Back in 2011, we were writing like crazy about the risks of China VIEs.  And every time we did, someone with a financial stake in one would tell us that we were being too negative.  VIE stands for variable interest entity and those are entities that are used to allow a company in China to technically be a Chinese domestic company, but de facto controlled by a foreign-owned entity or entities.  VIE structures are usually used to allow foreign companies to get involved in various sectors of China’s economy that are forbidden to foreign companies.

In our last piece on VIEs, entitled, VIEs In China. The End Of A Flawed Strategy, we vehemently set forth the proposition that they are to be avoided:

None of this is actually new. These risks have long been known. However, the clarity of the Regulations means it is now nearly impossible to claim that Chinese law on these issues is ambiguous or unclear. Where Chinese law says that ownership by foreigners is restricted or prohibited, the law means what it says.  Foreigners who invest in violation of the law are making a bet that the violation will be ignored. This is extremely unlikely in today’s China. Such bets are sucker’s bets and should be avoided at all costs.

We have been speaking out against VIEs for years and just about every time we do so, someone says that if they are illegal, why have so many large law firms, large accounting firms, and large companies gone along with them? The answer is simple. Money. Big money. Really big money. Now, some of these same law firms and accounting firms and companies are denying that anything has changed. And why is that? Again, money. Only this time they are taking positions not so much to make more money going forward, but to avoid losing through lawsuits the money they have already made.

And then we stopped.  Not because our position on VIEs had changed, but because we had said our piece (way more than once) and it was time to move on.

I am writing on VIEs today not just to say to everyone who doubted us that we told you so, but to emphasize that whatever the risks were with VIEs back in late 2011, they are even greater now.  They are even greater now because exactly what we said about China’s laws forbidding VIEs has been borne out by a recent China Supreme Court case with a very unfavorable ruling for those invested in a VIE.

The New York Times Deal Book did an article on that case today, entitled, In China Concern about a Chill in Foreign Investment, on the recent case. According to the Supreme Court, the contractual agreements between the foreign and the Chinese company “had clearly been intended to circumvent China’s restrictions on foreign investment, and amounted to ‘concealing illegal intentions with a lawful form.'”  Though some commentators in the story talk of how such deals are more “sophisticated” today, in the end, they too are “intended to circumvent China’s restrictions on foreign investment….with a lawful form.”

The article goes on to note that since 2010, “Shanghai’s arbitration board has invalidated two variable interest entities that had been used by foreign companies to control onshore businesses. In one case involving an online game company, the panel applied China’s contract law to reach the same conclusion as the supreme court in the Chinachem case — saying that the variable-interest entities were ‘concealing illegal intentions with a lawful form.'”  It then quotes Paul Gillis (who truly knows whereof he speaks when it comes to VIEs) to the effect that “China is attacking these VIE structures and the other ways that people have used legal form to get around the substance of what Chinese law says you can’t do.’

We were not surprised.  Were you?

GLG Research is going to be moderating what I am certain will be a fascinating discussion tomorrow on China VIEs and the SEC’s pending investigation into New Oriental Education (EDU). The event is entitled, VIEs – SEC Investigation into New Oriental Education and it will be taking place live on the net and by teleconference on July 25 at 2:00 PM EDT.

The two speakers at this event will be China Law Blog’s own Steve Dickinson and Paul Gillis, Professor of Practice at Guanghua School of Management at Peking University.  The webcast/teleconference is expected to focus on the following:

  • The structure and legality of VIEs
  • The enforceability of New Oriental Education’s (EDU) VIE contracts under Chinese law
  • The Significance of the SEC’s investigation into EDU and its impact on other US-listed VIE companies.

For more information on this event, go here.  If you miss it live, there will be an audio replay within around 24 hours and there will also be a transcript available for purchase.

For those of you who really want to prepare for this event beforehand, I recommend you read the following China Law Blog posts:

And the following China Hearsay posts:

And the following China Accounting posts:

And the following China Finance posts:

If you read all of the above, you will probably know more about VIEs than anyone else alive. If you are going to read just one post, make it “Explaining VIE structures.” Oh, and just to give you more to read, I also recommend you read the Silicon Hutong post, “VIEs, The Long Resolution.” In that post, David Wolf talks of how the Chinese government likes to “boil its frogs slowly, not all at once,” and he then talks of how VIEs are on the wrong side of where China wants to be going.

