Investor risk lurks in legal structure of China IPOs: lawyers

As the US market for Chinese stock offerings revives, some experts are warning that American investors could be left out in the cold if a company faces problems, due to an unusual business structure employed by many Chinese companies.

The structure, known as a variable interest entity, or VIE, is designed to let companies bypass Chinese government bans on foreign ownership in some business sectors.

A popular corporate form in Chinese IPOs, the VIE structure was used in this month’s successful, US$91 million (HK$705.9 million) flotation of Light-in-the-Box Holding Co, for instance. That IPO has richly rewarded investors, with the shares up 57 per cent from their IPO price of US$9.50, even after a steep decline recently amid a broad market selloff.

VIEs include several components: a Chinese business with a licence to operate in a restricted sector; a foreign holding company; and a web of contracts meant to give outside investors control and access to profits, but not actual corporate ownership.

In practice, if things go wrong, foreign investors in a VIE may have few legal rights, a risk underscored by a ruling in October by China’s highest court that has triggered fresh concerns among legal experts.

“These are extremely high-risk structures. ... Your lay investor has no idea that this is what they’re invested in,” said Jason Flemmons, a former US Securities and Exchange Commission enforcement official.