CSRC policy recommendations on VIEs | China Accounting Blog | Paul Gillis

CSRC policy recommendations on VIEs

The CSRC paper that Reuters reported on a couple of weeks ago has been leaked onto the web. This paper has led to some strange things over the past week, from big drops in the stock prices of internet companies to overreaching claims that “VIEs are 100% legal”. Here are my observations and speculations.

The CSRC paper appears to be a well reasoned document that is likely motivated by its frustration with criticism over overseas listed Chinese companies that has landed on the CRSC despite its general lack of jurisdiction over these companies. Accordingly, the document appears to apply to all overseas listed Chinese companies rather than just those that use the VIE structure. Using national security as a talisman, it seems to me that a key objective is for the CSRC to gain regulatory oversight over these companies. 

There are four key recommendations. First the CSRC advocates tougher regulation of overseas listed companies, focusing on new listings rather than existing listings.  Existing regulations related to foreign investment, currency and taxes are probably adequate, but enforcement has been uneven and often circumvented by VIE structures. The paper proposes to deal with this by engaging with the SEC in helping to make sure that the rules are followed, and threatening lawyers and accountants with penalties if they permit clients to circumvent the rules.  Presently, U.S. listings depend on the accountants and lawyers looking the other way when they pass these regulatory problems. Simply enunciating this threat as the CSRC have done will likely chill the IPO market and force the companies to comply with the spirit of existing regulations. That is good news and will protect investors. 

Secondly, the paper suggests old rules for old companies, and new rules for new companies, suggesting some form of grandfathering for existing offshore structures. I think that means the CSRC is not pushing to have the structures declared illegal.  I do not think it means that VIEs are 100% legal or that there will not be further changes in the future. Nor will it protect those companies that have violated existing laws. But the paper does seem to imply that future restructuring is to be expected, suggesting that ways be found to bring some of the offshore internet companies home to list on the A-share market.   

Third, the paper calls for further development of China’s capital markets. This really gets to the root of the problem.  China’s private entrepreneurial companies were forced to list overseas because of their inability to raise capital at home. This has been changing with the opening of the SME board in Shenzhen in 2004 and the ChiNext board in 2009. Yet, by the end of 2009 only 16% of the market capitalization of Chinese exchanges related to privately controlled companies (rather than State controlled). By 2009, however, 67% of the capital raised on China’s stock exchanges was by privately controlled companies.  

Fourth, the paper calls for reforms that would allow Chinese companies to directly list overseas. That would require reform in China’s rules prohibiting foreign investment in certain sectors, but would have a significant positive effect for investors. These reforms would enable companies using offshore structures and VIE arrangements to simplify their operations by merging everything back into China. Investors would be much better protected by direct ownership in Chinese operations rather than the riskier VIE arrangements. 

It will probably take some time for these recommendations to come to fruition. There are likely to be some bumps in the road along the way. Some VIEs will continue to be riskier than others. All in all, I think it is a positive development for investors. 

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