ITEM
1A. RISK FACTORS
The
following risk factors apply to the business and operations of the Company. These risk factors are not exhaustive. Investors are
encouraged to perform their own investigation with respect to the business, financial condition and prospects of the Company.
You should carefully consider the following risk factors, as well as the other information included in this Report. In particular,
please refer to the section entitled “Cautionary Note Regarding Forward-Looking Statements.” We may face additional
risks and uncertainties that are not presently known to us, or that we currently deem immaterial, which may also impair our business.
The following discussion should be read in conjunction with the financial statements and notes to the financial statements included
herein. For the purposes of these risk factors, unless otherwise indicated, the term “Borqs” “we,” “us,”
“our” or “the Company” refers to Borqs Technologies, Inc. together with our consolidated subsidiaries
and consolidated affiliated entities.
Risks
Related to Our Business and Industry
If
alternative mobile operating system platforms become more widely used or accepted, or mobile chipset manufacturers, mobile device
OEMs and mobile operators do not continue to make product and service offerings compatible with the Android platform, our business
could be materially harmed.
The
mobile operating system platform industry is intensely competitive and characterized by rapid technological changes, which often
result in shifts in market share among the industry’s participants as one operating system may become more widely used than
others. For example, in the past the Symbian mobile operating system platform, or Symbian, from Nokia Corporation, or Nokia, dominated
market share for consumer products and the BlackBerry mobile operating system platform, or BlackBerry, from Research in Motion
Limited, or RIM, dominated market share for enterprise products. In the past five years, with the rise of the iOS mobile operating
system platform, or iOS, from Apple Inc., or Apple, and the Android platform, both the Symbian and Blackberry platforms have experienced
a substantial decline. There can be no assurance that the Android platform will continue to compete effectively with alternative
mobile operating system platforms, such as the iOS platform or Windows Mobile mobile operating system platform, or Windows Mobile,
from Microsoft Corporation. If these or other mobile operating system platforms become more widely used or accepted, such as operating
system platforms being developed by Baidu, Inc., or Baidu, and Alibaba.com Ltd., or Alibaba, in China, the market appeal of the
Android platform and our Android+ software and service platform solutions could be diminished, which could materially adversely
affect our business and financial performance.
Furthermore,
the competitiveness of our Android+ software and service platform solutions is dependent upon the continued compatibility of the
Android platform with the offerings of our customers. If these customers choose not to continue to adopt the Android platform
or they are unable to retain or increase their market share, the demand for our Android+ software and service platform solutions
may be diminished, which could materially adversely affect our business and financial performance.
We
generate a significant portion of our net revenues from a small number of major customers and key projects and any loss of business
from these customers or key projects could reduce our net revenues and significantly harm our business.
We
have derived, and believe that in the foreseeable future we will continue to derive, a significant portion of our net revenues
from a small number of major customers and key projects. For 2015 and 2016, our top five customers accounted for 54.1% and 51.7%,
respectively, of our net revenues.
Our
ability to maintain close relationships with our major customers is essential to the growth and profitability of our business.
However, the volume of work performed for a specific customer is likely to vary from year-to-year and project-to-project, especially
since we are generally not the exclusive Android platform software and service solutions provider for our customers, some of our
customers have in-house research and development capabilities and we do not have long-term purchase commitments from any of our
customers. A major customer in one year may not provide the same level of net revenues for us in any subsequent year. The products
we provide to our customers, and the net revenues and income from those products, may decline or vary as the type and quantity
of products changes over time. In addition, reliance on any individual customer for a significant portion of our net revenues
may give that customer a degree of pricing leverage when negotiating contracts and terms of service with us.
In
addition, a number of factors not within our control could cause the loss of, or reduction in, business or revenues from any customer,
and these factors are not predictable. These factors include, among others, a customer’s decision to re-negotiate the royalty
payment of a contract if the volume of unit sales exceeds original expectations, pricing pressure from competitors, a change in
a customer’s business strategy, or failure of a mobile chipset manufacturer or mobile device OEM to develop competitive
products. Our customers may also choose to pursue alternative technologies and develop alternative products in addition to, or
in lieu of, our products, either on their own or in collaboration with others, including our competitors. The loss of any major
customer or key project, or a significant decrease in the volume of customer demand or the price at which we sells our products
to customers, could materially adversely affect our financial condition and results of operations.
We
have expanded our product offerings in both our Connected Solutions BU and MVNO BU, and there can be no assurance that our efforts
in these areas will be successful.
From
our inception in 2007 through 2014, we have focused primarily on providing our Android+ software platform solutions to mobile
chipset manufacturers, mobile device OEMs and mobile operators as well as complete product solutions of mobile connected devices
for enterprise and consumer applications. In 2014, after acquiring Yuantel Investment, we entered into the MVNO business. As we
continue to grow our business and markets, we will continue to increase our service product offerings in both our Connected Solutions
BU and MVNO BU. However, the success of these new product offerings will depend on many factors, including timely and successful
research and development, pricing, market and consumer acceptance of such new products and the product offerings of our competitors.
If new product offerings are not successful, our revenue growth will suffer and our results of operations may be harmed. Further,
we do not have significant experience in the MVNO business and cannot be assured that our investments in the development of our
MVNO business will result in increased revenue.
We
rely on a prominent mobile chipset manufacturer customer for a significant portion of our net revenues. Any deterioration of our
relationship with this manufacturer, or any interruption to the ongoing collaboration with this customer may significantly harm
our business, financial condition and results of operations.
We
generate a significant portion of our revenue from a prominent chipset manufacturer, which beneficially owned 12.3% of our outstanding
shares as of the date of this Report. We rely significantly on this customer from a strategic viewpoint since we scale products
developed for this customer to deploy with mobile devices for OEM customers and devote a portion of our research and development
resources accordingly. In 2014, 2015 and 2016, we generated 18%, 10.0% and 3.5% of our net revenues, respectively, from this customer.
We anticipate that our dependence on this customer will continue for the foreseeable future. Consequently, various events could
cause material fluctuations or declines in our net revenues or liquidity position and have a material adverse effect on our financial
condition and results of operations:
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this
customer’s collaborations with our competitors;
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reduced,
delayed or canceled of contracts from this customer;
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market
success of this customer’s Android-based products; and
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this
customer’s decision to move product development in-house.
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Although
we have collaborated with this customer on various projects since 2010, there can be no assurance that this customer will continue
working with us in the future, whether due to changes in management preferences, business strategy, corporate structure or other
factors. Our failure to continue our collaboration with this customer would adversely affect our business, financial conditions
and results of operations.
We
provide mobile communication services as a mobile virtue network operator in China. The current license to operate such services
is based on a government issued extension of a trial license that originally would have expired on December 31, 2015. If we cannot
obtain a renewed license or the current extension is terminated, we will need to cease this operation and our total revenues will
be significantly reduced.
Our
MVNO BU contributed 4.6%, 26.6% and 29.1% of our net revenues in 2014, 2015 and 2016, respectively, and we are currently one of
the top MVNO businesses in China, as measured in terms of registered subscribers.
The
ability of MVNOs to provide mobile communication services in China is based on trial licenses granted by the Ministry of Industry
& Information Technology of China, or MIIT, under the mobile virtue network trial program initiated by the MIIT in 2013 to
implement the Chinese State Council’s encouragement of private investments in various industries, including telecommunication
industry. The trial program and all trails licenses issued thereunder, including our own, were originally set to expire as of
December 31, 2015. According to the trial program policies issued by the MIIT, the MIIT will work on formalizing commercial policies
regarding the operation of MVNO based on the development of the trial program. On December 28, 2015, the MIIT issued a notice
stating that while the government is “diligently researching and determining the formal commercial policies regarding the
operation of MVNO, the temporary licenses issued continue to allow MVNO enterprises to operate, and the base telecommunication
enterprises shall continue to provide cooperation, support and maintenance services”, as translated from the MIIT’s
notice. There has been no other announcement to date regarding the timing of the formalize policies, or the granting of official
licenses, or changes to the current extension to operate. All MVNOs in China, including us, will continue to operate and provide
mobile communication services for subscribers based on the trial licenses.
Although
it is a common belief among MVNOs in China that since the MVNO business in China was initiated by the current Chinese administration
and has gained a large number of subscribers during the trial program, the continuation of MVNO operation will be supported by
the Chinese administration, there is no guarantee that the Chinese government or the MIIT will not terminate MVNO operation. If
we cannot obtain a renewed license or the current extension is terminated, we will be forced to cease this operation, our total
revenues will be significantly reduced and our investment into this business will be completely lost.
We rely on China Unicom, the incumbent operator,
to provide us with attractive and competitive bulk wholesale rates of voice-per-minute and MB-of-data to compete with our competitors.
If we are not provided competitive bulk wholesale rates from China Unicom, we will not be able to maintain our gross margin and
will not be able to operate profitably, which may lead to shutting down the MVNO Business Unit entirely.
Failure
to complete real-name registration of all users of our MVNO services could subject us to penalties, damage our reputation and
brand, and harm our business and results of operations.
Chinese
laws require telecommunication business operators to verify and register real names and identification information of users of
mobile phones. For example, in September 2016, the MIIT and certain other governmental departments issued the Notice regarding
Prevention of and Cracking Down Telecommunication or Online Frauds to emphasize the real-name registration requirements and to
further require telecommunication business operators, including MVNOs, to complete the real-name registration for all of their
existing users by end of 2016. In August 2016 and February 2017, we were warned by the MIIT for our failure to strictly comply
with the real-name registration requirement. We have since rectified such failure in accordance with the MIIT’s requirements
and have also established internal policies and required all our staff to strictly comply with the real-name registration requirements
for new users. However, we cannot assure you that all our staff will strictly implement our internal policies or that all users
will provide authentic information to us. If we are found by the authorities not to comply with the real-name registration requirement,
we may be subject to penalties, or be required to suspend or terminate our MVNO business. In addition, complying with these laws
and regulations could cause us to incur substantial costs.
PRC
laws and regulations governing our businesses and the validity of certain of our contractual arrangements are uncertain. If we
are found to be in violation, we could be subject to sanctions. In addition, changes in PRC laws and regulations or changes in
interpretations thereof may materially and adversely affect our business.
The
PRC government restricts or imposes conditions on foreign investment in telecommunication business. We and our PRC subsidiaries
are considered foreign persons or foreign-invested enterprises under PRC foreign investment related laws. As a result, we are
subject to PRC legal restrictions on or conditions for foreign ownership of telecommunication business. Due to these restrictions
and conditions, we conduct our MVNO business in China through BC-NW, our variable interest entity and the subsidiaries of BC-NW.
As all the registered shareholders of BC-NW are PRC citizens and all other shareholders of the subsidiaries of BC-NW are also
PRC citizens or PRC domestic enterprises, BC-NW and our subsidiaries are therefore considered PRC domestic enterprises under PRC
law. The “registered shareholders” of BC-NW refer to those shareholders who have pledged their equity interest in
BC-NW to WFOE and entered into exclusive option agreements with WFOE as part of the contractual arrangements. Our contractual
arrangements with BC-NW and the registered shareholders of BC-NW allow it to have the power to direct the activities of BC-NW
and our subsidiaries that most significantly impact economic performance.
