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China Risks No US IPOs, Terrified Foreign Investors, in VIEs Clampdown

There are fears in the international investment community that foreign investment will be squeezed out of Chinese web companies if authorities in Beijing clamp down on variable interest entity (VIEs). The structure is essentially an agreement between a foreign investor and an internet company in China, allowing the overseas company to generate payment from its holdings here.

While VIEs have been ratified and used for years in China, the recent Yahoo, Alibaba, and Alipay kerfuffle put this legal device in the global spotlight, showing that it was actually of dubious legality and sustainability. On the weekend, Reuters reported that China’s securities regulator is asking the government to clamp down on this virtual ownership mechanism. If such a tightening on foreign investment policy occurs, it could seriously impact Chinese web companies who utilise it, such as Baidu (NASDAQ:BIDU), Sina (NASDAQ:SINA), and Alibaba (HKG:1688). It also risks crippling any upcoming Chinese web US IPOs, which would become damn near impossible in the face of ministry-level approval for each VIE, or possible abolishment of all VIEs.

Reuters notes of the changing mood: "New rules from the Ministry of Commerce that took effect on September 1st bar foreign investors from using arcane investment structures to evade China’s security review process, but didn’t directly address VIEs. The CSRC report, if genuine, suggests the matter is more serious since regulators are indeed pushing to restrict the structure."

To get a better sense of its implications, let’s look at what three respected China observers – who bridge political, legal and business areas of expertise – say on this issue. Web = Media = Dangerous

First up, David Wolf, a Beijing-based analyst, who has followed the emerging controversy all year, and divined a possible clampdown from a state-run news-agency (Xinhua) editorial back in July. Tweeting this weekend, he said, “Enough soothsaying: time for the VIEs and bankers to batten down.” Recently, David wrote that the change is happening now because “the way China’s regulators look at and understand internet companies has changed.” One key aspect is that authorities now realise that the web is not just about buying books – it’s also a powerful form of media, and media is something that China controls very tightly, rarely allowing any foreign ownership or intervention. Undeniably, Sina’s Weibo platform is a more powerful news portal for young netizens than state-run TV, so there’s that element of authorities implementing control. “Technically illegal”

Digicha’s Bill Bishop, an experienced entrepreneur based in Beijing, is sounding a cautious note, despite also seeing this coming from miles off. In a new post today, Bill pointed to a Weibo post by a senior Chinese executive at various Internet companies, suggesting that existing VIE agreements will be honored and renewed.

Nonethless, he has often highlighted how China seems to be seeing foreign ownership of web firms as something of a national security hazard, and that VIEs are, fundamentally speaking, technically illegal.

How widespread is this mechanism in China? From a Financial Times article: “As of April 2011, 42 percent of Chinese companies listed in the US have used the VIE structure and thousands of unlisted companies continue to operate through the use of the VIE structure,” said Cadwallader, the law firm, in a note to clients.

But on a final note, Bill observes:

"I have heard it is increasingly hard to find a Chinese law firm (it has to be a Chinese firm) to bless the VIE structure as required by the underwriters and the SEC."

Making an example

Lastly, Business Insider contributor Paul Denlinger, playing devil’s advocate, suggests that authorities feel the time is right to shut this down, and shut out foreign investment. In two consecutive tweets, he says:

"China shutting down VIE structure would make complete sense; it doesn’t need foreign investment money anymore. In fact, foreign investment money in China contributes to inflation, local corruption. Beijing may be ready to make an example of VIEs." For now, the world needs to wait to see what actual policy change might be coming. In fairness, this could well be just about eliminating grey areas, so that regulators have proper jurisdiction in this area, and to avoid the kind of accounting scandal that tainted Chinese tech IPOs this summer. Also, mounting scrutiny does not necessarily equate with a clampdown. But for now, foreign investors in the Chinese web scene would be wise to examine their own set-ups in China.