China VIEs. In a nutshell, we don’t like them, don’t trust them, and don’t do them. Quite frankly, our malpractice insurance just isn’t high enough for the massive risks we see in these investment vehicles. We believe that when push comes to shove, China’s courts won’t enforce the contractual agreements necessary to support such a structure.
Seems we are not alone in this assessment and we now have company from a Chinese court. The New York Times just did a story on China VIEs and because both Steve Dickinson and I are quoted in it, I cannot resist retreading old ground here and again writing about VIEs. The story is entitled China Court Ruling Could Threaten Some Foreign-Invested Companies and it comes on the heels of a recent ruling by China’s Supreme People’s Court holding “contracts used by non-Chinese citizens to gain access to sectors of the Chinese economy that are protected from foreign investment were invalid.” It nicely explains why V.IEs exist at all:
Sectors the Chinese government considers sensitive, including finance, media, technology, the Internet and education, have long been largely off-limits to foreign investment. To get around that, some of the biggest companies in the country founded by Chinese people, including the Internet giants Baidu, Alibaba, Tencent and Sina, create variable interest entities, or V.I.E.’s, that give overseas investors de facto control over companies technically owned by their Chinese partners. V.I.E.’s account for differing proportions of these companies’ income and assets, ranging from several percent to as much as 100 percent.
VIEs have for the most part worked just fine and this likely will not change until there is a problem. And that itself is the problem. To make up a Yogi Berra quote, there is no problem with VIEs until there is a problem. Problems arise if the Chinese partners decide they don’t want to follow the contracts any longer because, for example, they already have the money and know-how they were seeking, as has happened several times. When this does happen, the foreign party most likely has no legal recourse. China Law Blog’s own Steve Dickinson is quoted on VIEs’ biggest problem:
“Chinese law has a very clear provision. A contract written to avoid the requirements of Chinese law is void and the court will not enforce it,” said Steve Dickinson, a partner at Harris Bricken and a co-author of the China Law Blog.
In other words, they almost certainly are not legal. Though some seek to distinguish this recent Supreme Court case because it involved a type of company structure that predated V.IEs, Steve isn’t buying that:
“This group of people will distinguish the recent Supreme People’s Court ruling because it was an earlier set of documents, not entirely the same as the V.I.E. structure,” Mr. Dickinson predicted. “But what the court said is that any contract that is designed to avoid the clear requirements of Chinese law is void from the very first step. That is what the V.I.E. is.”
I then chime in to explain why despite the risks to VIE formations just keep on coming:
“Accountants, lawyers and stock brokers make a ton of money off IPOs so they have no incentive to slow them down,” said Dan Harris, a China lawyer with Harris Bricken and a co-author of the China Law Blog. “They have every incentive to keep the V.I.E. structure going.”
Of course it is not just Steve and me who view VIEs with such trepidation. Andrew Gilhom, head of Asia analysis at Control Risks describes them as a way for foreigners “to make some money for a few years but ultimately it’s kind of open season.”
Does this mean all VIEs will disappear or be sued out of existence? Absolutely not, because as the article rightly notes, it is “unlikely the Chinese government wants to turn the V.I.E. structure into a huge issue”:
“They don’t want all the U.S.-listed stocks suddenly tumbling and companies failing and panic,” Mr. Gilholm said. “I don’t really see any signs that they are going to proactively go out and across the board say that all these structures have to be unwound.”
If you want to learn more about VIEs, I suggest you read China Law: Don’t Blame It On The Gray and Clear Speaking On China VIEs. I also recommend you read the Silicon Hutong post, VIEs, The Long Resolution, in which David Wolf talks of how the Chinese government likes to “boil its frogs slowly, not all at once,” and then talks of how VIEs are on the wrong side of where China wants to be going. I could not agree more. I do not see VIEs disappearing overnight; instead, I see foreign companies involved with VIEs suffering a very long and very gradual squeeze out.
What do you think?