The Global Zeitenwende
How to Avoid a New Cold War in a Multipolar Era
In September, Alibaba Group launched the largest IPO in history, raising $25 billion from investors keen to own a slice of China’s most successful e-commerce company. For the moment, the potential for vast wealth overrode concerns about Alibaba’s unusual corporate structure and governance practices. Maybe it shouldn’t have. Alibaba uses what is called a variable interest entity (VIE) structure, which has its roots in the collapse of the energy giant Enron in 2001 and could likewise be the downfall of investors in Alibaba and other Chinese stocks.
The VIE structure involves control of a company through contracts instead of ownership. In other words, significant parts of Alibaba are not owned by the public company but are, rather, held in corporations, which are owned by the Alibaba founder Jack Ma and his close associates. These corporations have signed contracts with the Alibaba Group that give the public company control of VIE operations and access to its profits. Contractual control is inferior to actual ownership, putting investors at considerable risk.
About half of the more than 200 Chinese companies that are traded on U.S. exchanges use the VIE structure. The purpose is to circumvent Chinese restrictions on foreign investment in sensitive sectors of the Chinese economy, most notably including the e-commerce and education sectors, which are particularly attractive to foreign investors. Because the VIE is owned by Chinese individuals, the company can present itself to Chinese regulators as locally owned, thereby enabling it to obtain permits that are not available to companies that receive foreign investment. Meanwhile, on the foreign investor side, the company can present the VIE as if it were a wholly owned subsidiary.
The differences in accounting on the Chinese and U.S. sides are possible because of U.S. accounting rules that were adopted in response to the Enron scandal. Enron had made clever use of special purpose entities (SPEs) owned by its treasurer, Andrew Fastow, to borrow significant sums. At the time, such entities were not required to be reported on a corporation’s financial statements unless that corporation owned a majority of their shares. Because Enron did not directly own any shares of the SPEs, then, it did not have to incorporate the debt held by them in its financial reports, even though Enron was indirectly on the hook for that money. Enron was thus able to say that it was nearly debt free, when in reality it was over $30 billion in the red. After the company collapsed and Fastow was taken off to jail, accounting standard setters closed the loophole by creating new variable interest entity accounting rules. The new VIE rules required financial consolidation when a company is controlled through means other than stock ownership.
Although the new VIE accounting rules were designed to force companies to put off-balance debt onto their balance sheets, clever Chinese accountants figured out that the rules could also be used to bring the assets of companies that could not be owned onto balance sheets. As a result, the Chinese Internet companies Sina, Sohu, Baidu, New Oriental, Youku, and Alibaba have been able to sell shares to U.S. investors while complying with Chinese regulations that forbid them from doing so.
Control of VIEs rests on the enforceability of the VIE contracts. Although some Chinese lawyers have argued that the contracts should be enforceable, in practice the contracts have not held up when challenged. China’s Supreme Court refused to enforce a VIE-like contract used to enable investment in Minsheng Bank, which operated in a restricted sector, because the agreements “concealed illegal intentions with a lawful form.” In another case, the VIE owner successfully took control of the Chinese operations of an online game company, Gigamedia, when an arbitrator decided that the VIE agreements were not enforceable because they, too, attempted to conceal illegal intentions with a lawful form.
The threat that VIE owners might not respect VIE agreements was highlighted in 2011 when Ma took the payment processor Alipay out of the Alibaba Group, ostensibly out of concern that new Chinese regulations for third-party payment processors might preclude both foreign ownership and use of the VIE structure. Major Alibaba Group shareholder Yahoo! appears to have been caught by surprise by Ma’s move. An agreement was reached to settle the dispute by giving Alibaba group a continuing interest in Alipay and a share of any IPO proceeds.
For now, Chinese regulators seem to have given tacit approval to the VIE structure. Regulations specifically prohibit use of the VIE structure in the online games industry, yet nearly every significant player in that field uses it. Local regulators did stop the IPO of Buddha Steel, a small specialty steel company, because the VIE structure was improperly circumventing restrictions on foreign investment in that sector. But regulators have looked the other way for other firms. In fact, these days, China’s Internet sector is mostly operated by companies using VIEs, so any effort to crack down could be widely disruptive. Indeed, the reality that these companies are operating outside the law may work to Chinese regulators' advantage since the threat of being shut down could help keep the companies in line better than any stricter rules.
On the U.S. side, the Securities and Exchange Commission (SEC) also regulates Chinese companies listed in the United States. It has been very active in making certain that the risks of VIE structures are fully disclosed to investors. SEC filings for companies using the VIE structure routinely state that the VIE agreements may prove unenforceable, and that Chinese regulators could decide to shut down operations. Investors appear to take these disclosures in stride, accepting the argument that the structures are necessary to facilitate investment in China.
Of course, an unexpected consequence of the VIE structure is that Chinese investors have been largely excluded from owning shares in many of China’s most promising companies. There are two reasons for that. First, China’s own stock exchanges will not permit companies with offshore parent companies and VIE structures to list (in general, foreign investment in stocks listed on Chinese stock exchanges is severely restricted). Second, China’s strict foreign currency controls make it difficult for Chinese investors to purchase shares of companies listed on foreign markets. China allows its citizens to convert only $50,000 of local currency to foreign currency every year, and foreign currency is needed to buy the shares of Chinese companies listed abroad.
China’s investment restrictions were meant to prevent foreign involvement in sensitive sectors. The restrictions have not worked; all of China’s major Internet companies are listed on foreign stock exchanges and have foreign ownership. Meanwhile, Chinese are prevented from taking part. There is a win-win solution to the problem, though, and China has begun to make moves toward achieving it.
In the Third Plenum meetings of the Communist Party held last year, officials announced that the rules for foreign investment in the e-commerce and education sectors would be liberalized. Although no details have been forthcoming, these reforms could make the VIE structure unnecessary by allowing Chinese companies to directly list on foreign exchanges instead of using offshore structures and VIEs. Reform along these lines could provide significant benefits to all.
If foreign investors could buy the shares that represent actual ownership of assets, their investments will be far less risky. Valuations of companies that formerly used the VIE structure should increase if the VIE structure is removed and replaced with something less dubious.
A further benefit of getting rid of the VIE structure by allowing direct foreign investment into Chinese companies is that companies such as Alibaba could seek secondary listings on the Chinese stock exchanges, enabling Chinese investors to own shares in these promising companies. Alibaba’s Ma has indicated that Alibaba would do this if it were permitted to do so.
Chinese regulators may wish to keep control of Chinese companies that operate in sensitive sectors. But the way they have gone about achieving that goal has had the opposite effect. The promised reforms for foreign investment are long overdue. China and the West will benefit from them.