But Beijing’s crackdown on China’s $ 100 billion tutoring industry over the past week has included a ban on companies using this structure, known as a Variable Interest Entity (VIE), looming large. the specter of a broader catastrophe for some of the world’s largest investors.
The move erased tens of billions of dollars from the market value of Chinese companies listed in New York City, fearing the ban on tutoring VIEs could spread to other industries.
The ban and an ambiguous warning that existing VIEs will be “rectified” have raised concerns that other VIEs will be affected, such as Alibaba, Pinduoduo and JD.com. Since Friday, the Nasdaq Golden Dragon China index has fallen 15%.
Chinese VIEs, typically based in tax havens such as the Cayman Islands, are essentially holding companies designed to circumvent strict rules that prohibit foreign investors from owning property in key industries, such as technology. In theory, they entitle US shareholders to the economic benefits of a Chinese company while limiting their operational control over the company.
“Investing in VIEs is a take it or leave it mentality,” said a person familiar with the New York Stock Exchange. “The owner does not have a legal right to the underlying entity, but it is the only way to access it. “
So far, Beijing and U.S. investors such as BlackRock and Fidelity have been happy to gloss over the risks of the structure, with the value of VIE-backed stocks rising to around $ 2 billion, according to the National Office. American economic research.
But this week’s shocking announcement stirred long-term critics of the structure, who expressed concerns that China could extend the crackdown on VIEs from education companies to other sectors.
Dan Harris, a lawyer at Bricken Harris, an international law firm that has warned clients about the legality of VIEs for more than a decade, said the Chinese Communist Party has “come after big business and now everything indicates that they are attacking VIE ”. .
“If I had money in any type of VIE right now, I would be very unhappy,” he added, adding that investors looking to make good their losses have limited options. “It is very unlikely that they [investors] get all their money back. Legally, they are on quicksand.
U.S. regulators have not approved any new listings of Chinese companies in recent weeks, due to uncertainty surrounding VIEs and broader regulatory crackdown from China.
On Tuesday, Reuters reported that SEC official Allison Lee said Chinese companies listed in the United States would be required to disclose risks of interference from China in its operations as part of their reporting obligations.
The risks of investing in VIEs are well known. When Alibaba was listed in New York in 2014, it devoted three pages of its prospectus to potential problems with its VIEs.
The attack on tutoring groups this week is not the first time China has banned an industry from using VIEs. In 2009, regulators announced restrictions on the use of VIE lists by online game companies, but the application has been almost non-existent, with online gaming and streaming company Bilibili listed on Nasdaq in 2018. .
But the growing battle between Beijing and the United States over Chinese overseas listings has shaken the trust they depend on. “VIEs are inherently risky and unenforceable – foreigners suspend their disbelief to participate in China’s growth story,” said Tim Clissold, a senior Chinese investor.
The battle escalated when US regulators threatened to deregister Chinese companies that had not opened their audit process to scrutiny. China, meanwhile, has passed a new data security law that prohibits companies from passing data to foreign officials without government permission.
Earlier this month, Chinese ridesharing company Didi became a high-profile victim of tensions when Beijing targeted its data security right after registering in New York. Its shares have fallen more than 40 percent since.
“The uncertainty is so high and so unpredictable that the protocol of simply disclosing risks during the IPO process may not be enough.” [to protect investors in New York]Said a senior lawyer in charge of the IPO of a US firm in Hong Kong. He added, “The ball is in the Chinese government’s court. The United States is responding to it, but it is not leading it. “
But some believe China’s renewed focus on VIEs could prove positive if it translates into greater clarity from regulators on which structure Beijing prefers for foreign listings.
“It has been going on for 25 to 30 years. The government has made it more and more difficult over the years to set up an offshore structure[but], over time, people find ways to overcome whatever obstacles the government poses, ”said Marcia Ellis, partner at US law firm Morrison & Foerster.
Fredrik Öqvist, a specialist in risks, including VIEs, said new rules requiring a security review of foreign listing plans by companies with data on more than one million users could end up granting official recognition to popular structures.
“If anything really stood out from this review, it would probably be the first time that a VIE structure has had some form of official approval,” qvist said.
The Hong Kong-based IPO lawyer suggested the government would likely give itself “greater powers to preserve the right to say no.”
“They will probably acquire new tools to regulate these companies but that does not mean that they will necessarily ban the whole structure because the consequences would be too great. But we don’t know yet. “
Additional reporting by Eric Platt in New York