If it seems we have been obsessed of late regarding Variable Interest Entities (VIEs), it is because we are. We are obsessed with them because we have spent massive amounts of time over the last few months working with investment companies (and others) investigating publicly traded Chinese companies that use VIE structures.
This work has led us to read pretty much whatever we can on VIEs and it led me to read a very clearly written article by Ballard Spahr lawyers Norman Goldberger and Laura Krabill.
One additional risk factor in investing in Chinese companies is that the use of a reverse merger is often accompanied by the creation of a variable interest entity (“VIE”). VIEs allow the public company to gain control of a private Chinese company and its assets through a series of contractual arrangements, rather than through a strict parent-subsidiary relationship or direct ownership of the operating Chinese company or its assets. The VIE structure is used to avoid Chinese regulations prohibiting foreign ownership of Chinese companies and assets. The VIE arrangement, however, creates further risk and complication for U.S. investors of public companies whose assets and operations are in China.
In particular, the contractual arrangements providing for control by the public company are only as strong as the enforcement mechanisms that can be effectively used — generally Chinese law and Chinese courts. There may be incentives for the Chinese company
or its insiders or their friends and family (who are likely the other parties to the VIE contracts) to simply renege on the contracts, and it might be impossible for the contracts to be enforced in China. Or, despite their best efforts to perform under the contracts, the VIE contracts could be nullified as a result of intervention by the Chinese government. Whatever the reason, the fact that VIE contractual arrangements may ultimately be unenforceable
creates a substantial risk that investors in a public company whose only assets arise from VIE arrangements will be left with nothing.
For more on the risks of VIEs, check out the following:
- Variable Interest Entities (VIE) In China. What Would The Buddha (Steel) Say?
- Gigamedia And The Perils Of VIEs. Dude, Where’s My Chop?
To Vie or not to Vie, that is the question. What do you think?
