The Biggest China Risk

When it comes to investing in China, I've seen a lot of "interesting" corporate structures. Nothing, however, has thrown me off more than recently listed online dating site Jiayuan.com (Nasdaq: DATE  ) . The reason? It's unclear whether this company even has the right to be in business in China.

There's shady, and then there's this
Like a lot of Chinese companies, Jiayuan is organized so that owners of the Nasdaq-listed stock don't actually "have any direct ownership interests or direct voting rights in any of our PRC [mainland China] operating companies."

Because the Chinese government restricts foreign ownership of things like Internet services and online payments businesses, and won't grant foreigners a license to provide online dating services, the listed company simply has contractual arrangements whereby the operating companies in China, which are owned by Jiayuan's Chinese management team, agree to allow the management team at the listed entity to direct the operations at the operating entities and obtain "substantially all" of their economic benefits. (Though "substantially all" -- their words, not mine -- seems to be something less than all.)

If you're thinking this is complicated, confusing, ripe for conflicts of interest, and probably unenforceable in a court of law, you're right.

All of this is quite common, though. Many of China's best-known companies, including Baidu (Nasdaq: BIDU  ) and Sina (Nasdaq: SINA  ) are organized in largely the same way. Of course, as any kindergartner knows, just because others are doing something doesn't make it right -- or in this case, legal.

This is even shadier
In fact, online gaming company GigaMedia (Nasdaq: GIGM  ) is currently being sued in federal court by the former head of its China operations, Wang Ji. At dispute is whether GigaMedia, because it controlled its Chinese operating subsidiary via contractual arrangement, actually has any right to its Chinese operations.

When GigaMedia sought to replace Ji, he effectively absconded with the company, refusing to give up any of the documents that another party would need to operate that business in China. Ji claims GigaMedia has no rights to the documents because the corporate structure they set up, the same general structure used by Jiayuan, Baidu, Sina, et al, is illegal. If the U.S. court agrees with him -- and I believe there's a high likelihood that it will -- then GigaMedia will likely be out of luck in China, and U.S. shareholders in many Chinese companies will have to face the reality that their shares, pending corporate reorganizations, are potentially worthless.

What will this do to valuations? I have no idea. It's unlikely, for example, that Baidu CEO Robin Li would run off with his company simply because he could. There's reputational risk in doing so, and Baidu also seems to enjoy the prestige and access that comes with a U.S. listing. At the very least, however, it's a huge unknown.

Even more uncomfortable
If this situation makes you uncomfortable, know that this isn't the only potential bomb ticking in Jiayuan's corporate structure. The company's registration statement further reveals a contractual relationship in China with a nonprofit entity known alternately as Shanghai Shiji Jiayuan Matchmaking Center or Jiayuan Shanghai Center.

This nonprofit was established by one of Jiayuan's operating subsidiaries and exists because the relevant Shanghai governmental authority refused to allow a for-profit entity to provide "marriage agency services" -- a term that may cover matchmaking, Jiayuan's core business. As a result, Jiayuan Shanghai Center has the license to do the actually matchmaking, and agrees to pay technology license and service fees to Jiayuan's operating subsidiary, which supports it. I guess that these fees amount to almost all of Jiayuan Shanghai Center's revenue, since it's supposed to be a nonprofit.

This seems like a convenient workaround for the company, and it was deemed legal by the company's Chinese legal counsel. But investors still don't know two things. First, how will regulators react when it becomes clear that the company is profiting from a nonprofit service? They could, among other things, fine the company or revoke its operating license -- events both potentially material to the financials and investment case here.

Second, who actually owns the Jiayuan Shanghai Center and its seemingly critical business license, and what are his or her incentives, motivations, and potential conflicts of interest? That information may come to light at some point, but when we talked to company representatives in June, they refused to identify the owner(s). If Jiayuan Shanghai Center walks off with its license, what will happen to Jiayuan?

