Every so often I get a scathing comment from an anonymous commenter on how we intentionally ignore such and such blog because we don’t want “the competition.”  That is completely untrue.  We ignore the blogs mentioned because we do not think they have much to say.

But there is one site about which I plead guilty for not having flogged enough here out of a subconscious fear of losing readers once we do so. The site is Sinocism and it is so over the top comprehensive and frequent that if you are going to read just one thing on China each day, you ought to at least consider making Sinocism  (a/k/a Sinocism’s China Newsletter) that one thing.

I was reminded of this the other day by a Sinosplice post noting the following:

Even so, I’ve come to recognize what a valuable resource Bill Bishop’s Sinocism is. You can sign up for the newsletter and get regular updates on all major issues facing China. I know more than one information junkie that reads every link in the newsletter, but for me, the headlines and blurbs are often enough. I click through when the articles especially interest me (and learn important new Chinese buzzwords from time to time too).

If you’re interested in China and you’re one of the few that haven’t heard of Sinocism, definitely check it out. Bill Bishop is also on Twitter (@Niubi) and the excellent podcast Sinica.

Sinocism’s tagline is “Be Informed about China” and if wish to be informed about any aspect of China, I recommend you check it out  But please don’t forget to come back here after doing so. Please!

Yesterday, co-blogger Steve Dickinson wrote a post essentially excoriating VIEs. That post went live early this morning. A few hours before our post went live, Bill Bishop (who knows as much about China’s tech industry as any human being alive) wrote a post essentially saying that those who are trashing VIEs are engaging in scare tactics and that there is little cause for worry.

Bishop makes his very powerful counter-argument on his Digi-Cha blog, in a post entitled, “Bloomberg Keeps VIE Fears Alive: China Companies Evading Rule With U.S. Listings Stump Regulators” [link no longer exists]. Bishop contends that “so many powerful interests have financial stakes in VIEs that it would be career suicide or worse for a Chinese bureaucrat to destroy this structure on a wholesale basis.” We do not disagree with this statement, but we do not think it deals with the two main issues. One, the government has come out with regulations making very clear that such structures are illegal. On top of that, and as we have said all along, these regulations probably should not have even been necessary because VIEs were almost certainly already illegal under a proper reading of the various applicable laws. Having said this, however, we fully recognize that the Chinese government has in the past come out and said something was illegal and then done nothing about it. See, for instance, “China Rules Skype Illegal. Tell Me Something New,” where we predicted that the government’s making Skype “illegal” would have no real impact.

But with VIEs it is different and Bishop does not address our main point (note again that his post came before ours).

Whether or not existing VIEs are shut down (and at this stage we tend to agree with Bishop that they generally very likely will not be), the reality is that they have now been deemed illegal and that cannot help but have a major and game-changing impact on them. As mentioned above, VIEs are a structure that allows foreign companies to control the Chinese entity via various contracts. Now that those various contracts have been declared illegal, it will be difficult/impossible to enforce those contracts in Chinese courts. In this VIE structures, many of the contracts involve foreign countries and foreign country enforcement so their illegality in China may be minimized to that extent. However, even outside China, the party seeking to avoid enforcement of a contract will, in many cases, still be able to argue against enforcement based on China’s having made the structure illegal.

In many ways, what is happening to VIEs is no different from what we have called “fake Joint Ventures” and on which we wrote in the post, “Fake China Joint Ventures: Why You Calling Me, I’m Not The Guy:

In that post, I very loosely transcribed into one conversation a number of conversations I had been having with people wanting to set up contractual arrangements to avoid China’s expensive and difficult joint venture laws:

Caller: I’ve got this great website and it is exactly what China wants/needs. And I’ve been working on developing it with some Chinese tech friends of mine and we want to take it legal so we can start getting VC (venture capital) funding for it. Here’s our plan. Now I know that the old/truly legal/expected/usual way to do this is for me to form my own company and then form a joint venture with my Chinese partners, but I also know that will cost a lot of money. So our plan is for the Chinese company to own the website and then we will have an oral agreement (or a written agreement) that I really own half of it.

