Variable Interest Entities: China’s Backdoor Access to U.S. Capital

The U.S. must do more to ensure that Chinese companies don’t dupe American investors out of billions with their Cayman Island shell company games and Congress’ sloth to make Chinese companies comply with U.S. audit laws.

Senator Marco Rubio (R-FL) agrees with that sentiment.

He released a statement on Wednesday about China investing. He called out the debacle that is Evergrande Group’s impending default — imploding real estate, not paying workers; a complete mess. The company, which has more than $300 billion in outstanding liabilities, is the world’s most indebted developer. As usual, major U.S. investment companies like BlackRock are invested in Evergrande’s international bonds. The pending bailout serves as an example of the risky nature of investing in China, something Rubio has been talking about for nearly two years now.

“Far too many Americans have retirement accounts, their pensions, and college funds invested in risky Chinese stocks without even knowing it,” Rubio said today. “Whether it is the collapse of Evergrande, Beijing’s DiDi intervention, or the temporary disappearance of Alibaba’s founder, no good can come from gambling Americans’ savings in risky foreign companies. The Biden Administration needs to recognize that while Wall Street may want to make friends in Beijing, the Chinese Communist Party will gladly enrich itself by wiping out Americans’ savings.”

This is a bigger problem than Evergrande.

Case in point is the Variable Interest Entity — welcome to the Enron-era Special Purpose Vehicle of investing in China. Here’s a primer.

VIE’s: A Pretty Good Trick

Unlike in the United States where we have an open, free capital market, the government of the People’s Republic of China (PRC) does not allow ownership investment in Chinese companies in certain sectors from people outside of China. These sectors include anything from defense contractors to construction companies and from technology firms to internet start-ups. This poses significant challenges to China and their Chinese Communist Party (CCP) monitored businesses as it limits what would otherwise be normal, natural access to capital. Their authoritarian thumb drives Chinese firms to find creative solutions to raising capital (predominantly dollars) to infuse its state-monitored and state-mandated corporations.

And so this is where the Variable Interest Entity (VIE) comes into play. While there is dissent in China regarding whether or not U.S. dollars or the Chinese renminbi are better for these sensitive industries, as of now, the dollar prevails as the currency of choice.

The problem is, China can’t easily get dollars. To raise the funds, Chinese parent companies set up VIEs outside of China and dupe Americans into funding them to the tune of billions.

VIE’s are extremely troubling. China establishes shell companies with names eerily similar to the real Chinese “parent” company in other countries (i.e., the Cayman Islands) to raise the money on U.S. exchanges to invest in the Chinese companies. This means that if average American investors think they are investing in some new, cutting-edge company in China, depending on the sector, they are most likely really investing in a shell company in the Caymans – not in the company directly. These shell companies in the Caymans and other offshore locations are not subject to the U.S. securities laws that would provide information and protection to American investors. Perhaps even worse, these companies are not subject to any protections in China either. The shell company VIE can easily disappear in a moment’s notice, leaving investors with no recourse to claim any loss or damages.

 

What Can We Do About This?

Recently, Securities and Exchange (SEC) Chairman Gary Gensler discussed this issue and outlined steps the SEC is taking to protect American investors. These steps include pausing listings for shell companies; asking SEC staff to provide information not known or readily available to American investors; and disclosing political and regulatory risk posed by the CCP and warnings on what the government of China could do to significantly change the rules in the middle of the game.

Additionally, over the last nearly two decades, basic protections required by law in the U.S. for auditing and inspecting the audits of public companies have been cleverly evaded by these Chinese companies. Beijing won’t allow third party financial audits of their companies listed here (other countries state-owned companies get audited) and has sought special memorandums of understanding with the U.S. government to be granted waivers for non-compliance with U.S. law.

Last year, the Holding Foreign Companies Accountable Act was signed into law, and the SEC is now working with the Public Company Accounting Oversight Board (PCAOB) to implement the law to require Chinese companies to comply at long last.

This is welcomed progress, but the Chinese offshore shell companies have three years to follow SEC auditing rules, or get delisted. That’s a long time.

Congress must enforce accountability and oversight of the SEC in implementing this law and passing others where necessary.

In the last three years alone, dollar funding from the U.S. accounted for about “70% of Chinese internet start-ups’ total fundraising haul,” the FT reported. While this trend may be in question as the CCP increases its national security, cyber, and data crackdowns, causing China IPO’s to be more volatile than ever, the VIE structure is still being exploited by Chinese firms. American investors and Wall Street must not be complicit in this Chinese shell game; a game that dupes millions of unwitting Americans into investing in Chinese companies that are fragile, risky investments, subject to draconian authoritarian controls, and often fueling industries that undermine American values, economic and national security interests.

Next Steps Needed to Shut VIEs Down

In June 2021, the Senate passed an update to the Holding Foreign Companies Accountable Act – it got the fancy name of the Accelerating Holding Foreign Companies Accountable Act (S. 2184). The bill is supported by the SEC.And some good news: it would speed up the timeline from a 3-year window down to a 2-year window.

Sadly, the House of Representatives has refused to take up this legislation. They have even cancelled a hearing on the topic.

The House must act to send the legislation to President Biden to sign to expedite closing this loophole; yet another one that gives China advantages others do not have. And puts investors at risk of buying dud Chinese assets that have little to do with the real company’s shares many investors believe they are holding.