The inherent risks behind Chinese ADRs

RYB Education’s child abuse scandal is a textbook example of the inherent legal risks that investors face when owning US-listed Chinese equities.

The directors of RYB Education rang the opening bell cheerfully as the share price of the Chinese preschool education firm shot up by 40% on its debut on the New York Stock Exchange in late September.

Two months later the firm was in the spotlight again. This time around, though, none of the company's managers are likely to have welcomed the public exposure.

In what was described as the worst child abuse scandal in Chinese history, RYB Education was investigated by the Beijing authorities after a number of parents reported that their children were being drugged, molested, and fed with unidentified pills at one of the schools in Beijing. 

Chinese newspapers and media outlets were abuzz with the alleged scandal and news of the police investigation sent RYB's share price down nearly 40% overnight, sending it below its listing price just two months earlier. Having priced at $18.50 each and traded above $30 as recently as mid-November, the American depositary shares now languish just above $17.  

The case of RYB exemplifies the one type of risk that is often neglected when it comes to investing in US-listed Chinese companies – legal risk.

Different legal system

At least four US law firms have filed securities class action lawsuits against RYB Education on behalf of the company’s shareholders, due to the financial losses incurred as a result of the investigation.

However, lawyers familiar with corporate law told FinanceAsia that it is unlikely shareholders will win the lawsuit, although they could yet recover some of the losses if the company decides to settle the case outside of court. RYB Education has not responded to the case so far.

That is because of fundamental differences between the Chinese and the US legal systems – China is a civil law jurisdiction while the US applies common law.

In practice, a criminal lawsuit cannot be filed against US-listed Chinese companies because criminal cases are governed by local laws, based on where the offence took place. So RYB shareholders are unable to file a criminal lawsuit against the company in the US.  

As a result, plaintiffs are left with a more indirect route in their legal disputes with US-listed Chinese companies; instead of suing companies directly, they tend to file lawsuits against them for breaching the US Securities Act, because of where they are listed.

Hence, in the case of RYB the shareholders are not suing the company for child abuse but for “failing to establish safety policies to prevent sexual abuse from occurring at its schools,” according to one of the lawsuits filed by a US law firm. 

Ambiguity around VIE

Even then, there is no guarantee that shareholders will win when they eventually have their day in court via this more convoluted route. It is a complex process and it can get even more complicated if the Chinese company in question has used a variable interest entity (VIE) structure to list in the US.

Under the VIE structure, the listed company itself is a special purpose vehicle (SPV) that owns the economic interest of the business through contractual arrangements.

Simply put, the SPV could assume all legal responsibility and leave the onshore holding company with nothing to answer for. 

In addition, US class action lawsuits generally take a long time to close. One corporate lawyer told FinanceAsia that only 26% of class action suits are settled within two years. The figure could be much lower for those against offshore companies or those using the VIE structure.

RYB Education is one of the many US-listed Chinese firms that adopt the VIE structure.

Vicious cycle

Class action lawsuits are often filed against US-listed Chinese companies for various reasons. Shareholders use them to recover losses on unfavourable events; short-sellers use them as a way to shake up their share price; and business rivals use them to disrupt their operations.

While these litigations can drag on for a long time and may not lead to any penalties, they have the potential to damage a company's reputation and can distract managers from their daily operations, which is why US-listed Chinese firms often seek to settle these litigations by agreeing compensation. 

But as more and more companies do this, more people are willing to take these companies to court, thus creating a vicious cycle.

The growing risk of US litigation may have been one of the reasons behind the go-private trend among US-listed Chinese companies between 2012 and 2015. However, with the number of these listings bouncing back this year, the issue could become relevant again.

For investors looking at high-flying Chinese companies in the US, the inherent legal risks should not be overlooked.

¬ Haymarket Media Limited. All rights reserved.
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