Do Most Chinese Internet Firms Have A Technically Illegal Corporate Structure?

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  • on September 2nd, 2011

The Financial Times reports today on a potentially problematic development for many Internet in China. In Foreign internet presence in China to face scrutiny, Kathrin Hille writes that:

Changes to China’s mergers and acquisitions rules that took effect on Thursday mean internet companies in the country are set to face greater scrutiny of the vehicles they have been using for more than a decade to circumvent foreign ownership restrictions in the sector…

Under the practice, a domestic company, a so-called variable interest entity (VIE), holds the license necessary for operating a business such as running an internet search engine or an e-commerce platform in China, and the foreign-invested company secures control of that domestic business through a set of contracts instead of share ownership.

The scheme is being used by foreign internet companies such as Google ($GOOG), but also Chinese internet groups that introduced foreign shareholders through overseas listings. These include as Baidu ($BIDU), the country’s largest online search engine by revenues, Sina ($SINA), the operator of China’s leading microblog, Youku ($YOKU), the biggest online video company by revenues and Renren ($RENN), the biggest Facebook clone by revenues.

“As of April 2011, 42 per cent of Chinese companies listed in the US have used the VIE structure and thousands of unlisted companies continue to operate through the use of the VIE structure,” said Cadwallader, the law firm, in a note to clients.

VIEs were in the news a few months ago when Jack Ma expropriated Alipay from the Alibaba Group on the grounds that for national security reasons the government would not allow foreign-backed firms, including those with a VIE, to obtain an online payments license. Ma eventually agreed to compensate Yahoo ($YHOO) and Softbank, but few believe he is paying them 100 cents on the dollar for an asset they once partly owned.

It is unlikely that the Chinese government intends a wholesale investigation or restructuring of the Internet industry, but investors should not be blind to this risk, nor should they believe arguments that the government would not dare because too many jobs would be lost. Jack Ma proved that you can you restructure the foreigners out without any job losses, and to the advantage of Chinese investors.

Foreign participation in the Internet, perhaps the last major industry in China that is not state-dominated, has come under increasing scrutiny, not just during the Alipay scandal but also in a recent article in Study Times, a publication of China’s Communist Party School, that decried the amount of foreign ownership in China’s Internet firms.

If there are any investigations of foreign ownership of Internet companies on national security grounds, one might be forgiven for thinking that search (Baidu) and Weibo (Sina and Tencent) are at least as important to national security as online payments are. Given that much of the foreign ownership in Chinese Internet firms is actually Chinese money offshore, and frequently very connected Chinese money, I would expect that in the unlikely event of any major restructurings there would some mechanism to take care of the important investors.

For those who want a deep dive into VIEs, I have embedded an excellent primer on the subject from the Cadwalader law firm. You can also follow this link to China Law Blog for several good articles and podcasts on the topic.

[UPDATE: I started a thread on Quora about this topic and there are already some very knowledgeable comments--Do most Chinese Internet firms have a corporate structure that is technically illegal? - Quora. END UPDATE]

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Full disclosure, at the time of posting I own shares of Yahoo.

 

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