While some reacted with surprise, this is actually part of a wider trend in China over the last few years. John Burn-Murdoch of the FT has a good summary and a handy graph showing the disappearance of official statistics published by China. You should read it if you want the views of someone smarter than me discussing these things. This would be hard to deal with for investors in and of itself, but it’s coupled with other restrictions in the ability to get company information from China, or even conduct due diligence on possible investments.

The issue is of course not just limited to the data not being published, it has a wider impact on the trust investors place on the data that is. If the government starts scrubbing data they don’t like the look of, this also creates the view that any data that is published has to be approved by the government, even if just implicitly. This of course means that many are likely to think that any bad data that is published has already been massaged to look better, otherwise it would also be cut.

The spiral this can set off is quite self-evident, as investors start over interpreting any bad data and the government feels attacked and misunderstood because of this and therefore implements even more curbs. But the information landscape is currently trending in this direction, and there’s not much evidence that we will see a turning point anytime soon.

The need for good information to drive increasingly tough business decisions certainly hasn’t diminished, so what we’re seeing instead is a return to alternative data to interpret the state of the Chinese economy. This can of course cause any number of problems as well, since alternative data sources can only approximate an answer to the actual questions being asked, but at times like this you work with what you have access to.

Long-time investors in China are used to operating in these types of environments anyway, with many using alt data as a sanity check on official data for a long time (see for instance the Li Keqiang index). But this time is perhaps a little bit different, and that can have a meaningful impact on the overall investment landscape.

The really big difference this time is the increased pressure on the banks and traditional sources of research on the Chinese economy. Given the pressure to stay positive - or at least not negative - on the state of the economy, it’s unlikely investors can turn to these sources for good alternative interpretations either.

This means that we’re likely to see a lot more in house research on these topics, or at least we should unless the powers that be decide to completely ignore the risks involved here. And this means we could be seeing increasingly varied views on the state of the Chinese economy, as well as specific industries between different market actors.

As someone who used to work a fair bit on alt data for China I find this very interesting. While it’s not ideal from a market efficiency point of view, it does mean that there should be a lot more opportunities for actual mispricing. This should mean that there are opportunities here for investors with good knowledge of the actual conditions on the ground, and the ability to use better data sets to stay ahead with the overall market view.

It might be a rockier ride than having an underlying 10% GDP growth to float your investment thesis, but it’s also a lot more interesting.

Over the next little while I’ll write some short pieces about alt data sources I come across and find interesting. It won’t be an exhaustive list, and it won’t ever be an endorsement to use any metric, and certainly never only one metric, but I hope it’ll at least be interesting and offer some ideas that can be put into practice.

My first impression when reading the statement is that it seems pretty political, the first paragraph is basically the chair thanking the fine folks who drafted the HFCAA for doing such a swell job. The HFCAA returns later for another round of praise as well, so I think it’s fair to say the writer wants to make a point.

I do think it’s important that we’re aware of this as it might be adding some colour to the rest of the statement. The writer wants to show that the HFCAA has been effective, and that the PCAOB is doing a good job fulfilling their end. I don’t doubt that they are thankful to finally be able to do their inspections, and it’s definitely good that they’re getting on with the work. However, I do think the setting might have necessitated them sounding a bit tougher than they might have otherwise chosen to do.

To the bad then. Both the inspected firms had deficiencies in their audits, in fact in almost all of the audits that were inspected there were issues found. This is clearly not great news, and this is the headline most publications have gone with. I also think it might be the statement the HFCAA drafters would want to hear as well.

In the very next paragraph the writer adds some better news:

As I have said before, any deficiencies are unacceptable. At the same time, it is not unexpected to find such high rates of deficiencies in jurisdictions that are being inspected for the first time. And the deficiencies identified by PCAOB staff at the firms in mainland China and Hong Kong are consistent with the types and number of findings the PCAOB has encountered in other first-time inspections around the world.

That is to say the PCAOB likely always expected to find these types of issues, and it’s within normal parameters for the audit firms to work these out. I suspect there have already been some conversations with said audit firms, and moves have likely already been made to comply with whatever issues the PCAOB have found.

In other words, the PCAOB found what they expected, and we can expect the audit firms to work hard to get their future work compliant with the PCAOB demands. It’s important to note that this is a good thing, and will likely lead to better audit work in the future. What it is not is some kind of smoking gun showing that all Chinese audit work is useless and they’re all just trying to steal your money.

The real issue to worry about ahead is likely something different. The audit work by the PCAOB was largely done prior to the Chinese government new hardline view on information and national security issues. This is much more likely to cause potential issues for the PCAOB inspections going forward than some seemingly routine issues at the accounting firms.

While the authorities have indicated a willingness to continue to work with the PCAOB on the audit issues there are often several competing priorities within the Chinese government. While the CSRC might be more than willing to accommodate information requests from the US regulator, it’s possible that the overall landscape has shifted enough that other departments might take a different view.

The new espionage rules as well as actions taken against due diligence firms, and expert networks signal a shift in what Beijing considers information of national interest. A shift from what was commonplace even a few months ago when the PCAOB did their work. I suspect this is where the real potential issues lie for future compliance with PCAOB inspections.

Others will write a lot more and a lot better about the deeper implications of these new rules, but I’d like to speculate a little bit about what the new rules will mean on a practical level for Chinese tech companies and the industry in general. We can at least attempt to sketch out some early potential winners from these new regulations.

