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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 20-F

 

(Mark One)

 

 

Commission file number: 000-51116

 

 

Ku6 Media Co., Ltd.

(Exact name of Registrant as specified in its charter)

 

N/A

(Translation of Registrant’s name into English)

Cayman Islands

(Jurisdiction of incorporation or organization)

Building 6, Zhengtongchuangyi Centre No. 18, Xibahe Xili, Chaoyang District Beijing 100028, People’s Republic of China

(Address of principal executive offices)

Xudong Xu Chief Executive Officer and Acting Chief Financial Officer Telephone: +86 10 5758-6813 Fax number: +86 10 5758-6834 Building 6, Zhengtongchuangyi Centre No. 18, Xibahe Xili, Chaoyang District Beijing 100028, People’s Republic of China

(Name, Telephone, E-mail and/or Facsimile number and Address of Company Contact Person)

 

Securities registered or to be registered pursuant to Section 12(b) of the Act:

 

 

*    Not for trading, but only in connection with the listing on the NASDAQ Global Market of American Depositary Shares, each representing 100 Ordinary Shares

 

Securities registered or to be registered pursuant to Section 12(g) of the Act:

 

None

(Title of Class)

 

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Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act:

 

None

(Title of Class)

 

Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the close of the period covered by the annual report:

4,763,360,860 Ordinary Shares.

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

o Yes   x No

 

If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or(15)(d) of the Securities Exchange Act of 1934.

o Yes   x No

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

x Yes   o No

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

x Yes   o No

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark which basis of accounting the registrant has used to prepare the financial statements included in this filing:

 

 

If “Other” has been checked in response to the previous question, indicate by check mark which financial statement item the registrant has elected to follow.

o Item 17   o Item 18

 

If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

o Yes   x No

 

[APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PAST FIVE YEARS]

 

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court.

 

o Yes   o No

 

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TABLE OF CONTENTS

 

		Page
Introduction		1
Forward-looking Information		1
Part I		3
Item 1.	Identity of Directors, Senior Management and Advisors	3
Item 2.	Offer Statistics and Expected Timetable	3
Item 3.	Key Information	3
Item 4.	Information on the Company	36
Item 4A.	Unresolved Staff Comments	57
Item 5.	Operating and Financial Review and Prospects	58
Item 6.	Directors, Senior Management and Employees	72
Item 7.	Major Shareholders and Related Party Transactions	78
Item 8.	Financial Information	81
Item 9.	The Offer and Listing	82
Item 10.	Additional Information	82
Item 11.	Quantitative and Qualitative Disclosures about Market Risk	95
Item 12.	Description of Securities other than Equity Securities	95
Part II		96
Item 13.	Defaults, Dividend Arrearages and Delinquencies	96
Item 14.	Material Modifications to the Rights of Security Holders and Use of Proceeds	96
Item 15.	Controls and Procedures	97
Item 16.	Reserved	97
Item 16A.	Audit Committee Financial Expert	97
Item 16B.	Code of Ethics	97
Item 16C.	Principal Accountant Fees and Services	98
Item 16D.	Exemptions from the Listing Standards for Audit Committees	98
Item 16E.	Purchases of Equity Securities by the Issuer and Affiliated Purchasers	98
Item 16F.	Changes in Registrant’s Certifying Accountant	98
Item 16G.	Corporate Governance	99
Item 16H.	Mine Safety Disclosure	99
Part III		99
Item 17.	Financial Statements	99
Item 18.	Financial Statements	99
Item 19.	Exhibits	99
Signatures		105

 

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INTRODUCTION

 

Except where the context otherwise requires and for purposes of this annual report on Form 20-F only:  “$” and “U.S. dollars” refer to the legal currency of the United States;

 

·                  “ADSs” refers to our American depositary shares, each of which represents 100 ordinary shares;

 

·                  “Cayman Companies Law” refers to the Companies Law (2013 Revision) of the Cayman Islands (as amended);

 

·                  “China” and the “PRC” refer to the People’s Republic of China, excluding, for the purposes of this annual report on Form 20-F only, Taiwan and the special administrative regions of Hong Kong and Macau;

 

·                  “Huzhong” refers to Huzhong Advertising (Shanghai) Ltd., an independent third party;

 

·                  “Ku6 Holding” refers to Ku6 Holding Limited and its subsidiaries, affiliates and predecessor entities;

 

·                  “Mr. Xu” refers to Xudong Xu, our largest shareholder;

 

·                  “New Shengyue” refers to Shanghai Shengyue Advertising Co., Ltd., an independent third party, with respect to our agreements with it on or after April 1, 2014;

 

·                  “Old Shengyue” refers to Shanghai Shengyue Advertising Co., Ltd., then wholly owned by Shanda Interactive, with respect to our agreements with it on or prior to March 31, 2014;

 

·                  “ordinary shares” refers to our ordinary shares, par value $0.00005 per share;

 

·                  “our consolidated affiliated entities” refers to Ku6 (Beijing) Information Technology Co., Ltd., or Ku6 Information Technology, Tianjin Ku6 Zheng Yuan Information Technology Co., Ltd., or Tianjin Ku6 Zheng Yuan, Ku6 (Beijing) Cultural Media Co., Ltd., or Ku6 Cultural, and Tianjin Ku6 Network Communication Technology Co., Ltd., or Tianjin Ku6 Network;

 

·                  “our PRC subsidiaries” refers to Ku6 (Beijing) Technology Co., Ltd., or Beijing WFOE, WeiMoSanYi (Tianjin) Technology Co., Ltd., or Tianjin WFOE, and Kusheng (Tianjin) Technology Co., Ltd., or Tianjin Ku6 Network WFOE;

 

·                  “Qinhe” refers to Shanghai Qinhe Internet Technology Software Development Co., Ltd., a company controlled by Mr. Xu and a related party;

 

·                  “RMB” and “Renminbi” refer to the legal currency of China;

 

·                  “Shanda Interactive” refers to Shanda Interactive Entertainment Limited, a Cayman Islands company;

 

·                  “Shanda Media” refers to Shanda Media Group Limited, a wholly owned subsidiary of Shanda Interactive;

 

·                  “Share Purchase Transaction” refers to the purchase of 1,938,360,784 of our ordinary shares by Mr. Xu from Shanda Media, our then controlling shareholder, which was completed on April 3, 2014. See Item 4.A. “History and Development of the Company”; and

 

·                  “we,” “us,” “our company” and “our” refer to Ku6 Media Co., Ltd. and its subsidiaries, consolidated affiliated entities and predecessor entities.

 

FORWARD-LOOKING INFORMATION

 

This annual report on Form 20-F contains forward-looking statements that are based on our current expectations, assumptions, estimates and projections about us and our industry. All statements other than statements of historical fact in this form are forward-looking statements. These forward-looking statements can be identified by words or phrases such as “may,” “will,” “expect,” “anticipate,” “estimate,” “plan,” “believe,” “is/are likely to” or other similar expressions. The forward-looking statements included in this form relate to, among others:

 

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·                  our goals and strategies;

 

·                  our future business development, financial condition and results of operations;

 

·                  our projected revenues, earnings, profits and other estimated financial information;

 

·                  expected changes in our margins and certain costs or expenditures;

 

·                  expected continued acceptance of our content;

 

·                  our plans to expand and diversify the sources of our revenues;

 

·                  expected changes in the respective shares of our revenues from particular sources;

 

·                  our plans for staffing, research and development and marketing;

 

·                  our plans to launch new products and services;

 

·                  our plans for strategic partnerships with other businesses;

 

·                  our acquisition and divestiture strategy, and our ability to successfully integrate past or future acquisitions with our existing operations and complete planned divestitures;

 

·                  competition in the PRC online video industry;

 

·                  the outcome of ongoing, or any future, litigation or arbitration;

 

·                  changes in PRC governmental preferential tax treatment and financial incentives we currently qualify for and expect to qualify for; and

 

·                  PRC governmental policies relating to media and the Internet and Internet content providers and to the provision of advertising over the Internet.

 

These forward-looking statements involve various risks and uncertainties. Although we believe that our expectations expressed in these forward looking statements are reasonable, we cannot assure you that our expectations will turn out to be correct. Our actual results could be materially different from and worse than our expectations. Important risks and factors that could cause our actual results to be materially different from our expectations are generally set forth in Item 3.D. “Risk Factors” and elsewhere in this annual report. The forward-looking statements made in this annual report relate only to events or information as of the date on which the statements are made in this annual report. We undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date on which the statements are made or to reflect the occurrence of unanticipated events.

 

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PART I

 

Item 1.                                 Identity of Directors, Senior Management and Advisors

 

Not Applicable.

 

Item 2.                               Offer Statistics and Expected Timetable

 

Not Applicable.

 

Item 3.                                 Key Information

 

A.                                    Selected Financial Data

 

The following table presents certain selected consolidated financial information for our business. You should read the following information in conjunction with our audited consolidated financial statements, the notes thereto and Item 5. “Operating and Financial Review and Prospects” included elsewhere in this annual report on Form 20-F. The data as of December 31, 2013 and 2014 and for the years ended December 31, 2012, 2013 and 2014 has been derived from our audited consolidated financial statements included in this annual report beginning on page F-1. The data as of December 31, 2010, 2011 and 2012 and for the years ended December 31, 2010 and 2011 has been derived from our audited consolidated financial statements not included in this annual report. Our consolidated financial statements are prepared and presented in accordance with United States generally accepted accounting principles, or U.S. GAAP. Our historical results do not necessarily indicate our results expected for any future periods.

 

In May 2010, we sold all of our 51% interest in Beijing Huayi Brothers Music Co., Ltd., or Huayi Music, to Huayi Brothers Media Corporation. In August 2010, we completed the disposal of our remaining wireless value-added services, or WVAS, and recorded music businesses to Shanda Interactive and also acquired from Shanda Interactive the control of Shanghai Yisheng Network Technology Co., Ltd., or Yisheng, an online audio business. The initial acquisition of the online audio business from Shanda Interactive was accounted for as an acquisition under common control and the disposal of the WVAS and recorded music businesses, including Huayi Music, was accounted for as discontinued operations in accordance with U.S. GAAP in our consolidated financial statements. In August 2011, we disposed of a significant interest in Yisheng and retained a 20% interest. The disposal gain was recognized as an increase in additional paid-in capital for the year ended December 31, 2011.

 

The audited consolidated financial statements included in this annual report on Form 20-F were prepared on the basis of a going concern which contemplates that we will be able to realize assets and discharge liabilities in the normal course of business. However, substantial doubt exists as to our ability to continue as a going concern. The audited consolidated financial statements do not include any adjustments that might result from the outcome of these uncertainties. See Item 5.B. “Liquidity and Capital Resources—Liquidity and Going Concern,” Item 3.D. “Risk Factors—Risks Related to our Business—There is substantial doubt as to our ability to continue as a going concern” and notes 1 and 2 to our audited consolidated financial statements included elsewhere in this annual report on Form 20-F.

 

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		For the Year Ended December 31,
		2010		2011		2012		2013		2014
		(in thousands of U.S. dollars, except for share and per share data)
Historical Condensed Consolidated Statement of Operations Data
Net revenues:
Advertising
Third parties		15,854		11,146		1,633		738		4,267
Related parties		702		8,076		12,482		12,404		4,317
Total net revenues		16,556		19,222		14,115		13,142		8,584
Cost of revenues:
Advertising
Third parties		(40,083	)	(30,501	)	(14,603	)	(15,649	)	(11,231	)
Related parties		(376	)	(379	)	—		(336	)	(910	)
Total cost of revenues		(40,459	)	(30,880	)	(14,603	)	(15,985	)	(12,141	)
Gross profit (loss)		(23,903	)	(11,658	)	(488	)	(2,843	)	(3,557	)
Operating expenses		(29,703	)	(37,912	)	(10,482	)	(40,608	)	(9,415	)
Operating loss		(53,606	)	(49,570	)	(10,970	)	(43,451	)	(12,972	)
Interest income		57		170		620		112		47
Interest expenses		(31	)	(1,119	)	(619	)	(16	)	—
Other income, net		—		1,294		1,730		4,101		745
Gain from disposal of equity interest		—		—		—		—		1,452
Loss from continuing operations before income tax benefits		(53,580	)	(49,226	)	(9,239	)	(39,254	)	(10,728	)
Income tax benefits		41		99		—		4,826		—
Equity in losses of affiliated company, net of tax		—		(263	)	(252	)	—		—
Net loss from continuing operations		(53,539	)	(49,390	)	(9,491	)	(34,428	)	(10,728	)
Discontinued operations:
Loss from operations of discontinued operations, net of tax		(3,383	)	—		—		—		—
Gain from disposal of discontinued operations, net of tax		4,487		—		—		—		—
(Loss) income from discontinued operations, net of tax		1,104		—		—		—		—
Net loss		(52,435	)	(49,390	)	(9,491	)	(34,428	)	(10,728	)
Plus: Net loss attributable to non-controlling interests from continuing operations		681		46		—		—		—
Plus: Net loss attributable to non-controlling interests and redeemable non-controlling interests from discontinued operations		244		—		—		—		—
Net loss attributable to Ku6 Media Co., Ltd.		(51,510	)	(49,344	)	(9,491	)	(34,428	)	(10,728	)
Loss from continuing operations, net of tax, attributable to Ku6 Media Co., Ltd.		(52,858	)	(49,344	)	(9,491	)	(34,428	)	(10,728	)
(Loss) income from discontinued operations, net of tax, attributable to Ku6 Media Co., Ltd.		1,348		—		—		—		—
Net loss attributable to Ku6 Media Co., Ltd.		(51,510	)	(49,344	)	(9,491	)	(34,428	)	(10,728	)
Loss per share, basic and diluted
Loss from continuing operations attributable to Ku6 Media Co., Ltd. ordinary shareholders		(0.02	)	(0.01	)	(0.00	)	(0.01	)	(0.00	)
(Loss) income from discontinued operations attributable to Ku6 Media Co., Ltd. ordinary shareholders		0.00		—		—		—		—
Net loss attributable to Ku6 Media Co., Ltd. ordinary shareholders		(0.02	)	(0.01	)	(0.00	)	(0.01	)	(0.00	)
Weighted average shares used in per share calculation—basic and diluted		3,096,421,097		4,265,277,638		4,901,279,176		4,728,185,434		4,746,324,022

 

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		As of December 31,
		2010		2011		2012		2013		2014
		(in thousands of U.S. dollars)
Historical Condensed Consolidated Balance Sheet Data
Cash and cash equivalents		27,295		26,750		13,071		1,671		4,380
Restricted cash		—		3,600		—		—		—
Accounts receivable (including related parties), net		8,461		3,517		4,466		6,587		115
Other current assets		9,051		20,424		6,620		2,173		493
Property and equipment, net		8,003		3,593		2,918		1,368		294
Goodwill		6,896		6,233		6,233		—		—
Other assets		27,264		24,673		22,862		339		348
Total assets		86,970		88,790		56, 170		12,138		5,630
Current liabilities		36,406		33,111		17, 778		12,085		9,766
Non-current liabilities		4,926		4,826		4,826		—		—
Total liabilities		41,332		37,937		22,604		12,085		9,766
Ordinary shares ($0.00005 par value; 12,000,000,000 ordinary shares authorized; 3,481,174,498, 5,019,786,036, 4,732,446,560, 4,730,648,360 and 4,763,360,860 ordinary shares issued and outstanding as of December 31, 2010, 2011, 2012, 2013 and 2014, respectively)		174		251		236		236		238
Other Ku6 Media Co., Ltd. shareholders’ equity / (deficit)		45,572		50,602		33,330		(183	)	(4,374	)
Non-controlling interests		(108	)	—		—		—		—
Total liabilities, redeemable non-controlling interests and shareholders’ equity(deficit)		86,970		88,790		56,170		12,138		5,630

 

Exchange Rate Information

 

We present our historical consolidated financial statements in U.S. dollars. Certain contractual amounts in Renminbi described in this annual report are translated into U.S. dollar amounts solely for the convenience of the reader. Except as otherwise specified, these amounts are translated at a rate of RMB6.2046 to $1.00, the exchange rate on December 31, 2014 as set forth in the H.10 statistical release of the Federal Reserve Board. We make no representation that any Renminbi or U.S. dollar amounts could have been, or could be, converted into U.S. dollars or Renminbi, as the case may be at any particular rate, or at all.

 

The following table sets forth information regarding exchange rates between Renminbi and U.S. dollars for the periods indicated:

 

		Exchange Rate
Period		Period End		Average(1)		High		Low
		(RMB per $1.00)
2010		6.6000		6.7603		6.8330		6.6000
2011		6.2939		6.4475		6.6364		6.2939
2012		6.2301		6.2990		6.3879		6.2221
2013		6.0537		6.1412		6.2438		6.0537
2014		6.2046		6.1620		6.2591		6.0402
October		6.1124		6.1251		6.1385		6.1107
November		6.1429		6.1249		6.1429		6.1117
December		6.2046		6.1886		6.2256		6.1490
2015
January		6.2495		6.2181		6.2535		6.1870
February		6.2695		6.2518		6.2695		6.2399
March		6.1990		6.2386		6.2741		6.1955
April(through April 17)		6.1976		6.2010		6.2152		6.1930

 

Source: Federal Reserve H.10 Statistical Release

 

(1)         Annual averages were calculated by using the average of the exchange rates on the last day of each month during the relevant year. Monthly averages were calculated by using the average of the daily rates during the relevant month.

 

B.            Capitalization and Indebtedness

 

Not Applicable.

 

C.            Reasons for the Offer and Use of Proceeds

 

Not Applicable.

 

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D.                                    Risk Factors Risks Related to Our Business

 

There is substantial doubt as to our ability to continue as a going concern.

 

Substantial doubt exists as to our ability to continue as a going concern. See Item 5.B. “Liquidity and Capital Resources—Liquidity and Going Concern.” We have incurred significant net losses and negative cash flows from operations in recent years. For the years ended December 31, 2012, 2013 and 2014, our net loss was $9.5 million, $34.4 million and $10.7 million, respectively. As of December 31, 2014, we had cash and cash equivalents of $4.4 million, accumulated deficit of $187.1million and working capital deficit of $4.8 million. For the year ended December 31, 2014, our net operating cash outflow was $5.2 million and we relied on financing support from our controlling shareholder to maintain liquidity for most of the year. Although we generated gross profit in the fourth quarter of 2014, we still had an operating loss and a net loss in that quarter. There is no assurance that such recent improved quarterly performance will continue. Our ability to continue as a going concern is subject to, among others, the following risks: “—Our new business models may not be able to generate sufficient revenues and operating cash flows,” “—Our cooperation arrangements with Qinhe are subject to considerable uncertainties,” “—We require a significant amount of cash to fund our operations. We cannot assure you that we can meet our working capital requirements or other capital needs through improved operating results,” and “—We cannot assure you that we can meet our working capital requirements or other capital needs through additional financings in amounts or on terms acceptable to us, or at all.” The audited consolidated financial statements included in this annual report on Form 20-F were prepared on the basis of a going concern, and do not include any adjustments that might result from the outcome of these uncertainties. If we became unable to continue as a going concern, we may have to liquidate our assets and the values we receive for our assets in liquidation or dissolution could be significantly lower than the values reflected in our audited consolidated financial statements. Our lack of cash resources, substantial uncertainty of our new business models, and our potential inability to continue as a going concern may materially adversely affect the price of our ADSs and our ability to raise new capital or continue our operations.

 

Our new business models may not be able to generate sufficient revenues and operating cash flows.

 

Historically, we derived substantially all of our revenues from online advertising services, for which we collect service fees from advertisers through our advertising agencies. From April 2011 to March 2014, we relied on Old Shengyue, an affiliate wholly owned by Shanda Interactive during that period, as our primary advertising agency, which managed our sales to, and collected payments from, substantially all of our advertisers. Our advertising agency agreement with Old Shengyue expired on March 31, 2014, and we generated advertising revenue of $2.7 million from Old Shengyue during the first quarter of 2014 prior to its expiration. As a result of our management’s review and adjustment of our business strategies after the Share Purchase Transaction, this agreement was not further renewed and we started to explore new revenue sources, including advertising agreements with independent third parties and cooperation with Qinhe.

 

In April 2014, we entered into a new advertising agency agreement with New Shengyue, which is no longer owned by Shanda Interactive and is an independent third party. In August 2014, we terminated this agreement with New Shengyue and entered into another new advertising agency agreement with Huzhong, an independent third party. We generated advertising revenue of $0.5 million in 2014 from New Shengyue.

 

Pursuant to our agreement with Huzhong, Huzhong will act as our exclusive advertising agency for standard media resources and non-exclusive advertising agency for highly-interactive advertising resources. Under this agreement, we guarantee a certain amount of web traffic per day for webpages on which Huzhong posts advertisements, and in return, Huzhong guarantees to us a minimum amount of advertising revenues per day. If we fail to meet the web traffic target, the minimum amount guaranteed by Huzhong will be proportionally adjusted for the shortfall. Huzhong agreed to prepay 50% of the minimum guaranteed amounts within five business days prior to the beginning of each month and settle the balance within five business days after the end of each month. This advertising agency agreement with Huzhong will expire on December 31, 2017. We generated revenue of $2.8 million under our agreement with Huzhong from August 29, 2014 to December 31, 2014. Going forward, we will continue to rely on third party advertising agencies like Huzhong for our advertising services and we cannot assure you that we will maintain our relationship with them and generate sufficient revenues from these sources.

 

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In addition, we explored new revenue models in cooperation with Qinhe, a company controlled by Mr. Xu, our largest shareholder after the Share Purchase Transaction. In April 2014, we started to provide interactive entertainment marketing services to iSpeak, a social platform that allows users to engage in real-time online group activities through voice, text and video. Under our cooperation agreement with Qinhe, which operates the iSpeak platform, Qinhe will share a certain percentage of the revenues that it generates from the viewers who visit the iSpeak platform through advertisements on our website. Users on the iSpeak platform may spend on virtual items during real-time video broadcasting, including gifts and avatars, and purchase other value-added services. In April 2014, we also started to provide game marketing services for Qinhe under a similar revenue sharing arrangement as the one for interactive entertainment marketing cooperation. We generated revenues of $1.6 million from Qinhe for the year ended December 31, 2014.

 

Our cooperation with Qinhe is relatively new and subject to change from time to time. In September 2014, we amended the interactive entertainment marketing services agreement with Qinhe. Pursuant to the amended agreement, Qinhe agreed to pay certain additional guaranteed revenue amounts from July 2014 to December 2014, and the term of this agreement was extended to December 31, 2015. Other terms of the original agreements, including the revenue sharing arrangement, remained the same. On March 30, 2015, we further amended this agreement with Qinhe. Pursuant to the further amended cooperation agreement, the revenue sharing arrangement in the original agreement will be reinstated without the additional guaranteed revenue amounts. Any further changes to this agreement may affect our ability to generate revenues from Qinhe.

 

The success of our cooperation arrangements with Qinhe is subject to the performance of the iSpeak platform operated by Qinhe. See “—Our cooperation arrangements with Qinhe are subject to considerable uncertainties.” In addition, there can be no assurance that these agreements will be extended or renewed after their expiration or that we will be able to further extend or renew such agreements on terms and conditions favorable to us. For example, our game marketing cooperation agreement with Qinhe expired in March 2015 and our management decided not to renew this agreement to focus on interactive entertainment marketing services.

 

As our revenue models for our advertising and marketing services are still relatively new and constantly changing, we cannot assure you that these arrangements will be successful or that we will be able to generate sufficient revenue and cash flows from these revenue models in the future. If either Qinhe or Huzhong breaches its obligations under the relevant agreements or refuses to extend or renew them on commercially reasonable terms when the terms expire, we may not be able to find suitable alternative revenue sources in a timely manner. Any termination or deterioration of our relationship with Qinhe or Huzhong, and any further extension or renewal on terms and conditions less favorable to us, would have a material adverse effect on our business, financial condition and results of operations. If we fail to introduce successful revenue models in the future, our business, financial condition and prospects may be materially and adversely affected.

 

We may not be able to continue to receive support from our major shareholders.

 

Our online advertising business had benefited significantly from Shanda Interactive’s brand name and strong market position in China prior to the Share Purchase Transaction. From April 2011 to March 2014, we relied on Old Shengyue, an affiliate wholly owned by Shanda Interactive during that period, as our sole advertising agency, which managed our sales to, and collected payments from, substantially all of our advertisers. Our advertising agency agreement with Old Shengyue, as previously renewed, expired on March 31, 2014. As a result of our management’s review and adjustment of our business strategies after the Share Purchase Transaction, this agreement was not further renewed. Shanda Interactive also disposed of their equity interest in Old Shengyue after the Share Purchase Transaction. We cannot assure you that we will be able to receive any support from Shanda Interactive for our operations in the future.

 

We have relied on Shanda Interactive to finance our capital needs, including the issuance of 1,538,461,538 ordinary shares to Shanda Media Group Limited, or Shanda Media, a wholly owned subsidiary of Shanda Interactive, for an aggregate purchase price of $50.0 million in April 2011, and the issuance of $50.0 million aggregate principal amount of senior convertible bonds to Shanda Media in June 2011. Furthermore, in connection with the Share Purchase Transaction, Shanda Interactive, through its affiliate, extended loans of RMB20.0 million to us in April 2014 and waived our obligation to repay the loan. In May 2014, Shanda Interactive, through its affiliates, extended loans of RMB21.4 million to us and waived our obligation to repay this loan. We have treated these transactions as capital contributions. See Item 7.B. “Related Party Transactions—Funding from Shanda Interactive.” As Shanda Interactive ceased to be our largest shareholder after the Share Purchase Transaction, we cannot assure you that we will be able to obtain additional financings from Shanda Interactive under terms acceptable to us or at all in the future.

 

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In addition, we have relied and will continue to rely on Mr. Xu to operate our business and to finance our capital needs. In April 2014, as a result of our management’s review and adjustment of our business strategies after the Share Purchase Transaction, we adopted new revenue models in cooperation with Qinhe, a company controlled by Mr. Xu. In March 2015, we obtained loans from Mr. Xu, our largest shareholder, in the amount of RMB30.0 million. We cannot assure you that we will be able to continue to obtain additional financings from Mr. Xu under terms acceptable to us or at all in the future.

 

Our cooperation arrangements with Qinhe are subject to considerable uncertainties.

 

Historically, we derived substantially all of our revenues from online advertising services, for which we collect service fees from advertisers through our advertising agencies. In April 2014, as a result of our management’s review and adjustment of our business strategies after the Share Purchase Transaction, we adopted new revenue models in cooperation with Qinhe, a company controlled by Mr. Xu, our largest shareholder. Currently, we provide interactive entertainment marketing services to Qinhe. Under the relevant agreement, Qinhe will share with us a certain percentage of the revenues or profits that it generates from the viewers who visit its iSpeak platform and access Qinhe’s media content through the advertisements on our website.

