U.S. and Chinese Regulators Are in a Bind Over a Three-Letter Acronym

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The variable interest entities, or VIEs, that enabled many Chinese companies to raise money in the US are facing increasing scrutiny

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Alibaba Group Holding Ltd.

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Didi Global Inc.

And virtually every Internet company in China that has gone public on US stock exchanges uses VIE structures to circumvent Chinese restrictions on foreign investment in domestic businesses. They collectively raised tens of billions of dollars from global investors who bought shares of holding companies involved in the Cayman Islands and other offshore jurisdictions.

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The structures are now being targeted by Chinese and US regulatory actions, raising concerns that the world’s two largest economies are headed for the disruption of financial markets.

In July, Securities and Exchange Commission Chairman Gary Gensler said that US investors should be aware of the risks of investing in VIE-structured Chinese companies, which would require more disclosures before selling stocks. In a September Wall Street Journal editorial, Mr. Gensler wrote, “These shell companies … raise capital on US exchanges, but the contracts do not actually give US investors ownership of the operating company.”

Beijing recently moved to strengthen its supervision of foreign listings by Chinese firms, as Didi went public in New York despite a suggestion from a regulator to delay its listing.

“Many investors did not understand the risks they were taking with the VIE structure until the SEC’s statement,” said Nana Lee, China research and projects director at the Asian Corporate Governance Association in Hong Kong.

It also highlighted a dilemma for Chinese officials, who wanted to plug regulatory loopholes but were concerned about closing a path that allowed Chinese companies—and by extension the Chinese economy—to benefit from foreign capital.

“Chinese regulators know they should have dealt with this long ago. Now they are being put on the spot by the SEC and have no choice but to address it,” Ms. Li said.

VIE gained notoriety more than two decades ago when Enron Corp. used several shell companies to hide large debts and keep them off its balance sheets. Changes in Enron’s post-bankruptcy accounting rules required such vehicles to be consolidated into the companies’ financial statements.

Ironically, this paved the way for the widespread adoption of VIEs of Chinese companies, thereby consolidating the financial results of their business operations in China into offshore holding companies. This allowed global investors to get the economic benefits of many businesses in China without owning shares in these businesses.

China restricts foreign investment in some areas it considers sensitive, such as Internet services. In 2000, SINA Corp., an online portal, successfully listed on the Nasdaq stock market using the VIE structure, and several companies followed.

In a typical VIE structure seen in a US-listed Chinese company, investors hold shares in a shell company established in an offshore tax haven such as the Cayman Islands.

Shell Company, directly or indirectly, owns an entity in China. This wholly foreign-owned entity, or WFOE, is incorporated in China and has a series of contracts with another domestically incorporated entity, the VIE. The contracts give the WFOE effective control over the VIE.

This means that the value of shares held by global investors is essentially dependent on contractual agreements in which investors have no rights.

According to a February report by GMT Research founder Gillum Tulloch, a dozen US-listed Chinese Internet companies are not remitting profits generated by VIE to offshore holding companies, raising questions about the value of their shares. . The report estimates that more than 80% of all US-listed Chinese companies operate VIEs that are critical to their operations.

The structure also falls into a gray area of ​​Chinese law. The China Securities Regulatory Commission is coordinating an inter-agency effort to draft rules that would govern foreign listings of Chinese companies with offshore structures. IPOs of Chinese companies in the US have almost come to a standstill since Didi’s listing. Some companies have changed course and moved to Hong Kong to raise money, while others are in limbo.

Beijing has already tried to deal with this issue. In 2015, China’s Ministry of Commerce proposed a draft foreign investment law with provisions addressing the VIE structure. It added that VIE could continue to operate if Chinese investors had effective control over the foreign-registered shell company. Otherwise, they would need to get approval from Chinese regulators to continue operating.

The proposal would retain the majority of VIE-structured companies, as the founders or management retain control of shell companies, usually by holding shares that have supervisory rights. The notable exception was Tencent Holdings. Ltd.

, whose largest shareholder was South Africa’s Naspers Ltd.

Shortly after, China’s domestic stock market crashed, forcing regulators to refocus their efforts to restore investor confidence.

In 2019—more than four years later—China’s rubber-stamp legislature passed a foreign investment law, without provisions on the VIE structure.

“It’s a workable compromise,” said Paul Gillis, a professor of practice at Peking University’s Guanghua School of Management, of the two-decade use of VIE structures by Chinese companies listed abroad. China’s internet boom was made possible because of this, and global investors were able to profit along the way, he said.

The use of VIE structures remains a contradiction in Beijing’s eyes, Dr. Gillis said. “China can hardly argue that this is a country that operates by the rule of law when it allows an artificial structure like the VIE to circumvent the intent of this foreign investment law,” he said.

The legal ambiguities created by VIE have allowed companies to circumvent other Chinese regulations, such as antimonopoly laws and IPO regulations.

Over the past decade, Chinese Internet companies, including Alibaba and Tencent, have grown rapidly by breaking stakes in smaller rivals or acquiring them outright. Such activities went virtually unchecked by regulators until late last year, when officials launched an antitrust investigation into Alibaba.

Since then, China’s newly empowered Antimonopoly Bureau has been retroactively implementing antitrust reviews, paying fines to dozens of companies for failing to seek approval on previous deals.

According to Marcia Ellis, a Hong Kong-based partner at law firm Morrison & Foster, Chinese securities regulators may outlaw the VIE structure. The fact that the Shanghai Stock Exchange has allowed VIE-structured companies to list is a sign of verification, she said.

“What the CSRC wants is approval rights in an ex-China list of offshore-incorporated companies with their assets and operations in China, whether or not they use VIE structures,” she said.

Jing Yang at [email protected]


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