Firstly, like most of China’s internet regulations they place a pretty heavy burden on the companies. Conforming to China’s internet regulations is already burdensome for companies, with ever-changing censorship, the need to strengthen socialist core values, and a whole slew of privacy protections to battle with. It’s not surprising then that these also form the basis of the new AI regulations. They should:

reflect the core values of socialism, and must not contain subversion of state power, overthrow of the socialist system, incitement to split the country, undermine national unity, promote terrorism, extremism, and promote ethnic hatred and ethnic discrimination , violence, obscene and pornographic information, false information, and content that may disrupt economic and social order

In a somewhat surprising move the regulators also demonstrated a very decent grasp of the technology in regulating not just the outputs, but also the processing and manual labeling of data for training. This is not something I saw coming, but it is definitely something that will be impactful. Especially since they seem to want to push some liability for this onto the companies.

For companies this means that compliance for any large model isn’t going to be cheap. This is the type of environment that will favor industry incumbents who are used to dealing with internet compliance, and have the money to set up large and stringent processes around their data and development.

Tencent, and Sensetime come to mind as strong players here. Baidu, historically a heavy-hitter in the AI space, also comes to mind, but their star has been waning for a while now and it’s unclear if this will be the change that allows them to pivot back to greatness.

Adhering to socialist core values, ensuring sufficient diversity in data, ensuring accuracy and truthfulness in a setting where such concepts can sometimes be more fluid than elsewhere, are also somewhat vague targets. These are not easy tasks, especially for large and open-ended models that can generate unpredictable results.

This means that companies that develop AI for specific and limited applications will have an advantage. They will face less uncertainty and difficulty in complying with the rules, and they will be able to develop their products faster, at least in the beginning. For example, instead of creating large and open models like chatGPT, they can use the technology for narrow solutions, like a copilot for excel.

Here, Alibaba seems like a clear winner. Most of their business is in areas like this, and their product portfolio is wide enough to allow for many interesting tie-ins. It’s also the space where it seems most likely we’ll see some startup activity, since the barrier is relatively smaller. They’d still need a lot of backing to make sure they’re in compliance, but development pace is normally very important for startups, especially in China, and this is where you’re most likely to find it.

The new AI regulations in China will have a significant impact on the industry and its players. The rules will likely favor large and established companies that have the resources and experience to comply with the complex and vague requirements. They are also likely to encourage more focused and specific applications of AI, rather than general and open-ended ones. The future of AI in China will depend on how well the companies can adapt to the new environment and how the regulators can balance the goals of security, ethics and development.

An open question is also if AI solutions internationally will favor openness, or if the ability to navigate complex regulations, no-go areas, and constantly shifting sands will become a comparative advantage.

Asian markets tend to be characterised by varying levels of protectionism for local players, usually in the form of some level of investment restrictions for non-domestic players. But governments will now have to reconcile with the fact that the Chinese tech space has helped the finance sector solve this problem, and more importantly it has established a precedent that international capital markets are relatively fine with it.

The investment landscape in southeast asia is naturally more fragmented than China’s, but we still find many key markets with investment restrictions that companies might want to work around. Or as SEA Limited (NYSE: SE) puts it:

The Company operates in various markets that have certain restrictions on foreign ownership of local companies. To comply with these foreign ownership restrictions, the Company conducts certain businesses through VIEs using contractual agreements (the “VIE Agreements”).

In the latest financial statement they’re largely vague on what these markets are, but we get a better view in last years annual report, so we can at least say where meaningful VIEs were used then.

According to that filing, accompanied by this less than informative org chart, SEA used VIEs primarily in Vietnam, but also previously in Taiwan.

There are some interesting differences here in that the shareholders of the VIEs aren’t laid out in detail, so it’s harder to do a proper risk evaluation of the structure, but since the company files in the US we still get a good breakdown of the financials involved.

They also use a novel ownership structure in Thailand, which looks a lot like a more advanced version of the sino-sino-foreign structure that used to be employed in China pre-VIE. So some variety to spice up the corporate risk assessments.

Lalatech, the company behind Lala Move and Huolala here in China, has also used a VIE structure in a non-Chinese market. We get some details from their recent HK IPO filing.

They of course also have a VIE for their China operations. Seemingly all owned by just one employee, which seems excessively risky when there should be better options around. Old-timers might be reminded of what happened at Gigamedia for instance.

The company has also used a VIE-style arrangement in Indonesia, however, since there are ownership restrictions for their industry. Which means that the company’s biggest market, and one of their key growth markets are now both subject to VIE risk.

What’s more, I haven’t seen much evidence that any of these companies using VIEs internationally are taking many steps to limit their use. That is to say, I’ve seen no structuring of key assets away from the VIEs for the local market, or even attempts to make sure that as much of the business as possible is structured into subsidiaries that the listed company owns through equity.

This last point is actually a requirement under HK listing standards, but I don’t think there will be much movement from the exchange or the regulators on that front.

Overall there’s actually less risk disclosure than I would have imagined, especially since these appear to be international agreements, which will open them up to another level of scrutiny which might be problematic. More on that in a later post.

It is perhaps somewhat poetic that at a time when the Chinese tech sector is still reeling from increased regulatory scrutiny, and an increasingly hostile foreign environment for expanding outward, one of their most successful exports is a financial machination for skirting regulations on foreign ownership. It will also be interesting to see if the widespread adoption of VIEs in China will become a comparative advantage for Chinese companies in some jurisdictions as they’re simply more familiar with how to operate in such an environment.

Still, a big question looms for both companies and investors. China has seemingly been okay with companies skirting their foreign ownership restrictions (their own ones at least), but will other countries also look the other way?

Golden shares are a way for the Chinese government to exert more control over the country’s internet firms, and look likely to be a permanent part of the operating landscape. They give Beijing board seats and certain veto rights, but importantly only in the actual units where the stakes are held. That means the impact of the golden shares varies depending on where they are placed and what they cover.

How much control Beijing takes from their stake varies based on the industry and corporate structure the company has employed. For a company like Weibo that operates almost exclusively in social media with a relatively simple VIE structure the stake is in their main VIE, and thus impacts the entire business. Alibaba on the other hand has managed to get their two golden shares in smaller units with a much smaller impact on the company’s core business.

