Governance: The bottom-line on VIE
Debunking the China VIE risk
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Let’s dive right into today’s topic.
2021 has been a year of regulations for Chinese stocks. Alongside the intensified regulatory landscape, we have seen concerns of VIE risk resurfacing in the media and in the discussions within some investing circles. Here we are again with the historic three year VIE “scare-cycle”!
There are those who have brought out the loudspeaker to drive the narrative that the risks associated with VIE is growing. We disagree. The narrative that an official VIE ban is in order, or that it constitutes the logical next step in today’s tightened regulatory landscape, stems from confusion and to us seems like an uninformed attempt at connecting the regulatory dots.
But let us preface by saying that nothing here is investment advice. In this article, we want to debunk some existing misconceptions, and provide a viewpoint based on a fact-based and a politically neutral review of the topic. We hope this can serve as the groundwork to help investors reach their own decision as to where they stand.
We assume the reader is already familiar with the basic construct of the VIE (see below diagram), which first came into existence when it was adopted by Sina.com for its Nasdaq listing in 2000. Ever since then, all offshore listings of Chinese tech and internet companies have adopted this construct. Offshore shareholders take on “economic ownership” of a company, rather than true legal ownership. The main point of contention relates to the validity of the economic contract between the offshore SPV (more correctly, the WFOE owned by the SPV) and the onshore operating company (VIE). What keeps investors up at night is the possibility that they could end up holding shares of a worthless shell company, in the event that the said economic contract is deemed illegal by the Chinese authorities, and therefore becomes unenforceable.
Source: The Law Society of Hong Kong
On the legality of VIEs, a wide range of expert interpretations and opinions exist. You can pay a lawyer to find out, but chances are that you’ll get an answer that falls anywhere between “downright illegal” to “almost legal but still not quite”. Traditionally, the process taken on by institutional investors has been to pay legal experts for consultations, to be told that the legal basis of VIEs remains murky at best, and that such structure entails considerable uncertainty and legal risk as a result. But for investors, in our view, the more interesting and practical aspect to consider concerns the enforcement of VIE rather than the endless debates about its legality.
To go on a slight tangent – if you had consulted with lawyers 40 years ago, you would have been told that private enterprises were also illegal in the PRC, and that they also had no legal basis for existence. Indeed, despite not being recognized by the government, many private enterprises formed throughout the 1970’s and 80’s and operated in the gray zone. It was not until the Tentative Stipulations on Private Enterprises (TSPE) was enacted in 1988 that China formally recognized private enterprises in the most basic form, and not until the Company Law of 1994 that modern forms of enterprises like Limited Liability company had the full recognition of law.
In such a way, China has a precedence of leaving certain legal constructs in the gray zone, to retain control over the interpretation, until they decide to formally acknowledge the practice later on. VIEs are hardly unique from such kind of developmental pattern. This is not to imply that there should necessarily be any guarantee that VIEs be recognized in the future or at all. However, when something that is deemed so legally murky continue to be in existence for the last 22 years, and in plain sight of authorities, there is a good reason why. Clearly, the Chinese authorities have implicitly recognized the following:
Aggregate economic benefit brought by VIE + cost of enforcement must be greater than (>) the cost of acceptance
Any attempt to discredit the investability of VIEs is incomplete without answering what would change the calculus from PRC authorities’ perspective. VIE allows Chinese companies to take advantage of foreign capital, without giving up even an inch of ownership control. Meanwhile, offshore investors recognize this fully and are content to trade in their legal control for economic returns. Tens of billions of dollars of cash has been returned to overseas investors through this structure to date (we’ll come back to this again later). What is the alternative to this win-win?
But enough with the appetizer, let’s get into the main course.
How has the PRC authorities’ stance changed over time with regards to their recognition of VIEs, based on the information we can glean as outsiders? While interpretations have seen ups and downs since the inception 22 years ago, The Law Society of Hong Kong made the case in its July 2020 publication that over the preceding two years, VIE structure has actually “come close to officially blessed”. It cites cases involving MOFCOM (Ministry of Commerce), CSRC (China Securities Regulatory Commission), and SAMR (State Administration for Market Regulation), where each of these State Council ministries have provided on separate occasions what may be interpreted as tacit approvals on the VIE structure (if you are interested, you can read more here)
The most notable case is perhaps CSRC’s approval in 2019 to allow companies that utilize a VIE Structure to list CDRs (China Depository Receipts) on the STAR (Science and Technology Innovation) Board of Shanghai Stock Exchange. The Law Society of Hong Kong argues:
“CSRC’s approval of companies that utilize a VIE Structure listing CDRs on the STAR Board represents a strong indication that the use of the VIE Structure, at least in high-tech industries, is officially approved of. CSRC would not have issued rules permitting companies utilizing VIE Structures to list CDRs in China unless all relevant regulators had come to a consensus on this point. How could VIE Structures in general be banned after CSRC had approved the listing of CDRs on a Chinese exchange by companies using VIE Structures?”
