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Reuters caused a stir this week when they reported on Sunday that “China’s securities regulator is asking the government to clamp down on the controversial corporate structure used by companies such as Sina (SINA.O) and Baidu (BIDU.O) to list overseas…”Sina’s stock tumbled Monday, not helped by news that the company is tightening controls over one of its most popular features, it’s Weibo site, a Twitter-like social media tool that has increasingly been used by citizens to express dissatisfaction with the government and to organise protests and other activities.
But it is not clear if this news is a sign that China will actually clamp down on the variable interest entity (VIE) structure, if this is the Chinese government testing the waters on a clamp down, if it is some lawyers trying to drum up some new business, or if it is just some public spill over of a debate within the Chinese government about the use and role of VIEs.
First, what are VIEs?
VIEs are typically used by companies in China that operate in restricted industries (industries where foreign investment is tightly monitored and often limited or not allowed at all) but are hoping to elicit foreign investment or list overseas.
They became popular after being used by Internet giants, Sina and Baidu to list on the NASDAQ in the late 1990s early 2000s. But they have always occupied a murky legal status.
A VIE, as explained by the US FASB, is an entity (investee or company) in which an investor holds the controlling interest but this interest is based on a series of contractual agreements and not on a majority of voting rights. It is similar to a Special Purpose Entity (SPE).
In China, a VIE often gives ownership and control of a domestic Chinese company to a company registered outside of China (usually the Cayman Islands). One major issue with the VIE is that investors in the company don’t actually own the assets. The assets remain in the hands of the Chinese company and while the agreements give ownership to the Cayman company there is actually very little to prevent the Chinese company from simply walking away with the money and the assets. And this has happened, more than once.
Until recently, the government has largely ignored the use of VIEs because it was either not aware, didn’t care, or found the activity useful at the time. Probably a combination of all three.
In April, China watchers were alerted to concerns with VIEs after the case of Buddha Steel and its IPO withdrawal. The IPO was withdrawn when the company disclosed that it had discovered legal issues with its corporate structure, a VIE. However, this was passed off as a one-of-event that was likely the result of local politics and not national priorities.
Now, according to the Reuters report, based on comments from lawyers at four different firms in China and Hong Kong, The China Securities Regulatory Commission (CSRC) sent an internal report, dated August 17, to China’s State Council, the highest government body, asking them to take action against VIEs.
No Chinese government officials have made public comments on the matter yet, but according to the lawyers, the government is taking the issue seriously.
This could be a serious move, but it is more likely that the Central government is testing the waters with regard to a VIE crackdown or that the CSRC is unhappy with the current regulatory framework, and its position within that framework, and is pushing for a change.
Some Potential Issues the Government May Have With VIEs:
- Reuters reported that one cause for the CSRC letter is an increasing number of complaints from the SEC to the CSRC about fraud cases involving Chinese companies using the VIE structure.
- The use of VIE structures to enable foreign investment into restricted industries, initially the Internet and telecommunications industries but now other industries as well may be a growing cause for concern to Beijing.
- Internet companies which use the VIE structure have come under increasing pressure from Beijing to control their users for activities which the authorities do not appreciate, like the outpouring of unhappiness after the July train crash, the use of weibo by independent electoral candidates, and its use as a platform to organise protests and strikes. The release of this information could be a subtle warning to such companies that their legal status could be questioned if they don’t fall into line. Interestingly, Sina announced today that it would be tightening censorship controls and monitoring of its Weibo, Chinese Twitter, users.
The New Regulations:
Few details have been released on what these new regulations might be. In fact, the letter from CSRC isn’t a policy memo as much as a request for more research into a better regulatory structure. Stan Abrams from China Hearsay explains what the regulatory framework might look like in a recent post for Business Insider.
What does this mean?
The Chinese government is known for releasing “test balloons” before passing or enforcing new laws. The legal framework in China is known for its opacity and complexity, characteristics that enable the government to use or ignore laws depending on their priorities. The use “test balloons” often allows Beijing to see how an action will be received and then opt to move forward or quietly stop (without loss of face).
It could also be a part of the broader debate within the Chinese government about how to handle and deal with VIEs. Many of the tech companies and those in the finance or commerce ministries see the VIE as an acceptable and useful way for Chinese companies to list abroad and gain valuable foreign investment, while others see them as a legal loophole that could place some of the country’s most important and valuable companies and industries in the hands of foreigners.
It is also possible, that the lawyers who leaked the information are simply hoping to raise concern about the VIE structure to increase business opportunities related to advising companies about the VIE structure.
But this is an important issue to resolve because, as research shows, the use of VIEs by Chinese companies is on the rise, in 2010 47% of NYSE listings and 65% of NASDAQ listings used VIEs. Figuring out whether these companies will be able to continue operating and whether their foreign investors actually have any ownership of them will be critical.
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