While there is still a lot we don’t know about how the government thinks about these golden shares, they seem to follow something of a pattern. In general they favour taking one stake instead of many, but they want to make sure they cover all of the relevant online services. We see this in the government making sure they cover the ICP licenses needed to run these services in the stakes they take.

The government does seem to show some restraint in how they take their golden shares, adopting more of a scalpel than a hammer when possible. We see this in Bytedance, for example.

While the easiest solution for the government would have been to take a stake in the company’s top-level VIE (Douyin Co., Ltd.), making sure they exert control over the entire business, the golden share is actually in a subsidiary (Beijing Douyin Information Service Co., Ltd.). This is still a higher level entity, and seems to cover all the necessary ICP licenses and operations, but it’s not strictly speaking the entire business.

But while a scalpel treatment of sorts is possible, Tencent might be in a structural position that means they have to get the hammer nonetheless.

Firstly, the company’s VIE utilisation (how much business is in and runs through their VIEs) is much higher than Alibaba’s. Tencent’s VIEs account for around 47% of total revenue as opposed to 13% for Alibaba, according to the annual reports. It would be possible to do a significantly more detailed comparison if both filed under US standards, or if HK starts requiring the same levels of disclosure. But alas.

The nature of the company’s business also means the government is likely to want a say in a larger part of the core businesses, but the biggest issue is likely structural. While many internet company’s have a more distributed model, with licenses held in specific business units, Tencent seems to have adopted a more centralised approach.

According to records for their online service licenses it seems almost all core assets are held in their main VIE (Tencent computer), which means that, unless there is some restructuring, this is likely where the government would have to take its golden share, if it follows the same general method as before.

This is not great for shareholders. At the best of times VIEs already concentrate power in the hands of company insiders, and are therefore bad for minority shareholders in the listco. This is part of the reason why you want to structure the business away from VIEs and into the equity owned subsidiaries. Adding a government stake with veto rights in the main part of the business isn’t ideal from a corporate governance perspective, and should be avoided if at all possible.

The good news is that there does seem to be some leeway from the government to control or limit where the golden shares are taken. The bad news is that this likely has to happen before the arrangement is solidified, and companies are unlikely to be prepared for this. Investors should push companies to take action on this early, to make sure any changes take minority interests into account.

I’ve long argued that we should be working with VIE structures and risk limitation from a corporate governance perspective on the board level. The golden share arrangements now risk exacerbating the downside risks associated with poorly managed VIE structures, but perhaps it’s the type of key event needed to start taking the issue seriously.

The reshuffle raises questions about how Bytedance will align the interests of its VIE shareholders, who effectively own its lucrative Chinese business, with those of its offshore investors. Interest alignment is key to effectively managing VIE structure risks, especially from the viewpoint of foreign minority shareholders, and having employees rather than large shareholders in the foreign listco own the shares can create issues.

While the move is in line with the founder taking a step back from the operational side of the company it’s still notable that the largest shareholder in the off-shore entity has given up all ownership in the VIE. And it’s a level of uncertainty that the company could probably do without.

With the breakup of the Alibaba empire currently in the news, the further side-lining of another tech entrepreneur could be seen as the state continuing to assert its power and influence, even if the moves are motivated by streamlining operations cleaning up the corporate structure for further liquidity events.

The change would is also likely to lessen the chance of potential anti-monopoly issues going forward. So there are a lot of potential positives, but what seems like a certainty is that it will make one of the worlds most complex corporate structures more complex, and with that also comes potential downsides.

On the face of it the news seems quite surprising, but there have been signs along the way that this might be coming. The business areas being put forward were already outlined and organised in the same manner in the company financial statements, and there have been rumours of this type of restructuring to increase autonomy since 2021.

It’s also interesting to note that the current corporate structure is largely in line with what is being proposed here, so it’s quite likely that this is something that has been planned for some time.

Here’s the heavily simpliefied org chart from the company’s 20-F:

This means that the company should be well placed to act on the plan, and we should hopefully see a relatively smooth transition.

It’s also unlikely that they would have announced the plan now without first getting some informal clearances from the government for any restructuring that would have to take place. I suspect the government would have insisted on it given the scrutiny the company has been put under.

So while we’re likely to see movement on the plan relatively soon, the changes in operations will create more complexity for investors to navigate, as well as potential conflicts of interest and governance issues.

For instance, Alibaba currently discloses that they have basically no revenue or income running through their VIEs, the business that is actively running through a VIE setup is related to the cloud services. It’s never been entirely clear how they’ve set up in order to accomplish this, but given that essentially no other company has been able to keep their VIE utilisation so low in any of their individual businesses means we might expect independently operating units to have to increase their reliance on the VIEd entities.

Speaking of the VIEs, they are currently set up with ownership held by members of the Alibaba Partnership, which will create some detrimental corporate governance realities for new investors in the spinoff companies. Minority rights are already an issue for Alibaba, and it’s likely to be even worse for the spinoff companies.

Finally, while the government has indeed taken golden shares in two of Alibaba’s VIEs, due to how the company has structured their business the influence of these shares on the core business of the company is actually pretty limited. However, if the units will be operating independently it’s possible to government will demand golden shares in each listed unit individually. This coupled with increased VIE utilisation would drastically increase the amount of influence and leverage this golden shares can have over day-to-day operations.

So, we’ll end up with the same corporate structure at the top, but with more minority shareholders in listed subsidiaries with related governance challenges. They would also likely increase the reliance on VIEs and the exposure to government interference via golden shares. The plan makes sense on paper, but it is not a slam dunk for investors.