There
are substantial uncertainties regarding the interpretation and application of PRC laws and regulations, including, but not limited
to, the laws and regulations governing the MVNO business, or the enforcement and performance of our contractual arrangements with
BC-NW. These laws and regulations may be subject to change, and their official interpretation and enforcement may involve substantial
uncertainty. New laws and regulations that affect existing and proposed future businesses may also be applied retroactively.
Although
we believe we are in compliance with current PRC laws and regulations, we cannot assure you that the PRC government would agree
that our contractual arrangements comply with PRC licensing, registration or other regulatory requirements, with existing policies
or with requirements or policies that may be adopted in the future. The PRC government has broad discretion in determining penalties
for violations of laws and regulations. If the PRC government determines that we do not comply with applicable law, it could revoke
our business and operating licenses, require us to discontinue or restrict our operations, restrict our right to collect revenues,
block our websites, require us to restructure our operations, impose additional conditions or requirements with which we may not
be able to comply, impose restrictions on our business operations or on our customers, or take other regulatory or enforcement
actions against us that could be harmful to our business. Any of these or similar occurrences could significantly disrupt our
business operations or restrict us from conducting a substantial portion of our business operations, which could materially and
adversely affect our business, financial condition and results of operations. If any of these occurrences results in our inability
to direct the activities of any of our consolidated affiliated entities that most significantly impact our economic performance,
and/or our failure to receive the economic benefits from any of our consolidated affiliated entities, we may not be able to consolidate
such entity in our consolidated financial statements in accordance with U.S. GAAP.
We
operate in a rapidly evolving industry. If we fail to keep up with technological developments and changing requirements of our
customers, business, financial condition and results of operations may be materially and adversely affected.
The
mobile industry is rapidly evolving and subject to continuous technological developments. Our success depends on our ability to
keep up with these technological developments and the resulting changes in customers’ demands. There may also be changes
in the industry landscape as different types of platforms compete with one another for market share. If we do not adapt our Android+
software and service platform solutions to such changes in an effective and timely manner as more mobile operating system platforms
become available in the future, we may suffer a loss in market share. Given that we operate in a rapidly evolving industry, we
also need to continuously invest significant resources in research and development in order to enhance our existing products and
to respond to changes in customer preference, new challenges and industry changes in a timely and effective manner. If we fail
to keep up with technological developments and continue to innovate to meet the needs of our customers, our Android+ software
and service platform solutions may become less attractive to customers, which in turn may adversely affect our reputation, competitiveness,
results of operations and prospects.
We
face intense competition from onshore and offshore third party software providers in the Android platform and software market,
and, if we are unable to compete effectively, it may lose customers and our revenues may decline.
The
Android platform and software market is highly fragmented and competitive, and we expect competition to persist and intensify
from both existing competitors and new market entrants. We believe that the principal competitive factors in our industry are
reliability and efficiency, performance, product features and functionality, development complexity and time-to-market, price,
support for multiple architectures and processors, interoperability with other systems, support for emerging industry and customer
standards and protocols and levels of training, technical services and customer support.
Our
business model is to provide a full suite of Android+ software and service platform solutions to a broad range of customers, including
mobile chipset manufacturers, mobile device OEMs and mobile operators. As of the date of this Report, we are not aware of any
significant independent competitor that provides a full range of Android platform software and service solutions as we do to the
range of customers it has, although we have a number of competitors that provide one or several Android platform software and/or
service solutions to one or more of our range of customers. See “Business — Competition.”
In
addition, we face competition from companies seeking to compete with the Android platform by developing their own operating systems,
such as Baidu and Alibaba in China, and major mobile device OEMs, such as Foxconn Technology Group and BYD Electronic (International)
Company Limited, which are able to develop low-level software for mobile chipsets, as well as Huawei, GTE and Xiaomi.
We
believe that we presently compete favorably with respect to each segment identified above. However, the market for Android platform
software and service solutions is still rapidly evolving, and we may not be able to compete successfully against current and potential
competitors in the future. In addition, some of our independent competitors are more focused on one or several particular segments
of the value chain and may deliver better services in those segments than we do. Furthermore, some of our competitors may have
significantly greater financial, technical, marketing, sales and other resources and significantly greater name recognition than
we have. If we are unable to compete successfully on the principal competitive factors described above or otherwise, our business
could be harmed.
As
an MVNO, we face intense competition in the wireless communications market and if we cannot compete effectively our revenues,
profits, cash flows and growth may be adversely affected.
The
wireless communications market is extremely competitive, and competition for customers is increasing. We compete with other MVNOs
such as Snail Mobile, d.Mobile and Soshare. We are one of the top MVNOs in China as measured in terms of registered subscribers,
and we intend to expand our market share organically or by acquiring smaller MVNOs. However, we continue to face intense competition
from the dozens of other MVNOs and we may not be able to compete successfully in the future. In addition, continued consolidation
in the industry creates even large competitors, and such competitors may have greater financial, technical, personnel and marketing
resources and a larger market share than us, and we may not be able to compete successfully against them. If we are unable to
compete successfully on the principal competitive factors described above or otherwise, our MVNO business could be harmed.
Acquisition and Investment Risks.
We may undertake acquisitions, investments,
joint ventures or other strategic alliances in the future, which could expose us to new operational, regulatory and market risks.
In addition, such future and past undertakings may not be successful, which may adversely affect our business, results of operations,
financial condition and prospects.
In
connection with our growth strategy, we intend to grow both organically by expanding our current business lines and geographic
coverage and through acquisitions, investments, joint ventures or other strategic alliances if the appropriate opportunities arise.
These potential business plans, acquisitions, investments, joint ventures and strategic alliances may expose us to new operational,
regulatory and market risks, as well as risks associated with additional capital requirements. In addition, we may not be able
to identify suitable future acquisition or investment candidates or joint venture or alliance partners. Even if we identify suitable
candidates or partners, we may be unable to complete an acquisition, investment or alliance on terms commercially acceptable to
us. If we fail to identify appropriate candidates or partners, or complete desired acquisitions, investments or alliances, we
may not be able to implement our strategies effectively or efficiently.
In
addition, our ability to successfully integrate acquired companies and their operations may be adversely affected by a number
of factors, including, among others, the ability to capitalize on anticipated synergies, diversion of resources and management’s
attention, difficulties in retaining personnel of the acquired companies, unanticipated problems or legal liabilities and tax
and accounting issues. If we fail to integrate any acquired company efficiently, our earnings, revenues, gross margins, operating
margins and business operations could be adversely affected. The integration of acquired companies is a complex, time-consuming
and expensive process.
For our merger with
Pacific Special Acquisition Corp in which we received $18.0 million in net proceeds, administrative procedures are still in process.
Delay in such process may have a negative effect on our operations.
We
are dependent upon the Android platform and, if Google determines to no longer develop the Android platform and our further development
is not taken up by reliable alternative sources, our business could be materially harmed.
Our
business model is dependent upon the Android platform, which is a free and fully open source mobile software platform developed
by Google. The Android platform has been updated frequently since our original release and the development of the Android platform
is an ongoing process which we do not control. If Google determines to no longer develop the Android platform or our further development
is not taken up by reliable alternative sources, such as another third party or the open source community, demand for our Android+
software and service platform solutions could decline significantly and our revenue and financial condition could be materially
harmed.
If
our customers move more research and development work in-house, lower demand for our solutions could reduce our net revenues and
harm our business.
Collaboration
with customers is essential to the growth and profitability of our business. However, our customers may elect to move more research
and development work in-house, and reduce collaboration with us for Android platform projects. There are many factors beyond our
control that could cause our customers to move their work in-house, such as spending reductions due to a challenging economic
environment, corporate restructuring, cost control, pricing pressure and concerns regarding the protection of technology know-how,
trade secrets and other intellectual property rights. If our customers decide to change their strategy by moving more research
and development work in-house, our net revenues may decline, and our business, financial condition and results of operations may
be adversely affected.
Our
limited operating history makes it difficult to evaluate our business, financial performance and prospects.
We
were incorporated under the laws of the Cayman Islands in 2007 as Borqs International Holding Corp and have experienced rapid
growth since then. This limited operating history may make it difficult to evaluate our business, financial performance and prospects.
We may not have sufficient experience to address the risks frequently encountered by fast-growing companies entering new and rapidly
evolving markets such as the Android platform and software market, which may increase the difficulty of evaluating our prospects.
We incurred a net loss in 2014 of $8.1 million, and had net income of $0.8 million in 2015 and $2.6 million in 2016. There can
be no assurance that we will continue to generate net income in future periods, and we may incur losses in the future. Due to
our limited operating history, our historical growth may not be indicative of our future performance and may not be able to sustain
our profitability. You should consider our prospects in light of the risks and uncertainties that fast-growing companies with
a limited operating history may encounter or to which such companies may be exposed.
Most
of our engagements with customers are for a specific project only and do not provide for subsequent engagements. If we are unable
to generate a substantial number of new engagements for projects on a continuing basis, our business and results of operations
will be adversely affected.
Our
customers generally retain us on project-by-project basis in connection with specific projects rather than on a recurring basis
under long-term contracts. Historically, a significant portion of our net revenues has been comprised of product fees. These revenues
relate to one-time research and engineering work performed for customers. For 2014, 2015 and 2016, our net revenues from products
fees were $17.2 million, $22.5 million and $14.9 million, respectively, representing 36.2%, 29.9% and 12.4% of total net revenues.
Although a significant amount of our net revenues are generated from repeat business, which we define as revenues from a customer
who also contributed to our revenues during the prior fiscal year, our engagements with our customers are typically for individual
projects that are often on a non-exclusive, project-by-project basis. In addition, a majority of our customer contracts from which
we generate product fees can be terminated by customers with or without cause. There are many factors outside of our control that
might lead customers to terminate a contract or project with us, including, among others:
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financial
difficulties for our customers;
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business
going to our competitors or remaining in-house;
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unsuccessful
launch of a product;
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disclosure
of core technology by a third party; and
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mergers
and acquisitions or significant corporate restructurings by our customers.
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Furthermore,
some of our customer contracts specify that if a change of control occurs during the term of the contract, the customer has the
right to terminate the contract upon advance notice. If our customers terminate our contracts before completion or choose not
to renew their contracts, our business, financial condition and results of operations may be materially and adversely affected.
Therefore,
we have to continuously seek new engagements while our current engagements are being performed or are completed or terminated,
and we are constantly seeking to expand our business with existing customers and secure new customers. If we are unable to generate
a substantial number of new engagements on a continuing basis, our business and results of operations will be adversely affected.
Because
of the characteristics of open source software, there are limited technology entry barriers into the Android platform and software
market in which we compete, and it may be relatively easy for competitors, some of which may have greater resources than we have,
to enter our markets and compete with us.
One
of the characteristics of open source software is that anyone can modify and redistribute the existing open source software and
use it to compete against us. Such competition can develop without the degree of overhead and lead time required by traditional
proprietary software companies. It is possible for new competitors with greater resources than us to develop their own Android
platform software and service solutions, potentially reducing the demand for, and putting pricing pressure on, our Android+ software
and service platform solutions. In addition, some competitors make their open source software available for free download and
use on an
ad hoc
basis, or may position their open source software as a loss leader in order to win customers. There can
be no assurance that we will be able to compete successfully against current and future competitors or that competitive pressure
and/or the availability of open source software will not result in price reductions, reduced operating margins and loss of market
share, any of which could seriously harm our business.
