VIE in the Evolving Capital Market Landscape: A Risk Analysis

The Variable Interest Entity (VIE) model has long been a key strategy employed by Chinese companies seeking to access international capital markets, mainly the U.S. Trillions of USD worth of Chinese companies publicly traded abroad were listed through this strategy, which circumvents China’s stringent restrictions on foreign investment in sectors such as technology and education. Since Sina’s first adoption of VIE in the U.S. stock market in 2000, the model has enabled the IPOs of various companies such as, and Alibaba Group—the largest IPO in U.S. history and the second largest globally. Despite many tech stocks having generated substantial profits for foreign investors in the past decade, critics often express concerns regarding VIE’s inherent validity and legal risks, particularly amidst evolving regulations. This article elaborates on some of the risks associated with VIE.

VIE is a structure via which a Chinese company creates an offshore entity to be listed abroad. Under this system, the U.S.-listed company from which investors buy stocks is often a holding company incorporated neither in the U.S. nor China but in the Cayman Islands or the British Virgin Islands. According to the SEC, such an offshore entity is incorporated to “enter into contractual arrangements with the China-based operating entity,” rendering the latter a wholly foreign-owned enterprise. Although the listed company frequently does not own stock or any equity in the actual operating entity, it purports to “exercise power over” and “obtain economic rights from” it based on contractual arrangements, which often include powers of attorney, equity pledge agreements, and exclusive services or business cooperation agreements.

Although the Chinese government has never formally approved or outlawed VIE, the China Securities Regulatory Commission (CSRC) published the “New Rules” on February 17, 2023, which became effective on March 31. Before the “New Rules” came into effect, amidst rumors of an outright ban, seven Chinese firms rushed to launch U.S. IPOs in March, compared with four in the previous two months. According to Dentons, however, the CSRC “eased” the concern of a ban by suggesting that China “w[ould] not shut down this financing loophole,” which the CSRC considers “a viable channel for its companies to access foreign capital,” despite potentially harsher scrutiny as well as more detailed filing requirements. Recently, the CSRC approved CheChe Technology Inc.’s U.S. listing, bringing it closer to becoming “the first Chinese company using VIE to issue shares in the U.S.” under the “New Rules.”

Yet, risks associated with VIE, notably regulatory risks and agency problems, have long existed and may persist. Under VIE, a listed entity has economic rights and power to direct the activities of the operating company without actual equity ownership. The SEC does not “assess the merits or appropriateness” of the listed entity’s VIE structure but “oversees a disclosure-based system” that provides relevant information. Hence, the SEC has warned that “if the parties to [the VIE] contracts. . . do not meet their obligations as intended or there are effects on the enforceability . . . from changes in Chinese law, the U.S.-listed company may lose control over the China-based company, and investments in its securities may suffer significant economic losses.” In cases with a void or breach of contract, there may be “little or no recourse available” to effectively remedy the losses borne by U.S. investors. This is because the listed entities are often incorporated offshore with different governance regarding disclosure and reporting from the U.S. requirements. Additionally, Chinese law and jurisdiction often govern such disputes, but ambiguity persists concerning the legality of VIEs and the enforceability of such contracts.

More specifically, regulatory issues would occur when Chinese authorities outlaw the underlying contractual agreements on which the listed entity’s control of the operation is based. The consequent invalidation of such contracts could lead to “a mandatory reorganization to expel foreign control” or “a withdrawal of the business license of the Chinese operating entity.” For instance, in July 2021, China halted for-profit educational tutoring, banning foreign investments in this industry via VIE. Similarly, Alibaba shares also dropped significantly when the Chinese regulators “ordered to break up Ant’s Alipay.” Yet, Chen has noted it is unlikely that Chinese authorities would grant reasonable compensation in such cases. In addition, agency problems exist because the VIE structure’s success hinges on “the integrity of the shareholder of the operating entity as a key person.” Yet, if the shareholders prioritize personal interests over the entity’s best agenda, this could result in significant economic harm. One of the most notorious VIE digression issues was the Alibaba group incident over a decade ago, where its founder separated Alipay from Alibaba to be an independent company under his name without informing the latter’s shareholders. This resulted in a sharp 9.8 percent drop in Alibaba’s stock price when disclosed.

In response, the SEC has taken measures to enhance investor protection and tighten its control over VIE listings. It mandated further disclosure of listed companies’ VIE status and required the companies to release their dialogues with the CSRC concerning their VIE structures’ legality. It investigated the appropriate consolidation of financial results and suspended trading of certain companies’ stocks after alleged fraud. Yet, with President Biden’s Executive Order addressing the country’s investments in “National Security Technologies and Products in Countries of Concern” expected to be implemented next year, uncertainties remain regarding the future of VIE entities. Despite potential economic gains, investors should continue to exercise their due diligence in measuring the costs, benefits, and appropriateness of their investments, particularly in ventures that contain higher risks.