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China’s new rules for VIEs leave tech companies in uncharted territory

Written by Brady Ng Published on     3 mins read

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Beyond the record-setting fines, China’s tech firms are now a new kind of business entity.

Big tech in China is getting fined left and right. Some companies, particularly those that operate in fintech, are in the process of restructuring their businesses based on instructions from the government. An overlooked consequence of the crackdown on antitrust business moves in China is that variable interest entities, or VIEs, have finally been folded into the legal system.

This is no small matter, as new rules define what business deals may look like in China in the future, hampering the ultra-acquisitive strategies of the likes of Tencent and Alibaba. Also, because VIEs are set up so that Chinese companies can gain ticker symbols and codes outside of mainland China, the impact may be felt by every investor who owns stock offered for sale by Chinese tech firms.

First things first: What are variable interest entities?

VIEs give Chinese companies, particularly those that offer technology, media, and telecommunication (TMT) services, the ability to list shares outside of mainland China. Think of Alibaba’s presence on the NYSE, or Tencent on the Hong Kong Stock Exchange. At its core, a VIE is a financial duplicate of a company’s structure to satisfy the listing requirements of bourses. There is no transfer of assets, staff, or cash from China to overseas parties, but this arrangement gives investors in other parts of the world a share of profits. There’s a kicker—public market investors technically hold no actual stakes in these companies, and hence have no voting rights.

The biggest names in Chinese big tech all do it—Alibaba, Tencent, Baidu, Meituan, and more. As KrASIA reported in January, VIEs are utilized to bypass rules related to capital movement in China. For TMT companies to gain a pipeline to stock investors’ cash in New York or Hong Kong, it is practically a prerequisite to set up VIEs. This has been the status quo for years.

If VIEs are the norm, then what’s the catch?

For around 15 years, VIEs existed in legal limbo. Regulators in China did not accept filings that covered transactions involving VIEs—including mergers and acquisitions, even though the Ministry of Commerce set rules in 2006 that said all transactions of this sort involving Chinese business entities must be vetted and approved by the government. If antitrust authorities were to vet those deals, then they would have granted legitimacy to VIEs, according to Angela Zhang, associate professor of law and director of the Center for Chinese Law at the University of Hong Kong. The recent shift, Zhang said, stems from a “greenlight from Beijing.”

No rules covering VIEs were inscribed in black and white. Within absent definition, Chinese companies were able to gain billions of dollars from abroad, mainly the US, and this cash flushed straight into the economy of mainland China. In a sense, VIEs made financial matchmaking possible in New York and Hong Kong.

That changed in February 2021, when the State Council’s Anti-Monopoly Committee finally released new guidelines covering VIEs. Plus, TMT companies that utilized these structures were already operating in a precarious position—the Chinese government forbids foreign entities to be “internet content providers,” and VIEs were technically entities that existed abroad.

Once VIEs were viewed as legal entities, oversight kicked in, and every absent notification about a merger or acquisition fell under the purview of regulators.

Should overseas investors worry about the new status of VIEs in China?

The short answer is probably not. Companies that use VIEs are no longer exempt from antitrust regulations, but the fines meted out by regulators, however sizable, have been far from the maximum penalty.

With that said, consider how Naspers, Tencent’s biggest shareholder, sold USD 15.7 billion worth of shares in Hong Kong in April—the largest block trade the world has ever seen. Yet even after the partial exit, Naspers’ current stake in Tencent is still worth USD 221 billion.

Some may argue big tech is too big to fail in China, particularly since some provide essential services like designing part of the protocols behind the digital yuan or health QR codes. But new rules that cover VIEs are just one way that these companies are getting squeezed. No one is sure how this will shake out, not even the dozens of tech companies that must now navigate new waters.

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