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Scarlet Letters? Understanding China’s Regulatory View of ADRs and VIEs

Jason Hsu, PhD

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When it rains, it pours.


First the U.S. government passed a law (the Holding Foreign Companies Accountable Act), which threatened to delist many Chinese ADRs. Then the Chinese government fined Alibaba, the largest Chinese ADR by market cap, $2.8B for anti-competitive business practices. Next, the government singled out an additional 34 major consumer tech firms – including many U.S. ADRs – for stern warnings and potential, yet unspecified, future fines. And finally, DiDi’s price plummeted 40% last week just days after its NYSE listing. This drop, which also shook other ADRs, was triggered by news of a formal investigation by the Chinese Cyber Security Administration.


In other words, this is not a good time to be a Chinese ADR.


Some of the recent market activity is being driven by Chinese regulatory action. But much of it is also being driven by fears that the “variable interest entity” – or VIE – is in Beijing’s crosshairs. The VIE is the legal structure that permits Chinese firms incorporated offshore to circumvent Chinese foreign ownership rules, forex restrictions, and tax codes. Without the VIE structure, Chinese ADRs would not be possible. And because Chinese ADRs rely on the VIE structure, these securities could lose all their value if Chinese regulators determine the structure is illegal.


There are many lenses through which one might view these current events. Some western journalists – particularly those with limited China experience and a desire to generate clicks– prefer narratives that paint China as anti-market, anti-capitalism, anti-success, anti-business, anti-investor, etc. These narratives do not give appropriate weight to the legitimate interests the Chinese government has in regulating its markets – interests that are, frankly, no different than those in the United States and elsewhere. While tactics and approaches might vary, the Chinese government’s actions in this instance serve an understandable purpose.


To help investors understand that regulatory purpose, let me focus on VIEs. This structure is at the heart of the current volatility in Chinese ADRs, and investors will benefit from understanding this exotic structure and the risks it entails. More importantly, it may help investors better understand the Chinese regulatory approach and how to more effectively incorporate it into their investment decisions regarding onshore and offshore Chinese securities.


First, investors must understand that VIEs exist for the sole purpose of circumventing rules that would generally apply to Chinese companies. China is an economy that imposes foreign ownership restrictions and currency controls on its businesses. To avoid these limitations, Chinese companies developed the “variable interest entity” structure, through which offshore entities can own up to 100% of an onshore Chinese entity’s profits through a set of licensing and service contracts. Alibaba China provides an excellent example of a VIE, and I’ve described how that scheme operates in a footnote at the end of this article.1


But the important point for investors to understand is that the VIE structure is specifically intended to bypass China’s rules around foreign ownership restrictions, forex controls, and taxation. So, it should be no surprise to investors that regulators are scrutinizing this structure. Schemes such as VIEs – which are designed to generate returns by skirting the edge of the law — appear all over the world from time-to-time. And in all cases, they are exposed to regulatory “black swan events.”


Of course, investors don’t need to panic yet. Chinese regulators have been aware of the VIE loophole for years and have not taken action. And it is not in China’s interest to destroy offshore Chinese companies by challenging the existing VIEs aggressively. ADR investors can take some comfort in this knowledge.


However, Beijing knows it holds the trump card. And as direct foreign investment in China A-shares becomes easier through QFII and HK connect, there is less-and-less reason for the Chinese government to permit structures that bypass their established rules. U.S. investors are beginning to realize this, and I predict VIEs seeking to list in the U.S. may now find the NYSE door slammed shut. I think we’ll also see investors who want China exposure increasingly turn to onshore opportunities like A-shares.


I have now spent more than a decade managing investments in China, and as boring as it sounds, I have generally found Chinese financial regulators to be remarkably similar to their western counterparts in terms of intent, experience, and education. Chinese regulators are generally not anti-market, anti-capitalism, anti-success, or anti-business. At most, one might cast Chinese regulators as being opposed to rich business interests that circumvent laws, dodge taxes, pose national security risks, and engage in monopolistic practices—and in that regard, they are exactly like their American and European counterparts.



1 For example, assume Alibaba China, owned by Chinese national Jack Ma, has revenue of $100M and a cost of $50M before paying its licensing fee. Alibaba China would then pay $50M in licensing fees to Alibaba Cayman, which is owned by a consortium of U.S. PE funds and Jack Ma. Through this structure, Alibaba China’s profit is rerouted to Alibaba Cayman and the hands of foreign PE funds. Eventually, Alibaba Cayman can IPO in the U.S. raising tens of billions in USD and providing billions in exit money for said PE funds and Jack Ma. Notice how this scheme by-passes China’s foreign ownership restriction as well as forex control—and tax codes—but still results in Jack Ma receiving billions in USD for selling shares in a stream of RMB revenue. Many westerners would decry this kind of scheme – which makes wealthy people richer while flouting local laws and regulations –were it replicated in their own countries. At a minimum, regulators would take a keen interest.


This article was first published to LinkedIn:

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