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Variable Interest Entity (VIE)

A Variable Interest Entity (VIE) is an entity based overseas but actually controlled by investors in the Chinese mainland, and therefore it was not regulated. The VIE had been widely adopted by domestic Internet companies including Alibaba Group Holding and Baidu Inc to be listed on overseas markets. Those companies establish a shell company abroad that controls the domestic firm through contracts and then lists the shell company overseas in a simple way. The VIE structure is a business structure that was widely used by Chinese companies in certain “sensitive” or “strategic” business sectors that had restrictions on foreign investment under the 2015 Foreign Investment Industrial Guidance Catalogue, such as telecommunications, e-commerce, and online games.

Chinese companies are taking advantage of US capital markets while ignoring the transparency that is required under US law to access US markets. According to the U.S.-China Economic and Security Review Commission, as of October 2020 there were 217 Chinese companies listed on U.S. exchanges, including 13 companies that are claimed by the CCP as Chinese state-owned enterprises.

On 11 July 2021 China tightened cybersecurity reviews for internet companies that seek IPOs in the overseas markets with a set of draft rules, including a new threshold that businesses holding data of more than a million users in China must undergo a regulatory review before applying for an overseas IPO, which indicated the country's resolve to rein in potential national security risks brought by domestic businesses that own oceans of data amid their cross-border operations. It was the first time that the Cyberspace Administration of China (CAC) released a draft amendment and sought public opinion on the cybersecurity review measures since June 2020, when the original measures became effective.

If the draft rules were implemented, domestic firms that had originally planned to conduct a listing abroad were likely to postpone due to the uncertainties ahead and might reconsider the market where they finally go public. Chinese medical data group LinkDoc Technology has shelved plans for an IPO in the US amid the clampdown on overseas listings. It is said to be the first Chinese firm known to have pulled back from overseas IPO plans since China's cybersecurity regulator's review on the country's top ride-hailing firm Didi Chuxing just two days after its New York debut. Separately, China's largest mobile sports platform Keep and podcasting platform Himalaya have both cancelled plans to go to the US for IPOs.

China would ramp up efforts to seal the loopholes around the Variable Interest Entity model, an equity structure that Chinese companies have exploited in past years to attract foreign investment and list on US stock exchanges, which also meant they could bypass local regulations including data security review.

China’s crackdown, including banning a swath of private education companies from making profits, triggered a dramatic selloff in shares as investors reassess how far the government will go in tightening its grip on the economy. By July 2021 losses in Chinese tech and education stocks have surpassed US$1 trillion since February 2021.

The draft rules as well as the recent policy tightening csme as the US government doubled down on its crackdown on Chinese companies listed in the US. The Holding Foreign Companies Accountable Act that became law in 2020 after passing both chambers of Congress unanimously. This law will delist Chinese companies that do not comply with Public Company Accounting Oversight Board inspections within three years. The US requires audit inspections on Chinese firms, which would expose operational data from Chinese businesses.

Many Americans invest in US stock exchanges as part of their retirement and college savings, and dishonest companies operating on the exchanges put Americans’ investments at risk. This legislation protects the interest of hardworking American investors by ensuring that foreign companies traded in America are subject to the same independent audit requirements that apply to their competitors in America and other countries.

SEC Chairman Gary Gensler said 31 July 2021 that the Chinese government’s recent actions, including its announcement of enhanced security reviews of firms seeking foreign listings, are “relevant to US investors.” He asked SEC staff to seek additional disclosures from Chinese firms before signing off their registration statements to sell stock. “I believe such disclosures are crucial to informed investment decisionmaking and are at the heart of the SEC’s mandate to protect investors in US capital markets,” Gensler said.

Variable Interest Entity (VIE) - Background

Red-chip companies are mainland-based companies that are incorporated and listed outside the mainland, especially on the Hong Kong stock exchange and on bourses in New York, London and Frankfurt. Variable interest entity are adopted by some redchip companies, especially internet companies such as Alibaba and Tencent. VIE structures enable investors abroad to invest in and control mainland-based companies by contracts instead of ownership. China does not allow foreign capital to take control of companies in certain industries via direct stock ownership.

The Variable Interest Entity, also known as VIE, usually refers to the separation of a listed company registered overseas and its entity operating in China. The listed company is an overseas company, and the overseas company controls the domestic business entity through agreement. Variable Interest Entities is a way for Chinese companies to achieve overseas listing. In the case that domestic financing channels are not smooth, domestic capital market development is imperfect, and financial support is urgently needed, this kind of listing, chosen as the last resort, has its own rationality in existence and development.