 

As a result, revenues we generate under these agreements will depend on the performance of the iSpeak platform operated by Qinhe, which will be affected by factors beyond our control. Performance of the iSpeak platform may be affected by, among others, Qinhe’s ability to: successfully monetize the user base of iSpeak; offer popular virtual items on the iSpeak platform; attract new users, retain and expand paying users, and encourage additional purchases by its paying users for the iSpeak platform; develop innovative technologies in response to user demand; and integrate new devices, platforms and operating systems.

 

Our history with Qinhe is very short and the form of cooperation between Qinhe and us continues to change. The level of information that is available for Qinhe, a privately held company, is highly limited. Therefore, it is very difficult to effectively assess our future prospects with respect to our cooperation with Qinhe. You should consider our business and prospects in light of the risks and considerable uncertainties with respect to such arrangements.

 

We require a significant amount of cash to fund our operations. We cannot assure you that we can meet our working capital requirements or other capital needs through improved operating results.

 

The operation of an online user-generated content, or UGC, video business requires continuous, substantial investment in content, technology, talent and infrastructure. In order to implement our development strategies to expand our infrastructure and optimize our services across Internet-enabled devices, and further expand and diversify our revenue sources, we may incur additional capital needs in the future. We will also need to fund our research and development activities in order to remain competitive on cost and technology. We cannot assure you that we will be able to generate sufficient cash flows or otherwise procure sufficient working capital to finance our anticipated operations and capital expenditure requirements, or achieve projected cash collections from customers and contain expenses and cash used in operations. As of December 31, 2014, we had cash and cash equivalents of $4.4 million and a working capital deficit of $4.8 million. We reported net losses attributable to our company of $10.7 million for the year ended December 31, 2014. Our net cash used in operating activities in 2014 was $5.2 million.

 

After the Share Purchase Transaction, as a result of our management’s review and adjustment of our business strategies, we adopted new revenue models in cooperation with Qinhe, a company controlled by Mr. Xu, our largest shareholder, and entered into new advertising agency agreements with independent third parties like Huzhong. Future performance of such arrangements are subject to considerable uncertainties. See “—Our new business models may not be able to generate sufficient revenues and operating cash flows” and “—Our cooperation arrangements with Qinhe are subject to considerable uncertainties.” In addition, we cannot assure you that any future plans to further reduce our operating expenses would be successful.

 

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We cannot assure you that we can meet our working capital requirements or other capital needs through additional financings in amounts or on terms acceptable to us, or at all.

 

If we cannot meet our liquidity needs through improved operating results, we may need to obtain financings from financial institutions or issue debt securities. We cannot assure you that we will be able to obtain any future financings if required under commercially reasonable terms, or at all. In addition, we may have to issue and sell additional equity securities to meet our liquidity needs, but our ability to sell our equity securities is not assured. Any additional issuance of equity securities would dilute the ownership of our shareholders and ADS holders. Our ability to obtain additional financings in the future is subject to a number of uncertainties, including:

 

·                  our future business development, financial condition and results of operations;

 

·                  changes in financial market conditions or our business condition that could limit our access to existing credit facilities or make new financings more costly or even unfeasible;

 

·                  changes in China’s currency exchange control regulations that could limit our ability to access cash in China to meet liquidity requirements for our operations in China or elsewhere;

 

·                  general market conditions for financing activities by companies in our industry; and

 

·                  macroeconomic, political and other conditions in China and elsewhere.

 

In the past, Shanda Interactive and Mr. Xu provided debt and equity financings for us in various situations. In March 2015, we obtained loans from Mr. Xu, our largest shareholder, in the amount of RMB30.0 million. However, we may not receive any support from Shanda Interactive and Mr. Xu in the future. See “—We may not be able to continue to receive support from our major shareholders.”Furthermore, the report of our independent registered public accounting firm expresses substantial doubt about our ability to continue as a going concern. This could impair our ability to finance our operations through the sale of equity, issuance of debt, or other financing alternatives. In the absence of support from our major shareholders, there is no assurance that we will be able to independently obtain any financing from any third party on terms acceptable to us or at all. If we cannot obtain sufficient funding to meet our working capital requirements or other capital expenditure needs, our business, financial condition and prospects may be materially and adversely affected.

 

We have a history of losses, and we may be unable to achieve or sustain profitability.

 

We incurred net losses in each of the fiscal years from 2010 through 2014. Our ability to achieve profitability is affected by various factors, many of which are beyond our control, including:

 

·                  growth or decline of the online video industry;

 

·                  the transition from long-form professional content to short-form UGC;

 

·                  the continued growth and maintenance of our user base;

 

·                  our ability to control our costs and expenses and effectiveness of our cost reduction plans;

 

·                  our ability to provide new advertising services to meet the demands of our advertising customers;

 

·                  growth or decline of the online advertising market in China; and

 

·                  brand advertisers’ allocation of more budgets to online video industry.

 

Our ability to achieve profitability also depends on the success of our new business models, including our cooperation arrangements with Qinhe, which are subject to considerable uncertainties. See “—Our new business models may not be able to generate sufficient revenues and operating cash flows” and “—Our cooperation arrangements with Qinhe are subject to considerable uncertainties.”

 

Despite our cost reduction measures, we may continue to incur net losses in the future due to our continued investments in content, technology, bandwidth and talent. If we cannot sustain or grow our revenues to offset our costs, or if our cost reduction measures lead to a further decrease in our revenues, our gross margin, financial condition and results of operations could be materially and adversely affected. We may also continue to incur net losses in the future due to changes in the macroeconomic and regulatory environment, competitive dynamics and our inability to respond to these changes in a timely and effective manner. We anticipate incurring substantial additional net losses and may never achieve profitability. Even if we raise sufficient capital through equity or debt financing or otherwise, there can be no assurances that our net revenues or capital infusion will be sufficient to enable us to develop our business to a level where it will be profitable or generate positive cash flow.

 

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The report of our independent registered public accounting firm expresses substantial doubt about our ability to continue as a going concern.

 

Our independent registered public accounting firm indicated in its reports on our financial statements for the fiscal years ended December 31, 2013and 2014 that conditions exist that raise substantial doubt about our ability to continue as a going concern due to our working capital deficit and the uncertainty relating to the new business models. A “going concern” opinion could impair investor perceptions and our ability to finance our operations through the sale of equity, incurring debt, or other financing alternatives. Our ability to continue as a going concern will depend upon many factors beyond our control, including the availability and terms of future funding, growth in revenues from our agreements with Qinhe and Huzhong and the effectiveness of our cost reduction measures. See “—There is substantial doubt as to our ability to continue as going concern.” If we are unable to achieve these goals, our business would be jeopardized and we may not be able to continue. If we ceased operations, it is likely that all of our investors would lose their investment.

 

We may implement further restructuring of our business, including through strategic acquisitions, in the future.

 

In order to improve our business operations, we may implement further restructuring of our business in the future, including through strategic acquisitions. There could be a material adverse effect on our business, results of operations and prospect if we fail to successfully execute any such restructuring plans and acquisitions, or if the contemplated benefits from any such restructuring or acquisitions do not materialize.

 

In addition, the success of any acquisition, if any, will depend upon a number of factors, including:

 

·                  our ability to acquire businesses on a cost-effective basis;

 

·                  our ability to obtain necessary financings for such acquisition;

 

·                  our ability to integrate acquired personnel, operations, products and technologies into our organization effectively; and

 

·                  our ability to retain and motivate key personnel and to retain the clients of acquired firms.

 

Any such restructuring or strategic acquisition may require a significant commitment of management time, capital investment and other resources. Our business operation may also be severely disrupted by any such transactions. We may be unable to consummate such transactions, we may not be able to effectively integrate an acquired business or we may be required to incur significant expenses to complete a transaction. We may also experience increased employee turnovers in our existing workforce. As a result, our business, financial condition and results of operations may be materially and adversely affected. In addition, if we use debts to finance any such restructuring or acquisition, we may become highly leveraged. If we use our equity securities as consideration for transactions, the value of your ADSs may be substantially diluted.

 

In addition, according to the amendments to Schedule 13D filed by Shanda Interactive on April 1, 2014 and the Schedule 13D filed by Mr. Xu on April 9, 2014, under the share purchase agreement relating to the Share Purchase Transaction, Shanda Media, a wholly owned subsidiary of Shanda Interactive, has agreed that if we propose to acquire Sky Profit Limited, a company controlled by Mr. Xu, our largest shareholder, and such transaction is recommended to the shareholders for approval by our board of directors and any special committee of disinterested directors, Shanda Media shall vote all its shares in line with such recommendation. Sky Profit Limited controls Qinhe, which operates iSpeak, a social platform that allows users to engage in real-time online group activities through voice, text and video. Shanda Media has a right under this share purchase agreement to subscribe to equity or equity-linked securities issued by affiliates of Mr. Xu for an amount up to $25,000,000 that is equal to, or convertible into, 20% of Sky Profit Limited on a fully diluted basis. However, this right is not available to other holders of our ADSs or ordinary shares. Currently, our company has no plan to acquire Sky Profit Limited.

 

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We operate in a highly competitive market and we may not be able to compete successfully against our competitors.

 

We face significant competition, primarily from those companies that operate online video websites in China, which our management estimates to currently number over one hundred. A large number of independent online video sites, such as Youku Tudou and iQiyi.com, compete against us. In addition, Chinese Internet portals, including Sina.com, Sohu.com and Baidu.com, and some of China’s major TV networks, such as China Central Television, or CCTV, Phoenix Satellite TV and Hunan Satellite TV, which have longer operating histories and more experience in attracting and retaining users and managing customers than we do, have launched their own video businesses. We also face competition from Internet video streaming platforms based on the P2P technology, such as PPS and PPTV. We compete with these companies for users and advertisers. Our competitors may compete with us in a variety of ways, including by conducting brand promotions and other marketing activities and making acquisitions. In addition, certain online video websites may continue to derive their revenues from providing content that infringes third-party copyright and may not monitor their websites for any such infringing content. As a result, we may be placed at a disadvantage to some of these websites that do not incur similar costs as we do with respect to content monitoring. Some of our competitors have a longer operating history and significantly greater financial resources than we do, and in turn may be able to attract and retain more users and advertisers. If any of our competitors achieves greater market acceptance than we do or is able to offer more attractive online video content, our user traffic may decrease and our market share may decrease, which may result in a loss of advertisers and have a material and adverse effect on our business, financial condition and results of operations.

 

In addition, Internet streaming of content represents only one of many existing and potential new technologies for viewing video. Many users maintain simultaneous relationships with multiple video providers and can easily shift from one provider to another. For example, users may subscribe to cable, buy a DVD, and download a movie from Apple iTunes or other sources, or some combination thereof. New competitors may be able to launch new businesses at a relatively low cost.

 

We also face competition from other types of advertising media, such as newspapers, magazines, yellow pages, billboards and other forms of outdoor media, television and radio. Most large companies in China allocate, and will likely continue to allocate, most of their marketing budgets to traditional advertising media and only a small portion of their budgets to online marketing and other forms of advertising media. If these companies do not devote a larger portion of their marketing budgets to online marketing services provided by our online video business, or if our existing customers reduce the amount they spend on online marketing, our results of operations and future growth prospects could be adversely affected.

 

The online video industry in China and user acceptance of our online video content may not grow as quickly as expected, which may adversely affect our revenues and business prospects.

 

Our business prospects depend on the continuing development of the online video industry in China. As an emerging industry, China’s online video industry has experienced substantial growth in recent years in terms of both users and content. We cannot assure you, however, that the online video industry will continue to grow as rapidly as it has in the past. With the development of technology, new forms of media may emerge and render online video websites less attractive to users. Growth of the online video industry is affected by numerous factors, such as users’ general online video experience, technological innovations, development of Internet and Internet-based services, regulatory changes, especially regulations affecting copyrights, and the macroeconomic environment. If the online video industry in China does not grow as quickly as expected or if we fail to benefit from such growth by successfully implementing our business strategies, our user traffic may decrease and our business and prospects may be adversely affected.

 

We operate in a rapidly evolving industry. If we fail to keep up with the technological developments and users’ changing requirements, our business, results of operations and prospects may be materially and adversely affected.

 

The online video industry is rapidly evolving and subject to continuous technological changes and changes in industry standards. Our success will depend on our ability to keep up with the changes in technology and user behavior resulting from the technological developments. For example, the development of broadband enabled the enjoyment of high definition videos online. In addition, the number of people accessing the Internet via devices other than personal computers, including mobile phones and other hand-held devices, has increased in recent years. With the rapid development of 3G and 4G mobile communication services in China, we expect this trend to continue. If we do not adapt our products and services to such changes in an effective and timely manner, we may suffer from a decreased user traffic, which may result in a reduced number of advertisers using our online advertising services. Furthermore, changes in technologies may require substantial capital expenditures in product development as well as in modification of products, services or infrastructure. Failure in keeping up with technological development may result in our products and services being less attractive, which in turn, may materially and adversely affect our business, results of operations and prospects.

 

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If we fail to continue to provide attractive products and services, we may not be able to generate sufficient user traffic to remain competitive.

 

Our success depends on our ability to generate sufficient user traffic through provision of attractive products and services. To attract and retain users and compete against our competitors, we must maintain high-quality UGC that provides our users with a satisfactory online video experience. With UGC, users can upload and share their own videos and spend a longer time on our website, and we believe a “community-like” environment will enhance users’ loyalty to our website and such network effect broadens advertisers’ reach of audience. Previously, we purchased the licensing rights to some popular UGC and shared advertising revenues with individual users whose number of uploads exceed certain thresholds. We also had a revenue sharing program to reward users for contents they uploaded in order to encourage more users to upload UGC to our website. In April 2014, in connection with the change of our business models after the Share Purchase Transaction, we announced a suspension of this revenue sharing program from May 1, 2014. This program has not been resumed and may not be resumed in the future.Historically, contracted users contributed approximately 50% of all the videos on our website. As a result of the suspension of this revenue sharing program, the quality and quantity of our UGC may deteriorate in the future, which, in turn, may materially and adversely affect our business, results of operations and prospects.

 

We may not be able to continue to anticipate user preferences.

 

Based on the feedback on our website design and our statistics regarding users’ watching behavior, we keep developing new website features that appeal to users, such as designing more user-friendly content searching tools, creating additional interactive social functions or offering better website compatibility with new Internet-enabled devices. We need to continuously anticipate user preferences and industry changes and respond to such changes in a timely and effective manner. If we fail to cater to the needs and preferences of our users and, as a result, fail to deliver satisfactory user experience, we may suffer from reduced user traffic and our business and results of operations may be materially and adversely affected.

 

We may not be able to maintain and enhance our brand.

 

We may not be able to maintain and enhance our Ku6 brand (“” and “ 6”). The online video market is highly competitive, and a well-recognized brand is critical to increasing our user base and, in turn, enhancing our attractiveness to advertisers for our online advertising business. Our success in promoting and enhancing our brand, as well as our ability to remain competitive, will depend on our success in offering high-quality content, features and functionality. If we fail to promote our brand successfully or if visitors to our website or advertisers do not perceive our content and services to be of high quality, we may not be able to grow our business and may lose users and advertisers.

 

You may not be able to rely on our quarterly operating results as an indication of our future performance because our quarterly operating results may be subject to significant fluctuations.

 

We may experience significant fluctuations in our quarterly operating results due to a variety of factors, many of which are beyond our control. Significant fluctuations in our quarterly operating results could be caused by many factors, including, but not limited to:

 

·                  our ability to retain existing users, attract new users at a steady rate and maintain user satisfaction;

 

·                  the creation of new content by our users and the popularity of such content;

 

·                  technical difficulties, system downtime or Internet failures for our websites;

 

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·                  the amount and timing of operating costs and capital expenditures relating to expansion of our business, operations and infrastructure;

 

·                  the adoption of new, or changes to existing, governmental regulations; and

 

·                  economic conditions in general and specific to the online video industry in China.

 

As a result, you should not rely on quarter-to-quarter or semiannual-to-semiannual comparisons of our operating results as indicators of our future performance. Although we generated gross profit in the fourth quarter of 2014, we still had an operating loss and a net loss in that quarter. There is no assurance that such recent improved quarterly performance will continue. Our operating results may be below our expectations or the expectations of public market analysts and investors in one or more future quarters. If that occurs, the price of our ADSs could decline and you could lose part or all of your investment.

 

We may be subject to administrative actions by PRC regulatory authorities and other liabilities because of advertisements shown on our website.

 

Under PRC advertising laws and regulations, we are obligated to monitor the advertising content shown on our website to ensure that such content is true, accurate and in full compliance with applicable laws and regulations. In addition, where a special government review is required for specific types of advertisements prior to website posting, such as advertisements relating to pharmaceuticals, medical instruments, agrochemicals and veterinary pharmaceuticals, we are obligated to confirm that such review has been performed and approval has been obtained from competent governmental authority, which is generally the local branch of the State Administration for Industry and Commerce, or the SAIC. Violation of these laws and regulations may subject us to penalties, including fines, confiscation of our advertising income, orders to cease dissemination of the advertisements and orders to publish an announcement correcting the misleading information. In circumstances involving serious violations, such as posting a pharmaceutical product advertisement without approval, or posting an advertisement for fake pharmaceutical products, PRC governmental authorities may force us to terminate our advertising operation or revoke our licenses. Furthermore, advertisers, advertising operators or advertising distributors, including us, may be subject to civil liability if they infringe on the legal rights and interests of third parties.

 

Substantially all of the advertisements shown on our website are provided to us by our advertising agency on behalf of advertisers. We cannot assure you that all the content contained in such advertisements is true and accurate as required by the advertising laws and regulations, especially given the uncertainty in the application of these laws and regulations. For example, Article 38 of the Advertisement Law provides that an advertisement operator who knows or should have known the posted advertisement is false or fraudulent will be subject to joint and several liabilities. However, for the determination of the truth and accuracy of the advertisements and the actual or constructive knowledge of the website, there are no implementing rules or official interpretations, and such a determination is at the sole discretion of the relevant local branch of the SAIC, which results in uncertainty in the application of these laws and regulations.

 

If we are found to be in violation of applicable PRC advertising laws and regulations in the future, we may be subject to penalties and our reputation may be harmed, which may have a material and adverse effect on our business, financial condition, results of operations and prospects. See Item 4.B. “Business Overview—Government Regulation—Regulations on Advertisements.”

 

System failures, security risks and data protection breaches could impair our users’ online video experience and adversely affect our reputation.

 

We rely on the efficient and uninterrupted operation of complex information technology applications, systems and networks to operate our business. Our ability to provide users with a high-quality online video experience depends on the continuous and reliable operation of our systems. We cannot assure you that we will be able to procure sufficient bandwidth in a timely manner or on acceptable terms or at all. Failure to do so may significantly impair user experience on our website and decrease the overall effectiveness of our website to both users and advertisers. Disruptions, failures, unscheduled service interruptions or a decrease in connection speeds could hurt user experience and our reputation, causing our users and advertisers to switch to our competitors’ websites. Our systems and proprietary video content delivery network, or CDN, are vulnerable to damage or interruption as a result of fires, floods, earthquakes, power losses, telecommunications failures, cyber-attacks, undetected errors in software, computer viruses, hacking and other attempts to harm our systems. We have experienced service interruptions in the past which typically were caused by (i) overload of our servers, (ii) unexpected overflow of user traffic, and (iii) service malfunction of the telecommunications operators, such as power outage of Internet data centers or network transmission congestion. We may continue to experience similar interruptions in the future despite our continuous efforts to improve our systems. Since we host our servers at third-party Internet data centers, any natural disaster or unexpected closure of Internet data centers operated by third-party providers may result in lengthy service interruptions. If we experience frequent or persistent service disruptions, whether caused by failures of our own systems or those of third-party service providers, our users’ experience may be negatively affected, which in turn, may have a material and adverse effect on our reputation. We cannot assure you that we will be successful in minimizing the frequency or duration of service interruptions. In addition, the risks of cyber-attacks have increased significantly recently. Some of these attacks may originate from well organized, highly skilled organizations. Any such attack could result in a loss of our intellectual property, the release of commercially sensitive information, customer or employee personal data. Failures to protect the privacy of customer and employee confidential data against breaches of network security could result in damage to our reputation.

 

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Undetected programming errors could adversely affect user experience and the market acceptance of our video programs, which may materially and adversely affect our business and results of operations.

 

The video programs, including advertising video programs, on our website may contain programming errors that may only become apparent after their release. We receive user feedback in connection with programming errors affecting their user experience from time to time, and such errors may also come to our attention during our monitoring process. We generally have been able to resolve such programming errors in a timely manner. However, we cannot assure you that we will be able to detect and resolve all these programming errors effectively. Undetected audio or video programming errors or defects may adversely affect user experience and cause our advertisers to reduce their use of our services, any of which could materially and adversely affect our business and results of operations.

 

Our operations depend on the performance of the Internet infrastructure and telecommunications networks in China and third-party service providers.

 

Our products and services depend on the ability of our users to access the Internet. Therefore, the successful operation of our business depends on the performance of the Internet infrastructure and telecommunications networks in China. Almost all access to the Internet is maintained through state-owned telecommunications operators under the administrative control and regulatory supervision of China’s Ministry of Industry and Information Technology, or the MIIT. Moreover, we have entered into contracts with various subsidiaries of a limited number of telecommunications service providers in each province and rely on them to provide us with data communications capacity through local telecommunications lines and Internet data centers to host our servers. We have limited access to alternative networks or services in the event of disruptions, failures or other problems with China’s Internet infrastructure or the telecommunications networks provided by telecommunications service providers. Our Ku6.com website regularly serves a large number of users and advertisers. With the expansion of our business, we may be required to upgrade our technology and infrastructure to keep up with the increasing traffic on our websites. However, we have no control over the costs of the services provided by telecommunications service providers. If the prices we pay for telecommunications and Internet services rise significantly, our results of operations may be materially and adversely affected. If Internet access fees or other charges to Internet users increase, our user traffic may decline and our business may be hurt. Our servers, which are partly hosted at third-party Internet data centers, are vulnerable to break-ins, sabotage and vandalism. The occurrence of a natural disaster or a closure of an Internet data center by a third-party provider without adequate notice could result in lengthy service interruptions. Moreover, the agreements we have entered into with domestic telecommunications carriers to host our servers typically have terms of approximately one year and are renewable subject to early termination. If we are not able to renew such hosting services agreements with the telecommunications carriers when they expire and are not able to enter into agreements with alternative carriers at commercially reasonable terms or at all, the quality and stability of our services may be adversely affected. In addition, our domain names are resolved into Internet protocol (IP) addresses by systems of third-party domain name registrars and registries. Any interruptions or failures of those service providers’ systems, which are beyond our control, could significantly disrupt our own services.

 

If we experience frequent or persistent system failures on our websites, whether due to interruptions and failures of our own information technology and communications systems or those of third-party service providers we rely upon, our reputation and brand could be permanently harmed. The steps we take to increase the reliability and redundancy of our systems are expensive, may reduce our operating margin and may not be successful in reducing the frequency or duration of service interruptions.

 

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We also depend significantly on relationships with leading technology providers and the licenses that the technology providers have granted to us. Our competitors may establish the same relationships as we have, which may adversely affect us. We may not be able to maintain these relationships or replace them on commercially attractive terms.

 

We have been and expect to continue to be exposed to intellectual property infringement and other claims, including claims based on content posted on our website.

 

Our success depends, in large part, on our ability to operate our business without infringing third-party rights, including third-party intellectual property rights. Internet companies, technology and media industries own, and are seeking to obtain, a large number of patents, copyrights, trademarks and trade secrets, and they are frequently involved in litigation based on allegations of infringement or other violations of intellectual property rights or other related legal rights. There may be patents issued or pending that are held by others that cover significant aspects of our technologies, products, business methods or services.

 

We have been and may continue to be subject to claims for defamation, negligence, infringement of third-party copyright and other rights, such as privacy and image rights, or other claims based on the nature or content of videos or other information provided by us or our users. We paid $0.1 million to settle such claims and recorded expenses relating to such claims of $0.3 million for the year ended December 31, 2014, and the balance of accrued litigation provision was $1.7 million as of December 31, 2014. We do not carry any liability insurance covering such risks.

 

Due to the significant number of videos uploaded by users, which currently amounts to an average of approximately 48,790 files on a daily basis, we may not be able to identify all content that may infringe on third-party rights. Thus, our failure to identify unauthorized videos posted on our website may subject us to, and may continue to subject us to, claims of infringement on third-party intellectual property rights or other rights. Third parties may also make claims against us for losses incurred in reliance on the information on our websites. In addition, we may be subject to administrative actions brought by the National Copyright Administration of the PRC, or the NCAC, or its local branches for alleged copyright infringement. Although we have not previously been subject to legal actions for copyright infringement in jurisdictions other than the PRC, it is possible that we may be subject to such claims in the future. Such other jurisdictions may impose different protections for copyrights, and the claims may result in potentially larger damages awards than have been imposed in the PRC. For example, although our operations are in China and our site is targeted at audiences in Asia, our site includes some English-language content and is accessible by users in the United States and elsewhere. There is a risk that a U.S. court may determine that it has jurisdiction over us in connection with claims for U.S. copyrights. Although U.S. copyright laws, including the Digital Millennium Copyright Act (17 U.S.C. § 512), or the DMCA, provide safeguards from claims for monetary relief for copyright infringement for certain entities that host user-uploaded content and that comply with specified statutory requirements, it is possible that a U.S. court would conclude that it has jurisdiction and that we are not eligible for, or have not complied with all the statutory requirements to qualify for, the safeguards provided by the DMCA. Under such circumstances, it is possible that we could be subject to claims of copyright infringement in the United States.

 

It could be time-consuming and costly to defend these claims, which, with or without merit, may cause us to incur significant costs and liabilities and could materially and adversely affect our business, and also result in diversion of the attention of our management and our financial resources and negative publicity on our brand and reputation. The failure to successfully defend any of them may result in substantial damage awards and/or court orders that may prevent us from continuing to provide certain of our existing services.

 

We may not be able to adequately protect our intellectual property rights, and any failure to protect our intellectual property rights could adversely affect our revenues and competitive position.

 

We believe that trademarks, trade secrets, patents, copyrights and other intellectual property we use are important to our business. We rely on a combination of trademark, copyright, patent and trade secret protection laws in China and other jurisdictions, as well as confidentiality procedures and contractual provisions to protect our intellectual property and our brand. We have invested significant resources to develop our own intellectual property and acquire licenses to use and distribute the intellectual property of others for our online video site; failure to maintain or protect these rights could harm our business. In addition, any unauthorized use of our intellectual property by third parties may adversely affect our current and future revenues and our reputation.