Security
and privacy breaches may expose us to liability and harm our reputation and business.
As
part of our business we receive and process information about our employees, customers and partners, and we may store (or contract
with third parties to store) our customers’ data. While we take security measures relating to our Android+ software and
service platform solutions, specifically, and our operations, generally, those measures may not prevent security breaches that
could harm our business. Advances in computer capabilities, inadequate technology or facility security measures or other factors
may result in a compromise or breach of our systems and the data we store and process. Our security measures may be breached as
a result of actions by third parties or employee error or malfeasance. A party who is able to circumvent our security measures
or exploit inadequacies in our security measures, could, among other things, misappropriate proprietary information (including
information about our employees, customers and partners and our customers’ information), cause the loss or disclosure of
some or all of this information, cause interruptions in our operations or our customers’ or expose our customers to computer
viruses or other disruptions or vulnerabilities. Any compromise of our systems or the data it stores or processes could result
in a loss of confidence in the security of our Android+ software and service platform solutions, damage our reputation, disrupt
our business, lead to legal liability and adversely affect our financial condition and results of operations. Moreover, a compromise
of our systems could remain undetected for an extended period of time, exacerbating the impact of that compromise. Actual or perceived
vulnerabilities may lead to claims against us by our customers, partners or other third parties, which could be material. While
our customer agreements typically contain provisions that seek to limit our liability, there is no assurance these provisions
will be enforceable and effective under applicable law. In addition, the cost and operational consequences of implementing further
data protection measures could be significant.
We
are vulnerable to technology infrastructure failures, which could harm our reputation and business.
We
rely on our technology infrastructure for many functions, including selling our Android+ software and service platform solutions,
supporting our customers and billing, collecting and making payments. We also rely on our own technology infrastructure, which
is located on a third party site, as well as the technology infrastructure of third parties, to provide some of our back-end services.
This technology infrastructure may be vulnerable to damage or interruption from natural disasters, power loss, telecommunication
failures, terrorist attacks, computer intrusions and viruses, software errors, computer denial-of-service attacks and other events.
A significant number of the systems making up this infrastructure are not redundant, and our disaster recovery planning is not
sufficient for every eventuality. This technology infrastructure is also subject to break-ins, sabotage and intentional acts of
vandalism by internal employees, contractors and third parties. Despite any precautions we or our third-party partners may take,
such problems could result in, among other consequences, interruptions in our services and loss of data, which could harm our
reputation, business and financial condition. We do not carry business interruption insurance sufficient to protect us from all
losses that may result from interruptions in our services as a result of technology infrastructure failures or to cover all contingencies.
Any interruption in the availability of our websites and on-line interactions with customers and partners would create a large
volume of questions and complaints that would need to be addressed by our support personnel. If our support personnel cannot meet
this demand, customer and partner satisfaction levels may fall, which in turn could cause additional claims, reduced revenue,
reputation damage or loss of customers.
We
may not be able to continue to use or adequately protect our intellectual property rights, which could harm our business reputation
and competitive position.
Although
Android is an open source mobile software platform for mobile devices, we are not required to share the source code for our Android
software, which we have invested significant resources to develop. Accordingly, we believe that patents, trademarks, trade secrets,
copyright, software registration and other intellectual property we use are important to our business. We rely on a combination
of patent, trademark, copyright, software registration and trade secret protection laws in China and other jurisdictions, as well
as confidentiality procedures and contractual provisions to protect our intellectual property and brand name. Any failure by us
to maintain or protect our intellectual property rights, including any unauthorized use of our intellectual property by third
parties or use of “Borqs” as a company name to conduct software or services business, may adversely affect our current
and future revenues and our reputation.
In
addition, the validity, enforceability and scope of protection available under intellectual property laws with respect to the
mobile and Internet industries in China, where a significant part of our business and operations are located, are uncertain and
still evolving. Implementation and enforcement of PRC intellectual property-related laws have historically been deficient, ineffective
and hampered by corruption and local protectionism. Accordingly, protection of intellectual property rights in China may not be
as effective as in the United States or other countries. Furthermore, policing unauthorized use of proprietary technology is difficult
and expensive, and we may need to resort to litigation to enforce or defend patents issued to us or to determine the enforceability,
scope and validity of our proprietary rights or those of others. Such litigation and an adverse determination in any such litigation,
if any, could result in substantial costs and diversion of resources and management attention, which could harm our business and
competitive position.
We
also may be required to enter into license agreements with certain third parties to use their intellectual property for our business
operations. If such third parties fail to perform under these license agreements or if the agreements are terminated for any reason,
our business and results of operations may be negatively impacted. Furthermore, if we are deemed to be using third parties’
intellectual property without due authorization, we may become subject to legal proceedings or sanctions, which may be time-consuming
and costly to defend, divert management attention and resources or require us to enter into licensing agreements, which may not
be available on commercial terms, or at all.
The
international nature of our business exposes it to risks that could adversely affect our financial condition and results of operations.
We
conduct our business throughout the world in multiple locations. Our corporate structure also spans multiple jurisdictions, with
our parent holding company incorporated in the British Virgin Islands and intermediate and operating subsidiaries incorporated
in China, Hong Kong, India, Brazil, Japan and South Korea. In addition, one of our growth strategies is to further expand our
business in Europe and into the United States. As a result, we are exposed to risks typically associated with conducting business
internationally, many of which are beyond our control. These risks include, among others:
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significant
currency fluctuations between the Renminbi and the U.S. dollar and other currencies in
which we transact business;
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difficulty
in identifying appropriate mobile chipset manufacturers, mobile device OEMs, mobile operators
and/or joint venture partners, and establishing and maintaining good relationships with
them;
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legal
uncertainty owing to the overlap and inconsistencies of different legal regimes, problems
in asserting contractual or other rights across international borders and the burden
and expense of complying with the laws and regulations of various jurisdictions;
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potentially
adverse tax consequences, such as scrutiny of transfer pricing arrangements by authorities
in the countries in which we operate;
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adverse
effect of inflation and increase in labor costs;
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current
and future tariffs and other trade barriers, including restrictions on technology and
data transfers;
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general
global economic downturn;
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unexpected
changes in political environment and regulatory requirements; and
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terrorist
attacks and other acts of violence or war.
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The
occurrence of any of these events could have a material adverse effect on our results of operations and financial condition.
Furthermore,
we are in the process of implementing policies and procedures designed to facilitate compliance with laws and regulations in various
jurisdictions applicable to us, but there can be no assurance that our employees, contractors or agents will not violate such
laws and regulations or our policies. Any such violations could, individually or in the aggregate, materially and adversely affect
our financial condition and operating results.
We
may not be able to manage our anticipated growth and our current and planned resources may not be adequate to support our expanding
operations; consequently, our business, results of operations and prospects may be materially and adversely affected.
We
have experienced rapid growth since we commenced operations. Our rapid expansion may expose us to new challenges and risks. To
manage the further expansion of our business and the growth of our operations and personnel, we need to continuously expand and
enhance our infrastructure and technology, and improve our operational and financial systems and procedures and controls. For
example, we currently manage all of our human resources functions manually and expect that we will need to upgrade our current
system as we continue to increase our headcount. We also need to expand, train and manage our growing employee base. In addition,
our management will be required to obtain, maintain or expand relationships with mobile chipset manufacturers, mobile device OEMs
and mobile operators, as well as other third-party business partners. We cannot assure you that our current and planned personnel,
infrastructure, systems, procedures and controls will be adequate to support our expanding operations. If we fail to manage our
expansion effectively, our business, results of operations and prospects may be materially and adversely affected.
Due
to intense competition for highly skilled personnel, we may fail to attract and retain qualified personnel to support our research
and development operations; as a result, our ability to bid for and obtain new projects may be adversely affected and our net
revenues could decline.
The
mobile industry relies on the talents and efforts of highly skilled personnel, and our success depends to a significant extent
on our ability to recruit, train, develop, retain and motivate qualified personnel for all areas of our organization. The mobile
industry in China has experienced significant levels of employee attrition. Our attrition rates were 19% in 2014, 18% in 2015,
and 12% in 2016. We may encounter higher attrition rates in the future, particularly if the mobile industry continues to experience
strong growth.
Competition
in our industry for qualified employees, especially technical employees, is intense, and our competitors directly target our employees
from time to time. We have also experienced employees leaving us to start competing businesses or to join the in-house research
and development teams of our customers. The loss of the technical knowledge and industry expertise of any of these individuals
could seriously impede our success. Moreover, the loss of these individuals, particularly to a competitor, some of which are in
a position to offer greater compensation, and any resulting loss of customers or trade secrets and technological expertise could
further lead to a reduction in our market share and adversely affect our business. If we are required to increase the compensation
payable to our qualified employees to compete with certain competitors with greater resources than we have or to discourage employees
from leaving us to start competing businesses, our operating expenses will increase which, in turn, will adversely affect our
results or operations.
Our
success depends substantially on the continuing efforts of our senior executives and other key personnel, and our business may
be severely disrupted if we lose their services.
Our
future success heavily depends upon the continued services of our senior executives and other key employees. In particular, we
rely on the expertise, experience, customer relationships and reputation of Pat Chan, our founder, chairman and chief executive
officer. We currently do not maintain key man life insurance for any of the senior members of our management team or other key
employees. If one or more of our senior executives or key employees are unable or unwilling to continue in their present positions,
it could disrupt our business operations, and we may not be able to replace them easily or at all. In addition, competition for
senior executives and key employees in our industry is intense, and we may be unable to retain our senior executives and key employees
or attract and retain new senior executive and key employees in the future, in which case our business may be severely disrupted,
and our financial condition and results of operations may be materially and adversely affected.
If
any of our senior executives or key employees joins a competitor or forms a competing company, it may lose customers, know-how
and other key employees and staff members to them. Also, if any of our business development managers, who generally keep a close
relationship with our customers, joins a competitor or forms a competing company, we may lose customers, and our net revenues
may be materially and adversely affected. Additionally, there could be unauthorized disclosure or use of our technical knowledge,
practices or procedures by such employees. All of our executives and key employees have entered into employment agreements with
us that contain non-competition provisions, non-solicitation and nondisclosure covenants. However, if any dispute arises between
our executive officers or key employees and us, such non-competition, non-solicitation and nondisclosure provisions might not
provide effective protection to us, especially in China, where most of these executive officers and key employees reside, in light
of the uncertainties with China’s legal system. See “Risk Factors—Risks Related to Doing Business in China—Uncertainties
with respect to the PRC legal system could harm us.”
A
significant majority of our outstanding ordinary shares are held by a small number of shareholders, which may have significantly
greater influence on us due to the size of their shareholdings relative to other shareholders.
As
of the date of this Report, Asset Horizon International Limited, Keytone Ventures, L.P., Norwest Venture Partners X, L.P., GSR
Ventures II, L.P. and our affiliates, and Intel Capital Corporation beneficially own approximately 10.7%, 9.8%, 10.8%, 8.4% and
12.3%, respectively, of the outstanding ordinary shares of the Company. These major shareholders have significant influence in
determining the outcome of any corporate transactions or other matters submitted to our shareholders for approval, including mergers,
consolidations and schemes of arrangement, election and removal of directors and other significant corporate actions. They may
not act in our best interests or our minority shareholders’ interests. In addition, without the consent of these major shareholders,
we could be prevented from entering into transactions that could be beneficial to us. This concentration of ownership may also
discourage, delay or prevent a change in control, which could deprive our shareholders of an opportunity to receive a premium
for their shares as part of a sale of our company and might reduce the price of our ordinary shares. These actions may be taken
even if they are opposed by our other shareholders.
