Muddy Waters Throws Too Much Mud at New Oriental
Muddy Waters Research, an equity research firm specializing in China concept companies, recently issued a report on New Oriental Education & Technology Group, one of the largest providers of private educational services in China. The research report alleged, among other things, that New Oriental’s corporate structure is designed to enable the company chairman to defraud shareholders. The Muddy Waters report does not, however, present a fair or accurate analysis of New Oriental’s corporate structure.
At a time when Chinese companies listed on American stock exchanges have come under intense scrutiny in the wake of a series of accounting scandals, the Muddy Waters report may have caused damage not just to New Oriental, but also to the wider hopes of Chinese companies hoping to go public in the US. The misleading report compounds a perception problem that continues to sully the reputation of companies like New Oriental that might otherwise have found favor among foreign investors.
New Oriental operates its business in China through a variable interest entity (VIE) structure, which is very common among China companies with securities listed on US stock exchanges, such as Baidu, NetEase, and Sina. These companies use the VIE structure to achieve technical compliance with China’s restrictions on foreign investment, though the structure does violate the intent of these restrictions.
In a China VIE structure (as helpfully explained here), the public company with securities listed in the US does not own the company that operates its business in China, but instead approximates ownership through a series of contractual arrangements. For a China VIE structure to function properly, these contractual arrangements must accomplish two things. They must provide the listed company with the power to control the operating company, and they must enable the listed company to extract nearly all of the profits of the operating company.
As summarized in greater detail in the table below, the Muddy Waters report highlights three technical deficiencies in New Oriental’s VIE structure: failure to register an equity pledge agreement with local authorities; failure to execute a shareholder proxy; and failure to extend the term of certain revenue agreements. Muddy Waters argues that the presence of these technical deficiencies means that the chairman of New Oriental designed this VIE structure so that he could steal the business and leave public shareholders with nothing but an empty shell company. At best, this is poor analysis. At worst, it is a deliberate attempt to mischaracterize New Oriental’s VIE structure.
The VIE agreements that bind New Oriental with its operating company achieve the goal of control as well as the goal of profit extraction. On the control front, while the New Oriental VIE structure does not include all of the features that are present in other VIE structures, New Oriental can change the nominee shareholders of the operating company at any time. The power to remove is the power to control, and therefore New Oriental can control the nominee shareholders of its operating company, and through them control the operating company itself.
On the financial front, New Oriental extracts the profits from its operating company through two types of revenue agreements – trademark license agreements and software license agreements. Both provide flexible pricing mechanisms so that New Oriental can change the license fees on a quarterly basis to ensure that nearly all of the operating company profits are extracted. Only one type of revenue agreement is necessary to achieve the profit extraction goal of a VIE structure, but New Oriental originally had four.
Muddy Waters claims that because two of these revenue agreements expired, all is lost. But as long as substantially all of the profits from the operating company are transferred to New Oriental, it doesn’t matter if there is one revenue agreement or 1 million revenue agreements. When two expired, all New Oriental needed to do was adjust the pricing in the remaining two agreements to transfer any profit that had previously been transferred under the two now expired revenue agreements. Nothing is lost.
China VIE structures are, however, fraught with risk. You can read about the failed VIE structure of Gigamedia here, and about how a founder’s wife exploited the VIE structure to nearly derail the initial public offering of Tudou here. In a China VIE structure, moral hazard is present whenever the management of the listed company also serves as nominee shareholders of the operating company. As Muddy Waters warns, management could breach their duties to the listed company, terminate the VIE agreements, take the operating company as their own, and leave the public shareholders holding an empty shell.
It is important to remember, however, that this risk exists with every China VIE structure. Muddy Waters claims that technical deficiencies in New Oriental’s VIE structure increase the risk of moral hazard. But New Oriental’s VIE structure is fully functional, and even if the VIE agreements were “perfect”, the moral hazard risk would remain the same. Muddy Waters failed its readers, and the market, by suggesting otherwise.
[Illustration by Hallie Bateman]
[Click the graphic below for an enlarged version.]