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Since Sina Corp first went public using the VIE structure on New York’s Nasdaq in 2000, hundreds of Chinese firms have taken the same path. Photo: Bloomberg
Opinion
Frank S. Hong
Frank S. Hong

Why China turns a blind eye to VIE tech firms and their foreign investors

  • As long as variable interest entities continue to raise foreign capital to boost China’s economy, without threatening it or Beijing, there is no danger of a regulatory crackdown

Since Chinese variable interest entity (VIE) companies made their debut in the early 2000s in the first wave of the internet economy, once in a while, international lawyers and investment bankers get anxious and ask: when is China going to crack down on VIE structures?

This is not so much about a US$4 trillion ticking time bomb – the capitalisation in the MSCI China Index estimated to be held by more than 100 VIE companies – as a hammer in search of a Chinese nail to hit. Yet Western professionals are not equipped to make a prediction.
For economic and ideological reasons, China fiercely protects its internet business from foreign influence or competition. By law, foreign investment in the internet sectors is restricted. Yet hundreds of such internet companies in the education and media sectors are listed on the US or Hong Kong stock exchanges, thanks to the regulatory workaround of VIEs.

Under this structure, the revenues of Chinese-owned VIEs, under service contracts, can flow into wholly foreign-owned entities, benefiting international investors.

The contracts are essential. Without them, international investors cannot reap the financial benefits of the Chinese businesses they have put money in. The contractual facade lets Chinese regulators look away as the entities that directly conduct business in the restricted domains are companies owned by Chinese nationals.

Two questions emerge. Any board of directors has to ask: what if the Chinese party reneges on the contractual arrangement, and will a Chinese court enforce the contract, given the legal ambiguity of VIEs? The other is: why does Beijing tolerate this thinly veiled circumvention in the first place?

In tackling the first question, lawyers try to read the tea leaves of ever-changing Chinese laws and regulations to forecast which way the regulatory wind will blow. The media, quoting sound bites from lawyers, wittingly or unwittingly, adds to the mythology of VIEs.

Yet few confront the second question, even though its answer holds the key to the first. The second question can be meaningfully explored only when one goes beyond a strictly legal analysis.

It is not that regulators in Beijing fail to see through VIEs. Rather, they see a much larger web of substantive forces that keep VIEs in check.

Mainland China regulators and tech giants should work together

All the VIE deals of concern share a common background. Except for the foreign capital raised, all the essential elements that make a VIE success story are rooted in China.

The founders typically remain controlling shareholders even after the initial public offering, and the middle management and core workforce, the market – especially the initial market – the consumer base, the supply chain, the infrastructure and, increasingly, the technology are all based in China.

Even if the Chinese founders acquire foreign citizenships, by virtue of their residency in China, they are subject to the “round-trip investment registration” regime, which includes all onshore investments by Chinese residents via special purpose vehicles such as VIEs.

No foreign-born non-Chinese national has ever pulled off a VIE-based success as a controlling founder and it is unlikely that one ever will. This is no accident.

As far as Beijing is concerned, the capital raised overseas is foreign only in a nominal sense. In all the sectors popular with VIEs, foreign capital is neither in control not brings in any foreign competition to threaten jobs or the Chinese economy.

06:22

Three trends shaping China's internet from SCMP's China Internet Report 2020

Three trends shaping China's internet from SCMP's China Internet Report 2020

In the early 2000s when capital was scarce, China could not afford to risk major capital on an emerging innovative sector. It is simply untrue that Beijing merely tolerates foreign capital, especially when it comes to non-threatening foreign capital raised in public markets that benefit Chinese people.

Foreign capital is the safe and inexpensive fuel that has powered growth in spaces where Chinese companies face no foreign competition.

China’s accommodation of VIEs is not an oversight. On the contrary, it is a farsighted, highly pragmatic and incredibly fruitful move of regulatory forbearance that deserves to be studied in law schools and public administration schools the world over.

To predict when VIEs will fall out of grace, one should put down the law books and focus on the situation on the ground. Are foreign investors collectively moving towards dominating or controlling internet businesses in China? No.

Are China’s tech giants facing serious threats of competition from foreign players? No. Is China losing control of its internet or cross-border capital flows? No. Is the Chinese consumer base being eclipsed by an overseas population? No.

As China leads the recovery in a pandemic-stricken world and consumers increasingly shoulder a greater share of China’s economic growth, VIE companies could not be safer.

Frank S. Hong is a corporate lawyer and the founder of the Shanghai-based Cook Ding Institute. www.cookding.org

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