Foreign investors seek alternative to China's VIE structure

Sina Corporation won many plaudits when it became the first Chinese online media company to list on Nasdaq, back in 2000. The secret behind its success was the variable interest entity (VIE) structure, which it used smartly to bypass restrictions at home.

Under the VIE arrangement, nominee shareholders, who are mostly Chinese entrepreneurs, hold shares on behalf of foreign investors under a custodial agreement. In the early days, the structure seemed ideal for Chinese companies operating in sectors closed to foreign investors, such as the internet, education and media industries, giving them the opportunity to list abroad without running afoul of rules against foreign ownership.

After the high-profile success of Sina’s listing, VIEs became the default structure for many Chinese companies seeking overseas listings. However, the structure has led to governance issues and has become increasingly problematic.

One of the biggest problems is that the nominee shareholders in China are, in many cases, the founders or principal managers of the listed companies. In effect, this gives them ownership of both the Chinese and US entities.

“When the founders are only concerned for their own benefits, there are loopholes which allow them to disregard the interests of minority shareholders and to operate the company in ways which would be tailored to their own agendas,” said Violet Ho, senior managing director at Kroll, a corporate investigations and risk consulting firm.

A lack of transparency means that it is usually not easy to see how these founders are treating the companies’ assets, she said. When there is a dispute, these individuals often have board seats on both sides of the argument, which gives them a lot of leeway in how they solve the dispute.

“Even some allegation by short sellers, which may not be well founded at all, can nevertheless create a difficult situation for companies using the VIE structure because it is difficult for the listed company to have enough credibility to prove the revenue and clients are there,” said Ho, who oversees the firm’s Greater China business intelligence practice.

The VIE structure has been at the centre of the argument between Yahoo and Alibaba, when the US internet company, which owns 43% of its Chinese peer, complained that Alibaba had split its online payment platform into a separate entity without notifying its US shareholders.

Then there was New Oriental Education, which triggered an SEC probe after the language-school chain consolidated all the equity interests in New Oriental China, its VIE, under founder Michael Yu. He argued that it was for the best of the company, but the move clearly gave him a lot more power.

So is the tactical structure still viable for Chinese companies seeking foreign listings? Companies need first to answer these questions: “Do you want to list overseas? Do you want to have a VIE structure and still be engaged in a company that has clear regulatory restrictions for foreign investment? If answers to all these questions are yes, then the VIE structure is really the only option at the moment,” said Ho.

But if the VIE structure is no longer desirable, Chinese authorities will have to loosen restrictions on the kinds of companies foreign investors can own to continue attracting overseas capital. In the end, the passing of the VIE structure may be a good thing for investors and for China.