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This article is part of our Rising Star Portfolios series. You can read about the Dada Portfolio here.

In a previous article, I took a look at the standard holding structure for U.S.-listed Chinese companies, and noted the benefit of having multiple layers of intermediary shell companies located in tax havens such as the Cayman Islands and Hong Kong.

The inevitable "but..."
That doesn't mean you should assume that all complicated Chinese corporate structures benefit U.S. shareholders. Today's article looks at the seedy, gray underside of these complicated holding structures.

Let's look at China Wind Systems' (Nasdaq: CWS  ) organization. The red font is my additional explanation, while the black font comes from company filings:

Source: Company filings. WFOE = wholly foreign-owned enterprise.

A quick reminder – these corporate entities are the business equivalent of Russian nesting dolls. The "China Wind Systems" entity is just a wrapper for the "Fulland" entity, which is itself just a wrapper for the "Green Power Environment Technology" entity, which, again, is just an empty shell filled by the "Huayang" entities at the very bottom. These Huayang companies are the actual operational businesses, and we speak of their financial results when we refer to China Wind Systems.

Between China Wind Systems, Fulland, and Green Power Environment Technology, there is 100% equity ownership, which means the shareholders of China Wind Systems also own both subsidiary entities.

So close, yet so far
But that's as far as your ownership stake takes you. The grayed-out arrow between Green Power Environment Technology and the Huayang companies and the words "Contractual arrangements" next to it mean that, among other things, equity ownership for U.S. shareholders does not extend all the way down to the operational companies.

Let me repeat that, just in case you didn't follow: As a shareholder of China Wind Systems, you do not own the actual operating company! Instead, you own contracts that stipulate, in their words: "the right to appoint senior executives of the Huayang Companies ... The Huayang Companies, in return, agrees to pledge their accounts receivable and all of their assets to Green Power."

The contractual arrangement is designed to mimic equity ownership. That's why, when you look at China Wind Systems' financial statements, you see the operational results of the Huayang entities, even though you don't own them directly.

Wait! Don't sell all your shares yet!
I can imagine that a few of my readers have already muttered profanities by now, but the situation is more complicated than "All Chinese companies are frauds!" I only singled out China Wind Systems because its holding structure was relatively easy to decipher. These contractual arrangements are much more common than most investors may realize. Look at Baidu (Nasdaq: BIDU  ) :


The dotted lines between Baidu Online Network Technology, Beijing Baidu Netcom Science and Technology, Robin Yanhong Li, and Eric Yong Xu all indicate some sort of contractual agreement intended to mimic equity ownership. And if you thought Wall Street would run screaming from this tenuous arrangement, you'd be wrong.

Baidu has at least 19 analysts covering the stock, and shares of the Cayman Islands holding company are up almost 1,400% in the past five years! Argue all you want about valuation and fraud-this fraud-that, but I'll take a 14-bagger any day.

So is the coast clear?
I wouldn't be writing this article if I didn't think there were any risks to this arrangement. First of all, nobody, not the shareholder or the company's management, truly benefits from these types of arrangements. On the whole, while the situation can seem very sketchy, I don't believe that most Chinese management teams intentionally structure their companies in this way in the hope of one day severing those contractual ties with little more than an "oops." The Dada Portfolio wouldn't have purchased China Yida (Nasdaq: CNYD  ) if I did, since they, too, have only contractual arrangements with a key operating subsidiary.

In truth, most of these arrangements are created out of necessity. As I mentioned in my last article, the Chinese government regulates business entities differently based on their ownership structure. PRC (People's Republic of China) corporate entities that are wholly owned by foreign companies (WFOEs) are governed and subjected to different do's and don'ts compared to corporate entities that are entirely domestically owned. For one thing, foreign investment in Internet and online advertising businesses is entirely forbidden!

Thus, a wholly owned foreign enterprise with direct equity ownership that reached all the way up to U.S. shareholders would not be able to operate a search engine, especially not a profitable one that derives revenue from online ads. Baidu couldn't exist any other way! Similar restrictions exist for many other industries, particularly in the technology sector, which is why the preponderance of these contractual arrangements apply to Internet or IT companies.

Intentions aside, these are clearly gray-zone loopholes. Baidu, China Wind Systems, and many others clearly state in their risks sections: "PRC laws and regulations governing our businesses and the validity of certain of our contractual arrangements are uncertain." And that's not just an obligatory disclosure.

Late last year, (Nasdaq: NTES  ) , the Beijing-based video game company that operates the Chinese version of World of Warcraft, found itself caught between two feuding government departments regarding the legality of its being a U.S.-listed (and thus, U.S.-shareholder-owned) company operating in the highly restricted Internet services and online games industry. As the legitimacy of NetEase's operations came into question, the stock dropped almost 30% on fears that these contractual arrangement loopholes might finally be closed. That said, the company's shares have since bounced back, after China's government decided that the workaround could continue to exist.

And the moral is...
As with most things regarding China, there are no right or wrong answers, no black or white; just shades of gray. That's a huge risk that, understandably, most people don't and shouldn't take on. At the same time, where there's risk, there's opportunity. You don't find 14-baggers by looking where everyone else is looking, and agreeing with what everyone else is saying. Wal-Mart is a great company, but the stock has only grown 11% in five years. That 2% annualized CAGR doesn't even beat U.S. inflation!

