6 Things Investors Should Know About Variable Interest Entities

By: Wayne Duggan

China’s economy is one of the best sources of growth in the world for investors willing to shoulder the risks associated with investing in emerging markets. There are plenty of big-name Chinese companies with stocks that trade on the U.S. markets. However, some of the most popular U.S.-listed Chinese stocks use a controversial corporate structure known as a variable interest entity (VIE). Here are five things traders should know about VIEs.

1. VIE shareholders don’t own company assets.

When U.S. investors buy shares of a VIE stock, they own a contractual right to a percentage of the Chinese company’s profits. However, they do not have legal ownership of the Chinese company’s assets. The VIE is a completely separate legal entity than the Chinese company itself.

2. Chinese companies set up VIEs because they have to.

If the VIE structure seems sketchy, it’s not because Chinese companies are trying to pull a fast one on American investors. Chinese companies in certain sectors, particularly the internet business, are forbidden by law by the Chinese government from being owned by foreign investors. To get around the ban, these companies set up VIEs as legal loopholes to gain access to foreign capital.

3. There are some big-name VIEs.

VIEs have been around since SINA Corp (NASDAQ: SINA) used the structure back in 2000. Today, Chinese internet giants Baidu Inc (ADR) (NASDAQ: BIDU) and Alibaba Group Holding Ltd (NYSE: BABA) both utilize the VIE structure. The largest U.S. IPO of 2016, ZTO Express (Cayman) Inc (ADR) (NYSE: ZTO) is also a VIE.

4. The Chinese government could close the loophole at any time.

One of the biggest risks of investing in Chinese stocks is that the Chinese government can swoop in and change laws and regulations without notice or justification. Since the VIE structure was created to get around the original intention of the ban on foreign investors, the Chinese government could choose to close the loophole by banning or restricting VIEs at any time. That action would certainly leave U.S. VIE investors with a mess on their hands.

5. The Chinese government won’t pull the plug on VIEs.

Once traders understand the risk that the Chinese government could technically eliminate VIEs at any time, it’s important to understand that they will likely never do so. If the government banned VIEs or did anything to harm U.S. VIE investors, Chinese companies would lose the trust and the precious capital that only U.S. investors can provide. China wants to continue tapping the massive U.S. capital market for as long as possible and will likely do everything it can to keep U.S. investors happy.

6. VIE investors have few rights.

Because there is a degree of separation between VIE investors and the Chinese company itself, VIE shareholders have no voting rights and no avenue for legal recourse. Shareholders are entitled to sue the VIE or vote on matters concerning the VIE, but the VIE is nothing more than a shell company. If the Chinese CEO runs the company into the ground, VIE shareholders can’t boot him out. If the Chinese company cooks the books, VIE investors can’t sue.

Disclosure: the author is long BABA.

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