Buyer Beware of Variable Interest Entity Structures
What investors in Chinese ADRs should know.
NYSE-listed Chinese firm New Oriental Education (EDU) recently acknowledged a Securities and Exchange Commission investigation that the firm believes is related to its variable interest entity structure. New Oriental and other Chinese ADRs we cover use a VIE structure to effectively be in control of Chinese operations while bypassing restrictions on foreign direct investments in regulated sectors, including Internet, media, and private education. New Oriental's share price has fallen 36% since the unexpected announcement in mid-July. While there may be other factors at play (such as reduced investor appetite for emerging-market exposure and the Muddy Waters Research report accusing New Oriental of improper disclosure and accounting of its franchise business), we think investor panic over the opaque VIE structure was the key driver of the sell-off.
It is not yet clear whether the SEC probe was triggered by the recently disclosed change that consolidated control of the VIE with New Oriental founder, chairman, and CEO Michael Yu. (He has a 17.1% stake and is the largest shareholder.) It is also unknown whether the probe will spread to other Chinese ADRs that use a similar structure. In any case, we believe it's helpful for investors to better understand how the VIE structure is set up and what provisions can offer protection to holders of American depositary receipts, should conflicts of interest with the VIE controlling party arise.
Dan Su does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.