 

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The validity, enforceability and scope of protection available under intellectual property laws with respect to the Internet industry in China are uncertain and still evolving. Implementation and enforcement of PRC intellectual property-related laws have historically been deficient and ineffective. Accordingly, protection of intellectual property rights in China may not be as effective as in the United States or other western countries. Furthermore, policing unauthorized use of proprietary technology is difficult and expensive, and we may need to resort to litigation to enforce or defend copyrights issued to us or our other intellectual property 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.

 

Complexity, uncertainties and changes in government policies or regulations of Internet industry may have a material and adverse effect on our business, financial condition, results of operations and prospects.

 

Our online video business is subject to strict government regulations in China. The PRC government extensively regulates the Internet industry, including foreign ownership of, and the licensing and permit requirements pertaining to, companies in the Internet industry. Under the PRC regulatory scheme, a number of regulatory agencies, including the State Administration of Press, Publication, Radio, Film and Television, or SAPPRFT, including its predecessor ministries, the State Administration of Radio, Film, and Television, or SARFT, and the General Administration of Press and Publication, or the GAPP, the Ministry of Culture, the Ministry of Industry and Information Technology, or MIIT, the State Council Information Office, or SCIO, and the State Internet Information Office established by SCIO in May 2011, jointly regulate all major aspects of the Internet industry, including the online video industry. Operators must comply with restrictions related to foreign investment in value added telecommunication services industry in China and obtain various government approvals and licenses, including an Internet content provider license, or ICP license, and an Internet audio/video program transmission license, prior to the commencement of online video operations.

 

We believe that we have obtained the licenses and permits essential for our business operations. However, given the Internet-related laws and regulations are relatively new and rapidly evolving in China, their interpretation and enforcement involve significant uncertainty. As a result, in certain circumstances it may be difficult to determine what actions or omissions may be deemed to violate applicable laws and regulations. The permits, licenses or approvals that we hold may be subject to challenge, we may fail to obtain permits or licenses that may be deemed necessary for our operations, or we may not be able to renew certain permits or licenses. We may also need to apply for additional permits or licenses when we enter new sectors of the Internet industry. For example, we may need to apply for the Internet News Information Service Permit issued by the SCIO or the Internet Publication License issued by SAPPRFT, in connection with the current events channel on our website. We may also need to expand the scope of our audio/video program transmission licenses to cover more categories of audio/video services. If we fail to maintain any of the required permits, licenses or approvals, we may be subject to various penalties, including fines and discontinuation of, or restriction on, our operations. Any such disruption of our business operations may have a material adverse effect on our business, financial condition, results of operations and prospects.

 

In addition, actions by the PRC government, including the interpretation, re-interpretation and application of existing PRC laws, regulations and policies and promulgation of new laws, regulations or policies relating to the Internet industry, may create substantial uncertainties regarding the legality of existing and future foreign investments in the Internet industry in China. Any such actions may have a material adverse effect on our business, financial condition, results of operations and prospects. For example, in December 2012, the GAPP published a proposed rule relating to Internet publication which, among other things, seeks to clarify the meaning of the “Internet publication service” and “Internet publication” as well as modify the application procedures for the relevant license. We plan to apply for the required license once the final rule is issued. However, we cannot assure you that such application would be approved by the relevant governmental agencies in a timely manner or at all. If we fail to obtain the license, we may be subject to various administrative penalties, including fines and confiscation of our income or assets, and we may be forced to discontinue our business and our website may be blocked.

 

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We have limited business insurance coverage.

 

Insurance companies in China currently do not offer as extensive an array of insurance products as insurance companies do in more developed economies. We do not have any business liability or disruption insurance to cover our operations. We have determined that the costs of insuring for these risks and the difficulties associated with acquiring such insurance on commercially reasonable terms make it impractical for us to have such insurance. Any uninsured occurrence of business disruption may result in our incurring substantial costs and the diversion of resources, which could have an adverse effect on our results of operations and financial condition.

 

Regulation and censorship of information disseminated over the Internet in China may adversely affect our business and subject us to liability for information displayed on or linked to our websites.

 

The PRC government has adopted regulations governing Internet access and the distribution of news and other information over the Internet. Under these regulations, Internet content providers and Internet publishers are prohibited from posting or displaying over the Internet content that, among other things, violates PRC laws and regulations, impairs the national dignity of China, or is reactionary, obscene, superstitious, fraudulent or defamatory. Furthermore, Internet content providers are also prohibited from displaying content that may be deemed by relevant government authorities as “socially destabilizing” or leaking “state secrets” of the PRC. Failure to comply with these requirements may result in administrative penalties, such as fines, the revocation of licenses to provide Internet content and other licenses and the closure of the concerned websites. In the past, failure to comply with such requirements has resulted in the closure of certain websites. The website operator may also be held liable for such censored information displayed on or linked to the website.

 

In addition, the MIIT has published regulations that subject website operators to potential liability for content displayed on their websites and the actions of users and others using their systems, including liability for violations of PRC laws and regulations prohibiting the dissemination of content deemed to be socially destabilizing. The Ministry of Public Security has the authority to order any local Internet service provider to block any Internet website at its sole discretion. From time to time, the Ministry of Public Security has stopped the dissemination over the Internet of information that it believes to be socially destabilizing. The State Secrecy Bureau is also authorized to block any website it deems to be leaking state secrets or failing to meet the relevant regulations relating to the protection of state secrets in the dissemination of online information. Furthermore, we are required to report any suspicious content to relevant governmental authorities, and to undergo computer security inspections. If we fail to implement the relevant safeguards against security breaches, our websites may be shut down and our business and ICP licenses may be revoked.

 

Although we attempt to monitor the content on our websites, we are not able to control or restrict the content of other Internet content providers linked to or accessible through our websites, or content uploaded to, or generated or placed on, our websites by our users. To the extent that PRC regulatory authorities find any content displayed on our websites objectionable, they may require us to limit or eliminate the dissemination of such information on our websites. If third-party websites linked to or accessible through our website operate unlawful activities such as online gambling on their websites, PRC regulatory authorities may require us to report such unlawful activities to relevant authorities and to remove the links to such websites, or they may suspend or shut down the operation of such websites. PRC regulatory authorities may also temporarily block access to certain websites for a period of time for reasons beyond our control. Any of these actions may reduce our user traffic and adversely affect our business. In addition, we may be subject to penalties for violations of those regulations arising from information displayed on or linked to our websites, including a suspension or shutdown of our online operations.

 

Concerns about collection, use and security of personal data could damage our reputation and deter current and potential users from using our services.

 

We have an extensive user base for our video platform, from which we collect personal data about our registered users. Under our privacy policy, without our users’ prior consent, we may not provide any of our users’ personal data to any unrelated third party. While we strive to comply with our privacy policies and other applicable data protection laws and regulations, any failure or perceived failure of compliance may result in proceedings or actions against us by our users, government authorities or other parties, and could damage our reputation. User and regulatory attitudes toward privacy are evolving, and their concerns about the extent to which personal data may be recorded, used or shared may adversely affect our ability to record, use or share such data, which may limit our advertising capabilities and the effectiveness of the marketing efforts of our advertising agencies.

 

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Recently, the PRC government started to require, to certain extent, real name registration for Internet services. According to the Provisions on Administration of Internet User Account Names promulgated by the National Internet Information Office in February 2014, the Internet information service providers shall, pursuant to the principle of “mandatory real name registration at the back-office end, and voluntary real name display at the front-office end,” require the Internet information service users to sign up accounts after passing real identity information authentication.  See Item 4.B. “Business Overview—Government Regulation—Regulations on Internet Privacy.” We currently do not require real name registration by our users, which may be deemed to violate relevant PRC laws and regulations, and the PRC regulatory authorities may impose administrative penalty or other sanctions on us.

 

In addition, concerns about the security of personal data could also lead to a decline in general Internet usage, which could lead to lower user traffic on our platform. Decrease of anonymity may impair user experience of online media consumption, deter our users from viewing, uploading and sharing videos on our website and reduce the amount of their interactive activities. A significant reduction in user traffic could lead to lower advertising revenues. Any of the above could have a material adverse effect on our business, financial condition, results of operations and prospects.

 

If we fail to maintain an effective system of internal control over financial reporting, we may not be able to accurately report our financial results or prevent fraud.

 

We are subject to reporting obligations under the U.S. securities laws. The Securities and Exchange Commission, or the SEC, as required by Section 404 of the Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act, adopted rules requiring every public company to include a management report on the effectiveness of such company’s internal control over financial reporting in its annual report. Our management concluded that our internal control over financial reporting was effective as of December 31, 2014, as reported under criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission, or COSO.  However, as a non-accelerated filer, we are not required to provide an attestation on the effectiveness of our internal control by our independent registered public accounting firm under the Sarbanes-Oxley Act or the requirements of the SEC promulgated thereunder. Our independent registered public accounting firm previously reported on the effectiveness of our internal control over financial reporting in our prior years’ annual reports. However, for this annual report on Form 20-F for the year ended December 31, 2014, our independent registered public accounting firm did not report on the effectiveness of our internal control over financial reporting. We cannot assure you that we will be able to maintain the effectiveness of our internal control over financial reporting on a continuing basis in the future, or that our management’s assessment of the effectiveness of our internal control is accurate or will not be challenged. As effective internal control over financial reporting is necessary for us to produce reliable financial reports and is important to help prevent or detect fraud, any failure to maintain effective internal control over financial reporting could harm our business and result in a loss of investor confidence in the reliability of our financial statements, which in turn could negatively impact the trading price of our ADSs. Furthermore, we may need to incur additional costs and use additional management and other resources in an effort to comply with Section 404 of the Sarbanes-Oxley Act and other requirements going forward.

 

We believe that we were a passive foreign investment company (“PFIC”) for taxable years 2006, 2007, 2008 and 2009 and it was not clear whether we were a PFIC for taxable year 2011. Although we believe we were not a PFIC for taxable year 2014, we may be a PFIC for subsequent taxable years, which could result in adverse U.S. federal income tax consequences to U.S. investors.

 

We will be a PFIC for U.S. tax purposes for a taxable year if either (a) 75% or more of our gross income for such taxable year is passive income or (b) 50% or more of the average quarterly value, generally determined by fair market value, of our assets during such taxable year consists of assets that either produce passive income or are held for the production of passive income. For such purposes, if we directly or indirectly own 25% or more of the shares of another corporation, we generally will be treated as if we (a) held directly a proportionate share of the other corporation’s assets and (b) received directly a proportionate share of the other corporation’s income. We believe that we were a PFIC for taxable years 2006, 2007, 2008 and 2009, and it was not clear whether we were a PFIC for taxable year 2011. The determination of our PFIC status is subject to uncertainty because the treatment of the contractual arrangements between our PRC subsidiaries and our consolidated affiliated entities for purposes of the PFIC rules is uncertain. If we were a PFIC for 2006, 2007, 2008, 2009 and 2011, and you held ordinary shares or ADSs during any such taxable years, we would continue to be treated as a PFIC with respect to those ordinary shares or ADSs for all succeeding years during which you hold them. Our PFIC status for any taxable year will not be determinable until after the end of the taxable year and will depend on the composition of our income and assets and the market value of our assets for such taxable year, which may be, in part, based on the market price of our ordinary shares or ADSs (which may be especially volatile). For these reasons, and because of the uncertainties regarding the treatment of our contractual arrangements with our consolidated affiliated entities, there can be no assurance that we will not be a PFIC for any taxable year. Such characterization could result in adverse U.S. federal income tax consequences to a U.S. investor. In general, if we are a PFIC, then “excess distributions” to a U.S. investor and any gain realized by a U.S. investor on the sale or other disposition of our ordinary shares or ADSs will be allocated ratably over the U.S. investor’s holding period for the ordinary shares or ADSs; the amount allocated to the taxable year of receipt of the proceeds of such distribution or disposition and any year prior to our becoming a PFIC will be taxed as ordinary income; and the amount allocated to each other taxable year will be subject to tax at the highest rate in effect for the applicable class of taxpayer for that year. Additionally, an interest charge will be imposed with respect to the resulting tax attributable to each such other taxable year and the U.S. investor will be subject to U.S. tax reporting requirements. Alternatively, if we are a PFIC and if our ADSs are “regularly traded” on a “qualified exchange,” a U.S. investor could make a mark-to-market election that would result in tax treatment different from the general tax treatment for PFICs described above.

 

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Given the complexity of the issues regarding our classification as a PFIC, U.S. investors are urged to consult their own tax advisors for guidance as to the U.S. federal, state and local and other tax consequences of our status as a PFIC in light of their particular circumstances, as well as the availability of, and procedures for making, a mark-to-market or other available election. For further discussion of the adverse U.S. federal income tax consequences of our classification as a PFIC, see Item 10.E. “Taxation—U.S. Federal Income Taxation” below.

 

Risks Related to Our Corporate Structure

 

If the PRC government finds that the agreements that establish the structure for operating our businesses in China do not comply with PRC governmental restrictions on foreign investment in Internet business, we could be subject to severe penalties or be forced to relinquish our interests in those operations.

 

Current PRC laws and regulations place certain restrictions on foreign ownership of companies that engage in Internet business, including the provision of online video and online advertising services. Specifically, foreign ownership in an Internet content provider or other value-added telecommunication service providers may not exceed 50%. Moreover, a foreign investor must have certain track record in the value-added telecommunication business or advertisement business before it can obtain direct equity interests in a PRC company that operates in these industries. Since we are a Cayman Islands company without any track-record of value-added telecommunication service or advertisement operations, neither we nor our PRC subsidiaries are eligible to hold a license to operate our website or our advertisement business in China. As a result, we conduct our operations in China principally through contractual arrangements among our PRC subsidiaries, our consolidated affiliated entities, and their respective shareholders. These contractual arrangements enable us to exercise effective control over these entities and hence treat them as our consolidated affiliated entities and consolidate their results. For a detailed discussion of these contractual arrangements, see Item 4.C. “Organizational Structure.”

 

PRC laws and regulations governing the validity of these contractual arrangements are uncertain and the relevant government authorities have broad discretion in interpreting these laws and regulations. Although we believe we are in compliance with current PRC regulations, we cannot assure you that the PRC government would hold the same view with us or these contractual arrangements comply with regulations or policies that may be amended or adopted in the future.

 

On July 13, 2006, the MIIT issued the Notice of the MIIT on Intensifying the Administration of Foreign Investment in Value-added Telecommunications Services. This notice prohibits domestic telecommunication services providers from leasing, transferring or selling telecommunications business operating licenses to any foreign investor in any form, or providing any resources, sites or facilities to any foreign investor for their illegal operation of a telecommunications business in China. According to this notice, either the holder of a value-added telecommunication business operating license or its shareholders must legally own the domain names and trademarks used by such license holders in their provision of value-added telecommunication services. The notice further requires each license holder to have the necessary facilities, including servers, for its approved business operations and to maintain such facilities in the regions covered by its license. In addition, all value added telecommunication service providers are required to maintain network and Internet security in accordance with the standards set forth in relevant PRC regulations. If a license holder fails to comply with the requirements in the notice and cure such noncompliance, the MIIT or its local counterparts have the discretion to take measures against such license holders, including revoking their valued-added telecommunication business operating licenses.

 

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In January 2015, MOFCOM published on its website for public comment on a draft Foreign Investment Law of the PRC, or the draft FIL. The draft FIL is believed to strengthen the regulation of PRC companies, such as our VIEs, which have contractual arrangements with foreign investors or foreign invested companies. Under the draft FIL, a company controlled by foreign investors through contractual arrangements is considered to be a foreign invested enterprise and as a result is explicitly subject to restrictions on foreign investment. If the current version of the draft FIL becomes effective, our VIEs could fall within the scope of foreign invested companies and be subject to restrictions on foreign investment in the telecommunication service industry including online video business, and the related contractual arrangements between our VIEs and us could be challenged. Under the draft FIL, it is unclear how “control” would be determined for such purpose, and the draft FIL is silent as to the enforcement actions that might be taken against existing companies, such as our VIEs, that operate in restricted industries.

 

Ku6 Information Technology, one of our consolidated affiliated entities, holds the licenses and permits necessary to conduct our online video, online advertising and related businesses in China. However, the related trademarks are owned by Beijing WFOE, one of our wholly owned PRC subsidiaries. If the MIIT strictly enforces the notice, we may be required to transfer those trademarks from Beijing WFOE to Ku6 Information Technology. If the PRC government determines that we do not comply with the currently applicable laws and regulations or policies that may be adopted in the future such as the proposed Draft FIL, it could revoke our business and operating licenses, including our value-added telecommunication license and ICP license, require us to discontinue or restrict our operations, restrict our right to collect revenues, block our website, require us to restructure our operations, impose additional conditions or requirements with which we may not be able to comply, or take other regulatory or enforcement actions against us that could be harmful to our business. The imposition of any of these penalties would result in a material and adverse effect on our ability to conduct our business.

 

Substantial uncertainties exist with respect to the enactment timetable, interpretation and implementation of the draft Foreign Investment Law and how it may impact the viability of our current corporate structure, corporate governance and business operations.

 

In January 2015, MOFCOM published the draft FIL aiming to, upon its enactment, replace the existing laws regulating foreign investment in the PRC, namely, the Sino-foreign Equity Joint Venture Enterprise Law, the Sino-foreign Cooperative Joint Venture Enterprise Law and the Wholly Foreign-invested Enterprise Law.  The draft FIL is believed to embody a 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. MOFCOM is currently soliciting comments on the draft FIL and substantial uncertainties exist with respect to its enactment timetable, interpretation and implementation. The draft FIL, 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 FIL expands the definition of foreign investment and introduces the principle of “actual control” in determining whether a company is considered a foreign-invested enterprise, or an FIE. The draft FIL specifically provides that entities established in the PRC but “controlled” by foreign investors will be treated as FIEs, whereas an entity set up in a foreign jurisdiction would nonetheless be, upon market entry clearance by MOFCOM, treated as a PRC domestic investor provided that the entity is “controlled” by PRC entities and/or citizens. “Control” is broadly defined in the draft FIL to cover the following categories: (i) holding, directly or indirectly, not less than 50% of shares, equities, share of voting rights or other similar rights of the subject entity; (ii) holding, directly or indirectly, 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 materially influence the board, the shareholders’ meetings, 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. Once an entity is determined to be an FIE, it will be subject to the foreign investment restrictions or prohibitions set forth in a catalogue of “special administrative measures” to be separately issued by the State Council, which will classify industries into the “catalogue of prohibitions” and the “catalogue of restrictions.” Foreign investors are not allowed to invest in any sector set forth in the catalogue of prohibitions.

 

The “variable interest entity” structure, or the 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 FIL, variable interest entities that are controlled through contractual arrangements could also be deemed FIEs if they are ultimately “controlled” by foreign investors. If MOFCOM takes this position, our VIEs may be deemed FIEs and we may be deemed to operate FIEs in industries listed in the “catalogue of restrictions” based on the current catalogue relating to foreign investment, and our current corporate structure may be challenged. The draft FIL has not taken a position on what actions shall be taken with respect to the existing companies with a VIE structure and MOFCOM is soliciting comments from the public on this point. Moreover, it is uncertain whether the industry in which our variable interest entities operate will be subject to the foreign investment restrictions or prohibitions set forth in the “catalogue of special administrative measures” to be issued. We cannot assure you that the Foreign Investment Law and the final “catalogue of special administrative measures,” if enacted, will not mandate further actions to be completed by companies with an existing VIE structure like us or that we will be able to comply with such requirements within reasonable time, on commercially acceptable terms, or at all.

 

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The draft FIL, if enacted as proposed, may also materially impact our corporate governance practices and increase our compliance costs. For instance, the draft FIL imposes stringent ad hoc and periodic information reporting requirements on foreign investors and the applicable FIEs. Aside from an investment information report required at each investment, and investment amendment reports, which shall be submitted upon changes to investments, it is mandatory for entities established by foreign investors to submit an annual report, and large foreign investors meeting certain criteria are required to report on a quarterly basis. Any company found to be non-compliant with these 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.

 

Our existing contractual arrangements with our consolidated affiliated entities and their shareholders may be subject to national security review by MOFCOM, and the failure to pass the national security review could have a material adverse effect on our business, results of operations and reputation.

 

In August 2011, the Ministry of Commerce, or MOFCOM, promulgated the Rules of Ministry of Commerce on Implementation of Security Review System of Merger and Acquisition of Domestic Enterprises by Foreign Investors, or the MOFCOM Security Review Rules, to implement the Notice of the General Office of the State Council on Establishing the Security Review System for Merger and Acquisition of Domestic Enterprises by Foreign Investors promulgated on February 3, 2011, or Circular 6. The MOFCOM Security Review Rules became effective on September 1, 2011. Under the MOFCOM Security Review Rules, a national security review is required for certain mergers and acquisitions by foreign investors raising concerns regarding national defense and security. Foreign investors are prohibited from circumventing the national security review requirements by structuring transactions through proxies, trusts, indirect investments, leases, loans, control through contractual arrangements or offshore transactions. The application and interpretation of the MOFCOM Security Review Rules remain unclear.  If MOFCOM or other PRC regulatory agency subsequently determines that we need to submit our existing contractual arrangements with our affiliated PRC entity and its shareholders for national security review by interpretation, clarification or amendment of the MOFCOM Security Review Rules or by any new rules, regulations or directives promulgated after the date of this report, we may face sanctions by MOFCOM or other PRC regulatory agency. These sanctions may include revoking the business or operating licenses of our PRC subsidiaries or our consolidated affiliated entities and its subsidiaries, discontinuing or restricting our operations in China, confiscating our income or the income of our PRC subsidiaries or our consolidated affiliated entities, requiring us to undergo a costly and disruptive restructuring such as forcing us to transfer our equity interest in our PRC subsidiaries to a domestic entity or invalidating the agreements that our PRC subsidiaries have entered into with our consolidated affiliated entities and their respective shareholders, and taking other regulatory or enforcement actions that could be harmful to our business. Any of these sanctions could cause significant disruption to our business operations, including rendering us unable to access cash and other assets of, exercise our ownership rights in and consolidate the results of operations of our affiliated entities in China, which would have a material adverse effect on our business, results of operations and reputation.

 

We rely on contractual arrangements with our consolidated affiliated entities in China and their shareholders for our operations, which may not be as effective as direct ownership in providing operational control.

 

Since PRC laws restrict foreign equity ownership in companies engaged in online video and advertising businesses in China, we rely on contractual arrangements with our consolidated affiliated entities and their respective shareholders to operate our business in China. If we had direct ownership of Ku6 Information Technology, Tianjin Ku6 Zheng Yuan, Ku6 Cultural and Tianjin Ku6 Network, we would be able to: (i) exercise our rights as a shareholder to effect changes in the board of directors of these entities, which in turn could effect changes at the management level, subject to any applicable fiduciary obligations, and (ii) derive economic benefits from the operations of these entities by causing them to declare and pay dividends. However, under the current contractual arrangements, we rely on our consolidated affiliated entities and their respective shareholders’ performance of their contractual obligations to exercise effective control. In general, neither our consolidated affiliated entities nor their respective shareholders may terminate the contracts prior to the expiration date. However, the shareholders of Ku6 Information Technology, Tianjin Ku6 Zheng Yuan, Ku6 Cultural or Tianjin Ku6 Network may not act in the best interests of our company or may not perform their obligations under these contracts, including the obligation to renew these contracts when their initial terms expire. Such risks exist throughout the period in which we intend to operate our business through the contractual arrangements with our consolidated affiliated entities. However, if any dispute relating to these contracts remains unresolved, we will have to enforce our rights under these contracts through the operations of PRC law and courts and therefore will be subject to uncertainties in the PRC legal system. See “—Any failure by our consolidated affiliated entities or their respective shareholders to perform their obligations under our contractual arrangements with them may have a material adverse effect on our business” below. Therefore, these contractual arrangements may not be as effective as direct ownership in providing us with control over these consolidated affiliated entities.

 

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Any failure by our consolidated affiliated entities or their respective shareholders to perform their obligations under our contractual arrangements with them may have a material adverse effect on our business.

 

Our consolidated affiliated entities and their respective shareholders may fail to take certain actions required for our business or follow our instructions despite their contractual obligations to do so. If they fail to perform their obligations under their respective agreements with us, we may have to rely on legal remedies under PRC law, including seeking specific performance or injunctive relief, which may not be effective.

 

All of our contractual arrangements with them are governed by PRC law and provide for the resolution of disputes through arbitration 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 environment in China is not as developed as in certain other jurisdictions, such as the United States. As a result, uncertainties in the PRC legal system could limit our ability to enforce these contractual arrangements, which may make it difficult to exert effective control over our consolidated affiliated entities, and our ability to conduct our business may be adversely affected.

 

Contractual arrangements with our consolidated affiliated entities may result in adverse tax consequences to us.

 

Under applicable PRC tax laws and regulations, arrangements and transactions among related parties may be subject to audit or scrutiny by the PRC tax authorities within ten years after the taxable year when the arrangements or transactions are conducted. We could face material and adverse tax consequences if the PRC tax authorities were to determine that the contractual arrangements among our PRC subsidiaries, our consolidated affiliated entities in China and their respective shareholders were not entered into on an arm’s-length basis and therefore constituted unfavorable transfer pricing arrangements. Unfavorable transfer pricing arrangements could, among other things, result in an upward adjustment to our tax liability. In addition, the PRC tax authorities may impose interest on late payments on our consolidated affiliated entities for the adjusted but unpaid taxes. Our results of operations may be materially and adversely affected if our consolidated affiliated entities’ tax liabilities increase significantly or if they are required to pay interest on late payments.

 

On March 18, 2015, the State Administration of Taxation promulgated the Announcement of the State Administration of Taxation on Issues Relating to Enterprise Income Tax on Expenses Paid by an Enterprise to its Overseas Affiliated Party, or Circular 16, which took effect as of the date of promulgation. Under Circular 16, any expense paid by an enterprise to its overseas affiliated party shall be in compliance with the “arm’s length principle.” Otherwise, the PRC tax authorities may adjust our tax liability in a manner that is unfavorable to us.

