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Questions Remain for Focus Media and 'The Handset Six'

Updated 12/06/2011

There were two rounds of allegations and rebuttals between Muddy Waters ("MW") vs. Focus Media (FMCN), respectively, so it is should be no surprise that we have followed this story closely. The one issue we feel needs added attention is MW's allegations that the acquisitions of six handset companies ("The Handset Six") had not been consummated, a point of contention discussed in both reports.


It appears that FMCN took an atypical approach to previous possible acquisitions of six handset companies through variable interest entity (VIE) arrangements, giving those familiar with these kinds of transactions reason to delve into the mechanics of the deals in order to understand FMCN's motives, or to postulate if the events even occurred. Raising concern is the lack of information provided by FMCN needed to verifywhat should be the obviousplayers/entities whose roles are to follow protocols, clearly defined by PRC law, which would lead to track-able and legal consummations of the series of acquisitions. The notable red flags that support the case for what appear to be invalid deals are:

  • We can find no evidence that can lead one to conclude that there was ever a transfer of 100% ownership to nominees who should have been assigned by and represented FMCN. Without the nominees, risks exist that threaten the integrity of these alleged deals.
  • It is unclear who the Wholly Owned Foreign Enterprises (WFOE) were that had the responsibility of executing six separate Variable Interest Entity (VIE) agreements after the alleged handset company acquisitions.
  • Given the type of information provided by FMCN, we were not able to verify that the BVI holding companies of the allegedly acquired handset companies were actually real.

So as Muddy Waters observed inconsistencies in what should be normal and acceptable business practices, without additional information we are hard pressed to disagree with them after analyzing the situation ourselves, also concluding that Muddy Waters' claims could be accurate.

However, FMCN addressed this issue, going so far as to lend the following information in the second response:

"Focus Media acquired each of the six mobile handset advertising companies, which Muddy Waters falsely claims were "phantom" acquisitions, by purchasing the shares of the offshore holding companies that had VIE structure contracts in place with each of the six mobile handset advertising companies.

The following offshore holding companies of each of the six companies are disclosed as subsidiaries in Exhibit 21.1 to the Company's 2007 20-F.


PRC entity

Offshore holding company

Guangzhou Xuanwu

Summitworld Limited

Shenzhen Julan

Surge Zhenghe Holding Limited

Shenzhen Mengwang

Speedaccess Limited

Beijing Shiji Zhongkai

Profitbest Worldwide Limited

Shenzhen Jingzhun

Newking Investment Limited

Dongguan Yaya

Directvantage Limited


The share purchase agreements the Company entered into prove that Focus Media acquired the offshore holding companies of these six holdings companies."

The first statement above referencing FMCN's acquisition of The Handset Six caught our experienced PRC attorney's attention, also known as Bob.

Per our detailed discussions with Bob, PRC law dictates that it is not possible or legal for an offshore entity to have a VIE contract with a PRC company. Closer Look:

We fully understand that FMCN needs to apply VIE structure contracts to acquire The Handset Six. As explained by MW, after the acquisition with the VIE structures, the nominees of the VIE should be changed from the original shareholders of the VIE to the executives of the acquirer.

Who is the Nominee?

The nominee must be a Chinese individual who directly holds shares of the VIE. Please keep in mind that the VIE also refers to the PRC operating company. Before a VIE contract is established, the "nominee(s)" would be the original shareholders of the operating entity. When a change of ownership can't be directly accomplished, a VIE arrangement is established that basically gives the acquiring company control and a right to receive cash flows. However, since this arrangement is not for direct ownership, the acquiring company needs to feel assured (safe) that it really has control of these cash flows. This is why they will assign their own PRC based "nominee" to hold all shares in the VIE. If not, the acquiring company could have little recourse if the original shareholders decided to unilaterally just walk away and break the VIE contract. It makes very little business sense to enter a VIE contract without a nominee representing the acquiring company. And in fact, MW was quick to point out that FMCN followed the norm in other business combination transactions by assigning nominees).

Legal VIE arrangements are established between the PRC WFOE (directly owned by the non-PRC entity) and the PRC operating company. In essence the WFOE is the non-PRC entity's representative. Through the VIE agreements, the nominees pledge their shares of the VIE to the WFOE and the VIE pays (transfers) all of its interests to the WOFE. Change of the nominees of the VIE must be legally filed with the SAIC.

