Because of China’s strict capital controls, foreigners interested in investing in many Chinese companies must do so through a variable interest entity. In the simplest terms, a variable interest entity (or, VIE) is an offshore holding company that has a contractual right to the income of a Chinese company. The linked Wall Street Journal article provides a useful diagram explaining how VIEs work:
Until recently, the Chinese government mainly turned a blind eye to VIEs – a very blind eye, when considering the size of some of them, like Alibaba and Baidu. Investing in VIEs has thus always carried some – though of debatable seriousness – risk of some rash action by the Chinese government.
Recent draft proposals suggest the Chinese government plans to take a more active role in overseeing this channel of foreign investment. This new policy might carry some drawbacks for foreign investors, like requiring Chinese control over Chinese companies. However, the central government’s recognition should prove a net boon for those previously burdened worried about the legality of VIEs.
The new rules still might not address one of the largest risks carried by Chinese VIEs: the constant threat that the actual Chinese company will not honor its contractual obligations to the holding company / VIE. Take for example, Alibaba’s 2011 transfer of Alipay to Jack Ma without the VIEs immediate knowledge or consent.
China’s new stance potentially could mitigate these risks if firm contractual enforcement accompanies legal recognition. Indeed, ensuring VIE’s contractual rights could spur greater foreign investment, even under stringent requirements for Chinese majority control. However, at this point, BABA and BIDU shareholders still face the harsh reality that they really do not own Alibaba or Baidu.