Variable Interest Entities: China’s Trillion Dollar Shell Game

News Analysis U.S. investors have trillions of dollars invested in Chinese variable interest entities (VIEs) without knowing it. These are illegal contracts under Chinese law and could be shut down by Chinese regulators at any time. When U.S. investors buy shares of Chinese companies, particularly internet companies, on NYSE and NASDAQ, they generally do not own shares in the actual company. They own shares in Cayman Island shell companies that have no employees and no buildings—an entity whose only assets consist of contracts with the real company, which is privately held back in China. The Chinese Communist Party (CCP) restricts foreign investment in certain sectors such as education and e-commerce, the internet, and certain technologies; while others are completely off-limits such as nuclear weapons. China does not allow foreign companies to operate an internet company. They would need to have an internet providers license, which will not be given to companies that have foreign investment. A way for Chinese internet companies to circumvent this rule and obtain U.S. investment is to use a variable interest entity. In the United States, VIEs are often formed as special purpose vehicles (SPVs) to hold financial assets and to keep securitized assets off corporate balance sheets. Investors do not participate in the profits and losses of the entity, neither do they have voting rights. Under U.S. law, public companies must disclose their relationship to VIEs. Using a VIE, a company can control another company through contracts, rather than through ownership. The company is allowed to consolidate the operations of the VIE with the parent company as if it was a wholly owned subsidiary and include its results in in its financial statements. However, in spite of the fact that they appear on the company’s balance sheet, the company does not own the assets or even the revenues of the entity. A private technology company in China can obtain a government internet license. They can then set up a Cayman Islands company, which foreigners can invest in. The private company then signs contracts with the public company, transferring control of the VIE over to the public company. So the public company, which is invested by foreigners, would have contractual control of the technology and the internet license in China. But technically, those assets would still be owned by the private company in China, not the public company. The public company, where the foreigners invested, would own nothing. Enron used special purpose entities to borrow money and keep the debt off of the Enron balance sheets. In China, the VIE is used in the opposite way. In China, the VIE rules were created to help companies put assets on their balance sheet, even when they did not own them. VIEs causes problems for investors. If the owner of the VIE decides not to follow the contract, the public company has to take them to court. But these contracts are in China and the Chinese courts have ruled at times that VIE contracts are illegal and unenforceable. This means that the shareholders could lose all their value. An Alibaba employee walks through a room at the company headquarters in Hangzhou, China, on June 20, 2015. (Peter Parks/AFP/GettyImages) In 2011, Jack Ma took Alipay out of the Alibaba Group. The group was largely owned by Yahoo and Softbank, and Alipay was taken out for fear that the Chinese regime would prohibit foreign investors from owning a third-party payment processor. Yahoo did not even find out that Ma had moved Alipay out of the company until after the fact, even though Yahoo believed it had ownership. Investors were given pennies on the dollar as compensation. Later, the Alipay/Ant Group’s IPO was blocked by Chinese regulators, showing the risks associated with investing in VIEs. Many of the Chinese companies listed abroad are owned through VIE structures, including DiDi, JD.com, Alibaba, and Tencent. Ironically, internet companies are some of the most popular among foreign investors, but are also one of the most restricted sectors for foreign investment. It would be illegal for Tencent, for example, to sell any of its shares to foreign investors. In order to take advantage of U.S. capital markets, Chinese technology companies create VIEs. Shares of the public company are sold in the United States, but investors do not understand that they do not own the company they believe they do. Instead, they have bought shares of a foreign company that has a contractual relationship with the internet company they were interested in. Since VIEs are technically illegal in China, U.S. investors run the risk of arbitrary enforcement of the law. When this happens, VIE investors could wind up with nothing or a small fraction of their money returned. Two high-profile examples of foreign investors trying to get a Chinese court to enforce the VIE contracts are Mingsheng Bank and Gigamedia. In both cases, they failed. In recent weeks, as Beijin

Variable Interest Entities: China’s Trillion Dollar Shell Game

News Analysis

U.S. investors have trillions of dollars invested in Chinese variable interest entities (VIEs) without knowing it. These are illegal contracts under Chinese law and could be shut down by Chinese regulators at any time.

When U.S. investors buy shares of Chinese companies, particularly internet companies, on NYSE and NASDAQ, they generally do not own shares in the actual company. They own shares in Cayman Island shell companies that have no employees and no buildings—an entity whose only assets consist of contracts with the real company, which is privately held back in China.

