on its books. 

Any CIPS credits in favor of the IDP are credited to the DP's account with CIPS. The DP then credits the account of the IDP on its books. In this respect this is a mirror of CHIPS in New York City.

What are the benefits of CIPS?

1. CNAPS/HVPS operates in the Chinese language only. CIPS allows a bank to send in an English language instruction which CIPS then “translates” into Chinese.
2. It speeds up payments. CIPS participants send their payments direct to a DP in the PRC. They do not have to work through a bank in their time zone that first processes their payment, then relays it to one or more banks for payment in the PRC.
3. CIPS is open 24 hours five days a week plus an additional four hours providing coverage in all time zones.

As of 31 December 2015, CIPS had 19 Direct Participant Banks and 185 Indirect Participant Banks with 50 countries in the world covered according to the Peoples Bank of China “2015 China Payment System Development Report” page 116.

As of 31 July 2020, CIPS has 33 Direct Participants (list here).and some 951 Indirect Participants in 97 countries, according to CIPS Participants’ Announcement #55. 

Among the Indirect Participants were 421 banks in Mainland China, 310 in the rest of Asia, 124 in Europe 37 in Africa, 26 in North America, 18 in Oceania, and 15 in South America, according to the same CIPS information.

Again an impressive change from its beginnings in October 2015.

If you’re interested in following this topic or checking AA’s math, data on CIPS performance is available in PBC quarterly and annual payment reports. You can access them here. 

Growth is very impressive. Trillions of US Dollars in payments per year sounds very impressive.

But let’s take a look at comparatives.

Based in New York, CHIPS bills itself as the “largest private sector USD clearing system in the world”. A claim supported by the average daily value of the transactions it processes.

CHIPS says that it processes some USD 1.5 trillion per day.

According to the BIS CPMI Payment Statistics for 2018, that would seem to be an understatement. Dividing the aggregate amount shown there (USD 418 trillion) by 252, the average is more like USD 1.7 trillion per working day.

Whatever the amount CHIPS processes the equivalent of CIPS yearly volumes in roughly 3 business days.

Per the same CPMI report (Table 8), CHIPS processed 115 million messages in 2018 or 82 times the messages processed by CIPS.

CIPS has made remarkable progress but still lags in US Dollar cross-border payments. And lags the HK RMB CHATS payment system.

That is not surprising.

It is relatively “early days” for the RMB as a global currency.

CIPS is a "youngster" compared to HK RMB CHATS –founded in 2007.

The US Dollar, Euro, and Sterling still dominate cross-border financial transactions with roughly a 75% to 77% share of all payment orders transmitted through SWIFT.

(SWIFT does not process payments but is a secure communication service for the transmission of financial information).

Per SWIFT the RMB generally has around a 2% share in global cross-border payment traffic.

You can see the statistics here in SWIFT’s RMB Tracker for July.

Sign up for the RMB Tracker here.