With the Dada Portfolio, we don't have any illusion of being great white knights or socially conscious capital allocators. Our goal is honestly quite simple: We want to deliver great returns and have an awesome time doing it. We define risk as the possibility of permanent capital loss, and we control it the only sensible way we know of -- from our wallets. We don't run away from it, but we do demand an appropriate potential upside as compensation for taking it on.

All that said, we very, very strongly believe in investing carefully. If you take nothing else away from this article, please keep this statement from recently IPOed vegetable producer Le Gaga (Nasdaq: GAGA  ) in mind:

Your ability to bring an action against us or against our directors and officers, or to enforce a judgment against us or them, will be limited because we are incorporated in the Cayman Islands, because we conduct substantially all of our operations in China and Hong Kong and because all of our directors and officers reside outside of the United States.

Translation: "Hey guys! If something happens and you get screwed, don't expect to be able to do anything about it!" That's a straightforward lesson with relevance beyond Chinese companies alone.

The Dada Portfolio is a part of the Rising Stars series of real-money portfolios. It is co-managed by Sean Sun and Ilan Moscovitz. If you're interested in learning more about the portfolio, click hereto join us on our discussion board or follow us on Twitter @TMFDada! A full list of our articles can be found on the Dada Portfolio Foolsaurus page.

Sean Sun doesn't own shares of any company mentioned. Baidu and are Motley Fool Rule Breakers picks. The Fool owns shares of China Yida Holding. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (8) | Recommend This Article (15)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 18, 2010, at 10:32 AM, gman5454 wrote:

    Funny, you guys wrote a negative article about CWS a while ago. Since then the company has done everything it said it would and their business is growing. And now, out of all the Chinese US listed companies out there to use as an example, you choose CWS. Could this be more than a coincidence? Your little comment you made is useless: “All that said, we very, very strongly believe in investing carefully. If you take nothing else away from this article, please keep this statement from recently IPOed vegetable producer Le Gaga (Nasdaq: GAGA) in mind: etc.” The shareholder has very little recourse even in US based listed companies. Oh that’s right shareholders can partake in a class action lawsuit where the lawyers get paid and the shareholder get pennies on THEIR dollar. Fraud is fraud and is everywhere, even in the US and your only protection from it is Managements’ integrity.

  • Report this Comment On November 18, 2010, at 11:45 AM, TMFSun wrote:

    gman5454: Agreed, which is why I ended the article with this line: "That's a straightforward lesson with relevance beyond Chinese companies alone."

    As for CWS -- I had no idea that wrote a negative article about the company before. I chose them for this example because they have a relatively simple structure compared to the diagonals and multiple subsidiaries of a Baidu, for instance, or the 20 other US-listed Chinese companies that I looked at when researching this article. Incidentally, I obviously did not mean to single out CWS and included Baidu's structure as well.... I think you can rest assured that this is just a coincidence and no offense was meant.

    Thanks for commenting and feel free to visit our discussion boards. We're always interested in new ideas if you want to make a positive case for CWS --


  • Report this Comment On November 18, 2010, at 11:46 AM, chinacleantech wrote:

    Your points about COntroactual (VIE strustures being less than ideal is indeed valid.

    CWS established a WFOE which is wholly owned by the offshore company, and thus wholly owned by the public company, which has complete ownership over the forging and ESR business and machines, the two most valuable busienss sectors. These comprise approximately 75% of the earnings of CWS. The VIE (Contractual) arrangement is still in place for the industrial machine business however, which is about 25% of earnings for the company.

  • Report this Comment On November 18, 2010, at 11:48 AM, chinacleantech wrote:

    Which means that CWS structure is 75% great and 25% just OK. Much better than most chinese companies listed in USA in my humble opinion

  • Report this Comment On November 18, 2010, at 2:34 PM, gman5454 wrote:

    Sean, If what chinacleantech wrote is true, why not put out another news release stating how much better CWS's structure is compared to all the other China US listed companies. Maybe do that after you close your short position in CWS........ just kidding.... NOT. Facts are facts but the way facts are reported tells people what to think. I really think your article rips CWS. Why not rip one of the China US listed companies that you own? After all the due diligence you guys do before you invest in a company, you would have known the company sturcture and would not have to do much more research.

  • Report this Comment On November 18, 2010, at 9:18 PM, walt373 wrote:

    Good article Sean. Keep up the great work. Articles clearly explaining little but important details like this are too rare. gman, chill out dude, it was just an example.

  • Report this Comment On November 19, 2010, at 10:24 AM, TMFSun wrote:

    Thanks walt :)

  • Report this Comment On November 19, 2010, at 4:56 PM, gman5454 wrote:

    It was not good work nor was it a good article. Why pick a company structure that is pretty clean and easy to follow as the example? It does not prove the point you are trying to make. Walt, if it hit your stock you'd be pis@ed as I am. Once again, why not write a positive article about how CWS company sturcture is one of the best US listed China companies. Oh, remember to go long right before you release the article. Nice.

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