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Crackdown on US listings: Will China close $1.6tn VIE loophole?

Variable interest entities used by Alibaba and Didi poised as next target

Didi Global and FANG+ Index components Alibaba Group Holding and Baidu all listed in New York using variable interest entities.   © Reuters

SHANGHAI/NEW YORK -- A method used by top Chinese companies to offer shares in the U.S. while skirting restrictions on foreign listings risks coming into regulators' crosshairs as Beijing ramps up oversight.

Variable interest entities are used by businesses in sectors where China limits foreign ownership, including telecommunications and education, to let foreign investors buy in through shell companies based in jurisdictions such as the Cayman Islands. This is also called the "Sina model," after the internet company that used it to list in New York in 2000.

U.S. listings of Chinese companies using VIEs -- which include such big names as Alibaba Group Holding, Pinduoduo and JD.com -- are worth a total of $1.62 trillion. Of the estimated $700 billion in Chinese shares held by American investors in 2017, Caymans-based shells accounted for $477 billion, according to a report last year by the U.S.'s National Bureau of Economic Research.

But the method is in a legal gray area. If Chinese authorities start to question it amid the crackdown that has already battered ride-hailing company Didi Global -- another VIE user -- the resulting loss of investor trust could send shock waves through global financial markets.

Rules set by China in 1994 require companies to get approval from the State Council to list on foreign stock markets. But these assume that the company issuing the shares is based in China, and do not consider the possibility of listing through an overseas shell company.

The China Securities Regulatory Commission is leading the charge to change this, according to U.S. media. As the government tightens restrictions on foreign listings, authorities could require businesses using VIEs to seek permission to list abroad, even via a foreign-registered holding company.

The U.S. Securities and Exchange Commission noted the uncertain legal status of VIEs in a report last November on disclosure considerations for Chinese companies. "China-based Issuer VIE structures pose risks to U.S. investors that are not present in other organizational structures," the report said.

"The Chinese government could determine that the agreements establishing the VIE structure do not comply with Chinese law and regulations," which "could subject a China-based Issuer to penalties, revocation of business and operating licenses, or forfeiture of ownership interests," the SEC warned.

The U.S.-China Economic and Security Review Commission, a bipartisan advisory body to Congress, has recommended legislation to block Chinese companies from issuing shares on American markets through VIEs.

Alibaba set up Alibaba Group Holding as a Caymans-based shell company to let foreign investors buy in.   © Kyodo

Typically, VIE listings involve a U.S.-listed shell company registered in the Caymans signing contracts through a China-based subsidiary with the Chinese enterprise actually running the operations. These in effect grant the Caymans company control over the business and a claim on its profits even without direct ownership. This allows overseas investors to become de facto shareholders in the Chinese company.

Alibaba, for example, set up Alibaba Group Holding as a Caymans-based shell company to go public in New York. The holding company established foreign-owned subsidiaries in China, which inked contractual control agreements with the enterprises handling Alibaba's e-retail and other operations, and with their shareholders, turning the companies into variable interest entities.

The contracts give the Caymans-based holding company control of the operating enterprises and allow their profits to flow to it as well.

In a 2016 case, the Supreme People's Court of China rejected an argument that an education company's VIE contract was not valid under China's restrictions on foreign ownership, a ruling that in effect tacitly validated the arrangement.

"This was the first decision by the Supreme People's Court touching on the legality of VIEs," said Gao Xiang, a partner at Chinese law firm Jingtian & Gongcheng and an expert on overseas listings.

But, he added, "China is not a country that uses judicial precedent, so it's still possible that another court could rule differently."

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