I did my first post on VIEs on March 9, 2011. While I had been aware of the structures since their inception, I focused in my doctoral thesis on how they were used to develop China’s capital markets, and this blog was a conceived of as a way to put some of my ideas out for criticism. I got plenty of that early on. Some said I was overstating the issue and that I just did not understand China. Over the past six months, however, the risks I pointed out in those early posts have all materialized. I said in that first post that I would do two more on VIEs; I have now done 19. The post explaining VIE structures is still the most popular on this site, with over 17,500 page views since it was posted. It still gets 600 visits a week. Several months ago my former student Fredrik Oqvist started his own excellent blog to discuss VIE issues, partly because I wanted to make this more than just a VIE blog. I have not been able to stay away, because VIEs have become central to the issues that most interest me – the role of accounting and transnational regulation in the development of China.
In my fifth post on VIEs on April 7, 2011, I set forth recommendations to Chinese regulators on how to clean up the VIE sector. I have reviewed those early recommendations and was surprised to find that they remain applicable after all the developments of the past six months. They are consistent with the direction that the CSRC seems to be heading. I have learned a lot in the past six months, so here is an update on those recommendations:
1. Make it easier for Chinese companies to directly list overseas without using an offshore entity. Many companies have chosen the VIE approach as a way of getting around cumbersome Chinese regulations.
Most of the problems with overseas listed Chinese companies are rooted in the offshore and VIE structures. The structures were designed to take the companies outside of the scope of Chinese regulation. They have succeeded in putting the companies into a regulatory hole where neither Chinese or foreign regulators could effectively regulate them. That has created an environment that was perfect for those cooking up frauds.
China needs to change its rules to allow Chinese companies to directly list the shares of Chinese parent companies overseas. The CSRC suggests this.
2. Recognize the reality that there already is significant foreign investment in prohibited sectors, and find a way to regulate this investment instead of pretending to prohibit it. Prohibition has not worked, and China needs entrepreneurial companies like Baidu, Dangdang, CTrip and Ambow Education.
VIEs are used to get around Chinese rules prohibiting foreign investment in certain sectors, and to avoid restrictions on Chinese companies listing directly overseas.
There is increased attention in China to the national security risks associated with foreign ownership of the Internet sector. If you think this concern is overblown, wait for the uproar in the U.S. if Jack Ma tries to buy Yahoo, in the process giving a Chinese citizen (perhaps party member?) access to Yahoo's billions of pieces of data on U.S. citizens. The Chinese are thinking the same way.
A possible solution is to have the internet companies issue two classes of stock – A-shares with voting power that can be held only by Chinese nationals and B-shares, with all the same rights except for the right to vote on management issues. The B-shares would trade as ADRs in the U.S. The A shares could be listed in China. Yes, we have been here before - early on many state-owned enterprises adopt a similar structure.
3. Bring the offshore structures back onshore. Encourage U.S. listed Chinese companies with offshore parents to merge the offshore company into the Chinese operating company. This will give China better regulatory control over these companies and it will give the shareholders real ownership of the operations. That is a good tradeoff for investors. China needs to develop rules to make this possible.
If you do the two reforms above – allow Chinese companies to list directly overseas and allow some form of direct foreign investment into prohibited sectors – the need for VIE structures and offshore parent companies disappears. Good riddance!
4. Develop a regulatory structure that works for these companies, and which coordinates effectively with the SEC and PCAOB.
It is becoming increasingly clear that the regulatory holes that U.S. listed Chinese companies have crawled into are making it impossible for either U.S. or Chinese regulators to deal effectively with frauds and other problems. Bringing the companies into China at least gives one regulator complete control over them. That might help China find a way to work a deal with U.S. regulators - maybe.
5. Create opportunities for U.S. listed Chinese companies to obtain a listing on Chinese stock exchanges. Let the markets decide the best place for a Chinese company to obtain capital, not regulatory barriers or even worse, the opportunity to avoid regulatory oversight. Think Baidu is hot on NASDAQ? Wait till you see what it does on ChiNext.
Private companies were forced to look for capital offshore because China’s equity markets have historically focused on facilitating the restructuring of state-owned enterprises. The private use of the markets has increased rapidly with the opening of ChiNext in 2009, and I think that the days of U.S. listings by Chinese entrepreneurial companies are numbered. Today, however, the market is too small and the listing process too opaque for Chinese companies to fix the current issues by moving their listings to China.
6. Use a carrot and a stick. Make it easy for firms to regularize their operations, and then strictly enforce existing Chinese laws on any companies that do not restructure.
I expect this is exactly what Chinese regulators will do. The CRSC gave some hints about this when suggesting old rules for old companies and new rules for new companies, followed by punishment of accountants and lawyers who find ways around the regulations. This is going to take some time. While the changes required are not significant, they have ideological implications – both overseas listings that may transfer value out of China and foreign investment in prohibited sectors are sensitive political issues for Chinese bureaucrats.