The Chinese Communist Party (CCP) restricts foreign investment in certain sectors such as education and e-commerce, the internet, and certain technologies; while others are completely off-limits such as nuclear weapons. China does not allow foreign companies to operate an internet company. They would need to have an internet providers license, which will not be given to companies that have foreign investment. A way for Chinese internet companies to circumvent this rule and obtain U.S. investment is to use a variable interest entity.

In the United States, VIEs are often formed as special purpose vehicles (SPVs) to hold financial assets and to keep securitized assets off corporate balance sheets. Investors do not participate in the profits and losses of the entity, neither do they have voting rights. Under U.S. law, public companies must disclose their relationship to VIEs.

Using a VIE, a company can control another company through contracts, rather than through ownership. The company is allowed to consolidate the operations of the VIE with the parent company as if it was a wholly owned subsidiary and include its results in in its financial statements. However, in spite of the fact that they appear on the company’s balance sheet, the company does not own the assets or even the revenues of the entity.

A private technology company in China can obtain a government internet license. They can then set up a Cayman Islands company, which foreigners can invest in. The private company then signs contracts with the public company, transferring control of the VIE over to the public company. So the public company, which is invested by foreigners, would have contractual control of the technology and the internet license in China. But technically, those assets would still be owned by the private company in China, not the public company. The public company, where the foreigners invested, would own nothing.

Enron used special purpose entities to borrow money and keep the debt off of the Enron balance sheets. In China, the VIE is used in the opposite way. In China, the VIE rules were created to help companies put assets on their balance sheet, even when they did not own them.

VIEs causes problems for investors. If the owner of the VIE decides not to follow the contract, the public company has to take them to court. But these contracts are in China and the Chinese courts have ruled at times that VIE contracts are illegal and unenforceable. This means that the shareholders could lose all their value.

An Alibaba employee walks through a room at the company headquarters in Hangzhou, China, on June 20.
An Alibaba employee walks through a room at the company headquarters in Hangzhou, China, on June 20, 2015. (Peter Parks/AFP/GettyImages)

In 2011, Jack Ma took Alipay out of the Alibaba Group. The group was largely owned by Yahoo and Softbank, and Alipay was taken out for fear that the Chinese regime would prohibit foreign investors from owning a third-party payment processor. Yahoo did not even find out that Ma had moved Alipay out of the company until after the fact, even though Yahoo believed it had ownership. Investors were given pennies on the dollar as compensation. Later, the Alipay/Ant Group’s IPO was blocked by Chinese regulators, showing the risks associated with investing in VIEs.

Many of the Chinese companies listed abroad are owned through VIE structures, including DiDi, JD.com, Alibaba, and Tencent. Ironically, internet companies are some of the most popular among foreign investors, but are also one of the most restricted sectors for foreign investment. It would be illegal for Tencent, for example, to sell any of its shares to foreign investors. In order to take advantage of U.S. capital markets, Chinese technology companies create VIEs. Shares of the public company are sold in the United States, but investors do not understand that they do not own the company they believe they do. Instead, they have bought shares of a foreign company that has a contractual relationship with the internet company they were interested in.

Since VIEs are technically illegal in China, U.S. investors run the risk of arbitrary enforcement of the law. When this happens, VIE investors could wind up with nothing or a small fraction of their money returned. Two high-profile examples of foreign investors trying to get a Chinese court to enforce the VIE contracts are Mingsheng Bank and Gigamedia. In both cases, they failed.

In recent weeks, as Beijing has cracked down on the for-profit education sector and the tech sector, they have also cracked down on the VIE market, wiping billions of dollars off the value of Chinese stocks listed on overseas exchanges. Ending the VIE arrangement altogether could result in trillions in losses for U.S. investors.

U.S. regulators are finally waking up to the threat of Chinese VIEs. Gary Gensler, the chairman of the U.S. Securities and Exchange Commission (SEC), has announced new disclosure rules, requiring Chinese companies to be clearer with U.S. investors regarding which assets they actually own and which they do not. Among other disclosures, the SEC will require Chinese companies to disclose “whether the operating company and the issuer, when applicable, received or were denied permission from Chinese authorities to list on U.S. exchanges.”

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.


Antonio Graceffo

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Antonio Graceffo, Ph.D., has spent over 20 years in Asia. He is a graduate of Shanghai University of Sport and holds a China-MBA from Shanghai Jiaotong University. Antonio works as an economics professor and China economic analyst, writing for various international media. Some of his China books include "Beyond the Belt and Road: China’s Global Economic Expansion" and "A Short Course on the Chinese Economy."