China VIEs are Dead and I Told You so

China VIEs

The Wall Street Journal just published an article on the threat the proposed PRC foreign investment law poses for companies that used the VIE structure to enter into prohibited business sectors in China. Among the companies in the cross hairs are a number of major foreign businesses such as Amazon, Pearson and CBS. Add to that Chinese Internet giants Sina, Weibo, Alibaba, Baidu, Tencent and Youku and you pretty much have the entire Chinese Internet sector lined up on the firing line. The Journal seems to be treating this as a shocking new development.

But none of this is new. In fact, I told you so, as the below posts (which are just a sampling) reveal.

1-22-2015 China VIEs Are Dead. Done. Over. Stick A Fork In Them.

6-3-2013 China VIEs. Avoid, Avoid, Avoid.

Way back in 2011, in an article I wrote for a leading Chinese business magazine that is no more, I vehemently set forth the proposition that VIEs are to be avoided as illegal:

None of this is actually new. These risks have long been known. However, the clarity of the Regulations means it is now nearly impossible to claim that Chinese law on these issues is ambiguous or unclear. Where Chinese law says that ownership by foreigners is restricted or prohibited, the law means what it says. Foreigners who invest in violation of the law are making a bet that the violation will be ignored. This is extremely unlikely in today’s China. Such bets are sucker’s bets and should be avoided at all costs.

I have been speaking out against VIEs for years and just about every time I do so, someone says that if they are illegal, why have so many large law firms, large accounting firms, and large companies gone along with them? The answer is simple. Money. Big money. Really big money. Now, some of these same law firms and accounting firms and companies are denying that anything has changed. And why is that? Again, money. Only this time they are taking positions not so much to make more money going forward, but to avoid losing through lawsuits the money they have already made.

The big time business press is now picking up on what I have been saying for years: the VIE structure is illegal, its underlying contracts are void, and VIE companies will now be required to restructure or shut down. Foreign investors will lose a lot of money and the Chinese side will come out on top. This all makes me wonder why it was that so many kept insisting China would permit foreign companies to operate illegally in China.

It is important to understand how this will all go down. Over the years analysts have said there is no real risk with VIEs because the Chinese government will not want to shut down these major players in the Internet and e-commerce sector. The Journal article above repeats this. The problem with this proposition is that it misses the real threat.

First we need to consider the background. The fact that Internet/e-commerce companies are big and profitable is not relevant. The Chinese government does not care about this. What the Chinese government cares about is that its Internet and e-commerce sector is now dominated by foreign investors and it does not consider that to a good thing. To understand this basic attitude, check out my recent posts on China File.

On the other hand, the Chinese government understands China requires a powerful and well run Internet as a prerequisite for a modern and powerful state. Thus, the Chinese government has no desire to shut down the foreign controlled internet; but it does wish to regain control over it. The Chinese government likely will accomplish this in two stages:

First, the truly foreign owned and controlled VIEs such as the Amazon and Pearson ventures will be required either to shut down or transfer their assets to Chinese entities.

Second, the majority of VIEs formed by Chinese entities will be required to restructure by buying out their foreign investors at what will likely be fire sale prices. The goal here will be to put Chinese citizens permanently in control of what are nominally public entities. This is apparently the path currently being forged by Alibaba and Baidu.

In either case, the foreign investors will be squeezed out of VIEs and those VIES will then come under the control of Chinese persons and entities. The result of this mandatory sale will be a destruction in value for the foreign investors. In other words, the money invested by the foreign investors will essentially be “gifted” to the Chinese people.


3 responses to “China VIEs are Dead and I Told You so”

  1. So Baidu, Alibaba, Tencent etc’s shareholder structure is based on VIE, and they are publicly traded entities on global exchanges… and now you expect the Chinese government to require that all shareholders transfer their interests to Chinese entities at “fire sale” prices? Please, Cassandra, April fools was almost a month ago. VIE’s are treated differently depending on the industry in which the investment is made. In the tech sector, the Chinese government has consistently taken a careful approach towards foreign investment to point of ignoring existing law. With the new investment law coming into play, the government has repeatedly stated that it is looking into resolving the existing VIE conundrum. Just because the VIE is dead does not mean that investors who have used a system that has been tacitly approved by the government for nearly 2 decades will also be wiped out.

  2. And *BOOM* goes the dynamite!
    Great piece from Steve Dickinson, really nails the likely future of companies established under this structure. For far too long people have been saying that the Chinese government cannot do X because X would be bad for business or unjust to foreigners, but they forget that the CCP only cares about what is good for business and foreigners to a certain extent, and that extent does not include handing over what it considers to be vital areas of its economy to what it believes to be foreign control.
    Put simply, the CCP is far more interested in maintaining 100% control over the internet in China, this being (amongst other things) the main way in which government opposition may be voiced, than it is in whether some investors in foreign countries lose money. The bottom line for the CCP is its continued role as governing party – nothing else really matters that much.

  3. The new draft Foreign Investment Law expressly distinguishes between VIEs that are truly foreign-owned and those that are ultimately Chinese-controlled. If you’re making that distinction in legislation, you’re doing so to create a basis for treating them differently.
    I agree with Steve that anyone using a VIE past its sell-by-date does so at their own risk (then again anyone using one now is in the same situation). By the same token though, I don’t really see the signs that the Chinese government wants foreign investors out entirely: that runs counter to the rest of its strategy (HK-Shanghai Stock Connect, or the slow but steady removal of areas from China’s restricted/prohibited lists in successive versions of the foreign investment catalogue). Politically, it’s also hard to see the Chinese government getting comfortable with mass-scale protests by – for example – Alibaba’s public shareholders against being expropriated: what sort of retaliation might its trading partners take? The emphasis in the FIL is on actual control and I think that that is where any enforcement action will be aimed at: making sure control of strategic industries remains in Chinese hands.
    Put another way, foreign minority investment in internet companies is all upside and no downside for the Chinese authorities. It seems more likely that they are looking for a framework to have foreign investors fund Chinese-controlled Internet companies in the public gaze and without obtaining any form of positive or negative control rights.

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