We have never liked VIEs (Variable Interest Entities), as we have many times made clear over the years:
- VIEs In China. The End Of A Flawed Strategy (2011)
- China VIEs. Avoid, Avoid, Avoid. (2013)
- China VIEs Are Dead. Done. Over. Stick A Fork In Them. (2015)
What we most dislike is when relatively small foreign companies structure their China transaction as a VIE. We see these deals as likely to fail and as likely to harm the foreign company when they do. But we must be clear on why VIEs are so likely to fail, because it is clear that most foreigners who participate in VIEs failed to understand the nature of the risks inherent in VIEs.
I have for years publicly asserted that the VIE structure is illegal under Chinese law. But at the same time, I have always said there is virtually no risk of the Chinese government shutting down a VIE. This has so far been proven true as the Chinese government has not taken any action to shut down or even restrict the operations of any VIE. So the risk of a government shut down of VIEs is extremely low. On the other hand, the Chinese government has multiple times clearly stated that it views the VIE structure as illegal.
This means the real risk VIE investors face is from their China-side “partners” who are pretty much free to exploit the VIE with impunity. How can a foreign investor in a VIE pursue legal action against their China-side “partners” for abusing a relationship in which the foreign investment was illegal from day one? The short answer is that it probably can’t.
But in the last few years the China lawyers at my firm have been getting an increasing number of phone calls from foreign investors who believe that the solution to their VIE problems is to pursue legal action against their China-side VIE “partners.”
VIE ventures fail not because of the normal risks of business. Taking business risk is what investors do. These investments failed because the structure was illegal and unenforceable from inception. Their failure was built into their structure. The U.S. funds that promoted these VIE ventures either knew or should have known this all along, but they sold the investments anyway, with “sign-off” from accountants and lawyers.
Foreign investors who call us wanting to sue the Chinese companies involved in their VIEs are often surprised when we tell them that we have no interest in taking on that case, either on an hourly or a contingency fee basis. They do not seem to realize that money lost in a VIE venture will almost certainly never be paid back by the Chinese companies involved in the VIE simply because the VIE structure is designed so that will not be legally necessary.
Have you checked your China VIE lately?