 

According to Circular 16, any expense paid by an enterprise to its overseas affiliated party, which fails to perform functions, bear risks or conduct substantial business activities, shall not be deducted in calculating corporate income tax. When an enterprise pays expenses to its overseas affiliated party for the services rendered thereby, such services shall help the enterprise gain directly or indirectly economic interests. The expenses paid by an enterprise to its overseas affiliated party for the following services shall not be deducted in calculating corporate income tax: (i) services irrelevant to the risks that the enterprise bears or businesses that the enterprise carries out, (ii) services such as control, management and supervision conducted by the affiliated party over the enterprise for the purpose of protecting the nterests of direct or indirect investors in the enterprise, (iii) services rendered by the affiliated party that the enterprise has purchased or carried out by itself, (iv) specific services carried out by the affiliated party within the group specially for the enterprise, although the enterprise has gained extraneous earnings due to the affiliation to a group, (v) services that have been compensated in other affiliated transactions; and (vi) other services that cannot bring about direct or indirect economic interests to the enterprise. When an enterprise needs to pay royalties to its overseas affiliated party for using an intangible asset provided thereby, it shall determine the economic interests to which each affiliated party is entitled by taking into account the degree of contribution made by each affiliated party to the value of the intangible asset. If the royalties paid by the enterprise to the affiliated party, which only owns the legal ownership of the intangible asset but does not contribute to the value thereof, are not in compliance with the arm’s length principle, such royalties shall not be deducted in computing the corporate income tax payable by the enterprise. Where an enterprise establishes an overseas holding company or financing company for the purpose of financing for going public, the royalties paid to its overseas affiliated party for the carried interests generated from the activities of financing for going public, shall not be deducted in calculating corporate income tax.

 

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We are a holding company incorporated outside of the PRC and any potential income would be based on the dividends, service fees, royalties or other distributions from our PRC subsidiaries and our consolidated affiliated entities. We may need to rely on our PRC subsidiaries and our consolidated affiliated entities to fund our cash and financing requirements through certain of the transactions described in Circular 16. Therefore, Circular 16 may significantly increase our tax liability if we decide to carry on any of such transactions in the future.

 

The shareholders of our consolidated affiliated entities may have potential conflicts of interest with us, which may materially and adversely affect our business.

 

We conduct substantially all of our operations, and generate substantially all of our revenues, through our consolidated affiliated entities. Our control over these entities is based upon contractual arrangements with our consolidated affiliated entities and their shareholders that provide us with the substantial ability to control these entities. We provide no incentives to any of the shareholders of our consolidated affiliated entities for the purpose of encouraging them to act in the best interest of our company in such capacity. These shareholders may breach their contractual arrangements, or cause our consolidated affiliated entities to breach their contractual arrangements, with us or cause these contracts to be amended in a manner contrary to the interest of our company, if they believe such action furthers their own interest, or if they otherwise act in bad faith. We cannot assure you that, when conflicts arise, these shareholders will act in the best interest of our company or that conflicts will be resolved in our favor. If we cannot resolve any conflicts of interest or disputes between us and any of these shareholders, we would have to rely on legal proceedings, which may be expensive, time-consuming and disruptive to our operations. There is also substantial uncertainty as to the outcome of any such legal proceedings.

 

We rely on our PRC subsidiaries and our consolidated affiliated entities to fund our cash and financing requirements. Any limitation on the ability of our PRC subsidiaries and our consolidated affiliated entities to transfer funds to us could have a material adverse effect on our ability to grow or otherwise fund our cash and financing requirements.

 

We are a holding company and our operations are principally conducted through our PRC subsidiaries and our consolidated affiliated entities. As a result, the ability of our company to pay dividends and to finance debts depends upon the service fees and license fees paid by our consolidated affiliated entities to our PRC subsidiaries and dividends and other distributions paid by our PRC subsidiaries to our company. If any of our subsidiaries or consolidated affiliated entities incurs debt on its own behalf, the instruments governing the debt may restrict its ability to pay service fees or dividends directly or indirectly to our company.

 

Under PRC laws and regulations, our PRC subsidiaries and our consolidated affiliated entities may pay dividends only out of their retained earnings as determined in accordance with PRC accounting standards and regulations. There is no significant difference between retained earnings as determined in accordance with PRC accounting standards and in accordance with U.S. GAAP. In addition, our PRC subsidiaries and our consolidated affiliated entities are required to set aside at least 10% of their after-tax net income each year, if any, to fund certain statutory reserves, which are not distributable as cash dividends, until the aggregate amount of such funds reaches 50% of their respective registered capital. As of December 31, 2014, the registered capital was $11.7 million for Beijing WFOE, $60.0 million for Tianjin WFOE and $45.2 million for Tianjin Ku6 Network WFOE, respectively. As none of our PRC subsidiaries has made any profits to date, our PRC subsidiaries have not been subject to the statutory reserve fund requirements and have not set aside any money to fund the statutory reserve funds or staff welfare and bonus funds. Our PRC subsidiaries will not be able to pay dividends to us or our offshore subsidiaries until they generate accumulated profits and meet the requirements for statutory reserve funds. As a result of these and other restrictions under PRC laws and regulations, our PRC subsidiaries and consolidated affiliated entities are restricted in their ability to transfer a portion of their net assets to our company either in the form of dividends, loans or advances, which restricted portion amounted to approximately $30.9 million as of December 31, 2014. In addition, our PRC subsidiaries and our consolidated affiliated entities may, at their discretion, allocate a portion of their after-tax profits based on PRC accounting standards to staff welfare and bonus funds. These staff welfare and bonus funds are not distributable as cash dividends.

 

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Any limitation on the ability of our PRC subsidiaries to pay dividends or make other distributions to us could materially and adversely limit our ability to grow, make investments or acquisitions that could be beneficial to our business, pay dividends, or otherwise fund and conduct our business.

 

We may be unable to collect long-term loans extended to the shareholders of our consolidated affiliated entities.

 

As of December 31, 2014, we had outstanding long-term, interest-free loans in an aggregate principal amount of RMB31.0 million ($5.0 million) to the shareholders of our consolidated affiliated entities to enable them to fund the initial capitalization and the subsequent financial requirements of our consolidated affiliated entities. Each of the loans to the shareholders of Ku6 Information Technology and Ku6 Cultural has an unspecified term and will be repayable upon demand. Each of the loans to the shareholders of Tianjin Ku6 Network has an initial term of 20 years expiring in December 2031, which can be extended upon written agreement. We may in the future make additional loans to the shareholders of our consolidated affiliated entities in China in connection with any increase in the capitalization or financial requirements of these entities to the extent necessary and permissible under applicable PRC laws and regulations. Our ability to collect these long-term loans will depend on the profitability and results of operations of these consolidated affiliated entities, which are uncertain.

 

The PRC Property Rights Law may affect the perfection of the pledge in our equity pledge agreements with our consolidated affiliated entities and their individual shareholders.

 

Under the equity pledge agreements among our PRC subsidiaries, certain of our consolidated affiliated entities and the shareholders of our consolidated affiliated entities, the shareholders of our consolidated affiliated entities have pledged all of their equity interests in these entities to our relevant subsidiaries by recording the pledge on the shareholder registers of the respective entities. According to the PRC Property Rights Law, a pledge is not valid unless it is registered with the relevant local administration for industry and commerce. The SAIC and its local branches have adopted registration procedures with respect to the registration of equity pledges according to the Property Rights Law. All of our consolidated affiliated entities have completed their registration of the applicable equity pledges under the PRC Property Rights Law and the registration procedures. However, our corporate structure may change from time to time, and the various equity pledge agreements may need to be frequently amended. For example, the shareholders of Ku6 Culture and Ku6 Information Technology changed in August 2012, which required us to amend the registered equity pledges. We completed both amendments in 2012. We cannot assure you, however, that our consolidated affiliated entities will be able to register the equity pledges or their amendments in the future. If they are unable to do so, the pledges may be unenforceable under the PRC Property Rights Law. Until such pledge interests are registered, they are not considered perfected under the PRC law. Consequently, if any individual shareholder of our consolidated affiliated entities breaches his or her obligations under the contractual arrangements with respect to these entities while the relevant equity pledges are not registered, there is a risk that our PRC subsidiaries may not be able to successfully enforce the equity pledges and would need to resort to legal proceedings to enforce their contractual rights.

 

Our major shareholders will have substantial influence on the outcome of shareholder actions in our company that might not be beneficial to you as a holder of our ADSs.

 

As of March 31, 2015, Mr. Xu and Shanda Interactive beneficially held1,938,360,784 and 1,396,333,818 ordinary shares, respectively, representing 40.7% and 29.3%, respectively, of the voting power in our company.  Such ownership interest of Mr. Xu and Shanda Interactive gives them substantial influence on actions that require shareholder approval under Cayman Islands law, our memorandum and articles of association, or the NASDAQ listing requirements, including the election and removal of members of our board of directors, mergers, consolidations and other business combinations, changes to our memorandum and articles of association, the number of shares available for issuance under equity incentive plans and the issuance of significant amounts of our ordinary shares in private placements. Under the share purchase agreement relating to the Share Purchase Transaction, Mr. Xu has agreed to use his best efforts and take necessary actions to appoint two persons nominated by Shanda Media, an entity controlled by Shanda Interactive, as our directors, subject to certain conditions. Mr. Xu and Shanda Interactive may also approve a merger or consolidation of our company which may result in you receiving a stake (either in the form of shares, debt obligations or other securities) in the surviving or new consolidated company which may not operate our current business model and dissenter rights may not be available to you in such an event. Under the share purchase agreement relating to the Share Purchase Transaction, Shanda Media has agreed that if we propose to acquire Sky Profit Limited and such transaction is recommended to the shareholders for approval by our board of directors and any special committee of disinterested directors, Shanda Media shall vote all its shares in line with such recommendation. Sky Profit Limited controls Qinhe, which operates iSpeak, a social platform that allows users to engage in real-time online group activities through voice, text and video. Shanda Media also has a right under this share purchase agreement to subscribe to equity or equity-linked securities issued by affiliates of Mr. Xu for an amount up to $25,000,000 that is equal to, or convertible into, 20% of Sky Profit Limited on a fully diluted basis. This right is not available to holders of our other ADSs. Furthermore, the voting powers of Mr. Xu and Shanda Interactive may also prevent a transaction involving a change of control of us, including transactions in which you as a holder of our ADSs might otherwise receive a premium for your securities over the then-current market price.

 

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We may have conflicts of interest with our major shareholders or their respective affiliates, and we may not be able to resolve such conflicts on terms favorable to us.

 

As of March 31, 2015, Mr. Xu and Shanda Interactive beneficially held 1,938,360,784 and 1,396,333,818ordinary shares, respectively, representing 40.7% and 29.3%, respectively, of the voting power in our company. Conflicts of interest may arise between Mr. Xu or Shanda Interactive and us in a number of areas relating to our past and ongoing relationships. In addition to the conflicts of interests we have discussed in other risk factors, potential conflicts of interest that we have identified include the following:

 

·                  Our board members or executive officers may have conflicts of interest. Mr. Xu currently serves as the chairman of our board of directors, chief executive officer and acting chief financial officer. Mr. Robert Chiu, who is our director, also serves as president of Shanda Interactive. Mr. Haifa Zhu, who is our director, also serves as chief investment officer and senior vice president of Shanda Interactive. These relationships could create perceived or actual conflicts of interest when these persons are faced with decisions with potentially different implications for Shanda Interactive and us.

 

·                  Agreements with Mr. Xu and its affiliates. The various agreements that we entered into with Qinhe, a company controlled by Mr. Xu, including the interactive entertainment marketing cooperation agreement and the game marketing cooperation agreement, may be less favorable to us than would be the case if they were negotiated with third parties. Moreover, Mr. Xu may leverage his substantial influence over us to prevent us from bringing a legal claim against him or his affiliates in the event of a contractual breach, notwithstanding our contractual rights under the agreements and any other agreement we may enter into with Mr. Xu and his affiliates from time to time.

 

·                  Business opportunities. Business opportunities may arise that we, Mr. Xu and Shanda Interactive find attractive, and which would complement our respective businesses. Due to the substantial influence of Mr. Xu and Shanda Interactive, we may not be able to pursue these business opportunities effectively if Mr. Xu or Shanda Interactive decides to take advantage of such opportunities.

 

We may not be able to resolve any potential conflicts, and even if we do so, the resolution may be less favorable to us than if we were dealing with an unaffiliated shareholder. Even if all of the parties seek to transact business on terms intended to approximate those that could have been achieved among unaffiliated parties, this may not succeed in practice.

 

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Risks Related to Doing Business in China

 

Substantially all of our assets are located in China and substantially all of our revenues are derived from our operations in China. Accordingly, our business, financial condition, results of operations and prospects are subject, to a significant extent, to economic, political and legal conditions and developments in China.

 

The PRC legal system embodies uncertainties which could limit the legal protections available to you and could also adversely affect our ability to operate our business.

 

The PRC legal system is a civil law system based on written statutes. Unlike common law systems, it is a system in which decided legal cases have little precedential value. Although legislation in China over the past 20 years has significantly improved the protection afforded to various forms of foreign investment and contractual arrangements in China, these laws, regulations and legal requirements are relatively new and their interpretation and enforcement involve uncertainties, which could limit the legal protection available to us, and foreign investors, including you. In addition, the PRC government may enact new laws or amend current laws that may be detrimental to our current contractual arrangements with respect to our consolidated affiliated entities, which may in turn have a material adverse effect on our ability to operate our business.

 

PRC regulations relating to the establishment of offshore special purpose vehicles, or SPVs, 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.

 

On July 4, 2014, the PRC State Administration of Foreign Exchange, or the 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 SAFE Circular 37, which replaced the former circular commonly known as “SAFE Circular 75” promulgated by SAFE in October 2005. SAFE 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 assets or equity interests of onshore companies or offshore assets or interests held by the PRC residents, referred to in SAFE Circular 37 as a “special purpose vehicle.” SAFE Circular 37 further requires amendment to the registration in the event of any significant changes with respect to the special purpose vehicle, such as increases or decreases in capital contributed by PRC residents, transfers or exchanges of shares, mergers, divisions, or other material changes. The term “control” under SAFE Circular 37 is broadly defined as the operation rights, beneficiary rights or decision-making rights acquired by the PRC residents in special purpose vehicles or PRC companies by such means as acquisition, trust, proxy, voting rights, repurchase, convertible bonds or other arrangements.

 

If our shareholders or beneficial owners who are PRC citizens or residents do not complete their registration under Circular 37, our PRC subsidiaries may be prohibited from distributing their profits and proceeds from any reduction in capital, share transfer or liquidation to us, and we may be restricted in our ability to contribute additional capital to our PRC subsidiaries. As a result, our business operations and our ability to make distributions to you may be materially and adversely affected. Moreover, failure to comply with the various SAFE registration requirements described above may result in liabilities for our PRC subsidiaries under PRC laws for evasion of applicable foreign exchange restrictions.

 

It is unclear how SAFE Circular 37 and any future regulation concerning offshore or cross-border transactions will be interpreted, amended and implemented by the relevant government authorities. We cannot predict how these regulations will affect our business operations or future strategy. We may be subject to a more stringent review and approval process with respect to our foreign exchange activities, such as remittance of dividends and foreign-currency-denominated borrowings, which may adversely affect our financial condition and results of operations.

 

PRC regulation of loans to, and direct investment in, PRC entities by offshore holding companies and governmental control of currency conversion may limit our ability to make loans or additional capital contributions to our PRC subsidiaries and consolidated affiliated entitie.

 

As the offshore holding company of our PRC subsidiaries, we have historically financed, and may continue to finance, our PRC subsidiaries by extending loans or making additional capital contributions to them. Any loans to our PRC subsidiaries are subject to PRC regulations. For example, loans by us to finance the operations of any PRC subsidiary which is a foreign-invested enterprise may not exceed statutory limits and are required to be registered with SAFE. We may also need to increase the registered capital of our PRC subsidiaries or finance them through capital contributions. Such changes and capital contributions must be approved by MOFCOM or its local branches.

 

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In August 2008, SAFE promulgated the Circular on the Relevant Operating Issues Concerning the Improvement of the Administration of the Payment and Settlement of Foreign Currency Capital of Foreign Invested Enterprises, or Circular 142, regulating the conversion by a foreign-invested enterprise of foreign currency registered capital into Renminbi by restricting how the converted Renminbi may be used. Circular 142 provides that the Renminbi capital converted from foreign currency registered capital of a foreign-invested enterprise may only be used for purposes within the business scope approved by the applicable governmental authority and may not be used for equity investments within China, unless it is provided for otherwise. In addition, SAFE strengthened its oversight of the flow and use of the Renminbi capital converted from foreign currency registered capital of a foreign-invested company. The use of such Renminbi capital may not be altered without SAFE approval, and such Renminbi capital may not in any case be used to repay Renminbi loans if the proceeds of such loans have not been used. Furthermore, SAFE also promulgated the Notice regarding Further Clarification and Regulation of the Administration of Certain Capital Account Transactions, or Circular 45, in November 2011. Circular 45 restricts, among other things, a foreign-invested enterprise from using Renminbi converted from its registered capital to provide entrusted loans or repay loans between non-financial enterprises.

 

In July 2014, SAFE issued the Circular on the Relevant Issues Concerning the Launch of Reforming Trial of the Administration Model of the Settlement of Foreign Currency Capital of Foreign-Invested Enterprises in Certain Regions, or Circular 36. Circular 36 suspends the application of Circular 142 in certain regions and allows a foreign-invested enterprise registered in these regions with equity investments as main business to use the Renminbi capital converted from foreign currency registered capital for equity investments within the PRC. On March 30, 2015, SAFE issued the Circular on the Reforming of the Management Method of the Settlement of Foreign Currency Capital of Foreign-Invested Enterprises, or Circular 19, which will become effective on June 1, 2015. Under Circular 19, a foreign-invested enterprise may also choose converting its registered capital from foreign currency to Renminbi on self-discretionary basis, but shall not use such converted registered capital to provide entrusted loans or repay loans between non-financial enterprises. A foreign-invested enterprise with equity investments as main business can use the Renminbi capital converted for equity investments within the PRC. Once Circular 19 becomes effective, Circular 142 and Circular 36 will be abolished.

 

In light of the various requirements imposed by PRC regulations on loans to and direct investment in PRC entities by offshore holding companies, including SAFE circulars referred to above, we cannot assure you that we will be able to complete the necessary government registrations or obtain the necessary government approvals on a timely basis, if at all, with respect to future loans or capital contributions by us to our PRC subsidiaries and conversion of such loans or capital contributions into Renminbi. If we fail to complete such registrations or obtain such approvals, our ability to capitalize or otherwise fund our PRC operations may be negatively affected, which could adversely affect our ability to fund and expand our business.

 

Any failure to comply with PRC regulations regarding our employee equity incentive plans may subject the PRC plan participants or us to fines and other legal or administrative sanctions.

 

On February 15, 2012, SAFE issued the Notices on Issues concerning the Foreign Exchange Administration for Domestic Individuals Participating in Stock Incentive Plan of Overseas Publicly-Listed Company, or Circular 7, which replaced the Operating Procedures for Administration of Domestic Individuals Participating in the Employee Stock Ownership Plan or Stock Option Plan of an Overseas Listed Company issued by SAFE on March 28, 2007. According to Circular 7, domestic individuals, which include PRC residents and non-PRC residents who reside in China for a continuous period of not less than one year other than foreign diplomatic personnel and representatives of international organizations, are required to register with SAFE and complete certain other procedures if such individuals participate in an employee stock ownership plan or a stock option plan in a publicly listed overseas company. These participants should retain a PRC agent, which can be a subsidiary of the overseas listed company in China, to handle various foreign exchange matters associated with these plans. They must also retain an overseas entrusted institution to handle matters in connection with their exercise of stock options and their purchase and sale of stocks. The PRC agent of a PRC domestic individual participant must apply for the approval of an annual allowance if such participant needs to use funds in China in connection with the stock incentive plan. The PRC agent is also required to submit a filing form with respect to the stock incentive plan at the beginning of each quarter. The foreign exchange proceeds received by the PRC domestic individual participants from the sale of shares under the stock option plans granted by the overseas listed companies must be remitted into the bank accounts in China opened by their employers or PRC agents. We and our PRC domestic individual employees who have been granted share options will be subject to these rules. While we have completed the required registration of our 2010 Equity Compensation Plan, or the 2010 Plan, with the Tianjin Branch of SAFE in November 2012, we cannot assure you that all future participants will register with SAFE in a timely manner, or at all. Any failure to comply with such regulations may subject us and the participants of our equity compensation plans who are PRC citizens to fines and legal sanctions and prevent us from being able to grant equity compensation to our personnel which is currently a significant component of the compensation of many of our PRC employees, as a result of which our business operations may be adversely affected.

 

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In addition, the State Administration for Taxation has issued circulars concerning employee share options or restricted shares. Under these circulars, employees working in the PRC who exercise share options (i.e. our existing equity compensation plans), or whose restricted shares vest, will be subject to PRC individual income tax. The PRC subsidiaries of an overseas listed company have obligations to file documents related to employee share options or restricted shares with relevant tax authorities and to withhold individual income taxes of those employees related to their share options or restricted shares. Although we currently withhold income tax from our PRC employees in connection with their exercise of options and the vesting of their restricted shares, if the employees fail to pay, or the PRC subsidiaries fail to withhold, their income taxes according to relevant laws, rules and regulations, the PRC subsidiaries may face sanctions imposed by the tax authorities or other PRC government authorities.

 

The PRC tax authorities’ enhanced scrutiny of PRC enterprise income tax on offshore equity transfers may have a negative impact on your investment in our ADSs.

 

In December 2009, the State Administration of Taxation issued the Notice Concerning the Strengthening of Enterprise Income Tax Administration with Respect to Equity Transfers by Non-Resident Enterprises, or Circular 698, which became effective retroactively as of January 1, 2008. By promulgating Circular 698, the PRC tax authorities have enhanced their scrutiny over the direct or indirect transfer of equity interests in a PRC resident enterprise by a non-PRC resident enterprise. Circular 698 has the effect of taxing foreign companies on gains derived from the indirect sale of a PRC company. Where a foreign investor indirectly transfers equity interests in a PRC resident enterprise by selling the shares in an offshore holding company, and the latter is located in a country or jurisdiction that has an effective tax rate less than 12.5% or does not tax foreign income of its residents, the foreign investor must report this indirect transfer to the tax authority in charge of that PRC resident enterprise. Using a “substance over form” principle, the PRC tax authority may disregard the existence of the overseas holding company if it lacks a reasonable commercial purpose and was established for the purpose of avoiding PRC tax. As a result, gains derived from such indirect transfer may be subject to PRC withholding tax at a rate of up to 10%.

 

The State Administration of Taxation subsequently released public notices to clarify issues relating to Circular 698, including the Announcement on Several Issues Concerning the Enterprise Income Tax on the Indirect Transfers of Properties by Non-Resident Enterprises, or SAT Notice 7, which became effective on February 3, 2015. SAT Notice 7 abolished the compulsory reporting obligations originally set out in Circular 698. Under SAT Notice 7, if a non-resident enterprise transfers its shares in an overseas holding company that directly or indirectly owns PRC taxable properties, including shares in a PRC company, via an arrangement without reasonable commercial purpose, such transfer shall be deemed a direct transfer of the underlying PRC taxable properties. Accordingly, the transferee shall be deemed a withholding agent with the obligation to withhold and remit the income tax to the competent PRC tax authorities. SAT Notice 7 also establishes safe harbors for the “reasonable commercial purpose” test.

 

There is limited guidance and practical experience regarding the application of Circular 698 and the related SAT notices. We, our non-PRC resident enterprise subsidiaries and our PRC subsidiaries may be subject to these regulations for our previous and future restructuring or disposal of shares in our offshore subsidiaries, in which case we may have disputes with tax authorities and need to incur expenses to establish that we are not subject to these regulations, or otherwise may be subject to additional tax liabilities. If this happens, it may have a negative impact on our business operations.

 

We may be deemed a PRC resident enterprise under the EIT Law and be subject to PRC taxation on our worldwide income.

 

The PRC Enterprise Income Tax Law, or the EIT Law, includes a provision specifying that legal entities organized outside China will be considered residents for PRC income tax purposes if their place of effective management or control is within China. If legal entities organized outside China were considered residents for PRC income tax purposes, they would be subject to the 25% enterprise income tax imposed by the EIT Law on their worldwide income. The implementation rules to the EIT Law provide that non-resident legal entities will be considered China residents if substantial and overall management and control over the manufacturing and business operations, personnel, accounting, properties, etc. reside within China. Although substantially all of our operational management is currently based in China, it is uncertain whether our company and our offshore intermediate holding company would be deemed as PRC tax resident enterprises under the EIT Law and other related PRC laws and regulations. If our company and our offshore intermediate holding company were deemed as PRC tax resident enterprises and have earned income other than dividends from our PRC subsidiaries, a 25% enterprise income tax on our global income could increase our tax burden and negatively affect our financial condition and results of operations.

 

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Dividends that we receive from our PRC subsidiaries are subject to PRC withholding tax.

 

In accordance with the EIT Law and its implementation rules, dividends which arise from profits of foreign invested enterprises earned after January 1, 2008 are subject to a 10% withholding tax. As of December 31, 2014, our PRC subsidiaries had no undistributed earnings available for distribution. In addition, our company does not have any present plan to pay any cash dividends on our ordinary shares in the foreseeable future and we intend to retain most of our available funds and any future earnings for use in the operation and expansion of our business in China.  Accordingly, no provision has been made for the PRC dividend withholding taxes that would be payable upon distributions of dividends by our PRC subsidiaries to us. Any future dividends that our company receives from our PRC subsidiaries will be subject to PRC withholding tax.

 

The enforcement of the PRC labor contract law may materially increase our costs and our net loss.

 

The PRC National People’s Congress promulgated the Labor Contract Law and its implementation rules, both of which became effective on January 1, 2008. Compared to previous labor laws, the Labor Contract Law and its implementation rules provides stronger protection for employees and imposes more stringent obligations on employers with regard to, among others, minimum wages, severance payments upon permitted termination of employment by an employer and non-fixed term employment contracts, time limits for probation period as well as the duration and the times that an employee can be placed on a fixed-term employment contract.  Compliance with the Labor Contract Law and its implementation rules may increase our operating expenses, in particular our personnel expenses. In the event that we decide to terminate some of our employees or otherwise change our employment or labor practices, the Labor Contract Law and its implementation rules may also limit our ability to effect those changes in a manner that we believe to be cost-effective or desirable, and could result in a material decrease in our profitability.

 

In addition, pursuant to the Labor Contract Law and its amendments, dispatched employees are intended to be a supplementary form of employment, and the fundamental form should be direct employment by enterprises and organizations that require employees. Further, it is expressly stated in the Interim Provisions on Labor Dispatch, which became effective on March 1, 2014, that the number of dispatched employees and employer uses may not exceed 10% of its total labor force and the employer has a two-year transition period to comply with such requirement. A significant number of our employees are contracted through third-party human resources companies that are responsible for managing, among others, payrolls, social insurance contributions and local residency permits of these employees. We may be held jointly liable if such human resources companies fail to pay such employees their wages and other benefits or otherwise become liable to these employees for labor law violations. As the interpretation and implementation of labor-related laws and regulations are still evolving, we cannot assure you that our employment practice does not and will not violate labor-related laws and regulations in China, which may subject us to labor disputes or government investigations. If we are deemed to have violated relevant labor laws and regulations, we may be required to provide additional compensation to our employees and our business, financial condition and results of operations may be materially and adversely affected.

