China Court Ruling Could Threaten Foreign Investments in Country
Some are calling it “bigger than Enron” and “a bit of a Ponzi scheme.” A recent ruling by the Supreme People’s Court, the highest court in China, raises an important question: Is the future in question for more than half of the 200 Chinese companies listed on the New York and Nasdaq stock exchanges?
Earlier this month, my colleague, Neil Gough, wrote about the landmark ruling, in which the court found that contracts used by non-Chinese citizens to gain access to sectors of the Chinese economy that are protected from foreign investment were invalid.
Sectors the Chinese government considers sensitive, like finance, media, technology, the Internet and education, have long been largely off-limits to foreign investment. To get around that, some of the biggest companies in the country founded by Chinese people, including the Internet giants Baidu, Alibaba, Tencent and Sina, create variable interest entities, or V.I.E.’s, that give overseas investors de facto control over companies technically owned by their Chinese partners, as Neil reported. V.I.E.’s account for differing proportions of these companies’ income and assets, ranging from several percent to as much as 100 percent.
Problems arise if the Chinese partners decide they don’t want to follow the contracts any longer because, for example, they already have the money and know-how they were seeking, as has happened in several instances. When that happens, the foreign party most likely has no legal recourse.
“Chinese law has a very clear provision. A contract written to avoid the requirements of Chinese law is void and the court will not enforce it,” said Steve Dickinson, a partner at Harris Bricken and a co-author of the China Law Blog.
The Chinese government and industry insiders have warned for years about the dangers of V.I.E.’s. Last Friday, an article in the China Business News said the situation represented “a war for the right of control” between Chinese and overseas partners.
It’s a very insecure situation, lawyers said. “Every V.I.E. company – Baidu, Sina, Alibaba, Tudou, all of them – is operating by the grace of their Chinese partners. This mess is going to make Enron look like a trivial, little drop in the bucket,” Mr. Dickinson said.
Take, for example, New Oriental, one of the largest private education providers in China. Because New Oriental earns all of its income in its V.I.E., if the company was forced to deconsolidate it from its accounts, it would demonstrate to investors that they don’t actually own the business, said Paul Gillis, an accounting professor at Peking University and the editor of the China Accounting Blog.
Others said that the case before the court was not exactly applicable — it involved a different company structure from the V.I.E. — lessening the likelihood that the ruling would affect the companies.
“This group of people will distinguish the recent Supreme People’s Court ruling because it was an earlier set of documents, not entirely the same as the V.I.E. structure,” Mr. Dickinson predicted. “But what the court said is that any contract that is designed to avoid the clear requirements of Chinese law is void from the very first step. That is what the V.I.E. is.”
Considering the possible wide-reaching implications of this recent ruling, is it being underplayed?
“Accountants, lawyers and stock brokers make a ton of money off I.P.O.’s so they have no incentive to slow them down,” said Dan Harris, a China lawyer with Harris Bricken and a co-author of the China Law Blog. “They have every incentive to keep the V.I.E. structure going.”
The local Chinese partner is likely to have less to lose than the foreign partner. Even if the court deems the V.I.E. contracts invalid, the Chinese partner, who is usually the founder of the company, will continue to own it, lawyers said.
“The local partner brings the market access and the foreigner makes some money for a few years but ultimately it’s kind of open season,” said Andrew Gilhom, the head of Asia analysis at Control Risks, a business risk consulting firm.
Will anything actually happen to these companies in light of the recent Supreme People’s Court ruling, or are V.I.E.’s now too big to fail?
“The only three successful U.S. I.P.O.’s from China in the past 15 months all have V.I.E. structures – LightInTheBox, YY and VIP Shop. Investor confidence has been strong in all of these companies,” said David Roberts, a partner at the law firm O’Melveny & Myers.
It is also unlikely that the Chinese government wants to turn the V.I.E. structure into a huge issue.
“They don’t want all the U.S.-listed stocks suddenly tumbling and companies failing and panic,” Mr. Gilholm said. “I don’t really see any signs that they are going to proactively go out and across the board say that all these structures have to be unwound.”