Foreign investors have often proved adept at exploiting regulatory loopholes in China, particularly in circumventing government restrictions on what they can and cannot own in the country.
Some of those strategies can be dated back to the Qing Dynasty. In 1897, a British-incorporated firm known as the Peking Syndicate became the first foreign investor in Chinese coal mining.
How so when foreign ownership was still prohibited? It outflanked the ban with a perpetual loan to a local shell company, which had been granted the relevant mining concession in Shanxi province. The mine’s profits serviced the loan repayments, with interest rates set by the Peking Syndicate. (The scheme forced the Qing government to rethink the ban and in 1898 it allowed the Peking Syndicate to become the legitimate owner of the mine in what the New York Times described at the time as the “most important step ever taken in the industrial development of China”.)
“It was China’s earliest VIE,” Victor Wang, president of Mtone, a mobile phone gaming firm, says of the case on his weibo.
He is referring to an opaque ownership structure known as variable interest entities. VIEs vary in form but in essence are devised to get around Chinese rules on bringing in overseas investors into sectors that are out of bounds to foreign money. While ownership is technically classed as Chinese, a foreign investor maintains de facto control through agreements that can involve purchase options, equity pledges, loans or even spread-betting contracts.
The practice is particularly prominent in the tech sector. But according to Paul Gillis, an accounting professor at Peking University, over 100 Chinese firms listed in the United States rely on VIEs to control onshore assets at home. But he reckons the practice isn’t foolproof. “You may agree with me that the Emperor has no clothes,” Gillis warns on his China Accounting Blog, which has run a series of articles unwrapping the uncertainties of VIE structures and whether their agreements are enforceable.
Last year, an investigation by US regulators into New Oriental’s VIE arrangements wiped $2 billion off the firm’s market value in a week (see WiC160). In 2011, internet giant Alibaba also had a major fallout with its American shareholder Yahoo over ownership of Alipay, China’s most popular online payment system (see WiC112 and WiC107). It ended up being transferred out of the VIE structure when the central bank made clear it would not tolerate foreign control of a domestic payments system. Yahoo was understandably disgruntled but could do nothing about it.
But a court ruling last week may have done the most damage to the VIE and discourage its future use.
The Economic Observer says the case centres on a judgement involving Nina Wang, now deceased but formerly Asia’s richest woman and head of the Hong Kong property firm Chinachem.
At stake were the economic rights to Rmb5 billion ($815 million) of shares and dividends in China’s Minsheng Bank. Chinachem invested $11 million for a 6.5% stake in Minsheng Bank via a local holding firm in 1995. But at that time, overseas investors (including Hong Kongers) were barred from holding stakes in Chinese lenders. So Chinachem employed complex VIE contracts to get around the restrictions.
Eighteen years on and China’s supreme court has ruled that its economic rights to these Minsheng Bank shares are invalid. According to the final verdict, the VIE contracts were “concealing illegal intentions with a lawful form”. Chinachem has received $300 million in compensation from its local partners, far less than the value of its Minsheng stake.
The ruling will be sounding the alarm at other VIE-controlled companies, highlighting that similar contracts may also be struck down by the Chinese courts.
As the New York Times reports, it marks the first time that the judicial system has taken this stance on foreign control over VIEs. And according to a leaked internal report from the China Securities Regulatory Commission, the central government wants to crack down further on VIE arrangements.
Who could be next? Perhaps Ping An Insurance. Like Minsheng Bank, the insurance giant has a highly fragmented shareholding structure and relied heavily on private sector capital for expansion in its early development.
According to investigative reports by Ming Pao newspaper in 2008, two Hong Kong tycoons have accumulated substantial stakes in Ping An. One of them reportedly owns 12% of Ping An’s Shanghai-listed shares (now worth about Rmb36 billion), which could also become the subject of a legal challenge.
Most of the VIE structures are only “morally binding” and offer investors little legal protection, says the Economic Observer. Indeed, the ruling on Chinachem’s stake in Minsheng Bank may encourage local parties to dishonour their contracts too, triggering more lawsuits.
The problem, says the EO, is that VIEs were born of a very different era. Regulators turned a blind eye to unlawful foreign investment because the capital was required for rapid economic development. Now, with China needing less foreign money and making more noise (selectively, it often seems) about the rule of law, VIEs look far more exposed and unwanted.
That leads to speculation, especially on how changes in enforcing the rules might impact the VIE ownership structure of New York-listed tech giants like Baidu, China’s Google-equivalent.
Might Baidu be forced to unwind its VIE set-up, delist from the US and relist in Shanghai or Shenzhen?
Or will Chinese regulators offer amnesty to US-listed firms that have employed VIEs structure in the past, but make clear that the practice cannot be used in future?
In the meantime, international shareholders in VIEs will be hoping that their own investments don’t go the same way as the Peking Syndicate. It was kicked out of Shanxi in 1907, following a national protest against foreign holdings in Chinese mines.
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