Is your VIE structure HK compliant?

As the trickle of US-listed Chinese companies moving to HK becomes a steady stream some of them might have issues living up to HK guidance on the use of VIE structures.

As laid out in previous posts I think we’re about to see a great migration of Chinese listings from the US exchanges to HKex. In many ways it’s already started, with the first companies trickling in with secondary listings years ago, but the pace is picking up.

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.