Is VIE Right For Your Company?
Variable Interest Entity, or VIE, has gain popularity among Chinese companies looking to raise capital in the US. VIEs allow Chinese companies to exploit a loophole in Chinese regulations of restricting foreign ownership in companies operating in areas the Chinese government deems as “Prohibited” or “Restricted.” See China’s Foreign Investment Law.
VIE is a corporate structure in which investors have a controlling interest despite not having voting rights. Under this structure, inventors do not have direct ownership stakes in the entity but rather have rights to a percentage of profits stipulated in special contracts. These investors do not participate in profits or losses, nor have control.
“Stock” Ownership in VIE
A VIE share certifies ownership interest in a contractual right to a percentage of a company’s profits. Unlike a traditional stock share, the VIE share provides a legal interest in a shell company that is entitled to the company’s profits. VIE shareholders only have a traditional stock certificate in the shell company that is entitled to a percentage of the company’s profits via private contracts between the shell company and the company’s other assets.
The best-known example of VIE structure is Alibaba. In many ways, Alibaba pioneered this corporate structure to exploit a loophole in Chinese regulations. Alibaba shares traded in the US are ownership stakes in Alibaba’s shell company in Cayman Islands. This shell company has contractual relationships with Alibaba’s assets in China to receive a percentage of profits.
US Regulations
The Securities and Exchange Commission (SEC) does not regulate VIE companies directly. Rather, the SEC regulates them through the Public Company Accounting Oversight Board (PCAOB), which was formed under the Sarbanes-Oxley Act of 2002 which gives the SEC the power to oversee the PCAOB.
The PCAOB is responsible for registering accounting firms that audit financial results of public companies. Only the registered accounting firms can prepare or issue audit reports on public companies. In addition, the PCAOB has the authority to inspect registered accounting firms - whether domestic to the US or foreign. For inspection of foreign registered accounting firms, the PCAOB has formal cooperative arrangements with foreign regulators. The PCAOB can discipline and sanction registered accounting firms for failure to comply to US audit standards and ethics. Without certification of financial results, public companies will face delisting from US-based exchanges.
In general, the PCAOB has been successful in obtaining regulatory cooperation in foreign jurisdictions to inspect foreign registered accounting firms in those jurisdictions. However, as of 2021, the PCAOB had never completed an inspection of any registered accounting firm based in China. See https://www.davispolk.com/insights/client-update/us-and-chinese-regulators-made-progress-pcaob-oversight-registered. As on August 2022, the PCAOB and its Chinese counterparty has a Statement of Protocol that allows the PCAOB to inspect and investigate registered accounting firms based in China and HK. See https://pcaobus.org/news-events/news-releases/news-release-detail/fact-sheet-china-agreement.
Key Takeaway
A Chinese company looking to raise capital in the US through public markets must first consider whether area the company operates in is deemed by the Chinese government as “Prohibited” or “Restricted under China’s Foreign Investment Law. If determined as such, then the company should consider structuring the company as a VIE.
Please note, structuring a company as a VIE comes with its own geopolitical, regulatory, and government risks. For example, VIE ownerships have not yet been challenged or tested in the US nor China. Further, regulations in either country can change based on geopolitical environments. Careful and prudent considerations are needed.
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