 

Restrictions on currency exchange may limit our ability to utilize our revenues effectively.

 

Substantially all of our revenues and operating expenses are denominated in Renminbi. The PRC government imposes controls on currency conversion between Renminbi and foreign currencies and, in certain cases, the remittance of currency out of and into China. Under existing PRC foreign exchange regulations, payments of current account items, including payment of dividends, interest payments and trade and service-related foreign exchange transactions, can be made in foreign currencies without prior SAFE approval by complying with certain procedural requirements. Our PRC subsidiaries may also retain foreign exchange in their current accounts, subject to a ceiling approved by SAFE, to satisfy foreign exchange liabilities or to pay dividends. In addition, approval of the appropriate governmental authorities is required if Renminbi is to be converted into foreign currency and remitted out of China to pay capital expenses such as the repayment of offshore bank loans denominated in foreign currencies. However, we cannot assure you that the relevant PRC governmental authorities will not limit or eliminate our ability to purchase and retain foreign currencies in the future. Under our current corporate structure, the income of our company will be primarily derived from dividend payments from our PRC subsidiaries. Shortages in the availability of foreign currency may restrict the ability of our PRC subsidiaries to remit sufficient foreign currency to pay dividends to us, or otherwise satisfy its foreign currency-dominated obligations.

 

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Our business, financial condition and results of operations could be materially and adversely affected by a severe and prolonged global economic downturn and a corresponding slowdown of the PRC economy.

 

Recent global market and economic conditions have been unprecedented and challenging and have caused persisting recession in most major economies in 2008 and 2009 and significant market volatility since 2010. Continued concerns about the systemic impact of a potentially long-term and widespread recession, energy costs, geopolitical issues and the availability and cost of credit have contributed to increased market volatility and diminished expectations for economic growth around the world. The difficult economic outlook has negatively affected business and consumer confidence and contributed to volatility at unprecedented levels. The PRC economy also faces challenges. In 2014, China’s gross domestic product expanded by only 7.4%, which was its slowest rate in the past 20 years and below the PRC government’s growth target. Since we derive substantially all of our revenues in China, any prolonged slowdown in the growth of the PRC economy could have a material adverse effect on our business, financial condition and results of operations. Disruptions of the financial markets could also significantly restrict our ability to obtain financing in the capital markets or from financial institutions.

 

Changes in China’s political and economic policies could harm our business.

 

The economy of China has historically been a planned economy subject to governmental plans and quotas and has, in certain aspects, been transitioning to a more market-oriented economy. Although we believe that the economic reform and the macroeconomic measures adopted by the PRC government have had a positive effect on the economic development of China, we cannot predict the future direction of these economic reforms or the effects these measures may have on our business, financial position or results of operations. In addition, the PRC economy differs from the economies of most countries belonging to the Organization for Economic Cooperation and Development, or OECD. These differences include:

 

·                  economic structure;

 

·                  level of government involvement in the economy;

 

·                  level of development;

 

·                  level of capital reinvestment;

 

·                  control of foreign exchange;

 

·                  methods of allocating resources; and

 

·                  balance of payments position.

 

As a result of these differences, our business may not develop in the same way or at the same rate as might be expected if the PRC economy were similar to those of the OECD member countries.

 

Inflation in China and measures to contain inflation could negatively affect our profitability and growth.

 

While the PRC economy has experienced rapid growth, such growth has been uneven among various sectors of the economy and in different geographical areas of the country. Rapid economic growth can lead to growth in the money supply and rising inflation. If prices for our advertising services rise at a rate that is insufficient to compensate for the rise in our costs, our business may be materially and adversely affected. In order to control inflation in the past, the PRC government has imposed controls on bank credits, limits on loans for fixed assets and restrictions on state bank lending. Such austerity measures can lead to a slowing of economic growth. A slowdown in the PRC economy could also materially and adversely affect our business and prospects.

 

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Registered public accounting firms in China, including our independent registered public accounting firm, are not inspected by the U.S. Public Company Accounting Oversight Board, which deprives us and our investors of the benefits of such inspection.

 

Auditors of companies whose securities are registered with the U.S. Securities and Exchange Commission and traded publicly in the United States, including our independent registered public accounting firm, must be registered with the U.S. Public Company Accounting Oversight Board, or the PCAOB, and are required by the laws of the United States to undergo regular inspections by the PCAOB to assess their compliance with the laws of the United States and professional standards applicable to auditors. Our independent registered public accounting firm is located in, and organized under the laws of, the PRC, which is a jurisdiction where the PCAOB, notwithstanding the requirements of U.S. law, is currently unable to conduct inspections without the approval of the Chinese authorities. In May 2013, the PCAOB announced that it had entered into a Memorandum of Understanding on Enforcement Cooperation with the China Securities Regulatory Commission, or the CSRC, and the PRC Ministry of Finance, which establishes a cooperative framework between the parties for the production and exchange of audit documents relevant to investigations undertaken by the PCAOB, or the CSRC or the PRC Ministry of Finance, in the United States and the PRC, respectively. The PCAOB continues to discuss with the CSRC and the PRC 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.

 

This lack of PCAOB inspections in China prevents the PCAOB from fully evaluating audits and quality control procedures of our independent registered public accounting firm. As a result, we and investors in our ADSs are deprived of the benefits of such PCAOB inspections. The inability of the PCAOB to conduct inspections of auditors in China makes it more difficult to evaluate the effectiveness of our independent registered public accounting firm’s audit procedures or quality control procedures as compared to auditors outside of China that are subject to PCAOB inspections, which could cause investors and potential investors in our ADSs to lose confidence in our audits and reported financial information and the quality of our financial statements.

 

Any occurrence of pandemic avian influenza, Ebola or other widespread public health problem, or any recurrence of severe acute respiratory syndrome, or SARS, could adversely affect our business and results of operations.

 

An outbreak of pandemic avian influenza or other widespread public health problem, or a renewed outbreak of SARS in China, where most of our revenues are derived, and in Beijing, where our operations are headquartered, could have a negative effect on our operations. There have been recent reports of outbreaks of an avian flu caused by the H7N9 virus, including confirmed human cases, in China. In 2014, the outbreak of Ebola fever in West Africa received considerable worldwide media attention. Experts warn that China is at serious risk of Ebola because of the large numbers of travelers from Africa as well as poor hospital standards.

 

Our operations may be affected by a number of health-related factors, including the following:

 

·                  quarantines or closures of some of our offices which would severely disrupt our operations,

 

·                  the sickness or death of our key officers and employees, and

 

·                  a general slowdown in the PRC economy caused by any public health problems.

 

Any of the foregoing events or other unforeseen consequences of public health problems could adversely affect our business and results of operations.

 

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Risks Related to Our ADSs

 

If we fail to meet continued listing standards of NASDAQ, our ADSs may be delisted, which could have a material adverse effect on the liquidity of our ADSs.

 

Our ADSs are currently traded on the Nasdaq Global Market. The NASDAQ Stock Market LLC has requirements that a company must meet in order to remain listed on NASDAQ Global Market, including maintain a minimum bid price of $1.0 per share of our ADSs and a minimum $50.0 million market value of our company. If we fail to meet any continued listing requirement, our ADSs could be subject to delisting procedures. If our ADSs were to be delisted, the liquidity of our ADSs would be adversely affected and the market price of our ADSs could decrease. Recently, the bid price of our ADSs frequently fell below $1.0 per share and the total market value of our company frequently fell below $50.0 million. There can be no assurance that we will be able to continue to meet the minimum requirements for listing in the future or that, had we failed to do so, we will be able to regain compliance within the period prescribed by NASDAQ.

 

The price of our ADSs has been volatile historically and may continue to be volatile, which may make it difficult for holders to resell the ADSs when desired or at attractive prices.

 

The trading price of our ADSs has been and may continue to be subject to wide fluctuations. The sale price of our ADSs on the NASDAQ Global Market ranged from $0.99 to $3.84 per ADS in 2014 and the last reported sale price on April 17, 2015 was $1.05.

 

Our ADS price may fluctuate in response to a number of events and factors, including among other factors:

 

·                  announcements of technological or competitive developments;

 

·                  regulatory developments in our target markets affecting us, our customers or our competitors;

 

·                  announcements of share repurchase program;

 

·                  actual or anticipated fluctuations in our quarterly operating results;

 

·                  changes in financial estimates by securities research analysts;

 

·                  changes in the economic performance or market valuations of our website;

 

·                  addition or departure of our executive officers and key research personnel; and

 

·                  sales or perceived sales of additional ordinary shares or ADSs.

 

In addition, the financial markets in general, and the market prices for Internet-related companies in particular, have experienced extreme volatility that often has been unrelated to the operating performance of such companies. These broad market and industry fluctuations may adversely affect the price of our ADSs, regardless of our operating performance.

 

Future sales or perceived sales of substantial amounts of our ordinary shares or ADSs by our major shareholders could adversely affect the price of our ADSs.

 

If any of our major shareholders sells, or is perceived as intending to sell, substantial amounts of our ordinary shares or ADSs, including those issued upon the exercise of our outstanding stock options, the market price of our ADSs could fall. Such sales, or perceived potential sales, by any of our major shareholders might make it more difficult for us to issue new equity or equity-related securities in the future at a time and place we deem appropriate. If any of our major shareholders sells a substantial amount of ordinary shares it currently holds, the prevailing market price for our ADSs could be adversely affected.

 

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As a foreign private issuer with ADSs listed on the NASDAQ Global Market, we follow home country corporate governance practices instead of certain NASDAQ requirements.

 

As a foreign private issuer whose ADSs are listed on the NASDAQ Global Market, we are permitted to follow home country corporate governance practices instead of certain NASDAQ requirements. A foreign private issuer that elects to follow its home country practice must submit to the NASDAQ Stock Market LLC a written statement from an independent counsel in such issuer’s home country certifying that the issuer’s practices are not prohibited by the home country’s laws. In addition, a foreign private issuer must disclose in its annual reports filed with the SEC each NASDAQ requirement with which it does not comply followed by a description of its applicable home country practice.

 

As a company incorporated in the Cayman Islands with ADSs listed on the NASDAQ Global Market, we intend to follow our home country practice instead of NASDAQ requirements that mandate that:

 

·                  our board of directors be comprised of a majority of independent directors;

 

·                  our directors be selected or nominated by a majority of the independent directors or a nomination committee comprised solely of independent directors;

 

·                  our board adopt a formal written charter or board resolution addressing the director nominations process and such related matters as may be required under the U.S. federal securities laws;

 

·                  the compensation of our executive officers be determined or recommended by a majority of the independent directors or a compensation committee comprised solely of independent directors; and

 

·                  issuances of securities in connection with equity-based compensation of officers, directors, employees or consultants be approved by shareholders.

 

As we are a Cayman Islands company, our shareholders may face difficulties in protecting their interests, and our ability to protect our rights through the U.S. federal courts may be limited.

 

Our corporate affairs are governed by our memorandum and articles of association, by the Cayman Companies Law and the common law of the Cayman Islands. The rights of shareholders to take action against the directors, actions by minority shareholders, and the fiduciary responsibilities of our directors to us under Cayman Islands law are to a large extent governed by the common law of the Cayman Islands. The common law in the Cayman Islands is derived in part from comparatively limited judicial precedents in the Cayman Islands as well as from English common law, the decisions of whose courts are of persuasive authority but are not binding on a court in the Cayman Islands. The rights of our shareholders and the fiduciary responsibilities of our directors under Cayman Islands law in this area may not be as clearly established as they would be under statutes or judicial precedents in existence in some jurisdictions in the United States. In particular, the Cayman Islands has a less developed body of securities laws as compared to the United States, and some states, such as Delaware, have more developed and judicially interpreted bodies of corporate laws. Moreover, under the Cayman Companies Law, for mergers and consolidations involving two Cayman Islands companies or a Cayman Islands company and an overseas company, dissenting shareholders have the right to be paid the fair value of their shares (which, if not agreed to by the parties, will be determined by the Cayman Islands court) if they follow the required procedures, subject to certain exceptions, and such rights may not be comparable to the appraisal rights that would ordinarily be available to dissenting shareholders of a U.S. company. Finally, Cayman Islands companies may not have standing to initiate shareholder derivative actions before any federal court of the United States. As a result, our shareholders may have more difficulties in protecting their interests in the face of actions by our management, directors or major shareholders than would shareholders of a public company incorporated in a jurisdiction in the United States.

 

Our shareholders may have difficulties in enforcing judgments obtained against us.

 

We are a Cayman Islands company and substantially all of our assets are located outside of the United States. Substantially all of our current operations are conducted in China. In addition, most of our directors and officers are nationals and residents of countries other than the United States. A substantial portion of the assets of these persons are located outside the United States. As a result, it may be difficult for our shareholders to effect service of process within the United States upon these persons. It may also be difficult for our shareholders to enforce judgments obtained in U.S. courts based on the civil liability provisions of the U.S. federal securities laws against us and our officers and directors, most of whom are not residents in the United States and the substantial majority of whose assets are located outside of the United States.

 

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There is uncertainty as to whether the courts of the PRC would recognize or enforce judgments of U.S. courts against us or such persons predicated upon the civil liability provisions of the securities laws of the United States or any state due to the lack of reciprocal treaty in the PRC providing statutory recognition of judgments obtained in the United States. Furthermore, it is uncertain whether such PRC courts would be competent to hear original actions brought in the PRC against us or such persons who reside outside the United States predicated upon the securities laws of the United States or any state.

 

Although there is some uncertainty as to the enforcement in the Cayman Islands, in original actions or in actions for enforcement of judgments of United States courts, of liabilities predicated upon U.S. federal securities laws, a final and conclusive judgment in personam of a competent foreign court, including a competent United States court, against our company based upon the agreements under which a definite sum of money is payable other than a sum payable in respect of taxes or other charges of a like nature of a fine or other similar penalty, may be the subject of enforcement proceedings in the Grand Court of the Cayman Islands under the common law doctrine of obligation by action on the debt evidenced by the judgment of such competent foreign court. A final opinion as to the availability of this remedy should be sought when the facts surrounding the foreign court’s judgment are known, but, on general principles, it would be expected that such proceedings would be successful provided that (a) the court which gave the judgment was competent to hear the action in accordance with private international law principles as applied in the Cayman Islands and (b) the judgment is not contrary to public policy in Cayman Islands, has not been obtained by fraud or in proceedings contrary to natural justice and is not based on an error in Cayman Islands law.

 

Anti-takeover provisions in our organizational documents may discourage our acquisition by a third party, which could limit your opportunity to sell your shares at a premium.

 

Our memorandum and articles of association include provisions that could limit the ability of others to acquire control of us, modify our structure or cause us to engage in change of control transactions, including, among other things, provisions that authorize our board of directors, without action by our shareholders, to issue preferred shares and to issue additional ordinary shares, including ordinary shares represented by ADSs.

 

These provisions could have the effect of depriving you of an opportunity to sell your ADSs at a premium over prevailing market prices by discouraging third parties from seeking to acquire control of us in a tender offer or similar transactions.

 

The voting rights of holders of ADSs are limited by the terms of the deposit agreement.

 

A holder of our ADSs may only exercise the voting rights with respect to the underlying ordinary shares in accordance with the provisions of the deposit agreement. Upon receipt of voting instructions of a holder of ADSs in the manner set forth in the deposit agreement, the depositary will endeavor to vote the underlying ordinary shares in accordance with these instructions. Under our memorandum and articles of association and Cayman Islands law, the minimum notice period required for convening a general meeting is five days. When a general meeting is convened, you may not receive sufficient notice of a general meeting to permit you to withdraw your ordinary shares to allow you to cast your vote with respect to any specific matter. In addition, the depositary and its agents may not be able to send voting instructions to you or carry out your voting instructions in a timely manner. We will make all reasonable efforts to cause the depositary to extend voting rights to you in a timely manner, but we cannot assure you that you will receive the voting materials in time to ensure that you can instruct the depositary to vote your shares. Furthermore, the depositary and its agents will not be responsible for any failure to carry out any instructions to vote, for the manner in which any vote is cast, or for the effect of any such vote. As a result, you may not be able to exercise your right to vote and you may lack recourse if your ordinary shares are not voted as you requested.

 

We may be required to withhold PRC income tax on the dividends we pay you (if any), and any gain you realize on the transfer of our ordinary shares and ADSs may also be subject to PRC tax if we are treated as a PRC resident enterprise.

 

Pursuant to the EIT Law, we may be treated as a PRC resident enterprise for PRC tax purposes. See “—Risks Related to Doing Business in China—We may be deemed a PRC resident enterprise under the EIT Law and be subject to PRC taxation on our worldwide income” above. If we were so treated by the PRC tax authorities, we would be obligated to withhold PRC income tax on payments of dividends on our ordinary shares and ADSs to investors that are non-resident enterprises, provided that such dividends are deemed as China-sourced income. A non-resident enterprise is an enterprise that does not have an establishment or place of business in China or that has such establishment or place of business but its income is not effectively connected with the establishment or place of business. In addition, any gain realized by investors that are non-resident enterprises from the transfer of our ordinary shares or ADSs may be deemed as China-sourced income and generally be subject to PRC tax. Such dividends and gains to investors that are non-resident enterprises would generally be subject to a 10% PRC withholding tax, unless a reduced tax rate is provided by any applicable tax treaty and the holders have completed the relevant procedures prescribed by the PRC tax authorities to prove their beneficial owner status.

 

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Moreover, under the PRC Individual Income Tax Law, or the IITL, if we are treated as a PRC resident enterprise, non-resident individual investors would be subject to PRC individual income tax on dividends paid to such investors and any capital gains realized from the transfer of our ordinary shares and ADSs, provided that such dividends and gains are deemed as China-sourced income. A non-resident individual is an individual who has no domicile in China and does not stay within China or has stayed within China for less than one year. Pursuant to the IITL and its implementation rules, for purposes of the PRC capital gains tax, the taxable income will be based on the total income obtained from the transfer of our ordinary shares or ADSs after deducting all the costs and expenses that are permitted under PRC tax laws to be deducted from the income. If we were considered a PRC resident enterprise and dividends paid with respect to our ordinary shares and ADSs and the gains realized from the transfer of our ordinary shares and ADSs were considered China-sourced income by relevant PRC tax authorities, such dividends and gains earned by non-resident individuals would generally be subject to PRC tax at a rate of 20%, unless a reduced tax rate is provided by any applicable tax treaty and the holders have completed the relevant procedures prescribed by the PRC tax authorities to prove their beneficial owner status.

 

The foregoing PRC taxes may reduce your investment return on our ordinary shares and ADSs and may also affect the price of our ordinary shares and ADSs.

 

You may be subject to limitations on transfer of your ADSs.

 

Your ADSs are transferable on the books of the depositary. However, the depositary may close its books at any time or from time to time when it deems expedient in connection with the performance of its duties. The depositary may close its books for a number of reasons, including in connection with corporate events such as a rights offering, during which time the depositary needs to maintain an exact number of ADS holders on its books for a specified period. The depositary may refuse to deliver, transfer, or register transfers of our ADSs generally when our books or the books of the depositary are closed, or at any time if we or the depositary thinks it is advisable to do so because of any requirement of law, any government, governmental body or commission or the NASDAQ Global Market, or under any provision of the deposit agreement, or because of a meeting of shareholders of our company, or for any other reason.

 

Your right as a holder of ADSs to participate in any future rights offerings may be limited, which may cause dilution to your holdings.

 

We may from time to time distribute rights to our shareholders, including rights to acquire our securities. However, we cannot make rights available to our ADS holders in the United States unless we register the rights and the securities to which the rights relate under the Securities Act or an exemption from the registration requirements is available. In addition, the deposit agreement provides that the depositary bank will not make rights available to you unless the distribution to ADS holders of both the rights and any related securities are either registered under the Securities Act or exempted from registration under the Securities Act. We are under no obligation to file a registration statement with respect to any such rights or securities or to endeavor to cause such a registration statement to be declared effective nor is it our current intention to do so. Moreover, we may not be able to rely on an exemption from registration under the Securities Act. Accordingly, ADS holders may be unable to participate in future rights offerings, if any, and may experience dilution in their holdings. In addition, if the depositary is unable to sell rights that are not exercised or not distributed or if the sale is not lawful or reasonably practicable, it will allow the rights to lapse, in which case you will receive no value for these rights.

 

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If additional remedial measures are imposed on the Big Four PRC-based accounting firms, including our independent registered public accounting firm, in administrative proceedings brought by the SEC alleging the firms’ failure to meet specific criteria set by the SEC, we could be unable to timely file future financial statements in compliance with the requirements of the Securities Exchange Act of 1934.

 

In December 2012, the SEC instituted administrative proceedings against the “Big Four” PRC-based accounting firms, including our independent registered public accounting firm, alleging that these firms had violated U.S. securities laws and the SEC’s rules and regulations thereunder for failing to provide to the SEC such firms’ audit work papers with respect to certain PRC-based companies that are publicly traded in the United States.

 

In January 2014, the administrative law judge presiding over the matter rendered an initial decision that each of the firms had violated the SEC’s rules of practice for failing to produce audit workpapers to the SEC. The initial decision censured each of the firms and barred them from practicing before the SEC for a period of six months. The Big Four PRC-based accounting firms appealed the judge’s initial decision to the SEC. As a result, the decision will not take effect unless and until it is endorsed by the SEC.

 

In February 2015, the four PRC-based accounting firms each agreed to a censure and to pay a fine to the SEC to settle the dispute and avoid suspension of their ability to practice before the SEC and audit U.S.-listed companies. The settlement required the firms to follow detailed procedures and to seek approval from the CSRC to provide the SEC with access to such firms’ audit documents in response to future document requests by the SEC made through the CSRC. If the Big Four PRC-based accounting firms, including our independent registered public accounting firm, fail to comply with the document production procedures that are in the settlement agreement or if there is a failure of the process between the SEC and CSRC, the SEC retains authority to impose a variety of additional remedial measures on the accounting firms, such as imposing penalties on such firms and restarting the proceedings against such firms, depending on the nature of the failure.

 

The principal auditor of our financial statements, PricewaterhouseCoopers Zhong Tian LLP, is one of the Chinese affiliates of the “Big Four” global networks of accounting firms and is subject to the proceedings and the initial decision. If the accounting firms are subject to additional remedial measures, our ability to file our financial statements in compliance with SEC requirements could be impacted. A determination that we have not timely filed financial statements in compliance with SEC requirements could ultimately lead to the delisting of our ADSs from NASDAQ or the termination of the registration of our ADSs under the Securities Exchange Act of 1934, or both, which would substantially reduce or effectively terminate the trading of our ADSs in the United States.

 

Item 4.                                 Information on the Company

 

A.            History and Development of the Company

 

We became an independent company in September 1999 when we were spun-off from UT Starcom Inc., a NASDAQ-listed company that manufactures telecommunication equipment in China. In April 2002, we established a new holding company, Hurray! Holding Co., Ltd., in the Cayman Islands.  In August 2010, we changed our name from “Hurray! Holding Co., Ltd.” to “Ku6 Media Co., Ltd.”

 

In June 2014, we disposed of a 10% equity interest in Bale Interactive (Beijing) Culture Media Co., Ltd., or Bale, to a third party for RMB9.0 million ($1.5 million).

 

On March 31, 2014, Mr. Xu entered into a share purchase agreement with our then controlling shareholder, Shanda Media, a wholly owned subsidiary of Shanda Interactive, to purchase 1,938,360,784 of our ordinary shares, amounting to approximately 41% of our issued and outstanding share capital. The Share Purchase Transaction was completed on April 3, 2014, and the aggregate consideration for these ordinary shares was $47,350,831.05. Mr. Xu funded the purchase price through a loan from Shanda Media, which is secured by a charge of all of our ordinary shares beneficially owned by Mr. Xu.

 

Our principal executive offices are located at Building 6, Zhengtongchuangyi Centre, No. 18, Xibahe Xili, Chaoyang District, Beijing 100028, People’s Republic of China. Our telephone number is +86 10 5758-6813. Our agent for service of process in the United States is Puglisi & Associates, located at 850 Library Ave, Suite 204, Newark, DE 19711.

 

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B.            Business Overview

 

Introduction

 

We currently operate and focus on our online video business. Through our online brand Ku6 and our online video website www.ku6.com, we provide video information services and entertainment to viewers in China. As an online video portal, www.ku6.com offers news, reports and interactive entertainment programs and also provides a video platform for video-sharing and watching UGC.

 

Our online video business focuses on UGC and community-based content. We seek to be strategically focused on users’ experience and technology development. We provide a comprehensive selection of unique and differentiated UGC and, to a lesser extent, some in-house developed content and licensed content on our websites. Our broad selection of online video content includes news, comedies, Channel V music videos, games, micro movies and sub-channels such as entertainment, sports, finance, fashion, technology, automobile, education and others. We also provide an online platform that allows users to share comments on videos, ensuring that our users enjoy a highly engaging and interactive experience on our websites. As of December 31, 2014, our content library had more than 273 million video clips.  The volume of high-quality and differentiated content available on our website has allowed us to establish a valuable user base in China, consisting primarily of young urban educated users between the ages of 18 and 44, a particularly attractive demographic to advertisers.

 

Our marketing solutions present customers with a complete range of advertisement creation, matching, placement and presentation. Our online marketing services include in-video, display, sponsorship and other forms. Historically, we derived substantially all of our revenues from online advertising services, for which we collect service fees from advertisers through our advertising agencies. In April 2014, as a result of our management’s review and adjustment of our business strategies after the Share Purchase Transaction, we started to explore new revenue sources, including advertising agreements with independent third parties and cooperation with Qinhe. For our advertising services, we currently engage Huzhong, an independent third party, as our exclusive advertising agency for standard media resources and non-exclusive advertising agency for highly-interactive advertising resources. In addition, we currently provide interactive entertainment marketing services to iSpeak, a social platform that allows users to engage in real-time online group activities through voice, text and video. Under our cooperation agreement with Qinhe, which operates the iSpeak platform, Qinhe will share a certain percentage of the revenues that it generates from the viewers who visit the iSpeak platform through advertisements on our website. As these revenue sources are relatively new, there is also no assurance that they will generate sufficient revenues and operating cash flows in the future. See Item 3.D. “Risk Factors—Risks Related to Our Business—Our new business models may not be able to generate sufficient revenues and operating cash flows.”