The first question is interestingly probably the hardest to answer. After many years there’s not a new deal to allow the PCAOB to inspect the audit papers of Chinese auditing firms. The details and text of the new deal hasn’t been published so it’s quite hard to say much more, which is perhaps why there have been so many hot-takes.

What seems clear is that the reviews will initially take place in HK rather than on the mainland, which might not be ideal, but given the time-crunch to get the inspections done and the current restrictions on travel to the mainland it seems like a reasonable compromise. There have also been hints that inspections will move to the mainland at a later point.

The statements from the PCAOB and CSRC regarding other parts of the deal have some differences. If you ask some commentators these differences are apparently enough to declare the deal dead on arrival, or they constitute a clear point of conflict between the two sides. I suspect the truth is a little less spectacular, and the two sides are using the fact that the exact deal isn’t published to emphasise different parts to their domestic audiences. If you look at the statements they’re not inherently incompatible, and if they were, presumably the deal wouldn’t have been signed by the US part in the first place.

According to the PCAOB they will have access to any documents they request and need for their audit work, and will be able to conduct interviews when they want. According to the CSRC they will be providing the documents to the PCAOB and will be conducting the interviews together with them. This of course doesn’t mean there can’t be conflicts ahead, but the statements are hardly enough to declare the two interpretations of the deal incompatible.

There is room for some healthy skepticism, however. It’s important to remember that this isn’t the first deal to secure access to audit papers to allow the PCAOB to do their job. We had a MOU in 2013 to solve the issue of access to audit working papers, but this deal was declared dead by the PCAOB since it was unable to get the CSRC to follow through with sufficient access to conduct their audits. Lessons from this will clearly have played a part in these negotiations, and will be a key reason the PCAOB will take a wait and see approach now.

If we look at one of the key points myself and others made before the deal, the ability of the CSRC to drive through a deal with the other ministries that the PCAOB could accept, you could argue the concern has merely been moved. They’ve clearly managed to give the PCAOB an acceptable deal, but will it be able to actually follow through and provide the access?

In the end then the deal certainly isn’t dead, but it also only signals the start of the work and everyone is approaching it with some caution. It’s clear the CSRC wants the deal to work, and there have been repeated assurances that they want international listings to remain an option for Chinese companies going forward. These are all positive signals that there will at the very least be a willingness to make the deal work on their side, the question remains if that will be enough to produce everything the PCAOB will need.

For some investors and companies it might all be for nothing though. If recent reports are to be believed the Chinese government is looking to ban companies with sensitive data from listing overseas. Depending on how this is classified it would likely include all major internet companies, and many of the startups currently looking at their options. In effect, this would have the same effect as a PCAOB delisting for many of the companies foreign investors are interested in.

So in the end we might get both a PCAOB audit deal, and a mass delisting and exodus from US exchanges to HK. But maintaining access to US exchanges for companies without sensitive data is certainly a positive, and might push more Chinese startups to limit their scope of business and data-collection in order to qualify for such a listing.

However, while the HKex is likely to do everything in its power to make the process as smooth as possible, it’s not entirely clear how some US-listed companies will be able to have a HK listing approved, given how they have structured their VIEs.

As a brief summary, a VIE in this context is an entity in China the list co controls through contracts rather than equity ownership. The contracts are between the VIE and one of the WFOEs the list co does have equity ownership of, so the entire VIE structure itself is on-shore in China. The entity is still consolidated into financial statements (under both US and HK accounting rules), but there is no outright ownership, and this comes with risks relating to the legal viability of the contracts, transfer pricing and tax issues, as well as other operational issues.

In many cases investors will wrongly assume that because a company uses a VIE shareholders in the list co don’t actually own any equity in the business in China. This is not necessarily true, it will obviously depend on how much of the business is conducted in the contractually controlled VIE, and how much of it has been structured away from the VIE and into the WFOE’s where the list co does have equity ownership.

In a well-managed VIE structure we often find that very little of the company assets and/or business activities are conducted in the VIE, and instead most of it has been moved to WFOE’s to ensure shareholders in the list co hav an actual ownership stake.

This is something that the HK regulators had in mind when they drafted guidance on the use of VIE structures on the HKex. The idea seems to have been to push for better VIE governance on the HKex compared to what you may see in other places, and among other things companies should;

The Structured Contracts should be narrowly tailored to achieve the issuer’s business purpose and minimise the potential for conflict with relevant PRC laws and regulations

It goes on to clarify;

For the avoidance of doubt, Contractual Arrangements may only be used to the extent necessary to address any limits on foreign ownership, except as provided in sub-paragraphs (1) and (2) below. The issuer must otherwise directly hold the maximum permitted interest in the OPCO.

This is aimed to push out companies that don’t use VIEs for their intended purpose, to allow the list co to operate in the regulated industry while maintaining the maximum allowable amount of equity ownership of operations for shareholders in the list co. In other words, only use VIEs when you actually need to.

For most US-listed Chinese companies this is unlikely to cause an issue. Alibaba, for instance, actually maintains very little of their actual business in their VIE entities, with most of if conducted in the WFOE’s, other examples include Nio and Xpeng, where there are no disclosed assets or any material business at all conducted in their VIEs.

However, there are companies where this could be an issue. For instance some companies may use a VIE structure when they could have direct equity ownership of the business, others might have their entire Chinese operations in their VIE when there simply is no need for it.

Investors should look over any US-listed Chinese companies in their portfolio and do a basic assessment to see if there are likely to be issues moving the listing to HK. Conversely, investors might ask themselves if it’s likely HK will take a hardline approch to this and cut the flow of some US-listed Chinese companies onto the exchange. Dealers choice.

The PCAOB vs China audit dispute has been ongoing since the early 2010’s, and throughout the entire time it has been characterised by being a seemingly very solvable problem, that simply never finds a solution. Throughout the history of the dispute it has often looked like a dance between two parties where one is unwilling to engage, and for the last few years the actual mechanics of what a deal would look like have mattered less than the politics driving both sides.

