Investing in China: Be careful about the Variable Interests Entities
About a half of Chinese companies listed in NYSE and NASDAQ are using Variable Interests Entities so as to avoid the restrictions over foreign investments. While they are a very good way for foreigners to benefit from Chinese companies’ rapid growth, major risks loom, threatening foreign investors’ ability to exercise their shareholding rights on the Chinese company. In this article, S.J.Grand offers you an overview of the VIE’s advantages and drawbacks.
Investing in China’s lucrative restricted fields
Since direct foreign ownership of a Chinese company operating in a restricted industry is forbidden, the Chinese company needs to create a company outside China. It will usually be done in Cayman Islands, offering low taxes and transparent legal framework. The latter can be listed on foreign exchanges without restrictions, since it is not subject to Chinese laws. However, it is worth nothing at this point. So as to give the foreign company a value, the Chinese company needs to find a way to transfer its profits, which can be achieved through several contracts, mimicking the foreign company’s ownership of the Chinese one. Due to regulation, those contracts can only be signed by a Chinese company though: the foreign company has to create a Wholly Foreign-Owned Enterprise (WFOE) in China, with who the contracts will be signed. Therefore the structure can be represented as follow:
VIEs’ structural risks
VIEs are often described as a good way for foreign investors to acquire stakes in a Chinese restricted industry. It has also been a way, for Chinese companies from these industries, to get access to foreign capital. All in all, it seems that both sides win. But bypassing the Chinese Laws necessarily comes at a cost:
- Unreachable assets: At the end of the day, shareholders only own contracts tying the VIE’s profits to the WFOE’s. Even though one of those contracts stipulates that its owner can purchase the assets of the VIE at a fixed price (Call Option Agreement), a foreign investor will never be able to exercise this right in China, because of the industry restrictions. This means the VIE’s assets are unreachable for foreign investors. It may not be a problem for asset-light companies, such as internet firms (Tencent, Sina or Alipay), as the service they provide can be easily transferred to the WFOE while the VIE only holds licenses and certifications. More troubles arise when the VIE owns large amounts of assets which cannot be easily transferred to the WFOE due to legal and fiscal regulations. In such cases, there is a real risk for investors to lose their investments.
- Variable policies: As VIE is a way to bypass Chinese laws, there is always a risk that regulators tighten rules over such structures. In the worst case, it could result with the contracts to be cancelled. Alipay is a good case-in-point: in 2010, as People’s Bank Of China had decided to further regulate online payments processors, Alipay’s founder, Jack Ma, who had opted for a VIE structure, was refused the newly created license needed to keep his business legal. The VIE wouldn’t be licensed by the PBOC.
- Over-dependence on the Chinese Owner: The Chinese Owner is the only legal shareholder of the VIE. As Chinese laws invalidate contracts whose effects are illegal - and foreign investments in restricted industries are of this kind - the Chinese Owner can easily breach the contracts. End of Alipay’s case: Jack Ma ends the contracts between Alipay and its associate WFOE so as to get the new license. As a consequence, he legally becomes the only shareholder of Alipay. Yahoo!, the other main shareholder, loses its shares. Even though an agreement was reached later, it still shows that the VIE owner can act unilaterally.
- Volatility of the stocks: As a consequence, VIE stocks are very sensitive to policy shifts and Chinese Owner’s actions. In 2011, a report was released by the China Securities Regulatory Commission (CSRC) asking for more regulations over the use of VIEs, leading to general depreciation of VIE titles on markets.
Future of VIEs: what will be the consequences of regulators’ next move?
As the VIE’s reason of being is to enable something forbidden – foreign investment into restricted Chinese Industries – it is likely that it will be subject to reforms sooner or later. However, it is highly implausible that the Chinese government will merely forbid it, as it would be disastrous for both Chinese companies and foreign investors. Furthermore, the government has already allowed certain State-Owned Enterprises in restricted industries (Telecommunications) to be directly listed in the US. Therefore, it will probably ease the restriction, proposing the companies currently using a VIE to restructure so as to merge its different entities. So as to keep the sector under state control, it will probably use a multiple share structure, letting a part of the shares to be exchanged on foreign exchanges but keeping a majority of them at home.