All eyes were on Alibaba in its $22 billion initial public offering (IPO) on 19 September 2014, the largest ever in US history. Investors were so eager to add the Chinese e-commerce giant to their portfolios that the shares rocketed 38% on its debut and Alibaba closed with a valuation of $231 billion on the first day, more than the market value of Amazon and E-Bay combined. However, investors were not really investing in Alibaba – they were investing in Jack Ma. As the founder himself observed in front of cameras at the New York Stock Exchange: “Today, what we’ve got is not money. What we’ve got is trust from the people.”
The Variable Interest Entity (VIE) structure that is Alibaba, is all about trust indeed. Essentially, it uses various contractual arrangements to avoid direct foreign ownership in restricted or prohibited industries or other requisite government approvals. In a typical VIE, Chinese founders remain registered as shareholders of the domestic capital company holding the required licences and permits needed for the business to operate. As these permits could practically only be obtained by a domestic capital company, separate contractual arrangements are put in place to transfer the actual control or economic benefits of the operating company (OpCo) from the Chinese founders, to a wholly foreign-owned enterprise (WFOE) separately established by an offshore holding company (HoldCo) set up by the Chinese founders, for offshore financing purposes.
A TYPICAL VIE STRUCTURE CHART
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The contractual arrangements often include: (1) a technical services agreement between the WFOE and the OpCo, where the OpCo’s revenue and profits are transferred to the WFOE, typically as service fees, before being repatriated to the HoldCo as profits; (2) a voting proxy from the Chinese shareholders of the OpCo granting the HoldCo or its affiliates the right to exercise shareholders’ rights and management control over the OpCo’s operations; (3) an equity pledge agreement between the OpCo’s Chinese shareholders and the WFOE, as security for the proper performance of the contractual arrangements; and (4) an option agreement granting the HoldCo or its affiliates the right to acquire, if and when permitted by PRC law, the equity interests in and/or assets of the OpCo for the lowest permissible price.
VIEs’ CHECKERED HISTORY
In the 1990s, the ‘Chinese-Chinese-Foreign’ (C-C-F) structure was first attempted by China Unicom to get around the prohibition against establishing mobile telecommunication joint ventures involving foreign investors. China Unicom’s C-C-F joint venture ultimately failed in 1998 when it was declared ‘irregular’ by the Ministry of Information Industry (MII), and this was notwithstanding that the contracts were approved by the Ministry of Foreign Trade and Economic Cooperation (MOFTEC), the State Administration of Industry and Commerce (SAIC) or local level officials.
However, the C-C-F structure soon re-emerged in new forms and guises such as VIEs, which became and continue to be exceedingly popular among Chinese internet-based companies seeking to be listed in the US. The Sina listing in 2000 was especially notable because MII, being the industry regulator then, issued an opinion to SAIC recognising the spin- off of Sina’s internet content provider business to a domestic company, and granted permission for the newly-incorporated domestic entity to be issued with an operating permit as part of pre-IPO restructuring, which was probably the closest that VIEs ever got to getting the nod from MII.
Now, the problem is that VIEs are not only being used to circumvent foreign investment restrictions in sensitive industries, its utility has since expanded to defeat the PRC Provisions on the Merger or Acquisition of Enterprises in China by Foreign Investors (M&A Rules) that was promulgated in 2006. The M&A Rules impose a new set of restrictions by the Ministry of Commerce (MOFCOM) on cross-border acquisitions of domestic capital companies, which are often carried out in pre-IPO restructurings for an overseas listing.
LISTABILITY OF VIEs
Given the substantial legal risks involved, it is fascinating that VIEs even pass muster for listing at all. While there are usually standard banners in prospectuses disclosing that the PRC government may at some point take the view that VIEs are illegal notwithstanding longstanding industry practice, these health warnings are often buried under a mountain of other information in the listing documents. Or perhaps, it is the investors who are choosing to look the other way.
When the company is growing fast, many problems are glossed over, but when the company starts to struggle, these issues come back to haunt investors. The trouble is that the legal contracts that form the cornerstone of the entire set-up are extremely fragile. Why? They are enforceable only if Chinese courts are willing to uphold them, which is highly questionable when the structure is built for the very purpose of circumventing Chinese government regulations in the first place. There is essentially no difference in the motivations behind the denounced C- C-F structure and the VIE structure and clearly, the continued existence of the latter depends entirely on where the winds are blowing in China in terms of its policies.
VIEs IN SINGAPORE
Whereas the US stock exchange has embraced VIEs with all its shortcomings, the situation has been a lot more muted in Singapore, though this has not always been the case. For a while, there were some listed VIEs on the Singapore Exchange (SGX) but the numbers have petered out along with the dearth of new S-chips listings on the exchange. The reputation of S-chips has unfortunately taken a severe beating amongst investors in Singapore following a string of spectacular corporate scandals owing to poor corporate governance, and a large number of S-chips originally listed in 2000s have been delisted. New VIE entrants have been virtually non-existent since the 2006 delisting of e- learning education service provider, ChinaCast Communications, which was one of the last notable VIEs in Singapore.
DIFFERENT REGULATORY APPROACHES
The regulatory philosophy in the US has long been, since the introduction of the Securities Act 1933, anchored in the ancient rule of caveat emptor (i.e. “let the buyer beware”) and the further doctrine of caveat venditor (i.e. “let the seller also beware”), which effectively places the burden of full disclosure on the seller. Singapore, on the other hand, moved towards a disclosure-based regime gradually and the express association with a caveat emptor philosophy was only emphasised in the early 2000s. On a continuum where the disclosure- based approach and the merit-based approach are placed on opposite ends, the US is probably closer to the disclosure-based end than Singapore is today – regulatory authorities in Singapore still exercise a gatekeeping function that to some extent assesses the merits of listing candidates substantively. As for Hong Kong, it is notable that it continues to expressly allow the listing of VIEs, although VIEs will generally be rejected if the applicant is allowed to directly hold the entire equity interest in the target business in the PRC without such structure. For applicants that are involved in a restricted industry where foreign investment is limited, the VIE structure will be considered on a case-by-case basis, provided that certain pre-specified conditions and requirements are met.
Many Chinese companies are forced to list overseas because it is too difficult to get approval to list in the PRC and Chinese citizens are denied of the opportunity to invest in some of their country’s most successful firms listed offshore due to capital controls, yet foreign investors do not technically buy into Chinese companies structured as VIEs either – nobody wins.
Some are hopeful that the recent direct listing (DL) framework between the China Securities Regulatory Commission (CSRC) and the SGX may alleviate the problem. Under the DL framework which was announced late last year, PRC companies may list directly in Singapore and thus do away with VIEs or pre-IPO restructurings that require MOFCOM approval. The catch however, is that listing approval will need to be obtained from CSRC and SGX such that both authorities will have jurisdiction over the listed company. Of course, if CSRC takes just as long to approve a listing under the DL framework as for a local PRC listing, the Chinese company might as well list in the PRC. Anecdotally however, the CSRC approval process for the DL framework is expected to be that much quicker. Moreover, the upside of CSRC retaining regulatory oversight over such overseas listed Chinese companies is the mitigation of the problem of lack of accountability and enforcement where there is bad behaviour.
The DL framework holds much promise as a viable alternative to VIEs without all its attending problems – it is just waiting to be seized.