Me: Listen, my firm has been contacted at least twenty times after these situations have gone bad and I am aware of at least another twenty times where the same thing has happened, and let me tell you, these arrangements (it is NOT proper to call these joint ventures) virtually always end the same way. They end with the Chinese company booting you out completely and leaving you with no recourse. Protecting foreign companies in legitimate joint ventures is difficult enough, but it is pretty much impossible under the scenario you are describing. We had a guy who paid us a lot of money once for us to do everything we could to try to get “his” multi-million dollar business back. Guess what, we could not even come close to getting it back. Every Chinese lawyer we talked to about suing to get it back told us we had no chance of winning at all. I mean, just listen to the argument we would need to make to the judge:

Your honor, my client knew that China’s laws are very clear on what foreign companies must do to operate legally in China, but he thought these very clear laws should not apply to him because, well because he is an American tech company and he was just too smart/too poor to bother to comply with the very clear laws. So instead, he had this great method for completely circumventing China’s very clear laws. His idea was to not form a company, but rather, have his Chinese friends form the company and he would have a little side deal with that company. Well, that side deal has now gone bad and my client wants you to go against China’s very clear public policy on how foreign business is to be done in China and enforce this unwritten side deal.

What do you think of that argument?

Caller: (long pause) I understand things could go wrong with that kind of arrangement, but would you be willing to draft the contract between me and the Chinese company?

Me: No. I can’t do that. I can’t draft a contract that I know will never work. I just can’t. Give me a call if you ever want to do this legally, in a way where you actually have a chance of profiting from your work down the road.

For more on this, check out “China SMEs, Own If You Want To Own.” To get a feel for how difficult it can be even with a fully legal joint venture, check out this article by Steve Dickinson in China Brief, entitled, “Avoiding Mistakes in Chinese Joint Ventures.” and this Wall Street Journal article I wrote, entitled, “Joint Venture Jeopardy.

Update: In, “Private Equity, Venture Capital and ‘Fake’ China Joint Ventures,” China Hearsay very nicely maps out the way these deals are typically done (using an offshore holding company) and notes that you might have legal recourse in the rare instances where your Chinese partner has “huge assets offshore” in a country in which you can sue and win:

You can tie up the Chinese founders in 100 different contractual knots, but unless those founders have huge assets offshore (real assets, not equity in the holding company) that you can go after in a dispute, they can always tell you to piss off and kick your ass out of the business.

All I can say is that I have never and I will never invest in a company based on so thin a reed.

FULL DISCLOSURE: Our firm long ago made the decision to work with those companies and individuals with claims based on the arrangements set forth above, as opposed to representing those wanting to enter into such arrangments.

THIS JUST IN: Stan Abrams over at China Hearsay is out with a post, entitled, “A Post-Holiday Update on VIE Chatter,” that essentially says what this post says, which is that the dividing line between Bishop and us is that Bishop is analyzing what the government is likely to do with existing VIES while we are analyzing the risks involved in having a corporate structure based on unenforceable contracts. Stan completely nails it when he says he thinks the differences between us and Bishop stem largely from the angle from which we are looking at the VIE issues:

Anyway, I have nothing new to say, but I did want to point out a couple of new things for you VIE groupies to read. First is a lengthy Bloomberg overview of the issue. It’s generic, and therefore a decent place to start if you’re looking for a jumping-off point to the topic. Second and third are two opinion pieces, by Bill Bishop (DigiCha) and Steve Dickinson (China Law Blog), who sort of set themselves up on opposing sides of the issue.

It was interesting reading these two blog posts, since both authors are wicked smart, experts in their respective fields, and very opinionated (not that there’s anything wrong with that).

Stan then describes Bishop’s post as putting forth “The sky is not falling” position and Steve’s post as “VIEs are complete rubbish and should be avoided like the plague.” Stan then notes how the positions appear very different, but maybe not so:

So, at first glance, two very different views, and I bet they would get into a serious argument if the opportunity arose. But I actually think that their fundamental conclusions are both right but are merely coming at the issue from two very different perspectives. Bill is a Internet and finance guy, and is looking at the market, firms’ access to capital, and what the government is likely to do.

Steve, on the other hand, is a corporate lawyer. He is looking at potential risk, at what might go wrong, and what is/is not a technical violation of the law.

When Bill says that we shouldn’t worry about the government going after Chinese listed firms in the U.S. that use the VIE structure, I think he’s right. All the inside chatter on that issue seems to indicate that the government will grandfather in those companies even if it adopts a new enforcement strategy.