At some level I suspect that one of the key issues is that the government ministry negotiating on the Chinese side (the CSRC) is not the one likely to have the most objections to the deal, but they wouldn’t have been able to drive any deal through the other ministries involved in regulating these companies. The already wide definition of what constitutes national security matters in China have also somewhat widened in the last few years, which always meant any deal on audit inspections would have harsher seas to navigate.

Increasing reluctance on the US side to accept any compromise from their Chinese counterparts was likely the final straw, although it’s always hard to know how much of these things are simply negotiating positioning, and what constitutes actual red lines. It’s been fairly obvious that the driving force for finding a deal switched from the PCAOB - who did a lot of the work early on - to the Chinese side over the past few years.

Still, here we now are, with a deal looking very unlikely, and Chinese SOEs voluntarily delisting from the US exchanges. So it’s high time to in earnest start preparing for the fallout of a no-deal scenario.

For some fun reading, and a reminder of what has and hasn’t changed on this I recommend starting by reading this post from Professor Paul Gillis speculating on the effects of no audit deal, in 2011.

Luckily, many Chinese companies have already started this preparation with a secondary listing in HK, and I expect this to pick up some real speed now. I’ve long said not getting a secondary listing already is verging on negligence from the management of these companies.

As the majority of the bigger private companies affected by this are using VIE structures for parts of their business the only viable mainland exchange where they could list is the STAR market. However, it seems unlikely the STAR market can handle this type of migration, so a switch to HK, or potentially using the new deal to cross-list over to Singapore seem like the most viable alternatives.

This is bad news for investors since they’ll lose a lot of insights into how these companies are using their VIE structures, which will impact risk assessments going forward. At present I’d say it’s virtually impossible to do an accurate VIE risk assessment based only on HK filings. Hopefully this will add pressure on HK to adopt US-style VIE disclosures in order to cater to US investors, but I somewhat doubt it.

Another potential issue is auditing international companies with large China operations, since foreign auditors can’t come in, and the audit papers can’t go out. This feels like a situation where we could see the actual mechanics of what a solution to the impasse would have looked like, since it has all of the same problems, but virtually none of the politics involved.

Overall, I think the only real potential winner here is HK, and they could really use a win right now. They are likely to be very aggressive in courting these companies, and will use this as their opportunity to become the exposure point to international capital for Chinese companies. Some of them will likely also choose a secondary listing on the local STAR market, in the same way that Ant financial was planning to do before their IPO was scrapped.

For investors though, it means getting used to new capital market rules, worse disclosures, and likely more focus on individual due diligence work in a country that is as closed off to foreign visitors as it has been since… a good wee while.

One such instance is the reports that the Shanghai government was stopping investments into VIEs. It’s really interesting to me for two reasons:

Firstly, the Shanghai government haven’t stopped investments into VIEs, they seem too have stopped investments into offshore listing structures. These are definitely related to VIEs, but this move has implications for companies that don’t use VIEs as well.

Secondly, looking at the potential impact of an actual stop to investments/money flows into VIEs is interesting, and this type of move would have a very wide range of impacts based on how well the company has structured its VIEs.

In, not out

The key early indicator that the moves from the Shanghai regulators aren’t stopping investments into VIEs is that they are stopping outbound investments into the Cayman’s. As we know from earlier the Cayman company is not the VIE, which is an entity incorporated in China.

So if you’re stopping investments into the VIE, you’re actually stopping inbound investments or money-flows, not outbound. But more on this later.

It’s useful to take a bit of a deeper dive here into the difference between the VIE structure, and the offshore listing structure. These are often confused with each other as we have seen, and the offshore listing structure is sometimes included in the discussions about the VIE structure.

If we look at the corporate structuring of Chinese companies listed abroad that use VIEs, there are actually two parts to the setup. The VIE is there as a workaround to the foreign investment rules, and the offshore listing structure is there as a workaround to Chinese rules related to floating the shares on an exchange.

The VIE structure is actually an entirely onshore affair. When we’re discussing what the VIE structure is, and what risks are related to it, how they’re managed and governed, what we’re really discussing is the relationship between the VIE entity, and the Listco’s wholly owned subsidiaries (WFOEs) in China.

The core of the VIE structure is the contractual control element between the WFOE and the VIE entity, but operationally and from a risk perspective it’s also important to look at how the VIEs operate together with the WFOEs. A well-managed VIE structure will tend to have most assets, and revenues handled in the WFOEs instead of the VIE, for instance, so that these are under the direct control of the foreign shareholders in the Listco.

Notice that this entire discussion is still related to onshore activities, the problem is that you’re unlikely to be able to get approval to list this overseas. In fact there are plenty of companies that don’t use VIEs at all (ie they’re not operating in negative list industries) that have this very same problem. It has traditionally been very hard to get approval to list shares of your Chinese entity abroad.

So, this requires another, separate workaround. Luckily this workaround is a bit more straightforward.

While you can’t list your Chinese company overseas without approval, if the Chinese company was taken over by a Cayman Island company they wouldn’t need to apply for permission to list. So the standard setup was created to establish an offshore structure for listing overseas, and it’s the establishment of these entities that the Shanghai government has stopped (or rather the reorganisation of them that established the ownerships etc.).

So, while the reported regulatory actions definitely does impact companies using VIEs, it’s very likely that it actually shuts down the establishment of offshore listing structures for all applicants. This essentially stops the now standard way for most Chinese companies to list abroad, although it could be that the Shanghai authorities are being more granular than this.

This also means that the impact of this could potentially be much broader, and more in line with the CSRCs recent statement that they want to firm up listing procedures overall.

But, what if?

