As China reasserts control over its powerful private enterprises, US and Hong Kong investors in Chinese stocks need to be aware of a rarely discussed risk that has the potential to jeopardise their holdings: the fact that they do not technically own the companies.
To skirt China’s restrictions on foreign investment in certain industries and to raise capital from overseas stock markets, many Chinese companies adopted a so-called VIE structure, short for “variable interest entity”. By one estimate, more than 100 VIE companies now command about US$4 trillion of capitalisation in MSCI China Index. US-based investors could hold as much as US$700 billion worth of them, according to a government report in July.
This peculiar corporate structure enables offshore investors to share the profits of some of China’s most successful companies – from Tencent Holdings to Alibaba Group Holding – in some of the most lucrative and fastest-growing sectors, like the internet, e-commerce, media and education.
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They do so through contractual agreements with onshore operators – seen as the “real” companies they intend to invest in – that give them an economic claim instead of an equity stake, because direct foreign ownership is limited.
The entire arrangement falls into a legal grey area in China.
While this has been working fine for two decades, the issue could explode after China flexed its regulatory muscle by halting Ant Group’s US$39.5 billion stock debut in November, while distrust between China and the US climbs to an unprecedented level.
“If the authorities [suddenly decide to] disagree with and take a swipe at the VIE structure, the consequences could be significant,” said Bruce Pang, head of macro and strategy research at China Renaissance, which estimated more than 900 VIE firm listed in the US and Hong Kong. This could lead to “businesses being shuttered and growth of the private sector being hampered in the absence of required capital,” he added.
Even though investors and companies generally expect Beijing to keep the status quo and do not foresee an immediate clampdown on the VIE structures, it still constitutes a potential existential crisis for the stocks and their investors.
As Washington has dialled up pressure on US-listed Chinese companies over the past year, a number of American regulators including the Securities and Exchange Commission (SEC) have voiced concerns over the VIE structures recently.
“These China-based issuer VIE structures pose risks to US investors that are not present in other organisational structures,” said the SEC’s division of corporation finance in a document published in November, outlining several scenarios where the companies’ operations could come under threat and the investors’ interests be harmed.
Pang describes the arrangement as having “substantial regulatory uncertainties, given the VIE structure represents an attempt to avoid restrictions on foreign investment in the relevant sectors”.
The VIE structure works through a web of complex legal agreements. An offshore entity, usually incorporated in a tax haven like the Cayman Islands, controls the business operator in China through contract agreements, instead of direct equity ownership.
The China-based company is fully owned by Chinese nationals – usually the founder or key executives – and is therefore allowed to obtain the necessary licences to operate. Meanwhile, the offshore entity is floated on markets including the US, Hong Kong and beyond.
This arrangement, originally created by a team of innovative lawyers led by Liu Gang at Chinese law firm Commerce & Finance Law Offices, has not gained any official approval from the Chinese government.
The latest Foreign Investment Law that took effect early this year did not mention VIE structures at all, pulling back from a previous draft released in 2015 that had taken a harsh stance on it. This means that Beijing is so far still officially silent on the issue of VIE’s legality, even if it has the power to invalidate or even outlaw it.
And if the onshore entity for any reason decides to breach the contracts, there is also no guarantee that Chinese regulators would enforce any legal obligations.
The Chinese government on Saturday published details of a system to review foreign investments for national security risks, covering sectors including the military, energy, agriculture, internet and financial services. The rules did not bring up the issue of VIE structures.
Since Sina Corp first experimented with the VIE structure and successfully went public on the Nasdaq in 2000, hundreds of Chinese firms have taken the same path.
Now, all US-listed constituents of the MSCI China Index operate under VIE structures. A large number of Hong Kong-listed constituents are also VIE stocks, accounting for about half of the weightings of all MSCI China stocks traded in Hong Kong.
The 10 largest VIE stocks’ market value is around US$2.3 trillion, accounting for nearly half of the weight of the MSCI China benchmark, according to China Renaissance.
US-based investors could hold as much as US$700 billion worth of Chinese equities, mostly through the VIE stocks, according to a National Bureau of Economic Research working paper published in July.
These positions have been vastly understated in the past because US official statistics did not treat those Cayman Islands-incorporated firms as Chinese, the paper says. Retail investors are also part of the picture, as they could own the shares through mutual funds in retirement accounts.
Companies traditionally disclose the VIE structures and risks associated with them in their listing prospectus, but the technicality of it means only professional investors tend to understand what is really behind it.
“It is hard to believe that when retail investors buy Alibaba shares on the NYSE they understand that they are buying a claim on a Cayman Islands-based holding company with a complex and tenuous legal relationship with the Chinese firm,” the authors, led by Antonio Coppola at Harvard University, said in the paper.
“Our results suggest that this risk may be underappreciated by regulators due to the understatement of its scale in official statistics.”
Companies holding less assets in their Chinese entities, such as Tencent and Alibaba, would be safer for investors in the unlikely event of a breach of VIE agreement, according to China Renaissance. Asset-light firms, like JD.com, Meituan and Xiaomi Corp, are also safer than asset-heavy firms such as those in the education industry, the report says. Alibaba owns this newspaper.
As relations between Beijing and Washington have plunged to a new low this year, US regulatory scrutiny of Chinese companies escalated to an unprecedented level. Legislation pending the president’s approval threatens to delist Chinese stocks from American exchanges if they refuse to increase their accounting transparency as US standards required.
“We may see [overseas-listed] Chinese companies reassess their own internal corporate structures and continue to monitor audit controls,” said Shaun Wu, partner at law firm Paul Hastings in Hong Kong.
The Biden administration is likely to confront China on bilateral investment issues including the VIE structures at some point, even though the market is now hopeful that the new president will bring some initial reprieve to souring US-China relations when he takes office, according to Matt Gertken, geopolitical strategist at BCA Research.
“When the Biden administration goes back to negotiate with China, there will be ongoing discussions about foreign investments in China, about access to different sectors, the negative list, technology transfer, and the rights of foreign shareholders,” he said.
Special arrangements like the VIE structures were created in an environment of good trade and investment relationships over the past three decades.
However, “now there is more distrust and more scrutiny, the special arrangements don’t hold up all that well to the scrutiny,” Gertken said.
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