This blog was among the first to explore the Chinese phenomenon of the variable interest entity. Explaining VIE Structures is the most viewed page on this site, with over 9,000 hits. It has been cited in numerous other publications that seek to explain the risks of the VIE structure. As regular readers may have observed, I have moved away from covering every development regarding VIEs because there are other China accounting issues that fit better with the purpose of this blog. My former student Fredrik Öqvist is blogging on VIEs, and I recommend his blog for the latest developments.
That said, Rocky Lee of Cadwalder, Wickersham and Taft has published an excellent ten page summary of VIEs on the firm's website. His conclusion, that the VIE structure remains valid when structured and used properly, is perhaps a bit self-serving. He does, however, acknowledge the considerable uncertainty present.
Indirectly citing this site, Lee points out that 42% of U.S. listed Chinese companies use the VIE structure. Interestingly, he also asserts that thousands of unlisted companies continue to operate through the use of the VIE structure. Private deals structured through VIE agreements probably rely more heavily on trust than the enforceability of legal agreements, but this does point out that VIE risks may be more pervasive than just the China concept stocks.
I have been asked to look for VIE structures in a number of Hong Kong listed companies, and it is not an easy task. Anyone who has worked with the public information of both U.S. and Hong Kong listed companies knows that disclosures in Hong Kong are less complete than U.S. disclosures. Because the VIE is a U.S. accounting term, you will not find it in the disclosures of Hong Kong listed companies, which file under IFRS (or HKFRS which is essentially IFRS). You can reach the same accounting answer under IFRS as under U.S. GAAP – that a company can be consolidated even where no stock is owned if group has the upside and downside of its activities.
Finding the VIE in Hong Kong can be challenging. Some companies, like Tencent, lay it out pretty clearly in the notes to the financial statements. Some others with suspected VIE arrangements do not specify the details of the VIE arrangements, Instead, they provide this sort of cryptic statement as the basis for consolidation:
The consolidated financial statements incorporate the financial statements of the Company and entities controlled by the Company (its subsidiaries). Control is achieved where the Company has the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities.
This sort of accounting policy allows broad discretion in consolidating VIE type interests. It appears many companies that control VIEs simply list them as wholly owned subsidiaries under this policy and do not disclose the fact that they own none of the underlying stock. While this may be permissible under IFRS, it does a significant disservice to investors, who deserve to know the details of who actually owns significant parts of the business. The Hong Kong Stock Exchange should tighten disclosures in this area.