In
the course of preparing our consolidated financial statements, we identified material weaknesses, significant deficiencies and
other deficiencies in our internal control over financial reporting.
Prior
to the Business Combination, we have been a private company with limited accounting personnel and other resources with which to
address our internal controls and procedures for financial reporting. We identified material weaknesses, significant deficiencies
and other deficiencies in our internal control over financial reporting, and are in the process of implementing remedial steps
to improve our internal control over financial reporting. If we fail to timely achieve and maintain the adequacy of our internal
controls, we may not be able to conclude that we have effective internal control over financial reporting. Moreover, effective
internal control over financial reporting is necessary for us to produce reliable financial reports and is important to help prevent
fraud. If we fail to maintain effective internal control over financial reporting, investors could lost confidence in the reliability
of our financial statements, which could harm our business and the trading price of our ordinary shares. In addition, we anticipate
that we will incur considerable costs and devote significant management time and efforts and other resources to our efforts to
maintain effective internal control over financial reporting.
If
we fail to maintain effective internal control over financial reporting, we may not be able to accurately and timely report our
financial results or prevent fraud, and investor confidence and the market price of our ordinary shares may be adversely impacted.
We
are subject to the reporting requirements of the Sarbanes-Oxley Act. The Sarbanes-Oxley Act requires, among other things, that
we maintain effective disclosure controls and procedures and internal control over financial reporting. Our current controls and
any new controls that we develop may become inadequate because of changes in conditions in our business. Further, weaknesses in
our disclosure controls and internal control over financial reporting may be discovered in the future. Any failure to develop
or maintain effective controls or any difficulties encountered in their implementation or improvement could harm our operating
results or cause us to fail to meet our reporting obligations and may result in a restatement of our financial statements for
prior periods. Any failure to implement and maintain effective internal control over financial reporting also could adversely
affect the results of periodic management evaluations and annual independent registered public accounting firm attestation reports
regarding the effectiveness of our internal control over financial reporting that we will eventually be required to include in
our periodic reports that will be filed with the SEC. Ineffective disclosure controls and procedures and internal control over
financial reporting could also cause investors to lose confidence in our reported financial and other information, which could
have a negative effect on the trading price of our ordinary shares.
In
addition, if we are unable to continue to meet these requirements, we may not be able to remain listed on the Nasdaq Capital Market.
We are not currently required to comply with the SEC rules that implement Section 404 of the Sarbanes-Oxley Act and are therefore
not required to make a formal assessment of the effectiveness of our internal control over financial reporting for that purpose.
We will be required to provide an annual management report on the effectiveness of our internal control over financial reporting
in our 2017 annual report on Form 10-K or Form 20-F.
Our
independent registered public accounting firm is not required to formally attest to the effectiveness of our internal control
over financial reporting until after we are no longer an “emerging growth company” as defined in the Jumpstart our
Business Startups Act of 2012. At such time, our independent registered public accounting firm may issue a report that is adverse
in the event it is not satisfied with the level at which our internal control over financial reporting is documented, designed,
or operating. Any failure to maintain effective disclosure controls and internal control over financial reporting could have a
material and adverse effect on our business and operating results and could cause a decline in the price of our ordinary shares.
We
could be an emerging growth company for up to five full fiscal years following the date of Pacific’s initial public offering,
although circumstances could cause us to lose that status earlier, including if the market value of our ordinary shares held by
non-affiliates exceeds $700 million as of any June 30 before that time, in which case we would no longer be an emerging growth
company as of the following December 31.
We
are subject to, and therefore may be exposed to liability risk under, various anti-corruption and anti-bribery laws, including
the U.S. Foreign Corrupt Practices Act, the U.K. Bribery Act, and PRC and Indian anti-corruption and anti-bribery laws; any determination
that we have violated such laws could damage our business and reputation, limit our ability to bid for certain business opportunities,
and subject us to significant criminal and civil penalties, civil litigation (such as shareholder derivative suits), and commercial
liabilities.
We
are subject to anti-corruption and anti-bribery laws in the United States, United Kingdom, China, and India that prohibit certain
improper payments made directly or indirectly to government departments, agencies, and instrumentalities; officials of those government
departments, agencies, and instrumentalities; political parties and their officials; candidates for political office; officials
of public international organizations; persons acting on behalf of the foregoing; and commercial counterparties. These laws include
the U.S. Foreign Corrupt Practices Act, the U.K. Bribery Act 2010, the PRC Criminal Law, the PRC Anti-Unfair Competition Law,
the Indian Prevention of Corruption Act 1988, the Indian Penal Code and anti-corruption laws in various Indian states.
We
are engaged in business in a number of countries that are regarded as posing significant risks of corruption. Of particular note,
we conduct operations, have agreements with state-controlled enterprises and other third parties and make sales in the PRC, and
we have research and development activities in India, each of which may be exposed to corruption risk. It is our policy to implement
safeguards and procedures to prohibit these practices by our employees, officers, directors, or by third parties acting on our
behalf. However, we cannot rule out the risk that any of our employees, officers, directors, or third parties acting on our behalf
may engage in breaches of our policies or anti-corruption laws, for which we might be held responsible.
Allegations
of violations of these anti-corruption and anti-bribery laws, and investigation into such allegations, could negatively affect
our reputation, business, operating results, and financial condition. The violation of these laws may result in substantial monetary
and even criminal sanctions, follow-on civil litigation (such as shareholder derivative suits), and monitoring of our compliance
program by the United States or other governments, each of which could negatively affect our reputation, business, operating results,
and financial condition. In addition, the United States or other governments may seek to hold us liable for violations of these
laws committed by companies in which we invest or acquire.
There
can be no assurance that our ordinary shares and warrants will continue to be so listed on Nasdaq or, if listed, that we will
be able to comply with the continued listing standards of Nasdaq.
To
continue listing the Company’s securities on the Nasdaq Capital Market, we will be required to demonstrate compliance with
Nasdaq’s initial listing standards, which are more rigorous than Nasdaq’s continued listing requirements. For instance,
the Company must maintain a minimum number of holders (300 round-lot holders). The Company cannot assure you that we will be able
to meet those initial listing standards.
If
the Nasdaq Capital Market delists the Company’s ordinary shares or warrants from trading on its exchange due to our failure
to meet the Nasdaq Capital Market’s initial and/or continued listing standards, we and our securityholders could face significant
material adverse consequences including:
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a
limited availability of market quotations for our securities;
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a
determination that our ordinary shares are a “penny stock,” which will require
brokers trading in our ordinary shares to adhere to more stringent rules, possibly resulting
in a reduced level of trading activity in the secondary trading market for our ordinary
shares;
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a
limited amount of analyst coverage; and
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a
decreased ability to issue additional securities or obtain additional financing in the
future.
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Risks
Related to Doing Business in China
China’s
economic, political and social conditions, as well as changes in any government policies, laws and regulations, could have a material
adverse effect on our business.
A
substantial portion of our operations are conducted in China, and a significant portion of our net revenues are derived from customers
where the contracting entity is located in China. Accordingly, our business, financial condition, results of operations, prospects
and certain transactions we may undertake are subject, to a significant extent, to economic, political and legal developments
in China.
China’s
economy differs from the economies of most developed countries in many respects, including the amount of government involvement,
level of development, growth rate, control of foreign exchange and allocation of resources. While the PRC economy has experienced
significant growth in the past two to three decades, growth has been uneven, both geographically and among various sectors of
the economy. Demand for our services and products depends, in large part, on economic conditions in China. Any slowdown in China’s
economic growth may cause our potential customers to delay or cancel their plans to purchase our services and products, which
in turn could reduce our net revenues.
Although
China’s economy has been transitioning from a planned economy to a more market-oriented economy since the late 1970s, the
PRC government continues to play a significant role in regulating industry development by imposing industrial policies. The PRC
government also exercises significant control over China’s economic growth through allocating resources, controlling the
incurrence and payment of foreign currency-denominated obligations, setting monetary policy and providing preferential treatment
to particular industries or companies. Changes in any of these policies, laws and regulations could adversely affect the economy
in China and could have a material adverse effect on our business.
The
PRC government has implemented various measures to encourage foreign investment and sustainable economic growth and to guide the
allocation of financial and other resources, which have for the most part had a positive effect on our business and growth. However,
we cannot assure you that the PRC government will not repeal or alter these measures or introduce new measures that will have
a negative effect on us. China’s social and political conditions may also not be as stable as those of the United States
and other developed countries. Any sudden changes to China’s political system or the occurrence of widespread social unrest
could have a material adverse effect on our business and results of operations.
Uncertainties
with respect to the PRC legal system could harm us.
Our
operations in China are governed by PRC government laws and regulations. The PRC legal system is a civil law system based on written
statutes. Unlike common law systems, prior court decisions have limited precedential value. Borqs Beijing is generally subject
to laws and regulations applicable to foreign investments in China and, in particular, laws applicable to wholly foreign-owned
enterprises, and our other wholly-owned subsidiaries in China may be subject to certain laws and regulations in connection with
investments made by foreign-invested enterprises.
Since
1979, PRC legislation and regulations have significantly enhanced the protections afforded to various forms of foreign investments
in China. However, China has not developed a fully integrated legal system and recently-enacted laws and regulations may not sufficiently
cover all aspects of economic activities in China. In particular, because these laws and regulations are relatively new, and because
of the limited volume of published decisions and their nonbinding nature, the interpretation and enforcement of these laws and
regulations involve uncertainties. In addition, the PRC legal system is based in part on government policies and internal rules
(some of which are not published on a timely basis or at all) that may have a retroactive effect. As a result, we may not be aware
of our violation of these policies and rules until sometime after the violation. Moreover, some regulatory requirements issued
by certain PRC government authorities may not be consistently applied by other government authorities, including local government
authorities, thus making strict compliance with all regulatory requirements impractical, or in some circumstances, impossible.
In addition, any litigation in China may be protracted and result in substantial costs and diversion of resources and management
attention.
Our
subsidiaries in China are subject to restrictions on making dividends and other payments to it or any other affiliated company.
We
are a holding company and may rely on dividends paid by our PRC subsidiaries for our cash needs, including the funds necessary
to pay dividends and other cash distributions to our shareholders to the extent we choose to do so, to service any debt it may
incur and to pay our operating expenses. Current PRC regulations permit our PRC subsidiaries to pay dividends to us only out of
their accumulated profits, if any, determined in accordance with Chinese accounting standards and regulations. In addition, each
of our PRC subsidiaries are required to set aside at least 10% of our after-tax profits each year, if any, to fund a statutory
reserve until such reserve reaches 50% of our registered capital. Appropriations to the employee welfare funds are at the discretion
of the board of directors of Borqs Beijing. These reserves are not distributable as cash dividends.
