VIE Shell Game

CII Highlights Chinese VIE Corporate Structure Risk

A new report from the Council of Institutional Investors (CII) underlines the risks posed to investors by a corporate structure called a variable interest entity (VIE). Sixty two percent of Chinese companies listed on U.S. stock exchanges use a VIE, including internet giants Sina, Baidu, Alibaba and U.S. exchanges are experiencing a surge of Chinese VIE IPOs, with 20 filings this year, including 15 since September 1, compared to six in 2016 and seven in 2015.

VIE Corporate Structure Risk: Comments

Said Ken Bertsch, CII’s executive director.

Chinese companies using VIE structures have made a splash in the U.S. market and elsewhere, but investors should be aware that VIEs lack legal protections that investors normally expect.

Adds James McRitchie, investor advocate and blogger:

I visit China fairly frequently. It is a dynamic economy. It is tempting to invest in their many quickly growing companies. However, their typical VIE structure offers far few rights to investors than even controlled companies like Facebook and Alphabet. At US companies, even if shareholders have little or no say through votes, at least we have the courts. Personally, I have chosen India over China because companies there typically offer better shareholder rights.

VIE Corporate Structure Risk

What is a VIE? The Chinese government restricts Chinese companies in certain industries from receiving foreign investment. To sidestep these regulations, companies seeking foreign capital have adopted the VIE structure by constructing a complex network of entities, one of which is an offshore shell company that conducts an IPO on a U.S. exchange. The operating company remains technically owned by Chinese nationals, not foreign shareholders, since the entities are connected through contractual arrangements rather than direct ownership.

Investors in companies with VIEs do not own equity in the Chinese company’s operations. Because the contracts are designed to evade foreign investment restrictions, they might be invalid under Chinese contract law. As a result, investors are left without any real right to residual profits, control over the company’s management or legal protections and recourse they would ordinarily enjoy through equity ownership.

VIE Corporate Structure Risk: Key Takeaways

  • The shell company conducting the IPO typically neither has operations of its own nor directly owns a company with operations. Its financial statements consolidate the Chinese operating company since the contractual arrangements are designed to mimic direct ownership. Confusingly, the shell company often bears the same name as the Chinese operating company.
  • Since the enforceability of the contracts is in question, investors could suffer financially if Beijing enforces its foreign investment restrictions or the Chinese company’s management expropriates the assets or earnings. A high profile case of expropriation took place between Alibaba’s Jack Ma and Yahoo in 2011 (see page 9 of the report).
  • These companies could be subject to punitive levels of taxation in China as they move money through the structure, and this potential tax liability—possibly as high as 50%—is not fully reflected in the financial statements. These potential liabilities are widely overlooked.
  • The vast majority of Chinese VIEs state in their filings with the U.S. Securities and Exchange Commission (SEC) that they have no plans to pay dividends to investors and will reinvest their earnings in China indefinitely. Investors may have to rely solely on the appreciation of the company’s stock price for a return on their investment.
  • These companies often adopt poor corporate governance practices. Sixty one percent that IPO’d in the last two years employ a dual-class structure with unequal voting rights. Among all Chinese VIEs, 83% are incorporated in the Cayman Islands or British Virgin Islands where required governance provisions are weak, and 56% rely on legal exemptions from board independence standards.
  • The report includes a list of known VIEs. Check before investing.

VIE Corporate Structure Risk: Recommendations

The report concludes by offering five recommendations to the SEC on how to improve transparency and accountability to shareholders of Chinese companies using VIEs by strengthening disclosure rules.

  1. Requiring Chinese companies using VIE structures to disclose in their 20-F filings the full legal opinion regarding the contracts on which they rely as the basis for consolidating the VIE;
  2. Requiring separate, unconsolidated financial statements for each entity—the VIE, the WFOE, and the ListCo—so investors can understand where the company’s operations exist and the cash flow between the entities;
  3. Promoting higher quality implementation of the accounting for deferred tax liabilities, including disclosing the potentially applicable tax rates of moving cash flow through the VIE structure;
  4. Requiring Chinese companies with VIEs to disclose a succession plan that details the arrangement and procedures that will ensue should the VIE’s Chinese owners depart; and
  5. Strengthening disclosure requirements for FPIs, given that 82% of U.S.-listed Chinese companies with VIEs are FPIs, to include a certification of compliance with Chinese regulations and the enforceability of any contractual arrangements that underpin the business model.

Given the action on Snap that resulted in banning dual-class shares from future listing on the S&P 500, maybe CII and others should attempt a similar ban of VIEs from S&P’s international indexes. Follow CII in Twitter @CouncilInstInv.


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