In October 2020, Ninebot, a leading supplier of electric scooters, successfully became the first company employing a VIE structure to list under the above rules on the STAR Board.
Today, while Chinese authorities have fallen short of explicitly recognizing VIEs, the structure continues to be implicitly integrated into a growing number of regulatory frameworks. For example, as part of the process to address cybersecurity and national security concerns, CSRC has mandated that companies seek permission and clear an approval process before being legally allowed to list offshore. Understandably, nearly all of these offshore listings employ the VIE structure. It makes no sense why CSRC would grant any approvals, if they feel the structure has any reasonable degree of risk of being retroactively declared illegal. Once the dust settles, it’s more likely that we could look back at 2021 - the record year in terms of new regulations - as ironically also the year that has led to further de-risking of the VIE structure.
Regarding the new CSRC rule requiring approval for offshore listings, some mainstream news outlets have spun the narrative that this is yet another example of a draconian and restrictive regulation that undermine the capital market. However, CSRC Vice Chairman Fang Xinghai’s comments presents this regulation under a different spirit. He explains that under the new approval process, cases such as Didi could be avoided, and that it could contribute to make overseas listing of Chinese companies sustainable by assuring overseas investors are well protected. In his words,
“(Overseas regulators such as) SEC will be much assured because this company has went through an approval process in China…this new regulation gives companies a formal process to follow. And gives overseas regulators confidence in Chinese companies that go to list on their market. And if some of these companies have problems in terms of regulations, there will be already an understanding between CSRC and SEC prior to listing. And regulation will be much easier.” - Fang Xinghai, Vice Chairman of CSRC
Again, does this de-risk or increase risk? You may say this is just a convenient way for the CSRC to spin the narrative, but the point is this - perhaps we should not subscribe to the view that every regulation is necessarily a zero-sum game between the regulators and the capital market.
Those of you who follow Chinese news closely will still remember the Bloomberg article on December 1st, which dropped the following bomb:
“China is planning to ban companies from going public on foreign stock markets through variable interest entities, according to people familiar with the matter, closing a loophole long used by the country’s technology industry to raise capital from overseas investors.”
Some serious accusation with massive implication if true! Four days later, CSRC put out the following press release:
“Some overseas media reported that Chinese regulators will ban overseas listing of companies with VIE structure and demand Chinese companies to delist from U.S. stock exchanges, which is a complete misunderstanding and misinterpretation.”
We will leave it to you to decide if you want to place more emphasis on a Bloomberg article quoting an anonymous source, or the official communication from CSRC, a ministry under the State Council. But it’s interesting again to see how quickly the CSRC came to the defense of this purportedly soon-to-be-banned structure.
The Alipay Case
In the context of VIE’s long history, there’s actually been surprisingly small number of problematic cases. What we mean here are cases where “real” losses have materialized for offshore investors of otherwise legitimate Chinese businesses, as a direct consequence related to the shortcomings of the VIE structure.
Critics of VIE are usually quick to bring out the Alipay case from 2011. This particular one gets a lot of attention, because it’s the only notable case where a founder (Jack Ma) has unilaterally and intentionally transferred out a significant group asset (Alipay) out of the structure and into a separate company under his own control. Legalized theft, in other words. Jack Ma eventually reached a settlement with his investors, but under financial terms that returned only a fraction of the value that the investors thought they had a legitimate claim to. There were real losses borne by investors in this case, and it was by far the most notable case where VIE risk has materialized into permanent investor losses.
However, the one caveat here is that this involved the controlling shareholder of a private company (Alibaba Group wasn’t listed) and that of its major investors Yahoo/Softbank which owned close to 80% of the company at the time. The nature was that of failing between private business partners, rather than a theft from the public markets, which had it been the case could have escalated this issue to a whole new level. We can’t imagine this episode being repeated by companies like Alibaba and Tencent today while being publicly listed companies.
