Buyer beware over Telstra's Autohome float

Telstra this week took steps to cash in on boom time in technology floats, pushing ahead with a planned US stock market listing of China's Autohome, the largest car sales website in the world.

Telstra this week took steps to cash in on boom time in technology floats, pushing ahead with a planned US stock market listing of China's Autohome, the largest car sales website in the world.

Analysts value the float at more than a $1 billion, which will represent a significant windfall for Telstra shareholders after the telco just paid a little over $100 million as it increased its holding in the company to 71.5 per cent over several years.

The planned float comes as the stock market debut of Twitter saw the social network's value soar to more than $US27 billion.

Autohome is likely to attract investors who want to gain access to the Chinese auto market, which recently replaced the US as the world's largest market for passenger cars.

However, Telstra's "nice little property", as described by its chief executive David Thodey, has one significant risk, which it disclosed in its prospectus lodged with the US regulator but buried on page 24 as one of the many potential pitfalls.

Here Telstra warns of risks related to Autohome's corporate structure. Essentially Telstra, and new shareholders, have exposure to the business not through ownership but a contract which gives them a claim of the returns on the business.

The agreement mentioned in the prospectus is a complex legal structure known as variable interest entity - or VIE - which is designed to get around China's tough foreign ownership laws in sensitive areas such as finance, telecommunication and internet services. In essence, Telstra is not legally eligible to obtain a licence to run an internet business in China. So it has entered into a set of contractual agreements with Chinese nationals who hold the required licences to reap economic benefits from its investment and exercise indirect control.

Even so, the Autohome prospectus notes if the Chinese government finds that the contracts operating services in China fail to comply with government restrictions on foreign investment in internet businesses then Autohome "could be subject to severe penalties or be forced to relinquish our interests in those operations".

This has been a manageable risk so far as Beijing turns a blind eye to this practice. However, there are worrying signs that the Chinese government is clamping down on this questionable legal structure and especially after a recent ruling by China's Supreme People's Court.

The court ruled that contracts used by non-Chinese citizens to gain access to sectors of the Chinese economy that are protected from foreign investment were invalid.

"They (VIE) almost certainly are not legal," said Steve Dickinson, a partner at Harris & Moure on his popular China Law Blog.

This assessment is echoed by Niranjan Arasaratnam, head of telecommunication and media practice at Allens, and he said the whole legal structure that Telstra relied on could be "illegal".

Mr Arasaratnam said there was a worrying trend lately that Beijing was less willing to accommodate this practice.

King &Wood Mallesons, a law firm with extensive China practice, also warns about the "great controversy regarding the legality of VIE structure". It says a recent leaked report from China Securities Regulatory Commission recommends future overseas listing using a VIE structure should first obtain Chinese regulatory approval.

Telstra bought into the business in 2008 when former boss Sol Trujillo paid $76 million for a 55 per cent stake in Sequel Media, a technology start-up that owned the Autohome brand.

Telstra then paid $37 million to lift its stake by an additional 11 per cent this year. This effectively values the entire business at about $330 million.

Potential investors in Telstra's Autohome should realise that the telco relies on a questionable legal structure to control its Chinese investment.

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