And when Steve says that VIEs are rubbish, he’s of course right. These things are illegal in that their purpose is to deliberately skirt foreign investment restrictions. I don’t actually agree with him on what the M&A rules mean (I think it’s too early to tell), but I definitely agree with his overall legal opinion.

Stan then goes on to say essentially what I say above, which is that the story is not the shutting down of VIEs, it is the inherent risks they present by being based on illegal contracts:

All this being said, if I have one bone to pick with recent commentary on this subject it’s that it emphasizes the latest regulatory goings-on without paying attention to the real risk story with respect to VIEs. The most likely source of problems with these companies has nothing to do with the government, but rather with unenforceable contracts and unstable shareholding structures. Perhaps this is one of those things to which Bill was referring when he said that there are other reasons to be cautious about investing in China. (I should also point out that Steve regularly writes about these sorts of legal issues as well.)

I completely agree.

UPDATE: Fredrik Öqvist over at the China Finance Blog did an excellent post today, entitled, Consolidating Recent Opinions on VIEs, in which he seeks to synthesize all the posts that have been written on VIEs in the last few days by me, by Steve Dickinson, by Stan Abrams, and by Bill Bishop. Fredrik concludes his post with his own take on VIEs:

Here’s where I think the real issue lies, but I don’t think it’s entirely confined to future deals and PE/VC investors. This could for all intents and purposes have a deeply negative impact for listed companies as well.

In order to consolidate VIEs one has to show that the listed company not only receives the economic benefits and takes the economic risks of the venture, a second condition is to show that the VIE is in fact controlled by the listed company. If the contracts, which are put in place to establish this control, are indeed deemed illegal and unenforceable, fulfilling the second part of the consolidation requirement becomes decidedly more difficult.

I agree.

Not sure if it is cynicism or realism, but I am getting increasingly willing to blame “the victim” of China business problems. I am convinced that nine times out of ten when bad things happen to good people who do business internationally (that includes in or with China) it is the “good person’s” fault. Like all lawyers who work with China, I have a ready set of horror stories, which I rotate depending on the occasion, but usually include one or more of the following (modified slightly to protect the guilty):

1. The guy who “invested” $500,000 into a China business because the owner of the Chinese business was allegedly the son of a five star general. Co-blogger Steve Dickinson suggested to this investor that instead of investing this money into the Chinese company, that he use the money to fly him and Steve to Vegas (this was before Macao got so big) and put the money on red because, as Steve put it, the chances of his not losing his money were much greater this way and it would be a lot more enjoyable. This guy went ahead and invested the $500,000 and lost every bit of it. He then wanted us to sue the “son of the general” on a contingency fee basis, but we would not have taken on that case for a 150% contingency.

2. The guy who bought a million dollar condo in Shanghai in the name of his girlfriend because he believed foreigners were not allowed to own real property in China. His girlfriend then left him and claimed he had given her the condo as a gift. The guy wanted us to sue the girlfriend but we demurred, saying that we just did not like a case where our client would need to stand in front of a Chinese judge and explain the deal by starting out saying that he had put the condo in his girlfriend’s name so as to avoid the Chinese law that says…. And here’s the kicker. When he bought this condo for his girlfriend, he could have purchased it in his name, no problem! His girlfriend had lied to him about Chinese real property ownership laws.

3. The countless people who call my firm after having sent tens of thousands of dollars (sometimes hundreds of thousands of dollars) to someone in China for a product that never arrives. Eventually the person and “company” to whom they sent the money disappears. We have never taken one of these cases because we deem them pretty much hopeless.

4. The US company that used the local Chinese lawyer of its joint venture partner (what was this company thinking?) who drafted up agreements that involved the American company giving its critical technology to the joint venture permenantly without getting any real influence or control in it (this is an amalgamation of probably half a dozen poorly formed joint ventures in which we have been called in). For more on this type of joint venture deal, check out, When in China Trust Everyone.

I could easily go on and on.

So what can a foreign investor do?

A lot.

Here goes.

