by Thomas Kirchner
Legal uncertainties rekindled by Chinese clampdown.
VIE structures have been found to be illegal by Chinese courts.
Nuclear economic option unlikely except in major geopolitical conflict.
After Chinese regulators clamped down recently on tutoring companies and some online services, which is said to have wiped one trillion dollars off stock market valuations [i] some investors have expressed concern about further regulatory action. Especially at risk are Variable Interest Entities (VIEs), the structure used by all U.S.-listed Chinese companies because these structures are merely allowed by administrative action, and no law specifically allows them. With such weak legal underpinnings, a simple administrative measure could declare the VIE structure illegal and would wipe out $1.6 trillion in equity of all 248 U.S.-listed companies[ii]. The question is not whether, but on what occasion Chinese regulators will wipe out foreign shareholders.
Chinese VIEs and their risks
When Sino Forest went bankrupt after fraud allegations were revealed in June 2011, the complex structures of Chinese companies listed in the West became known widely. Because foreigners are not allowed to own companies in industries on China's 'restricted' list, a workaround was developed: Chinese nationals own the assets in China and then assign their economic interests to a holding company, often based in Cayman or the BVI, whose shares or ADRs are then listed on foreign exchanges. For example, Alibaba and ANT Financial are actually majority owned by co-founders Jack Ma and Simon Xie. The IPO prospectus states clearly how it works:
Due to PRC legal restrictions on foreign ownership […] we operate our Internet businesses and other businesses in which foreign investment is restricted or prohibited in the PRC through wholly-foreign owned enterprises, majority-owned entities and variable interest entities. The relevant variable interest entities, which are 100% owned by PRC citizens or by PRC entities owned by PRC citizens, hold the ICP licenses. [...]These contractual arrangements collectively enable us to exercise effective control over, and realize substantially all of the economic risks and benefits arising from, the variable interest entities.[iii]
The key risk of this complicated arrangement is also disclosed in plain English:
If the PRC government deems that the contractual arrangements in relation to our variable interest entities do not comply with PRC governmental restrictions on foreign investment, or if these regulations or the interpretation of existing regulations changes in the future, we could be subject to penalties or be forced to relinquish our interests in those operations. […] It is uncertain whether any new PRC laws, rules or regulations relating to variable interest entity structures will be adopted or if adopted, what they would provide. [iv]
In other words: nobody knows how solid the structure is.
There seem to be two schools of legal thought here: not surprisingly, law firms writing legal opinions for IPO prospectuses hold the view that the VIE structure is legal. This view is bolstered by their tacit endorsement by Chinese bureaucrats, who would probably take action if hundreds of large, public financial transactions were gross violations of the law.
Skeptics counter that contracts written to circumvent the law are unenforceable under Chinese law. There have been several cases in which Western shareholders have tried to enforce VIE contracts in Chinese courts, all of which failed. In the 2012 Chinachem case, the People's Supreme Court ruled after 12 years of litigation that Hong Kong-based Chinachem could not enforce the VIE contracts for shares of Mingsheng Bank because the contracts were designed to circumvent the law. However, the court ordered compensation be paid to Chinachem in the amount of 40% of the value of the shares, so the investor did not suffer a complete loss. In Gigamedia, the local nominee owner of the business, Wang Ji, simply transferred the assets to himself. When VIE shareholders attempted to recover their investment through arbitration, the tribunal took a similar rationale as the People's Supreme Court in Chinachem and declared the VIE contract unenforceable. [v] [vi] It is notable that a private arbitration tribunal came substantially to the same conclusion as a court of law. We take that as an indication that the favorable legal opinions of law firms in IPO prospectuses may be overly optimistic.
It appears to us that VIEs are tolerated by Chinese regulators mainly because they bring in foreign investment. Regulators maintain the upper hand and have a free option to enforce Chinese law any time it becomes convenient for them to expropriate foreign shareholders quietly.
How serious is the VIE risk?