For investors to more clearly understand a VIE structure, here  typical diagram for such a case:

VIE Chart


As illustrated, through the VIE agreement between the new nominee and the WFOE, the acquirer can ultimately control the VIE. Again, without the change of the nominee, the acquirer cannot really 100% control the VIE as it is possible that the nominee of the VIE may breach the VIE agreement, at will. In fact, we have yet to find a business combination case where the nominee of the VIE was not changed. We have only seen cases where the original nominee(s) (shareholder) of the VIE become the executives of the acquirer when he/she loses nominee status. Furthermore, as explained by MW, there was such a nominee change in its other acquisitions such as with their Beijing Yitong acquisition.

In an extreme case, we surmise that consummated acquisitions under the VIE structure, without the change of the nominees of the VIE from the original shareholders to a newly assigned one, may be legally accepted by the US-GAAP principles which allow the WFOE to consolidate the financial statement of the VIE. Apparently, FMCN argues that this is the case for the acquisition of The Handset Six, different from Beijing Yitong acquisition. However, FMCN fails to disclose the identity of the WOFE's that would legally have to be party to the VIE arrangements with the handset companies.

Enter the WFOE: Investors and Auditors Require more Proof

In its second rebuttal FMCN claimed that "The share purchase agreements the Company entered into prove that Focus Media acquired the offshore holding companies of these six holdings companies." Using the chart we made as an example, it is to say that before the acquisition, FMCN is basically alleging that all six handset companies had their own VIE structure in place and FMCN directly purchased the shares of the offshore holding companies, which can be offshore company I and/or offshore company II in our chart, who had owned a WFOE. The purchase of the BVI companies would then result in FMCN's indirect purchase of the six WFOEs and six VIEs.

Also in its second rebuttal, FMCN provided the names of the alleged offshore holding companies (BV1 and BVI 2) of the The Handset Six and claimed that these names were disclosed as subsidiaries in Exhibit 21.1 of the Company's 2007 20-F. However, as we explain next this disclosure did not solve the issue, but instead raises more questions.

As we now all understand, the VIE agreement needs to be between a VIE and a WFOE (or at least an FIE which is substantially owned by an offshore company). It is 100% illegal and thus impossible for the offshore companies (for example, BVI companies) to directly execute the VIE agreement with the onshore Chinese VIE. Therefore, the question to FMCN becomes, what are the names of six WFOE's established by those six offshore holding companies named by FMCN in its second response? Without the WFOE, there is/was no legal acquisition. FMCN never specifically mentioned the existence of a WFOE. They just mentioned that a VIE agreement exists.

Where/who are the WFOEs

In the 2007 20-F, we noticed that there were only two PRC companies in the handset advertising service network:

    1. Beijing Focus Media Wireless Co., Ltd.
    2. Beijing Yitong Wireless Information Technology Co., Ltd.

At first, we trusted that FMCN may have acquired The Handset Six through the VIE agreement executed between the nominees (VIEs) and these two handset advertising service companies. But after reading filings it is clear that this was not the case.

To be clear, if there are six different offshore holding entities to hold the interests of The Handset Six, there should be also six WFOE's to execute six series of VIE agreements with the six VIEs after the acquisition. However, in the 2007 20-F we cannot find six possible PRC companies to represent the six WFOEs.

Investors need to understand that, without the consent of the six BVI companies referenced by FMCN , there is no way to check the BVI company's shareholder/subsidiary information as this information is usually not registered with the BVI government but only with the company's registration secretary. In other words, there is no way for a third party to check whether or not these six BVI companies are the real offshore holding companies of the six allegedly acquired companies.

To clarify the acquisition issue of The Handset Six, we believe that FMCN's explanation must disclose:

  1. The names of the six WFOEs who are owned by the six offshore holding companies disclosed by FMCN in its second response.
  2. The executed VIE agreements with these six handset companies.

We also suggest that FMCN disclose the six executed series of VIE agreements covering the six handset companies. If FMCN can not disclose these pieces of information, we will assume that FMCN is hiding information for some reason and that Muddy Water's opinion on the acquisition issue becomes more credible. We also suggest that the Auditor, NASDAQ and SEC demand that this information be made public. Furthermore, since many Chinese based auditors have not fully cooperated with and opened their doors to U.S. regulatory authorities we demand that the U.S. arm of FMCN's PRC auditor (Deloitte Touche Tohmatsu, Shanghai) play a big role in solving the FMCN riddle.

Disclosure: The GeoTeam holds no position in FMCN, Long or Short

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