Banning money-flows into VIEs would be a very different endeavor, it would have a narrower but potentially deeper impact, and some of the groundwork for it has been around for a long time.

Getting money into VIEs isn’t actually all that straightforward in the first place. I first wrote about this issue with Shoushuang Li back in 2011, and while we have of course moved on somewhat since then the core issues remain.

Moving money into a company you don’t control, in an industry you’re technically limited from engaging in is always going to throw up some challenges. In fact, there are risk disclosures about the potential inability of moving the money raised offshore into the VIE in most filings from Chinese companies using the structure.

Here’s one from Didi:

PRC regulation of loans to and direct investment in PRC entities by offshore holding companies and governmental control of currency conversion may delay or prevent us from using the proceeds of this offering to make loans or additional capital contributions to our PRC subsidiary, our VIEs and their subsidiaries, which could materially and adversely affect our liquidity and our ability to fund and expand our business.

          We are an offshore holding company conducting our operations in China through our PRC subsidiaries, our VIEs and their subsidiaries. We may make loans to our PRC subsidiaries, our VIEs and their subsidiaries, or we may make additional capital contributions to our PRC subsidiaries, or we may establish new PRC subsidiaries and make capital contributions to these new PRC subsidiaries, or we may acquire offshore entities with business operations in China in an offshore transaction.

          Most of these ways are subject to PRC regulations and approvals or registration. For example, loans by us to our wholly owned PRC subsidiary to finance its activities cannot exceed statutory limits and must be registered with the local counterpart of SAFE. If we decide to finance our wholly owned PRC subsidiary by means of capital contributions, these capital contributions are subject to registration with the State Administration for Market Regulation or its local branch, reporting of foreign investment information with the Ministry of Commerce, or registration with other governmental authorities in China. Due to the restrictions imposed on loans in foreign currencies extended to PRC domestic companies, we are not likely to make such loans to our VIEs, which are PRC domestic companies. Further, we are not likely to finance the activities of our VIEs by means of capital contributions due to regulatory restrictions relating to foreign investment in PRC domestic enterprises engaged in certain businesses.

…

          In light of the various requirements imposed by PRC regulations on loans to and direct investment in PRC entities by offshore holding companies, we cannot assure you that we will be able to complete the necessary government registrations or obtain the necessary government approvals on a timely basis, or at all, with respect to future loans to our PRC subsidiaries or VIEs or future capital contributions by us to our PRC subsidiaries. As a result, uncertainties exist as to our ability to provide prompt financial support to our PRC subsidiaries or VIEs when needed. If we fail to complete such registrations or obtain such approvals, our ability to use the proceeds we expect to receive from this offering and to capitalize or otherwise fund our PRC operations may be negatively affected, which could materially and adversely affect our liquidity and our ability to fund and expand our business.

It’s a bit of a mouthful, admittedly.

But since it’s hardly a straightforward issue to begin with, it’s not too much of a stretch to imagine there being some scrutiny coming to the topic. Some might argue it’s a bit strange that we haven’t seen anything so far, but then others would say that’s a good indication that the relevant authorities are OK with it.

And while the restrictions on establishing offshore listing structures don’t really matter to the companies already listed, this would be another matter entirely.

Companies would be unable to move any money raised or held overseas into their VIEs, and if you’re a company that primarily operates through your VIE this would be a big problem. More well managed companies like Alibaba would likely still do OK, since they directly own and control the vast majority of their assets and revenues through their WFOEs. Meaning they’re unlikely to be limited in their ability to transfer money to their operational subsidiaries, but not all companies are structured so well.

As we can see, limits on establishing offshore listing structures and limits on money-flows into VIEs are very different both by their nature, and regarding what types of issues they generate. While the currently reported one is likely to affect all Chinese companies looking to list overseas in the future, stopping money-flows into VIEs would have a direct, and potentially material impact, on companies listed now.

One section where we have some more clarity is in the tech sphere, where it appears the Chinese government is pivoting their relationship to the VIE structure. While the structure in the past has mostly been tolerated, it seems like it will now become an active part of the mechanism the government uses to control its foreign listed companies.

It used to be said that the VIE structure could potentially be useful for the government to control these companies. Having a regulatory sword of Damocles hanging over their heads, they were always unlikely to want to cause much trouble, or so the theory went. It now seems like we’re moving from this more passive role to a more active one.

As we see in the case of Bytedance, and some rumours elsewhere, the government can take an active ownership stake in the VIE itself, and with it secure board seats to assert some control or veto power over major decisions in the VIE. This would also likely mean more direct insight into the day-to-day operations of the VIE, although some might question if this was ever a major issue to start with.

Coupled with this I think we’re likely to see a centralisation of key assets into the company VIE, and away from direct ownership of foreign shareholders. This runs counter to the best practices of VIE governance, which relies on moving assets away from the VIE and into the direct ownership of the listed company in the WFOE.

Contrary to what some investors think there are definitely examples where this has been done relatively well. The end goal was to create a organisational safety net in case the VIE contracts fell through, the idea being that the VIE on its own should be incapable of actually running the business, which would make it useless to take it out of the listed company.

If the government moves into the VIE we will see a force trying to reverse this dynamic. The goal is likely to be to make sure that the listed company cannot possibly operate without the VIE, thereby further strengthening the relative power of controlling this entity.

It’s interesting to note that this control element doesn’t necessarily have to come in the form of ownership or board seats for an SOE investor in the VIE. I previously suspected that the government might use the party committee to achieve the same effect. Setting up a similar system to what we’ve seen in many European companies with permanent board seats for union representatives.

I still suspect this would be a workable solution for smaller companies, likely before they list overseas, with the SOE investment coming in before any potential IPO to further formalise the setup.