Just back from Los Angeles, where I met with countless people in the movie industry and discussed with nearly all of them how Chinese entertainment companies are and will be buying into Western entertainment companies, and vice-versa. In just the past week, we are hearing of Wanda (China) looking to buy into AMC Entertainment (U.S.) and News Corporation (Rupert Murdoch’s company) having just announced that it will be buying approximately 20% of Bona Film Group, a China-based movie distributor and producer.

And that is where things get complicated.

As soon as I heard about the Bona film deal, my legal cap went on and I wondered it would be accomplishing that when, technically, foreign companies generally are not allowed to own a piece of a Chinese company, which would be even more true (if it needed to be) of a company in a sensitive industry like the China film business.  So I did a quick Google search that immediately confirmed my suspicions. Bona Film Group is not technically a Chinese company; it is a Cayman Islands holding company that lists on NASDAQ.  Variable Interest Entity (VIE), I immediately thought.

So I did some more research and discovered that China Hearsay has already done a fine post on all of this, entitled, “News Corp Purchases Stake in Bona Film Group: Just What Are They Buying Into?” In its post, China Hearsay sets out exactly how this deal can be realized and the risks/uncertainties in a deal like this, involving as it does VIEs.  China Hearsay does a great job analyzing the relevant portions of Bona Film Group’s disclosures regarding VIEs and concludes that Bona did a better job than most in terms of explaining the risks.  I agree and so I recommend this China Hearsay post to those who want to know (or should want to know) the risks of investing in companies that operate through VIEs.

Bottom Line:  We foresee many more such entertainment deals in the next year involving VIEs, so get used to it.

On November 4, CLB’s own Steve Dickinson participated in an Internet discussion regarding Variable Interest Entities (VIEs) in China. The discussion was entitled, “Foreign Ownership in China: Still VIEable?” and the other participants were China Hearsay’s Stan Abrams (an attorney), China Accounting Blog’s Paul Gillis (an accountant), and China Finance Blog’s Fredrik Öqvist (a financial analyst).  A full transcript of the proceedings can be found here. If you have any interest in VIEs or investing in the companies that have VIEs, I strongly urge you to read the transcript. I also urge you to check out this post on VIEs, which has a long list of good readings on VIEs.

What I found most interesting about the discussion is that everyone seemed to agree that Chinese courts will not enforce the contracts on which VIE structures are based. In light of this, what exactly do U.S. listed companies with VIE structures really have in China?

For the last couple of years, there has been massive discussion regarding Variable Interest Entities (VIEs) in China. We at China Law Blog have taken a strong stand on them and our position has always been that we will not do them because we do do not think they hold up to legal scrutiny. Or to put it another way, our law firm is too small to withstand the onslaught of malpractice litigation we forsee when these VIEs start to unravel.

Under a VIE structure, a Chinese Internet provider is effectively owned by a foreign entity through a complex set of contractual arrangements, rather than through ownership of stock.  The control by the foreign entity is so total and complete that the arrangement is considered the equivalent of ownership under U.S. accounting rules. However, by there being no actual foreign ownership of stock, these VIE structures have managed to operate in China, evading the clear rules restricting foreign ownership.

Our concern has always been that the Chinese side in these deals will be able to jettison the foreign company because the foreign company will not be well positioned to fight back because its connection with China is not legal. We are hearing that none of the Big Four accounting firms will have anything more to do with VIE deals so it appears that our stand on this issue has now become the new reality.

Others do not see things the same as us and think that we are being too cautious and that VIEs are too important to China and so will always be protected.

This Tuesday, November 1, there is going to be a web discussion/debate/cage fight involving some very outspoken people on VIE structures. The event is going to consist of CLB’s own Steve Dickinson (an attorney), China Hearsay’s Stan Abrams (an attorney), China Accounting Blog’s Paul Gillis (an accountant), and China Finance Blog’s Fredrik Öqvist (a financial analyst).

There will also be a VIE-related Q&A through the G+ site during the course of the week. Anyone with an interest in VIEs should tune in. Go here to find out more. The main event will take place this Tuesday, November 1, from 10 am until 11 am EST.