A VIE is an entity in which equity investors do not have sufficient equity at risk for that entity to finance its activities without additional subordinated financial support. Under a basic VIE structure, foreign investors buy into an offshore shell company, which, through a complicated web of contracts, controls the domestic company holding licenses to operate in industries otherwise under strict government control. One benefit to having Chinese companies investing in the US is if the US insists on transparency and governance standards for companies to list. By as of 2021 the US wasn’t doing that.

The simplest VIE structure includes a foreign holding company which is usually an exempt limited company in the Cayman Islands, a China wholly foreign owned enterprise (WFOE) and a China domestic operating company owned only by Chinese nationals. The founders, foreign investors and other shareholders hold equity in the Caymans holding company, which in turn owns a 100% equity interest in the WFOE. The operating company is a purely China domestic company that is licensed to operate in the restricted industry in China.

The major business risk for the investors is they don’t have access to the assets of the operating company. In a VIE structure, the investors do not own equity interests in the operating company. It is common for them to negotiate a call option agreement (in which the owners agree to sell all of the equity interests in the operating company to the WFOE) but arguably the foreign investors may never exercise the option, because they are barred from owning the operating company under Chinese law. This means the assets of the operating company are unreachable for foreign investors.

The key point of the VIE structure is that the WFOE exercises de facto control over the operating company through a series of contractual arrangements entered between the WFOE and the operating company. The SEC filings for the recent ZTO Express IPO contain the current state-of-the-art set of control agreements. The Chinese founders of the domestic company borrow funds from the WFOE and pledge their shares in the operating company as collateral under the loan agreement. The WFOE usually provides technical services to the operating company and is compensated for its services. The financial statements of the Cayman holding company are consolidated with the WFOE and VIE which makes the holding company financeable.

As a group, the holders of the VIE equity investment at risk lack one or more of the following three characteristics: (a) the power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entity’s economic performance, (b) the obligation to absorb the expected losses of the entity, or (c) the right to receive the expected residual returns of the entity. US shareholders face major risks from the complexity and purpose of the VIE structure. For example, the legal contracts that serve as the basis of the structure are enforceable only in China, where rule of law remains rudimentary. Variable interests in a VIE are contractual, ownership, or other pecuniary interests in an entity that change with changes in the fair value of the entity’s net assets exclusive of variable interests. When a bank or other company has a variable interest or interests in a VIE, ASC Topic 810 provides guidance for determining whether the bank or other company must consolidate the VIE. If a bank or other company has a controlling financial interest in a VIE, it is deemed to be the primary beneficiary of the VIE and, therefore, must consolidate the VIE.

Unable to access sufficient capital from China’s state banking system or from its undersized bond market, many Chinese Internet companies relied on foreign investors to enable their businesses to operate and growi. But the Chinese government restricts foreign investment in its Internet sector through foreign equity caps and complex licensing requirements. Most private Chinese companies must obtain permission to list overseas. To bypass these restrictions, Chinese Internet companies use a complex and highly risky mechanism known as a Variable Interest Entity (VIE). VIEs, usually based in tax havens such as the Cayman Islands, are essentially holding companies that link foreign investors and Chinese firms via a set of complex legal contracts.

Since SINA unveiled the VIE structure to public investors during its IPO offering on NASDAQ in 2000, this complex corporate structure has become very popular among Chinese companies who want access to foreign investment. Data shows that by 2016 more than half of the Chinese companies listed on the NYSE or NASDAQ were using the VIE structure.

If a company like Alibaba lists in the US, makes an IPO in the US, that is ja reverse capital flow from the US to China which has to be offset by a bigger official capital flow, so that $25 billion [from Alibaba’s IPO] will put pressure on the renminbi and the government will have to step in and offset that.

A 2015 draft version of the Foreign Investment Law, which would bring foreign investment using the Variable Interest Entity (VIE) structure under regulation, would encourage companies to list in the A-share market and distribute their profits to shareholders in China. The VIE structure, which was initially not under regulation, would be regulated as other forms of foreign investment. According to the draft released by the Ministry of Commerce of China in January 2015, any entity that is under the "actual control" of non-Chinese individuals, enterprises incorporated under foreign laws, foreign government bodies and international organizations, will all be considered as foreign investors. The new draft will bring the cash flow under control and benefit investors at home, as this law will encourage companies to list on the Shanghai and Shenzhen bourses and pay stock dividends to shareholders.

Although many lawyers and financial industry professionals warned investors over time that the VIE structure has inherent risks and the validity of the control contracts are at best in a gray area under Chinese law. The risk factors in the prospectus of almost all of the listed companies who use the VIE structure states that “there are substantial uncertainties regarding the interpretation and application of current and future PRC laws and regulations” or similar words.



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Page last modified: 01-08-2021 14:06:39 ZULU