The global view
Although it doesn't quite take a titanium spine to invest in China, it does require some thinking about how one can get comfortable with the existence of unknown unknowns. We've attacked this problem at Motley Fool Global Gains tactically by recommending investors only invest small amounts in a diversified basket of companies with China exposure, including some multinationals, and by avoiding companies with the most confusing and/or convoluted ownership structures. It seems the biggest China risk of all is whether foreign investors, when push comes to shove, will ever own the right to assets and cash flows in the country.

Jiayuan is a profitable business with a significant market opportunity, but its corporate structure ranks among the most convoluted I've seen. That's why this Fool -- acknowledging that some of my Foolish colleagues disagree -- is staying away.

Is Jiayuan too much risk for you? Let me know in the comments below.

Get Tim Hanson's top global stock picks by joining Motley Fool Global Gains. Tim's "Global View" column appears every Thursday on Fool.com.

Tim Hanson is co-advisor of Motley Fool Global Gains. He does not own shares of any company mentioned. Motley Fool newsletter services have recommended buying shares of Jiayuan.com, Baidu, and Sina. 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 (7) | Recommend This Article (20)

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 August 18, 2011, at 6:35 PM, MazonCreekRich wrote:

    Solid and helpful!

  • Report this Comment On August 18, 2011, at 6:45 PM, Pat4Ra wrote:

    Tim,

    How does this affect your recommendations such as WWIN, CGA, CCSC, YONG. Do US shareholders own these companies in any form? Thx, Pat.

  • Report this Comment On August 18, 2011, at 7:01 PM, TMFMmbop wrote:

    None of those companies use the VIE/contract structure.

    Tim

  • Report this Comment On August 19, 2011, at 11:41 AM, pmacpherso wrote:

    Tim: You are pumping the stock... The Fool has been recommending BIDU for three years now and it has been a great buy...but putting BIDU in with the rest of the characters in your article is irresponsible.

    It is painful to watch you guys do 3 good articles then a bad one with lots of supposed innuendo and dread...

    Just what we do not need w/ these volatile markets

  • Report this Comment On August 20, 2011, at 5:57 PM, maniladad wrote:

    I don't consider myself an expert on Asia but I've lived there for 14 years and I've learned a few things. The most pertinent to this particular issue is that the ethical standards that we in the West assume are not the same standards that apply here. This is not a judgement, just an observation. You have to realize that the rules of conduct are different. For the large majority of people in Asia it is acceptable to cheat, to lie, to defraud business partners, friends, neighbors and in some cases even family members. When their actions come to light they do not seem to feel remorse but rather embarrassment -- for you, that you were so naive and stupid to allow yourself to be duped. And they will attempt to continue to do business with you! I was astonished the first time I experienced this but I learned that it's the norm. Of course many Asians have integrity and many Westerners do not but my impression is that the proportions are reversed, with about 80% of businessmen in the west demonstrating an enlightened integrity, as a way of long-term success, while about 80% of Asian businessmen demonstrate no integrity, as a way to achieve short-term success. I may be wrong but I would advise anyone doing business in Asia to consider the possibility of betrayal at any stage of a business relationship. It's not about ethics, it's about reality.

  • Report this Comment On August 21, 2011, at 2:01 AM, LarryHK wrote:

    Maniladad expresses the situation very well, its different set of rules in Asia generally and China in particular, Similarly I am no expert but 12 years here has given me some "interesting" experiences, fortunately none were financially terminal !!

    As a culture, Asians approach problems & opportunities on a completely different but parallel plane to westerners , and they achieve results etc but through a route or process that is often unintelligable to us.

    So the tenor of the MF advice seems to be tread cautiously, the opportunities are clearly there, and so are the bear traps.

    What is it the french say "Vive La Difference " ?

  • Report this Comment On August 26, 2011, at 1:48 AM, mikecart1 wrote:

    I bought GIGM at $2/share. It turns out to be the worst investment of my life. I believe anyone investing in Chinese stocks should have their head examined. The worst US stock is better than 99% of Chinese stocks.

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