On April 2, China’s Luckin Coffee announced that some of its employees, including the chief operating officer, had fabricated over $300 million in reported revenues. On April 21, the Securities and Exchange Commission and the U.S. Public Company Accounting Oversight Board alerted investors that firms based in “emerging markets, including China,” often do not satisfy the auditing standards normally met by firms traded on U.S. exchanges. In May 2020, the Nasdaq Stock Market ordered Luckin to delist and proposed stricter listing requirements for firms based in markets that restrict U.S. regulators’ access to information. Concurrently, the U.S. Senate enacted, and the House of Representatives is now considering, legislation to bar firms from U.S. exchanges if they do not comply with certain audit oversight requirements.
These actions are consistent with the investor protection and information-providing objectives that motivate the disclosure requirements in U.S. securities laws and regulations. Those same policy rationales should also prompt reexamination of the disclosure being provided concerning, and associated governance risks posed by, the “variable interest entity” or “VIE” structures that are widely used by China-based firms (including Luckin) listed on U.S. exchanges. Alibaba Group Holding Inc., which conducted a $25 billion initial public offering (still the largest ever) on the New York Stock Exchange in 2014, trades under this structure. With certain variations, the VIE structure has been used by tens of other China-based firms listed on Nasdaq and the NYSE, including market leaders such as Baidu and JD.com.
Remarkably, U.S. and other investors have collectively placed, either directly or through trusted intermediaries, billions of dollars in these structures without acquiring even indirect equity ownership in the ultimate operational entities.
The VIE Structure
To illustrate the VIE structure in its simplest form, suppose an investor holds one share of common stock (technically, an “American depositary receipt”) issued by Alibaba on the NYSE. That share does not represent an ownership interest in Alibaba. Rather, it represents an ownership interest in a Cayman Islands entity, which in turn has an indirect contractual interest in the earnings of Alibaba, which is based in China. The reason for this convoluted structure is that Alibaba, as an entity operating in a “restricted” industry, is barred under Chinese law from issuing equity interests to foreign investors.
U.S. individuals and institutions are significant investors – or more precisely, indirect investors at several steps removed – in Alibaba, as reflected by the fact that fund managers such as Blackrock, T. Rowe Price, and Vanguard are among its largest institutional shareholders. It might be argued that investors in VIE-structured issuers can get comfortable with this obvious end-run around protectionist regulation. But there is significant and, given the current geopolitical climate, increasing room for reasonable doubt.
First, Chinese regulators have never approved this structure, although they have never rejected it either. Yet that position could change at any time, threatening investors in VIE structures with economic wipeout if those structures were explicitly deemed illegal under Chinese law.
Second, given that VIE investors have no more than an indirect contractual relationship with the China-based operational entity, they may have little effective legal recourse if, for example, Alibaba management acts adversely to them. This means that the core “agency cost” risk to which shareholders are exposed in any public corporation is left largely unmitigated by the voting rights, derivative litigation, and other familiar mechanisms that protect shareholders in entities organized under the laws of Delaware or any other U.S. state. Public shareholders’ protections in a VIE-structured entity are effectively reduced to the ability to sell. In a Luckin-type situation, however, “voting with your feet” is a remedy that comes too late.
VIE Risks Realized
The risks relating to VIE structures are not merely theoretical.
Again, Alibaba can illustrate. In 2010, Jack Ma, the company’s then-CEO and largest individual shareholder, transferred Alipay, its lucrative online payments unit, from Alibaba to an entity that he controlled, allegedly to address certain Chinese regulatory issues. This understandably prompted opposition from Alibaba’s largest shareholders, Yahoo! and Softbank. While these large institutional shareholders were able to reach a settlement (reportedly, however, for an amount representing a significant devaluation of the Alipay segment), individual shareholders would be largely powerless in this type of situation.
This pattern reemerges in the case of Luckin. After the accounting scandal emerged, there was a public outcry to replace the chairman and board of directors. In early July 2020, the company’s chairman was removed but nonetheless still reportedly influenced the outcome of a shareholder vote in Beijing to replace the board of directors. Being owners of no more than an indirect contractual interest through a Cayman Islands entity, which is governed in turn through a dual-class voting structure that favors the founders, public shareholders have limited voice in this process.
Do VIE Risks Really Matter?
It might nonetheless be argued that Chinese regulators would never choose to invalidate the VIE structure given the draconian effects any such action would have on China-based firms that raise, or seek to raise, capital in the rich U.S. public markets. Yet the same might have been said concerning the extension of Chinese “national security” laws to Hong Kong. It might have been argued that China would never elect to do so since this would risk inducing multinationals and investors to shift operations and capital elsewhere. Reality says otherwise.
Some observers might still view VIE risks as a non-issue. As suggested by empirical research indicating that the market discounts the shares of individual VIE-structured issuers to various extents (depending on size and other factors), institutional and other informed investors may simply be trading off governance risks for the value of participating economically in the Chinese market.
Yet it is unclear that individual investors in an “irrationally exuberant” stock such as Luckin typically appreciate the issuer’s multi-layered VIE structure, often bundled as noted above with a dual-class voting structure that doubly disadvantages public shareholders. Even investors who diligently sought information on a particular VIE’s organizational structure might encounter obstacles in doing so. While the prospectus of a VIE-structured issuer typically discloses this structure and associated regulatory risks, a 2017 report by the Council for Institutional Investors reported that the level of disclosure varied significantly across issuers. Moreover, the more generic disclosure supplied to individual investors who are exposed indirectly to VIEs through China-focused ETFs and mutual funds at least sometimes omits any specific discussion of these structures.
Avoiding a Race to the Bottom
There is a final point to consider. It might be (and commonly is) argued that strengthening listing requirements for VIE-structured issuers on U.S. exchanges might simply lead those firms to raise capital on exchanges in other jurisdictions. Again, Alibaba can illustrate: Its Ant Group just announced plans to conduct dual IPOs on the Hong Kong and Shanghai exchanges, implicitly foregoing a New York listing.
That might be a good thing. A short-term diversion of even a significant volume of listing fees may operate to the long-term advantage of the U.S. capital markets by effectively removing them from an international race to the bottom in disclosure and governance standards. This was the rationale behind the refusal in 2014 of Hong Kong’s securities regulator and stock exchange to list Alibaba due to its weighted voting structure that failed to conform to the exchange’s one-shareholder, one-vote requirement. While the Hong Kong exchange abandoned this policy in 2018, there is much to recommend it.
Investors are likely to discount capital markets in which a significant number of issuers do not provide meaningful shareholder protections, or do not fully disclose the absence of such protections, to account for the generalized risk of managerial opportunism and more serious forms of malfeasance. Consistent with a classic “lemons market” outcome, a looming “agency cost” cloud would discourage high-quality issuers on the supply side, which in turn would discourage investment capital on the demand side. It is probably no accident that public equity markets tend to be underdeveloped when disclosure practices are less than fully transparent, disproportionate voting structures are common, and effective protections for minority shareholders are weak. Without assurances that issuers meet a minimum level of disclosure requirements and governance protections, investors rationally place capital elsewhere.
This post comes to us from Jonathan Barnett, the Torrey H. Webb Professor of Law at the University of Southern California’s Gould School of Law.