VIEs as Control Mechanisms

As the new age of regulation sweeps over the Chinese business landscape, VIEs are likely to take a central role in how the government asserts control over tech companies.

As the new age of regulation sweeps over the Chinese business landscape we’re starting to get some clues as to where we are going. A reimagining of the dynamics of the business landscape and the role of private enterprise in society is on the way, but we will see what this actually means in practice as we move along.

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.