Investing in China Just Got a Whole Lot Riskier

The following commentary comes from an independent investor as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( TheStreet) -- Some say State Administration for Industry and Commerce (SAIC) filings for Chinese reverse takeovers (RTOs) don't matter. And neither do State Administration of Taxation (SAT) documents that are inaccessible to independent third parties such as auditors. Think again.

SAIC and SAT filings do matter. Deloitte Touche Tohmatsu (DTT) finally chose to reference SAIC and SAT documents in its probe into China MediaExpress Holdings ( CCME) operations:

Issue raised: Information on file with the State Administration of Industry and Commerce as to certain subsidiaries appearing to be inconsistent with comparable financial information provided to DTT.

Issue raised: The verification of certain subsidiary tax payments with the local office of the State Administration of Taxation.

If auditors are referencing SAIC filings in audits, shouldn't they be important to investors? Investors who ignore them may find that their portfolios of diamonds in the rough with glorious price-to-earnings ratios of 5 or less are piles of worthless paper. (Investors also need to be aware that companies that amend past filings likely aren't alerting SAT agencies of changes.)

Investigating Chinese Reverse Mergers

Short sellers -- those who benefit from a decline in share prices -- have pointed to differences between SAIC filings and financial reports filed with the U.S. Securities and Exchange Commission as a basis for fraud accusations. Short sellers claim that companies like China Sky One Medical ( CSKI) and China Education Alliance ( CEU) are exaggerating sales and income to U.S. regulators to attract investors.

Several companies have downplayed the discrepancies between SAIC and SEC filings. In September, China Green Agriculture ( CGA) argued that individuals who are knowledgeable about China do not rely on SAIC filings as a basis for determining a company's financial position.

"Oftentimes, Chinese companies access SAIC filings to learn more about their competitors to gain a commercial advantage," China Green said in the statement. "As a result, many companies have understated their financial results in such filings."

I will even go a step further and say that investing in companies that downplay the significance of SAIC filings or have failed to include auditor comments attesting to the independent viewing of SAT documents (mainly when SAIC filings don't match) will expose your portfolio to meaningful risks.

It seems things can't get any worse for investors who desire to go long in the Chinese RTO space.

Well, it just did. By now, anyone who follows China should be aware of VIE and FIE corporate structures. Simply put, an FIE structure is dictated by a direct ownership of a Chinese operating company by an offshore entity (for example, U.S. British Virgin Islands or Hong Kong), while a VIE structure is enforced by management/consulting contracts between Chinese operating subsidiaries and a Chinese intermediary directly owned by an off shore entity.

VIE arrangements were crafted by ambitious lawyers to enable Chinese companies to go public in the U.S., circumventing Chinese laws that prohibit foreign ownership in domestic companies operating in certain industries. Keep in mind that the Chinese government hasn't clearly commented on the legality of VIE arrangements.

Related to this topic, let's reference a 10K passage in the "risk factors" section of a typical "China hybrid" company such as Buddha Steel ( AGVO).

"There are risks involved with the operation of our business in reliance on the VIE Agreements, including the risk that the VIE Agreements may be determined by PRC regulators or courts to be unenforceable. Our PRC counsel, AllBright Law Offices, has provided a legal opinion that the VIE Agreements are binding and enforceable under PRC law, but has further advised that if the VIE Agreements were for any reason determined to be in breach of any existing or future PRC laws or regulations, the relevant regulatory authorities would have broad discretion in dealing with such breach, including:

"Imposing economic penalties; discontinuing or restricting the operations of HAIC or Baosheng Steel; imposing conditions or requirements with respect to the VIE Agreements with which HAIC or Baosheng Steel may not be able to comply; requiring our company to restructure the relevant ownership or operations; taking other regulatory or enforcement actions that could adversely affect our company's business; and revoking the business licenses and/or the licenses or certificates of HAIC, and/or voiding the VIE Agreements.

"Any of these actions could adversely affect our ability to manage, operate and gain the financial benefits of Baosheng Steel, which would have a material adverse impact on our business, financial condition and results of operations. If we are unable to restructure our relationship with Baosheng Steel in such circumstances, our resulting corporate structure (Buddha, Gold Promise and HAIC) would have essentially no operations or means of operating a steel business."

Most investors in the China hybrid space assumed VIE structures wouldn't be challenged. That would jeopardize companies such as Baidu ( BIDU). Well, a VIE structure has finally been challenged in the case of AGVO, leading to the termination of its recent reverser merger transaction:

"On March 22, 2011, Buddha Steel, Inc., a Delaware corporation; the majority shareholder of Buddha; Gold Promise (Hong Kong) Group Co., Limited, a Hong Kong Corporation ("Gold Promise"); Hebei Anbang Investment Consultation Co., Ltd., a Chinese company ("HAIC"); and Dachang Hui Autonomous County Baosheng Steel Products Co., Ltd., a Chinese company ("Baosheng Steel") entered into a Termination Agreement pursuant to which the parties terminated the Consulting Services Agreement; Operating Agreement; Voting Rights Proxy Agreement; Option Agreement and Equity Pledge Agreement all dated as of April 2, 2010.

In March 2011, Baosheng Steel was advised by local governmental authorities in Hebei Province of the People's Republic of China that the Control Agreements contravene current Chinese management policies related to foreign-invested enterprises and, as a result, are against public policy."

Realistically, I don't think companies such as Baidu are at risk here. But we at Geoinvesting are postulating that China may be finally taking measures to regulate companies that choose to go public via reverse mergers. I don't want to cause undue panic yet, but investors need to be aware of another risk thrown into the "beloved cesspool" of Chinese RTO companies that embody VIE structures.

A difference between FIE and VIE structures is that FIEs are required to undergo a joint inspection by SAIC and SAT agencies, but VIEs aren't. Therefore, the analysis of SAIC filings for VIEs can't automatically be used in the same way they are used for FIEs. It's plausible that if this "VIE" risk morphs into a bigger ordeal, RTO VIE's will be lucky to experience significant P/E expansions.

On a related topic, I think that there could be equally large problems for companies that embody FIE structures that operate in industries in which China doesn't allow direct ownership. China Education Alliance ( CEU) and Subaye ( SBAY) come to mind. Both companies portray an FIE structure even though, according to our findings, foreign direct ownership is strictly prohibited in their industries. Stay tuned, as I have come across another company with a broken ownership structure that I feel could send shares tumbling by at least 50%.

Disclosures: Short and puts on CBEH, short SBAY and short CCME after the exercise of puts.

Maj Soueidan founded The Market's Edge, Ltd. in 1994, The Markets Edge Hedge Fund in 2006 and GeoInvesting LLC in 2007. Through his involvement with the equity markets, he developed the strategies that are now at the core of the hedge fund and geoinvesting.com. He currently leads a team of researchers and analysts (the GeoTeam) that help investors identify opportunities in today's volatile stock market. The team uses fundamental criteria to analyze stocks in the micro-cap to small-cap arena.

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