 

Due to PRC legal restrictions on foreign ownership and investment in value-added telecommunications services and advertising businesses in China, we operate our business primarily through our consolidated affiliated entities in China. We do not hold equity interests in our consolidated affiliated entities. However, through a series of contractual arrangements with these consolidated affiliated entities and their respective shareholders, we effectively control, and are able to derive substantially all of the economic benefits from, these consolidated affiliated entities.

 

Our Video Platform

 

Our Website

 

In 2011, we moved our content focus from long-form videos to short-form videos. Users can access our website for short-form videos, including hot news and reports, first-hand information and entertainment videos, which can be provided by users or our content partners or produced in-house.

 

Our website has a series of user-friendly functions such as search tools and recommendations. We also help users navigate our database and find videos of interest by creating popularity ranking indices and interest-based video channels, such as ent.ku6.com for entertainment and sports.ku6.com for sports. We provide social features, such as community web pages and video sharing and commenting tools. We also offer a search history for frequent visitors to help them quickly locate recently viewed video clips. We present a chat box alongside videos so that users viewing the same video at the same time can have live, online chats. Users may create a playlist based on their preferences so that the requested video will be broadcast continuously. Registered visitors may upload video clips easily to our website and comment on each video clip to share their opinions. We believe all these features help provide an enhanced user experience and reinforce user loyalty.

 

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In addition, users can download our proprietary P2P software, “Speed Ku6,” and install it on their personal computers to enhance their viewing experience with high-quality videos and smooth connections. We also provide an application, “Upload Speed,” for users to upload video clips from their personal computers. We also have ChannelMe, a product that gives our priority value creating users/units, or VCUs, a unique identity and provide additional features for them to customize their homepage. It also allows users to interact with our priority VCUs online, such as sending virtual gifts to their favorite priority VCUs.

 

In January 2012, we entered into an agreement with YouTube, a renowned international video-sharing website owned by Google, which allowed our international users to view original videos from China on a new channel on YouTube’s website. In March 2012, we established a partnership arrangement with Channel V, a music video entertainment TV channel, to bring its content to our users on our website. From 2012 to 2014, we cooperated with Kaixin001.com, a Chinese social network service website, and NetEase, Inc., a Chinese Internet company with microblog services, respectively, for video sharing. In October 2013, in cooperation with Zhejiang TV, we sponsored the UGC Entertainment Awards, the first TV and Internet simultaneous-broadcasting program focusing on UGC in China. In December 2013, we held the UGC Entertainment Award Ceremony in Beijing with Zhejiang TV and SINA.com.

 

Mobile Platform

 

We significantly expanded our product portfolio for mobile platforms in 2013. Users can use their mobile phones to watch a large number of videos on ku6.com through compatible web browsers. For iPhones and Android devices, users may also install the mobile version of our Ku6 application, Ku6 Show, which allows them to view video clips on our website online and offline, and to shoot and upload video clips onto our website on the go. Our Channel V application caters to users with music videos. We have also cooperated with Shanda Innovations and developed a microfilm application, Micro Cool, which provides a mobile community platform for video sharing and focuses on short videos of not more than thirty seconds. Once installed, this application connects mobile devices to our mobile community platform and supports video shooting, editing, uploading and sharing. In 2013, we launched another mobile app, Duan Ku, which enables our users to create personalized videos using photos of their choices.

 

Our Content

 

UGC (User-Generated Content)

 

Our website allows Internet users to easily upload, watch and share UGC video clips. We offer creative talents, particularly the younger Chinese generation, channels for artistic expression outside the traditional mainstream content formats such as television. Our UGC covers a wide range of subject matters from entertainment to news, comedies, sports, finance, fashion and beyond. UGC is well embraced by Internet users, particularly young Internet users, given its sharing and interactive qualities.

 

Our editorial team is responsible for communicating with users on the types of UGC we believe are popular and well demanded.

 

Previously, we purchased the licensing rights to some popular UGC and shared advertising revenues with individual users whose number of uploads exceed certain thresholds. We also had a revenue sharing program to reward users for contents they uploaded in order to encourage more users to upload UGC to our website. In April 2014, in connection with the change of our business models after the Share Purchase Transaction, we announced a suspension of this revenue sharing program from May 1, 2014. This program has not been resumed and may not be resumed in the future. Historically, contracted users contributed approximately 50% of all the videos on our website. As a result of the suspension of this revenue sharing program, the quality and quantity of our UGC may deteriorate in the future, which, in turn, may materially and adversely affect our business, results of operations and prospects. See Item 3.D. “Risk Factors—Risks Related to Our Business—If we fail to continue to provide attractive products and services, we may not be able to generate sufficient user traffic to remain competitive.”

 

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In-house Developed Content

 

In addition to UGC, our content includes in-house developed content that we produce from time to time, such as online talk shows, celebrity interviews and reality shows to our viewers. We select the types of content to be produced generally based on our assessment of users’ preferences and information gathered by us from analyzing user data collected through our video platform. We typically cooperate with third parties engaged in in-house production, taking advantage of talents of local production teams and their relatively low production costs. In 2013, we cooperated with a major TV station in China to jointly produce shows that could be aired on our website and TV simultaneously.

 

Licensed Content

 

In June 2011, we ceased purchasing copyrights of movies and TV dramas from professional studios and their distributors. Previously purchased movies and TV drama will be shown on ku6.com through the end of their license periods.

 

Our Users

 

We have an extensive user base for our video platform. Our users visit our website from direct navigation, organic search results or third-party website links connecting to us. Our user base consists primarily of young urban educated users, between ages 18 and 44, which is a particularly attractive demographic to advertisers.  Online viewers in China also represent a more affluent and better-educated segment of the population in China. We have tracked and maintained extensive user data, including viewing history and information voluntarily provided by registered users. We use sophisticated statistical tools to analyze user data, to better understand users’ viewing preference and habits. This greatly facilitates our efforts in providing service to our advertising customers.

 

Marketing Services and Customers

 

Our online marketing services include in-video, display, sponsorship and other forms of advertisements. In-video advertisements appear at certain times during the playback of a video. These video advertisements can be pre-roll, post-roll, mid-roll or pause advertisements. Display advertisements can be delivered alongside a video and may take the form of graphic banners or text hyperlinks. Other forms of advertisements include product placements in our in-house produced web video series or sponsored live events. Our marketing solutions present opportunities to combine the visual impact and engagement of traditional television-like multimedia formats with the interactivity and precise targeting capabilities of the Internet.

 

·                  Innovative Targeting. Some targeting solutions are unique to the online video platform and cannot be transplanted into other media platforms. We are able to track and monitor an advertiser’s campaign on a real-time basis and can make adjustments to enhance its effectiveness within parameters specified by the advertiser upfront. Our targeting strategies enable advertisers to reach targeted users based on any or a combination of standards, including the demographic information about the user, the nature of the video’s content, the geographic location of the user, the time of day at which a video is being watched, or the keywords associated with the video. Our video channels also help segregate videos based on users’ interested content, which allows us to deliver advertisements tailored to the viewers of different channels; and

 

·                  Product Placements. As an online video provider with a permit for radio and television program production and operation, we are able to produce web-based content, such as web serial dramas, interviews and variety shows, with embedded product placements. If a program’s storyline is consistent with a brand’s or product’s marketing initiatives, a product placement can have strong branding effects on viewers.

 

Advertising Sales

 

We have an advertising tracking system which records and maintains the traffic statistics and other data relating to the effectiveness of advertisements. Our system tracks the reach, delivery duration and frequency, targeting and quantity of advertisements delivered by our website. It supports monitoring of our advertising efforts by enabling retrieval of real-time advertisement delivery data using certain system application interfaces. We have also introduced an advertising results forecasting system that is used in an increasing number of large advertising campaigns on our website. This system is designed to help optimize our advertisers’ strategy by forecasting the results of a given campaign, factoring in the covered audience and the frequency and reach of such campaign. After the broadcasting of a customer’s advertisement, we will provide them with a report of advertising effectiveness either prepared in-house or by an independent research firm upon their request.

 

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The list prices of our advertising services depend on various factors, including the form of advertising, specific targeting requirements, duration of the time slot purchased and popularity of the content that the advertisements would be associated with. Prices for the aggregate time slots purchased by each advertiser or advertising agency are fixed under sales contracts, typically at a discount to our list prices. We review the list prices quarterly. In addition, we employ a cost per 1,000 impressions (CPM)-based model for our in-video advertisements. This approach is similar to that of traditional television in that the advertisements are priced based in part on the user reach and viewing frequency. It allows advertisers to better compare the online and offline advertising services at their disposal. It also enables us to better monetize our growing user base and provide measurable results to our advertisers.

 

We engage in advertising sales primarily through advertising agencies. Historically, we derived substantially all of our revenues from online advertising services, for which we collect service fees from advertisers through our advertising agencies. From April 2011 to March 2014, we relied on Old Shengyue, an affiliate wholly owned by Shanda Interactive during that period, as our primary advertising agency, which managed our sales to, and collected payments from, substantially all of our advertisers. Our advertising agency agreement with Old Shengyue expired on March 31, 2014, and we generated advertising revenue of $2.7 million from Old Shengyue during the first quarter of 2014 prior to its expiration. As a result of our management’s review and adjustment of our business strategies after the Share Purchase Transaction, this agreement was not further renewed.

 

In April 2014, we entered into a new advertising agency agreement with New Shengyue, which is no longer owned by Shanda Interactive and is an independent third party. In August 2014, we terminated this agreement with New Shengyue and entered into another new advertising agency agreement with Huzhong, an independent third party. We generated advertising revenue of $0.5 million in 2014 from New Shengyue.

 

Pursuant to our agreement with Huzhong, Huzhong will act as our exclusive advertising agency for standard media resources and non-exclusive advertising agency for highly-interactive advertising resources. Under this agreement, we guarantee a certain amount of web traffic per day for webpages on which Huzhong posts advertisements, and in return, Huzhong guarantees to us a minimum amount of advertising revenues per day. If we fail to meet the web traffic target, the minimum amount guaranteed by Huzhong will be proportionally adjusted for the shortfall. Huzhong agreed to prepay 50% of the minimum guaranteed amounts within five business days prior to the beginning of each month and settle the balance within five business days after the end of each month. This advertising agency agreement with Huzhong will expire on December 31, 2017. We generated revenue of $2.8 million under our agreement with Huzhong from August 29, 2014 to December 31, 2014.

 

We expect to continue to engage third party advertising agencies for our advertising sales in the future.

 

Marketing Cooperation

 

In April 2014, as a result of our management’s review and adjustment of our business strategies after the Share Purchase Transaction, we started to explore new revenue models in cooperation with Qinhe, a company controlled by Mr. Xu, our largest shareholder.

 

In April 2014, we started to provide interactive entertainment marketing services to iSpeak, a social platform that allows users to engage in real-time online group activities through voice, text and video. Under our cooperation agreement with Qinhe, which operates the iSpeak platform, Qinhe will share a certain percentage of the revenues that it generates from the viewers who visit the iSpeak platform through advertisements on our website. Users on the iSpeak platform may spend on virtual items during real-time video broadcasting, including gifts and avatars, and purchase other value-added services. In April 2014, we also started to provide game marketing services for Qinhe under a similar revenue sharing arrangement as the one for interactive entertainment marketing cooperation.  We generated revenues of $1.6 million from Qinhe for the year ended December 31, 2014.

 

Our cooperation with Qinhe is relatively new and subject to changes from time to time. In September 2014, we amended the interactive entertainment cooperation agreement with Qinhe. Pursuant to the amended agreement, Qinhe agreed to pay certain additional guaranteed revenue amounts from July 2014 to December 2014, and the term of this agreement is extended to December 31, 2015. Other terms of the original agreements, including the revenue sharing arrangment, remained the same.In March 2015, our game marketing cooperation agreement with Qinhe expired and our management decided not to renew this agreement to focus on interactive entertainment marketing services. On March 30, 2015, we further amended our interactive entertainment cooperation agreement with Qinhe. Pursuant to the further amended cooperation agreement, the revenue sharing arrangement in the original agreement will be reinstated without the additional guaranteed revenue amounts.

 

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As the revenue models under our cooperation with Qinhe are relatively new, there is also no assurance that they would generate sufficient revenues and operating cash flows in the future. See Item 3.D. “Risk Factors—Risks Related to Our Business—Our new business models may not be able to generate sufficient revenues and operating cash flows.”

 

Marketing and Brand Promotion

 

We have initiated various marketing activities to further promote our brand awareness among existing and potential users and customers, which include:

 

·                  Direct Advertising. We engage in direct advertising in print, radio and TV media to market and promote our online video products. We believe that direct advertising is one of the most effective ways to market and promote our services to Internet users.

 

·                  Online Advertising. We engage in online advertising on other websites with user bases similar to our own or likely to watch online videos.

 

·                  Promotional Events. We organize and run a number of online promotional events which we believe help create brand awareness by associating the Ku6 brand with well-known and respected organizations and events in China.

 

·                  We also market our products and services by displaying our name and logo in Ku6 media player screens when users embed our content on third-party websites.

 

Technology and Infrastructure

 

We believe our proprietary technologies and infrastructure are critical to our success. With a dedicated research and development department, we have made significant investments in developing a proprietary, scalable technology platform that differentiates our online video distribution system.

 

Architecture

 

Since 2011, we have invested significantly in CDN infrastructure to support faster delivery of our online video content. As a pioneer in implementing this technology, we have established a more stable and scalable CDN and gained valuable CDN operations experience.

 

Our CDN technology utilizes distributed data storage to maintain copies of popular content at the “edge” of the network, which enables end-users to more quickly access that content. CDN technology facilitates faster responses to users’ requests for content, avoids buffering and associated delays caused by low bandwidth and user congestion of Internet traffic, and is therefore critical to the success of online video providers.

 

By hosting our Internet data centers along the major nodes of the transmission backbones operated by the local subsidiaries of China’s telecommunications carriers, we seek to maintain high standards in terms of delivery quality and speed as video content is transmitted from our servers to users throughout China. We have established a large number of servers nationwide, which contribute significantly to our fast streaming speeds and reliable viewing experience. Our servers are located at service sites of the local subsidiaries of the major domestic telecommunications carriers, which provide a stable power supply and maintenance for our servers.

 

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Content Monitoring and Copyright Protection

 

We are committed to the protection of third-party copyrights. We are required to monitor our website for content prohibited by the PRC laws and regulations. See “—Government Regulation—Regulations on Internet Content Services.”

 

We have invested significantly in content monitoring and copyright protection technologies. We have a content screening team dedicated to screening and monitoring the content uploaded on our website to ensure that no content that may be deemed to be prohibited by government rules and regulations is posted and the prompt removal of any allegedly infringing content once we receive proper notification from the legitimate copyright owner. We provide training to these employees and supervise and monitor their work. We implemented monitoring procedures to remove infringing content, including: (i) a text filtering system screens content based on pre-set key words; (ii) manual review, where the content that passes the technology screening is reviewed by the content screening team on a 24-hour, 7-day basis, and the flagged content identified by our technology is reviewed and confirmed that it can be released; and (iii) back-office professional supervision, where certain professional content providers who we grant access to our back-office database can directly flag the infringing content for removal. Other content on our website is also monitored. For example, user-posted comments are typically screened by the text filtering system and are monitored by our screening team. Substantially all of the videos uploaded on our website are manually screened by our employees. All of the other content, primarily consisting of comments posted by users, are first screened by our filtering systems and the content containing prohibitive words or images is manually screened by our contract employees.

 

When infringing content is discovered, we may take action under the agreement with our users. After a user registers and before each upload, we require the user to click a check box to confirm that the content to be uploaded is in compliance with the terms and conditions set forth in the user agreement, and to guarantee that he or she is the copyright owner or has obtained all necessary consents and authorizations for such content and that he or she is responsible for such content. Pursuant to the user agreement, each user agrees to indemnify us for all damages arising from third-party claims against us caused by violating or infringing content uploaded or linked by the user. In addition, if we find a user has violated applicable laws or regulations or infringed other parties’ legal rights, we may terminate the user account and block the user’s future uploads without prior notice under the user agreement.

 

Despite our efforts, due to the large amount of content uploaded by our users, we may not be able to identify all infringing content. See Item 3.D. “Risks Related to Our Business—We have been and expect to continue to be exposed to intellectual property infringement and other claims, including claims based on content posted on our website” and “—Regulation and censorship of information disseminated over the Internet in China may adversely affect our business and subject us to liability for information displayed on or linked to our websites.”

 

Privacy Protection and Information Security

 

We have established information security systems to ensure our network and information security, including website security procedures, a security and confidential information management system, and user security system. These information security systems have been filed with the MIIT or its local branch. However, we may not be able to adequately protect the privacy rights of third parties from infringing content uploaded by our users. See Item 3.D. “Risk Factors—Risks Related to Our Business—We have been and expect to continue to be exposed to intellectual property infringement and other claims, including claims based on content posted on our website.”

 

Intellectual Property

 

We rely primarily on intellectual property laws and our contractual arrangements with our employees, clients, business partners and others to protect our intellectual property rights. We require our employees to enter into agreements requiring them to keep confidential all information relating to our customers, methods, business and trade secrets during and after their employment with us. Our employees are required to acknowledge and recognize that all inventions, trade secrets, works of authorship, developments and other processes generated by them on our behalf, whether or not patentable or copyrightable, made by them during their employment are our property. They also sign agreements to transfer any ownership that they may claim in those works to us. We have registered our domain names, including ku6.com.

 

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Competition

 

The online video industry in China is rapidly evolving and highly competitive. We believe the key competitive factors in the online video industry in China include brand recognition, demographic composition of users, robust technology platform, ability to acquire popular premium licensed content at a reasonable cost and create differentiated content in-house, ability to source creative UGC, ability to provide innovative advertising services to customers, relationships with advertising customers, advertising prices, as well as the range of services provided to advertising customers.

 

We face competition from other major online video companies. Among the independent or “pure-play” online video sites, our major competitors in China include Youku Tudou and iQiyi.com. Several large Chinese Internet companies, such as SINA Corporation, Baidu, Inc., Sohu.com Inc., Tencent Holdings Limited, NetEase.com, Inc. and/or their affiliates, have launched online video websites. In addition, some of China’s TV networks, such as CCTV, Phoenix Satellite TV and Hunan Satellite TV, have launched their own video broadcasting websites. We also face competition from Internet video streaming platforms based on the P2P technology, such as PPS and PPTV.

 

Certain international online video sites, such as YouTube and Hulu, have large content portfolios and high brand recognition, particularly among users outside China. Currently, YouTube is not accessible by viewers in China. If China lifts the restrictions, YouTube may become our major competitor in China.

 

We also compete with traditional advertising media, such as television, radio, newspapers and magazines, and major out-of-home media, such as billboards, for advertisers’ advertising budgets. Large enterprises currently spend a relatively small percentage of their advertising budgets on online advertising as compared to the percentage they spend on traditional advertising media, but we expect the percentage spent on online advertising to increase in the future.

 

Seasonality

 

We experience seasonality in our online advertising business. Historically, in the China market, the fourth calendar quarter represents the best season for the general advertising market. This is followed by the third and second calendar quarters. The first calendar quarter is usually the worst season in China due to the Chinese New Year holidays.

 

Government Regulation

 

The following is a summary of the principal governmental laws and regulations that are or may be applicable to companies such as ours in China. The scope and enforcement of many of the laws and regulations described below are uncertain. We cannot predict the effect of further developments in the PRC legal system, including the promulgation of new laws, changes to existing laws or the interpretation or enforcement of laws. For a description of the regulatory risks related to our business, see Item 3.D. “Risk Factors—Risks Related to Our Business—Complexity, uncertainties and changes in government policies or regulations of Internet industry may have a material and adverse effect on our business, financial condition, results of operations and prospects,” “—Risks Related to Our Corporate Structure” and “—Risks Related to Doing Business in China.”

 

Regulation on catalogue relating to foreign investment

 

Investment activities in the PRC by foreign investors are subject to the Catalogue for the Guidance of Foreign Investment Industry, or the Catalogue, which was promulgated and is amended from time to time by the Ministry of Commerce and the National Development and Reform Commission, or the NDRC. The Catalogue divides industries into three categories: encouraged, restricted and prohibited. Industries not listed in the Catalogue are generally open to foreign investment unless specifically restricted by other PRC regulations.

 

Pursuant to the latest Catalogue amended in 2015, the provision of value-added telecommunications services falls in the restricted category, and the percentage of foreign ownership cannot exceed 50%. The provision of internet cultural operating services (including online game operation services), internet news, and production and online transmission of audio-visual programs fall in the prohibited category, and foreign investors are prohibited from engaging in such services. We conduct our operations in China principally through contractual arrangements among our PRC subsidiaries, our consolidated affiliated entities, and their respective shareholders. These contractual arrangements enable us to exercise effective control over these entities and hence treat them as our consolidated affiliated entities and consolidate their results. For a detailed discussion of these contractual arrangements, see Item 3.D.”Risk Factors—Risks Related to Our Corporate Structure” and Item 4.C. “Organizational Structure.”

 

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Regulations on Value-Added Telecommunications Services

 

In September 2000, the State Council promulgated the Telecommunications Regulations, or the Telecom Regulations. The Telecom Regulations draw a distinction between “basic telecommunication services” and “value-added telecommunication services.” Internet content provision services, or ICP services, is a subcategory of value-added telecommunications businesses. Under the Telecom Regulations, commercial operators of value-added telecommunications services must first obtain an operating license from the MIIT or its provincial level counterparts.

 

In September 2000, the State Council issued the Administrative Measures on Internet Information Services, or the Internet Measures, which was amended in January 2011. According to the Internet Measures, commercial ICP service operators must obtain an ICP license from the relevant government authorities before engaging in any commercial ICP operations in China. In November 2000, the MIIT promulgated the Administrative Measures on Internet Electronic Messaging Services, or the BBS Measures. BBS services include electronic bulletin boards, electronic forums, message boards and chat rooms.

 

In March 2009, the MIIT issued the amended Telecom License Measures, which became effective in April 2009. These measures set forth the types of licenses required to operate value-added telecommunications services and the qualifications and procedures for obtaining such licenses. For example, an ICP service operator providing value-added services in multiple provinces is required to obtain an inter-regional license, whereas an ICP service operator providing the same services in one province is required to obtain a local license.

 

Ku6 Information Technology, as our ICP service operator, holds an ICP license issued by Beijing Telecommunications Administration Bureau, which will expire in November 2016.

 

Regulations on Internet Content Services

 

National security considerations are an important factor in the regulation of Internet content in China. The National People’s Congress, the national legislature of the PRC, has enacted laws with respect to maintaining the security of Internet operation and Internet content. According to these laws, as well as the Internet Measures, violators may be subject to penalties, including criminal sanctions, for Internet content that:

 

·                  opposes the fundamental principles stated in the PRC constitution;

 

·                  compromises national security, divulges state secrets, subverts state power or damages national unity;

 

·                  harms the dignity or interests of the state;

 

·                  incites ethnic hatred or racial discrimination or damages inter-ethnic unity;

 

·                  undermines China’s religious policy or propagates heretical teachings or feudal superstitions;

 

·                  disseminates rumors, disturbs social order or disrupts social stability;

 

·                  disseminates obscenity or pornography, encourages gambling, violence, murder or fear or incites the commission of a crime;

 

·                  insults or slanders a third party or infringes upon the lawful rights and interests of a third party; or

 

·                  is otherwise prohibited by law or administrative regulations.

 

ICP service operators are required to monitor their websites. They may not post or disseminate any content that falls within these prohibited categories and must remove any such content from their websites. The PRC government may shut down the websites of ICP license holders that violate any of the above-mentioned content restrictions, order them to suspend their operations, or revoke their ICP licenses.

 

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Restrictions on Foreign Ownership in Value-Added Telecommunications Services

 

According to the Provisions on Administration of Foreign Invested Telecommunications Enterprises, or the FITE Provisions, promulgated by the State Council in December 2001 and amended in September 2008, the ultimate foreign equity ownership in a value-added telecommunications services provider must not exceed 50%. Moreover, for a foreign investor to acquire any equity interest in a value-added telecommunication business in China, it must demonstrate a good track record and experience in operating value-added telecommunications services. Foreign investors that meet these requirements must obtain approvals from the MIIT and MOFCOM or its authorized local branches, and the relevant approval application process usually takes six to nine months.

 

In July 2006, the MIIT issued the Notice of the MIIT on Intensifying the Administration of Foreign Investment in Value-added Telecommunications Services. This notice prohibits domestic telecommunication services providers from leasing, transferring or selling telecommunications business operating licenses to any foreign investor in any form, or providing any resources, sites or facilities to any foreign investor for their illegal operation of a telecommunications business in China. According to this notice, either the holder of a value-added telecommunication business operating license or its shareholders must legally own the domain names and trademarks used by such license holders in their provision of value-added telecommunication services. The notice further requires each license holder to have the necessary facilities, including servers, for its approved business operations and to maintain such facilities in the regions covered by its license. In addition, all value-added telecommunication service providers are required to maintain network and Internet security in accordance with the standards set forth in relevant PRC regulations. If a license holder fails to comply with the requirements in the notice and cure such non-compliance, the MIIT or its local counterparts have the discretion to take measures against such license holders, including revoking their valued-added telecommunication business operating licenses.

 

In January 2015, MIIT issued the Announcement on Lifting Restrictions on Foreign Equity Ratio in Online Data Processing and Transaction Processing Business (For-profit E-commerce) in China (Shanghai) Pilot Free Trade Zone, or the MIIT 2015 Circular. The MIIT 2015 Circular provides that in Shanghai FTZ, foreign investors in those companies engaging in the business of providing online data processing and transactions processing services (E-commerce) would be permitted to hold up to 100% of equity interests in such companies. However, restrictions on foreign investments in companies engaging in value-added telecommunications services other than online data processing and transaction processing business are not affected.

 

In January 2015, MOFCOM published on its website for public comment on a draft Foreign Investment Law of the PRC, or the draft FIL. The draft FIL is believed to strengthen the regulation of PRC companies, such as our VIEs, which have contractual arrangements with foreign investors or foreign invested companies. Under the draft FIL, a company controlled by foreign investors through contractual arrangements is considered to be a foreign invested enterprise and as a result is explicitly subject to restrictions on foreign investment. If the current version of the draft FIL becomes effective, our VIEs could fall within the scope of foreign invested companies and be subject to restrictions on foreign investment in the telecommunication service industry including online games, and the related contractual arrangements between our VIEs and us could be challenged. Under the draft FIL, it is unclear how “control” would be determined for such purpose, and the draft FIL is silent as to the enforcement actions that might be taken against existing companies, such as our VIEs, that operate in restricted industries.

