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Monday, May 23, 2011

For COGO, better hope the CEO stays forever

One of the odd things about the chinese microcap space is that most companies don't actually own the equity of the underlying chinese company. In the filings, these chinese company report they are unable to give the holding company a 100% equity interest due to regulations, or in COGO case because it's too much of a hassle.
At the time of its incorporation, foreign shareholding in a trading business such as Shenzhen Comtech could not exceed 65%. With subsequent PRC deregulation, foreign ownership of such a trading business can now reach 100%. However, foreign ownership of companies in the PRC engaged in commodity trading businesses—which includes agency trade, wholesale, retail and franchise operations—is subject to restrictions under PRC laws and regulations, and requires special approval from the PRC Ministry of Commerce, which is time consuming to obtain. In order to exercise control over Shenzhen Comtech (a PRC operating company legally permitted to engage in a commodity trading business), without direct shareholding by us (a U.S.-listed company and therefore a foreign-invested entity), our principal shareholder and chief executive officer, Jeffrey Kang and his wife, Nan Ji, own through contractual agreements and for the benefit of our 100% directly owned subsidiary, Comtech China, all of the equity interest in our PRC operating company, Shenzhen Comtech, which, in turn, owns 60% equity interest in another of our PRC operating companies, Shanghai E&T. While we do not have any equity interest in Shenzhen Comtech, through these contractual agreements, we enjoy voting control and are entitled to the economic interests associated with Jeffrey Kang’s and Nan Ji’s equity interest in Shenzhen Comtech. For additional details regarding these contractual agreements, see “Related party transactions.” These contractual agreements may not be as effective in providing us with control over Shenzhen Comtech as direct ownership because we rely on the performance of Jeffrey Kang and Nan Ji under the agreements. If Jeffrey Kang or Nan Ji fail to perform his or her respective obligations under the agreements, we may have to incur substantial costs and resources to enforce such agreements and may not be able to do so in any case. Also, we must rely on legal remedies under applicable law, which may not be as effective as those in the United States. Because we rely on Shenzhen Comtech and Shanghai E&T in conducting our business operations in China, the realization of any of these risks relating to our corporate structure could result in a material disruption of our business, diversion of our resources and the incurrence of substantial costs, any of which could materially and adversely affect our operating results ayound financial condition.

Funny/weird enough they ended up changing this equity arrangement so the wife didn't own part of the company, instead the CEO's wife owns part of the company.
In 2005, Nan Ji has executed an agreement to transfer her 70% equity interest in Shenzhen Comtech to Jeffrey Kang and her 1% equity interest in Shenzhen Comtech to Huimo Chen, the mother of Jeffrey Kang, who is a PRC citizen. Jeffrey Kang and Huimo Chen have also agreed that upon the successful transfer of Nan Ji’s equity interest as described above, they will enter into and be bound by the same contractual arrangements with Comtech China relating to the voting control of Shenzhen Comtech.

You just can't make stuff like this up...it's incredible. Imagine if the board ever decides the CEO (not like this is at all likely), what are they doing to do? The CEO and his mother own the equity interest, and even though they have a "contractual agreement" with the company, I have a hard time foreign investors will be able to enforce this regulation. Even filings say this might be hard to enforce.
In the opinion of our PRC counsel, Grandall Legal Group, the ownership structure of Shenzhen Comtech and the contractual agreements among Comtech China, Mr. Kang and Ms. Ji do not violate existing PRC laws, rules and regulations. There are, however, substantial uncertainties regarding the interpretation and application of current or future PRC laws and regulations, including but not limited to the laws and regulations governing the validity and enforcement of these contractual agreements. In particular, this type of contractual agreement is not commonly seen in China and accordingly, we cannot assure you that PRC regulatory authorities will not determine that these contractual agreements with Jeffrey Kang and Nan Ji violate or conflict with PRC laws or regulations, including those regarding restrictions on foreign investments in trading businesses.

This information all comes from the 2005 10K. I've read the 2010 10K and I believe the equity interest has changed, but the crazy contractual agreement still stays on.

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