Don’t worry, nothing has really happened on the VIE front in the past week or so. However, the chatter over these risky corporate structures continues as lots of US investors slowly wake up and realize that many Chinese listed firms in the U.S. have fundamental flaws. Oops. That’s what due diligence is for.
Anyway, I have nothing new to say, but I did want to point out a couple of new things for you VIE groupies to read. First is a lengthy Bloomberg overview of the issue. It’s generic, and therefore a decent place to start if you’re looking for a jumping-off point to the topic. Second and third are two opinion pieces, by Bill Bishop (DigiCha) and Steve Dickinson (China Law Blog), who sort of set themselves up on opposing sides of the issue.
It was interesting reading these two blog posts, since both authors are wicked smart, experts in their respective fields, and very opinionated (not that there’s anything wrong with that).
Bill’s post is a reaction to the Bloomberg article, which he found to be too alarmist (among other things). Bill has maintained this “The sky is not falling” position over the past several weeks on the VIE issue as the regulatory speculation has swung back and forth in the press. Bill thinks that all this unnecessary hand wringing has been a negative influence on the market. His concluding statement:
[O]verall I believe the VIE issue is overstated and being kept in the news in part by lawyers using scare tactics to market their services and by investors talking up their short positions. There are many reasons to be cautious about the risks related to China investing, but the VIE issue is not nearly the most important.
Turning to the other VIE blog post of the day, ironically written by a lawyer, Steve seems to think that VIEs are complete rubbish and should be avoided like the plague. Much of Steve’s post is devoted to a discussion of the recent MOFCOM M&A rules, which I first discussed here. He says that the new rules solidify the illegality of the VIE structure and should remind folks that companies that use it could be shut down by the government at any time. Steve summarizes thusly:
None of this is actually new. These risks have long been known. However, the clarity of the Regulations means it is now nearly impossible to claim that Chinese law on these issues is ambiguous or unclear. Where Chinese law says that ownership by foreigners is restricted or prohibited, the law means what it says. Foreigners who invest in violation of the law are making a bet that the violation will be ignored. This is extremely unlikely in today’s China. Such bets are sucker’s bets and should avoided at all costs.
So, at first glance, two very different views, and I bet they would get into a serious argument if the opportunity arose. But I actually think that their fundamental conclusions are both right but are merely coming at the issue from two very different perspectives. Bill is a Internet and finance guy, and is looking at the market, firms’ access to capital, and what the government is likely to do.
Steve, on the other hand, is a corporate lawyer. He is looking at potential risk, at what might go wrong, and what is/is not a technical violation of the law.
When Bill says that we shouldn’t worry about the government going after Chinese listed firms in the U.S. that use the VIE structure, I think he’s right. All the inside chatter on that issue seems to indicate that the government will grandfather in those companies even if it adopts a new enforcement strategy.
And when Steve says that VIEs are rubbish, he’s of course right. These things are illegal in that their purpose is to deliberately skirt foreign investment restrictions. I don’t actually agree with him on what the M&A rules mean (I think it’s too early to tell), but I definitely agree with his overall legal opinion.
All this being said, if I have one bone to pick with recent commentary on this subject it’s that it emphasizes the latest regulatory goings-on without paying attention to the real risk story with respect to VIEs. The most likely source of problems with these companies has nothing to do with the government, but rather with unenforceable contracts and unstable shareholding structures. Perhaps this is one of those things to which Bill was referring when he said that there are other reasons to be cautious about investing in China. (I should also point out that Steve regularly writes about these sorts of legal issues as well.)
I don’t think investors are going to avoid these VIE structures like the plague. However, if they do wish to take a very cautious approach, they should do it for corporate governance reasons, not just because of what Beijing might do.
Update: Dan Harris at China Law Blog has posted a follow-up to Steve’s post. His main point is that the M&A rules will have an impact on court enforcement of VIE contracts. This is useful point of clarification from the earlier post. It also (sort of) supports my general contention that the big risk here is about contracts and corporate governance and not the government swooping in to unroll VIEs. On the other hand, these suckers are generally not enforced anyway, so there’s still a big question as to whether this would have a significant practical impact in the real world, especially when one considers the risk appetite of some of these investors.