Variable Interest Entities: A Risky Investment in China

No other investment opportunity has captured the attention of investors than China. According to World Bank Statistics, China’s GDP is expected to be in excess of $12 Trillion USD by 2018. Additional estimates suggest that China will overtake the United States as the largest economy in the world by 2030. Given these valuations, many see China as a rising dragon, awakening from a long period of dormancy.

These trends aside, China’s legal framework represents a difficult point of entry for many investors. One of the most prescient risks facing foreign investors is the very corporate entity providing them access to otherwise restricted Chinese markets: Variable interest Entity (VIE) entities.

Background: Restricted Foreign Investment

The People’s Republic of China (PRC) enforces strict barriers against foreign investment capital going into China. The PRC Ministry of Commerce (MOFCOM) and the National Development and Reform Commission (NDRC) are the two (2) Government agencies tasked with developing catalogues delineating the classes of industries for which foreign investment is permitted, restricted, and prohibited. Industries listed under the permitted category have few restrictions associated wit h foreign investment; however, those listed under the restricted and prohibited categories face significant legal hurdles.

The Catalogue of Industries for Guiding Foreign Investment (Revision 2017) is the PRC published document containing the list of all permissible, restricted, and prohibited industries. Some of the industries listed in the prohibited section of the document are those most likely to attract the interests of foreign investors including, pharmaceuticals, genetically modified organisms, telecommunications, and internet-based technologies

This is where variable interest entities come into play.

The VIE Structure

Variable interest entity (VIE) corporate structures are often used by China-domiciled companies as a means of bypassing foreign direct investment restrictions and prohibitions imposed by MOFCOM and the NDRC.

The essential element of the VIE corporate entity is its form of structuration. When adopting a VIE structure, Chinese nationals incorporate a China-domiciled entity and link it to various intermediary companies outside PRC government jurisdiction, typically in the Cayman Islands. US investors purchasing shares in a publicly listed China-domiciled company with a VIE structure are actually purchasing shares in the offshore entity, not the China-domiciled company itself.

These offshore entities do not own the revenue generating business operations nor any equity in the PRC operating company. Instead, investors are provided a share of profits solely from contractual arrangements between the publicly listed entity and the underlying PRC-domiciled corporate entity.

SSLJ.com SEC 20-K Form

There are at least two (2) inherent risks associated with investing in publicly listed Chinese companies with VIE corporate structures.

Uncertain Legal Status

The PRC government has not yet explicitly legalized the right of corporate entities to adopt a VIE structuration. One possible explanation for this is that the PRC is making a politically strategic calculation. By refraining from weighing on the legal status of VIE corporations, the PRC government provides restricted industries the means of raising capital while also retaining the ability to invalidate the structure should the need to do so emerge.

These concerns are compounded by the fact that there have been numerous rulings at both the local and national level suggesting a negative view of VIE corporate structures. In one particular instance, Hebiei provincial authorities banned Buddha Steel, a publicly traded company in the United States, from operating with a VIE structure. The announcement of the ruling resulted in Buddha Steel withdrawing its IPO from the NASDAQ.

Additionally, at the national level, the PRC government has expressed a negative attitude towards VIE corporate entities. Specifically, in a determination made Aug. 13th, 2012 by the Chinese Ministry of Commerce, Wal-Mart’s acquisition of Yihaodian was approved on the condition that Wal-Mart did not use a VIE structure when executing on value-added telecommunication businesses operations.

The Wal-Mart case in 2012 was the first time that the Chinese Ministry of Commerce explicitly prohibited the use of a VIE structure. Compounded with the Buddha Steel verdict in Hebei, it appears that though the PRC has not outright ruled against VIE corporate entities, their view of them is distinctively negative.

(In)Validity of Contracts

Adding to the unfavorable governmental response, it is possible that the contractual arrangements associated with the VIE corporate structure may not even be legally enforceable. Since the VIE structure is specifically used as a means of subverting both the intent and the spirit of the law, they may be inherently void. As noted by Steve Dickinson, partner at Harris & Moure and Co-Author of the China law Blog, “To the extent a VIE Contract structure is designed to circumvent the requirements of Chinese law, such contracts are void, not voidable, void.”

This represents a major risk to investors. Until a ruling is made, it is entirely possible that the legality of the VIE corporate structure could be invalidated at any time, retroactively leaving foreign investors with little to no recourse for recovering their foreign direct investment capital.

The Yahoo-Alibaba case is the most salient expression of these concerns. The issue arose when Jack Ma, The Founder and CEO of Alibaba Group, a VIE corporate entity, terminated the VIE structure unilaterally and transferred Alipay, a high-value subsidiary in the online payments industry, to a separate China-domiciled entity listed in his name. Yahoo, a major Alibaba Group shareholder with over 40% ownership shares, was not consulted prior to the transfer. Instead, Yahoo was given no other alternative but to enter private negotiations with Jack Ma to recuperate the lost investment capital. Yahoo ultimately brokered a deal with Jack Ma entailing that Alibaba Group would give up $6 Billion in proceeds of any future Alipay IPO or sale. This figure represents a 62.5% devaluation of Yahoo’s stake in Alipay had it remained fully under Alibaba Group’s control.

Perhaps no other document better epitomizes the tenuous relationship between foreign investors and China-domiciled VIE corporate entities than Alibaba's SEC Prospectus. The Prospectus states, “If the PRC government deems that the contractual arrangements in relation to our variable interest entities do not comply with PRC governmental restrictions on foreign investment…we could be subject to penalties or be forced to relinquish our interests in those operations.”

Conclusion

China is an attractive location for foreign investors. The economy is improving, the population is growing, and the marketplace is maturing; however, investment opportunities are still limited. Investors may turn to VIE corporate entities as a solution to their needs, but they quickly learn (painfully) that VIE investments come with problems of their own.

A major component of successful long-term investments is the reduction of risk. VIE corporate entities do not reduce risk; they are a risk.

Solution

Presidium Investigations offers due diligence reports on China-domiciled companies. Using our intelligence-based solutions approach, we identify adverse information associated with your foreign investments and reduce your level of risk.

Contact us now and see how our solutions can serve your needs.