 

Ku6 Information Technology, one of our consolidated affiliated entities, holds the licenses and permits necessary to conduct our online video, online advertising and related businesses in China. We currently operate our website through Ku6 Information Technology through a series of contractual arrangements. We believe that it would be impracticable for us to acquire any equity interest in Ku6 Information Technology without diverting management attention and resources. We believe that our contractual arrangements with Ku6 Information Technology and its respective individual shareholders provide us with sufficient and effective control over it. Accordingly, we currently do not plan to acquire any equity interest in Ku6 Beijing Information Technology. In addition, the related trademarks are owned by Beijing WFOE, one of our wholly owned PRC subsidiaries, and we may be required to transfer the related trademarks from Beijing WFOE to Ku6 Information Technology. These contractual arrangements may be subject to challenges by the PRC government authorities. See Item 3.D. “Risk Factors—Risks Related to Our Corporate Structure—If the PRC government finds that the agreements that establish the structure for operating our businesses in China do not comply with PRC governmental restrictions on foreign investment in Internet business, we could be subject to severe penalties or be forced to relinquish our interests in those operations” and Item 3.D. “Risk Factors—Risks Related to Our Corporate Structure—Substantial uncertainties exist with respect to the enactment timetable, interpretation and implementation of the draft Foreign Investment Law and how it may impact the viability of our current corporate structure, corporate governance and business operations.”

 

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Regulations on Broadcasting Audio/Video Programs through the Internet

 

In July 2004, SARFT promulgated the Rules for the Administration of Broadcasting of Audio/Video Programs through the Internet and Other Information Networks, or the Audio/Video Broadcasting Rules. The Audio/Video Broadcasting Rules apply to the launch, broadcasting, aggregation, transmission or download of audio/video programs via the Internet and other information networks. Anyone who wishes to engage in Internet broadcasting activities must first obtain an audio/video program transmission license, with a term of two years, issued by the SARFT and operate pursuant to the scope as provided in such license. Foreign invested enterprises are not allowed to engage in the above business.

 

In April 2005, the State Council announced Several Decisions on Investment by Non-state-owned Companies in Culture-related Business in China. These decisions encourage and support non-state-owned companies to enter certain culture-related business in China, subject to restrictions and prohibitions for investment in audio/video broadcasting, website news and certain other businesses by non-state-owned companies. These decisions authorize the SARFT, the Ministry of Culture and the GAPP to adopt detailed implementing rules according to these decisions.

 

In December 2007, the SARFT and the MIIT jointly issued the Rules for the Administration of Internet Audio and Video Program Services, commonly known as Circular 56, which came into effect as of January 31, 2008. Circular 56 reiterates the requirement set forth in the Audio/Video Broadcasting Rules that online audio/video service providers must obtain a license from the SARFT. Furthermore, Circular 56 requires all online audio/video service providers to be either wholly state-owned or state controlled. According to relevant official answers to press questions published on the SARFT’s website in February 2008, officials from the SARFT and the MIIT clarified that online audio/video service providers that already had been operating lawfully prior to the issuance of Circular 56 may re-register and continue to operate without becoming state-owned or controlled, provided that such providers have not engaged in any unlawful activities. This exemption will not be granted to online audio/video service providers established after Circular 56 was issued. Such policies have been reflected in the Application Procedure for Audio/Video Program Transmission License. We have obtained an audio/video program transmission license in 2008, which was renewed in 2011 and expired in February 2015. We are currently in the process of renewing this license.

 

In June 2008, the SARFT issued the Notice on the Application Procedures for Audio/Video Program Transmission Licenses. Under this notice, all online audio/video service providers are required to maintain a registered capital of not less than RMB10.0 million, and audio/video service providers that offer news, movies, television, entertainment and other designated content must have a registered capital of not less than RMB20.0 million. In connection with the expansion of our business, we have increased the registered capital of Ku6 Information Technology, our consolidated affiliated entity which holds the operating licenses for Internet audio/video business, from RMB10.0 million to RMB20.0 million in September 2012.

 

In March 2009, the SARFT released the Notice on Strengthening the Administration of Online Audio/Video Content. This notice reiterated, among other things, that all movies and television shows released or published online must be in compliance with relevant regulations on the administration of radio, film and television. In other words, these movies and television shows, whether produced in China or overseas, must be pre-approved by the SARFT and distributors of these movies and television shows must obtain a permit before releasing any movie or television show.

 

In April 2010, the SARFT issued the Internet Audio/Video Program Services Categories (Provisional), which classified Internet audio/video programs into four categories. Category I is only open to state-owned broadcast/television media companies operating in the broadcasting/television section, and the other three categories are open to non-state-owned entities.

 

We obtained an Internet audio/video program transmission license for our website www.ku6.com, the scope of which was subsequently expanded in August 2013 to cover multiple categories of audio/video services. The amended license is valid for three years from February 2012 to February 2015. We are currently in the process of renewing this license.

 

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Regulations on Internet News Publication

 

Publishing and disseminating news through the Internet are highly regulated in China. In November 2000, the SCIO and the MIIT jointly promulgated the Provisional Measures for Administrating Internet Websites Carrying on the News Publication Business, or Internet News Measures. These measures require an ICP service operator (other than a government authorized news unit) to obtain an approval from the SCIO in order to publish news on its website or disseminate news through the Internet. Furthermore, any news disseminated through the Internet must be obtained from government-approved sources based on contracts between the ICP service operator and these sources. Copies of such contracts must be filed with relevant government authorities.

 

In September 2005, the SCIO and the MIIT jointly issued the Provisions on the Administration of Internet News Information Services. Under this regulation, Internet news information service providers must obtain an approval from the SCIO for the services, and such approval is subject to annual inspection. This regulation also provides that Internet news information service providers may not receive any foreign investment or establish any cooperative relationship with a foreign invested enterprise before the SCIO completes the security evaluation. We currently operate, in cooperation with some media companies and news agencies, a current events channel on our website, which includes audio/video contents relating to current topics and social events. The SCIO requires entities that offer Internet news services, such as us, to apply for and obtain an “Internet News Information Service Permit” from it. To our knowledge, in practice SCIO has not accepted any application for such permit. We will continue to closely monitor any development regarding this permit and will submit an application for it once SCIO starts to accept such applications. See Item 3.D. “Risk Factors—Risks Related to Our Business—Complexity, uncertainties and changes in government policies or regulations of Internet industry may have a material and adverse effect on our business, financial condition, results of operations and prospects.”

 

Regulations on Internet Publication

 

The GAPP is responsible for nationwide supervision and administration of publishing activities in China. In June 2002, the GAPP and the MIIT jointly promulgated the Internet Publication Tentative Administrative Measures, or the Internet Publication Measures, which took effect on August 1, 2002. Pursuant to the Internet Publication Measures, any entity engaged in Internet publishing activities must obtain the Internet Publication License from the GAPP before conducting any Internet publication activities.

 

The Internet Publication Measures were promulgated in June 2002, which is approximately three years prior to the establishment of China’s first group of online audio/video websites. At the time of promulgation, these measures were intended to regulate the traditional audio/video products and online gaming and did not consider the issues directly relevant to online audio/video business. Furthermore, the definition of “Internet publication” under these measures is very broad and the GAPP has not provided any implementing rule or official interpretation as to the applicability of the Internet Publication Measures to a website such as Ku6.com that exclusively distributes audio/video content.

 

In December 2012, the GAPP published a proposed rule relating to Internet publication. The proposal is intended to, among other things, clarify the meaning of the “Internet publication service” and “Internet publication” as well as modify the application procedures for the license. We plan to apply for the license with respect to certain services provided by Ku6 Information Technology once the final rule is issued. However, we cannot assure you that such application would be approved by the relevant governmental agencies in a timely manner or at all. See Item 3.D. “Risk Factors—Risks Related to Our Business—Complexity, uncertainties and changes in government policies or regulations of Internet industry may have a material and adverse effect on our business, financial condition, results of operations and prospects.”

 

Regulations on Internet Medical and Health Information Services

 

In July 2004, the State Drug Administration, or the SDA, issued the Measures for the Administration of Internet Drug Information Services. Under these measures, websites publishing drug-related information must obtain a license from the SDA or its provincial departments. Ku6 Information Technology, our consolidated affiliated entity that is an ICP service operator, obtained the Qualification Certificate of Internet Drug Information Service from the Beijing Drug Administration in May 2013, with a validity term up to May 2018. We will apply for renewal of this certificate within the stipulated period in accordance with these measures.

 

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Regulations on Advertisements

 

The SAIC, including its local branches, is the government agency responsible for regulating advertising activities in China.

 

In November 2004, the SAIC issued the Administrative Regulations for Advertising Operation Licenses, taking effect as of January 1, 2005, granting a general exemption to enterprises (other than radio stations, television stations, newspapers and magazines, non-corporate entities and other entities specified in laws or administrative regulations) from the previous requirement to obtain an advertising operation license in addition to a business license. We conduct our online advertising business on our website “www.ku6.com” through Ku6 Information Technology and Tianjin Ku6 Network, each of which holds a business license that permits placing advertisements as part of its business scope.

 

Advertisers, advertising operators and advertising distributors are required by PRC advertising laws and regulations to ensure that the contents of the advertisements they prepare or distribute are true and in full compliance with applicable laws and regulations. In addition, where a special government review is required for certain categories of advertisements before publishing, the advertisers, advertising operators and advertising distributors are obligated to confirm that such review has been performed and that relevant approval has been obtained. Violation of these regulations may result in penalties, including fines, confiscation of advertising income, orders to cease dissemination of the advertisements and orders to publish an advertisement correcting the misleading information. In circumstances involving serious violations, the SAIC or its local branches may force the violator to terminate its advertising operation or even revoke its business license. Furthermore, advertisers, advertising operators or advertising distributors may be subject to civil liability if they infringe on the legal rights and interests of third parties.

 

Regulations on Foreign Ownership in Advertising Business

 

The principal regulations governing foreign ownership in advertising businesses in China include:

 

·                  The Administrative Regulations on Foreign-invested Advertising Enterprises; and

 

·                  The Circular Regarding Investment in the Advertising Industry by Foreign Investors through Equity Acquisition.

 

These regulations require foreign entities that directly invest in the PRC advertising industry to have at least a two-year track record with a principal business in the advertising industry outside China. Since December 2005, foreign investors have been permitted to directly own a 100% interest in advertising companies in China, but such foreign investors are also required to have at least a three-year track record with a principal business in the advertising industry outside China. PRC laws, rules and regulations do not permit the transfer of any approvals or licenses, including business licenses containing a scope of business that permits engagement in the advertising business.

 

Because we are a Cayman Islands company without the required track record in the advertisement industry, we are not eligible to hold direct equity interests in PRC advertisement companies. As a result, we conduct this portion of our operations through a series of contractual arrangements among our PRC subsidiaries and our consolidated controlled entities. See Item 4.C. “Organizational Structure” and Item 3.D. “Risk Factors—Risks Related to Our Corporate Structure—If the PRC government finds that the agreements that establish the structure for operating our businesses in China do not comply with PRC governmental restrictions on foreign investment in Internet business, we could be subject to severe penalties or be forced to relinquish our interests in those operations.”

 

Regulations on Internet Culture Activities

 

The Ministry of Culture promulgated the Amended Internet Culture Administration Tentative Measures, or the Internet Culture Measures, which became effective as of April 1, 2011. The Internet Culture Measures require ICP service operators engaging in “Internet culture activities” to obtain a permit from the Ministry of Culture. The term “Internet culture activities” includes, among other things, online dissemination of Internet cultural products, such as audio-video products, gaming products, performances of plays or programs, works of art and cartoons, and the production, reproduction, importation publication and broadcasting of Internet cultural products. We obtained the permit in June 2009, which was renewed in May 2012 and is valid through June 2015.

 

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In November 2006, the Ministry of Culture issued Several Suggestions of the Ministry of Culture on the Development and Administration of the Internet Music, or the Suggestions, which became effective on November 20, 2006. The Suggestions, among other things, reiterate the requirement for the Internet service provider to obtain an Internet culture business permit to carry on any business relating to Internet music products. In addition, foreign investors are prohibited from operating Internet culture businesses. However, the laws and regulations on Internet music products are still evolving, and there have not been any provisions stipulating whether or how music video will be regulated by the Suggestions.

 

In August 2009, the Ministry of Culture promulgated the Notice on Strengthening and Improving the Content Review of Online Music. According to this notice, only “Internet culture operating entities” approved by the Ministry of Culture may engage in the production, release, dissemination (including providing direct links to music products) and importation of online music products. The content of online music shall be reviewed by or filed with the Ministry of Culture. Internet culture operating entities should establish a strict self-monitoring system of online music content and set up a special department in charge of such monitoring.

 

In August 2013, the Ministry of Culture issued the Notice of the Ministry of Culture on Implementing the Administrative Measures for the Content Self-examination of Internet Culture Business Entities. According to this notice, any cultural product or service shall be reviewed by the provider before being released to the public and the review process shall be done by persons who have obtained the relevant content review certificate.

 

To comply with these laws and regulations, our content examination team reviews the music videos on our website as well as certain other content and we have two employees who have obtained the applicable content review certificates.

 

Regulations on Producing Audio/Video Programs

 

In July 2004, the SARFT promulgated the Administrative Measures on the Production and Operation of Radio and Television Programs, effective as of August 20, 2004. These Measures provide that anyone who wishes to produce or operate radio or television programs must first obtain an operating permit. Applicants for this permit must meet several criteria, including having a minimum registered capital of RMB3 million. We hold a permit for radio and television program production and operation with its scope to cover the production of animated programs, variety program and special features. This permit is valid through December 2015.

 

Regulations on Software Products

 

In October 2000, the MIIT issued the Administrative Measures on Software Products, or the Software Measures, to strengthen the regulation of software products and to encourage the development of the PRC software industry. In March 2009, the MIIT issued amended Software Measures, which became effective in April 2009. The Software Measures provide a registration and filing system with respect to software products made in or imported into China. These software products may be registered with the competent local authorities in charge of software industry administration. Registered software products may enjoy preferential treatment status granted by relevant software industry regulations. Software products can be registered for five years, and the registration is renewable upon expiration.

 

The State Council promulgated the Computer Software Protection Regulations in December 2001, which was amended in January 2011 and January 2013. In connection with this regulation, the NCAC issued the Computer Software Copyright Registration Procedures in February 2002, which apply to software copyright registration, license contract registration and transfer contract registration. We have obtained and maintain seven software copyright registrations.

 

Regulations on Intellectual Property Rights

 

China has adopted legislation governing intellectual property rights, including trademarks, patents and copyrights. China is a signatory to the main international conventions on intellectual property rights and became a member of the Agreement on Trade Related Aspects of Intellectual Property Rights upon its accession to the World Trade Organization in December 2001.

 

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Patent. The National People’s Congress adopted the Patent Law in 1984, and amended it in 1992, 2000 and 2008. The purpose of the Patent Law is to protect lawful interests of patent holders, encourage invention, foster applications of invention, enhance innovative capabilities and promote the development of science and technology. To be patentable, invention or utility models must meet three conditions: novelty, inventiveness and practical applicability. Patents cannot be granted for scientific discoveries, rules and methods for intellectual activities, methods used to diagnose or treat diseases, animal and plant breeds, substances obtained by means of nuclear transformation or a design which has major marking effect on the patterns or colors of graphic print products or a combination of both patterns and colors. The Patent Office under the State Intellectual Property Office, or SIPO, is responsible for receiving, examining and approving patent applications. A patent is valid for a term of twenty years in the case of an invention and a term of ten years in the case of utility models and designs. A third-party user must obtain consent or a proper license from the patent owner to use the patent. Otherwise, the use constitutes an infringement of patent rights.

 

Copyright. The National People’s Congress adopted the Copyright Law in 1990 and amended it in 2001 and 2010, respectively. The Copyright Law extends copyright protection to Internet activities, products disseminated over the Internet and software products. In addition, there is a voluntary registration system administered by the China Copyright Protection Center. Creators of protected works enjoy personal and property rights, including, among others, the right of disseminating the works through informational network.

 

In December 2012, the PRC Supreme People’s Court adopted the Provisions on Some Issues Concerning Applicable Laws for Trial of Disputes of Infringement of Rights to Communication through Information Networks, which became effective on January 1, 2013 and replaced the previous interpretations on the same topic. Under the provisions, Internet users or service providers are subject to civil liabilities if they provide uncopyrighted content, including works, performance or sound or video recordings, through information networks. An ICP service operator will be liable if it assists or incites infringing acts, whether through words, technical support, virtual awards or other forms. An ICP service operator will be liable if it fails to delete, screen or block content that such ICP service operator knows or should know is infringing, or if it actively provides technical support for an infringing act. The knowledge requirement is met if the ICP service operator recommends the infringing content by ranking, indexing or summarizing such content and the public can directly access the infringing content on its website. Under these interpretations, the liability of an ICP service operator is predicated on its fault. If an ICP service operator can prove that it has used reasonable and effective technical measures to block the relevant content, and that the infringing content is difficult to be identified despite such measures, such ICP service operator is not at fault.

 

In April 2005, the NCAC on and the MIIT jointly promulgated the Measures for Administrative Protection of Copyright Related to Internet, which became effective on May 30, 2005. This measure applies to situations where an ICP service operator (i) allows another person to post or store any works, recordings, audio or video programs on the websites operated by such ICP service operator or (ii) provides links to, or search results for, the works, recordings, audio or video programs posted or transmitted by such person, without editing, revising or selecting the content of such material. Upon receipt of an infringement notice from a legitimate copyright holder, an ICP service operator must take remedial actions immediately by removing or disabling access to the infringing content. If an ICP service operator knowingly transmits infringing content or fails to take remedial actions after receipt of a notice of infringement harming public interest, the ICP service operator could be subject to administrative penalties, including cessation of infringement activities, confiscation by the authorities of all income derived from the infringement activities and payment of a fine of up to three times the unlawful income or, in cases where the amount of unlawful income cannot be determined, a fine of up to RMB100,000. An ICP service operator is also required to retain all infringement notices for a minimum of six months and to record the content, display time and IP addresses or the domain names related to the infringement for a minimum of 60 days. Failure to comply with this requirement could result in an administrative warning and a fine of up to RMB30,000.

 

In September 2003, the NCAC promulgated the Measure for the Implementation of the Copyright Administrative Punishment. In August 2002, the State Council promulgated the Implementing Regulations of The Copy right Law of the PRC, which was amended in January 2013. Under these regulations, an ICP service operator that infringes upon a third party’s copyright may be subject to a fine of one to five times the unlawful income if such income exceeds RMB50,000, or up to RMB 250,000 if such income is less than RMB50,000.

 

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In May 2006, the State Council promulgated the Regulation for the Protection of the Right of Communication through Information Networks, which was amended in January 2013. This regulation provides a safe harbor principle for ICP service operator that provides information storage space to users through which users may provide works, performance or sound or video recordings to the public. An ICP service operator will not be liable to the right owners if the following conditions are met: (i) the ICP service operator has clearly indicated that the information storage space is provided to the users, and published the name, contact person and IP address of the network service provider; (ii) it has not altered the works or recordings provided by the users; (iii) it did not know, or could not reasonably have been expected to know, that the content provided by the users infringed upon other’s rights; (iv) it has not received any direct financial gain from the users’ provision of the content; and (v) it deletes the allegedly infringing content upon receiving written notice from the right owners. An ICP service operator that provides users with search or link services will not be liable to the right owner if the ICP service operator promptly disconnects the link to the infringing content after receiving the right owner’s notice. This exemption is not valid however if the ICP service operator knew or should know that the linked content infringed upon another’s rights. In that scenario, it will be jointly liable with the user who provided the content. Under this regulation, an ICP service operator may be subject to civil liabilities, including ceasing the infringing activities, eliminating the adverse effects, and paying damages. If public interest is harmed, the ICP service operator that infringes upon a third party’s copyright may be subject to a fine of one to five times the unlawful income if such income exceeds RMB50,000, or up to RMB250,000 if such income is less than RMB50,000, or confiscation of assets used to provide infringing services.

 

In each of the years since 2005, the NCAC, together with certain other PRC governmental authorities, have jointly launched annual campaigns specifically aimed to crack down on Internet copyright infringement and piracy in China, which normally last for three to four months. One of the main targets, among others, of these annual campaigns is Internet audio and video programs. Since the 2010 campaign commenced in late July, the local branches of the NCAC have been focusing on popular movies and television series, newly published books, online games and animation, music and software and illegal uploading or transmission of a third party’s works without proper license or permission, sales of pirated audio/video and software through e-commerce platforms, providing search links, information storage, web hosting or Internet access services for third parties engaging in copyright infringement or piracy and the infringement by use of mobile media. In serious cases, the operating permits of the websites engaging in illegal activities may be revoked, and such websites may be ordered to shut down. To comply with the Campaign’s requirements, we have adopted related measures to mitigate copyright infringement risks and submitted the supervision report to the NCAC regularly. For example, our policy is to remove links to web pages if we know these web pages contain materials that infringe upon third-party rights or if we are notified by the legitimate copyright holder of the infringement with proper evidence.

 

In December 2009, the Standing Committee of the National People’s Congress adopted the Torts Liability Law, which became effective on July 1, 2010. Under this new law, both Internet users and Internet service providers may be liable for the wrongful acts of users who infringe the lawful rights of other parties. If an Internet user utilizes Internet services to commit a tortious act, the party whose rights are infringed may request the Internet service provider to take measures, such as removing or blocking the content, or disabling the links thereto, to prevent or stop the infringement. If the Internet service provider does not take necessary measures after receiving such notice, it shall be jointly liable for any further damages suffered by the rights holder. Furthermore, if an Internet service provider fails to take necessary measures when it knows that an Internet user utilizes its Internet services to infringe the lawful rights and interests of other parties, it shall be jointly liable with the Internet user for damages resulting from the infringement.

 

In January 2011, the Supreme People’s Court, the Supreme People’s Procuratorate and the Ministry of Public Security jointly issued the Opinions on Issues Concerning Applicable Laws for Criminal Cases Involving Intellectual Property Right Infringement, which provide clear guidance on circumstances in which online piracy results in criminal liabilities.

 

In June 2012, The Beijing Treaty on Audiovisual Performances, a multilateral treaty that regulates copyright of audiovisual performances and expands the performers’ rights, was adopted by the Diplomatic Conference on the Protection of Audiovisual Performances of the World Intellectual Property Organization. Forty-eight countries, including the United States and the PRC, signed the treaty. The treaty will become effective after ratification by at least 30 eligible parties.

 

Trademark. The PRC Trademark Law, adopted in 1982 and revised respectively in 1993, 2001 and 2013, with its implementation rules adopted in August 2002 and amended in April 2014,protects registered trademarks. The Trademark Office under the SAIC handles trademark registrations and grants a term of ten years to registered trademarks. Trademark license agreements must be filed with the Trademark Office for the record.

 

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“” and “ 6” are registered trademarks in China. We have also applied to register additional trademarks.

 

Domain Name. In May 2012, the China Internet Network Information Center, or the CNNIC, issued the amended Implementing Rules for Domain Name Registration setting forth detailed rules for registration of domain names. In November 2004, the MIIT promulgated the Measures for Administration of Domain Names for the Internet in China, or Domain Name Measures. The Domain Name Measures regulate the registration of domain names, such as the first-tier domain name “.cn.” In May 2012, the CNNIC issued the amended Measures on Domain Name Disputes Resolution and its implementing rules, pursuant to which the CNNIC can authorize a domain name dispute resolution institution to decide disputes. We have registered ku6.com and certain other domain names with the CNNIC.

 

Regulations on Information Security

 

The National People’s Congress has enacted legislation that prohibits use of the Internet that breaches the public security, disseminates socially destabilizing content or leaks state secrets. Breach of public security includes breach of national security and infringement on legal rights and interests of the state, society or citizens. Socially destabilizing content includes any content that incites defiance or violations of PRC laws or regulations or subversion of the PRC government or its political system, spreads socially disruptive rumors or involves cult activities, superstition, obscenities, pornography, gambling or violence. State secrets are defined broadly to include information concerning PRC national defense, state affairs and other matters as determined by the PRC authorities.

 

According to the Protection and Management Regulations for Computer Information Network and Internet Security promulgated by the Ministry of Public Security in December 1997, which was amended in 2011, and other relevant regulations, ICP service operators must complete mandatory security filing procedures and regularly update information security and censorship systems for their websites with local public security authorities, and must also report any public dissemination of prohibited content.

 

According to the PRC Law on Protection of State Secrets, which became effective on October 1, 2010, an ICP service operator must not disseminate any information that may be deemed to be state secrets and must promptly report any relevant events to the state and public security authorities. Failure to do so may subject the ICP service operator to liability and certain penalties by the State Secrecy Bureau, the Ministry of Public Security and the MIIT or their respective local branches.

 

In addition, the State Secrecy Bureau has issued provisions authorizing the blocking of access to any website it deems to be leaking state secrets or failing to comply with the relevant legislation regarding the protection of state secrets during online information distribution.

 

In December 2005, the Ministry of Public Security promulgated Provisions on Technological Measures for Internet Security Protection, or Internet Protection Measures, which became effective in March 2006. The Internet Protection Measures require all ICP service operators to keep records of certain information about its users (including user registration information, log-in and log-out time, IP address, content and time of posts by users) for at least 60 days and submit the above information as required by laws and regulations.

 

In August 2014, the Supreme People’s Court of the PRC promulgated the Provisions of the Supreme People’s Court on Several Issues Concerning the Application of Law to Trial of Civil Dispute Cases over Infringement upon Personal Rights and Interests by Using Information Networks, which provides that if an ICP operator uses the network to disclose the genetic information, medical records, health examination data, criminal records, home address, private events and other personal privacy and information of a natural person causing damages, the aggrieved party will be entitled to hold the ICP operator liable unless: (i) the natural person has given written consent and the disclosure is within the agreed scope; (ii) the information is disclosed in order to promote the public interest and it is within the necessary extent; (iii) the information is disclosed for the purposes of public interest of academic research or statistics by schools and research institutions that is consented by the natural person in a written form, and the way of disclosure is not sufficient to identify the specific individuals; (iv) the information is self-disclosed by the natural person or has been lawfully disclosed on the Internet; or (v) the personal information is obtained in a lawful manner.

 

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As an ICP service operator, we are subject to the regulations relating to information security. We have taken measures to comply with such regulations. We are registered with the relevant government authority in accordance with the mandatory registration requirement. Our policy is to remove links to web pages and any content which to its knowledge contain information that would be in violation of PRC laws or regulations. In addition, we monitor our websites to ensure our compliance with such laws and regulations.