In
addition, under the PRC Enterprise Income Tax Law, or the EIT Law, which became effective on January 1, 2008, dividends paid to
us by our PRC subsidiaries are subject to withholding tax. Currently, the withholding tax rate is 10.0% (subject to reductions
by the relevant tax treaties, if applicable).
Furthermore,
if our PRC subsidiaries incur debt on their own behalf in the future, the instruments governing the debt may restrict their ability
to pay dividends or make other payments to us.
To
date, our PRC subsidiaries have not paid dividends to us out of their accumulated profits. In the future, we do not expect to
receive dividends from our PRC subsidiaries because the accumulated profits of these PRC subsidiaries are expected to be used
for their own business or expansions. Any limitation on the ability of our PRC subsidiaries to distribute dividends or other payments
to us could materially and adversely limit our ability to grow, make investments or acquisitions that could be beneficial to our
businesses, pay dividends or otherwise fund and conduct our business.
The
discontinuation of any of the preferential tax treatments currently available to our PRC subsidiaries could materially increase
our tax liabilities.
Preferential
tax treatments and incentives granted to our PRC subsidiaries by PRC governmental authorities are subject to review and may be
adjusted or revoked at any time in the future. The discontinuation or revocation of any preferential tax treatments and incentives
currently available to them will cause their effective tax rate to materially increase, which will decrease our net income and
may adversely affect our financial condition and results of operations.
We
face uncertainty with respect to indirect transfers of equity interests in PRC resident enterprises by their non-PRC holding companies.
Pursuant
to the Notice on Strengthening Administration of Enterprise Income Tax for Share Transfers by Non-PRC Resident Enterprises, or
Circular 698, issued by the State Administration of Taxation, or the SAT, on December 10, 2009 with retroactive effect from January
1, 2008, where a non-resident enterprise transfers the equity interests of a PRC resident enterprise indirectly by disposition
of the equity interests of an overseas holding company, the non-resident enterprise investor, being the transferor, may be subject
to PRC enterprise income tax, if the indirect transfer is considered to be an abusive use of company structure without reasonable
commercial purposes. As a result, gains derived from such indirect transfer may be subject to PRC withholding tax at the rate
of up to 10%. In addition, the PRC resident enterprise may be required to provide necessary assistance to support the enforcement
of Circular 698.
On
February 3, 2015, the SAT issued a Public Notice Regarding Certain Enterprise Income Tax Matters on Indirect Transfer of Properties
by Non-Tax Resident Enterprises, or Public Notice 7. Public Notice 7 has introduced a new tax regime that is significantly different
from that under Circular 698. Public Notice 7 extends our tax jurisdiction to not only indirect transfers set forth under Circular
698 but also transactions involving transfer of other taxable assets, through the offshore transfer of a foreign intermediate
holding company. In addition, Public Notice 7 provides clearer criteria than Circular 698 on how to assess reasonable commercial
purposes and has introduced safe harbors for internal group restructurings and the purchase and sale of equity through a public
securities market. Public Notice 7 also brings challenges to both the foreign transferor and transferee (or other person who is
obligated to pay for the transfer) of the taxable assets. Where a non-resident enterprise conducts an “indirect transfer”
by transferring the taxable assets indirectly by disposing of the equity interests of an overseas holding company, the non-resident
enterprise being the transferor, or the transferee, or the PRC entity which directly owned the taxable assets may report to the
relevant tax authority such indirect transfer. Using a “substance over form” principle, the PRC tax authority may
re-characterize such indirect transfer as a direct transfer of the equity interests in the PRC tax resident enterprise and other
properties in China. As a result, gains derived from such indirect transfer may be subject to PRC enterprise income tax, and the
transferee or other person who is obligated to pay for the transfer is obligated to withhold the applicable taxes, currently at
a rate of up to 10% for the transfer of equity interests in a PRC resident enterprise. Both the transferor and the transferee
may be subject to penalties under PRC tax laws if the transferee fails to withhold the taxes and the transferor fails to pay the
taxes.
We
face uncertainties with respect to the reporting and consequences of private equity financing transactions, share exchange or
other transactions involving the transfer of our ordinary shares by investors that are non-PRC resident enterprises, or sale or
purchase of shares in other non-PRC resident companies or other taxable assets by us. We and other non-resident enterprises in
our group may be subject to filing obligations or being taxed if we and other non-resident enterprises affiliated with us are
transferors in such transactions, and may be subject to withholding obligations if we and other non-resident enterprises affiliated
with us are transferees in such transactions, under Circular 698 and Public Notice 7. For the transfer of shares in us by investors
that are non-PRC resident enterprises, our PRC subsidiaries may be requested to assist in the filing under Circular 698 and Public
Notice 7. As a result, we may be required to expend valuable resources to comply with Circular 698 and Public Notice 7 or to request
the relevant transferors from whom we purchase taxable assets to comply with these circulars, or to establish that we and other
non-resident enterprises affiliated with us should not be taxed under these circulars. The PRC tax authorities have the discretion
under Circular 698 and Public Notice 7 to make adjustments to the taxable capital gains based on the difference between the fair
value of the taxable assets transferred and the cost of investment. If the PRC tax authorities make adjustments to the taxable
income of the transactions under Circular 698 and Public Notice 7, our income tax costs associated with such transactions will
be increased in the event that we are a transferee of such transactions, which may have an adverse effect on our financial condition
and results of operations. Heightened scrutiny over acquisition transactions by the PRC tax authorities may also have a negative
impact on potential acquisitions we may pursue in the future.
It
is unclear whether we will be considered a PRC “resident enterprise” under the EIT Law and, depending on the determination
of our PRC “resident enterprise” status, we may be subject to 25.0% PRC enterprise income tax on our worldwide income,
and holders of our ordinary shares may be subject to PRC withholding tax on dividends paid by us and gains realized on their transfer
of our ordinary shares.
The
EIT Law and our Implementing Regulations, both of which became effective on January 1, 2008, provide that enterprises established
outside of China whose “
de facto
management bodies” are located in China are considered “resident enterprises.”
The Implementing Regulations of the EIT Law define the term “
de facto
management bodies” as a body which substantially
manages, or has control over the business, personnel, finance and assets of an enterprise. On April 22, 2009, the SAT issued the
Notice Regarding Determination of Chinese-Controlled Offshore Incorporated Enterprises as PRC Tax Resident Enterprises on the
Basis of De Facto Management Bodies, or Circular 82, which provides certain specific criteria for determining whether the “de
facto management body” of a PRC-controlled enterprise that is incorporated offshore is located in China. According to Circular
82, certain PRC-controlled enterprises will be classified as “resident enterprises” if all of the following conditions
are met: (a) the senior management and core management departments in charge of our daily operations function have their presence
mainly in the PRC; (b) our financial and human resources decisions are subject to determination or approval by persons or bodies
in the PRC; (c) our major assets, accounting books, company seals, and minutes and files of our board and shareholders’
meetings are located or kept in the PRC; and (d) more than half of the enterprise’s directors or senior management with
voting rights habitually reside in the PRC. Further, the Administrative Measures of Enterprise Income Tax of Chinese controlled
Offshore Incorporated Resident Enterprises (Trial), or Bulletin No. 45, took effect on September 1, 2011, and provides more guidance
on the implementation of Circular 82. The State Administration of Taxation issued an amendment to Circular 82 delegating the authority
to our provincial branches to determine whether a Chinese-controlled overseas-incorporated enterprise should be considered a PRC
resident enterprise, in January 2014.
Although
Circular 82, our amendment and Bulletin No. 45 only apply to offshore enterprises controlled by PRC enterprises or PRC enterprise
groups, not those controlled by PRC individuals or foreigners, the determining criteria set forth in Circular 82 and Bulletin
No. 45 may reflect the SAT’s general position on how the “de facto management body” text should be applied in
determining the tax resident status of all offshore enterprises, regardless of whether they are controlled by PRC enterprises
or individuals. Although we do not believe that our legal entities organized outside of the PRC constitute PRC resident enterprises,
it is possible that the PRC tax authorities could reach a different conclusion.
If
we are treated as a PRC “resident enterprise,” we will be subject to PRC enterprise income tax on our worldwide income,
as well as PRC enterprise income tax reporting obligations. Our income such as interest on other non-PRC sourced income may be
subject to PRC enterprise income tax at a rate of 25.0%. In addition, although under the EIT Law and our Implementing Rules dividends
paid to us by our PRC subsidiaries would qualify as “tax-exempt income,” we cannot assure you that such dividends
will not be subject to a 10.0% withholding tax, as the PRC foreign exchange control authorities, which enforce the withholding
tax, have not yet issued guidance with respect to the processing of outbound remittances to entities that are treated as resident
enterprises for PRC enterprise income tax purposes.
Furthermore,
if we are considered a PRC resident enterprise under the EIT Law, shareholders who are deemed non-resident enterprises may be
subject to the PRC enterprise income tax at the rate of 10% upon the dividends payable by us or upon any gains realized from the
transfer of our ordinary shares, if such income is deemed derived from China, provided that (i) such foreign enterprise investor
has no establishment or premises in China, or (ii) it has establishment or premises in China but our income derived from China
has no real connection with such establishment or premises. If we are required under the EIT Law to withhold PRC income tax on
our dividends payable to our non-PRC resident enterprise shareholders, or if any gains realized from the transfer of our ordinary
shares by our non-PRC resident enterprise shareholders are subject to the PRC enterprise income tax, your investment in our ordinary
shares could be materially and adversely affected.
In
addition, if we are considered a PRC resident enterprise and relevant PRC tax authorities consider dividends we pay with respect
to our shares and the gains realized from the transfer of our shares to be income derived from sources within the PRC, it is possible
that such dividends and gains earned by non-resident individuals may be subject to PRC individual income tax at a rate of 20%.
If we are required under PRC tax laws to withhold PRC income tax on dividends payable to our non-PRC investors that are non-resident
individuals or if you are required to pay PRC income tax on the transfer of our ordinary shares, the value of your investment
in our ordinary shares may be materially and adversely affected.
We
may not be able to obtain certain treaty benefits on dividends paid by our PRC subsidiary to us through our Hong Kong Subsidiary.
Under
the EIT Law, dividends generated from retained earnings after January 1, 2008 from a PRC company to a foreign parent company are
subject to a withholding tax rate of 10.0% unless the foreign parent’s jurisdiction of incorporation has a tax treaty with
China that provides for a preferential withholding arrangement. Pursuant to the Arrangement between Mainland China and the Hong
Kong Special Administrative Region for the Avoidance of Double Taxation and Prevention of Fiscal Evasion with respect to Taxes
on Income or the Hong Kong Tax Treaty, which became effective on December 8, 2006, a company incorporated in Hong Kong, such as
Borqs Hong Kong, will be subject to withholding income tax at a rate of 5% on dividends it receives from our PRC subsidiary if
it holds a 25.0% or more interest in that particular PRC subsidiary at all times within the 12-month period immediately preceding
the distribution of dividends and be a “beneficial owner” of the dividends. However, the SAT promulgated a tax notice
on October 27, 2009, or Circular 601, which provides that tax treaty benefits will be denied to “conduit” or shell
companies without business substance, and a beneficial ownership analysis will be used based on a “substance-over-the-form”
principle to determine whether or not to grant tax treaty benefits. On June 29, 2012, the SAT further issued the Announcement
of the SAT regarding Recognition of “Beneficial Owner” under Tax Treaties, or Announcement 30, which provides that
a comprehensive analysis should be made when determining the beneficial owner status based on various factors that supported by
various types of documents including the articles of association, financial statements, records of cash movements, board meeting
minutes, board resolutions, staffing and materials, relevant expenditures, functions and risk assumption as well as relevant contracts
and other information. In August 2015, the SAT promulgated the Administrative Measures for Non-Resident Taxpayers to Enjoy Treatments
under Tax Treaties, or SAT Circular 60, which became effective on November 1, 2015. SAT Circular 60 provides that non-resident
enterprises are not required to obtain pre-approval from the relevant tax authority in order to enjoy the reduced withholding
tax rate. Instead, non-resident enterprises may, if they determine by self-assessment that the prescribed criteria to enjoy the
tax treaty benefits are met, directly apply for the reduced withholding tax rate, and file necessary forms and supporting documents
when performing tax filings, which will be subject to post-filing examinations by the relevant tax authorities.