Of all the key assets I had previously expected to end up in the VIE data was always top of the list, but given what we’re hearing from Didi it’s not impossible that this will be even further removed from the overseas investors, essentially being hosted by SOE entities. It’s unclear how workable this type of solution actually is, or indeed what it would do to businesses such as Aliyun, so I suspect this cannot be a general requirement for all companies.

I would expect any data that remains, and likely data processing and analysis would have to be moved into VIEs, and any contract between the SOE data service and the company would be directly with the VIE, and not to any WFOE.

All of this seems to be building towards two goals.

Firstly, it will allow the government to increase its control over the entire sector, specifically relating to data, which is clearly where the biggest worries about foreign influence and access are centered.

But secondly, it also opens up for a deal between the CSRC and the PCAOB for audit inspections, although likely with limited access to the parts of the listed company that are in the VIE. That is to say they can inspect what the listed company actually owns, but not much beyond that. Once again laying bare the core issue of the VIEs where the subsidiary is at once a part of the listed company, and at the same time not.

These changes are likely to have some impact on how investors should view VIEs. While I’m sure most investors would take a VIE with objectively worse structuring and corporate governance in exchange for a stronger government backing of the contracts, other issues might come up.

For instance, the new shareholders and board members would have to be covered by the normal VIE agreements, which says they will vote in accordance with what the listed company tells them. This is a core part of the control agreements on which the consolidation of the VIE rests, meaning it’s necessary in order for the VIE to show up on the listed company balance sheet.

Given the current atmosphere on China in the US I would expect there will be some questions raised about taking the enforceability of these contracts with SOE representatives at face value. As well as some discussion about what happens to the control element of the VIE in general if an outside party has veto power over important decisions.

Some see this as the agency laying down the gauntlet, as best they can. However, I’m more confused that anything else. While there are some things in here that could indeed help clarify the risks involved, I doubt these nuances would be of much use to your average investor.

They’re more likely to drown in the high seas of the existing risk disclosures.

Firstly, let’s note that the letter starts with the mistaken assumption I discussed in my first substack post. At several points in the letter it is clear that the implicit structure the letter is referring to has a Contractual Control Point (or CCP, for fun) between the Cayman entity and a “China-based operating company” where all of the business actually happens.

As we saw before, while that can be the case, it usually isn’t. Normally you do have ownership over parts of your China operations, the key question is which parts. It is possible to structure companies so that the VIE utilisation remains relatively low, and this really is where the focus should be from the US side. Improving VIE structuring, making it a key part of the required governance framework for Chinese companies listed in the US.

Demanding some more boiler-plate disclosure around VIE risks is unlikely to make much of a difference. This is probably best illustrated by the fact that most of the new disclosures that the letter asks for actually exists already.

the China-based operating company, the shell company issuer, and investors face uncertainty about future actions by the government of China that could significantly affect the operating company’s financial performance and the enforceability of the contractual arrangements;

This is usually covered in a number of places in the risk disclosures of any US-listed Chinese company, often with a nice bullet-point list outlining the potential actions the Chinese government might take. There’s also the standard disclaimer that comes after the legal opinion saying the VIE contracts are all legal, basically stating that there’s no assurance that Chinese authorities will take the same view.

A quick search for “substantial uncertainties” on any annual filing from a Chinese company using a VIE will get you some examples.

Detailed financial information, including quantitative metrics, so that investors can understand the financial relationship between the VIE and the issuer.

This also already exists, although there is some difference in the level of detail we get. Sometimes we get condensed information, and others we get the entire balance sheet, coupled with revenue and cashflow information. It’s available in the footnotes to the financial statement.

Looking at this is a good way to see just how much of the company is actually in the VIE, so we can avoid assuming that all of it is. This is also one of the big issues with these companies switching over to a HK listing, as disclosures in HK has nowhere near this level of detail.

the Holding Foreign Companies Accountable Act, which requires that the Public Company Accounting Oversight Board (PCAOB) be permitted to inspect the issuer's public accounting firm within three years, may result in the delisting of the operating company in the future if the PCAOB is unable to inspect the firm.

This is also present for most companies that average investors will be likely to have shares in. It’s usually a standard part of the risk section for these companies, and searching for “Holding Foreign Companies Accountable Act” will get you to the right place.

Here’s an example from Netease as I had their annual filings open:

Our auditor, like other independent registered public accounting firms operating in China, is not permitted to be subject to inspection by the Public Company Accounting Oversight Board, and consequently you are deprived of the benefits of such inspection. Under the recently passed Holding Foreign Companies Accountable Act, our ADSs may be delisted from Nasdaq if the PCAOB continues to be unable to inspect our independent registered public accounting firm in the next three years. In addition, various legislative and regulatory developments related to U.S.-listed China-based companies due to lack of PCAOB inspection and other developments may have a material adverse impact on our listing and trading in the U.S. and the trading prices of our ADSs.

So that leaves two points that offer some new added disclosures.

That investors are not buying shares of a China-based operating company but instead are buying shares of a shell company issuer that maintains service agreements with the associated operating company. Thus, the business description of the issuer should clearly distinguish the description of the shell company’s management services from the description of the China-based operating company

Once again, this seems to assume that the Contractual Control Point is between the Cayman company and the China-based operating company, and for these companies this disclosure should be pretty easy. In fact many of them already have disclosures that cover this. They will clearly state that due to Chinese regulations the company’s operations are held in the VIE.

The new disclosures here would be for the better structured VIEs. Detailing exactly what parts of the company is in the WFOE as opposed to the VIE will be very interesting in identifying best-practices for how to structure companies to minimise VIE utilisation.

It’s not going to be easy though. I’m not entirely sure how you would write a disclosure that clearly distinguishes the parts of Alibaba’s business that is conducted in the WFOEs from the relatively limited parts that are handled in the many VIEs. I’m just very happy I don’t have to write it.