In Seven Rules Of China Due Diligence, I set out the following seven rules to analzye a Chinese company with which you are doing business, taking the first six from an article by Muddy Waters entitled, “The Six Rules of China Due Diligence“:

Approach the company as a potential customer does. “You want to see what the China side customers see. Fraudulent companies have far less confidence that they can fool a Chinese company in their industry than they do about fooling a starched shirt analyst. Moreover, they’re usually less willing to take legal risks in their home market (China) than they are in the United States.” In other words, look to see how the Chinese company with whom you are interested is treated by other Chinese companies.

Take all company-provided introductions with a grain of salt. “When companies set up meetings or conversations between you and their suppliers or customers, take them with a grain of salt….In a country where a lot of managers earn less than $500 per month, it’s not hard for an unscrupulous company to buy someone’s loyalty for the duration of a meeting or phone call. You should instead rely on your own networks to help you understand the company and industry. If you don’t have those networks, you unfortunately shouldn’t be making investment decisions in China by yourself.” I completely agree.

Try to construct your own fraud scenario. “At some point in evaluating every investment, you should stop and ask yourself how you could have staged everything you’ve been shown or done with the company. It’s good for American investors to practice this mentality because it makes us less credulous. More importantly, this kind of thinking makes clear how surprisingly simple measures (e.g., switching factory signs before you arrive, painting old machinery) can be so effective in fooling the credulous investor.” I absolutely love this advice and I urge everyone to follow it.

Forget about the paper. Focus on the operations. “In today’s world where you can buy a competent color printer for less than $200, it’s hard to understand why investors place so much faith in bank statements, invoices, and contracts. China’s deal making world abounds with stories of forged bank statements and other documents leading to disastrous deals. Unfortunately, most auditors apply the US audit playbook in China – reviewing and taking documents at face value….Instead, you have to look at the operation itself. How much does the output seem to be, how much material is moving into and out of the factory, does the office seem to be a hive of activity, how many employees can you count, what is the square footage of the facilities? These are all basic questions one should concern themselves with during site visits. And it pays to visit two to three (or more) times – a good fraudster can put on a show, but they’re unlikely to be able to do it the same way each time. Watch for the subtle differences. Ultimately if you cannot find a good way to measure the company’s sales or productivity (as in the case of a service company), you should think carefully about proceeding with the investment.” I completely agree with the advice to put the Chinese company’s operations under a microscope, but I completely disagree with the advice to ignore the paper, as I discuss more fully below. I advocate putting the paper under a microscope as well.

Always speak with competitors. “Competitors with real businesses can usually tell you one of two things about a fraudulent competitor – either that it’s obscure (sometimes the “competitor” is hearing about the company for the first time); or, that they know it’s a fraud. Many competitors will be reluctant to speak openly at first about a fraudulent competitor if they know you’re a potential investor in the fraudulent company. However, if you’re a potential customer who is shopping around for a vendor, it can be a different story.” This is excellent advice, but one should also take the views of competitors with at least a bit of salt.

Do not delegate. “A lot of experienced China investors have stories about subordinates who colluded with a target company to attempt (and sometimes succeed) to defraud the investor. Be attuned to the dichotomy between the investment funds at stake and the income/wealth of the people on whom you rely for judgment.” Very true. At least half the time when my firm has been brought into a fraud situation, we have to ask ourselves whether the “trusted subordinate” was incredibly stupid or in on the fraud.

The seventh rule (my added rule) is to put the documents you receive under a microscope because the fraudulent company will nearly always make some mistake in its documents. In my career, I have caught the following, all of which threw up massive red flags:

Company claimed to have a multi-million dollar account at a non-existent bank;

Company documents showed a subsidiary in the Marshall Islands, yet always spelled the country as Marshal Island. It had no such subsidiary;

Company claimed to have a branch office in a particular city, yet its documents on that branch office (including supposed government documents) put that city in the wrong province;

Company claimed to be bringing in twice as much product as physically possible on a particular ship;

Company claimed to have been shipping out product on a particular ship that did not exist during the first few years when the product was allegedly being shipped;

Company claimed to have won an IP lawsuit in a country’s Supreme Court (they produced the Supreme Court’s decision and everything), but there had never been such a case.