For background on VIEs, I suggest you read the following China Law Blog posts:

And the following China Hearsay posts:

And the following China Accounting posts:

And the following China Finance posts:

If you read all of the above, you will probably know more about VIEs than anyone else alive. If you are going to read just one post, make it “Explaining VIE structures.” Oh, and just to give you more to read, I also recommend you read the Silicon Hutong post, “VIEs, The Long Resolution.” In that post, David Wolf talks of how the Chinese government likes to “boil its frogs slowly, not all at once,” and he then talks of how VIEs are on the wrong side of where China wants to be going. I could not agree more. I do not see VIEs disappearing overnight; instead, I see foreign companies involved with VIEs suffering a very long and very gradual squeeze out.

What do you think?

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 arrangements.

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.

China continues to bar foreigners from owning companies in those sectors of the economy China considers particularly sensitive from the standpoint of national security. The Internet is one such sector where direct foreign ownership is prohibited. Yet it is well known that virtually the entire Internet sector has been funded by foreign IPOs, making foreign investors the owners of this sensitive sector in violation of the of the law. New regulations recently promulgated by MOFCOM (China’s Ministry of Commerce) appear to have ended this unusual situation.

Foreign companies have managed to “own” companies in China’s Internet sector by using what is known in the United States as a Variable Interest Entity (“VIE”). Under a VIE structure, a Chinese Internet provider is effectively owned by a foreign entity through a complex set of contractual arrangements, rather than through ownership of stock.  The control by the foreign entity is so total and complete that the arrangement is considered the equivalent of ownership under U.S. accounting rules. However, by there being no actual foreign ownership of stock, these VIE structures have managed to operate in China, evading the clear rules restricting foreign ownership.

New Regulations recently issued by MOFCOM appear to spell the end of VIEs. On September 1, the Regulation of the Ministry of Commerce on the National Security Review System for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (Regulations) became effective. The Regulations provide the long-awaited procedures for national security review for foreign related M&A activity that is required under the recently promulgated PRC Anti-Monopoly Law. To the surprise of many, the Regulations also took direct aim at the VIE procedure.

The provisions are deceptively simple. Article 9 of the Regulations provides that using “contractual controls” to evade the requirements of Chinese law that would otherwise restrict or prohibit foreign investment in a sensitive sector is prohibited. This is a clear prohibition against the use of VIE structures. The whole goal of the use of VIEs is to hide the fact of foreign investment from the Chinese regulators. Thus, it is likely that the use of a VIE will not be caught by national security review at the outset of the investment. To deal with this issue, Article 10 of the Regulations provides that where such contractual controls are used but not reported to the Chinese regulators, the parties involved have the independent duty to immediately terminate the offending conduct. If the parties do not take action on their own, the regulators have the authority to order the immediate termination of the offending investment by whatever means are necessary.

What does this mean for the future of foreign investment in China? Many foreign investors contend that existing VIE structures are sound and that VIE arrangements can safely be used in the future. I disagree.

The following has been occurring of late in the VIE arena:

  • In the Internet sector, IPOs continue to be proposed that rely explicitly on a VIE structure. Such IPOs are clearly under a cloud and are quite properly being delayed or cancelled.
  • Many investors have proposed expanding the VIE structure for foreign IPOs in other restricted sectors of the Chinese economy, such as the telecom and medical services sector. It is now clear that this proposed expanded use of the of the VIE structure in China will not succeed.
  • The new regulations only reaffirm that existing foreign investment in the Internet sector is built on a shaky foundation and the that the Chinese regulators are essentially only one phone call away from steppng in and ordering all of these investments be terminated. Even if the Chinese regulators doe not take this drastic step, it is now clear that the contractual arrangements on which the various VIEs are based are in clear violation of Chinese law. This renders the contracts unenforceable and makes existing VIE structures essentially meaningless.

None of this is actually new. These risks have long been known. However, the clarity of the Regulations means it is now nearly impossible to claim that Chinese law on these issues is ambiguous or unclear. Where Chinese law says that ownership by foreigners is restricted or prohibited, the law means what it says.  Foreigners who invest in violation of the law are making a bet that the violation will be ignored. This is extremely unlikely in today’s China. Such bets are sucker’s bets and should avoided at all costs.