At the end of the day though, it’s undeniable that the lack of legal investor protection do give ways for possible abuse of the structure, as the Alipay case has demonstrated. Investors have to make their own judgement. But in our view, the fact that this has been far from being rampant in the context of history, combined with the status quo inclination and the recent regulatory developments and comments by the PRC authorities (examined next section) indicates that the risk here is at least tolerable. This is especially so in light of the discounted valuation that Chinese equities are offering today.
The CSRC and State Council Draft Rules
On December 24th, the CSRC in conjunction with the relevant State Council departments released a set of draft rules to “promote lawful use of overseas capital markets by domestic companies to achieve sound development”. Specifically, they constitute:
Revisions to “Special Provisions of the State Council Concerning the Overseas Securities Offering and Listing by Limited Stock Companies”
Formulations of “Provisions of the State Council on the Administration of Overseas Securities Offering and Listing by Domestic Companies”; and
“Administrative Measures for the Filing of Overseas Securities Offering and Listing by Domestic Companies”
What we glean from a reading of the draft rules is the overarching spirit to enhance policy clarity. Through this, the authorities are aiming for more capital market stability and reduction of future surprises. This was echoed in a recent speech by the CSRC Chairman Yi Huiman:
“Currently, the CSRC is soliciting public opinions on the revised regulatory rules on overseas listings. We believe that the draft rules, when taking effect, will foster a sound and more predictable regulatory environment for overseas listings and better protect the legitimate rights of global investors.” - at the 15th Asian Financial Forum in Hong Kong, Jan 10, 2022
Let’s take a closer look.
The draft rules started with recognizing that offshore listings have played a positive role for Chinese companies:
“Overseas listings have played a positive role in supporting Chinese companies to utilize foreign capital, enhance corporate governance, and deeply integrate into the global economy”
The spirit of the draft is not to ban or discourage offshore listings (you can argue some policies have the outcome of incentivizing HK exchange listing over the US, but that’s a separate matter)
“We will strive to maintain effective channels for overseas capital-raising, and provide companies with clear, transparent and operable rules for overseas listings, and a more stable and predictable institutional environment.”
The drafts address some important areas, notably the much-needed strengthening of regulatory coordination both within China (between CSRC and other relevant State Council departments) and cross-border (between China CSRC and US SEC):
“In addition, the CSRC will support and cooperate with relevant authorities to jointly clarify the rules and regulations of certain sectors, in order to enhance policy predictability.”
In addition, the documents touch on the clarification of legal responsibilities – for example, what the consequences will be for companies that fail to perform the necessary filing procedures (as has been the case with Didi). The circumstances under which offshore listings will not be allowed is also mentioned explicitly:
“The Provisions forbids overseas listings that are prohibited by specific laws and regulations, constitute threat to national security, involve material ownership disputes, or involve criminal offenses. No extra thresholds or conditions are placed otherwise, supporting domestic companies’ lawful use of overseas capital markets to finance their development.”
While the draft does not go into detail on each of these conditions, the efforts are nonetheless laudable as far as setting a common language which can serve as starting point of consensus between regulators and the private sector.
What’s also interesting is that the documents mentioned protecting the “legitimate interests of foreign investors” twice. Yes, the phrase “legitimate interests of foreign investors” have found itself into a Chinese State Council legal document. Make of it what you will, but it’s interesting to see.
There is also a statement about dividend payments:
“Domestic companies that seek to offer and list securities in overseas markets can raise funds and pay dividend in foreign currency or Chinese Yuan(RMB)”
Overseas investors have long expressed skepticism regarding the ability of Chinese companies to return profit, claiming that the rules are vague. But the language here is actually pretty darn clear! Recently we have also seen a dramatic step up in shareholder returns from companies: Alibaba has purchased US$8.9bn of ADS between April to September 2021, while Baidu purchased $2.5bn since 2020. Tencent has paid dividend every year, and dividend per share has grown at 21.6% CAGR since 2005, with its most recent payment in 2021 totaling $2bn. NetEase and others also pay dividend consistently.
Finally, we saved the best for the last.
Take note of this excerpt from the CSRC press release on December 24th, following a press interview:
This is the most affirmative and direct response we have heard yet from the PRC authorities.
This post has focused on VIEs, but there are myriads of other factors to consider when it comes to investing in China. We look forward to sharing more thought pieces like this one, where we will focus on issues which investors encounter when investing in the international and emerging markets. We are open to all and any feedback!
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