The “Big Boys’ Market” VIEs—The “Myth” of Foreign “Ownership” of PRC Stocks

"Choose Your Investment Wisely
Not All Chips are Blue"

 

If I'm not mistaken (and as Madame Arqala could tell you, I often am), in his seminal work, Benjamin Graham made the observation above.  Along with the advice to carefully analyze a proposed investment before you commit funds. 

If you’ve been following recent financial news about the PRC government’s clampdown on private educational companies, you’ve probably seen comments about the Variable Interest Entity (VIE) structure which is typically used by companies in the PRC to access equity from foreign investors.

The VIE is used because under PRC law foreigners may NOT own stock in some sectors within the PRC.  Lots to be exact.

How does the VIE work or more accurately claim to work?

1. A PRC company wishing to access foreign equity markets establishes an offshore company with the same name as its own. The Cayman Islands is a “favorite” location.

2. The offshore company and the PRC-based company sign contracts that ostensibly (note that word) grant the offshore company legally enforceable rights to a share of profits of and a measure of control over the PRC company. These are portrayed as providing “the equivalent to ownership”. If you’re interested you’ll find a detailed discussion of the structure and the agreements in the two “warning” articles cited below.

3. The offshore company then issues shares to investors. Note these are shares in the offshore company not in the PRC company.

4. Net proceeds from the issue are upstreamed to the PRC company typically as loans in consideration for the contracts and agreements in point #2 above.

What are the issues with the structure?

1. As with other structures based on complex legal agreements that attempt to “work around” (or perhaps more accurately circumvent) law, they are inherently fragile.

2. The investors’ ownership rights are in the assets of the offshore company – those are solely the contracts and agreements with the PRC company—not in the assets of the PRC company. That is, the investors have no direct claim against the assets of the PRC company.

3. To enforce their constructive (or more accurately imaginary) ownership rights in the PRC company, the investors have to enforce the underlying contracts against the assets of the PRC company.

4. That legal action has to take place in the courts and under the laws of the jurisdiction where the PRC company holds assets. In both cases that is in the PRC.

5. “Small” problem with that. Under PRC law, foreign ownership of PRC companies is illegal.

6. Therefore, mechanisms that attempt to “get around” PRC law—the VIE and the various contracts and agreements that purport to give the rights of ownership-- are illegal.

7. And, thus, are not enforceable in the PRC.

This legal situation is analogous to the Peking University Founders Group offshore bonds debacle, chronicled here for Part 1 and here for Part 2

While for some time, the PRC authorities have turned a “blind” eye to the use of VIEs, that does not change the fact that these structures are illegal.

Whenever the authorities choose, they can enforce the law.

This month the PRC turned its “good” eye toward education companies. They will no longer be able to use VIEs.

That lead to a substantial drop in PRC “equities” listed on non Chinese markets.

As well as much angst among investors, some of them charter members of the “big boys” club that frankly should have known better.

The 31 July FT article Equities Watchdogs Bite. Investors Rethink China Stocks Strategy After Regulatory Shock (Harriet Agnew, Tabby Kinder and Hudson Lockett) contains a rather chilling quote.

“The VIE structure, which allows global investors to get around controls on foreign ownership in some Chinese sectors, has never been legally recognised in China, despite underpinning about $2tn of investments in companies like Alibaba and Pinduoduo on US markets.” 

First, you will note that there are some US$ 2 trillion in stock investments on US markets that use the VIE structure.

Second, that suggests that the FT journalists’ reference to a “rethink” is wrong because clearly there was no “thinking” at the time of investment.

Rather it was “faith-based” investment.

To be fair, some of this amount is via passive investing by funds seeking to track various global indexes that include these companies.

I’ve always thought it was a good idea for an index to only include investable stocks.

What is distressing about all of this is the simple fact that neither the FT article nor this post constitute an “overdue wake-up call” nor a “sobering fact”.

There have been many warnings about VIEs.

Here are just two:

• 2012 King and Wood Mallesons – A PRC/Australian law firm which described the structure as a “Sword of Damocles over their [foreign investors’] heads”.

• 2017 Council of Institutional Investors – a “buyer beware” alert.

If you look within these two articles, you will see further warnings in the form of prior actions taken by PRC authorities against VIE structures as well as some rogue activities, e.g., T2CN and GigaMedia. Or perhaps (?) more benign – Alipay and Alibaba.

All of these “wake-up calls” and “sobering facts” were clearly ignored.

• Over a prolonged period.

• To the tune of US $2 trillion.

Remind me again about the efficient market theory.

Don’t forget to also mention the role of the “sophisticated” investor in the markets.

I do really love a good laugh