Reuters: China VIE Company Structure Under Threat

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  • on September 18th, 2011

[UPDATE: This issue may be a bit exaggerated, if one of of China's veteran executives has good information. Xie Wen claims that Vice Premier Wang Qishan has issued an order to grandfather in existing VIEs--China VIE Issue Overblown, Vice Premier Issues Directive To Recognize Existing Ones? | DigiCha. END UPDATE]

Reuters reports that the China Securities Regulatory Commission is calling for action against variable interest entities (VIEs). In Sunday’s story China company structure under threat Reuters writes 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, and employed in thousands of other investments by foreigners into domestic Chinese companies, four legal sources told Reuters.

Lawyers at four different firms in China and Hong Kong said they have seen an internal report, dated August 17, said to come from the China Securities Regulatory Commission (CSRC) which asks China’s State Council, or cabinet, to take action against the structures known as Variable Interest Entities (VIEs).

The CSRC did not respond to a Reuters request to confirm whether or not the report is genuine. But lawyers say they are taking it seriously and that if the government were to accept the CSRC’s view it could jeopardize the way in which Chinese companies list overseas or receive foreign investment…

“If the PRC government did clamp down on the use of VIEs for overseas listings, it would leave few options for many of these companies to list outside of China, or even to take on foreign investment of any kind,” said Alan Seem, a partner at Shearman & Sterling in Beijing who has not seen the internal document.

“I don’t think U.S. investors would be that excited to be investing directly into a Chinese entity, and there is a question whether the CSRC would approve these companies for foreign listing even disregarding the VIE issue.”

The move by the CSRC is apparently driven in response to the raft of fraud cases seen recently at Chinese companies listed in North America, many of which used the VIE structure. The CSRC has repeatedly stated that it often has no jurisdiction over these companies, which tend to be incorporated offshore, but the wider impact of the scandals on investor sentiment to China is putting them under pressure to act.

I have posted on the VIE issue a few times, most recently in Do Most Chinese Internet Firms Have A Technically Illegal Corporate Structure?. From that post:

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.

I still think it is unlikely that this will have any significant impact on the major Internet firms like Baidu ($BIDU), Sina ($SINA), Tencent, Sohu ($SOHU), Netease ($NTES), Youku ($YOKU), Shanda ($SNDA) et al.

This development however may freeze new China Internet IPOs and slow new venture investments. I have heard it is increasingly to find a Chinese law firm (it has to be a Chinese firm) to bless the VIE structure as required by the underwriters and the SEC.

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