VIEs: The Long Resolution

In the Hutong
Prepping the Pack Meeting
0917 hrs.

In the course of some debates about China, all you learn is how strong peoples opinions are. Yet in a few cases, the debate itself is a socratic-style graduate seminar not only on the topic but on China. The back-and-forth online around the status and eventual fate of Chinese companies who have listed abroad via a structure called a Variable Interest Entity (VIE) has been just such a debate. The most prominent participants have been:

• Digicha, the blog by Bill Bishop, Beijing-based investor, former China online game company executive,  co-founder of CBS MarketWatch, and MVP of the China Twitterverse.
• China Hearsay, by Beijing-based Stan Abrams, a technology and intellectual property attorney and law professor; and
• China Law Blog, Dan Harris’ award-winning forum that chronicles the intersection of Chinese law and global business, among other things.
• In particular, take a look at this post on China Law Blog, “China VIEs: The End of a Flawed Strategy – an Update/Rebuttal,” along with all of the comments, which alone are a seminar on a very hot topic.

Rule of Policy

I had started to see this issue as a matter wherein the rule of law clashes with the political expediency of accommodating elites. But the aforementioned post on China Law Blog convinced me that this is not the case. As with most Chinese legal codes, the statutes are vague, there is huge room for political and administrative interpretation, and there are overlaps and conflicts among the laws that leave in question which agency has the authority to make or enforce a ruling against any or all of the companies involved.

The matter will be decided not on the basis of law, therefore, but on the basis of policy, and probably at the State Council level. Bishop, correctly, notes that no bureaucrat has the political cojones to take on the wall of entrenched interests that protect the VIE-based companies, and suggests that the easiest way to handle the situation would be to issue clarifying regulations about the legality of VIEs and to grandfather all current VIEs.

I agree, and I suspect that is what will happen, but I also suspect that this will not be the end of the matter. Even though no policy maker would be willing to risk his or her career by slamming the door on VIEs, if such structures are considered politically undesirable by China’s leaders, then we still have a problem.

Bringing the Capital Home

As someone quite wise once said to me, “the Chinese government likes to boil its frogs slowly, not all at once.” What this sage meant was that when dealing with any issue that affects a wide range of powerful interests, Chinese policy makers tend to eschew immediate and radical solutions in favor of a gradualist approach. In a system that depends increasingly on tenuous consensus, this is perhaps the only possible approach. Each step taken moves the matter closer toward resolution without causing severe disruptions for any of the interests involved. All that is necessary to understand whether a solution can be considered temporary or permanent is to look for the larger national goal that is driving the change in the first place.

An idea of what might be driving the government’s efforts around VIEs can be found in an article in New Century magazine last week that sums up the current state of play with the VIE issue. The article quotes a situation report provided to attorneys and the industry three weeks ago as saying that in the early days of the development of the internet in China, the local A-share market was inadequate to the capital needs of the industry, thus it was decided that overseas listings of these companies offered more good than harm. The report goes on, however, to suggest that it would be in China’s interest to arrange the earliest possible return of the shares of such “leading enterprises” to China’s own local exchanges in Shanghai and Shenzhen.

If repatriation of share ownership is (or becomes) the goal of the government, that is a more reasonable target than abruptly pulling the plug on VIEs, but it does point to a long-term dissolution of those arrangements by substituting offshore capital with capital from China’s own markets, either via domestic listing, private placements with domestic enterprises or sovereign funds, or all of the above. To give a simple example, were Jack Ma to recover the 40% of Alibaba that Yahoo! currently owns, he could replace the cash thus expended by a domestic share issue in China. Using similar mechanisms, the VIEs could be dissolved in a manner that would harm none of the powerful interests involved, yet would satisfy the government’s policy goals.

None of this would take place quickly, nor should it, and I do not think that regulators have come to an agreement yet on how to proceed, and things may roll out quite differently. The point is that a short-term accommodation with the VIE structure in the name of political expediency neither institutionalizes the structure as a long-term funding option, nor signals a change in the fundamental drivers of policy. It should, rather, be seen as the high-water mark in China’s effort to tap offshore capital to fund the growth of the nation’s leading online enterprises, and perhaps the beginning of the next phase in the maturation of China’s own domestic capital markets.

But it is Bigger than All of This 

If you think this is an issue of parochial interest to lawyers and China geeks only, think again. The reason the VIE issue is important goes beyond the effect the recent uncertainty has had on nearly 100 Chinese companies that have listed abroad (and their shareholders.) It is more important to anyone doing business in or with China because of the implications that the issue and its eventual resolution will have on foreign investors and business in the PRC in the coming decade.

A recurring theme of this blog of late has been the apparent shift in attitudes in China toward foreign enterprises and capital. Since the beginning of reforming and opening, foreign participation and foreign investment in the Chinese economy has always been seen as an expedient means to hasten development. What has changed is not the attitude, but China’s perception of itself and the extent to which it still needs the necessary evils of foreign capital and expertise. China still needs both more than either the Party or the people are willing to admit publicly: alongside other considerations, what will slow movement toward a resolution of the VIE issue is disagreement within China’s leadership over how much the door to such structures needs to remain open, and how much local capital is actually available to local high-growth businesses.

But the long-term goal should not be in doubt, and it is that desire for financial self-sufficiency, followed by global financial leadership, that guides the evolution of policy (and law) toward VIEs and all offshore listings.

Update: In what may be the first step in that share repatriation, Shanda Interactive’s founder Chen Tianqiao, his wife Luo Qianqian, and his brother Chen Danian have formed a group to buy the publicly-owned shares of Shanda (NASDAQ: SNDA) that they do not already own. J.P. Morgan is issuing the debt to finance the transaction.

Related articles

• The Alipay Warning (siliconhutong.com)
• It’s Media, Chief, but Not as We Know It (siliconhutong.com)
• Are Chinese VIEs More Illegal Today Than They Were Yesterday? (digicha.com)
• A New Front Opens in the War on VIEs – Part I (chinaheresay.com)
• China VIEs. The End Of A Flawed Strategy. An Update/Rebuttal. (chinalawblog.com)
• VIEs In China. The End Of A Flawed Strategy. (chinalawblog.com)
• Silicon Alley Insider: Is China Really About To Clamp Down On The Corporate Structure Used For Big American IPOs? (businessinsider.com)
• China VIE Structures, The Podcast. Money….So Money. (chinalawblog.com)