* Investor losses, court ruling highlight risks of VIEs
* Structure used by half of Chinese listings on NYSE, Nasdaq
* Legal questions cloud prospects for Chinese IPOs in U.S.
By Dena Aubin
NEW YORK, June 23 As the U.S. market for Chinese
stock offerings revives, some experts are warning that American
investors could be left out in the cold if a company faces
problems, due to an unusual business structure employed by many
The structure, known as a variable interest entity, or VIE,
is designed to let companies bypass Chinese government bans on
foreign ownership in some business sectors.
A popular corporate form in Chinese IPOs, the VIE structure
was used in this month's successful, $91 million flotation of
Light-in-the-Box Holding Co Ltd, for instance. That IPO
has richly rewarded investors, with the shares up 57 percent
from their IPO price of $9.50, even after a steep decline
recently amid a broad market selloff.
VIEs include several components: a Chinese business with a
license to operate in a restricted sector; a foreign holding
company; and a web of contracts meant to give outside investors
control and access to profits, but not actual corporate
In practice, if things go wrong, foreign investors in a VIE
may have few legal rights, a risk underscored by a ruling in
October by China's highest court that has triggered fresh
concerns among legal experts.
"These are extremely high-risk structures. ... Your lay
investor has no idea that this is what they're invested in,"
said Jason Flemmons, a former U.S. Securities and Exchange
Commission enforcement official.
"Even though you have agreements ... that are supposedly
protecting investors, actually exercising those purported rights
in the Chinese legal system would be virtually impossible," said
Flemmons, now a senior managing director at FTI Consulting.
COURT RULING CAUSES CONCERN
China's Supreme People's Court ruled in October that certain
contracts meant to "conceal illegal intentions" were invalid.
The ruling involved the late Nina Wang, head of privately held
Hong Kong property firm Chinachem, and contracts she used to
invest in China Minsheng Bank.
The October ruling went largely unnoticed until recent weeks
when concerns emerged that the decision could impact VIEs.
"To the extent a VIE contract structure is designed to
circumvent the requirements of Chinese law, such contracts are
void," said Steven Dickinson, a lawyer at Seattle-based law firm
Harris & Moure and co-manager of the firm's China practice.
"Not voidable, void. It is as if they did not exist," he
Dozens of Chinese companies have come to the U.S. market as
VIEs. VIEs are also used for Chinese listings in Canada, Hong
Kong and Britain, and by some multinational companies for their
Chinese operations, according to Paul Gillis, an accounting
professor at Peking University in Beijing.
Investors have mostly brushed off VIE risks because China
for years allowed major Internet companies such as Baidu
and Sina Corp to operate with VIEs.
About half of China-based companies listed on the Nasdaq and
New York Stock Exchange use VIEs, according to Fredrik Oqvist,
an independent investment analyst based in China.
Their murky legal status reflects China's confusing mix of
state control and market economy, experts said.
By leaving the issue in a legal gray area, China can attract
foreign investment to bolster key sectors of the economy, while
keeping the right to clamp down when it desires, experts said.
Lawyers said they do not expect a rash of legal challenges
to VIEs. But on the rare occasions when VIEs are challenged,
U.S. investors nearly always lose.
"I've yet to see a situation where shareholders have gotten
their hands on Chinese assets in an adversarial situation," said
Drew Bernstein, co-managing partner at accounting firm Marcum
Bernstein & Pinchuk who works with China-based companies.
STRING OF TROUBLES
Ambow Education Holding, a Chinese education
company using a VIE, was forced into liquidation earlier this
month by investors who said its Chinese executive had blocked an
investigation into alleged financial wrongdoing.
The Chinese founder denied the allegations and remains in
control of the VIE. Liquidators "are in for a Herculean task in
trying to liquidate and gain access to the assets," Oqvist, the
independent analyst, said in a recent blog.
In 2010, investors lost control of the VIEs at online gaming
company GigaMedia when its Chinese executive refused to
give up the licenses and corporate seals.
In anther situation, Internet group Yahoo's shares
tumbled in early 2011 after it learned that Alibaba,
a Chinese e-commerce company in which it was a major
shareholder, had terminated its VIE contracts and transferred a
valuable asset to Alibaba's Chinese chief executive, Jack Ma. He
defended the move and later settled his dispute with Yahoo over
The U.S. Securities and Exchange Commission has stepped up
scrutiny of VIEs, raising questions in at least 140 letters to
China-based companies since 2010, according to data from Audit
VIE accounting is a concern, too. Under U.S. accounting
rules, companies typically consolidate subsidiaries' results on
the parent company's financial statements.
In a VIE structure, the Chinese business's results go on the
financial statements of the U.S.-listed holding company. The
argument is that VIE contracts are nearly the equivalent of
ownership of the Chinese business by the U.S.-listed company.
But if the SEC were to decide a company's VIE contracts were
a sham, it would likely demand that the Chinese business be
taken out of the U.S.-listed company's results, lawyers said.
"That is the nightmare scenario," said Thomas Shoesmith, a
partner at law firm Pillsbury who works on China transactions.
Without the Chinese firm's assets, the balance sheet of the
U.S.-listed company could essentially be zeroed out, he said.
Companies going public now are detailing the risks.
Light-in-the-Box, for example, disclosed in its IPO documents
that it could lose its license and be shut down if the
government decides it does not comply with Chinese law.