Bill Bishop at DigiCha just did a post entitled, “Do You Know Where Your China Stock CFO Lives?” setting out China company (mostly publicly traded) warning signs. The post talks about how two Chinese companies Longtop Financial and Sino-Forest, that publicly trade in the United States and have recently been under scrutiny for alleged improprieties both have Canada-based CFOs even though the bulk of their operations are in China. Bishop posits that these companies may have hired foreign-based CFOs as “China fraud beards.”

Bishop then goes on to quote from an iChinaStock post, entitled, 5 Warning Signs That A Chinese Stock May Be a Fraud, listing out the following warning signs:

  1. Company went public through an OTCBB Transfer or other ways of back-door listing;
  2. Company name starts with “China” [unless they are state-owned they can not register a company in China starting the word “China”];
  3. The products are sold in China, but there is minimal Chinese-language information about those products;
  4. The business defies common sense;
  5. The underwriter, audit firm and accounting firm are second tier and/or have a track record of missing frauds (like Deloitte China).

Bishop adds a sixth item to the list, that “the CFO does not live in the same city as corporate HQ and is not a regular presence there.”

I like Bishop’s admonition not to invest in a business that defies common sense. Yes, that is pretty basic, but in many ways it is the key. It is not too disimilar from the advice I gave in the When in China Trust Everyone post mentioned above:

First off, THINK. That’s right, think. Secondly, do not do anything you would not do in any other country. Just because your Chinese partner and/or your Chinese partner’s lawyer tell you this is how things are in China does not mean you have to believe them and it certainly does not mean you have to abandon your common sense.

One more thing to do before you invest or, in some cases, even do business with a Chinese company: get their official corporate records from the official Chinese government sources. We have of late been doing this rather frequently for our clients and though it is not at all inexpensive or easy, it can be incredibly enlightening and it goes far beyond the information provided by the basic company search firms.

The China company search firms typically provide only a fairly basic list of information, such as the names, and addresses of those involved with the company and its registered capital. in addition to not being terribly complete, the information from these search firms is of dubious provenance. How did they get the information? Can we be sure they looked at the entire file? We know the files are only supposed to be open to lawyers. How did they obtain access? When did they review review the documents? Last year’s documents may be of no help at all.

We strongly suggest that you seek out the full SAIC (State Administration for Industry and Commerce) file on the Chinese company about whom you are seeking information.

In our experience, the SAIC only opens its file to licensed Chinese attorneys. Everyone else is turned down. The Chinese licensed attorney must go in person to the SAIC office, review the file, and make copies in the office. So far, no Chinese licensed attorney with whom we have worked has ever been denied access. It is our understanding that the Chinese companies investigated through the SAIC will know they are being investigated. Like I said, we have so far always been able to get the file, but there could come a day when a local SAIC in an outlying province will block access to the file of a powerful company within its purview.

These SAIC forays usually give us a massive amounts of documents in Chinese, which we then either translate for our clients or, more typically, summarize.

The hot topic in this arena right now is this: the parent company does an IPO in Hong Kong or the U.S. The parent claims the IPO proceeds were injected into a WFOE in China. Was the money injected into the WFOE or not. If so, when? If not, what is the most recent record on the registered capital status of the WFOE. For a WFOE that receives an injection of capital from an IPO, there is typically at least six months of advance work in increasing the registered capital amount. All of this is public and can normally be found in the SAIC file. In addition, the annual audit will show an injection of capital. But the audit is of the previous year. So for recent injections of capital, we have to rely on the approval for the increase in the registered capital.

For more on these issues, check out the following:

What do you think?

Bill Bishop, a China Internet guru, recently did a post on his DigiCha blog, entitled, “China’s Internet: The Invisible Birdcage” [link no longer exists]. Not sure I like the title, but I am sure that I like the post itself as it does a great job explaining China’s Internet and how different it is from most Western countries.

Because my firm is in a tech center and because so many of our existing clients are in tech or tech related businesses, we get a fairly steady stream of people/companies who come to us ready to make their fortune on China’s Internet, without having even the slightest clue how different it is. This article is for them and I highly recommend it for anyone else interested in marketing or selling or whatever on China’s Internet.

What do you think?

UPDATE: David Wolf at Silicon Hutong also very recently did an excellent post on China’s Internet. David’s post is entitled, “A China Internet Bubble? Maybe…How Much Do You Know?” and I highly recommend that also.