It is time China plugged the loophole on its controversial VIE structures. For a decade, it has remained mum about “variable interest entities”, which let foreign investors control companies in banned sectors, such as the internet, by drawing up a contractual agreement with a company that behaves like, but isn’t, a direct equity stake. The practice is getting widespread. Uncertainty over the rules is not only bad for regulators, but also for investors, who are left in limbo if things go wrong.
VIEs, popularised by companies like Baidu and Sina, are no longer only for restricted industries such as media, education and the Internet. Investors use them in industries are open for foreigners, since they offer a way to avoid the lengthy and unpredictable approval process. Coal trader Qinfa and ship-builder Rongsheng, both used VIEs successfully to list in Hong Kong.
Investors bear a lot of risk. Companies are double-taxed, for one. But, the service agreements on which VIEs are based can also prove hard to enforce if the legal owner of the business, usually the founder or a related Chinese local, flaunts the agreements and walks off with the company. That happened at Nasdaq-traded GigaMedia, resulting in shareholder lawsuits. Companies like Baidu warn explicitly in their filings that they exist in a grey area.
Clarity would make the regulator look less asleep on the job, but it would also be good for the companies themselves. Dotcom giant Sina saw its shares heavily sold off on a Reuters report that China’s securities regulator wants tighter regulation on VIEs. The best solution would be to officially approve the VIE structure. That would send a positive message to foreign investors. It is also in line with its broader capital account liberalisation efforts.
If that’s too much to ask, a second-best would be stop more companies from setting up these structures. Establishing the rule of law is important for China, and allowing grey areas to thrive undermine that task. Even if it reduces foreign investors’ access, it should make them safer.
