Walter Hutchens’ Blog

Many press stories have now reported on the deal involving Goldman Sachs and PRC banker Fang Fenglei to create a new investment banking venture in China. The Wall Street Journal chimed in on Friday, and Cajing magazine’s current cover story is available here (in Chinese). From these and other press accounts, the basic structure of the deal is discernible.

First, a PRC joint-venture investment bank (or, in official PRC parlance, a “foreign-invested securities company” or FISC) will be established. Goldman will own one-third of it, the maximum a foreign investor is allowed to own in an FISC under current PRC law.

The remainder of the FISC will be owned by a newly-established “Chinese” securities company to be called Gao Hua.

Besides paying for its own share in the FISC, Goldman will reportedly also bankroll the stake of the Chinese parties in Gao Hua. Goldman will reportedly loan about USD 100 million to PRC parties for the capitalization of Gao Hua.

In this respect, the name for Gao Hua is interesting. The are two Chinese characters in the name. The first one is also the first character used in the Chinese name of “Goldman Sachs.” The second character in the Gao Hua name is a common character meaning “China.” Thus the name Gao Hua suggests “Goldman Sachs China,” though it is ostensibly a PRC securities company which is invested in a FISC.

Gao Hua’s shareholders will be Fang Fenglei and some others, including perhaps some division of Legend computer company.

Presumably Goldman will get control rights of some kind over Gao Hua in exchange for the loans to PRC parties which fund Gao Hua’s establishment.

None of the press stories have revealed precise details of exactly how Goldman will control Gao Hua. They just indicate Goldman will indirectly fund Gao Hua’s capitalization. I am interested in these legal details. I presume Goldman will get rights to appoint the managers and maybe some directors of Gao Hua plus somehow direct the voting of Gao Hua shares whose capitalization was funded by Goldman loans. Repayment and profits on the loans may also be tied in with the profitability of Gao Hua.

This is clever stuff. Goldman has apparently come up with a structure that does not violate the PRC’s laws which restrict foreign investment in an FI-SC to one-third but yet manages to (1) avoid actual domination by the 67% PRC shareholders of the FISC and 2) create an entity that in its entirety (Gao Hua plus the FISC) can have a business scope broader than that allowed to an FISC alone.

Actually, solving issue 1 (control of the FISC) might not have required Goldman to fund and control Gao Hua (the Chinese partner to the FISC) because the relevant rules only cap foreign shareholding at one third. They do not actually prohibit contractual arrangements among the Chinese and foreign investors to an FISC concerning the FISC’s operations and management. Thus, if the CSRC were willing to allow a foreign party to control an FISC as its minority shareholder, they theoretically shouldn’t care if that control is arranged in the FISC’s own articles of association or through some other contract.

But the second issue (business scope) does seem to require this structure. The rules on establishing an FISC do limit business scopes for FISCs. They cannot broker A shares or trade for their own accounts. Gao Hua presumably can do those things, while the FISC can do underwriting and the other things permitted to FISCs under the regulations. Again, Goldman must have (as any FISC investor would) some way to be sure the Chinese investor in the FISC doesn’t compete with the FISC itself.

I admire the cleverness of Goldman’s structure. I imagine others will try to copy it. Contractual mechanisms of the sort I am imaging do not seem to break the letter of any PRC law.

However, I think there will be some risk that a deal such as this is only as durable as (1) the indulgence of the regulators who have signed off on it and (2) the continued cooperation of the PRC parties. If either of those things changes, Goldman might have a big mess on its hands. Apparently Goldman thinks such risks are tolerable in comparison to the potential advantages of the structure. They may be right. Or not. Time will tell. For Goldman, they are probably risking their reputation more than a meaningful amount of capital (to them).

However, as a cautionary tale I hope someone told the Goldman executives about what happened to many big, sophisticated foreign investors who established telecom ventures in the PRC using what was called the Chinese-Chinese-Foreign (Zhong-Zhong-Wai) structure. Many such deals were approved. Foreign capital and expertise poured in using the CCF structure. It seemed investors had found an acceptable way around regulations that kept foreign money out of certain telecom services. But before anybody established a lucrative telecom dynasty, PRC regulators reversed course and ordered that the CCH deals all be unwound. Lots of foreign money got burned.

Maybe such a risk is just like the risk that there will be a repeat of the nationalization of foreign property that occurred after the Communist revolution–a high-consequence but low-porability risk. Maybe.

There is another interesting aspect to this deal. Besides the Chinese partner to the FI-SC (Gao Hua,) being a new securities company indirectly funded (and apparently controlled) by Goldman, a USD 60 million “donation” has been made by Goldman to account holders of defunct Hainan Securities.

Some press stories have indicated a license for the new venture will come from Hainan Securities. Other stories have indicated the donation to Hainan only helps win approval. I do not know which version is correct, but I suspect it is the latter. Approval of both the new FI-SC and Gao Hua will entail various CSRC approvals and eventually issuance of business licenses, so I don’t see any great advantage in “buying” the Hainan CSRC license as opposed to obtaining a fresh one. If the CSRC will approve the creation of Gao Hua and the FISC, what’s the advantage of a license transfer, except maybe to save a little face about a naked “donation?”

My view of this reported “donation” is that if China wants to sell off rights for foreign investment in certain sectors (or approval of the arrangements for such investments), it should not sell an investment banking approval to Goldman Sachs in a one-off deal but rather hire Goldman Sachs to run a global auction for PRC approvals. That way China can get as much money as possible for granting government monopolies or waivers on existing restrictions.

I wrote in an article published last year that the essence of Chinese “law” is government approval, that the axiom “wei jing pizhun bu ke” (cannot be done without approval) is the PRC equivalent of Justice Marshall’s axiom that it is the business of the courts to say what the law is. “Markets” in government approval disgust me in some ways. Securities companies should exist and become strong by fulfilling market needs, not by getting special government approvals. But if the PRC is going to sell market entry, they should at least be sure they get top dollar for it.