As
a result, although our PRC subsidiary, Borqs Beijing, is currently wholly owned by Borqs Hong Kong, we cannot assure you that
we would be entitled to the tax treaty benefits and enjoy the favorable 5.0% rate applicable under the Hong Kong Tax on dividends.
If Borqs Hong Kong cannot be recognized as the beneficial owner of the dividends to be paid by our PRC subsidiaries to us, such
dividends will be subject to a normal withholding tax of 10% as provided by the EIT Law.
Restrictions
on currency exchange may limit our ability to receive and use our revenue effectively.
The
PRC government imposes controls on the convertibility of the Renminbi into foreign currencies and, in certain cases, the remittance
of currency out of China. We receive part of our revenue in Renminbi. Under our current corporate structure, our British Virgin
Islands holding company primarily relies on dividend payments from our PRC and Hong Kong subsidiaries to fund any cash and financing
requirements we may have. Under existing PRC foreign exchange regulations, payments of current account items, including profit
distributions, interest payments and trade and service-related foreign exchange transactions, can be made in foreign currencies
without prior approval of the SAFE, by complying with certain procedural requirements. Specifically, under the existing exchange
restrictions, without prior approval of SAFE, accumulated after-tax profits generated from the operations of Borqs Beijing in
China may be used to pay dividends to us. However, approval from or registration with appropriate government authorities is required
where Renminbi is to be converted into foreign currency and remitted out of China to pay capital expenses such as the repayment
of loans denominated in foreign currencies. As a result, we need to obtain SAFE’s approval to use cash generated from the
operations of our PRC subsidiaries to pay off any debt in a currency other than Renminbi owed to entities outside China, or to
make other capital expenditure payments outside China in a currency other than Renminbi. The PRC government may at our discretion
restrict access to foreign currencies for current account transactions in the future. If the foreign exchange control system prevents
us from obtaining sufficient foreign currencies to satisfy our foreign currency demands, we may not be able to pay dividends in
foreign currencies to our shareholders.
Fluctuations
in the value of the RMB may have a material adverse effect on your investment.
The
value of the RMB against the U.S. Dollar and other currencies is affected by, among other things, changes in China’s political
and economic conditions and China’s foreign exchange policies. On July 21, 2005, the PRC government changed its decade-old
policy of pegging the value of the Renminbi to the U.S. Dollar, and the RMB appreciated more than 20.0% against the U.S. Dollar
over the following three years. However, the People’s Bank of China regularly intervenes in the foreign exchange market
to limit fluctuations in Renminbi exchange rates and achieve policy goals. During the period between July 2008 and June 2010,
the exchange rate between the RMB and the U.S. Dollar had been stable and traded within a narrow band. However, the Renminbi fluctuated
significantly during that period against other freely traded currencies, in tandem with the U.S. Dollar. Since June 2010, the
Renminbi has fluctuated against the U.S. Dollar, at times significantly and unpredictably, and in recent months the RMB has depreciated
significantly against the U.S. Dollar. It is difficult to predict how market forces or PRC or U.S. government policy may impact
the exchange rate between the RMB and the U.S. Dollar in the future.
Approximately
half of our revenues and costs are denominated in RMB. Any significant revaluation of RMB may materially and adversely affect
our cash flows, revenues, earnings and financial position, and the value of, and any dividends payable on, our ordinary shares
in U.S. dollars. For example, an appreciation of RMB against the U.S. dollar would make any new RMB denominated investments or
expenditures more costly to us, to the extent that it needs to convert U.S. dollars into RMB for such purposes. An appreciation
of RMB against the U.S. dollar would also result in foreign currency translation losses for financial reporting purposes when
we translate our U.S. dollar denominated financial assets into RMB, as RMB is our reporting currency. Conversely, a significant
depreciation of the RMB against the U.S. dollar may significantly reduce the U.S. dollar equivalent of our earnings, which in
turn could adversely affect the price of our ordinary shares. Furthermore, a significant depreciation of the RMB against the U.S.
dollar may have a material adverse impact on our cash flow in the event we need to convert our RMB into U.S. dollars to repay
our U.S. dollar denominated payment obligations.
PRC
regulations relating to the establishment of offshore holding companies by PRC residents may subject our PRC resident beneficial
owners or our PRC subsidiaries to liability or penalties, limit our ability to inject capital into our PRC subsidiaries, limit
our PRC subsidiaries’ ability to increase their registered capital or distribute profits to us, or may otherwise adversely
affect us.
The
SAFE issued the Notice on Issues Relating to the Administration of Foreign Exchange in Fund-Raising and Round-Trip Investment
Activities of Domestic Residents Conducted via Offshore Special Purpose Companies on October 26, 2005, or Circular 75, requiring
PRC residents, including PRC resident individuals and PRC companies, to register with the local SAFE branch before establishing
or controlling any company outside of China for the purpose of capital financing with assets or equities of PRC companies owned
by such PRC residents, referred to in the notice as an “offshore special purpose vehicle.” The PRC resident individuals
include not only PRC citizens, but also foreign natural persons who habitually reside in China due to economic interests. SAFE
promulgated the Circular on Relevant Issues Concerning Foreign Exchange Control on Domestic Residents’ Offshore Investment
and Financing and Roundtrip Investment through Special Purpose Vehicles, or Circular 37, on July 4, 2014, which replaced the Circular
75. Circular 37 requires PRC residents to register with local branches of SAFE in connection with their direct establishment or
indirect control of an offshore entity, for the purpose of overseas investment and financing, with such PRC residents’ legally
owned assets or equity interests in domestic enterprises or offshore assets or interests, referred to in Circular 37 as a “special
purpose vehicle.” Under Circular 37, a PRC resident who is a foreign nature person is not required to complete the registration
if he/she uses assets outside China or equity interests in offshore entities to special purpose vehicles. The term “control”
under Circular 37 is broadly defined as the operation rights, beneficiary rights or decision-making rights acquired by the PRC
residents in the offshore special purpose vehicles or PRC companies by such means as acquisition, trust, proxy, voting rights,
repurchase, convertible bonds or other arrangements. Circular 37 further requires amendment to the registration in the event of
any changes with respect to the basic information of the special purpose vehicle, such as changes in a PRC resident individual
shareholder, name or operation period; or any significant changes with respect to the special purpose vehicle, such as increase
or decrease of capital contributed by PRC individuals, share transfer or exchange, merger, division or other material event. If
the shareholders of the offshore holding company who are PRC residents do not complete their registration with the local SAFE
branches, the PRC subsidiaries may be prohibited from distributing their profits and proceeds from any reduction in capital, share
transfer or liquidation to the offshore company, and the offshore company may be restricted in our ability to contribute additional
capital to our PRC subsidiaries. Moreover, failure to comply with SAFE registration and amendment requirements described above
could result in liability under PRC law for evasion of applicable foreign exchange restrictions. On February 28, 2015, SAFE promulgated
a Notice on Further Simplifying and Improving Foreign Exchange Administration Policy on Direct Investment, or Circular 13, which
became effective on June 1, 2015. In accordance with Circular 13, entities and individuals are required to apply for foreign exchange
registration of foreign direct investment and overseas direct investment, including those required under the Circular 37, with
qualified banks, instead of SAFE. The qualified banks, under the supervision of SAFE, directly examine the applications and conduct
the registration.
We
requested all of our current shareholders and/or beneficial owners to disclose whether they or their shareholders or beneficial
owners fall within the ambit of Circular 37 and Circular 13 and will urge relevant shareholders, upon learning they are PRC residents,
to register with the local SAFE branch as required under Circular 37 and Circular 13. As of the date of this Report, we are aware
that a few of our natural person shareholders who are not PRC citizens may otherwise be deemed as PRC residents pursuant to the
definitions under the SAFE regulations, but we are not aware that any of them uses assets inside China or equity interest in PRC
companies to invest in the Company. Before the issuance of Circular 37, we had attempted to submit applications to the Beijing
branch of SAFE for such individual shareholders in accordance with Circular 75, but those applications were not accepted by the
Beijing branch of SAFE because those individuals are not PRC citizens. After Circular 37 became effective, we understand these
individuals are not required to conduct the registrations since they do not use assets within China or equity interests in PRC
companies to invest in the Company. We cannot assure you, however, that the SAFE’s opinion will be the same as our opinion
and all of these individuals can successfully complete required filings or updates on a timely manner, or at all in the event
these individuals required to conduct the filings. Furthermore, as there is uncertainty concerning the reconciliation of the new
regulations with other approval requirements, it is unclear how these regulations, and any further regulation concerning offshore
or cross-border transactions, will be interpreted, amended and implemented by the relevant government authorities. We can provide
no assurance that we currently are, and we will in the future continue to be, fully informed of identities of all our shareholders
or beneficial owners who are PRC residents, and we cannot provide any assurance that all of our shareholders and beneficial owners
who are PRC residents will comply with our request to make, obtain or update any applicable registrations or comply with other
requirements required by Circular 37 and Circular 13 or other related rules in a timely manner. Any failure or inability by any
of our shareholders or beneficial owners who are PRC residents to comply with SAFE regulations may subject them to fines or other
legal sanctions, such as potential liability for our PRC subsidiaries and, in some instances, for their legal representatives
and other liable individuals, as well as restrictions on our ability to contribute additional capital into our PRC subsidiaries
or our PRC subsidiaries’ ability to distribute dividends to, or obtain foreign-exchange-denominated loans from our offshore
holding companies. As a result, our business operations and our ability to make distributions to you could be materially and adversely
affected.
Failure
to comply with PRC regulations regarding the registration requirements for employee stock incentive plans may subject the PRC
plan participants or us to fines and other legal or administrative sanctions.
