Relaxing capital controls is needed fast, argues Beida professor Paul Gillis at his accounting weblog, as he analyses the position of Chukong Holdings Limited. They filed last week for a US IPO, but also use a so-called variable interest entity (VIE) structure, a source of many problems, argues Gillis.
I suspect that Chukong is actually burning cash in its VIE. That would make sense, since 89% of revenues and presumably most of the business is in the VIE. It also appears that company got the cash to burn by selling preferred shares in the Cayman Islands parent company, and then somehow transferred that cash to the VIE.
Chukong carefully explains in their filing that they may not be able to convert the proceeds of their offering into RMB and to capitalize PRC operations. That is because China has strict capital controls. With proper approvals, Chukong would have been able to contribute the proceeds from the preferred stock sales as capital (or made a loan) to its Chinese subsidiaries, known as wholly foreign owned enterprises (WFOE). But getting the money from the WFOE to the VIE is where it gets tough. SAFE Circular 142 says that the RMB obtained from a capital contribution cannot be used for an equity investment in China. SAFE Circular No. 45 prohibits converted funds from being loaned to another company through entrust loans. Direct company-to-company loans (commercial paper) are not allowed in China, so entrust loans, with a bank in the middle, get around the prohibition. But entrust loans cannot be made from converted contributed capital. So how did Chukong get the funds into the VIE? Lots of ways have been invented to circumvent China’s capital controls, but all of them have one thing in common – they are illegal.
Chukong dutifully explains that all these rules may continue to limit the use of proceeds of the offering. That gets to the principal accounting issue – Is Chukong a going concern? Auditors have to assess whether a company has the financial wherewithal to survive another year. If they conclude that it is more likely than not that the company won’t make it, they are to issue a going concern opinion and the offering would likely be doomed. …
Readers know I have a poor opinion of the VIE structure. This is just another example of the deepening contradictions of it. This problem will be relieved when China relaxes capital controls, but a comprehensive solution to the VIE problem is needed.
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