We have been speaking out against VIEs for years and just about every time we do so, someone says that if they are illegal, why have so many large law firms, large accounting firms, and large companies gone along with them? The answer is simple. Money. Big money. Really big money. Now, some of these same law firms and accounting firms and companies are denying that anything has changed. And why is that? Again, money. Only this time they are taking positions not so much to make more money going forward, but to avoid losing through lawsuits the money they have already made.

We have written extensively on the perils of VIEs and if you want to read more, I urge you to check out the following:

What do you think?

If it seems we have been obsessed of late regarding Variable Interest Entities (VIEs), it is because we are. We are obsessed with them because we have spent massive amounts of time over the last few months working with investment companies (and others) investigating publicly traded Chinese companies that use VIE structures.

This work has led us to read pretty much whatever we can on VIEs and it led me to read a very clearly written article by Ballard Spahr lawyers Norman Goldberger and Laura Krabill.

One additional risk factor in investing in Chinese companies is that the use of a reverse merger is often accompanied by the creation of a variable interest entity (“VIE”). VIEs allow the public company to gain control of a private Chinese company and its assets through a series of contractual arrangements, rather than through a strict parent-subsidiary relationship or direct ownership of the operating Chinese company or its assets. The VIE structure is used to avoid Chinese regulations prohibiting foreign ownership of Chinese companies and assets. The VIE arrangement, however, creates further risk and complication for U.S. investors of public companies whose assets and operations are in China.

In particular, the contractual arrangements providing for control by the public company are only as strong as the enforcement mechanisms that can be effectively used — generally Chinese law and Chinese courts. There may be incentives for the Chinese company
or its insiders or their friends and family (who are likely the other parties to the VIE contracts) to simply renege on the contracts, and it might be impossible for the contracts to be enforced in China. Or, despite their best efforts to perform under the contracts, the VIE contracts could be nullified as a result of intervention by the Chinese government. Whatever the reason, the fact that VIE contractual arrangements may ultimately be unenforceable
creates a substantial risk that investors in a public company whose only assets arise from VIE arrangements will be left with nothing.

For more on the risks of VIEs, check out the following:

To Vie or not to Vie, that is the question. What do you think?

This post was written by Damjan DeNoble, a 1L at University of Michigan Law School and a summer associate at Harris & Bricken (Hey, check out the new website). Damjan (pronounced Dame-Yan) is also co-editor of Asia Health Care Blog.

By Damjan DeNoble

Meet Gigamedia, a NASDAQ-listed Taiwanese video game company at the center of a controversy that nicely highlights some of the inherent shortcomings/risks of variable interest entities (VIEs). The SEC case file on the dispute between Gigamedia and T2CN reveals nearly all the ways a VIE structure can go wrong in a country where he/she who posses the chop and license reigns supreme.

The following very briefly summarizes the facts:

  1. Gigamedia (Taiwanese company registered in Singapore) acquired control over a Chinese online game company, T2CN (a BVI holding company).
  2. T2CN owned 100% of T2 Technology. The VIEs contracted to T2 Technology are: Jinyou, T2 Entertainment, and T2 Advertising.
  3. At some point, Gigamedia became dissatisfied with the performance of T2CN Corporate Executive Officer, Wang Ji, and tried to push him out with a dressed up corporate restructuring maneuver that involved Wang Ji stepping down as CEO, and stepping into a board position
  4. Wang Ji retaliated: he walked off with the seals and chops to T2 Technology (the WFOE) as well as the VIEs.
  5. Gigamedia lost out.

The point of conflict arose when Gigamedia fully expected Wang Ji to go along with its restructuring plans, just like countless other executives in corporations across the world had done before him.

As sole owner the VIEs, however, Wang Ji knew he held all of the cards and he intended to use them. He controlled T2CN’s chop and the business registration certificates of T2 Technology and GigaMedia’s VIE.  Just as importantly, he also controlled key PRC licenses and records necessary for T2CN to operate in China. Unless Gigamedia could somehow gain physical control over these things it would not be able to do business in China without having to negotiate with Wang Jin.

Wang Jin must have been fairly confident, therefore, when he chose to execute “Dealing With Foreign Companies 101”: stay quiet and appear to do exactly what the foreign company wants you to do, while actually wholly undermining what the foreign company is seeking to accomplish.