In
December 2006, the People’s Bank of China promulgated the Administrative Measures of Foreign Exchange Matters for Individuals,
which set forth the respective requirements for foreign exchange transactions by individuals (both PRC or non-PRC citizens) under
either the current account or the capital account. In January 2007, SAFE issued implementing rules for the Administrative Measures
of Foreign Exchange Matters for Individuals, which, among other things, specified approval requirements for certain capital account
transactions such as a PRC citizen’s participation in the employee stock ownership plans or stock option plans of an overseas
publicly-listed company. In February 2012, SAFE promulgated the Notices on Issues Concerning the Foreign Exchange Administration
for Domestic Individuals Participating in Stock Incentive Plans of Overseas Publicly-Listed Companies, or the Stock Option Rules,
which replaced the Application Procedures of Foreign Exchange Administration for Domestic Individuals Participating in Employee
Stock Ownership Plans or Stock Option Plans of Overseas Publicly-Listed Companies issued by SAFE in March 2007. Under these rules,
PRC residents who participate in stock incentive plans in an overseas publicly-listed company are required to register with SAFE
or our local branches and complete certain other procedures. Participants of a stock incentive plan who are PRC residents must
retain a qualified PRC agent, which could be a PRC subsidiary of such overseas publicly-listed company or another qualified institution
selected by such PRC subsidiary, to conduct the SAFE registration and other procedures with respect to the stock incentive plan
on behalf of our participants. Such participants must also retain an overseas entrusted institution to handle matters in connection
with their exercise of stock options, the purchase and sale of corresponding stocks or interests and fund transfers. In addition,
the PRC agent is required to amend the SAFE registration with respect to the stock incentive plan if there is any material change
to the stock incentive plan, the PRC agent or the overseas entrusted institution or other material changes.
We
and our PRC resident employees who participate in our employee stock incentive plans are subject to these regulations. If we or
our PRC option grantees fail to comply with these regulations, we or our PRC option grantees may be subject to fines and other
legal or administrative sanctions.
PRC
regulations establish complex procedures for some acquisitions conducted by foreign investors, which could make it more difficult
for us to pursue growth through acquisitions in China.
The
Regulations on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, adopted by six PRC regulatory agencies in
August 2006 and amended in June 2009, among other things, established additional procedures and requirements that could make merger
and acquisition activities by foreign investors more time-consuming and complex. In addition, the Implementing Rules Concerning
Security Review on the Mergers and Acquisitions by Foreign Investors of Domestic Enterprises, issued by the Ministry of Commerce
in August 2011, specify that mergers and acquisitions by foreign investors involved in “an industry related to national
security” are subject to strict review by the Ministry of Commerce, and prohibit any activities attempting to bypass such
security review, including by structuring the transaction through a proxy or contractual control arrangement. We believe that
our business is not in an industry related to national security, but it cannot preclude the possibility that the Ministry of Commerce
or other government agencies may publish explanations contrary to our understanding or broaden the scope of such security reviews
in the future, in which case our future acquisitions in the PRC, including those by way of entering into contractual control arrangements
with target entities, may be closely scrutinized or prohibited. Moreover, the Anti-Monopoly Law requires that the Ministry of
Commerce be notified in advance of any concentration of undertaking if certain filing thresholds are triggered. We may grow our
business in part by directly acquiring complementary businesses in China. Complying with the requirements of the laws and regulations
mentioned above and other PRC regulations to complete such transactions could be time-consuming, and any required approval processes,
including obtaining approval from the Ministry of Commerce, may delay or inhibit our ability to complete such transactions, which
could affect our ability to expand our business or maintain our market share. Our ability to expand our business or maintain or
expand our market share through future acquisitions would as such be materially and adversely affected.
Substantial
uncertainties exist with respect to the enactment timetable, interpretation and implementation of draft PRC Foreign Investment
Law and how it may impact the viability of our current corporate structure, corporate governance and business operations.
The
Ministry of Commerce published a discussion draft of the proposed Foreign Investment Law in January 2015 aiming to, upon its enactment,
replace the trio of existing laws regulating foreign investment in China, namely, the Sino-foreign Equity Joint Venture Enterprise
Law, the Sino-foreign Cooperative Joint Venture Enterprise Law and the Wholly Foreign-invested Enterprise Law, together with their
implementation rules and ancillary regulations. The draft Foreign Investment Law embodies an expected PRC regulatory trend to
rationalize its foreign investment regulatory regime in line with prevailing international practice and the legislative efforts
to unify the corporate legal requirements for both foreign and domestic investments. The Ministry of Commerce is currently soliciting
comments on this draft and substantial uncertainties exist with respect to its enactment timetable, interpretation and implementation.
The draft Foreign Investment Law, if enacted as proposed, may materially impact the viability of our current corporate structure,
corporate governance and business operations in many aspects.
Among
other things, the draft Foreign Investment Law expands the definition of foreign investment and introduces the principle of “actual
control” in determining whether a company should be treated as a foreign-invested enterprise, or an FIE. According to the
definition set forth in the draft Foreign Investment Law, FIEs refer to enterprises established in China pursuant to PRC law that
are solely or partially invested by foreign investors. The draft Foreign Investment Law specifically provides that entities established
in China (without direct foreign equity ownership) but “controlled” by foreign investors, through contract or trust
for example, will be treated as FIEs. Once an entity falls within the definition of FIE, it may be subject to foreign investment
“restrictions” or “prohibitions” set forth in a “negative list” to be separately issued by
the State Council later. If an FIE proposes to conduct business in an industry subject to foreign investment “restrictions”
in the “negative list,” the FIE must go through a market entry clearance by the Ministry of Commerce before being
established. An FIE is prohibited from conducting business in an industry subject to foreign investment “prohibitions”
in the “negative list”. However, an FIE, during the market entry clearance process, may apply in writing to be treated
as a PRC domestic enterprise if its foreign investor(s) is/are ultimately “controlled” by PRC government authorities
and its affiliates and/or PRC citizens. In this connection, “control” is broadly defined in the draft law to cover
the following summarized categories: (i) holding 50% or more of the voting rights of the subject entity; (ii) holding less than
50% of the voting rights of the subject entity but having the power to secure at least 50% of the seats on the board or other
equivalent decision making bodies, or having the voting power to exert material influence on the board, the shareholders’
meeting or other equivalent decision making bodies; or (iii) having the power to exert decisive influence, via contractual or
trust arrangements, over the subject entity’s operations, financial matters or other key aspects of business operations.
The
“variable interest entity” structure, or VIE structure, has been adopted by many PRC-based companies, including us,
to obtain necessary licenses and permits in the industries that are currently subject to foreign investment restrictions in China.
Under the draft Foreign Investment Law, variable interest entities that are controlled via contractual arrangement would also
be deemed as FIEs, if they are ultimately “controlled” by foreign investors. Therefore, for any companies with a VIE
structure in an industry category that is included in the “negative list” as restricted industry, the VIE structure
may be deemed legitimate only if the ultimate controlling person(s) is/are of PRC nationality (either PRC government authorities
and its affiliates or PRC citizens). Conversely, if the actual controlling person(s) is/are of foreign nationalities, then the
variable interest entities will be treated as FIEs and any operation in the industry category on the “negative list”
without market entry clearance may be considered as illegal.
The
draft Foreign Investment Law has not taken a position on what actions shall be taken with respect to the existing companies with
a VIE structure, whether or not these companies are controlled by Chinese parties, while it is soliciting comments from the public
on this point. Moreover, it is uncertain whether the telecommunication business, in which our variable interest entity operates,
will be subject to the foreign investment restrictions or prohibitions set forth in the “negative list” to be issued.
If the enacted version of the Foreign Investment Law and the final “negative list” mandate further actions, such as
Ministry of Commerce market entry clearance, to be completed by companies with existing VIE structure like us, we face uncertainties
as to whether such clearance can be timely obtained, or at all.
The
draft Foreign Investment Law, if enacted as proposed, may also materially impact our corporate governance practice and increase
our compliance costs. For instance, the draft Foreign Investment Law imposes stringent ad hoc and periodic information reporting
requirements on foreign investors and the applicable FIEs.
Aside
from investment implementation report and investment amendment report that are required at each investment and alteration of investment
specifics, an annual report is mandatory, and large foreign investors meeting certain criteria are required to report on a quarterly
basis. Any company found to be non-compliant with these information reporting obligations may potentially be subject to fines
and/or administrative or criminal liabilities, and the persons directly responsible may be subject to criminal liabilities.
The
enforcement of the labor laws and other labor-related regulations in the PRC may adversely affect our results of operations.
On
June 29, 2007, the Standing Committee of the National People’s Congress of China enacted the Labor Contract Law, which became
effective on January 1, 2008. The Labor Contract Law introduces specific provisions related to fixed-term employment contracts,
part-time employment, probation, consultation with labor union and employee assemblies, employment without a written contract,
dismissal of employees, severance, and collective bargaining, which together represent enhanced enforcement of labor laws and
regulations. According to the Labor Contract Law, an employer is obliged to sign an unlimited-term labor contract with any employee
who has worked for the employer for ten consecutive years. Further, if an employee requests or agrees to renew a fixed-term labor
contract that has already been entered into twice consecutively, the resulting contract must have an unlimited term, with certain
exceptions. The employer must pay severance to an employee where a labor contract is terminated or expires, with certain exceptions.
In addition, the government has continued to introduce various new labor-related regulations after the effectiveness of the Labor
Contract Law. Among other things, it is required that that annual leave ranging from five to 15 days be made available to employees
and that the employee be compensated for any untaken annual leave days in the amount of three times of the employee’s daily
salary, subject to certain exceptions. As a result of these regulations designed to enhance labor protection and increasing labor
costs in China, our labor costs have increased. In addition, as the interpretation and implementation of these new regulations
are still evolving, we cannot assure you that our employment practice will at all times be deemed in compliance with the new regulations.
If we are subject to severe penalties or incur significant liabilities in connection with labor disputes or investigations, our
business and results of operations may be adversely affected.
Our
failure to make adequate contributions to various employee benefit plans as required by PRC regulations may subject us to penalties.
Companies
operating in China are required to participate in various government sponsored employee benefit plans, including certain social
insurance, housing funds and other welfare-oriented payment obligations. Our failure to make contributions to various employee
benefit plans and to comply with applicable PRC labor-related laws may subject them to late payment penalties. If we are subject
to such penalties in relation to the underpaid employee benefits, our financial condition and results of operations may be adversely
affected.
If
the custodians or authorized users of our controlling non-tangible assets, including corporate chops and seals, fail to fulfill
their responsibilities or misappropriate or misuse those assets, our business and operations could be materially and adversely
affected.
In
China, a company chop or seal serves as the legal representation of the company towards third parties even when unaccompanied
by a signature. Under PRC law, legal documents for corporate transactions, including contracts and leases that our business relies
upon, are executed using “corporate chops,” which are instruments that contain either the official seal of the signing
entity or the signature of a legal representative whose designation is registered and filed with the State Administration for
Industry and Commerce, or SAIC.
Our
PRC subsidiaries generally execute legal documents with corporate chops. One or more of our corporate chops may be used to, among
other things, execute commercial sales or purchase contracts, procurement contracts and office leases, open bank accounts, issue
checks and to issue invoices. We believe that it has sufficient controls in place over access to and use of the chops. Our chops,
or chops, including the chops at headquarters level and of each PRC subsidiary, are kept securely at our legal department under
the direction of the executive officers at vice president level or higher. Use of chops requires proper approvals in accordance
with our internal control procedures. The custodian at our legal department also maintains a log to keep a detailed record or
each use of the chops.