Finally, the disclosures around the new mechanism for approval of the foreign listing.

Whether the operating company and the issuer, when applicable, received or were denied permission from Chinese authorities to list on U.S. exchanges; the risks that such approval could be denied or rescinded; and a duty to disclose if approval was rescinded

This is clearly a reasonable inclusion, and a risk that should be disclosed. However, given that there are already so many risk disclosures that professional investors don’t get through them all, I doubt the inclusion of this will have any measurable impact on how the average investor understands China risk exposure.

So, the SEC letter has me confused. It could be that the devil is in the enforcement here, and the Chairman wants to substantially increase the amount of detail in these disclosures. I would be a big fan of this, as it would let investors get deeper into their risk analysis, and potentially create the necessary information for a functioning VIE governance reform.

Maybe this is a first step, however, on it’s own the letter makes little sense from a VIE risk assessment point of view. I suspect the impact on how the average investor understands VIE risk is likely to be minimal.

Much of this analysis is very interesting, well-argued, and often provides insightful takes on what might be next steps.

However, much of it also misses the mark when they’re describing how VIEs work, or sometimes even what a VIE is. Part of this is likely just due to space and time restrictions. VIEs are somewhat complex, and above all not easily introduced properly in a short paragraph, which is often what’s required of the writers.

The problem is that these simplifications are taking root and influencing what people think VIEs are; this is true for the general investor at home and for many analysts and fund managers. Thus, it leads to some fundamental errors when evaluating both the overall situation regarding VIEs and the possible impact on individual- or a portfolio of companies.

This is worrying, since it implies that many professional investors who hold major stakes in Chinese companies don’t understand how their investments work. I often say that investing in China without understanding VIE structures is like investing without knowing how equity ownership works. Further, in order to have productive conversations about VIE risk it’s important that at the very least we’re all talking about the same thing.

So, to clear up some basics I thought we’d start by pointing to the VIE on an org. chart.

That’s not the VIE

This might seem trite, but not understanding this and some of the misunderstandings that flow from it probably accounts for 85% of the bad VIE analysis I see.

“Chinese VIEs, usually based in tax havens such as the Cayman Islands, are essentially holding companies designed to get around strict rules that forbid foreign investors from any ownership over key sectors, such as tech”

This description or some derivative of it can been seen far too often, and it’s also something I’ve encountered in conversations. However, it gets the entire structure completely backwards, and leads to a whole slew of incorrect analysis based on this base misunderstanding.

The Cayman Holdco is not the VIE. I repeat, the Cayman Holdco is not the VIE.

The VIE is a domestic company in China, which is owned by PRC citizens. It is controlled by a set of contracts that are signed with a Chinese subsidiary of the listed company.

As we can see in this simplified diagram of the archetypal VIE, the Cayman Holdco is set up to hold ownership of the company’s subsidiaries (and to get around some securities and forex regulations regarding listing companies), and the VIE including all the VIE contractual relationships are all onshore in China. This means that as an investor in the Cayman company you still have equity ownership of everything, apart from your VIEs, and there is no contractual relationship or money flows directly from the VIE to the Cayman company.

A Common Misconception

The idea that the VIE is the Cayman company has created some issues when analysing VIE risks. For instance, the often-written sentiment that when you invest in “a Chinese VIE” you actually don’t have any rights to the assets of the company, you’re just buying synthetic exposure to the “real company’s” income.

This analysis makes sense if your view of VIEs is that they are a set of legally questionable contracts, and that they exist between the Chinese opco and the Cayman Holdco (“the listed VIE”). If this was how the relationship was set up then all VIEs really would be the same, and foreign shareholders wouldn’t own any part of the business in China.

However, since the disputed contractual relationship is not with the Cayman company that foreign shareholders invest in, but among the listed company’s subsidiaries in China, what we actually find is that VIEs vary widely both in how they are set up and in how they operate.

Instead of being the uniform risk implied when people say a company “is a VIE”, what we have is a wide range of VIE utilisation and risk profiles. Even within the same industry, VIE use can range from essentially 100% of the China operations, to literally zero.

We can use NIO as a pertinent example here. You may have seen it used to illustrate VIE risk in general, and it’s sometimes presented as a Tesla without any ownership of the underlying assets.

Once again, this analysis makes sense if you think of the Cayman company as the contractual control point, but since we now know that it’s not, we can have a look at the actual VIE usage and see what’s in this part of the business.

We can see from the org chart that currently NIO only discloses one VIE. The company used to have more but it terminated the agreements and thus deconsolidated the entities. In NIO’s case foreign shareholders own and control all of the operations that are outside of this one VIEd entity.

If we move further down the annual filings we can see that the company disclosures say there are no material assets or operations in its VIE, and the same goes for the VIEs that were deconsolidated. These entities are likely set up for planned products that might be in restricted industries, say a ride hailing app or some car-related online platform tech.

So, as far as the current business is concerned, foreign shareholders in NIO own all of the business, which is somewhat different to owning none of it.

As we can see this base misunderstanding can produce a VIE risk assessment that strays pretty far from reality, and incorporating this into your risk modelling and decision making is likely to lead to some pretty sub-optimal decision making.

Other issues that arise from this misconception is confusing issues relating to ADR’s and dual-class voting rights with VIE structure risk, and the idea that all profits are flowing out of the VIE and into the Cayman’s in a giant tax-dodge. In fact, you will find that profits often do not leave the VIE, never mind the country, and there are some potentially severe tax inefficiencies that can come from using VIEs, but that’s too much to cover for now.

There are plenty of issues relating to VIEs, both on a macro and a micro level, and these issues need to be discussed more and understood better by investors. But this is only possible if we’re at least talking about the same thing--and with the current levels of confusion about VIEs, we’re not.

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