Variable interest entities (VIEs) are used to include companies in consolidated financial statements in situations where the company is controlled through contracts instead of the more conventional control provided by ownership. Control by contract is often inferior to control through ownership, and investors have suffered badly when VIE arrangements go wrong.
Most of the attention to VIEs and their risks has been focused on U.S. listed Chinese companies. These companies make extensive use of VIEs (about half of the U.S. listed Chinese companies use them) primarily as a means of circumventing Chinese regulations that restrict foreign investment in certain sectors. VIEs have also been increasingly used to circumvent other cumbersome regulations and a few have been used for no discernable reason. Hong Kong regulators recently announced that they would not approve the use of VIEs for companies listed in Hong Kong unless the VIE operated in a restricted sector – a rule apparently designed to stop wider use of VIEs.
I have been hearing that the use of VIEs is not limited to U.S. listed Chinese companies. Rather, many multinational corporations (MNCs) are using the VIE structure to hold their China operations. Sometimes the VIE is used because the MNC wishes to operate in a restricted sector in China. In other cases, the VIE may be used to avoid other potentially cumbersome or problematic regulations, including those that require government approval for foreign investment.
It has been difficult to discern which MNCs use the VIE structure. Despite new accounting rules that require enhanced disclosure of VIE arrangements, few MNCs would need to make those disclosures because the operations of the VIE may be immaterial to the financial statements. Materiality is an equivocal standard. While VIE operations may not be significant in financial terms, investors might consider the future prospects of China operations very significant to the MNC.
Amazon is the first MNC I have seen to make disclosures regarding its Chinese VIEs. Here is what Amazon says in its risk factors:
The People’s Republic of China (“PRC”) regulates Amazon’s and its affiliates’ businesses and operations in the PRC through regulations and license requirements restricting (i) foreign investment in the Internet, IT infrastructure, retail, delivery, and other sectors, (ii) Internet content and (iii) the sale of media and other products. For example, in order to meet local ownership and regulatory licensing requirements, www.amazon.cn is operated by PRC companies that are indirectly owned, either wholly or partially, by PRC nationals. Although we believe these structures comply with existing PRC laws, they involve unique risks. There are substantial uncertainties regarding the interpretation of PRC laws and regulations, and it is possible that the PRC government will ultimately take a view contrary to ours. If our Chinese business interests were found to be in violation of any existing or future PRC laws or regulations or if interpretations of those laws and regulations were to change, the business could be subject to fines and other financial penalties, have licenses revoked or be forced to shut down entirely. In addition, the Chinese businesses and operations may be unable to continue to operate if we or our affiliates are unable to enforce contractual relationships with respect to management and control of such businesses.
Those disclosures are consistent with the disclosures made by U.S. listed Chinese companies that use the VIE structure. Amazon’s financial statements make mention of VIEs, but do not include the required disclosures of financial information about the VIE that would allow readers to understand the significance of VIE operations. These disclosures were presumably omitted because they were considered immaterial.
Investors and the SEC should be pressing MNCs that are doing business in China about their use of VIEs. Where companies use VIEs, the decision about disclosure should be based on what investors think is material. I expect most investors want more information in this area.
MNCs that use VIEs are subject to the same risks that are present with U.S. listed Chinese companies. The VIE could face regulatory challenges. The VIE could be stolen by its owner. Getting profits out of the VIE may result in high tax costs, and failure to get them out may undermine the entire basis for consolidating it in the first place.