Gigamedia made the first move against Wang Ji:

As a result, T2CN, as the sole shareholder of T2 Technology, removed Wang Ji as a director of T2 Technology on July 27, 2010.  Wang Ji was also duly removed as a director of T2CN on July 29, 2010.  On August 7, 2010, Wang Ji was removed as the legal representative, executive director and manager of T2 Entertainment with immediate effect by way of a shareholders’ resolution passed at a shareholders’ meeting of T2 Entertainment.  On August 10, 2010, the newly appointed legal representatives of T2 Technology and T2 Entertainment, together with their PRC legal advisers, went to the office premises to request that Wang Ji return all properties of T2 Technology and T2 Entertainment in his possession, custody or control.  At that time, the newly appointed legal representatives were forcibly removed from the office premises.  Also, Wang Ji’s employment contract with T2 Technology was terminated on August 12, 2010.

Seven months after Gigamedia announced the restructuring and right about when it was actually time for it to begin, Wang Ji made clear what he really intended to do:

GigaMedia believes that Wang Ji currently has in his possession, among other things, the company seals, financial chops and business registration certificates of T2 Technology and GigaMedia’s VIEs.  Wang Ji also has in his possession all documents, records and data and tangible property, including license agreements, trademark and domain name documentation, held in the offices of T2CN’s wholly-owned subsidiary, T2 Technology.  The company seals, financial chops and business registration certificates of T2 Technology and GigaMedia’s VIEs are necessary for the respective entities to declare dividends and approve service fee payments to GigaMedia, among other things. These documents are necessary for GigaMedia to run its online games business in the PRC.  Under PRC law, the company seals, financial chops and business registration certificates are essential for entering into contracts, conducting banking business, or taking official corporate action of any sort.  Consequently, GigaMedia has not been able to register the resolutions removing Wang Ji from his position as a director of T2 Technology and as the legal representative, executive director and manager of T2 Entertainment.  In short, Wang Ji has effectively usurped control over T2 Technology and T2 Entertainment’s operations and accounts.

If Gigamedia had an actual ownership stake in the VIE’s controlled by T2CN,  the situation would have been salvageable, since it could have argued for the right to gain back control of the chop and relevant documentation. But because Gigamedia enjoyed only a contractual relationship with those companies through T2CN’s VIE set up, its legal options were essentially limited to regaining control of its holding company, which would not be of much help, as Stan Abrams of China Hearsay explains in “GigaMedia: the Answer to the ‘What If?’ VIE Question.”

If so much of the Gigamedia dispute comes down to someone physically controlling the right documents, where does it leave VIEs?

Probably in the same place as before any of this happened. Foreign companies do not go into VIEs so much because they like them, but because they have no other choice if they want to get involved in Chinese markets closed to foreign businesses.

Gigamedia’s T2CN’s problems should be filed away in the multi-volume treatise of China caution stories, as an example of what can go wrong between a foreign company and its Chinese partner. This story should probably be go in the section of the treatise on the importance of holding on to that still important anachronism, the Chinese chop.

For more on the Gigamedia case, I urge you to check out Seeking Alpha’s “GigaMedia Will Survive Current VIE Turmoil,“and China Finance “What’s going on with GigaMedia?

I was on a panel of speakers yesterday at the Offshore Investment Conference 2011. We panelists were to give a statement enunciating “the one key point” from the talks we had given earlier in the day. Yongjun Peter Ni, who heads Zhong Lun’s tax practice, said something about how foreign companies need to abide by China’s tax laws because China is now very serious about enforcing them. My first thought when he said that was “absolutely” and my second thought was that this is becoming true of all the laws that apply to foreign companies.

In the last few years, corporate taxes in China have assumed pretty much the same level of significance for Western companies as in their home countries. China’s increased emphasis on maintaining transfer pricing controls is a salient example of this.

Which brings me to the China Accounting and the China Finance blogs. Both of these are relatively new blogs dealing with China accounting/finance issues and both are well worth reading.

China Accounting Blog is written by Paul Gillis, an Assistant Professor of accounting at Peking University’s Guanghua School of Management. Gillis joined academia in 2007, after an almost thirty year career at PricewaterhouseCoopers. China Finance is by Fredrik Oqvist, one of Mr. Gillis’s former students. Both have been providing in-depth coverage on Chinese Variable Interest Entities (VIEs) and reverse mergers.

Accounting and finance are rising to prominence in China and if you want to keep up, you should be reading China Accounting and the China Finance.

What do you think?