 

Regulations on Internet Privacy

 

The PRC Constitution states that PRC law protects the freedom and privacy of communications of citizens and prohibits infringement of such rights. In recent years, PRC government authorities have enacted legislation on Internet use to protect personal information from any unauthorized disclosure.

 

The Internet Measures prohibit an ICP service operator from producing, reproducing, disseminating or broadcasting illegal information, including information that insults or slanders a third party or infringes the lawful rights and interests of a third party. Pursuant to the BBS Measures, ICP service operators that provide electronic messaging services must keep users’ personal information confidential and must not disclose such personal information to any third party without the users’ consent or unless required by law. The regulations further authorize the relevant telecommunications authorities to order ICP service operators to rectify unauthorized disclosure. ICP service operators are subject to legal liability if the unauthorized disclosure results in damages or losses to users. The PRC government, however, has the power and authority to order ICP service operators to turn over personal information if an Internet user posts any prohibited content or engages in illegal activities on the Internet.

 

In December 2011, the MIIT promulgated the Several Provisions on Regulating the Market Order of Internet Information Services, which became effective on March 15, 2012. This regulation provides that ICP service operators must not, without a user’s consent, collect “user’s personal information,” that is, information that can be used, alone or in combination with other information, to identify the user. In addition, ICP service providers may not provide any such information to third parties without prior consent of the user. ICP service operators can only collect user’s personal information that is necessary to provide their services, and must expressly inform the users of the method and purpose of collecting and processing such information. An ICP service operator may only use user’s personal information for the stated purposes under its scope of service. ICP service operators must also ensure the data security of user personal information and take immediate remedial measures if any such information is suspected to have been leaked. If the consequences of any such leaks are expected to be serious, the ICP service operator must immediately report the incident to the relevant telecommunication regulatory authority and cooperate in the investigations.

 

In December 2011, the Beijing Municipal Government promulgated the Several Provisions on Management of Beijing Micro Blog Development, which requires micro bloggers to register their real names. In December 2012, the Beijing High People’s Court issued the Guidelines for Trial of Disputes Concerning Copyright Issues Related to Video Sharing, which provides that an ICP service operator that merely provides video sharing services, such as us, may have a valid defense to liability if it can submit the registered identification information, such as name, registered IP address and date of registration, of the person who uploaded the infringing content.

 

In December 2012, the Standing Committee of the National People’s Congress passed the Decision to Enhance Online Personal Data Protection and Safeguard Public Interest. According to the decision, Internet users must use real names to identify themselves to ICP service operators when signing web access agreements or acknowledging acceptance of the service provider’s service. In addition, the ICP service operators are required to instantly stop the transmission of illegal information once it is discovered, and to remove the information, retain records and report to supervisory authorities. Violation of this decision may lead to various penalties, including confiscation of illegal gains, revocations of licenses and website closures, and the ICP service operator may also be prohibited from conducting Internet-related business in the future. In addition, any person whose identity is leaked or whose rights is infringed upon has the right to require the ICP service operator to remove the relevant information and take other necessary remedial measures.

 

In July 2013, the MIIT issued the Order for the Protection of Telecommunication and Internet User’s Personal Information. Any collection or use of a user’s personal information must be subject to the consent of such user. An ICP service operator must keep such information strictly confidential, and it is prohibited from divulging, tampering or destroying any such information, and from selling or providing such information to other parties. Any violation may subject the ICP service operator to warnings, fines, confiscation of illegal gains, revocation of licenses, cancellation of registrations , shutdown of websites or even criminal liabilities. We have required our users to consent to our collection and use of their personal information, and have taken information security measures to protect our users’ privacy.

 

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In February 2014, the National Internet Information Office promulgated the Provisions on Administration of Internet User Account Names, which became effective on March 1, 2015. According to the Provisions, the Internet information service providers shall, pursuant to the principle of “mandatory real name registration at the back-office end, and voluntary real name display at the front-office end,” require the Internet information service users to sign up accounts after passing real identity information authentication.  When signing up accounts, the Internet information service users shall enter into agreements with the Internet information service providers to undertake to abide by the seven bottom lines in terms of laws and regulations, which are the socialist system, national interests, citizens’ legitimate rights and interests, public order, social morality and the truthfulness of information.  Where any Internet information service user falsifies information to get the account name registered or includes any illegal or unfavorable information in the head portrait, profile or any other registration information of the account, the Internet information service provider shall take measures such as issuing an notice to require such user to rectify within specified time limit, suspending the use of the account name by such user or deregistering the account of such user.

 

We currently do not require real name registration by our users, which may be deemed to violate relevant PRC laws and regulations, and the PRC regulatory authorities may impose administrative penalty on us, such as warning, fines, confiscation of illegal gains, revocation of website registration, or shutdown of our website. In addition, we may be liable for damages caused to our users.

 

Regulations on Foreign Exchange Controls

 

For information regarding relevant foreign exchange controls, please refer to Item 10.D. “Exchange Controls.”

 

Regulations on Dividend Distribution

 

The principal regulations governing dividend distributions by wholly foreign owned enterprises and Chinese-foreign equity joint ventures include the:

 

·                  Wholly Foreign-Owned Enterprise Law (1986), as amended;

 

·                  Wholly Foreign-Owned Enterprise Law Implementing Rules (1990), as amended;

 

·                  Chinese-foreign Equity Joint Venture Enterprise Law (1979), as amended;

 

·                  Chinese-foreign Equity Joint Venture Enterprise Law Implementing Rules (1983), as amended;

 

·                  The Companies Law (2013);

 

·                  The Notice on Implementation of Enterprise Income Tax Transition Preferential Policy under the PRC Enterprise Income Tax Law (2007);

 

·                  PRC Enterprise Income Tax Law (2007); and

 

·                  Implementation Rules of the PRC Enterprise Income Tax Law (2007).

 

Under these regulations, wholly foreign owned enterprises and Chinese-foreign equity joint ventures in China may pay dividends only out of their accumulated after-tax profits, if any, as determined in accordance with PRC accounting standards and regulations. Additionally, all enterprises are required to set aside at least 10% of their after-tax net income each year, if any, to fund their statutory capital reserves, until the aggregate amount of such reserves reaches 50% of their registered capital. These reserves are not distributable as cash dividends.

 

Labor Laws and Social Insurance

 

Pursuant to the PRC Labor Law, which became effective on January 1, 1995, the PRC Labor Contract Law, which became effective on January 1, 2008, and their implementation rules, employers must execute written labor contracts with their employees. All employers must compensate their employees with wages equal to at least the local minimum wage standards. All employers are required to establish a system for labor safety and sanitation, strictly abide by state national labor rules and standards and provide employees with workplace safety training. Employers are also obliged to provide employees with welfare schemes covering pension insurance, unemployment insurance, maternity insurance, work-related injury insurance, medical insurance and housing funds. Violations of the PRC Labor Law and the PRC Labor Contract Law may result in the imposition of fines and other administrative liabilities. Criminal liability may arise for serious violations.

 

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The PRC Labor Contract Law and its implemental rules also allow third-party human resource companies to enter into employment contracts with employers on behalf of dispatched employees. The dispatched positions are typically temporary and complementary in nature, and the employment contracts should state the position, term and compensation of the employee, including social insurance fees. The employers must protect the rights and interests of the dispatched employees. In December 2012, the Standing Committee of the National People’s Congress enacted an amendment to the PRC Labor Contract Law, which will become effective on July 1, 2013. The amended PRC Labor Contract Law protects the right to equal pay for equal work for dispatched employees, limits the number of dispatched workers and imposes more stringent penalties on unlawful labor dispatch practices. In addition, if the employer causes losses to the dispatched employees, the human resource companies and the employer are jointly liable.

 

We have entered into labor contracts with most of our employees. We provide our employees with the proper welfare and employment benefits. We employ the remaining employees through third-party human resources companies that are qualified to dispatch such employees to our PRC entities. These third-party human resources companies are responsible for managing, among others, payrolls, social insurance contributions of these employees.

 

Pursuant to the PRC Labor Contract Law and its latest amendments effective on July 1, 2013, dispatched employees are intended to be a supplementary form of employment and shall only apply to provisional, auxiliary or substitutive positions, and the fundamental form should be direct employment by enterprises and organizations that require employees. It is expressly stated that the number of dispatched employees an employer uses may not exceed a “certain percentage” of its total labor force. The Interim Provisions on Labor Dispatch which came into force on March 1, 2014, further set such percentage at 10% and provide a two-year transitional period for compliance with such requirement. Failure to comply with these requirements may result in orders of rectification and imposition of fines. See Item 3.D. “Risk Factors—Risks Related to Doing Business in China—The enforcement of the PRC labor contract law may materially increase our costs and decrease our net income.”

 

In addition, the State Administration for Taxation has issued circulars concerning employee share options or restricted shares. Under these circulars, employees working in the PRC who exercise share options (i.e. our existing equity compensation plans), or whose restricted shares vest, will be subject to PRC individual income tax. The PRC subsidiaries of an overseas listed company have obligations to file documents related to employee share options or restricted shares with relevant tax authorities and to withhold individual income taxes of those employees related to their share options or restricted shares. Although we currently withhold income tax from our PRC employees in connection with their exercise of options and the vesting of their restricted shares, if the employees fail to pay, or the PRC subsidiaries fail to withhold, their income taxes according to relevant laws, rules and regulations, the PRC subsidiaries may face sanctions imposed by the tax authorities or other PRC government authorities. See Item 3.D. “Risk Factors—Risks Related to Doing Business in China—Any failure to comply with PRC regulations regarding our employee equity incentive plans may subject the PRC plan participants or us to fines and other legal or administrative sanctions.”

 

Regulations on Concentration in Merger and Acquisition Transactions

 

In August 2006, six PRC regulatory authorities, including MOFCOM and the China Securities Regulatory Commission, jointly adopted the M&A Rule, which were amended in June 2009. The M&A Rules established additional procedures and requirements that could make merger and acquisition activities by foreign investors more time-consuming and complex. These rules require, among other things, that MOFCOM be notified in advance of any change-of-control transaction in which a foreign investor will take control of a PRC domestic enterprise or a foreign company with substantial PRC operations, if certain thresholds under the Provisions on Thresholds for Prior Notification of Concentrations of Undertakings issued by the State Council in August 2008 are triggered.

 

According to the Implementing Rules Concerning Security Review on the Mergers and Acquisitions by Foreign Investors of Domestic Enterprises issued by the MOFCOM in August 2011, mergers and acquisitions by foreign investors involved in “an industry related to national security” are subject to strict review by MOFCOM. These rules also prohibit any transactions attempting to bypass such security review, including by controlling entities through contractual arrangements. We believe that our business is not in an industry related to national security, but we cannot preclude the possibility that the MOFCOM or other government agencies may publish explanations contrary to our understanding or broaden the scope of such security reviews in the future.

 

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C.            Organizational Structure

 

We conduct our operations in China principally through contractual arrangements among our PRC subsidiaries, our consolidated affiliated entities in the PRC, and their respective shareholders. We hold no ownership interest in any of our consolidated affiliated entities in China. In August 2012, in connection with the repurchase of our ordinary shares from Mr. Shanyou Li, Mr. Shanyou Li and other shareholders of our consolidated affiliated entities Ku6 Information Technology and Ku6 Cultural transferred their equity interests in Ku6 Information Technology and Ku6 Cultural to new shareholders designated by us. Subsequently, we amended the relevant contractual agreements with respect to these controlled affiliated entities. As a result, our consolidated affiliated entities are owned, directly or indirectly, by certain individuals as follows:

 

·                  Ku6 Information Technology is 98% owned by Mr. Yingfeng Zhang and 2% owned by Mr. Mingfeng Chen;

 

·                  Tianjin Ku6 Zheng Yuan, which is wholly owned by Ku6 Information Technology, is 98% owned by Mr. Yingfeng Zhang and 2% owned by Mr. Mingfeng Chen;

 

·                  Ku6 Cultural is 98% owned by Mr. Yingfeng Zhang and 2% owned by Mr. Mingfeng Chen; and

 

·                  Tianjin Ku6 Network is 90% owned by Ms. Dongxu Wang and 10% owned by Mr. Qing Zhang.

 

Through our contractual arrangements with these consolidated affiliated entities, we have the power to vote all the shares held by the shareholders of these entities, through our PRC subsidiaries, as well as the right to enjoy the economic benefits derived from these entities and the exclusive right to purchase equity interests from the shareholders of these entities to the extent permitted by PRC law. For a detailed description of the regulatory environment that necessitates the adoption of our corporate structure, see Item 4.B. “Business Overview—Government Regulation.” For a detailed description of the risks associated with our corporate structure and the contractual arrangements that support our corporate structure, see Item 3.D. “Risk Factors—Risks Related to Our Corporate Structure.”

 

Under the guidance relating to the consolidation of consolidated affiliated entities, we are the primary beneficiary of the economic benefits of our consolidated affiliated entities, namely, Ku6 Information Technology, Tianjin Ku6 Zheng Yuan, Ku6 Cultural and Tianjin Ku6 Network. Transactions among our consolidated affiliated entities, our company and our subsidiaries are eliminated in consolidation.

 

The following diagram illustrates the corporate structure of our company, our subsidiaries, and our consolidated affiliated entities, as well as our shareholding in Yisheng, as of March 31, 2015:

 

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D.            Property, Plant and Equipment

 

Our principal executive offices are located on premises with a gross floor area of approximately 5,640 square meters in Beijing. We also have branch and representative offices in Tianjin.

 

Item4A.                           Unresolved Staff Comments

 

Not Applicable.

 

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Item 5.                                 Operating and Financial Review and Prospects

 

The following discussion of our financial condition and results of operations is based upon and should be read in conjunction with our consolidated financial statements and their related notes included elsewhere in this annual report on Form 20-F. This discussion contains forward looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act, including, without limitation, statements regarding our expectations, beliefs, intentions or future strategies that are signified by the words “expect,” “anticipate,” “intend,” “believe” or similar language. All forward-looking statements included in this annual report are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. In evaluating our business, you should carefully consider the information provided under the caption “Risk Factors.” We caution you that our businesses and financial performance are subject to substantial risks and uncertainties.

 

A.            Operating Results

 

Overview

 

We entered into the online video business through the acquisition of Ku6 Holding in January 2010.

 

In July 2012, we repurchased an aggregate of 269,409,276 ordinary shares from certain former officers, Mr. Shanyou Li, Mr. Zhizhong Hao and Ms. Xingye Zeng, and Kumella Holdings Limited, a company controlled by Mr. Shanyou Li, at a price of $0.0291 per share, and repurchased 79,717 ADSs from Mr. Shanyou Li at a price of $2.91 per ADS. The repurchase was approved by shareholders at our annual general meeting of shareholders on July 12, 2012 and consummated on July 13, 2012. All the repurchased ordinary shares and ADSs were cancelled upon repurchase.

 

On March 31, 2014, Mr. Xu entered into a share purchase agreement with our then controlling shareholder, Shanda Media, a wholly owned subsidiary of Shanda Interactive, to purchase 1,938,360,784 of our ordinary shares, amounting to approximately 41% of our issued and outstanding share capital. The Share Purchase Transaction was completed on April 3, 2014, and the aggregate consideration for these ordinary shares was $47,350,831.05. Mr. Xu funded the purchase price through a loan from Shanda Media, which is secured by a charge of all of our ordinary shares beneficially owned by Mr. Xu.

 

Historically, we derived substantially all of our revenues from online advertising services, for which we collect service fees from advertisers through our advertising agencies. In April 2014, as a result of our management’s review and adjustment of our business strategies after the Share Purchase Transaction, we started to explore new revenue sources, including advertising agreements with independent third parties and cooperation with Qinhe. See Item 4.B. “Business Overview—Marketing Services and Customers.” As these revenue sources are relatively new, there is also no assurance that they would generate sufficient revenues and operating cash flows in the future. See Item 3.D. “Risk Factors—Risks Related to Our Business—Our new business models may not be able to generate sufficient revenues and operating cash flows.”

 

For the years ended December 31, 2012, 2013 and 2014, our revenues were $14.1 million, $13.1 million and $8.6 million, respectively, and our net loss was $9.5 million, $34.4 million and $10.7 million, respectively.

 

Factors Affecting Our Results of Operations

 

Our business, financial condition and results of operations have been and will continue to be subject to general conditions affecting the online video and online marketing industries in China. These conditions, among others, include the stability and growth of China’s economy, the growth of the Internet and mobile Internet penetration rate in China, and the increasing acceptance of online video marketing by the advertisers.

 

In addition, our business, financial condition and results of operations are affected by a number of company-specific factors including our ability to:

 

·                  maintain and expand our user base;

 

·                  obtain and produce popular video content cost-effectively;

 

·                  procure Internet bandwidth cost-effectively;

 

·                  provide effective online marketing services;

 

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·                  control sales and marketing expenses; and

 

·                  maintain our brand and market position.

 

Our business, financial condition and results of operations may also be affected by a number of factors relating to the performance of the iSpeak platform operated by Qinhe. See Item 3.D. “Risk Factors—Risks Related to Our Business—Our cooperation arrangements with Qinhe are subject to considerable uncertainties.”

 

Furthermore, substantial doubt exists as to our ability to continue as a going concern. See Item 5.B. “Liquidity and Capital Resources—Liquidity and Going Concern,” Item 3.D. “Risk Factors—Risks Related to Our Business—There is substantial doubt as to our ability to continue as a going concern” and notes 1 and 2 to our audited consolidated financial statements included elsewhere in this annual report on Form 20-F.

 

Description of Certain Statement of Operations Items

 

Net Revenues

 

In 2012, 2013 and 2014, we derived substantially all of our net revenues from online advertising services. Prior to April 2011, we derived these revenues primarily from various third-party advertising agencies. In April 2011, we entered into an advertising agency agreement with Old Shengyue, an affiliate then wholly owned by Shanda Interactive, pursuant to which Old Shengyue agreed to act as our exclusive advertising agency for our standard media resources and as our non-exclusive advertising agency for our highly interactive advertising resources. We relied on Old Shengyue as our primary advertising agency, which managed our sales to, and collected payments from, substantially all of our advertisers from April 2011 to March 2014. This agreement with Old Shengyue, as previously renewed, expired on March 31, 2014 and was not further renewed.

 

In April 2014, we entered into a new advertising agency agreement with New Shengyue, which is no longer owned by Shanda Interactive and is an independent third party. In August 2014, we terminated this agreement with New Shengyue and entered into another new advertising agency agreement with Huzhong, an independent third party. Pursuant to our agreement with Huzhong, Huzhong will act as our exclusive advertising agency for standard media resources and non-exclusive advertising agency for highly-interactive advertising resources. Under this agreement, we guarantee a certain amount of web traffic per day for webpages on which Huzhong posts advertisements, and in return, Huzhong guarantees to us a minimum amount of advertising revenues per day. If we fail to meet the web traffic target, the minimum amount guaranteed by Huzhong will be proportionally adjusted for the shortfall. Huzhong agreed to prepay 50% of the minimum guaranteed amounts within five business days prior to the beginning of each month and settle the balance within five business days after the end of each month.

 

For the years ended December 31, 2011, 2012, 2013 and 2014, we generated advertising revenues of $8.1 million, $12.5 million, $12.4 million and $6.0 million from advertising agencies in total.

 

In addition, in April 2014, as a result of our management’s review and adjustment of our business strategies after the Share Purchase Transaction, we started to explore new revenue models in cooperation with Qinhe, a company controlled by Mr. Xu, our largest shareholder. See Item 7.B. “Related Party Transactions—Cooperation Agreements with Qinhe.” In April 2014, we started to provide interactive entertainment marketing services to iSpeak, a social platform that allows users to engage in real-time online group activities through voice, text and video. Under our cooperation agreement with Qinhe, which operates the iSpeak platform, Qinhe will share a certain percentage of the revenues that it generates from the viewers who visit the iSpeak platform through advertisements on our website. Users on the iSpeak platform may spend on virtual items during real-time video broadcasting, including gifts and avatars, and purchase other value-added services. In April 2014, we also started to provide game marketing services for Qinhe under a similar revenue sharing arrangement as the one for interactive entertainment marketing cooperation. We generated revenues of $1.6 million from Qinhe for the year ended December 31, 2014.

 

Our cooperation with Qinhe is relatively new and subject to changes from time to time. In September 2014, we amended the interactive entertainment cooperation agreement with Qinhe. Pursuant to the amended agreement, Qinhe agreed to pay certain additional guaranteed revenue amounts from July 2014 to December 2014, and the term of this agreement was extended to December 31, 2015. Other terms of the original agreements, including the revenue sharing arrangement, remained the same. In March 2015, our game marketing cooperation agreement with Qinhe expired and our management decided not to renew this agreement to focus on interactive entertainment marketing services. On March 30, 2015, we further amended our interactive entertainment cooperation agreement with Qinhe. Pursuant to the further amended cooperation agreement, the revenue sharing arrangement in the original agreement will be reinstated without the additional guaranteed revenue amounts.

 

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As the revenue models are relatively new, there is no assurance that they would generate sufficient revenues and operating cash flows in the future. See Item 3.D. “Risk Factors—Risks Related to Our Business—Our new business models may not be able to generate sufficient revenues and operating cash flows.”

 

Cost of Revenues

 

Our cost of revenues consists of Internet bandwidth costs, payroll costs associated with the platform operation and content, depreciation expenses, User Generated Content costs, in-house developed content costs, and other costs. Our total cost of revenues amounted to $12.1 million for the year ended December 31, 2014.

 

		Year ended December 31,
		2012		2013		2014
		(in thousands of U.S. dollars)
Internet bandwidth costs		7,790		7,445		5,920
User Generated Content costs		1,248		1,340		336
Payroll costs		2,806		2,540		3,270
Depreciation of servers and other equipment		1,425		1,620		1,032
In-house developed content costs		—		1,439		149
Other costs(1)		1,334		1,601		1,434
Total costs		14,603		15,985		12,141

 

(1) Include primarily advertisement production costs, platform operation costs and outside service fees.

 

Internet bandwidth costs. Internet bandwidth costs are the fees we pay to telecommunications carriers and other service providers for telecommunications services and for hosting our servers at their Internet data centers. Bandwidth is a significant component of our cost of revenues and therefore an important factor affecting our profitability. The bandwidth costs as a percentage of our net revenues increased from 56.7% for the year ended December 31, 2013 to 69.0% for the year ended December 31, 2014. In order to maintain our user community to support our new revenue models, we expect Internet bandwidth costs to remain relatively stable in the future.

 

User Generated Content costs, or UGC costs. User Generated Content costs are fees paid to users for videos they uploaded to our website. The costs remained flat for the years ended December 31, 2012 and 2013. Our UGC costs decreased in 2014 as we suspended the revenue sharing program for UGC in May 2014. We expect no UGC costs in 2015. See Item 4.B. “Business Overview—Our Content—UGC (User-Generated Content).”

 

Payroll costs. Payroll costs consist of salaries and benefits for our platform operation and content personnel. The payroll costs increased from $2.5 million for the year ended December 31, 2013 to $3.3 million for the year ended December 31, 2014. The increase was primarily attributable to compensation expenses for layoffs paid in 2014 as result of our headcount reduction plan. Because such compensation expenses were non-recurring in nature, we expect our payroll costs to decrease in 2015 with a lower headcount.

 

Depreciation of servers and other equipment. We include depreciation expense for servers and other equipment that are directly related to our business operations and technical support in our cost of revenues. Our depreciation expense decreased from $1.6 million in 2013 to $1.0 million in 2014 primarily due to the full depreciation of certain assets in 2014 and lower capital expenditures. We intend to engage cloud computing service providers and use their servers and other equipment instead of purchasing new servers and other equipment on a large scale. As a result, we expect our depreciation expense to generally remain stable or decrease in future periods.

 

In-house developed content costs. In-house developed content costs represent costs related to the production of our news, reports and interactive entertainment programs, but do not include any salaries and benefits paid to our employees. The in-house developed content costs for the year ended December 31, 2013 were mainly attributable to video production costs incurred for the UGC Entertainment Awards Ceremony held by us in Beijing in December 2013. Such costs have been immediately expensed due to the uncertainties of revenues and economic benefits derivable from such activities. We did not have any significant in-house developed content in 2014 and the related costs decreased accordingly.

 

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Operating Expenses

 

The following table sets forth certain historical consolidated operating expenses data, for the periods indicated:

 

		Year ended December 31,
		2012		2013		2014
		(in thousands of U.S. dollars)
Operating Expenses
Product development		1,973		3,496		1,385
Selling and marketing		1,689		1,797		942
General and administrative		6,820		8,089		7,088
Impairment of goodwill and intangible assets		—		27,226		—
Total operating expenses		10,482		40,608		9,415

 

Product Development Expenses. Product development expenses consist primarily of salaries and benefits for product development personnel, including share-based compensation costs.

 

Selling and Marketing Expenses. Selling and marketing expenses consist primarily of sales and marketing personnel payroll compensation and related employee costs, advertising and market promotion expenses, and other overhead expenses incurred by our sales and marketing personnel.

 

General and Administrative Expenses. General and administrative expenses consist primarily of salary and benefits, including share-based compensation, for general management, finance and administrative personnel, bad debt provisions (reversals), litigation accruals (and related reversals), depreciation, amortization of intangible assets and goodwill, professional service fees, office rental fees, and other expenses.

 

Impairment of Goodwill and Intangible assets. We recorded significant impairment charges of $6.2 million and $21.0 million for goodwill and for definite-lived intangible assets (mainly trademark), respectively, for the year ended December 31, 2013. See Item 5.A. “Operating Results—Critical Accounting Policies—Goodwill and Intangible Assets Impairment.”

 

Furthermore, in order to reduce operating cash outflows, we have carried out a plan to reduce our headcount by approximately 40% in various departments in April 2014. See Item 6.D. “Employees.” As a result, we expect the payroll expenses included in the above items to decrease in 2015.

 

Critical Accounting Policies

 

The methods, estimates and judgments we use in applying our accounting policies have a significant impact on the results we report in our financial statements. Some of our accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. We have summarized our accounting policies below that we believe are both important to an understanding of our financial results and involve the need to make estimates about the effect of matters that are inherently uncertain. We also have other policies that we consider to be key accounting policies. However, these policies do not meet the definition of critical accounting policies because they do not generally require us to make estimates or judgments that are difficult or subjective.

 

Business Combinations and Non-controlling Interests

 

We account for our business combinations using the purchase method of accounting. This method requires that the acquisition cost to be allocated to the assets, including separately identifiable intangible assets, and liabilities we acquired based on their estimated fair values. Any non-controlling interest was reflected at historical cost. Where the consideration in an acquisition includes contingent consideration the payment of which depends on the achievement of certain specified conditions post-acquisition, contingent consideration was not recorded until the contingency was resolved.

 

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