HONG KONG -- Chinese companies listing their shares on offshore exchanges are increasingly relying on a precarious legal structure that lawyers previously believed had been rendered obsolete.
The prospectus filed last week by Tencent Music Entertainment, China's largest music streaming service operator, for a billion-plus initial public offering in New York shows how what are known as "variable interest entities" are more alive than ever.
According to data compiled by Fredrik Oqvist, founder of financial research company blueflag.io in Beijing, the share of Nasdaq-listed Chinese companies using a VIE structure has risen to 92% from 53% seven years ago. Over the same period, the VIE share of Chinese listings on the New York Stock Exchange rose to 64% from 29%.
The overall number of Chinese companies listed in New York declined over the period, but the VIE structure is also used for listings in Hong Kong and other offshore markets.
A VIE allows a foreign-invested company to operate in industries where China restricts foreign participation via affiliates that are fully Chinese owned but obligated to provide services through contractual arrangements. Such restrictions are common in tech-related sectors in China, especially internet services. Technology companies however also dominate the ranks of those flocking to list in recent months in New York.
"For many restricted sectors in China, the VIE structure is the only way for a foreign company to operate their business," said Philip Li, a partner at the global law firm Freshfields Bruckhaus Deringer in Hong Kong.
Aside from Tencent Music, a unit of Hong Kong-listed Tencent Holdings, other recent large Chinese offshore IPOs that relied on VIEs include social shopping service Pinduoduo, phone maker Xiaomi, electric car producer Nio, local services company Meituan Dianping and video streaming service iQiyi. Alibaba Group Holding and Tencent itself, China's two most valuable companies, both are based on VIEs as are fellow tech majors Baidu and JD.com.
The VIE appeared to be on its last legs in 2015 due to provisions included in a draft foreign investment law unveiled that year. The law however has yet to be finalized.
The danger for investors from the VIEs is that since the listing companies do not actually own their Chinese operating businesses, their control could easily be disrupted by changes in Chinese policy and enforcement.
"The use of the VIE has potential risk for investors because it could threaten the investor's ownership fundamentally," said Nana Li Rui, a senior research analyst at the Asian Corporate Governance Association in Hong Kong. Noting that the structures are used specifically in restricted sectors, she added, "The VIE structure is opposite to what the Chinese government intends and Chinese regulators have full grounds to go after these companies if they wish to."
Referring to the government by the acronym for People Republic of China, Tencent Music's prospectus noted, "If the PRC government finds that the agreements that establish the structure for operating some of our operations in China do not comply with PRC regulations relating to the relevant industries, or if these regulations or the interpretation of existing regulations change in the future, we could be subject to severe penalties or be forced to relinquish our interests in those operations."
For Pinduoduo, Tencent Music and many other Chinese companies using VIEs, the VIE operations generate all or nearly all of the nameplate company's revenue.
Yet as Tencent Music's prospectus said, "If our VIEs or their respective shareholders fail to perform their respective obligations under the contractual arrangements, we could be limited in our ability to enforce the contractual arrangements that give us effective control over our business operations."
While the Chinese authorities have yet to put a spotlight on specific VIEs, in an atmosphere of tightening controls on internet content, it is not hard to imagine they might.
The highest-profile confrontation to date over VIEs gives little comfort. In 2011, Alibaba abruptly transferred Alipay, its flourishing online payment business, to a private company Chairman Jack Ma had ownership control over. While Alibaba said this would protect the business' legal status amid regulatory changes to limit foreign involvement in payments, the sudden move led to a heated public dispute with Alibaba shareholders SoftBank and Yahoo.
While there has yet to be another such high-profile stand off, investors have taken too little notice of the potential risk, many market observers say.
"I would say 99% of individual investors are unaware of the risks," said Maggie Lin, a corporate governance consultant with the World Bank's International Finance Corp. in Beijing. "They don't understand VIEs at all. In fact, even institutional investors could find the structure tricky, especially when they are new to the Chinese market."
As with the Tencent Music prospectus, VIE risks are regularly disclosed in the IPO process -- for those paying enough attention.
Referring to Tencent Music's discussion of its use of VIEs, Paul Gillis, an accounting professor at Peking University in Beijing, said: "It is extensively disclosed, but the filling is 300 pages long. Many investors do not read it."
Meanwhile, it remains unclear when Beijing will move forward with the draft foreign investment law, as Tencent Music's prospectus notes.
Said Gillis, "If investors cannot stand ambiguity, they should stay out of China."