However,
we cannot assure you that unauthorized access to or use of those chops can be prevented. Our designated employees who hold the
corporate chops could abuse their authority by, for example, binding us to contracts against our interests or intentions, which
could result in economic harm, disruption or our operations or other damages to them as a result of any contractual obligations,
or resulting disputes, that might arise. If the party contracting with us asserted that we did not act in good faith under such
circumstances, then we could incur costs to nullify such contracts. Such corporate or legal action could involve significant time
and resources, while distracting management from our operations. In addition, we may not be able to recover corporate assets that
are sold or transferred out of our control in the event of such a misappropriation if a transferee relies on the apparent authority
of the representative and acts in good faith.
If
a designated employee uses a chop in an effort to obtain control over one or more of our PRC subsidiaries, we would need to take
legal action to seek the return of the applicable chop(s), apply for a new chop(s) with the relevant authorities or otherwise
seek legal redress for the violation of their duties. During any period where we lose effective control of the corporate activities
of one or more of our PRC subsidiaries as a result of such misuse or misappropriation, the business activities of the affected
entity could be disrupted and we could lose the economic benefits of that aspect of our business. To the extent those chops are
stolen or are used by unauthorized persons or for unauthorized purposes, the corporate governance of these entities could be severely
and adversely compromised and the operations of those entities could be significantly and adversely impacted.
The
financial statements included in this Report are audited by an auditor who is not inspected by the Public Company Accounting Oversight
Board and, as such, you are deprived of the benefits of such inspection.
Our
independent registered public accounting firm, as auditors of companies that are traded publicly in the United States and a firm
registered with the PCAOB, is required by the laws of the United States to undergo regular inspections by the PCAOB to assess
our compliance with the laws of the United States and professional standards. Because our auditors are located in the PRC, a jurisdiction
where the PCAOB is currently unable to conduct inspections without the approval of the Chinese authorities, our auditors are not
currently inspected by the PCAOB. In May 2013, PCAOB announced that it had entered into a Memorandum of Understanding on Enforcement
Cooperation with the CSRC and the Ministry of Finance, which establishes a cooperative framework between the parties for the production
and exchange of audit documents relevant to investigations undertaken by PCAOB, the China Securities Regulatory Commission, or
the CSRC, or the Ministry of Finance in the United States and the PRC, respectively. PCAOB continues to be in discussions with
the CSRC and the Ministry of Finance to permit joint inspections in the PRC of audit firms that are registered with PCAOB and
audit Chinese companies that trade on U.S. exchanges.
Inspections
of other firms that the PCAOB has conducted outside China have identified deficiencies in those firms’ audit procedures
and quality control procedures, which may be addressed as part of the inspection process to improve future audit quality. This
lack of PCAOB inspections in China prevents the PCAOB from regularly evaluating our auditor’s audits and our quality control
procedures. As a result, investors may be deprived of the benefits of PCAOB inspections.
The
inability of the PCAOB to conduct inspections of auditors in China makes it more difficult to evaluate the effectiveness of our
auditor’s audit procedures or quality control procedures as compared to auditors outside of China that are subject to PCAOB
inspections. Investors may lose confidence in our reported financial information and procedures and the quality of our financial
statements.
Our
contractual arrangements may not be as effective in providing control over the variable interest entity as direct ownership.
We
rely on contractual arrangements with our variable interest entity to operate part of our businesses in China and other businesses
in which foreign investment is restricted or prohibited. These contractual arrangements may not be as effective as direct ownership
in providing us with control over our variable interest entity and our subsidiaries. If we had direct ownership of the variable
interest entity, we would be able to exercise our rights as an equity holder directly to effect changes in the board of directors
of the variable interest entity, which could effect changes at the management and operational level. Under our contractual arrangements,
we may not be able to directly change the members of the board of directors of the variable interest entity and would have to
rely on the variable interest entity and the variable interest entity equity holders to perform their obligations in order to
exercise control over the variable interest entity. The variable interest entity equity holders may have conflicts of interest
with us or our shareholders, and they may not act in the best interests of us or may not perform their obligations under these
contracts. For example, our variable interest entity and our respective equity holders could breach their contractual arrangements
with them by, among other things, failing to conduct their operations, including maintaining our websites and using our domain
names and trademarks which the variable interest entity has exclusive rights to use, in an acceptable manner or taking other actions
that are detrimental to our interests. Pursuant to the call option, we may replace the equity holders of the variable interest
entity at any time pursuant to the contractual arrangements. However, if any equity holder is uncooperative and any dispute relating
to these contracts or the replacement of the equity holders remains unresolved, we will have to enforce our rights under the contractual
arrangements through the operations of PRC law and arbitral or judicial agencies, which may be costly and time-consuming and will
be subject to uncertainties in the PRC legal system.
Any
failure by our variable interest entity or our equity holders to perform their obligations under the contractual arrangements
would have a material adverse effect on our business, financial condition and results of operations.
If
our variable interest entity or our equity holders fail to perform their respective obligations under the contractual arrangements,
we may have to incur substantial costs and expend additional resources to enforce such arrangements. Although we have entered
into exclusive option agreements in relation to the variable interest entity, which provide that we may exercise an option to
acquire, or nominate a person to acquire, ownership of the equity in that entity to the extent permitted by applicable PRC laws,
rules and regulations, the exercise of these call options is subject to the review and approval of the relevant PRC governmental
authorities. We have also entered into share pledge agreements with respect to the variable interest entity to secure certain
obligations of the variable interest entity or our equity holders to us under the contractual arrangements. However, the enforcement
of such agreements through arbitral or judicial agencies may be costly and time-consuming and will be subject to uncertainties
in the PRC legal system. Moreover, our remedies under the share pledge agreements are primarily intended to help it collect debts
owed to us by the variable interest entity or the variable interest entity equity holders under the contractual arrangements and
may not help us in acquiring the assets or equity of the variable interest entity.
In
addition, although the terms of the contractual arrangements provide that they will be binding on the successors of the variable
interest entity equity holders, as those successors are not a party to the agreements, it is uncertain whether the successors
in case of the death, bankruptcy or divorce of a variable interest entity equity holder will be subject to or will be willing
to honor the obligations of such variable interest entity equity holder under the contractual arrangements. If the variable interest
entity or our equity holder (or our successor), as applicable, fails to transfer the shares of the variable interest entity according
to the respective exclusive option agreement or share pledge agreement, we would need to enforce our rights under the exclusive
option agreement or share pledge agreement, which may be costly and time-consuming and may not be successful. The contractual
arrangements are governed by PRC law and provide for the resolution of disputes through arbitration or court proceedings in China.
Accordingly, these contracts would be interpreted in accordance with PRC law and any disputes would be resolved in accordance
with PRC legal procedures. The legal system in the PRC is not as developed as in some other jurisdictions, such as the United
States. Moreover, there are very few precedents and little formal guidance as to how contractual arrangements in the context of
a variable interest entity should be interpreted or enforced under PRC law, and as a result it may be difficult to predict how
an arbitration panel or court would view such contractual arrangements. As a result, uncertainties in the PRC legal system could
limit our ability to enforce the contractual arrangements. Under PRC law, if the losing parties fail to carry out the arbitration
awards or court judgments within a prescribed time limit, the prevailing parties may only enforce the arbitration awards or court
judgments in PRC courts, which would require additional expense and delay. In the event we are unable to enforce the contractual
arrangements, we may not be able to exert effective control over the variable interest entity and our subsidiaries, and our ability
to conduct our business, as well as our financial condition and results of operations, may be materially and adversely affected.
We
may lose the ability to use, or otherwise benefit from, the licenses, approvals and assets held by our variable interest entity,
which could severely disrupt our business, render us unable to conduct some or all of our business operations and constrain our
growth.
Although
the significant majority of our revenues are generated, and the significant majority of our operational assets are held, by our
wholly-foreign owned enterprises, which are our subsidiaries, our variable interest entity hold licenses and approvals and assets
that are necessary for our business operations, as well as equity interests in a series of our portfolio companies, to which foreign
investments are typically restricted or prohibited under applicable PRC law. The contractual arrangements contain terms that specifically
obligate variable interest entity equity holders to ensure the valid existence of the variable interest entity and restrict the
disposal of material assets of the variable interest entity. However, in the event the variable interest entity equity holders
breach the terms of these contractual arrangements and voluntarily liquidate the variable interest entity or any of our subsidiary,
or any of these entities declares bankruptcy and all or part of our assets become subject to liens or rights of third-party creditors,
or are otherwise disposed of without our consent, we may be unable to conduct some or all of our business operations or otherwise
benefit from the assets held by the variable interest entity or our subsidiaries, which could have a material adverse effect on
our business, financial condition and results of operations. Furthermore, if our variable interest entity undergoes a voluntary
or involuntary liquidation proceeding, our equity holders or unrelated third-party creditors may claim rights to some or all of
the assets of such variable interest entity, thereby hindering our ability to operate our business as well as constrain our growth.
The
equity holders, directors and executive officers of the variable interest entity, as well as our employees who execute other strategic
initiatives may have potential conflicts of interest with us.
PRC
laws provide that a director and an executive officer owes a fiduciary duty to the company he or she directs or manages. The directors
and executive officers of the variable interest entity must act in good faith and in the best interests of the variable interest
entity and must not use their respective positions for personal gain. We control our variable interest entity through contractual
arrangements and the business and operations of our variable interest entity are closely integrated with the business and operations
of our subsidiaries. Nonetheless, conflicts of interests for these individuals may arise due to dual roles both as directors and
executive officers of the variable interest entity and as our directors or employees, and may also arise due to dual roles both
as variable interest entity equity holders and as our directors or employees. We cannot assure you that these individuals will
always act in our best interests should any conflicts of interest arise, or that any conflicts of interest will always be resolved
in our favor. Moreover, we also cannot assure you that these individuals will ensure that the variable interest entity will not
breach the existing contractual arrangements. If we cannot resolve any such conflicts of interest or any related disputes, we
would have to rely on legal proceedings to resolve these disputes and/or take enforcement action under the contractual arrangements.
There is substantial uncertainty as to the outcome of any such legal proceedings.
The
contractual arrangements with our variable interest entity may be subject to scrutiny by the PRC tax authorities. Any adjustment
of related party transaction pricing could lead to additional taxes, and therefore substantially reduce our consolidated net income
and the value of your investment.
The
tax regime in China is rapidly evolving and there is significant uncertainty for taxpayers in China as PRC tax laws may be interpreted
in significantly different ways. The PRC tax authorities may assert that we or our subsidiaries or the variable interest entity
or their equity holders owe and/or are required to pay additional taxes on previous or future revenue or income. In particular,
under applicable PRC laws, rules and regulations, arrangements and transactions among related parties, such as the contractual
arrangements with our variable interest entity, may be subject to audit or challenge by the PRC tax authorities. If the PRC tax
authorities determine that any contractual arrangements were not entered into on an arm’s length basis and therefore constitute
a favorable transfer pricing, the PRC tax liabilities of the relevant subsidiaries and/or variable interest entity and/or variable
interest entity equity holders could be increased, which could increase our overall tax liabilities. In addition, the PRC tax
authorities may impose late payment interest. Our net income may be materially reduced if our tax liabilities increase.
Any
of these factors could result in a significant or material adverse effect on our results of operations or financial condition.
Additional risk factors not presently known to us or that we currently deem immaterial may also impair our business or results
of operations. As of the date of this Quarterly Report, there have been no material changes to the risk factors disclosed in our
Annual Report filed with the SEC, except we may disclose changes to such factors or disclose additional factors from time to time
in our future filings with the SEC.