New four-letter word
China investors have a new four-letter word to decry. Really it’s an acronym: VIEs, for “variable interest entities.” These are the structures used by nearly half of all Chinese firms listed on the Nasdaq to get around restrictions at home. A new Securities and Exchange Commission probe of New Oriental Education may sound their death knell. In the end, that’s probably best for investors – and for China.
These loopholes were designed to let Chinese companies active in certain sectors – such as the Internet and education – list abroad without running afoul of rules against foreign ownership. Under this arrangement, the listed entity effectively draws up a contractual agreement with the Chinese company through some complex arrangements that mimic, but do not constitute, a direct equity stake. These structures have created all sorts of grey governance areas and famously figured in a recent spat between Yahoo and Alibaba.
New Oriental Education appears to have triggered the SEC probe by taking the VIE structure to another level of control by its founder. The company said on July 11 it had changed the shareholding structure by consolidating all the equity interests in New Oriental China, its VIE, under founder Michael Yu. While the company argued this strengthened its corporate structure, it also clearly gave Yu more power. Investors responded by marking the stock down some 3 percent.
But the bigger hit came Tuesday when the company, alongside a profit warning, revealed an SEC investigation into the matter. Investors freaked out and sliced 30 percent off the stock. Scrutiny by the U.S. regulator into VIEs is long overdue. About 97 of the 230 Chinese companies traded in New York use this structure, according to Macquarie, despite the risk that they offer American investors little protection from, say, the founder of a company absconding with valuable assets. That happened when online gaming company Gigamedia tried to sack the owner of its Chinese license.
True, closing the VIE loophole might make it harder for future Chinese companies to access overseas investors. But that may provoke two beneficial outcomes over the long run. First, it might convince Beijing to relax its rules on the kinds of companies foreign investors can own. Second, it could entice Chinese companies to simply work harder to list at home, which ought to help deepen China’s capital markets. In the meantime, though, it looks like more pain for investors in Chinese companies listed abroad.