To gauge the risk that Chinese regulators may take action against VIEs and wipe out U.S. shareholders, it helps to look at another precedent in which an emerging market dictatorship seized a company and wiped out foreign shareholders: the 2003 arrest of Russian oligarch Mikhail Khodorkovsky and subsequent breakup and forced bankruptcy of oil company Yukos over allegedly unpaid taxes.
As Russia's richest man at the time, Khodorkovsky had challenged Vladimir Putin's ascent to power and was openly contemplating entering politics. The ferocity of Khodorkovsky's prosecution and seizure of Yukos should not be mistaken as capricious acts of a mad dictator, but were carefully calculated to set an example and dissuade others from challenging Putin. In that sense, the strategy worked very well, because numerous other Putin-critical oligarchs promptly went into exile.
We believe that China's current clampdown follows a similar logic of power preservation by a dictator who is still consolidating his position. This view is consistent with the suspension of Ant Group's IPO in October 2020, which is reported to have been ordered by President Xi Jinping personally [vii], a clear indication the decision was political in nature. The widely reported explanation for the suspension concerns Jack Ma's October 24 criticism of regulators during a conference in Shanghai. However, a decision taken at such a high level points to another reason: Jack Ma was close to former Premier Jiang Zemin, whose vision of free enterprise is on the opposite end of the spectrum compared to Xi's stone-age communist emphasis on state ownership. Many Zemin associates are said to have been investors in a private equity fund run by Zemin's grandson, which was heavily invested in ANT Financial. The IPO would have given Zemin's circle a multi-billion dollar windfall, which would have been a substantial war chest in any future power battle, an outcome Xi prevented by stopping the IPO.
We believe that we can extrapolate this precedent and that an eventual clampdown on VIEs is inevitable, but it will not come as a result of domestic policy considerations, much less due to random, capricious regulatory actions. Wiping out $1.6 trillion in wealth from foreigners is not something the Chinese government would take lightly. It is an economic nuclear option whose use makes sense only under overwhelming foreign policy considerations. For example, should China attempt to invade Taiwan and should the United States actively support Taiwanese resistance, a cancellation of all VIE contracts would be a possible form of economic warfare. Similarly, should the trade war escalate, disputes over mineral right in the South China Sea intensify or should the West become more serious about human rights violations in China, retaliation against VIEs could be a policy option for Xi.
The market, of course, recognizes the risks inherent in Chinese companies listed in the West. That is why many trade at a discount to what they would be worth in the Chinese market, which opens the door for management to take them private for a low valuation and relist them shortly thereafter in China at a much higher valuation, pocketing the difference.
[i] “Investors Lose $1 Trillion in China's Wild Week of Market Shocks” bloomberg.com, July 30, 2021.
[ii] Noriyuki Doi, Takenori Miyamoto: “Crackdown on US listings: Will China close $1.6tn VIE loophole?” Nikkei Asia, July 14, 2021.
[iii] Form F-1 filed with the Securities and Exchange Commission by Alibaba Group Holding Limited on May 6, 2014.
[iv] ibid.
[v] Brandon Whitehill: “Buyer Beware: Chinese Companies And The VIE Structure.” Council of Institutional Investors, December 2017.
[vi] Charles Comey , Paul McKenzie, Y. Michelle Yuan, Sherry Yin: “China VIEs: Recent Developments And Observations.” Morrison and Foerester, August 19, 2013.
[vii] Jing Yang, Lingling Wei: “China’s President Xi Jinping Personally Scuttled Jack Ma’s Ant IPO.” The Wall Street Journal, November 12, 2020.
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Thomas Kirchner, CFA, has been responsible for the day-to-day management of the Camelot Event Driven Fund (EVDIX, EVDAX) since its 2003 inception. Prior to joining Camelot he was the founder of Pennsylvania Avenue Advisers LLC and the portfolio manager of the Pennsylvania Avenue Event-Driven Fund. He is the author of 'Merger Arbitrage; How To Profit From Global Event Driven Arbitrage.' (Wiley Finance, 2nd ed 2016) and has earned the right to use the CFA designation.
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