IS THE LAW of unintended consequences — or intended ones — in play with the new draft revisions to China’s foreign investment law? And if the later, whose intentions need to be examined?
What may be at stake is control of three of the fastest growing sectors of the Chinese economy — the internet, e-commerce, and cloud computing. Privately owned companies, not state-owned enterprises dominate all three. More to the point, these are about the only sectors of the economy to create large privately owned Chinese companies and from which state-owned behemoths are absent.
As Steve Dickinson of the China Law Blog points out, Baidu, Sina, and Alibaba are at risk of getting their wings clipped. To be fair, that is not the wording he uses. However, this Bystander sees it as a consequence of the significant implication he does note will result from the draft foreign investment law newly published by the commerce ministry: it will end a corporate governance structure known as the Variable Interest Entity (VIE).
All three companies and hundreds of others, particularly technology and telecoms firms, use VIEs to get round the investment regulatory rigidities of sectors of the economy the government deems strategically important and so proscribes or limits foreign investors.
The new draft revisions specifically set out to end VIEs. The revisions’ other main goals are:
- to lessen the red tape for foreign direct investors wanting to own businesses in China;
- to switch to a system of monitoring foreign investors via annual reports from pre-approvals for new foreign investments, save for in sectors of national significance; and
- to put Chinese companies with foreign investors under the same legal regime as domestic companies.
China’s foreign investment law is outdated, so modernisation is to be welcomed — even if the draft law runs to a weighty 179 articles across eleven chapters.
VIEs are a loophole that has let foreigners operate businesses in the country through Chinese front companies. They are a corporate sleight of hand by which an investor controls a company through contractual legal agreements rather than through share ownership.
In short, VIEs say to authorities in country A ownership resides in country A while at the same time telling investors in country B that ownership resides in country B. This Bystander doesn’t need to be a lawyer to see that doesn’t pass many smell tests for good corporate governance.
There have been a number of VIE-related scandals, including involving Alibaba, Sina.com, and New Oriental Education, as VIEs open too many creases along which any or all of regulatory, ownership and operational risk can spread.
Nevertheless, VIEs have become widely used. At first, they were a way for inward foreign investors to enter parts of the Chinese market otherwise closed to them. Increasingly they have been used by privately-owned Chinese companies that list overseas, especially those from industries in which having any foreign shareholders is forbidden or restricted, such as tech and telecoms.
They circumnavigate regulatory rigidities: the constraints on Chinese firms raising capital domestically and the need for private firms to get permission to invest overseas, and restrictions on foreign investors and firms having ownership of Chinese enterprises in certain sectors of the Chinese economy. But given those restrictions on foreign investment exist, VIEs aid and abet in breaking the spirit of the law, if not its letter.
The straightforward solution would be to remove the regulatory rigidities. However, Beijing is not going to abandon keeping sectors of the economy ‘off-limits’ to foreign investors. Its new draft foreign investment regulations use where ‘effective control’ of a company resides to determine ownership.
At a stroke of the legal drafting pen, VIEs becomes irrelevant. Any business that authorities determine to be effectively foreign controlled will be breaking the law if it operates in a restricted or prohibited industry.
All of which would leave the likes of Baidu, Sina and Alibaba and all the other internet businesses that operate as VIEs in China, in a pickle. So, too, foreign investors who bought into the initial public offerings with such gusto and who could end up holding the paper of a company that is illegal.
Now, we don’t doubt that between drafting and final promulgation of a new foreign investment law, accommodations will be made to resolve any such discomforts. While the regulators appear to have rejected lobbing from the companies to, in effect, grandfather them into legality, the draft regulations would let a VIE that is controlled by Chinese to be considered a Chinese company. That determination would be made by authorities on a case by case basis. It would be incumbent on the VIE to show it should be exempted from being put out of business like every other VIE.
Beijing has to walk a fine line if it is not to discourage the development of those industries in which Baidu, Sina and Alibaba operate. All of them could play critical roles in encouraging domestic consumption and thus help meet the government’s goal of rebalancing the economy away from infrastructure investment- and export-led growth. On the other hand, it can’t be too blatant in showing that there is one rule for the powerful and well connected and another for all the rest.
Such companies could also switch their governance to a two-share-class model, and keep the relationship between investors and owners as effectively separated as they are with a VIE. (We don’t approve of companies having A and B shares as a matter of good governance, but that is a topic for another day.)
However, the cost of that will be greater government regulation over them and possibly the promotion of state-owned enterprises to rival them, though perversely it may also give the big, established players some protection from new entrants who won’t be allowed to go the VIE route or anything that looks like it (though opening the capital account would mitigate the need to).
There are several parts of the political establishment, from the security and propaganda arms to the state-owned enterprises themselves, who would welcome reining in the big private Internet groups. Abolishing VIE’s might be intended primarily to kill a lot of flies, but, intentionally or not, there are some endangered tigers, too.