VIE and dry
Investors are worried about Chinese accounting practices after a string of alleged frauds at U.S.-listed companies. But it’s not just the numbers they should be concerned about. Risks may also lie in a complex structure used by companies from search engine Baidu to recently-listed social network Renren to get around rules on foreign ownership. Some have already gone wrong; more could follow.
The device in question is the variable interest entity. A VIE facilitates foreign investment in taboo sectors like internet and advertising. It puts the company’s sensitive operating licence in a separate box, owned by Chinese citizens – often the founder or a relative. The foreign-invested holding company gets a contractual right to use and control the licence, and claim earnings from it, but doesn’t have outright ownership.
The structures are pretty common: two-thirds of NASDAQ Chinese listings used them in 2010, according to independent analyst Fredrik Oqvist. There is also a criss-cross of provisions in place to keep the licence holder honest. Strongly worded contracts are the first. An equity pledge is the second. This usually says that if the licence holder breaks the contract, the operating company can seize the licence back.
Yet it’s not clear what would happen if VIEs were put under real strain. Contracts in China, where there is no independent judiciary, are hard to enforce. Shareholders might find themselves pursuing a claim in a local court against a tycoon with powerful connections. Since there are no legal precedents on VIEs, investors may even avoid pursuing claims, in case a ruling against them starts a pernicious domino effect.
The other problem is that the government may yet step in and deem VIEs illegal, since the structures are plainly designed to circumvent the rules. Authorities have turned a blind eye so far, but that’s no guarantee they will do so in future. A spat between Yahoo and Chinese ecommerce partner Alibaba over their online payment system may have started after regulators decided, according to local media, that control through a VIE was too close for comfort.
In a couple of cases, VIEs have already started to go wrong. Singaporean online gaming company Gigamedia tried to sack the owner of its Chinese licence, only for him to abscond with it. Gigamedia has decided to start again from scratch rather than pursue the claim further. In March, steelmaker Buddha Steel pulled a U.S. stock listing because local government deemed its VIE to be against public policy.
Investors can’t say they haven’t been told. Renren’s prospectus warned that contractual agreements may not be as effective as ownership, and may not even be legal. Some investors assume that because some of the companies involved are so big – Baidu’s market capitalisation is $41 billion – there is almost no chance of these structures being challenged. Maybe. But if recent accounting scandals have created a sceptic’s discount over China stocks, VIEs seem a good place to apply it.